Random Thoughts on Reform

I just finished discussing the “random walk” theory in my Corporate Finance class, so I thought I would close out my stint on Credit Slips with some “random thoughts” on reform.

First, two expressions of sincere gratitude: I want to thank Bob Lawless and everyone at Credit Slips for the opportunity to blog about reform these past two weeks. It has been great fun. I also would like to thank the many practitioners, judges, financial advisors, academics, and industry groups who participated in the ABI Commission reform study process. Everyone made a meaningful contribution to the project. 

The Art of Valuation

Anyone who has ever litigated a valuation issue knows that valuation is more art than science. Experts often arrive at widely divergent valuations. Yet, these valuations are of the same company, for the same time period, based on the same data, and often invoke the same model. How then can the valuations be so different and, more importantly, which expert is right? Valuations of course can vary for a number of reasons, including different assumptions and inputs, and sometimes because of the methodology itself. But as one of my very astute students in Corporate Finance recently pointed out, valuations also likely differ because of the legal position (he actually used the term "self-interest") of the party employing the expert and offering the particular valuation into evidence.

Deflate Gate and Bankruptcy Reform

People (and institutions) like rules that give them a competitive edge. You need only to look at the recent headlines and the media coverage of “Deflate Gate” to understand this basic concept. Reportedly, Tom Brady, Peyton Manning, and other quarterbacks lobbied the NFL to allow each team to supply its own set of footballs for use by that team’s quarterback during games. Note—I am not suggesting ill motive on the part of either Brady or Manning (or the others).  Although I never played quarterback, I can understand a quarterback’s desire to select personally his own game-day equipment. 

How does any of this relate to chapter 11 reform? To answer that question, ask yourself a different one: Do you like how chapter 11 currently resolves your client’s key issues in most instances? If you answered “yes,” you likely see no reason for reform. If you answered “no,” you likely would favor reform, but perhaps only those aspects of reform beneficial to your client. Therein lies the ever-present dilemma for policymakers:  implementing the best policy for the overall federal bankruptcy system in the midst of so much noise.

The Melting Ice Cube Fallacy

Can a company really melt? Putting aside a business with a perishable product or inventory, does management really wake up one morning and say, “Wow, if we do not sell this company in 30 days or less, we will lose significant value for our stakeholders.” I highly doubt it. Rather, I think a company “melts” because management leaves the freezer door open too long, or perhaps a particular stakeholder has its foot in the door. (For a thoughtful article on the melting ice cube issue, see here.) 

If the Code simply did not permit expedited sales, what would happen? Could it be that the possibility of an expedited sale with all of the bells and whistles of a confirmed plan enables management and senior creditors either to delay the chapter 11 filing or to manufacture urgency? From my perspective, this question is the central difficulty with section 363 going concern sales. A company should be able to reorganize through a value-maximizing sale in chapter 11. But those sales should not include quick fire sales that offer little opportunity for a robust auction or the need to use chapter 11 tools to enhance value in that auction. Chapter 7 is already well suited for such fire sales.

Rethinking “Small” Business Bankruptcies

It may surprise some, but approximately 90% of all chapter 11 debtors have less than $10 million in assets or liabilities, less than $10 million in annual revenues, and 50 or fewer employees (see data on small and medium-sized enterprises (SMEs) in the ABI Commission Report, here). These companies are the heart of chapter 11. Nevertheless, most of the media and caselaw coverage discusses only the megacases—e.g., Caesars, American Airlines, Tribune Company, etc.—representing approximately 2-3% of chapter 11 debtors. It is time to change the focus of the conversation.

When a small business closes its doors, an entire community feels the impact. Consider the following description of the ripple effects of the closing of a small mine in Lincoln County, Montana:

In addition to the workers and families directly impacted by the loss of jobs, the ripple effects of the loss of that income will impact local businesses at every level. Restaurants, stores and other shops depend upon local consumers to keep themselves afloat, the dollars that are paid to those employees find their way into the hands of a number of additional places, keeping a small local economy alive.  (Full story here.)

Similar stories occur most everyday in towns across America (see, e.g., here).

