Chapter 11 at twilight.

• Author: Baird, Douglas G.
• Position: Chapter 11 bankruptcy

INTRODUCTION I. LARGE BUSINESS CHAPTER 11S IN 2002 II. ASSET SALES AND GOING-CONCERN VALUE A. Fungible Assets B. Relationships C. Asset Sales and Absolute Priority III. CONTROL RIGHTS IN CHAPTER 11 A. Residual Owners B. The Board of Directors CONCLUSION INTRODUCTION

The traditional account of corporate reorganizations assumes a financially distressed business faces three conditions simultaneously: (1) It has substantial value as a going concern; (2) its investors cannot sort out the financial distress through ordinary bargaining and instead require Chapter 11's collective forum; and (3) the business cannot be readily sold in the market as a going concern. Remove any one of these conditions, and the standard account of corporate reorganization law falters. In The End of Bankruptcy, we showed that any one of these conditions is rarely found in a financially distressed business today. It is even less likely that all three of them will exist at the same time. Hence, modern Chapter 11 practice cannot be squared with the traditional account. (1) Regardless of whether the number of businesses entering Chapter 11 rises or falls, (2) something different is going on.

In his thoughtful Response, Lynn LoPucki urges us to provide a more rigorous empirical grounding for these ideas. (3) Part I of this Reply provides such a foundation. It reviews all the large Chapter 11 cases that concluded in 2002. (4) As we claimed in The End of Bankruptcy, traditional reorganizations have largely disappeared. Put concretely, in 84% of all large Chapter 11s from 2002, the investors entered bankruptcy with a deal in hand or used it to sell the assets of the business. In the remaining cases, going-concern value was small or nonexistent. (5)

Central to the ideas presented in The End of Bankruptcy was the relationship between the different sources of going-concern value and financial distress. Part II returns to this theme. It grounds our conception of going-concern value. We use a case LoPucki brought to our attention to illustrate why financially distressed businesses often have so little value as going concerns and why whatever value exists is usually best preserved through a sale.

In Part III, we revisit the control that creditors exercise before bankruptcy, during it, and afterward. The powers they enjoy reduce the work that Chapter 11 can perform as well as the powers that others (such as the board of directors) are able to exercise. Again, the facts speak for themselves. Even in the cases most resembling the traditional reorganization, creditor control is the dominant theme. Indeed, if the experience of large businesses leaving Chapter 11 in 2002 is any guide, those at the helm do the bidding of the creditors throughout the case. Moreover, by the end of the case, the creditors usually acquire the right to appoint a new board of directors. They commonly appoint themselves or others (such as their employees) whom they can trust to protect their interests. Corporate reorganizations today are the legal vehicles by which creditors in control decide which course of action--sale, prearranged deal, or a conversion of debt to a controlling equity stake--will maximize their return.

1. LARGE BUSINESS CHAPTER 11S IN 2002

   In 2002, 93 large businesses completed their Chapter 11 proceedings. (6) Of these, 52 (or 56% of the sample) were sales of one sort or another. In 45 of these cases, there was a sale of assets such that the business did not even emerge intact as an independent entity under a plan of reorganization. (7) In addition to these clear cases of asset sales, seven other cases were in substance sales even though the business did emerge as a stand-alone enterprise under a plan of reorganization. (8) We review each of these seven cases briefly. They provide a nice illustration of modern Chapter 11 practice.

   Fruit of the Loom filed for Chapter 11 at the end of 1999. From the beginning, the senior creditors exercised control. They planned initially to take a controlling equity interest in the company, but when competing bidders appeared, they were content for the bankruptcy court to conduct a sale. Warren Buffett's Berkshire Hathaway proved to be the high bidder at $800 million in cash. (9) Similarly, George St. Laurent was the high bidder for Fine Air Services. (10)

   In Sterling Chemicals, the court oversaw the sale of one-half of the company, and the proceeds went to the secured creditors. A new investor acquired most of the equity of the remaining business, with the balance going to the unsecured creditors. The equity was wiped out, and, as provided in the plan of reorganization, the entire board of directors tendered their resignations. The new investor controlled the appointment of their successors. (11) Similarly, a distressed-debt fund acquired control of Classic Communications in Chapter 11 and became its owner as part of the reorganization plan. (12)

