Market Failure II: Corporate Bankruptcy

In her Sunday New York Times column, “‘For Sale’ May Mean ‘You Lose’,” Gretchen Morgenson notes in passing that bankruptcies don’t get as much attention as sexier mergers or IPOs (and it’s confirmed by the dearth of comment on the usual suspect sites in the blogsphere). But there is a lot of money made in this seeming backwater, and not all of it on the up-and-up.

Morgenson’s article focuses on a paper, “Bankruptcy Fire Sales,” by Lynn M. LoPucki, a bankruptcy expert who is a professor at the law school of the University of California, Los Angeles, and Joseph W. Doherty, director of the law school’s Empirical Research Group. Contrary to conventional wisdom in deal-land, that an auction process always produces the best price, the authors found, based on an examination of 54 large bankruptcies between 2000 and 2004, that the companies that were sold yielded creditors roughly half of what was yielded through the reorganization process.

Put it another way: reorganizing a company results in a recovery twice as high as selling it. So why would anybody sell? Maybe adverse selection is at play. Perhaps the stronger companies are reorganized and the real dogs are put on the block.

Not so, say LoPucki and Doherty. The culprit is conflicts of interest and flawed mechanisms. The incumbent management drives the process, and often can cut sweetheart deals for itself in a sale. By contrast, the creditors have relatively little say, and investment bankers find they earn a higher return on their time by selling a company quickly rather than trying to extract a higher price. And judges have been corrupted because bankruptcy cases pay big fees, and venues compete for cases.

So here we have another example where a market does not deliver good results, meaning the best possible price, and it is because the participants can and do game the process to their advantage. This set of facts holds more often than most observers care to admit.

To Morgenson:

The study found that bankrupt companies whose managers chose to sell them — an increasingly popular route in recent years, according to Mr. LoPucki — received roughly half what was generated at companies that decided to reorganize. This suggests that creditors and shareholders can nearly double their recoveries by pushing their companies to reorganize rather than to sell, the authors said.

Management also appears to be using the veil of bankruptcy to cash in, according to the study. In 11 of 30 bankruptcy sales examined, the chief executives involved received specific benefits associated with the decision to sell. These benefits included severance payments generated by the sales or job offers from buyers after C.E.O.’s sell their companies. In other cases, chief executives became paid consultants to companies buying the assets.

Unfortunately, creditors and shareholders are often helpless bystanders in the bankruptcy process….

According to the study, companies that sold out during the bankruptcy process received an average of 35 percent of their book value, or net worth. Conversely, companies that reorganized did so at a value of 80 percent of book value. That’s some spread. And it was found across industries as diverse as retailing, energy, airlines, entertainment and technology.

“Companies that file bankruptcy have internal incentive types of problems that make them willing to sell their property for less than it’s worth,” Mr. LoPucki said in an interview last week. “The judges are supposed to control it. But they are making rulings that are favorable to the people that bring them cases, so they will continue to bring them cases.”

Big bankruptcy cases, of course, generate enormous fees and revenues for the court system. And judges are increasingly willing to let companies and their lawyers call the shots in these proceedings, Mr. LoPucki said.

This phenomenon was explored extensively in Mr. LoPucki’s 2005 book, “Courting Failure: How Competition for Big Cases Is Corrupting the Bankruptcy Courts.” He said competition has been pursued most aggressively in the bankruptcy courts in Delaware and New York City.

In filing for bankruptcies, companies can choose the court where their case will be heard. New Century Financial, a subprime lender that filed for bankruptcy protection earlier this month, is a case in point. Based in California and incorporated in Maryland, New Century chose to file its case in Delaware, where a subsidiary is incorporated. A company spokeswoman did not respond to an interview request inquiring about their choice of venue for their bankruptcy filing.

“This is a very sophisticated game,” Mr. LoPucki said. “The judges are not blatantly favoring one party over another; it’s very subtle. But when you see the pattern — and I see them in the cases — then you realize there is something very wrong going on. The parties who bring them the cases are getting what they want.” The LoPucki-Doherty study is a compelling rebuttal to academics who have argued in recent years that auctions were more effective than reorganizations at extracting value from a bankrupt company. Trust in the market’s ability to price assets rationally was behind that view; not surprisingly, bankruptcy sales have grown considerably.

Especially popular, Mr. LoPucki said, are sales under Section 363 of the federal bankruptcy code, which allows managers to sell a company quickly without giving creditors the chance to vote on the deal or providing a detailed disclosure statement required under reorganization law. Compounding the problem is that once a judge approves a sale, appeals are not available.

As it turns out, “the market” that is entrusted to price a bankrupt company may also be subject to what economists call an “agency problem” — characterized by managers and other parties putting their own interests ahead of those of owners or creditors in bankruptcy cases…..

Mr. LoPucki argues that investment bankers hired to sell a company have few incentives to maximize the bids they receive. Investment bankers may not think it worth their while to curry favor with the sellers who hired them because the companies are going out of business, he speculates. Furthermore, underpricing an asset creates value for the buyer, who may then compensate the banker with future business, he says.

While bankers often receive “success” fees totaling 1 percent of a company’s sale price, Mr. LoPucki said a fee resulting from a higher price is often not worth the extra effort required to achieve it. Better to go on to the next deal.

That leaves creditors and judges to make sure the process is effective, Mr. LoPucki said. Too often the creditors are powerless and the judges passive or eager to please.

As a result, Mr. LoPucki said, bankruptcy courts are not fulfilling their obligation to ensure that the best interests of the debtor’s estate are being served, the study concluded. “There are billions of dollars being pulled out of this system,” he said. The Michigan Law Review plans to publish the LoPucki-Doherty study in November. A copy is at www.law.ucla.edu/docs/lopuckidohertyfire_4-11-07.pdf.

That creditors would be treated like steerage passengers on the S.S. Bankruptcy is not really surprising. The practices described in the study and the results they bring are completely in keeping with the treatment that many public company shareholders receive today from me-first managers. Whether the company is thriving or diving, being an insider has never been better.

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