Creditors' ball: the "new" new corporate governance in Chapter 11.

• Author: Skeel, Jr., David A.
• Position: Symposium: Corporate Control Transactions

For well over a year, the papers have been filled with hand wringing about the sorry state of American corporate governance. We read that Wall Street's watchers--especially the securities analysts and auditors--were so riven with conflicts of interest during the stock market boom that the only things they were watching were their own bank accounts. As I write, the former chairman of the Securities and Exchange Commission ("SEC") is barnstorming the country, telling everyone that he tried to warn us back in the 1990s. The SEC needed more money, he says, among many other complaints, and more freedom from political interference to do its job. (1)

For the companies that epitomized the governance crisis, bankruptcy is now where the action is. Nearly all of them--Enron, WorldCom, Adelphia, Global Crossing--currently are doing their business in Chapter 11. An observer who followed the bankruptcy literature (and the occasional New York Times or Wall Street Journal article) in the 1990s, and who had lost touch since then, might well have expected the filings to prompt a second round of hand wringing, this time about America's miserable bankruptcy framework. A decade ago, many observers believed that Chapter 11 was irretrievably flawed. (2) Yet here we are, only a few years later, and surprisingly few people seem to be complaining about corporate bankruptcy. One hears occasional worries, to be sure. There was a brief flurry of articles suggesting that Chapter 11 may have been too "biased toward saving failing firms;" (3) WorldCom competitors such as Verizon and AT&T have complained that bankruptcy has given WorldCom unfair advantages; (4) and there have been running accounts of the size of the professionals' fees in the Enron case. (5) But these days bankruptcy is more often described as a solution than as a problem.

Perhaps this simply shows that it's all relative: American corporate governance looks so bad at the moment that even a deeply flawed bankruptcy framework comes out smelling like a rose by comparison. Another possible explanation is that Chapter 11 was always a better system than its most fervent critics contended.

Both of these explanations are at least partially true. I plan, however, to focus on a third explanation: the fact that Chapter 11 decision making itself has changed quite dramatically in the past decade. The endless negotiations and mind-numbingly bureaucratic process that seemed to characterize bankruptcy in the 1980s have been replaced by transactions that look more like the market for corporate control. Whereas the debtor and its managers seemed to dominate bankruptcy only a few years ago, Chapter 11 now has a distinctively creditor-oriented cast. Chapter 11 no longer functions like an antitakeover device for managers; it has become, instead, the most important new frontier in the market for corporate control, complete with asset sales and faster cases.

Unlike the "new" bankruptcy governance ushered in by Congress in 1978, (6) the "new" new (7) Chapter 11 governance is contractual in nature. Creditors have converted two existing contractual tools into important governance levers. (8) The first is debtor-in-possession (DIP) financing. Before they even file for bankruptcy, corporate debtors must arrange an infusion of cash to finance their operations in Chapter 11. To an increasing extent, lenders are using these loan contracts to influence corporate governance in bankruptcy. The fate of an asset or division of the company, even the terms of a transfer of control, has been spelled out as terms in a debtor's DIP financing agreement. The second is that key executives are increasingly given performance-based compensation packages in Chapter 11. The most common strategy is to promise the executives a large bonus if they complete the reorganization quickly; likewise, executives face ever-smaller bonuses if the case takes longer.

My aim in this Article is to make sense of these developments, both by putting them into historical context and by identifying the concerns they raise. In Part I, I describe the complaints about Chapter 11 in the 1980s and the increasing use of DIP financing agreements and performance-based pay to reshape Chapter 11 governance. I also explain how creditors can influence the composition and focus of the debtor's board of directors during the bankruptcy case. In Part II, I briefly summarize the virtues of the new Chapter 11 governance. In Parts III and IV, I consider some of the concerns raised by each of the governance levers. With respect to DIP financing (the subject of Part III), I point out that the DIP lender's priority slatus can produce a variety of troubling effects. An existing lender may use the new financing arrangement to improve its pre-bankruptcy position. Some lenders may also have too great a bias toward liquidation, which could hurt creditors as a whole and in coming years could undermine an aspect of Chapter 11 that I refer to as its "antitrust benefit." Although the debtor's managers agree to the terms of the financing, they cannot be expected to focus on the best interests of the firm when it has encountered financial distress. With executive compensation (Part IV), I argue that pre-bankruptcy bonuses raise serious fairness and efficiency concerns, but that the concerns are much weaker in the post-petition environment.

