Legislative Update

Journal Issue

Sep 2004

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This month's Update contains excerpts from the
testimony of Prof. Lynn LoPucki (UCLA Law School) before the House
Judiciary Committee on July 21, 2004. Prof. LoPucki testified about his
research on the effect of so many large public companies' decisions
to file for bankruptcy in either the District of Delaware or the Southern
District of New York. Prof. LoPucki's research and controversial
findings are in part funded by a grant from the ABI Endowment Fund.

The bankruptcy courts of
the United States have inadvertently been thrown into competition for big
bankruptcy cases. That competition is changing bankruptcy law and practice
in ways not contemplated by Congress and corrupting those courts.

By "corrupting," I mean that a
substantial number of bankruptcy judges are deciding particular matters
not as they believe they should, but as they believe they must, to maintain
the flow of cases to their courts. I can identify no particular decision as
corrupt, but I can show a pattern of decisions by the bankruptcy courts for
which corruption by the pressures of court competition is the most
reasonable explanation. I can also show that the competition is having an
adverse effect on reorganizing companies. Specifically, companies that
reorganized in the courts most successful in attracting cases were two to
10 times more likely to fail after bankruptcy than were comparable
companies reorganized in other courts.

<h4>Why Bankruptcy Courts Compete for Big Cases</h4>

Bankruptcy judges want large cases for at least three
reasons:

1. For the judge, a large
bankruptcy case is a career opportunity. The
judge will be able to work with the nation's leading bankruptcy
professionals, and the proceedings will be followed by the media and the
bankruptcy community as a whole. Judges who attract numerous large cases
are likely to become celebrities.

2. The cases are of
economic importance to the judges' communities. The court-awarded professional fees in a single, large
bankruptcy case are almost invariably in the millions of dollars, and may
be as high as a billion dollars. In most large cases, most fees paid will
go to local professionals. Thus, attracting the case of a large company to
the bankruptcy court in a city brings substantial revenues to the
bankruptcy professionals in that city. Attracting all of the big
bankruptcies in the United States to a single court—as the Delaware
Bankruptcy Court nearly succeeded in doing in 1996—could bring
billions of dollars to a local economy annually.

3. The loss of cases to
other courts humiliates the bankruptcy judges, lowers their standing in
their communities and may even cost them their jobs. Most—but not all—large, bankrupt companies are
linked in the minds of the public to the city in which they have long
maintained a national headquarters. Examples are Enron with Houston and
Polaroid with Cambridge, Mass. The bankruptcy court at that location is a
sort of "natural venue" where the company is expected to file.
The company that files in Delaware or New York is seen as rejecting the
local court. That rejection often leads to criticism of particular
bankruptcy judges for failure to take what action was necessary to retain
"their" cases. To illustrate the scope of the problem, of the
24 companies headquartered in the Boston area that filed for bankruptcy
since 1980, only four (17 percent) filed in the Boston Bankruptcy Court.
For Alexandria, Va., the number is two of 13 (15 percent). Some cites,
including Philadelphia, West Palm Beach, Fla., and Ft. Lauderdale, Fla.,
have lost all of their cases.

In some cases, the criticisms appear warranted. One
or more of the local judges may have poor skills or temperament. In other
cases, the criticisms are unwarranted. The judge is simply following laws
and rules the court-selecting lawyers and executives prefer to avoid.

Bankruptcy judges are not Article III judges and do
not enjoy life tenure. They serve 14-year terms and must apply for
reappointment to continue in office. A recent study by Bankruptcy Judge
Stan Bernstein of the Eastern District of New York found that more than 8
percent of the bankruptcy judges who applied for reappointment during the
period from 1998 to 2002 were not reappointed. Bernstein, Stan, The Reappointment of Bankruptcy Judges: A Preliminary
Analysis of the Present Process (unpublished
manuscript, Oct. 15, 2003). Other bankruptcy judges won reappointment, but
only after their competence had been challenged and they had been, in Judge
Bernstein's words, "put through the wringer." Because the
appeals courts usually seek the opinions of local bankruptcy lawyers as
part of the reappointment process, bankruptcy judges are probably more
sensitive than Article III judges as to how they are viewed in their
communities.

