The New Face of Chapter 11 Douglas G. Baird∗ This year marks the 25th anniversary of Chapter 11. Before it went into effect, the law governing corporate reorganizations in the United States was largely dysfunctional. Old Chapter X was slow, expensive and unwieldy. Old Chapter XI did not allow for the restructuring of secured debt, and the bench and bar that administered the system were inbred and sometimes corrupt. The Bankruptcy Reform Act set about changing all of this. Now that we have had 25 years of learn- ing, we can ask whether Chapter 11 has lived up to its expectations and what role, if any, it is filling. Boosters of Chapter 11 often talk as if financially troubled and businesses in Chapter 11 were one and the same. Nothing could be further from the truth. More than 500,000 businesses shut their doors each year in the United States. Many more encounter financial dis- tress. Of these, only 10,000 file for Chapter 11. To assess how well Chapter 11 deals with this comparatively small set of distressed businesses, Part I takes a close look at a discrete sample of Chapter 11 filings—all those for calendar 1998 in the Northern District of Illinois. The basic message is a simple one. We have to be realistic about the types of businesses that are using Chapter 11. We have electrical sub- contractors, mom-and-pop restaurants, and retailers with high mark- ups. There are few employees, and turnover of employees in these firms tends to be high. The principal value of preserving such small firms is that it allows their owners to continue to enjoy the psychic benefit of running their own business. The costs fall disproportion- ately on nonadjusting creditors. One can make the case that Chapter ∗ Harry A. Bigelow Distinguished Service Professor, University of Chi- cago Law School. The ideas in this paper and the empirical work that sup- ports them grow out of continuing collaborations with my colleagues Don- ald S. Bernstein, Edward Morrison and Robert Rasmussen, to whom I am most indebted. Lynn LoPucki’s database and commentary on my own work have also been most useful. I also thank Bethany Hollister for research assis- tance, as well as Visa, U.S.A., Inc., Verizon, Microsoft Corporation, the Sarah Scaife Foundation, and the Lynde and Harry Bradley Foundation. 2 / Douglas Baird / 11 does more good than harm in this environment, but the case is not an easy or compelling one. Much of the academic discourse on Chapter 11 has focused on the large businesses that find themselves there. Part II looks at all the large businesses that left Chapter 11 in 2002 and asks what role Chapter 11 is playing. Again, one can make an argument that it is performing a useful role, but the role that it is performing is quite different from the one usually ascribed to it. The traditional account of corporate reorganizations assumes a financially distressed busi- ness faces three conditions simultaneously: (1) It has substantial value as a going concern; (2) its investors cannot sort out the financial distress through ordinary bargaining and instead require Chapter 11’s collective forum; and (3) the business cannot be readily sold in the market as a going concern. Remove any one of these conditions, and the standard account of corporate reorganization law falters. A review of all the large Chapter 11s from 2002 shows than these conditions are rarely found in a financially distressed business today. It is even less likely that all three of them will exist at the same time. Chapter 11 performs a number of useful functions, such as a collec- tive action problem that arises by virtue of the Trust Indenture Act of 1940, but whether other benefits exist, ones that transcend the pecu- liar legal culture of the United States, is open to considerable doubt. Many academic accounts of Chapter 11 begin with the observation that, in practice, reorganization plans appear to depart from absolute priority. Part III of the paper shows that much of this debate has failed to ask basic questions about how such departures might come about. The departures from absolute priority that we see in plans of reorganization are, to a much greater extent that commonly appreci- ated, completely consistent with a legal regime in which judges me- ticulously adhere to the principle of absolute priority. I present a simple model that captures the essential features of the bargaining context in which many modern business reorganizations are negoti- ated. That model shows how, even where absolute priority is relig- iously enforced, relative priority plans emerge naturally when ra- tional actors negotiate in a world of uncertain asset values.1 1The basic intuition underlying this model was first set out in Donald S. Bernstein, Presentation to the American College of Bankruptcy Lawyers, New Face of Chapter 11 / 3 Part IV concludes with a few observations about the general les- sons other legal systems might take from the quarter-century ex- periment in the United States. The United States has a legal system that must contend with the problem of dual sovereignty. State law governs the creation of corporations, but the law