The prescriptive tone of this analysis should not obscure the fact that the two governance levers have dramatically improved the quality of Chapter 11 governance. Part V makes this explicit by re-emphasizing the virtues of the new regime.

1. CH-CH-CHANGES

The late 1980s and early 1990s were both the best and the worst of times for large-scale corporate reorganization in America. The enactment of the 1978 Bankruptcy Code (9) had taken off the fetters that stymied corporate bankruptcy for forty years. Chapter X of the Chandler Act (10)--the chapter designed for large corporations under the old Bankruptcy Act--replaced the managers of a debtor that filed for bankruptcy with a court-appointed trustee. Chapter 11 of the new 1978 Code, by contrast, authorized the managers to continue operating the business and gave them the exclusive right to propose a reorganization plan. (11) The number of large Chapter 11 cases soared, but there were also a growing number of complaints about the very provisions that had restored bankruptcy's luster. Chapter 11 seemed to give too much control to the debtor s managers, enabling them to stiff-arm creditors and drag out the bankruptcy cases for inordinate periods of time. Managers were playing with creditors' money, and large cases often lasted several years or more. (12)

The worst offender was Eastern Airlines (Eastern). Although it was clear to just about everyone that Eastern should be sold, Eastern's CEO Frank Lorenzo postponed the inevitable for several years as Eastern's value deteriorated. In the end, Eastern's assets were liquidated at a fraction of what they had been worth at the outset of the bankruptcy case. (13)

With Eastern as their poster child, critics began to call for major changes to Chapter 11. In the bankruptcy literature, a vibrant debate developed as to whether Chapter 11 should be replaced by a faster, more market-oriented alternative. (14)

And then a funny thing happened. The most obvious problems with Chapter 11--the endless cases and absence of market discipline--started to disappear. Within a few years, there were more auctions in bankruptcy, and claims trading sometimes simulated a market for corporate control. (15) In the past several years, the changes have been even more dramatic. In most large cases, the same creditors who seemed so helpless only a few years ago are now calling most of the shots. (16) Chapter 11 is still remarkably debtor friendly by international standards, but creditors now exert much more influence over a case than at any time in recent history. The result is faster cases that rely more on asset sales and the market for corporate control than on negotiations to move the restructuring process along.

How did everything change so fast? In part, the transformation reflects a change in the profile of American business. Unlike the businesses that traditionally landed in bankruptcy--railroads, in the nineteenth century, or industrial firms thereafter--many contemporary businesses depend on knowledge and ideas rather than on hard assets. Because these companies' most important assets can walk out the door at any moment, they cannot afford to negotiate for months or years toward an eventual restructuring. They must resolve their difficulties immediately; often, the only way to do this is to sell key assets at or shortly after the time of bankruptcy. In addition, markets for assets, and even for entire companies, are much more liquid than ever before. (17)

More importantly, several remarkable contractual developments have been intertwined with this shift in the nature of American business. First, lenders increasingly have used their post-petition financing agreements to shape the governance of the Chapter 11 case. The second contractual strategy makes a direct appeal to managers' wallets. By crafting "pay to stay" agreements that depend heavily on bonuses based on the speed of the reorganization or the price obtained in asset sales, creditors have given managers dramatically different incentives than they had in the 1980s.

These contractual changes have shifted the ethos of bankruptcy in ways that go beyond the contracts themselves. Although bankruptcy law does not formally authorize creditors to displace the company's directors, creditors have increasingly exercised de facto control. Directors are now more likely to respond, for instance, to creditors' not-so-subtle threat that "'sooner or later we'll own the company and we're not going to re-elect you so you should get out now.'" (18)

The following subsections briefly describe and explain each of these...