Winston Churchill once said: "Many forms of government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except all those others that have been tried from time to time."²

And so it is with chapter 11 of the Bankruptcy Code. Chapter 11 may not be a perfect corporate restructuring vehicle, but it is far better than any alternative yet posited in the debate that has raged over chapter 11's efficacy since its enactment in 1978.³ Indeed, in our view, although the basic structure of chapter 11 could be fine-tuned, it nonetheless remains the archetypal corporate restructuring statute against which all other putative alternatives should be adjudged.⁴

In this sometimes-heated debate about the efficacy of chapter 11, points of view have ranged from those advocating replacing chapter 11 with some sort of private contract-based restructuring system (the advocates of which we have dubbed as the "efficientists") to those who believe that the prospects for debtor rehabilitation should be enhanced (whom we call the "rehabilitationists"). Yet none of the proposed replacements for, or redefined roles of, chapter 11 properly reflect the economic realities of the modern restructuring markets.

The rehabilitationists, represented most famously by Harvey Miller, lament the passing of an era in which financially distressed companies (historically, railroads) were rehabilitated, typically with some sort of change in ownership.⁵ Miller and his fellow rehabilitationists thus have decried the increasing frequency and rise in importance of §363 sales, which, they claim, has come at the expense of traditional restructurings.⁶ They have ascribed this rise in the predominance of asset sales to the growing power of secured and debtor-in-possession (DIP) lenders and the rise of special-interest legislation amending chapter 11 to be less debtor-friendly and more receptive of certain special interests.⁷ Rehabilitationists such as Miller assert that this evolution away from classic "debtor rehabilitation" poses systemic dangers, including failure to maximize value and increased numbers of piecemeal liquidations that destroy jobs and reduce industry competition.⁸

Efficientists such as Profs. Baird and Rasmussen have also posited that the era of chapter 11 and "traditional" debtor reorganizations may be drawing to a close—but for a very different reason. They assert that larger economic forces have caused "going concern" value to be less common, which in turn makes preserving the historic debtor entity less viable, thereby largely rendering (in their view) chapter 11 obsolete—and best replaced by a private-market approach.⁹

But many of Baird's and Rasmussen's conclusions simply do not comport with the real, messy world.¹⁰ For example, they state that "[t]he traditional conception of corporate reorganizations starts with the belief that when a firm is in distress, control rights will not be vested in the hands of someone who exercises them sensibly."¹¹ In other words, Baird and Rasmussen view chapter 11 as resting on the assumption that it is needed because the residual owner will not act rationally.¹² They assert that the single residual owner will act rationally because that is the bedrock assumption of standard microeconomic theory.¹³ But things aren't that simple. It is our experience that there is no single residual owner in a large, complex chapter 11 case.¹⁴ Debt structures tend to be very complex and subject to potential challenge.¹⁵

Chapter 11 Fostered the Rise of the Modern Restructuring Markets

In having analyzed their views, we believe that there is, to borrow a phrase, a "third way" to view both the purpose and efficacy of chapter 11.¹⁶ We believe that chapter 11 continues to function well (albeit not perfectly) as the component of a larger restructuring market that efficiently processes market failure as the process of last resort. Indeed, chapter 11's inherent flexibility has fostered new means of preserving going-concern value in complex corporate transactions. The result is a restructuring market that is a quantum leap from the state of affairs when Congress enacted the current Bankruptcy Code in 1978. Indeed, chapter 11 is but one, albeit a critical, part of a broader restructuring market that also includes a vast number of out-of-court workouts because it serves as a critical court-supervised market of last resort when a consensual deal is not made.¹⁷ This often brutally competitive restructuring market has but one goal in the final analysis, whether in an out-of-court setting or in chapter 11: maximizing creditor recoveries.

We see three primary reasons for the primacy of maximizing creditor recoveries. First and foremost, the U.S. economy is market-driven. In addition, restructuring market participants (comprising both chapter 11 and the out-of-court markets) naturally enough seek the highest returns possible for their investments.¹⁸ Second, as an entity enters the zone of insolvency, the fiduciary duties ordinarily owed by the board of directors and management to shareholders extends to creditors.¹⁹ Finally, Congress, in enacting the Bankruptcy Reform Act, cited maximizing creditor recoveries as a major goal of chapter 11.²⁰ Indeed, the very structure of the Code confirms that Congress intended chapter 11 to function flexibly, with "debtor rehabilitation" being only one among several paths to exiting chapter 11.²¹