<h4>Historical Roots of the Problem</h4>

In 1974 and 1975, the Bankruptcy Rules Committee
liberalized the venue rules for cases under chapters X and XI of the
Bankruptcy Code. The new rules gave corporations the option to file their
bankruptcy cases at (1) the corporation's domicile or residence
(later interpreted to mean its state of incorporation), (2) the
corporation's principal place of business (essentially, its
headquarters), (3) the corporation's principal assets in the United
States or (4) the location at which the case of an affiliated corporation
was already pending. Committee members believed that if their liberal venue
rules were abused, the bankruptcy courts would exercise their broad power
to transfer cases to the most appropriate venues. 28 U.S.C. §1412.

In the context of a large, public company that
operates through subsidiaries in all parts of the United States, the effect
of these liberal venue rules has been to allow the company to file in the
bankruptcy court of its choice. The Enron case serves as an illustration. Enron Corp. was
incorporated in Oregon. Enron's headquarters, and the bulk of its
25,000 employees, were in Houston. Enron chose to file its bankruptcy in
the New York Bankruptcy Court. (References to the New York Bankruptcy Court
are to the Manhattan Division of the U.S. Bankruptcy Court for the Southern
District of New York.) To accomplish that, Enron directed its New York
subsidiary, a corporation with 157 employees, to file a bankruptcy petition
with the New York Bankruptcy Court. A few minutes later, Enron filed in New
York on the basis that the New York court was a court "in which there
[was] pending a case...concerning [Enron's] affiliate."
Numerous creditors joined in a motion to transfer Enron's cases to
Houston. The New York bankruptcy judge denied the motion.

Through the 1980s, the rate of forum shopping
(defined as filing away from the company's headquarters) in large
public company bankruptcies rose from about 20 percent to 40 percent. Most
of the shopping was to New York. During that decade, the Delaware
Bankruptcy Court had the case of only one large, public company. That
company, Phoenix Steel, had both its headquarters and its operations in
Delaware. The one-judge Delaware Bankruptcy Court began attracting cases in
1990. Delaware attracted four big cases in 1991 and six in 1992. In 1992,
Congress awarded the Delaware court a second bankruptcy judgeship. The
Delaware court's market share rose steadily until 1996, when 87
percent of the large, public companies filing for bankruptcy in the United
States (13 of 15) chose the Delaware court.

In 1996, the National Bankruptcy Review Commission
adopted a recommendation designed to end the rampant bankruptcy forum
shopping. That recommendation was to delete the provisions of the venue
statute that authorized filing at the debtor's place of incorporation
or where the case of an affiliate was pending.

In 1997, a study requested by the Judicial Conference
of the United States and conducted by the Federal Judicial Center revealed
that Delaware's chief bankruptcy judge routinely had ex parte contacts (for
scheduling purposes) with representatives of large, public companies that
intended to file in Delaware, and in the course of those contacts,
identified the judge that would be assigned to the case once it was filed.
Seventeen days after the release of the Federal Judicial Center's
report, the Delaware District Court took the unprecedented step of revoking
the reference to the bankruptcy court of all newly filed chapter 11 cases.
Although the district court asserted that its action was taken merely to
assist the bankruptcy court with its heavy docket, the action was widely
interpreted as a rebuke to the bankruptcy court. Large, public-company
bankruptcy filings in Delaware declined in 1997, but resumed their rise in
1998.

By 1998, it was apparent that Congress would not act
on the recommendation of the National Bankruptcy Review Commission. Over a
period of two or three years, bankruptcy lawyers in at least a dozen
cities, including New York, Chicago, Houston, Dallas, Los Angeles and
Miami, approached their local bankruptcy judges to request that the judges
make their courts more competitive with Delaware by liberalizing their
awards of professional fees and mimicking other Delaware practices.
Beginning in 1999 and 2000, nearly all of the courts responded by making
changes in local rules and practices, including those regarding the award
of professionals' fees.