of corporate reor- ganizations is federal. The complications of dual sovereignty do much to explain the value that Chapter 11 does contribute in the United States, but precisely for this reason one must question its use- fulness in a legal culture that is not similarly burdened. I. Small Chapter 11s While the number of large businesses filing for Chapter 11 has in- creased, the total number of Chapter 11s is only half what it was 20 years ago. Understanding the dynamics of small Chapter 11 cases (and these are the overwhelming majority of Chapter 11s) requires in the first instance asking how the businesses in financial distress that file for Chapter 11 are different from those that do not. A close look at the filings in one bankruptcy court allows us to gain some purchase on the dynamics of these small cases.2 In the Northern District of Illinois’s Eastern Division, 99 businesses filed for Chapter 11 in 1999. Some (but no more than one in three) are qualita- tively similar to the large Chapter 11 cases that I discuss below in Part II. A restaurant/microbrewery is sold as a going concern, as is a chain of Mrs. Field’s cookie franchises and a hotel. Senior lenders use Chapter 11 to sort out the problems of two subprime consumer fi- nance companies. A carpet retailer with several stores shuts down. A manufacturer of furnace linings sorts out its asbestos liabilities in Chapter 11. The central characteristic of these cases is that the busi- ness and the corporate entity largely overlap. At first approximation, someone who buys a controlling interest in the stock owns the busi- ness. A cattle feed manufacturer does business in corporate form. If I Washington, D.C. (Mar. 28, 2003). This model is set out in greater detail in Douglas G. Baird & Donald S. Bernstein, Relative Priority in an Absolute Priority World (February 2004). 2 This database was first used by Edward Morrison to examine how bankruptcy judges made shutdown decisions. See Edward R. Morrison, Bankruptcy Decision-Making: An Empirical Study of Small Business Bank- ruptcies (dissertation, University of Chicago, August 2003). 4 / Douglas Baird / buy a controlling interest in the equity of the corporation, I become the owner of this business. I acquire not merely the hard assets, but the economic benefits that flow from the many contracts of the busi- ness and the many relationships it has developed over the years. These range from the loyal customers to the dependable suppliers, as well as all of the intellectual property, from the patents to the busi- ness methods that are embedded in the day-to-day habits of supervi- sors that are passed down informally from one generation to the next. But these cases are only a minority of the operating businesses that file for Chapter 11. As businesses become smaller, less of it cen- ters on the corporate entity. Instead the affairs of the business revolve around its owner-manager. In the largest of these, the business and the owner-manager can still be distinguished from each other. We find an entrepreneur who built a business, such as a chain of jewelry stores or a contractor who specializes in ornamental plaster work, with a solid track record. The business has an identity distinct from the owner-manager. The owner-manager could turn over the reins to someone else and the business, while not the same, might still con- tinue. The business lands in Chapter 11 even though there is a core that may be sound. The jeweler overestimates his ability to expand. He opens new stores that fail, and the remaining ones are not profitable enough to cover the losses. The contractor’s estimate for renovating the concert hall of the Chicago Symphony Orchestra is off by $600,000. Notwithstanding these reverses, there is still synergy among the assets. The businesses have well-established reputations, trained staffs, and successful business plans. Unlike the large busi- nesses, however, a going-concern sale is less attractive.3 They need to scale back, and, as they scale back, the business increasingly turns on the owner-manager. These businesses that lie just at the fringe of where a going- concern sale is possible can be most comfortably reconciled with tra- ditional accounts of corporate reorganizations. Notwithstanding the 3 The nonbankruptcy sales of these businesses typically include promises from the old owner-manager to aid in the transition, as well as covenants not to compete. New Face of Chapter 11 / 5 reverses it has suffered, there is a core business that may survive if its current owner-manager remains in place. These businesses, however, are a distinct minority of those in Chapter 11. They constitute per- haps only one in ten. Even this overstates matters. In some cases, the Chapter 11 is precipitated not by a need to sort out a financial mess with multiple creditors, but rather to alter the dynamics of negotia- tions with a single creditor. In one case, for example, the Chapter 11 filing came minutes before a former waitress at a successful steak- house was about to begin her sexual harassment suit in District Court. The Chapter 11 was entirely consumed with negotiating