The importance of the interplay between chapter 11 and the broader restructuring markets cannot be overemphasized. Yet Miller ignores the importance—and the role—of out-of-court workouts, thereby giving short shrift to the broader restructuring milieu in which chapter 11 operates. Baird and Rasmussen, on the other hand, believe that out-of-court workouts do constitute an important segment of the restructuring markets. But they go too far in concluding that private, out-of-court workouts can entirely supplant chapter 11.²² We believe that the evidence shows that out-of-court workouts now dominate the restructuring markets because of the presence of chapter 11 as a restructuring alternative of last resort.²³ This presence (simply as the logical alternative to a private workout) normatively influences the markets because every market participant knows the price of failing to reach a consensual deal out of court—a chapter 11 case.²⁴

The modern-day restructuring market accomplishes the broader goals of chapter 11 by preserving going-concern value when such value is present, whether by a strategic sale of businesses (and their asset-based, human and/or financial capital) or by financially restructuring the historic corporate entity, in either case efficiently processing capital from the deathbed of a moribund business entity to the cradle of its highest and best use. It is on this basis that we believe that the development of the modern restructuring market has made an asset sale and a traditional reorganization economically equivalent.²⁵

As we discuss in more detail in our forthcoming article, the evidence of this economic equivalence (and concomitant arbitrage opportunities) is compelling.²⁶ For example, corporate debtors generally change ownership through some sort of recapitalization when their respective plans are consummated.²⁷ Moreover, by virtue of the rise of the secondary debt markets, the membership of each class of creditors receiving equity generally does not consist of the original creditors in that group. In other words, many (if not most) of the creditors receiving equity had acquired their claims in the distressed-debt markets.²⁸ By so doing, they had effectively purchased the prospect of receiving the reorganized debtor's equity.²⁹

Chapter 11's structure, which allows either the sale of the business as a going concern or its reorganization, thus presents the debtor and its creditor constituencies with an option: Sell to a willing buyer or reorganize, with ownership transferred to new equity-holders—at a price that tends to equal the consideration of any sale alternative. The question is which course to take. In our experience, there are a number of factors to consider:

• The speed with which the acquisition needs to occur. A §363 asset sale is usually faster than either a sale through, or a stock-for-debt transfer pursuant to, a confirmed reorganization plan. The length of time in chapter 11 may be minimized in the case of a stock-for-debt exchange by engaging in either a prepackaged or prearranged plan. But in either case, the deal is likely to be in the public eye longer than in the case of a §363 asset sale.
• Whether there is a potential competitor planning to bid for the target entity. If one potential purchaser already has a commanding debt position, a competitor coming to the proposed sale at a later point could potentially work a sweeter deal as a stalking-horse bidder in a §363 asset sale. On the other hand, purchasing a commanding debt position could preemptively dissuade other potential acquirors from actively pursuing the target.
• Need for the existing historic entity to continue.³⁰
• Need to shed legacy costs and non-performing assets.³¹
• The buyer's tolerance for minority holders of stock.³²

Conclusion

The death of a failed business should not be seen as a necessarily "bad" outcome.³³ Such failures merely manifest that great engine of the American economy, "creative destruction."³⁴ In other words, business failure is merely one part (along with successful businesses) of good old-fashioned American capitalism built upon a foundation of efficient markets. Dying businesses are thus a natural part of a dynamic, capitalist economy.³⁵

Editor's Note: This is a "short form" article based on a much longer piece that will be published in the forthcoming edition of The Journal of Bankruptcy Law and Practice. We thank the authors for allowing us to give you, our readers, an advance look at what they have to say.

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Footnotes

¹ Messrs. Sprayregen, Higgins and Friedland are attorneys with the Restructuring Group of Kirkland & Ellis LLP. Return to article

² James, Robert Rhodes, ed., "Winston Churchill, Speech, House of Commons, Nov. 11, 1947," 7 Winston S. Churchill: His Complete Speeches, 1897-1963, 7566 (1974). Return to article

³ ABI held a "Symposium on the Code After 25 Years: 1978-2003" in October 2003, and subsequently devoted an issue of the ABI Law Review to the topic. One of the recurring questions many of the symposium participants addressed is how well (or how poorly, as the case may be) chapter 11 is doing its job. See 12 ABI Law Review 1. Return to article

⁴ In our longer article, we briefly discuss several potential "fixes." We also discuss a number of provisions in the recently enacted Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) that we believe may materially detract from the efficacy of chapter 11 at the expense of overall restructuring market efficiency. Return to article

⁵ Miller and Weisman, "Does Chapter 11 Reorganization Remain a Viable Option for Distressed Businesses for the Twenty-first Century?," 78 Am. Bankr. L.J. 153 (2004) (discussing the 19th century origins of modern restructuring law). Return to article

