Bankruptcy fire sales.

• Author: LoPucki, Lynn M.

For more than two decades, scholars working from an economic perspective have criticized the bankruptcy reorganization process and sought to replace it with market mechanisms. In 2002, Professors Douglas G. Baird and Robert K. Rasmussen asserted in The End of Bankruptcy that improvements in the market for large public companies had rendered reorganization obsolete. Going concern value could be captured through sale. This Article reports the results of an empirical study comparing the recoveries in bankruptcy sales of large public companies in the period 2000 through 2004 with the recoveries in bankruptcy reorganizations during the same period. Controlling for company values measured at case commencement and operating profits, the recoveries in reorganization cases are more than double the recoveries from going concern sales. The authors attribute the low recoveries in sale cases to continuing market illiquidity, managers' and professional advisors' conflicts of interest, and the corruption of the bankruptcy process by competition among bankruptcy courts for large public company cases. As a result, debtors agree to sell at low prices, the auctions are rushed, and in most cases only a single bidder participates. The authors also report other sale characteristics. Bankruptcy recoveries are higher when debt capacity in the debtor's industry is lower--the opposite of the effect predicted by Professors Andrei Shleifer & Robert W. Vishny in their landmark article in 1992. Cases in which debtors sell their companies as going concerns--often in the first few months--on average remain pending significantly longer than reorganization cases. Bankruptcy recoveries are high in years when merger and acquisition activity is high for reasons other than high stock prices. Lastly, the number and proportion of bankruptcy sales have sharply declined in the past two years, suggesting that the sale era may be ending.

TABLE OF CONTENTS INTRODUCTION I. THE SALE VERSUS REORGANIZATION DEBATE A. Reorganization B. The Going-Concern Sale Alternative C. The Market for Large Public Companies D. Prior Empirical Evidence II. METHODOLOGY A. Sample Selection B. Research Design III. FINDINGS A. The Regression Models 1. The Choice between Sale and Reorganization 2. Timing 3. Stock Market and Merger Market Conditions 4. Industry Distress B. Negative Findings 1. Asserted Nonviability Did Not Correlate with Low-Sale Recoveries 2. Larger Firms Did Not Have Higher Recovery Ratios IV. EXPLAINING THE MARKET'S FAILURE A. Why Do Companies Sell Rather Than Reorganize? 1. Managers 2. Financial Advisors B. Why Don't Creditors Object? C. Why Do Courts Approve Inadequate-Price Sales? D. If Sales Are Bargains, Why Don't Bids Go Higher? E. Have Sales Been Increasing? CONCLUSION APPENDICES INTRODUCTION

[T]he best way to determine [bankrupt company] value is exposure to a market.

--United States Supreme Court (1999) (1)

Q. So the 20 million dollars in [estimated collectible] receivables is included in the assets that the purchaser is purchasing for 15.8 million dollars ?

A. That's correct.

--Hearing on the sale of Network Plus Corporation as a going concern for 4% of book value (2)

Bankruptcy reorganization provides a remedy for capital market inadequacy. It protects from dismemberment firms whose value cannot be realized through sale or preserved by soliciting investment in capital markets. Law and economics scholars--strong believers in the marketplace--are skeptical of the need for reorganization. They either deny the market's inadequacy or seek to design substitute markets. For decades, they have debated how best to end reorganization.

In 2002, two leading scholars, Douglas Baird and Robert Rasmussen, suddenly declared the mission accomplished. In the opening sentence of an article titled The End of Bankruptcy, Baird and Rasmussen claimed that "[c]orporate reorganizations have all but disappeared." (3) They argued as follows:

In the nineteenth century, no single group of investors could amass the capital needed to buy large firms, and the market for small ones was undeveloped. Today, both small and large firms can be sold as going concerns, inside of bankruptcy and out. The ability to sell entire firms and divisions eliminates the need for a collective forum in which the different players must come to an agreement about what should happen to the assets. That decision can be left to the new owners. (4) Baird and Rasmussen concluded that "[t]he days when reorganization law promised substantial benefits are gone." (5) Later, Baird expanded on the claim, writing that "[t]oday, creditors of insolvent businesses ... no longer need a substitute for a market sale. Instead of providing a substitute for a market sale, chapter 11 now serves as the forum where such sales are conducted." (6)

