Bankruptcy noir.

• Author: White, James J.
• Position: Response to Lynn M. LoPucki and Joseph W. Doherty, Michigan Law Review, vol. 106, p. 1, Oct 2007

TABLE OF CONTENTS INTRODUCTION I. VALUE TO CREDITORS II. SELECTION BIAS III. EXPLANATIONS A. Managers B. Bankruptcy Judges and the Process of Bankruptcy Sales CONCLUSION APPENDICES INTRODUCTION

In Bankruptcy Fire Sales, Professor LoPucki and Dr. Doherty do two things. First, they present provocative data about the relative payoff to be had in Chapter 11 by a full reorganization compared with the payoff from a section 363 sale without a full reorganization. Second, they give a yet more provocative explanation for their data. Taking a page from Professor LoPucki's recent book, they blame the meager return that they observe on 363 sales on the unprincipled behavior of the lawyers, managers, creditors, investment bankers, and even judges involved in the sales.

Messrs. LoPucki and Doherty's data appear to show that firms that leave Chapter 11 through the side door--that is, via section 363 sales--bring far less for their creditors than they would bring if they had left via the front door as reorganized companies:

[C]ompanies 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-reorganizations stock trading--of 91% of book value. 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. (1) So if you leave bankruptcy through the side door, you reap 35% of book value, but if you leave through the front door, you get as much as 91%. (2)

These are astounding numbers. If they are accurate, why would anyone, a creditor, a judge, or even the debtor or the debtor's lawyer, choose a 363 sale over reorganization? Professor LoPucki finds that most of the actors on the bankruptcy stage have malign motives--to bring more cases to their courts (the judges), to earn payments from third parties who buy their companies (the managers), or to ingratiate themselves with future clients (the investment bankers). It goes without saying that Messrs. LoPucki and Doherty doubt the auction market's ability to produce fair value.

Messrs. LoPucki and Doherty's article grandly avoids the traditional empiricists' nightmare, the null hypothesis. Academic papers that have failed because the data collected neither prove nor disprove the hypothesis are common. The problem for Messrs. LoPucki and Doherty is the opposite; their data are so powerful that many will find them impossible to believe. If a typical company that is worth $91 million in reorganization is truly worth only $35 million in a 363 sale, either the auction market must be grossly inefficient or--contrary to all belief--the reorganization process is so efficient that it enhances the value of the companies reorganized.

In this paper I raise two other possibilities. First, I believe that Messrs. LoPucki and Doherty's enterprise numbers overstate the value that goes to the reorganized companies' creditors. Second, I believe there is a selection error in the samples of Messrs. LoPucki and Doherty. Although the cases where reorganization occurred look much like the cases where there was a 363 sale, I believe that they are systematically different and that that difference explains a part of the apparent difference in payoff to creditors.

Note, too, that while a casual reader of the quote above might conclude that the entire difference between 80% (or 91%) payoff and 35% payoff is attributable solely to the choice of a 363 sale or a full reorganization, that is not the real claim of Messrs. LoPucki and Doherty. Table 1 and the discussion that follows on page 24 of their article show that the authors claim only that about 30% of the variance in the recovery ratios can be explained by the choice of sale versus reorganization. (3) Careful examination of Table 1 will reveal what most suspect, namely that at least some significant part of the difference is explained by the earnings and eaming potential of the companies. Messrs. LoPucki and Doherty put the influence of earnings before interest, taxes, depreciation and amortization ("EBITDA") at around 13%.

1. VALUE TO CREDITORS

   In 363 sales, there is an explicit payment for the company leaving Chapter 11. With some adjustments, that payment is the value that goes to the creditors. But there is no paymaster standing at the door of the reorganization exit to hand out checks to the company's creditors. So one must somehow value the assets that are passed to the creditors in a confirmed plan of reorganization. That value is usually "the company," but what is "the company" and how should it be valued?