⁶ Miller presented an unpublished paper on this subject at a recent conference. Miller, Trepper, Baker and Turetsky, "Debtor Dispossessed: The Rise of the 'Creditor-in-possession' and Chapter 11 Asset Sales: Does Chapter 11 Have a Future for Debtors?," (unpublished manuscript on file with authors) at 1-2 (2004) (hereinafter, variously "Miller, et al.," "Miller" and the "Miller article"). He also gave an interview espousing the views set forth in the Miller article. Miller and Porennan, "Creditor in Possession," TheDeal.com at http://www.thedeal.com, (last visited on Feb. 24, 2005) (Jan. 9, 2004). Return to article

⁷ Miller, et al., at 22-23. Return to article

⁸ Id. Return to article

⁹ See, e.g., Baird, "The New Face of Chapter 11," 12 Am. Bankr. L.J. 69, 71-72 (2004); Baird and Rasmussen, "Chapter 11 at Twilight," 56 Stan. L. Rev. 673 (2003); Baird and Rasmussen, "The End of Bankruptcy," 55 Stan. L. Rev. 751 (2002); Baird, "Bankruptcy's Uncontested Axioms," 108 Yale L.J. 573, 576 (1998); Baird and Rasmussen, "Chapter 11 at Twilight;" Baird and Rasmussen, "The End of Bankruptcy;" Baird, "Bankruptcy's Uncontested Axioms," 108 Yale L.J. 573, 576 (1998). Baird and Rasmussen, "Chapter 11 at Twilight" at 699; Baird and Rasmussen, "The End of Bankruptcy" at 788. Return to article

¹⁰ Miller, as Baird and Rasmussen themselves have noted, has criticized them in particular over not having descended from the ivory tower to participate in the rough and tumble of the day-to-day restructuring market. Miller, "Harvey's Outburst: A Rejoinder to Professor White's Comment," 69 Am. Bankr. L.J. 481, 483 (citing Warren, "Bankruptcy Policymaking in an Imperfect World," 92 Mich. L. Rev. 336, 339 (1993)). Others have also generally criticized efficientists on this same point. Lubben, "Some Realism Absent Reorganization: Explaining the Failure of Chapter 11 Theory," 106 L. Rev. at 267 (2001); Baird, "Uncontested Axioms," supra note 9 at 588 n. 44. Return to article

¹¹ Baird and Rasmussen, "The End of Bankruptcy," supra note 9 at 779. Return to article

¹² LoPucki, "The Nature of the Bankrupt Firm: A Reply to Baird & Rasmussen's The End of Bankruptcy," 56 Stan. L. Rev. 645 (2003) at 658 n. 79. Return to article

¹³ Baird and Rasmussen, "Four (or Five) Easy Lessons from Enron," 55 Vand. L. Rev. 1787, 1807 (2002). Return to article

¹⁴ Consider the Conseco chapter 11 case, in which there were two separate confirmed chapter reorganization plans—one reorganizing plan for Conseco Inc., which had 33 separate classes of creditors, and a second liquidating plan for Conseco Finance Corp., which had five classes of creditors. See In re Conseco Inc., et al., Reorganizing Debtors' Sixth Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the U.S. Bankruptcy Code, (Bankr. N.D. Ill., Sept. 9, 2003) (Conseco plan); In re Conseco Inc., et al., Finance Company Debtors' Sixth Amended Joint Liquidating Plan of Reorganization Pursuant to Chapter 11 of the U.S. Bankruptcy Code, (Bankr. N.D. Ill., Sept. 9, 2003) (Conseco Finance Corp. plan). In the Conseco plan, creditors in 10 of the 33 classes received some form of equity in satisfaction of their claims. In re Conseco Inc., et al., Reorganizing Debtors' Sixth Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the U.S. Bankruptcy Code, (Bankr. N.D. Ill., Sept. 9, 2003). LoPucki's research confirms our experience. LoPucki, "The Nature of the Bankrupt Firm," supra note 12 at 659 n.87 (In 48 of 78 large public firm reorganizations occurring between 1991 and 1996, creditors/investors at more than one priority level shared residual owner status such that they had materially adverse interests). Return to article

¹⁵ Nonetheless, many of their observations about what is happening in the restructuring market, and their application of principles of economics to the questions they pose, have been immensely valuable in putting the contours of everyday life in the restructuring market into much sharper focus (and in permitting trenchant analysis and criticism of their theories). Return to article

