The nature of the bankrupt firm: a response to Baird and Rasmussen's: the end of bankruptcy.

• Author: LoPucki, Lynn M.
• Position: Response to Douglas G. Baird and Robert K. Rasmussen, Stanford Law Review, vol. 55, p. 751, 2002

INTRODUCTION I. THE ARGUMENT WHAT FIRMS LACK GOING-CONCERN VALUE A. Baird and Rasmussen's Asset by Asset Analysis 1. Physical assets 2. Intangible assets 3. Teams B. Baird and Rasmussen's Conception of the Firm C. Coase's Conception of the Firm II. THE ARGUMENT THAT CONTRACT CONTROL HAS REPLACED REORGANIZATION III. THE ARGUMENT THAT SALE CAN SUBSTITUTE FOR REORGANIZATION CONCLUSION INTRODUCTION

In The End of Bankruptcy, Professors Douglas G. Baird and Robert K. Rasmussen give this description of the current state of affairs in the bankruptcy courts:

Corporate reorganizations have all but disappeared. Giant corporations make headlines when they file for Chapter 11, but they are no longer using it to rescue a firm from imminent failure. Many use Chapter 11 merely to sell their assets and divide up the proceeds.... Even when a large firm uses Chapter 11 as something other than a convenient auction block its principal lenders are usually already in control and Chapter 11 merely puts in place a preexisting deal. Rarely is Chapter 11 a forum where the various stakeholders in a publicly held firm negotiate among each other over the firm's destiny. (1) These assertions are factual, not theoretical. They constitute the foundation for the theoretical analyses Baird and Rasmussen present in their article. Yet Baird and Rasmussen offered no empirical basis for them. (2)

Data I collected over the past two decades show the actual pattern to be different in several respects. Corporate reorganizations are booming. (3) The number of large, public firms reorganizing in 2002 was greater than in any prior year in history. (4) Despite a sudden, recent increase in the numbers of liquidations, (5) most big firm bankruptcies still end in the reorganization of the firm. (6) On average, the emerging firm is about seventy-five percent its prefiling size. (7)

Baird and Rasmussen protest that I have taken the opening sentence of their article too literally. Their claim is not that "corporate reorganizations" have all but disappeared but only that "traditional reorganizations" have done so. (8) The definition I have employed in tracking reorganizations over the past two decades holds that a "reorganization" occurs when a firm files under Chapter 11, obtains confirmation of a plan of reorganization, and emerges as a stand-alone firm that intends to remain in business indefinitely. (9) Baird and Rasmussen do not define "traditional reorganization" explicitly but suggest they would exclude as untraditional at least the following: (1) any case in which the bankruptcy judge presided over an auction that changed ownership of the firm, (10) (2) any case in which the debtor struck a deal with a principal lender before filing, (11) (3) any case in which the company, by Baird and Rasmussen's analysis, seemed to have little going-concern value, (12) and (4) any case in which the dynamic is "utterly different" from what occurred in Chapter 11 cases in earlier years. (13) With so many bases for exclusion, it should not be surprising that the number of cases remaining--in any era--would be small.

Neither they nor I claim to have systematic data showing a change in the number or proportion of "traditional reorganizations" over time. Anecdotal evidence makes clear, however, that "traditional reorganizations" continue to occur. Seven of the thirteen largest firms ever to file under Chapter 11 did so in 2002. (14) The seven are Adelphia Communications, Conseco, Global Crossing, Kmart Corp., NTL, Inc., United Airlines, and Worldcom. All seven firms are using Chapter 11 to reorganize rather than liquidate. Each is a reorganization that will "rescue [the] firm from imminent failure." (15) In only one of the seven cases did the firm have a deal with its major lender when it entered Chapter 11, (16) and in none does the firm intend to sell either itself or its core business. (17) The courts have confirmed plans for four of these firms: NTL, Kmart, Conseco, and Worldcom. None has been sold (though a controlling interest in Global Crossing has) and each continues to operate its business. Each of the seven cases is or has been a "negotiat[ion] ... over the firm's destiny." (18)

In their Reply, Baird and Rasmussen argue from empirical data that few firms, if any, completed "traditional reorganizations" in 2002. The short deadlines in an exchange such as this, however, effectively precluded them from completing the much more extensive data collection that would have been necessary to show that things were different at some earlier time.