   Global Crossing, one of the largest bankruptcies ever, was from the start a sale of the business to a new investor) (13) After delays and a search for other bidders, the bankruptcy court confirmed a plan of reorganization that consisted primarily of a purchase agreement under which the prebankruptcy suitor would receive 60% of the equity in exchange for several hundred million dollars in cash. (14)

   Derby Cycle entered Chapter 11 as the second part of a plan, conceived by its investment bankers many months before, to sell its assets. The bankruptcy court approved the asset sale within five weeks of the petition. In the words of Derby's investment banker, "[B]ankruptcy can be a tool to get a transaction done.... This was a situation where it made a lot of sense for a lot of reasons to file for bankruptcy. But the primary reason was speed--we were just able to [do] the transaction a lot more quickly." (15)

   XO Communications filed for Chapter 11 with two alternative plans in hand. (16) The first was a deal by which Fortsmann Little would make a significant investment in exchange for control. The second was one that would wipe out equity and convert the bank debt to equity. Fortsmann Little decided not to go through with the deal, and Carl Icahn bought a majority of the company's debt. Ownership of XO Communications passed to him upon confirmation. The company exited Chapter 11 in early 2003, and Icahn remains its owner.

   We now turn to the cases (less than half the population) that were not asset sales. In most of these, the principal investors reached agreement with each other on a plan of reorganization before the Chapter 11 was filed, and that plan or one very much like it was confirmed in Chapter 11. All told, the Chapter 11 of 26 of the 42 businesses that were not sold in Chapter 11 merely implemented a deal that was already reached among the principal players at the time the petition was filed. (17) Three of the cases were ones in which the bankruptcy judge confirmed a prepackaged plan. (18) In 19 others, a prenegotiated plan was confirmed with only minor modifications. (19) In four additional cases, the court confirmed plans that adhered to the basic contours of the deal brokered before the petition was filed, albeit with some alterations. (20)

   The large Chapter 11s of 2002 confirm our claim in The End of Bankruptcy that going-concern sales and implementation of prenegotiated deals now dominate the scene. (21) More precisely, 52 of the 93 large reorganizations in 2002 were sales of one sort or another. Of the remaining 41 cases, 26 (or 62%) were situations where the bankruptcy merely put in place a deal agreed to before the proceedings began. Combined, sales and preexisting deals account for 84% of the large Chapter 11s from 2002. (22)

   We now turn to the handful that remain, the large Chapter 11 cases from 2002 that were neither sales nor preexisting deals. Only in these few cases might a traditional reorganization be found, yet they share in common one characteristic--a remarkable absence of going-concern value. We go through each of these cases in turn.

   Two of the businesses--Viatel and Teligent--were so transformed during the course of the Chapter 11 that the emerging entities could hardly be considered the same businesses at all. Far from preserving going-concern value, whatever value the old businesses had as going concerns disappeared during the course of the reorganization. Viatel entered Chapter 11 as an international long-distance telecommunications business headquartered in New York with 2000 employees. (23) It emerged thirteen months later as a business, based in England, that employed only 73 workers and specialized in the sale of fiber optic capacity to long-distance carriers and large corporations. It no longer has any assets in the United States. (24) Teligent entered Chapter 11 with 2000 employees as a business trying to use wireless technology to compete with local telephone companies. It emerged as a company with fewer than 100 employees that is trying to use its wireless licenses to provide transport services to other carriers and point-to-point broadband access services for multilocation businesses. (25) What is going on in Chapter 11 in these cases may be entirely salutary, but it has nothing to do with preserving the businesses that entered Chapter 11.

   Two other cases show a similar absence of going-concern value. In one (Glenoit), most of the business's plants located in the United States were shut down immediately after leaving Chapter 11. After leaving bankruptcy, production was moved to China, and the remaining sites in the United States are now used primarily as warehouses and distribution centers. (26) If the business had value as a going concern, it would not have shut down its domestic operations and recreated them abroad. Another case had little in the way of an ongoing business at all. FLAG's principal assets were three separate undersea fiber optic cables. (27) Each could have been sold separately or transferred to the creditor that held...