an end to this suit, as well as a racial discrimination action one of the cooks brought. In other cases, the dispute is with a single landlord. The negotiations that take place in Chapter 11 could take place else- where. These two types of cases—the larger business that can be sold as a going concern and the substantial business with crucial owner- manager—are not, however, what we usually encounter in the typi- cal Chapter 11. Instead, Chapter 11 most often involves much simpler businesses. The typical business has less (often far less) than $100,000 in assets and only one or two employees (if any). We have a com- puter consultant who happens to be doing business in corporate form. There are no employees. The business is run out of a home.4 The assets consist of a telephone and a personal computer. The busi- ness has little connection with the corporate entity. The relationships belong to the individual. If you were happy with the work per- formed last year and wanted to use the consultant again, you would be indifferent to the existence of the corporation. You might reengage the consultant without ever knowing that she was doing business in corporate form or that the corporate form she is using this year was different from the one she used last year. The business’s intangible assets reside in expertise that the individual possesses. Creditors have no way of reaching it.5 4 Sixty percent of businesses without employees beyond the owner- manager are run out of homes. In construction, the figure is 77.5%. Small Business Characteristics, Table 5.7 5 The corporate form does little more than partition assets. The creditors of the corporation cannot reach the home or the personal bank account of the consultant. On the other hand, these same creditors know that if the 6 / Douglas Baird / For such businesses, the financial failure of the corporation has virtually no effect on the future of the business. The consultant con- tinues to land new jobs. Garden-variety creditors of the corporation have no recourse against her. New customers have no connection with the old corporation. Its failure, of course, may provide informa- tion about the ability of the consultant going forward, but the sur- vival of the corporate entity or the fate of anyone who dealt with it is a matter of no consequence to new customers. The complete separation between the business and the corpora- tion explains why so few corporations that encounter financial dis- tress file for Chapter 11. The consultant needs to sort out the affairs of the corporation, but she does not need the corporation to continue her consulting businesses. When the business has no assets, it may be easier to start with a clean slate. What is true for the consultant ap- plies equally to slightly larger businesses. The same group of psy- chologists can reincorporate, rent new offices, and continue to see the same patients. The creditors will realize the futility of trying to real- ize anything from several pieces of used furniture or the patients who have not paid the bills they owe to the old corporation. A substantial number of the businesses in Chapter 11 are those of travel and insurance agents, lawyers, chiropractors, undertakers, liv- ery drivers, and other self-employed individuals whose businesses require few assets beyond a car, a desk, and a cell phone. Another substantial group are building contractors. The dry wall contractor, the plumber, the painter, and the electrician often work out of their home. They are likely to hire workers for particular jobs. Beyond a small office staff, they have no permanent employees. The assets they need to do their work again cost just a few thousand dollars. Most of the businesses in Chapter 11 file schedules that list assets worth less than $100,000. Moreover, asset values on the schedules are often inflated. They include uncollectable accounts receivable. Equipment is listed at book value. Assets include security deposits even when they are less than the rent arrearages. Lawsuits are valued corporation has an account receivable, they will be able to reach it before either the consultant or the painter or any of their own creditors. See Henry Hansmann & Reiner Kraakman, The Essential Role of Organizational Law, 110 Yale L.J. 387 (2000). New Face of Chapter 11 / 7 at the amount set out in the prayer for relief. In addition, the owner- manager does not need all the assets to continue working. An exca- vator whose corporation owns heavy earth-moving equipment can start another business and rent the equipment. The seller of plastic parts can lose the equipment but continue to do business by subcon- tracting out the actual fabrication. Most of the corporations that file Chapter 11 petitions are “human capital firms.” The “firm” and the person running it are indistin- guishable. The nexus of relationships and the organization of pro- duction revolve around the owner-manager. The travel agent will continue to be a travel agent and the electrician will continue to be an electrician. They will have the same business opportunities and em- ploy the same people, regardless of what