   Messrs. LoPucki and Doherty measure the value of the reorganized companies in two ways. In the first, they use the asset side of the newly reorganized company, and in the other they use the equity and liability side. They use "fresh start accounting value" to find the value of the assets and equate value of all of those assets to the value of the company. In the second, they estimate the value of the reorganized company by adding equity market capitalization to all of the liabilities of the reorganized company.

   Fresh start accounting, commonly used with reorganized companies, calls for the company to write its assets up or down to present value. If cash flow analysis or other methods of evaluation show that the company is worth more than the total value of the tangible and intangible assets whose value can be estimated by market comparisons (or by other means), the company adds "goodwill" to bring the value of all of the assets up to the apparent value of the company. Because total value of the newly reorganized company will be derived from calculations of discounted cash flows and other equally problematic data, fresh start accounting necessarily rests upon a series of assumptions and estimations (4) that are sometimes wrong. And there is reason to believe that the parties in the reorganization sometimes push the values up or down to suit their interests. (5) Using only the asset side of the balance sheet, Messrs. LoPucki and Doherty treat the companies as worth the full amount of the current and other assets shown on the fresh start balance sheet.

   Appreciating that they might be criticized for relying on a subjective fresh start value, Messrs. LoPucki and Doherty used actual post-confirmation stock trades to find an actual market value for the reorganized companies. (6) Their "market cap value" is the total of the value of stock outstanding plus all liabilities. (7) They treat the following formula as the measure of the company's value: value = (shares of stock outstanding x value per share) + (long-term debt) + (all other liabilities). (8)

   Since all the reorganized companies came out of bankruptcy as public companies, (9) we have actual market values to show the value that was in fact provided to the creditors. For that reason there is no need to review the less accurate fresh start estimations and so we disregard them. (10) Focusing on Messrs. LoPucki and Doherty's market cap valuations, I believe that their addition of all "other" liabilities exaggerates the value of the firms. Adding equity and debt is a way to estimate an asset's ability to produce a financial return to its owners. To find the present value of an asset's financial return over its life is, for corporate evaluators, the gold ring. Modern financial theory posits that it is irrelevant whether the rights of the "owners" are characterized as common stock, preferred stock, debt, or in some other way. The financial return is typically the discounted value of the free cash flow that the asset would generate for the owners. (11)

   We can estimate that number for a firm by totaling the market value of the current owners' interest (Total Enterprise Value or "TEV"). If a company has no debt and only one class of stock, the TEV of the company would be the total market value of the stock (number of shares x market value per share). Since modern financial practice recognizes long-term debt (sometimes described as interest-bearing debt) as an ownership interest, one would need to add the principal amount of debt outstanding if the firm issued both stock and debt. But, contrary to the calculation of Messrs. LoPucki and Doherty, neither the literature nor the practice treats non-interest-bearing debt as an ownership interest. In my opinion, their "market cap" numbers are substantially exaggerated by the improper inclusion of non-interest-bearing debt. (12)

   In their study on the valuation of bankrupt firms, Professor Gilson and his co-authors describe the standard capital cash flow method of valuation as follows:

   We use a capital cash flow (CCF) model to value cash flows, as developed in Ruback (1998). Capital cash flows measure the cash available to all holders of capital and include the benefit of interest and other tax shields. The CCF method values the firm by discounting capital cash flows at the discount rate for an all equity firm with the same risk. The firm's estimated going concern value equals the discounted value of projected capital cash flows plus a terminal value representing the present value of cash flows after the projection period. Cash flow adjustments include adding back depreciation, amortization, deferred taxes, and after-tax proceeds from asset sales, and subtracting working capital investment and capital expenditures. (13) In the appendix to their article, Gilson, Hotchkiss, and Ruback compute the postbankruptcy enterprise value for six firms that are leaving Chapter 11. They described the process as follows:

   At the end of each case we report the company's actual enterprise value immediately following Chapter 11, when its reorganization plan becomes effective (Postbankruptcy enterprise value). This latter value equals the face value (market value if available) of interest-bearing debt, and the market value of common stock (plus any preferred stock or...