Bankruptcy in America

The night of the killer zombies

Dec 12th 2002 | NEW YORK
From The Economist print edition

Critics of Chapter 11 say it prolongs companies' lives

beyond sensible limits, damaging healthy rivals

“BUSINESS as usual” was the message from United Airlines this week, as what was
once the world's biggest airline became the world's biggest airline bankruptcy. As
officials rushed to reassure customers, United pledged “even better” service, now that it
is operating under the protection of Chapter 11 of America's bankruptcy code. Glenn
Tilton, the veteran oilman hired three months ago to turn United round, promised “a new
beginning” for the ailing carrier—not Chapter 11, but Chapter one, as Mr Tilton put it.

Chapter 11 does indeed offer companies a shot at starting over. That is the point. Rather
than shutting a firm because it cannot meet its obligations to creditors, as happens in
many other countries, Chapter 11 gives a firm temporary protection from its creditors, as
they work out if it has any value left and who should have what stake, be it equity or debt,
in the company that eventually emerges from bankruptcy protection. Even so, the
efficiency of Chapter 11 is under growing scrutiny. A particular concern, in industries
such as telecoms and now airlines, is that bankrupt firms will return with manageable
debts and thus be better able to compete, with the result that they force hitherto healthier
rivals into bankruptcy in their turn (see article on how this may happen to United's rivals).
Does Chapter 11 create zombie companies that live on, only to drag other firms into their
graves?

There is no shortage of zombies. Bankruptcy courts in Delaware, New York and most
recently Chicago, where United filed, abound with undead giants. Of the ten biggest
bankruptcies since 1978, seven are now in the courts, dragging behind them combined
assets of nearly $300 billion. Is the system really working?

Chapter and verse

One philosophical objection raised increasingly often is the rule that puts the debtor in
control of the bankruptcy process, an idea that often leaves foreigners “stunned”, says
one bankruptcy lawyer. This typically means that the managers who bankrupt a firm can
have a go at restructuring it to keep it alive. They usually opt to try, rather than liquidate
the firm.

During the wave of bankruptcies in the late 1980s and early 1990s, the merits of this were
more obvious. Many firms went bust because they borrowed heavily during the
leveraged-buyout boom; restructuring the debt revealed essentially viable firms
underneath. Whether the 50-odd telecoms firms that have gone bust recently, let alone
United Airlines, have a business worth salvaging is less obvious.

Moreover, managers of a bankrupt firm are gaining more, not less, control over their fate.
For instance, Chapter 11 gives debtors the right to propose a restructuring plan within
120 days. But judges routinely extend this deadline. It used to be rare that judges would
allow debtors to auction assets before all creditors had approved a restructuring plan, says
Lynn LoPucki, a professor at the law school of the University of California, Los Angeles.
Recently, says Mr LoPucki, judges have allowed managers at Polaroid and Enron, for
example, to sell assets before even drafting a restructuring plan, thus avoiding a formal
creditor vote and the hundreds of pages disclosing information that must accompany it.
Since it filed for bankruptcy in December 2001, Enron has sold a wind farm, its energy-
trading arm and a construction company, among other businesses. Company officials say
that Enron ensures that its creditors support its asset sales. But without full disclosure,
who is to know for sure that Enron is making sales to the right people and at the right
prices?
Leaving incumbent managers in charge of a bankrupt firm has become increasingly
controversial since the bankruptcies of Enron and WorldCom prompted a more
widespread questioning of the usefulness of the executive class. Such concerns may be
overdone. In practice, incumbent managers rarely survive to lead restructured firms out of
the bankruptcy courts. But it is true that judges, often all too human, sometimes penalise
creditors who throw their weight around in the process of negotiating a restructuring plan.
This can let tainted managers cling on longer than may be prudent.

It took creditors three months of jostling to oust John Sidgmore from the helm of
WorldCom, and he agreed to go only when he was promised a new management position,
even though he was part of the management team that led the firm through its $9 billion
accounting scandal. Certainly, judges would deflect some critics of the bankruptcy
process if they worked closely with creditors to get new managers in place fast and to
agree a restructuring plan as quickly as possible.

Nor is the reputation of Chapter 11 helped by the sight of lawyers, accountants and other
restructuring experts feeding off the carcass. The headline figures for professional fees
for the latest batch of bankruptcies are likely to break all records. One creditor committee
at Enron, for instance, guesses that fees may hit $700m for the two years or more that the
firm thinks its bankruptcy will take. On recent trends, fees related to WorldCom could
easily top $1 billion.

Yet these headlines may be deceptive. Measured as a percentage of assets at the time of
filing, fees have actually been falling in America, from around 3-4% in the late 1980s to
1-2% today. This may be despite the apparent effort of some bankruptcy judges to drum
up business through their leniency. Officials from the Justice Department should spot
excessive fees. But their niggling objections typically focus on minutiae such as expensed
lunches and photocopying costs, and are mostly overruled by the judges, says one
bankruptcy lawyer. And it is “easier to get your fee application approved in New York
than in Ohio”, says the lawyer. Ohio, needless to say, is not a destination of choice for the
bankruptcy industry.

Nor do incumbent managers always get their way and creditors lose. Chapter 11 is “like a
giant convention, where everybody brings their own lawyer”, says one expert. This week,
Mr Tilton claimed to be in control of United. In practice, he will find that his power is
constrained. Creditor committees mostly keep a low profile, but behind the scenes they
pack a punch. Judges tend to seek balance—which may be more than the managers
deserve, it is true—so that one party does not gain at the expense of others. Mr Sidgmore
has called his experience in the courts “brutal”.

And the messiness of the process should not obscure the fact that a company can emerge
from Chapter 11 only if its creditors reckon it is worth more alive than dead. Zombie
companies may be the price that America pays for the second chances it generously
dishes out. As Stuart Gilson of Harvard Business School points out, nobody sees the lost
opportunities of systems such as Britain's or continental Europe's, which both favour
liquidation over restructuring—though that is changing. And more debtors may stay
buried this time around: Enron is liquidating itself.

Even so, a backlash may be coming. It is hard, even now, to point to an example of a
successful big bankruptcy, in which the patient emerged, refreshed and fit, to dominate its
industry. If the current batch ends in fat fees and failure, it may become even harder to
dispel the thought that all this hard work is not worth it. If so, the restructuring industry
may end up having to swallow some of its own medicine.