happens to the corporation in Chapter 11. For many small businesses, Chapter 11 has only a modest effect on the ability of its owner to continue running the same kind of busi- ness. She continues doing the same thing regardless of what happens in the Chapter 11, employing the same people and servicing the same customers. The data from the Northern District illustrate this point. Of those cases in which the Chapter 11 petition is dismissed or con- verted, the owner-manager continues running the same or related business in at least 40% of the cases. More precisely, in more than 40% of the cases the old owners start a new corporation, continue to run another corporation they already owned, or, notwithstanding the conversion or dismissal, strike some kind of deal with their creditors that allows them to remain with their existing business. Not included are those who remain entrepreneurs, but run sole proprietorships or incorporate outside of Illinois. Nor does it take account of those who are unable to run a business for reasons unrelated to the bankruptcy. (At least one of the owners in the sample was put in prison.) Nor does it include those who start a new business in an unrelated field. Nor does it include the half dozen or so who had failed in numerous other businesses in the field and had previous encounters with Chap- ter 11. Even when the business is a restaurant and relatively capital intensive, more than a third still run their own restaurants shortly after their unsuccessful use of Chapter 11. From this vantage point, Chapter 11 is not so much about saving businesses as it is about enabling a handful of the millions of self- employed to sort out their finances. In 80% of all Chapter 11s, the 8 / Douglas Baird / owner-manager has guaranteed a loan from its institutional lender or has become personally liable for unpaid taxes. Both these obligations prevent the owner-manager from just walking away from the old business before starting a new one. Chapter 11 buys time, even if the case is ultimately dismissed. The owner-manager gains two or three months during which she can hang on to her existing office and try to preserve the status quo while identifying other options. More im- portantly, Chapter 11 creates an environment in which creditors— particularly the IRS and other tax authorities—are willing to com- promise their claims. The cost of providing this benefit falls largely upon the trade creditors and small-time landlords. The filing of the petition cuts off trade creditors from the business’s income stream and the automatic stay prevents landlords from reentering the premises. In contrast to tax authorities and institutional lenders, they lack the personal re- course against the owner-manager. Hence, their negotiating positions in Chapter 11 are weak. In short, when we look at Chapter 11s as a group, we see little that fits the conventional stereotype of a process that allows viable busi- nesses to survive as stand-alone entities. In the case of the largest businesses, sales of the entire business are common. The overwhelm- ing majority of the remaining cases involve self-employed individu- als who can remain self-employed regardless of what happens in Chapter 11. The justification for Chapter 11 in these cases must come from the value we attach to making their paths somewhat easier. These benefits, however, are sufficiently modest that any justification of Chapter 11 must also take account of its costs. The costs of Chapter 11 are smallest when those who use it emerge and continue as viable businesses. In the Northern District, four in ten businesses emerge from Chapter 11 as operating busi- nesses. Most emerge intact under a traditional plan of reorganization. The rest are sold as going concerns or were dismissed after the debtor settled all of its outstanding disputes with creditors.6 A third 6 This success rate seems high relative to most estimates, but it is hard to tell whether the experience in the Northern District is typical. Unfortu- nately, other empirical studies of Chapter 11 do not focus on this question. They generally do not distinguish operating business in corporate form that New Face of Chapter 11 / 9 of these businesses did spend more than a year in Chapter 11. But the time these businesses spend in Chapter 11 is not itself problematic. Sometimes, all that is at issue is the formal closing of the Chapter 11 case, a bookkeeping entry of little consequence. The length of the proceeding does not matter if the sale of the business to a third party takes place quickly and the remainder is spent sorting out who gets what. Little may be at stake even when the old owner-manager is staying in place. The businesses themselves require neither new in- vestment nor change of strategic direction. The travel agent or the Subway sandwich shop continues to do business as usual. When we examine the 60% of the remaining businesses, the ones that do not emerge successfully, most striking is the speed with which these cases are dismissed. More than half the time, the bank- ruptcy judge dismisses the case or converts it to Chapter 7 within three months