The success of chapter 11: a challenge to the critics.

• Author: Warren, Elizabeth

Although Chapter 11 has served as a model for bankruptcy reform around the world, the conventional wisdom has been that it is characterized by a relatively low success rate and endless delay. The data from large samples of Chapter 11 cases filed in 1994 and 2002 demonstrate that this characterization is wrong. Nearly all troubled companies choose Chapter 11 over Chapter 7 liquidation, which means that the system serves a critical screening function to eliminate hopeless cases relatively quickly. Almost half the unsuccessful cases were jettisoned within six months and almost eighty percent were gone within a year. The cases that survive the early screening result in confirmed plans of reorganization around seventy percent of the time. The mistaken conventional view has not only skewed the academic debate, but also prompted changes to the statute in 2005 regarding small business reorganizations, changes that may have produced little benefit in reducing delay at the price of blocking many small business reorganizations of a sort that were succeeding prior to the amendments.

TABLE OF CONTENTS INTRODUCTION I. THE DATA A. The Business Bankruptcy Project B. One Measure of Success: A Confirmed Plan of Reorganization II. SUCCESS RATES A. Conventional Wisdom: Most Cases Fail B. Better Data: Measuring Success Rates 1. The Naive Metric 2. Realistic Confirmation Rates I: Companies with a Plan 3. Realistic Confirmation Rates II: Companies that Survive the Cull 4. Realistic Confirmation Rates III: Companies that Survive a Double Screening III. TIME TO CONFIRMATION A. Conventional Wisdom: Endless Delay B. Better Data: More Speed 1. How Long in Chapter 11? 2. Pushing out the Losers 3. Giving Winners Time to Win IV. WHO SUCCEEDS: SIZE, SPEED, AND SUCCESS A. A Critical Combination B. The Special Case of Congress and the Small Business. CONCLUSION APPENDIX INTRODUCTION

American law claims many innovations, from the Bill of Rights to the Superfund. In the pantheon of extraordinary laws that have shaped the American economy and society and then echoed throughout the world, Chapter 11 of the U.S. Bankruptcy Code deserves a prominent place. Based on the idea that a failing business can be reshaped into a successful operation, Chapter 11 was perhaps a predictable creation from a people whose majority religion embraces the idea of life from death and whose central myth is the pioneer making a fresh start on the boundless prairie. So powerful is the idea of reorganization that Chapter 11 has heavily influenced commercial law reform throughout the world. (1)

Yet even as the world has turned to Chapter 11 asa model to create value for a business's creditors, workers, investors, and communities, American-style reorganization has been widely disparaged. For many years, attacks on Chapter 11 have echoed through the academic community both in the United States and abroad. The critics often insist that economic efficiency requires the near abandonment of Chapter 11, (2) and some have lately declared its imminent demise. (3) These critics concede that reorganization is a worthy goal, but they claim that the current Chapter 11 system suffers from high failure rates and endless delays that prevent the system from yielding much value. (4)

This constant derision has had a potent impact. Congress recently amended Chapter 11, promoting its changes as fixes to a defective system riddled with delays. (5) Other countries that had been attracted by the promise of Chapter 11 significantly modified their new systems by inserting features to correct for the high failure rates and delays claimed to exist in the U.S. system. (6) For its part, the academic community has invested countless hours (and pages) arguing for corrections or replacements to deal with what it sees as a broken system of business reorganization. (7)

The claim of failure has been easy to make. A few cogent anecdotes coupled with an old government report have been sufficient to shift discussion immediately to proposals for change.

But before we bury--or perform further surgery on--Chapter 11, we suggest a more systematic factual inquiry. Before another country revamps its conception of reorganization to deal with the twin flaws of high failure rates and long delays, we recommend documenting both the rate of failure and the length of delay in the U.S. system as it existed before the 2005 Amendments. Here we offer data gathered from two large studies of business bankruptcies first filed in 1994 and 2002. These data show that much of the conventional wisdom about key elements of Chapter 11 is simply wrong. Contrary to so many assertions, Chapter 11 has been far more successful than supposed. (8)

Because the Chapter 11 hospital is explicitly designed to deal with both ailing patients and corpses, the business failure rate can be understood better if the two kinds of cases are separated. Isolating those cases with a reasonable chance of success, as measured by the debtor's ability to advance a plan--any plan--of reorganization, we discovered that the success rate soars to more than seventy percent. We also found that the courts processed the losers relatively quickly: more than half of the losers were booted out in less than six months. After the first cull, the remaining cases had a decent chance of having a plan of reorganization confirmed. If, for example, a case could survive for six months, the odds of eventual success exceeded fifty-fifty.