By 2000, an unprecedented rise in the number of big
case bankruptcy filings nationally had overwhelmed the resources of the
Delaware Bankruptcy Court. The Delaware court had been awarded its second
bankruptcy judge on the basis of six big cases in 1992. In 2000, the
Delaware court attracted 45 big cases. The effect of the overload was to
make Delaware a less-attractive venue. Most of the overflow went to New
York. Since 2000, the Delaware Bankruptcy Court has captured 34 percent of
all large, public-company filings in the United States, and the New York
Bankruptcy Court has captured 20 percent.

<h4>Adverse Effect on Reorganizing Companies</h4>

Evidence suggests that the court competition has
resulted in the destruction of many large, public companies that otherwise
could have been saved. In a study of all 98 large, public companies filing
for bankruptcy and emerging as public companies from 1991 through 1996,
Joseph Doherty and I found that 42 percent of Delaware-reorganized
companies filed a second bankruptcy case within five years of the
confirmation of their plans, as compared with 19 percent of New
York-reorganized companies, and only 4 percent of companies reorganized in
other courts.<a href="#1" name="1a">1</a> Roughly twice as high a proportion of the Delaware and
New York-reorganizing companies (25 percent) went out of business while in
financial distress during that five-year period.

<hr>
<big><center>
These changes were not preceded by congressional
action, appellate decisions or even policy discussions. They evolved
because the case placers wanted the changes, and the bankruptcy courts
stretched or broke the law to accommodate them.
</center></big>
<hr>
</blockquote></blockquote>

The high failure rates for Delaware and New
York-reorganized companies cannot be explained by any salient differences
in the companies choosing to reorganize in those courts. On a variety of
measures, the Delaware and New York-reorganizing companies were not in
worse financial difficulty than those reorganizing in other courts. The
Delaware and New York-reorganizing companies were somewhat larger than the
other court-reorganizing companies, but the larger companies in our study
did not fail more frequently than the smaller ones. We found no significant
differences by industry among the two sets of cases.

We found several indicators that the reorganization
process was less effective in Delaware and New York. Although the firms
filing in Delaware and New York had pre-bankruptcy earnings no lower than
those of the firms filing in other courts, the firms filing in Delaware and
New York had sharply lower earnings than the firms filing in other courts
during the five years after they emerged from bankruptcy. Average
post-bankruptcy earnings for firms emerging from Delaware reorganization
were -9 percent. The corresponding average for firms emerging from New York
reorganization was -3 percent. For firms emerging from other court
reorganizations, the corresponding average was 1 percent. Delaware and New
York reorganizations were significantly quicker than reorganizations in
other courts, and quicker reorganizations were generally more likely to
fail. Even though the Delaware and New York-reorganizing companies were
larger than the other court-reorganizing companies, the plans in Delaware
and New York reorganizations divided the creditors into fewer classes,
suggesting possible superficiality in the reorganization process.

<h4>Adverse Effect on Court Processes</h4>

In addition to its obvious adverse effect on the
integrity of the bankruptcy courts, the competition for big cases is also
having an adverse effect on court processes. The choice of a bankruptcy
court is made by the top executives of a debtor corporation. Those
executives usually have little experience with bankruptcy courts and so are
heavily dependent on information and advice furnished by the bankruptcy
attorneys retained to represent the corporation. In some cases, financial
institutions that will make post-petition loans to the debtor corporation
may also play a role in selecting the bankruptcy court. Generally speaking,
however, pre-petition creditors are excluded from the court-selection
process.