of the filing of the petition. More than three-quarters are dismissed or converted within 5 months. We do not see the own- ers of small businesses in hopeless condition use Chapter 11 to drag out the inevitable for very long. The creditors and the United States Trustee control the process.7 The failed businesses that last the long- est are usually the ones where there is the most uncertainty about the debtor’s prospects. In some cases, the bankruptcy judge takes longer to act because active criminal fraud on the part of the debtor makes the business’s true state harder to discern.8 The benchmark by which to judge the bankruptcy system is small cases is not the sheer number of businesses saved, but their ability to enter Chapter 11 and those that were never operating businesses (such as single-asset real estate cases) or are cases of individuals. Moreover, they do not differentiate between reorganizations in which the business continues in operation and those in which the plan calls for its piecemeal liquidation. Going-concern sales are sometimes scored as liquidations. 7 The bankruptcy judge will not act unless a motion is put before her. The timing of the motion is up to the creditors. Some dismissals come later than otherwise only because the creditors are content to continue negotia- tions with the debtor in Chapter 11, rather than elsewhere. 8 For example, the owner-managers conceals a $5 million liability to make the business appear sound when it is not. Until the fraud is discov- ered, the business cannot be distinguished from the ones that are viable. When such mischief is discovered, a trustee is appointed within days. 10 / Douglas Baird / sort effectively and quickly. Most important is identifying those cases in which the debtor is only playing for time. The evidence from the Northern District suggests that bankruptcy judges can do this job ex- ceedingly well. Indeed, the data are consistent with the conjecture that bankruptcy judges perform this job as well as a market actor subject to the same constraints.9 The bankruptcy judges seem to rely on several rules of thumb that are good proxies for businesses that can continue as going concerns. These include:10 1. The 13 O’Clock Rule. When a clock strikes thirteen, you know both that the clock is broken and that you have to doubt any- thing it has told you before. Judges are likely to dismiss or convert if those running the debtor firm have made any mis- representation to the court or have violated a court order, par- ticularly with respect to cash collateral. What matters is not only the seriousness of the violation, but that other misdeeds, as yet undiscovered, may exist as well. 2. The Cash-flow Rule. The judge does not regularly receive regular financials from firms in Chapter 11, but she will receive state- ments that show how much cash has come into the business and how much has left. A business that remains cash-flow negative for more than a few months is not likely to make it. 3. The Two-Strikes-and-You’re-Out Rule. A debtor in bankruptcy must cut square corners. If it fails to file a schedule, miss a §341 meeting, or fail to pay a fee, the United States Trustee will move for conversion or dismissal. The judge will forgive a single misstep if the debtor’s owner-manager quickly appears in court and is sufficiently repentant. But the debtor will not get a second chance. 4. The Meet-Your-Own-Goals Rule. At the status conference, the debtor will often put forward the goals that it expects to meet (e.g., a new investor will be found by a particular date). If this goal is not met and major players oppose the debtor’s effort to 9 Morrison was the first to put forward this conjecture. Morrison’s sub- sequent test of his conjecture and the statistical techniques he develops along the way (including the use of cure models) represent the state of the art in empirical bankruptcy research. See Morrison, supra note •. 10 The use of such proxies (or “heuristics”) is a standard part of expert decisionmaking. See Gerd Gigerenzer, Peter M. Todd, et al., Simple Heuris- tics That Make Us Smart (Oxford 1999). New Face of Chapter 11 / 11 push it back, the bankruptcy judge sees the failure as a red flag, a sign that the firm is not on the path to being reorgan- ized effectively. Anecdotal evidence from other bankruptcy courts suggests one addi- tional heuristic may also be at work: The Company-You-Keep Rule. Bankruptcy judges may take their cue from the identity of the debtor’s lawyer. When lawyers appear frequently before the same court, they develop reputations. Some may be inclined to take on cases that have no merit. If the Northern District is at all representative, the modern bank- ruutcy judge is, in the first instance, a triage officer. The modern bankruptcy bench has no desire to see debtors who are merely trying to put off the inevitable. Bankruptcy judges show little tolerance for losers once identified. The current system, as practiced in the North- ern District, does leave some room for those who cannot successfully reorganize to remain under the radar screen for a short period of time. The bankruptcy