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. TWA filed only to consummate the sale of its planes and landing gates to American Airlines. (1) Enron's principal assets, including its trading operation and its most valuable pipelines, were sold within a few months of its bankruptcy petition. (2) Within weeks of filing for Chapter 11, Budget sold most of its assets to the parent company of Avis. (3) Similarly, Polaroid entered Chapter 11 and sold most of its assets to the private equity group at BankOne. (4) 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. (5) Rarely is Chapter 11 a forum where the various stakeholders in a publicly held firm negotiate among each other over the firm's destiny.
Large firms, of course, form only a tiny portion of the Chapter 11 docket. (6) For the vast majority of firms in financial trouble, the traditional corporate reorganization has become increasingly irrelevant. Of the half million firms that will fail this year, only 10,000 will file for Chapter 11, half of what we saw a decade ago. (7) The typical case is the electrical subcontractor who uses the bankruptcy forum to cut a deal with the IRS while keeping other creditors at bay. (8) Marginally competent owner-managers, bureaucratically inept tax collectors, small-time landlords and suppliers, and unsophisticated workers and tort victims populate this world. (9) The business is run out of a small office with little in the way of hard assets and few long-term employees. To the extent we understand the law of corporate reorganizations as providing a collective forum in which creditors and their common debtor fashion a future for a firm that would otherwise be torn apart by financial distress, we may safely conclude that its era has come to an end.
This Article takes on the job of accounting for this new state of affairs. Our approach departs from much of recent bankruptcy scholarship in two important respects. (10) Most recent debates about corporate reorganizations have focused upon capital structures and priority rights. (11) People have argued about the extent to which nonbankruptcy priority rights are or should be vindicated in bankruptcy and what is the best mechanism for doing so. (12) The tools of modern finance have been front and center. We show that this approach neglects foundational questions about the nature of the firm itself. One should not ask about the shape the firm's capital structure should take without understanding first why the assets in question should be located within a particular firm. In other words, rather than beginning with Modigliani and Miller's irrelevance propositions and Black-Scholes option pricing, scholars of corporate reorganization should start with Ronald Coase and The Nature of the Firm.
This Article differs from much recent bankruptcy scholarship in a second respect. Rather than use the nineteenth-century railroad as the paradigmatic example of a firm that needs to be reorganized, (13) we use a large number of alternative examples, drawn from both history and recent events, from the Lancaster cotton mill to the automobile assembly plant to the modern dot-com. By using historical examples of prototypical industrial firms, we show that the basic forces that undermine the usefulness of the railroad paradigm have been in place for a long time. The modern examples show how these forces have accelerated over the last twenty years.
Part I establishes the basic framework. It connects the concept of going-concern value to the nature of the firm and transaction costs. There is no special magic beyond transaction costs in accounting for any particular collection of assets assembled within a single firm. From this familiar point, it follows that transaction costs themselves put a ceiling on the value of keeping different assets together in the same firm. By importing this well-known insight into the world of corporate reorganizations, we focus squarely on the central idea in corporate reorganizations, that of preserving the "going-concern surplus," preserving the value a firm has above and beyond the liquidation value of its discrete assets.
Part II explains why firms in financial distress are unlikely to have a substantial going-concern surplus. Such a surplus comes from assets that are dedicated to a particular purpose. Current law is predicated on the belief that financially distressed firms hold such assets. The oft-quoted phrase is that, absent bankruptcy law, a firm's assets would be "sold for scrap" (14) and value would be lost. Railroads provide an especially vivid illustration. The left-hand rails are worth little apart from the right-hand rails. We show that this example is misleading. Even at the height of the industrial revolution, railroads were a special case. Most firms did not depend upon assets that were custom-made for its operations and not of use elsewhere. The railroad paradigm makes even less sense today. In a service-based economy, intangible assets, such as a firm's proprietary business methods, are the assets most likely to be dedicated to a particular firm. Such assets, however, are precisely those that are likely to have little value when a firm is in financial distress. Many modern markets have a winner-take-all character. A hundred years ago, a railroad that connected two small cities might be less successful and less profitable than a railroad that connected two larger cities. By contrast, today a bookstore or an office supply store with a business plan that is only slightly worse than a competitor's might not be able to survive at all.
Part III shows that even when an economic enterprise depends on dedicated assets, rarely do the assets themselves need to remain in a particular firm. An economic enterprise may require collaboration among a particular group of highly skilled workers, but they do not need to work for the same firm, nor does their ability to work together depend on the continuation of any given firm. To make these points, we again draw on a number of different examples. We focus in particular on examples from the early history of the automobile industry. Even here, where it is commonly assumed that highly specialized assets require vertical integration of production within a single firm, (15) keeping assets together in a single firm was not in fact so important. (16)
Part IV suggests that the law of corporate reorganizations as traditionally conceived no longer matters much even in the rare case in which a valuable economic enterprise requires that dedicated assets be locked up in a single firm. Two things have changed in recent times. Investors in nineteenth-century railroads relied on primitive investment contracts that scarcely differed from real estate mortgages. Today's investors allocate control rights among themselves through elaborate and sophisticated contracts that already anticipate financial distress. In the presence of these contracts, a law of corporate reorganizations is largely unnecessary. (17) As long as the parties whose interests are at stake have already decided among themselves what will happen in bad states of the world, nothing is to be gained by second-guessing them. A second development makes corporate reorganizations less important. 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. (18)
We conclude with a few brief observations about small firms and corporate reorganizations. Small firms constitute the vast bulk of Chapter 11 filings in sheer numbers, but the total amount of assets at risk for most firms that enter Chapter 11 are modest relative to the large firms in Chapter 11. (19) In the typical small Chapter 11 filing, the bankruptcy judge is asked to decide whether the plumber, travel agent, or jeweler should be given another chance to run her small business. We suggest that the debate focus squarely upon whether its benefits (which inure largely to owner-managers who derive psychic income from running their own business) justify its costs (which fall upon tax collectors, unpaid workers, and others who are poorly positioned to bear risk).
Each of the independent strands of analysis we develop in this Article reinforces the others. In the aggregate they explain what bankruptcy judges and practitioners have increasingly come to recognize: The face of bankruptcy practice has changed dramatically over the last decade. To show how fundamental the change has been, however, we must first locate the law of corporate reorganizations within a coherent theory of the firm. This is the task to which we turn in Part I.
CORPORATE REORGANIZATIONS AND THE NATURE OF THE FIRM
In the fall of 1931, a twenty-year-old undergraduate left England to spend the year in the United States on a traveling fellowship. (20) The trip was in lieu of a final year at the London School of Economics. His research project was both simple and topical. Lenin had boasted that he would turn the Soviet Union into one giant factory. (21) This undergraduate wanted to write an essay explaining why such an ambition was doomed to fail. There were, of course, large firms. Henry Ford built the giant River Rouge Works. Iron ore began at one end, and cars...