Instead, they accept my admittedly imperfect classifications as a starting point and use data from my Bankruptcy Research Database to approximate the decline they assert. Their analysis shows that the proportion of cases I classified as (1) reorganizations and (2) not prenegotiated or prepackaged has fallen from 88% in the 1980s to 24% in 2002. The magnitude of that drop in proportion is dramatic. However, the number of large, public firms completing Chapter 11 cases in 2002 was more that 10 times the annual average number in the 1980s. The 24% of firms completing a nonprenegotiated reorganization in 2002--23 firms--is nearly three times the 88% of firms completing such a reorganization each year in the 1980s--8 firms. (19) The 16% of firms completing nonsale, nonprenegotiated reorganizations by Baird and Rasmussen's count--15 firms--is nearly double the annual average number in the 1980s. Reorganizations have not disappeared since the 1980s, they have doubled or tripled.

Nor, perhaps, is the decline in the proportion of reorganizations since the 1980s what it seems. Two changes in the law--rather than economic factors of the kind Baird and Rasmussen propose--may almost entirely account for that change in proportion. First, several of the reorganizations that occurred in 1980s were tax-NOL driven. Debtors sold all or nearly all of their businesses, then emerged as going concerns, owning little except their NOLs. Because this trafficking in NOLs has since been abolished, these same cases today would be liquidations. (20) Second, in the late 1990s, the courts began to allow debtors to sell their businesses in Section 363 sales, without proposing and obtaining confirmation of a plan of reorganization. This attracted a new kind of liquidation case to Chapter 11, one that previously would not have been in bankruptcy at all. (21) Eliminate the NOL-driven and Section 363 sale cases from the data, and the proportion of reorganizations remains roughly constant from the 1980s to the present. (22)

The second element in the dramatic decline Baird and Rasmussen identify is a decline in the proportion of prenegotiated reorganizations--generally referred to as "free fall" reorganizations. Baird and Rasmussen correctly calculate the decline from the 1980s (when nearly all reorganizations were free fall) to 2002. But that decline did not occur gradually over two decades as their theories would predict. It occurred suddenly, from 1991 to 1993. For the past decade, the proportion of free fall Chapter 11s has increased--from about 59% (23) to about 78%. (24) Thus, the empirical evidence regarding the decline in free-fall reorganizations does not support Baird and Rasmussen's theories. Over the past decade, an increasing proportion of firms have sought reorganization without prenegotiation.

Baird and Rasmussen also assert that "[t]o the extent that any firms contain the necessary ingredients for an old-fashioned 'successful' Chapter 11, they are likely to be small enterprises." (25) In fact, the data show that larger firms reorganize in greater proportions than smaller firms. (26) Old-fashioned successful Chapter 11 is most clearly dominant among the very largest firms.

I agree with Baird and Rasmussen that dramatic changes have recently occurred in the use of Chapter 11. The most striking was the increase in the number of Chapter 11 cases filed by large, public companies from 1997--when only 15 companies filed--to 2001--when 95 companies filed. Most of this increase occurred while the economy was expanding. The putative causes on which Baird and Rasmussen base their theories---changes in firms' going-concern values and improvements in markets and contracting--would operate far too slowly to explain this abrupt increase in filings. Alternative explanations to those offered by Baird and Rasmussen abound. The most promising is that the bankruptcy boom that peaked in 2001 reflects a roughly simultaneous boom of similar magnitude in merger and acquisition activity in the economy as a whole. The merger and acquisition boom peaked in 2000, the bankruptcy boom in 2001. (27) Ill-advised acquisitions (the opposite of the new sophistication in markets for which Baird and Rasmussen argue) may have jerry-built awkward firms that quickly fell apart in bankruptcy. Enron is a prominent example. Another alternative explanation for the boom is that merger and acquisition deals that previously occurred outside bankruptcy were brought into bankruptcy because of the bankruptcy courts' new willingness to permit sales of companies without requiring compliance with the plan process. (28) A third explanation also consistent with the data is that firms now delay their bankruptcies to later stages of financial decline. They negotiate over the firm's destiny in the shadow of bankruptcy and file only when liquidation is imminent. Each of these possible explanations fit the data at least as well as the explanations Baird and Rasmussen proffer.

Most firms that do liquidate in Chapter 11 did not file for that purpose. Only 20% of the 174 large (29) public firms that filed for bankruptcy in 2001 and 2002 indicated at filing that their intent was to sell or liquidate their businesses. (30) Only an additional 4% filed prepackaged cases intended "merely [to put] in place a preexisting deal." (31) Nearly all of the remaining firms filed for the purpose of reorganization and...