In this Article, we present empirical evidence that reorganization remains essential for dealing with distressed large public companies. We compared the prices for which thirty large public companies were sold with the values of thirty similar companies that were reorganized in the period 2000 through 2004. We found that companies sold for an average of 35% of book value but reorganized for an average fresh-start value of 80% of book value and an average market capitalization value--based on post-reorganization stock trading--of 91% of book value. (7) Even controlling for the differences in the prefiling earnings of the two sets of companies, sale yielded less than half as much value as reorganization. These results suggest that creditors and shareholders can more than double their recoveries by reorganizing large public companies instead of selling them.

Part I of this Article examines the reorganization process and explains why the market is an inadequate substitute. It then briefly describes law-and-economics scholars' efforts to fashion market substitutes for bankruptcy reorganization and elaborates on Baird and Rasmussen's claim that the market has in fact replaced reorganization.

Part II describes the methodology employed in our study, and Part III presents our findings. Those findings include a regression model that shows the choice between reorganization and sale to be a principal determinant of the value realized in the bankruptcy of a large public company. The companies sold had significantly lower earnings than the companies reorganized, but even controlling for that difference, sales produced much less value than reorganizations.

Part IV attempts to explain the market failure we document. The obvious problem is insufficient market liquidity. That problem, we argue, is compounded by managers' personal incentives to sell their companies for inadequate prices. In addition, the investment banks that advise those managers have interests of their own that may conflict with price maximization. Unsecured creditors--the principal losers when distressed companies are sold--sometimes object to the sales. But bankruptcy institutions discourage the objectors and impair their pursuit.

Bankruptcy law charges bankruptcy judges with the responsibility to prevent inadequate-price sales. But the judges are powerless to do so, because a historical accident placed the bankruptcy courts in competition for large public company bankruptcies. That accident gave the parties who select venue for bankruptcy cases--the debtor's managers, debtor-in-possession ("DIP") lenders, and professional advisors--the right to choose their bankruptcy courts. These parties prefer courts that will not scrutinize the adequacy of the prices at which they have chosen to sell, and there is no shortage of bankruptcy courts willing to bend the law as necessary to accommodate them. Appellate remedies are rarely available to challenge sale prices. (8)

In nearly every instance, the sales we examined were "market-tested" by public auction. But those auctions failed to prevent inadequate-price sales. In most cases, only a single bidder appeared. We interpret the data as showing that the high costs of evaluating companies, combined with the low probability of success for competing bidders, discourages competitive bids.

Part IV also presents new empirical evidence regarding Baird and Rasmussen's claim that going-concern sales have in fact replaced reorganizations. Although the numbers and proportions of bankruptcy going-concern sales had been increasing at the time Baird and Rasmussen first made their claims in 2002, those numbers and proportions have decreased sharply in the past two years.

1. THE SALE VERSUS REORGANIZATION DEBATE

   Bankruptcy offers three alternatives for addressing the problems of a large public company in financial distress. The debtor may reorganize the business, sell it as a going concern, or close the business and sell the assets piecemeal. Scholars and policymakers are in agreement that piecemeal sales are the least desirable alternative because they provide the lowest values. (9) Until recently, scholars and policymakers were also in agreement that markets were inadequate to support going-concern sales of bankrupt large public companies, leaving reorganization as the only practical alternative. (10)

   In the mid-1980s, however, Douglas Baird and Thomas Jackson each challenged that view. Baird merely raised the issue of whether goingconcern sales were capable of replacing reorganization. (11) Jackson flatly asserted (2) that they were. (12)

   To be effective, a sale or reorganization must, directly or indirectly, solve three problems of the bankrupt business: lack of operating profits, excessive debt, and illiquidity. A business lacks operating profit when its revenues are insufficient to cover the noninterest expenses of continued operation. Neither sale nor reorganization can directly affect a company's lack of operating profits. But if a debtor could either reduce its debt burden or ease its illiquidity, that might free up resources to address operating profits.

   The next Sections explain how...