Why Has Chapter 11 Failed as a Reorganizing Chapter?

The ABI has spent thousands of hours on its Chapter 11 Commission Report; the National Bankruptcy Conference is hard at work on its "Rethinking Chapter 11" project. Underlying these and other such efforts is an overwhelming frustration with the failure of Chapter 11, under current circumstances to empower true reorganization. Hard to believe but it was not always this way. During the first decade or two of the Bankruptcy Code it seemed to be working pretty well; in fact many courts were unwilling to consider quick sales of the entire business. Many large cases resulted in a confirmed reorganization plan although some led to further chapter 11 efforts or failure; the results in smaller or medium-sized cases were more uneven with a healthy percentage being dismissed or converted to Chapter 7.  There was almost no discussion of Section 363 at the Ten Year Retrospective on Chapter 11 in Williamsburg and there was little commentary on its use. Indeed, the 1997 report of the Bankruptcy Review Commission did not focus on this issue. 

Beginning sometime between the Code's tenth and twenty-fifth birthdays the tide shifted; not only did most courts back off from their legal position that Chapter 11 was for reorganization and that any sale of the entire business needed to be done within a Plan, but the vast majority of cases seemed to shift to quick 363 sales to a suitor that was identified before the filing with an auction possible if there were competing bidders. 

Current efforts at reform look carefully at the Section 363 process, the DIP lending process, the expense problems in small and medium size cases and various other important topics. Yet, they do not spend much time investigating the reasons that the 1978 goal of promoting true reorganization failed sometime in its first twenty-five years.

Seems to me that such an inquiry is an important factor in figuring out what to change and in deciding that it is or is not time to abandon that goal for either large or medium or small businesses in financial trouble or for all of them. 

Some of the changed circumstances are obvious. The emergence and domination of "loan-to-own" hedge funds and private equity funds and the reduced roles of traditional financial institutions and the growth in claims trading. The 2002 modification of Article 9 of the UCC that left the DIP with virtually no unencumbered assets. During the first years of the agricultural crisis of the 1980's and before the enactment of Chapter 12, judges worked hard to confirm farm chapter 11 cases.  After a few years of seeing the post-confirmation results, most of those same judges became more cautious. Is this same phenomenon one of the reasons that there seem to be so few efforts at reorganization in non-farm cases? My friend Dan Keating wonders if it is the market speaking; that is, the market must have concluded that the 363 process is more efficient for maximizing  value. That could be because they generate more value, or it could be that 363 sales do not generate more value, but are much less expensive than traditional chapter 11 plans.

It seems as if the creditors have powered these moves from Chapter 11 to Chapter 363 and that either:

1.The creditors have always had the power to impose quick 363 sales but did not  decide to do so until 1995 or so; and/or

2. They would have always preferred 363 sales but did not previously have the necessary power; and/or

3. The shift away from traditional financial institutional lenders to "loan to own" has changed the mix.

One of the key questions that needs to be answered in the various reform efforts is "what is the goal in 2015 and beyond?" Have we given up on the US Bankruptcy Code ideal of reorganization?  If it is all about a quick sale, then is the current structure the best one?

Comments

[Bob]

It's the fees, which became far more permissive with the 1994 Bankruptcy Reform Act. The cost of the process skyrocketed.

[Robert White]

Non-plan sales would not be so disproportionately leverage in the debtor’s/buyer’s favor if courts imposed all the conditions of a plan on the sale without the burden of proposing and confirming a plan.
But it has taken till now for such a idea to gain traction, but that too will slip off the road to reform.
Non-plan sale are popular because they accomplish what a plan doesn’t and what a sale outside bankruptcy can’t: immunity from fraudulent conveyance and successor liability law, non-application of the absolute priority rule, forcing liens and claims off title, absolute finality, etc.

Who would do a plan with all these benefits against a plan.

But maybe business failure has become more fatal than it was in 1978. Who would chose to reorganize in this prolonged cycle of stagnation.

[Andrew Thau]

I am glad you point out "The 2002 modification of Article 9 of the UCC that left the DIP with virtually no unencumbered assets." People overlook this issue a lot. In particular, it became much easier to obtain a security interest on cash. In the 2001-2002 cycles, debtors had free cash (and often some other unencumbered assets) so that secured creditors/DIP lenders didn't have as much leverage over the process as they do now. Many debtors now couldn't survive a week without DIP financing or at least the ability to use cash collateral.