The 2005 Amendments to the Bankruptcy Code, which imposed stricter time limits on both large and small cases, illustrate the high cost imposed by the Chapter 11 failure myth. (9) Under the amendments, small companies have only six months to confirm a plan unless they can make a rigorous showing of likely success. But the data we analyzed for this Article show that eighty- two percent of the successful small business cases took longer than six months to confirm their plans. (10) On that basis, most of these otherwise- successful businesses might have faced a serious risk of failing under the new provisions. Thus the cost of the six-month statutory time limit is potentially quite high, while our data show that the benefit of reducing supposed delays is much smaller because the failures were already being processed promptly.

No single study will quell concerns about Chapter 11, nor should it. As our economy changes, as lending practices evolve, and as financial markets innovate, newly configured businesses will rise and fall. Chapter 11 will be called on to adapt and to solve new problems. As it does so, new weaknesses and new strengths will be uncovered. We do not hope to stop debate, but urge that debate go forward informed by data from many sources.

1. THE DATA

   1. The Business Bankruptcy Project

      We have been working for a number of years on the Business Bankruptcy Project ("BBP"). The project now consists of two very large empirical studies of the businesses that file for bankruptcy. (11) With this Article, we offer the first comprehensive look exclusively at Chapter 11, using numbers from both rounds of data collection. (12)

      Unlike most recent empirical articles, this one examines a cross-section of all Chapter 11 business bankruptcies. The typical article about corporate reorganization is like a study of the sociology and economics of Park Avenue: the fabulous digs of the $100 million reorganization cases and the big firms that handle them. (13) By contrast, the total assets in our cases vary from a very modest $13 to more than $16 billion. Our set of cases thus more accurately reflects the Chapter 11 system as it operated throughout the U.S. economy. Park Avenue is here, but represented in context. We report data covering the full sweep of business reorganization in this large and richly varied country of ours, from Seattle to Orlando.

      The first wave of data comes from an extensive longitudinal study of business bankruptcies originally filed in 1994. To develop detailed information about the progress of the cases, we went back to the courthouses and conducted telephone surveys with the debtors several times over a period of almost six years. The advantage of such a study is that it can report much more useful information about the progress of business cases. The disadvantage is that some of the study's findings might be considered out of date by the time they are finally compiled. In 2003, we returned to the courthouses to execute a study of business bankruptcy cases filed in 2002 to update our central findings. Because we focused on fewer data points in fewer districts in the second study, we were able to complete the data gathering much more quickly. (14)

      The 1994 study collected nearly 200 data points from more than 3,000 business bankruptcy cases, spread across twenty-three districts across the United States. (15) The cases were selected systematically from those filed in each district in each quarter of the year 1994. They included business cases filed by both natural persons and legal entities under Chapters 7, 11, and 13. The methodology is detailed in our first article reporting on that sample. (16) For the current paper, we include the 985 Chapter 11 business cases from the 1994 study. (17)

      The 2002 study was undertaken with more limited resources. We could no longer maintain representation of all eleven circuits as we had in 1994, but geographic and legal diversity remained important, so we selected cases from districts in nine different circuits. (18) Again we took systematic samples of cases from each district, but in the second data collection we examined only business cases filed in Chapter 7 or Chapter 11. (19) For the current paper, we focus on the 437 Chapter 11 business cases from the 2002 study. With one exception, we do not compare the 1994 and 2002 samples statistically or try to assess trends in this paper. (20)

      The combined 1994 and 2002 data gave us 1,422 Chapter 11 business cases to work with. In order to track...