It follows that courts wishing to attract cases must
appeal to the debtor's executives, attorneys and post-petition
lenders. (I refer to them collectively as the "case placers.")
To make this appeal, the judges are under pressure to favor case placers on
a number of key issues in the court's cases generally. The court must
establish a reputation for generosity with professional fees and tolerance
for the professionals' conflicts of interest. The court must approve
the compensation proposed for the top executives, even when that
compensation includes huge "retention" loans and bonuses for
the same executives that caused the company's failure. The court
cannot appoint a trustee to replace corrupt management, even in such
extreme cases as Enron, WorldCom, Global
Crossing and Adelphia. The court must be willing to approve provisions in the
reorganization plan that release the case placers from liability for the
case placers' own wrongdoing. A judicial panel that did not yield to
these pressures would not be attractive to case placers and would not get
future filings.

Over the past 15 years, the pressures of competition
have resulted in major changes in the operation of the bankruptcy system.
These changes were not preceded by congressional action, appellate
decisions or even policy discussions. They evolved because the case placers
wanted the changes, and the bankruptcy courts stretched or broke the law to
accommodate them. These are three examples of such systematic changes:

1. Thirty-day
pre-packaged cases. Pre-packaged cases are
specifically authorized in the Bankruptcy Code. A debtor
"pre-packages" its case by distributing a plan and disclosure
statement to creditors prior to filing the bankruptcy case, and obtaining a
sufficient number of votes in favor of the plan to meet the requirements of
the Bankruptcy Code. Only then does the debtor file a bankruptcy case and
submit the plan, disclosure statement, and ballots to the court for
approval. The court can confirm a pre-packaged plan only if the court first
determines that the disclosure statement provided information adequate for
informed voting, the plan complies with the provisions of the Bankruptcy
Code and the vote is sufficient for approval. To assist the court in that
process, the Code requires that the U.S. Trustee appoint a creditors'
committee and convene a meeting of creditors after the filing of the case.

Under the pressures of competition, some bankruptcy
courts have dispensed with these two requirements—even though they
have no legal authority to do so—and rubber-stamp whatever
pre-packaged cases are submitted to them. The creditors in these cases
receive no official representation, even though there may be an unofficial
committee purporting to represent their interests. By so doing, those
courts make it possible for a debtor to obtain confirmation of its
pre-packaged plan in slightly over 30 days from the date of filing. Some of
these courts have adopted local rules or guidelines directing that
confirmation hearings be set 30 days after filing (Los Angeles). One court
has adopted a local rule authorizing the cancelling of the meeting of
creditors required by Congress in the event it cannot be completed by the
confirmation hearing (New York).

Before confirming a reorganization plan, the court is
required to determine that "confirmation of the plan is not likely to
be followed by the liquidation, or the need for further financial
reorganization, of the debtor...." 11 U.S.C. §1129(a)(11). In
our study, Doherty and I found that confirmation of a pre-packaged plan by
the Delaware Bankruptcy Court was followed by a distress liquidation or
further financial reorganization in nine of 14 cases (54 percent).

2. "Critical
vendor" orders. The Bankruptcy Code
prohibits the preferential payment of some creditors over others when both
have the same legal rights. The opinions of the appellate courts are pretty
much uniformly in accord. But in the mid-1990s, under the pressures of
competition, some bankruptcy courts began approving preferential payments
to so-called "critical vendors"—suppliers whose
cooperation was needed for reorganization and who would not provide it
unless the debtor paid its pre-petition debt to the supplier in full. In
their early years, critical vendor orders were rare and covered only small
numbers of creditors. But by 2002, critical vendor orders were being
approved in most large public company cases. In some, the orders authorized
preferential distributions of hundreds of millions of dollars to hundreds
or even thousands of creditors. In the Kmart case, for example, the Chicago Bankruptcy Court
permitted the distribution of $200 million to $300 million in preferential
payments to 2,300 supposedly "critical vendors" selected by the
debtor. The bankruptcy court's order was reversed on appeal, but the
damage was in large part irreversible because the money had already been
distributed.

3. Section 363 sales. The Bankruptcy Code specifically authorizes the use of
chapter 11 to sell a company. The appeals courts held that debtors may do
so pursuant to a reorganization plan after adequate disclosure to creditors
and a vote or, if the debtor has "sound business reasons" for
doing so, under §363 of the Bankruptcy Code without a plan, adequate
disclosure or a vote. Until the courts began competing for cases in the
1990s, §363 sales of entire companies were rare.