¹⁶ The Columbia Encyclopedia (6th ed. 2001), http://www.bartleby.com, April 19, 2005 ("In 1997...[Blair]...moved quickly to implement a "'third-way program'" in the wake of the landslide election that returned the Labour Party to power in Great Britain after a nearly 20-year absence from power). Return to article

¹⁷ See Brubaker and Klee, Debate at 274 and n. 3 (citing Wruck, "Financial Distress, Reorganization and Organization Efficiency," 27 J. Fin. Econ. 419 (1990) ("We think it's appropriate, in judging the success of chapter 11, to focus primarily not on what happens in chapter 11, but what happens outside chapter 11. The preferred means of responding to financial distress and default is a negotiated resolution, without resort to bankruptcy. And, at least half the time, those negotiations produce a successful, consensual, out-of-court deal with very low direct and indirect costs that deplete the value of the firm")). Return to article

¹⁸ See, e.g., Drummond, "Hedge Funds: Value or Vultures, They Play a Critical Role," Fin. Times, 2005 WLNR 3714483 (March 10, 2005) (describing how distressed debt and similar funds work). Return to article

¹⁹ Geyer v. Ingersoll Publications Co., 621 A.2d 784, 787 (Del. Ch. 1992) (recognizing that upon corporate insolvency, creditors become beneficiaries of directors' fiduciary duties). Return to article

²⁰ H.R. Rep. No. 595, 95th Cong., 1st Sess. 220 (1977); see, also, NLRB v. Bildisco & Bildisco, 465 U.S. 513, 527-28 (1984) ("(t)he fundamental purpose of reorganization is to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources"); see, also, Miller, et al. at 3. Return to article

²¹ Had Congress not intended to include liquidation as an acceptable type of reorganization plan, then presumably all provisions dealing with liquidation would fall within chapter 7, which is specifically titled "Liquidation." Courts have thus long recognized that chapter 11 sales of going concerns and other assets, often followed by a liquidating plan of reorganization, were a quite likely outcome. See, e.g., In re Deer Park, 136 B.R. 815, 818 (BAP 9th Cir. 1992); see, also, Dickerson, "The Many Faces of Chapter 11," 12 ABI Law Review 109, 114 (2003) (stating that chapter 11 has been utilized as a tool for liquidation since the enacting of the Code in 1978). Return to article

²² Baird and Rasmussen, "Chapter 11 at Twilight," supra note 9 at 699; Baird and Rasmussen, "The End of Bankruptcy," supra note 9 at 786-88. Their problem is that they want the broader market to subsume the chapter 11 segment. To do so would be akin to killing the goose that lays the golden egg; the broader restructuring markets would not be nearly as vibrant without chapter 11. See, infra, note 6. Return to article

²³ Brubaker and Klee, "Debate: The 1978 Bankruptcy Code Is a Success," 12 ABI Law Review 273, 274 and n.3 (2004) (citing Wruck, "Financial Distress, Reorganization and Organization Efficiency," 27 J. Fin. Econ. 419 (1990)). In other words, the mere presence of chapter 11 as the alternative of last resort has helped foster the development of a robust out-of-court restructuring market. As Sherlock Holmes once observed about the silence of a key player:

It is of the highest importance in the art of detection to be able to recognise out of a number of facts which are incidental and which are vital... I would call your attention to the curious incident of the dog in the night-time.
The dog did nothing in the night-time.
That was the curious incident.

Doyle, "Silver Blaze," The Memoirs of Sherlock Holmes (1893) (Mr. Holmes explaining to Inspector Gregory how he identified the horse thief), available at http://www.bartleby.com. (last visited on Apr. 28, 2005). Return to article

²⁴ There is also a coercive element to the presence of chapter 11 as a component of the broader restructuring markets. Its presence is rather like that of a strict aunt at the family gathering ameliorating the behavior of a child who might otherwise be inclined to misbehave. No rational market participant, least of all a creditor in the position to call most, if not all, of the shots in the out-of-court context, will want to participate in a chapter 11 case when there is an economically viable alternative. Return to article

²⁵ This economic equivalence between an asset sale and a recapitalization merely manifests the underlying concept that restructuring markets, like other capital markets, are governed by the same economic forces, and thus may be explained by the same economic theories. Brealey and Myers, Principles of Corporate Finance 354-71 (7th ed. 2003) (discussing structure of capital markets). Therefore, the process, from the debtor's perspective, of determining whether an asset sale or recapitalization will optimize creditor recoveries is essentially one of arbitrage, or exploiting price differentials within a market. Id. at 204-08 (discussing arbitrage pricing model theory). Return to article