Businesses Need Certainty; Distressed Businesses Need It Even More

The general counsel of a financially distressed company calls you.  She of course clearly states that her company does not need to file a chapter 11 case, but she is curious to understand how a chapter 11 case might work for her company.  Specifically, she wants to know: Can the company continue to use intellectual property it licenses and has integrated into its business operations?  Will some or all of the company’s existing shareholders be able to retain their ownership if they contribute to the company’s reorganization?  If the company decides to pursue a sale, can the company sell its assets free and clear of all claims?  Will she and the company’s other executives be released from any alleged liability if the company confirms a plan of reorganization?  What if the company reorganizes through a going concern sale instead?

All very astute questions, to which you will likely have to answer, “it depends.”  It depends primarily on where the company files its chapter 11 case.  These and other key issues in chapter 11 are subject to splits in the case law that create uncertainty and increase costs.  The splits require companies (and their creditors) to perform extensive jurisdictional analyses of issues likely to be important in any chapter 11 case.  Not surprisingly, one jurisdiction may be favorable on one issue, with another jurisdiction more favorable (or silent) on a different, equally critical issue. 

Let’s Not Just Create Jobs, Let’s Save Them, Too

In his State of the Union speech on Tuesday, President Obama talked a lot about job creation. I am all for growing the economy and creating more U.S. jobs, but I also am for saving jobs and keeping people employed at U.S. companies, even if those companies fall upon hard financial times. Strikingly, approximately 18,500 people lost their jobs when Hostess closed its doors; 34,000 people lost their jobs when Circuit City suffered the same fate; and over 9,900 people were let go as a result of four casinos in Atlantic City closing in the past twelve months.

It is undeniable that chapter 11 changes people’s lives. It can save an employee’s job, continue a customer relationship for a vendor, and preserve a tenant for a landlord. It also can, however, devastate all of these relationships in what feels like a nanosecond—relationships that many people rely on to support their families or their own business operations. As I suggested in an earlier post, I believe that the human face of chapter 11 often gets lost in all of the noise concerning the rate of return to creditors, disputes among institutional creditors, and whether a company should be sold quickly, or at all, through the chapter 11 process.

Have Retail Reorgs Gone the Way of the Dodo?

In the past two months, four retailers have filed bankruptcy cases. RadioShack is rumored to be preparing a chapter 11 filing, and other retailers certainly appear to be struggling (see Stephen Lubben’s post here). But if you were counseling any of these retailers, would you recommend a chapter 11 filing? Okay, put aside the professional fees you might earn—would filing really be in the best interests of your retail client? (For a discussion of fees and costs in chapter 11, see Part IV.A.8 of the ABI Commission Report.)

Consider this: from 2006-2013, the number of retailers liquidating in chapter 11 increased significantly. Although no data are perfect, the various data we have on chapter 11 filings are quite telling. For example, according to the UCLA-LoPucki Bankruptcy Research database, during 2006-2013, 41.2% of large public retailers (excluding eating and drinking places) emerged from chapter 11 and 58.8% liquidated while, during 1980-2005, 60.5% of large public retailers emerged from chapter 11 and only 39.5% liquidated. Likewise, a quick look at the New Generations Public and Major Private Companies database suggests a similar trend for 2006-2013: approximately 62% of retail cases in the database ended in a liquidation (36 of 58). A chapter 11 filing has, quite literally, become a “bet the company” decision for retailers.

What’s Fairness Got To Do with It? When the “It” Is Chapter 11, a Lot….

For those of you who are not familiar with my scholarship, I am fairly conservative in my approach, and I strive to remain objective in my analysis and balanced in my proposals. I believe that most companies try to get it right, I respect markets, and I do not think that financial institutions and private funds are evil. In fact, some of my scholarship suggests that private funds may actually add value to matters (see example here). I mention these things only to help you understand the lens through which I analyze corporate governance and restructuring issues, including the chapter 11 reform topics that will be the focus of my posts over the next several days.

Based on my research and my ten-plus years in private practice, chapter 11 is not just a value maximization and distribution scheme. It is much more. I was in Judge Bodoh’s courtroom during the LTV Steel cases when hundreds of steelworks packed the courthouse during hearings. I was in Judge Wedoff’s courtroom during the United Airlines cases when pilots and flight attendants would often be on hand. And I worked on several asbestos cases (see, e.g., here and here), which affected not only the livelihoods of thousands of people, but also the health and well-being of several thousand more. In each of these cases, and many others I worked on, the people—not the continuation of some fictitious legal entity or a particular creditor group’s return on its investment—were at the heart of the process.  (For another example of this principle, see here.)