LEGISLATIVE UPDATE

Journal Issue

Apr 2004

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This month's Update features excerpts from the debate at ABI's "25th Anniversary Symposium on the Bankruptcy
Code," held last October in Washington, D.C. Debating the resolution, "The 1978 Code Has Been a Success for
Business Bankruptcy," are Prof. Ralph Brubaker (pro) and Prof. Ken Klee (con). The full text of the debate will be
included in the forthcoming Spring 2004 issue of the ABI Law Review.

Prof. Ralph E. Brubaker: It's an honor to be debating Ken Klee, for whom I have so much admiration and
respect. But I find myself in the odd position today of being the champion of the work product of my antagonist
today. But as one of the people in this room, who shall remain nameless, remarked to me, if nothing else, it will be
so nice to hear Ken Klee admit he was wrong for once. [Laughter].

There's a recent paper from the World Bank that studied the relationship between the use of business bankruptcy
systems of 37 countries and overall economic development. And what they found is that higher levels of usage of a
country's bankruptcy system are strongly associated with a higher GDP per capita and greater efficiency in the
judicial system. And the United States, not surprisingly, has one of the very highest rates of usage of its business
bankruptcy system. The world, in general, considers the U.S. bankruptcy system, and chapter 11 in particular, to be
the standard benchmark for a successful business bankruptcy system and the model for design and reform of their
own business bankruptcy system.

Business bankruptcy under the Bankruptcy Code, of course, is largely synonymous with chapter 11 because nearly
all businesses of any significant size file under chapter 11. I 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. The chapter
11 regime is integral to fostering and facilitating those workouts. In fact, the rise of prepackaged and pre-negotiated
chapter 11s actually produces the phenomenon of creditors preferring chapter 11 over an out-of-court workout, even
with the added cost that chapter 11 brings, precisely because a confirmed chapter 11 plan will bind all creditors.

The cases that don't restructure out of court and end up in a traditional chapter 11 tend to be the "hard cases"—the
cases where the debtors have more complex capital structures, have relatively less bank debt, have a relatively higher
number of smaller creditors, like trade creditors, [or] have relatively more contingent or disputed debt, like tort
debts. The success of chapter 11 in that regard lies in its use by large companies to restructure. And these large
companies nearly always confirm a plan of reorganization or do a sale without a plan.

While we could debate endlessly about various aspects of the chapter 11 system, none of it seems to rise above the
level of details and tinkering. And none of it seems to undermine the proposition that chapter 11 has been an
extremely successful restructuring device. The primary challenges to that proposition have been primarily speed and cost. The argument has
gone [that] it takes way too long to confirm plans in chapter 11 with dire predictions of staggering direct and
indirect costs multiplying as the chapter 11 proceedings drag on. Of course, the only problem with that story is just
that: It's a story.

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[T]he inability to successfully restructure most of these businesses has nothing whatsoever to do with chapter 11 and has everything to do with the fact that they're just not viable businesses. 
—Prof. Ralph Brubaker
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The chapter 11 process for large debtors has become extremely expeditious. It now compares very favorably to the
time to restructure out of court.

One study put the average time to do a non-bankruptcy workout at 15 months. And another study put the average
time to negotiate, file and confirm a prepackaged or pre-negotiated chapter 11 plan at 22 months. Well, for large
chapter 11 cases that have been concluded in the last five years, even when we take out prepacks and pre-negotiated
cases, which are now about 30 percent of all cases, the average time to a sale or confirmation is only 16 months. So
there seems to be very, very little substance to the chapter 11-takes-too-long argument anymore.

The chapter 11-costs-too-much argument also seems overdone. A very recent study by [Lynn] LoPucki shows that
the direct costs of chapter 11 in large cases, on average, are only about two percent of the debtor's assets. So while
popular accounts of chapter 11 have tended to portray it as an incredibly inefficient, incredibly cumbersome,
incredibly expensive restructuring process, on the whole, the direct and indirect costs of restructuring in chapter 11
for large debtors appears to be quite low. Chapter 11 seems to be a very efficient and expeditious restructuring
process for large firms.

Prof. Kenneth N. Klee: Bankruptcy distorts state law entitlements. It distorts the rights of secured creditors. It
penalizes efficient businesses by preserving sick businesses and hampering the competitive nature of our capitalistic
system. In practice, the Bankruptcy Code has been a disappointing failure in practice for most small,
medium-sized, and yes, even large businesses.

I'd like to start with one that is particularly suspect—single-asset real estate cases. For single-asset real estate cases,
chapter 11 is simply an inefficient illusion. [It's] simply an effort to delay the inevitable foreclosure on the property
that the mortgagee bargained for as a matter of state law rights. All bankruptcy does in this regard is interfere with
that bargain and create inefficiencies.