²⁶ In our longer article, we analyze a large number of large corporate bankruptcies to support this conclusion. Our results are striking. We began with 22 sale cases cited by Miller in support of his thesis that chapter 11 is no longer fulfilling its role of rehabilitation. We found that these cases present a variety of outcomes that fall into two basic groups distinguished mainly by the intrinsic going-concern value of the operating businesses. The first group comprised companies such as Bethlehem Steel, LTV Steel, Pillowtex, National Steel and Burlington Industries, which really did cease to exist in their historic form. Each of these companies and their constituent business operations was no longer viable because there was no real going-concern value worth preserving in their historic corporate form. Their assets, which in many cases no longer constituted going concerns, were recycled to different owners who could use them to generate new going-concern value. The second group comprised companies such as ANC Rental, Loews, Top-Flite, Budget Group and Polaroid, each of which sold their core businesses to new owners that continued to operate those businesses, making money (in most cases), employing workers (whether the original workers or otherwise), creating value for their shareholders (albeit new ones), paying taxes and generally continuing as a corporate citizen. The sales and the concomitant liquidating plans were facets of complex restructuring transactions that required the aegis of chapter 11 to come to fruition. Finally, the evidence shows that there are a large number of debtor cases that culminate in a confirmed plan in which the historic business continues to operate, albeit under new ownership. In each case, we found that, contrary to Baird's and Rasmussen's hypothesis, the debtor retained an intrinsic going-concern value. See, also, LoPucki, The Nature of the Bankrupt Firm, supra note 12 (analyzing data that showed large debtors being reorganized in the historic entity). Return to article

²⁷ See, e.g., Regal Cinemas, Loews Cineplex, Covad Communications Inc., Conseco Inc., NRG Energy Inc., MCI Inc. (formerly WorldCom), Pacific Gas & Electric Co., United Artists, Zenith, Chiquita and Exide Technologies; see, also, LoPucki, The Nature of the Bankrupt Firm, supra note 26 at 647-48. Return to article

²⁸ Goldschmid, "More Phoenix than Vulture: The Case for Distressed Investor Presence in the Bankruptcy Reorganization Process," 2005 Colum. Bus. L. Rev. 191, 203-05 (2005) (vast majority of large debtor chapter 11 cases involve distressed debtor traders that have influential or even outright majority positions in debtors). Return to article

²⁹ This generalization is not meant to disregard those market participants who arbitrage trade and similar unsecured claims by purchasing them with the prospect of receiving a recovery (usually in cash or easily liquidated property) greater than the purchase price. Return to article

³⁰ The prime example of a factor requiring the historic entity to continue existing is if the debtor wishes to assume or assume and assign certain types of executory contracts that cannot otherwise be assigned under applicable law. 11 U.S.C. §365(c)(1). Return to article

³¹ Which will often militate in favor of an asset sale vice the acquisition of the historic entity. The debtor can carve out the nonperforming assets, which will allow a sale of the core assets—either as assets alone, or as a going-concern business. The buyer then has the ability to operate the going-concern assets without being saddled with the cost of disposing of the nonperforming assets. This circumstance has arisen in steel, textile and coal mining company chapter 11 cases. But it is worth noting that even purchasing assets out of a §363 sale will not guarantee that the buyer will simply be able to walk away from the seller's legacy costs unscathed. In the Cone Mills case, Wilbur Ross settled a $59 million pension claim by the PBGC against ITG for a $4 million stake in ITG and $500,000 in cash. Murray, "Cone Plan Clears," The Daily Deal, 2005 WLNR 5939697 (Apr. 18, 2005) (settlement of PBGC claim was part of confirmation of Cone Mills's liquidating chapter 11 plan). Return to article

³² Presumably, purchasing assets in a §363 sale would ensure that there were no minority holders. Return to article

³³ That is not to say that one should be (and we are not) indifferent to the societal costs of economic dynamism. Dealing with such societal impacts is really beyond the scope of chapter 11 without a specific legislative mandate such as that provided by §§507(a), 1113 and 1114. But it is safe to say that an entirely private, contract-based restructuring market would pay even less attention to the societal impact of dislocation costs than chapter 11. Return to article

³⁴ Schumpeter, Capitalism, Socialism and Democracy, 81, 130 (3d ed. 1950). Return to article

³⁵ Indeed, it is interesting to note that it is very hard for any company to remain on top. In 2004, only three companies that were part of the Dow Jones Composite Index in 1959 remain part of that index. Dow Jones Industrial Average History, found at http://www.djindexes.com/jsp/industrialAverages.jsp, last visited on Oct. 11, 2004. Return to article