[David Lander]

Your comment on the 2002 modification of Article 9 of the UCC brought to mind a memory long buried. The Article 9 drafting committee was extraordinarily successful in their effort to close off the ways that a borrower could previously retain unencumbered assets. At one point they reached out to a group of bankruptcy lawyers and profs on an ad hoc basis; on the first telephone call a majority of the group voted to recommend a proposal to require that a certain percentage of a borrower's assets be free and clear in the event of a bankruptcy proceeding. Before that proposal was presented to the drafting committee another call was scheduled and this time a few more friends of secured creditors were added to the group and there was no longer a majority in favor of the proposal.

[mt]

This is a misreading of the report and wholly based on a false premise. The report does not assert that chapter 11 has failed as a reorganization chapter. And given that most of the commission members work on large chapter 11 matters, it is implausible they would have so concluded. They contend, mainly, that in certain respects, chapter 11 has fallen out of some edenic balance that allegedly existed in the 1980s.

Chapter 11 has not "failed as a reorganization chapter". The author of this post offers zero data on that claim, nor did the abi commission. Nor does he establish an objective standard of what would be either a "reorganization" or a successful one. Most of these claims argue that balance sheet fixes or sales are somehow not "true" reorganizations, which is just a claim of form, nomenclature or taste, and not a substantive problem that any one of a pragmatic viewpoint to worry about. In substance, a chapter 11 filing that results in either a balance sheet deleveraging or one or more sales of operating businesses as going concerns fulfills the goal of chapter 11, which is to preserve the going concern for the economic benefit to the constituencies, primarily labor, that benefit from its continuation, and distribute the resulting value in a manner that conforms to out-of-court priorities. Did jobs stay intact during the sale or balance sheet fix? Did the trade get paid on time for post=petition goods and services? Did local government get its taxes paid? Did the company continue to comply with local health and safety laws? If yes to these, then the sale or balance sheet fix was a good thing for the community, and there is no reason, as objections of form, nomenclature and taste are not worth anyone's attention, to call it a "failure".

Proponents of this view also sponsor the absurdly overblown claim that bankruptcy law provides this magic "toolbox" for "fixing" businesses that is somehow unavailable to managers outside of bankruptcy. And that is never substantiated under close scrutiny. Certainly the Commission report offers little more than self-serving generalities for that proposition. "oh, if only we'd had more time - think of the wonders we could have worked!" That's nonsense. Solvent companies "fix" their operations and their portfolios of businesses all the time. The only thing bankruptcy law provides of an operational benefit is the power to reject certain contracts and not pay full damages. That's a really small toolbox and sponsors of this view are hard-pressed to point to more than a handful of cases where it was actually essential to enable a debtor to successfully re-organize its operations. Many times an overleveraged business just does not have a lot of bad operational arrangements. It has often just been overvalued at a time of easy credit.

Most of the business reorganizations of the last decade are due to macro or sectoral changes -- autos, airlines, retail deterioration due to the internet, casinos due to oversaturation, coal and gas price drops, etc. And most of them are better seen as overvaluations and overleveraging. There is little the power to reject contracts could have done to fix problems that were larger than the debtor itself.

And insofar as small businesses are concerned, the argument might seem stronger, but they too are at the mercy of structural forces well beyond the ability of rejecting contracts to address. In truth, small businesses don't have a lot of long-term contracts and leases to reject in the first place.

[David Lander]

I respect the points you make though i disagree with your conclusions. I believe that over time the secured creditors have either obtained greater control or have decided to use the control they always had in a different way,i.e. forcing a sale of the entire business on an expedited basis. That did not seem to me to be the intention of Chapter 11 at the time of its enactment nor its operation for its first couple of decades. I find that arc of history to be interesting and noteworthy and was the primary point of my post. Understainding these developments and the reasons they occurred seem to me to be important factors in fashioning "reform."

[Knute Rife]

Chapter 11 has certainly failed for anything that can honestly be characterized as a small business. The problem is the way small businesses have to obtain financing. Purchase loans are collateralized by the purchased item along with other things that have to be thrown in. Lines of credit are collateralized by anything the lender can demand, including A/R. Every loan after the first is cross-collateralized. And they are all backed by personal guarantees from the principals. How can you reorganize in the face of all that?