The ability of the mortgagee to foreclose on his or her collateral in an inexpensive and expeditious manner is a key
element of the bargain between the borrower and the lender that determines a market interest rate. Since lenders
never know who's going to go bankrupt, the presence of chapter 11 raises mortgage rates for all of us. This
inefficient intrusion on state law contract rights and remedies underscores the failure of chapter 11 in single-asset
real estate cases.

But beyond that, consider chapter 11 in the context of small-business cases. For most small-business cases, chapter
11 is far too expensive to constitute a meaningful alternative. We know, based on studies, that these small-business
cases comprise over 80 percent of the chapter 11 cases filed. They can barely sustain the costs of paying a debtor's
retainer, much less sustain the administrative costs and professionals. For these small businesses, an out-of-court
workout would be far more attractive. Before federal bankruptcy laws imposed a cumbersome legal apparatus
financed at taxpayer expense, debtors and creditors in fact did work matters out of court through a general
assignment for the benefit of creditors or through a consensual extension or composition agreement. Creditor
representations in small-business cases [are] almost nonexistent because there is no creditors' committee in most of
these cases.

We have a vacuum in these small cases that allows the debtor to run amok. It's forced some judges back into the
process to try to oversee the business and thereby lose their impartiality as dispute resolvers. It's extremely difficult
for debtors in small-business cases to obtain debtor-in-possession financing. The expense fees alone of the
debtor-in-possession financier would be beyond the means of most small-business debtors. If chapter 11 doesn't
work in over 80 percent of the cases, it must be a failure.

Chapter 11 is also something that doesn't work for medium-sized cases. Chapter 11 fails to cure business problems
in medium-sized cases because incompetent management is left in possession. And the cases just wind up
liquidating. That can hardly be said to be a success just because you confirm a chapter 11 plan that provides for
liquidation when chapter 7 was the route Congress prescribed for liquidation to begin with.

That leaves us with the handful of large cases that my opponent used as his sole justification for the benefits of
chapter 11. Chapter 11, though, also does not work for large cases. The cost of chapter 11 is enormous. In Enron,
the professional fees are accruing at $1 million a day. And even if we throw out Enron and some of the super-large
cases as aberrational, and the costs are only two percent of assets, in a $2 billion case, two percent is $20 million.
Taxpayers are subsidizing chapter 11 to the detriment of better-managed solvent companies.

Judges frequently confirm plans for large chapter 11 cases that are unfeasible and result in repeat filings. The rash of
repeat filings, particularly in jurisdictions that race to the bottom to attract chapter 11 business, is a testament to the
failure of chapter 11.

Management continues to extract large, private benefits in the form of retention payer bonuses that are not tied to
performance. The chief restructuring officer comes into these cases and gets huge success fees. Based on what?
Confirmation of a chapter 11 plan, a plan that rehabilitates the business? Oh, no. It could be a plan providing for
the sale of assets. Hello! That's what could happen if we didn't have chapter 11. The race to the bottom by courts to
compete for chapter 11 business is well known. And those within the system defend it. Those outside revile it.

Learned commentators suggest that our free-market system would function more efficiently if the assets of troubled
companies were sold or auctioned rather than tied up in a court-administered chapter 11 process. Even in the absence
of chapter 11, out-of-court workouts would continue to occur. For example, banks, insurance companies and other
debtors that are ineligible to file chapter 11 have been able to accomplish out-of-court restructurings.

Prof. Brubaker: I've always considered the greatest virtue of chapter 11 to be its tremendous flexibility. And
making an auction mandatory seems particularly unnecessary given that asset sales have always been a significant
aspect of large-firm reorganization. Chapter 11 practice has evolved on its own into a means for primarily [the]
expeditious sale of the business of a financially distressed firm in nearly half of the large-firm cases.

Mandatory auctions [have] a big problem in smaller cases, and that is that management would be loathe to ever file
the bankruptcy cases. One of the more prominent sources of indirect costs of financial distress is undue delay in
addressing the financial difficulties, and mandatory auctions would simply exacerbate that particular problem.

With respect to single-asset real estate cases, the function of bankruptcy in a single-asset real estate case is to
facilitate negotiations regarding a restructuring of the debtors' mortgage debt. And the fact that many cases are
ultimately dismissed and do not confirm a plan really tells us nothing about the Code's success in facilitating those
restructuring negotiations. In fact, dismissal is precisely what you would expect once debtor and mortgagee have
struck a deal.

With respect to medium-sized businesses, the inability to successfully restructure most of these businesses has
nothing whatsoever to do with chapter 11 and has everything to do with the fact that they're just not viable
businesses. Chapter 11 can't fix the business that's not viable. So with respect to these cases, chapter 11 essentially
functions as a sorting device. So the best measure of success in these cases is how well it performs that sorting
function, with the primary concern being that allowing nonviable businesses to continue operating too long imposes
all sorts of costs on both the court and creditors.

Journal Date

Thursday, April 1, 2004 - 12:00

Bankruptcy Rule

2004