Empirical data suggests that companies that emerge from chapter 11 are more likely to file for “chapter 22” than those that never filed. In general, companies that emerge from bankruptcy protection never reach their former level of strength and vitality. This article explores the principal reasons for “chapter 22” filings as well as the forces that encourage reorganization as the preferred chapter 11 outcome.
Bankruptcy is the legal action taken by a corporation (or other entity) that is intended to preserve the assets of the entity and therefore maximize the value of the estate. A fundamental component of this process consists of assessing the debtor’s rehabilitation prospects, as compared to other potential outcomes such as a sale of the business or a liquidation of the estate’s assets. The bankruptcy process should therefore provide the required mechanisms to assist stakeholders in identifying the optimal outcome for each case.
Reorganization as a Way to Delay the Inevitable
Some failed companies can be transformed into competitive, stand-alone entities via the chapter 11 reorganization process. Many others cannot, for different reasons, and should be sold or liquidated. However, it can be argued that many of the companies that emerge as stand-alone entities should have seen a different outcome. These companies file for a second time, and they usually destroy value in their failed attempts to rehabilitate.
Let’s look at an example. Geneva Steel, an integrated producer of flat steel products located in Utah, first filed for chapter 11 in February 1999. Geneva stated that one of the main reasons for filing included a dramatic surge in steel imports since mid-1998, which depressed domestic steel prices and severely affected Geneva’s shipment volumes and pricing. Geneva’s competitive advantage, its wide-product capable six-stand rolling mill, was clearly outweighed by its competitive disadvantages: inconvenient location (representing a freight disadvantage as compared to other mills), high percentage of commodity-type, low value-added product mix and an inefficient slab reheating system. Geneva emerged in January 2001 with an Emergency Steel Loan Guarantee (ESLG) facility as a key component of its exit-financing package. Management did not explore any other alternatives (i.e. §363 sale or liquidation) since they strongly believed that reorganization was the most desirable strategy. Only 10 months after emergence, Geneva was forced to shut down its steel-making operations and two months later filed for bankruptcy, citing adverse market conditions. This time the outcome was liquidation.
It could be argued that Geneva should have never emerged as a stand-alone entity from its first chapter 11 proceeding, given its apparent competitive disadvantages, and that it destroyed value (ESLG financing, trade credit, etc.) during its brief rehabilitation process.
Bias Toward Reorganization
Several internal and external forces and interests combine to influence the outcome of bankruptcy proceedings toward stand-alone reorganizations:
- The internal dynamics of the chapter 11 proceeding and the legal remedies available to a debtor strongly encourage the reorganization alternative. The bankruptcy process is designed to protect the business and the employees, while bondholders and shareholders take the hit.
- The management team has a natural interest in seeing the debtor emerge as a going concern with minimal changes to its pre-petition organizational structure as part of their job-preservation instinct. A potential sale of the debtor’s assets creates a great deal of uncertainty for the existing management team, especially in the case of a strategic acquirer, and the likely consequences of a liquidation of the debtor’s assets are evident for management.
- Trade creditors are sometimes more interested in having a customer in the future than to receive an extra dime in recoveries through liquidation or a §363 sale.
- Bondholders usually believe that their recoveries under a standalone reorganization may be higher than in a liquidation scenario or asset-sale scenario.
- Local authorities are sometimes interested in seeing the debtor emerge as a stand-alone business for job-preservation purposes if the debtor is a significant employer in the area. In some cases, state and local authorities will provide economic incentives to support the reorganization process.
- Financial projections prepared by the debtor for the post-emergence entity are usually tainted with management’s optimism and not significantly challenged by creditors and the bankruptcy court, resulting in higher hypothetical recovery values when compared to a sale transaction or an orderly liquidation.
- The liquidation alternative is usually presented as the worst-case scenario. Usually, the creditors don’t want to leave money on the table if there is hope for better recoveries.
This bias has taken and will continue to take a toll on estates that could have generated more value through liquidation or §363 sale processes. Despite a legal system strongly sympathetic to the debtor, some business problems are not fixable simply by going through the bankruptcy process.
The paramount objective should be to maximize the value of the estate. This responsibility is shared by management, creditors, professionals and the bankruptcy court. However, within the dynamics of a chapter 11 process, the qualitative aspects may sometimes override the quantitative analyses, which may lead to a less desirable outcome.
Major Reasons for Chapter 22 Filings
- Internal
- Inadequate capital structure at emergence
- Excessive financial leverage
- Limited financial flexibility
- Lack of sustainable competitive advantage
- Short period in chapter 11 (lack of preparation for emergence)
- Lack of management ability to execute plan of reorganization
- Post-emergence shareholders not interested in the debtor’s long-term viability
- External
- Industry condition (cyclical industries, changing technology)
- Economic environment
- Limited access to capital markets
Are Liquidations/§363 Sales Replacing Reorganization?
There is reason to believe that the U.S. concept that a company has greater value as a going concern in reorganization than in liquidation is under serious attack. Many chapter 11 cases are being converted into §363 sale processes due to several reasons, including increasing access to capital and the legal and economic advantages provided by §363 auctions as compared to out-of-court transactions.
Recent steel bankruptcies represent good examples of this trend. LTV, Bethlehem Steel, Weirton Steel and Rouge Steel all went through §363 transactions even though some of them spent significant time and resources exploring the reorganization alternative. It should be mentioned that the unions played a key role in influencing the outcome of these cases, favoring the deep pockets of potential acquirers over the promises of management teams with eroded credibility.
The growth of capital in distressed-debt markets and the impact of globalization are transforming the traditional relationship between debtors and creditors. In most cases, the outcome of the restructuring process is driven by creditors with objectives other than the debtor’s long-term viability.
Conclusion
An efficient chapter 11 process should help rehabilitate those companies that have a viable business and have a potential for creating value in the long-term and facilitate alternative outcomes (liquidation or §363 sale) for companies that are not likely to be competitive after emergence.
However, several factors contribute to create a bias for companies to reorganize as a stand-alone entity. Some companies use the first chapter 11 only to fix their balance sheet, and not the fundamental business issues that contributed to their decline.
In the future, we may see a decrease in chapter 22 filings, as reorganization is becoming a less popular outcome compared to §363 sales.