In the 1990s, such sales became common. The competing
courts so frequently and easily waived the requirement of "sound
business reasons" that debtors began arranging sales and announcing
those sales prior to even filing the debtors' bankruptcy cases. Since
1997, the Delaware Bankruptcy Court has given final approval to sales of
seven large public companies, each in less than 50 days of the filing of
the company's case. Once the bankruptcy court has finally approved a
§363 sale, the sale is final. Section 363(m) of the Bankruptcy Code
prohibits the reversal of that approval on appeal.

Section 363 sales of large public companies now
routinely occur without adequate disclosure to creditors or the opportunity
for creditors to vote on a plan.

The §363 sale procedure is fraught with
potential for abuse. The case placers often have interests in the sales
that conflict with those of the creditors, employees, suppliers and taxing
authorities of the debtor. The top managers may be purchasers or they may
expect to be employed by the buyer. Some of the managers receive large
stock bonuses from the buyer after the sale is complete. Investment bankers
retained as financial advisors often recommend sales that will result in
large fees to themselves; they may steer the debtor to a court that will
approve the sale without question. Discovery of such abuses is difficult
because the sales occur quickly, in near secrecy, and there is no legal
avenue for review.

<h4>Solutions</h4>

In addition to the serious adverse effects described
in the preceding section, the competition for big bankruptcy cases has also
had some positive effects on the bankruptcy courts. The Delaware court
pioneered the development of the omnibus hearing that reduced travel
expenses and inconvenience for out-of-town lawyers. That court also set a
new standard for judicial availability, achieved an unprecedented level of
judicial experience and expertise in the handling of large cases, and has
perhaps the best-functioning PACER web site in the country. Unfortunately,
these benefits are far outweighed by the accompanying problems.

The essence of the court competition problem is that
only a few of the many parties interested in the outcome of the case select
the court. To attract cases, the courts must cater to the interests of
those few at the expense of the debtor, the creditors and other interested
parties. Allowing those other parties to participate in case selection is
not practical because so much activity occurs in the first few days of the
bankruptcy case. To achieve a reasonable level of efficiency in the
handling of a big bankruptcy case, the issue of venue must be settled no
later than on the day the case is filed.

The simplest solution would be to amend the
bankruptcy venue statute to require that debtors file in their local
bankruptcy courts—that is, the courts where they have their
headquarters or their principal assets. Such an amendment would not
eliminate all forum shopping because firms could move their headquarters or
assets in the period before filing. Complete elimination of forum shopping
is not, however, necessary to solve the problem. Forum shopping need only
be reduced to a level at which the loss of cases by a court no longer
constitutes a serious threat to the judges of that court. The integrity of
the judges can take care of the rest.

An alternative solution would be to assign three or
four regional courts to handle large bankruptcy cases. The law would
require that all large debtors file their petitions with a single judge,
along with a simple statement of facts relevant to venue. Based on that
statement, the judge would assign the case to the most appropriate of the
regional courts on the same day the case was filed. The advantage of this
solution is that it would permit the development of large-case expertise
among the judges, without forcing them to compete for the cases.<a href="#2" name="2a">2</a>

<hr>
<h4>Footnotes</h4>

<a name="1">1</a> LoPucki,
Lynn M. and Doherty, Joseph W., "Why Are Delaware and New York
Bankruptcy Reorganizations Failing?," 55 Vanderbilt Law Review 1933
(2002). <a href="#1a">Return to article</a>

<a name="2">2</a> Each of the subjects discussed in this statement is also discussed in greater detail in the manuscript of my book, Courting Failure: How Competition for Big Cases is Corrupting Bankruptcy Courts. The book will be published by the University of Michigan Press in January 2005. <a href="#2a">Return to article</a>

Journal Date

Wednesday, September 1, 2004 - 12:00

Bankruptcy Rule

2004