judge can do nothing until a motion is brought before her. She can enjoin known recidivists from refiling, but little more. In most cases, a debtor can file a frivolous Chapter 11 petition, and it will take some time for the creditor or the United States trustee to find out about it, file a motion, properly notice the parties, and ap- pear in court. In the absence of some emergency, the process takes several weeks. Pushing such cases through the system more quickly would itself require additional oversight. It is not at all obvious whether the benefits from accelerating the process would be worth the costs. Academic discussions of small Chapter 11s have focused on its low success rate and the opportunities it offers for delay. In fact, the number of businesses that reorganize successfully today is signifi- cantly higher than commonly supposed. Among other things, stan- dard estimates omit going-concern sales and successful negotiations in which businesses emerge intact without confirmed plans. More- over, the ability of debtors to use Chapter 11 to stall is often over- stated. They can remain under the bankruptcy judge’s radar screen for a few weeks or months, but not longer. What is missing in the current debate is a more direct focus on the benefits Chapter 11 is providing in the typical case. In the over- whelming majority of cases in which there is not an asset sale, Chap- ter 11 is not about saving businesses or preserving jobs. The typical 12 / Douglas Baird / Chapter 11 makes it marginally easier for a small fraction of the self- employed (10,000 of the six million in the United States) to remain self-employed after their business defaults on loans they have per- sonally guaranteed or their business fails to pay taxes for which they are personally liable. Again, the question is not whether they will remain self-employed, but how easy it will be for them to do so. The person who runs the small trucking business or the boat repair shop will likely continue running these businesses with or without Chap- ter 11. While the vast majority of Chapter 11 cases are these small cases, most of the action is in the larger cases. Most of the assets (and most of the lawyers) can be found in a handful of cases. We turn to these in the next part. II. The Large Corporate Chapter 11 Today In December 2002, the bankruptcy court in Delaware confirmed Global Crossing’s plan of reorganization. One of the largest corpora- tions ever to go through Chapter 11, Global Crossing is emblematic of Chapter 11’s past and its future. Global Crossing was formed in 1997 to close one of the last gaps in the Internet. The telecommunica- tions cables connecting the continents were too small to accommo- date the expected growth in Internet use outside of North America. In 1997, those outside North America accounted for only 20% Inter- net use. By 2000, they would account for almost half. To take advantage of this change, Global Crossing laid a trans- Atlantic cable within 10 months and embarked on ambitious plans to create a global fiber network. It reached $1 billion in revenues within its first 20 months. Global Crossing continued to invest billions in creating the first network of fiber optic cable across the world’s oceans. Global Crossing was to be a major player in the Digital Age, and its market capitalization soon exceeded that of General Motors. Global Crossing’s fall, however, was as swift as its rise. Competi- tors appeared. Internet traffic grew, but it doubled only every year, not every hundred days as some had predicted. Moreover, techno- logical innovation allowed much more information to be carried over the same cable. As a result, there was massive overcapacity. Global Crossing’s revenue barely paid its ongoing expenses. Its stock price collapsed as people quickly came to see that Global Crossing would never make back the billions it spent building its fiber optic network. New Face of Chapter 11 / 13 Fiber optic cable was to the 1990s what iron rails and wooden ties were to the 1880s. A promising technology in a heavily regulated en- vironment will bring people together as never before. An entrepre- neur makes the enormous capital investment the technology re- quires, but demand falls far short of expectations. A visionary busi- ness that attracted capital from all over the world and that employs thousands cannot generate the funds needed to pay its creditors. Games are played with the business’s finances to hide this reality for a time, but the truth is discovered soon enough. At this point, we have to make the best of a bad situation. While we investigate the financial frauds and those who perpetrated them, we have to accept that the railroad has been built and the fiber optic cable has been laid. We need to sort through the financial mess and still ensure these assets are put to their best use. The equity receiver- ship allowed 19th Century investors to take control of the business, throw out bad managers, and agree upon a new capital structure consistent with the less-than-expected revenue of the railroad going forward. Chapter 11 provides a similar forum today. From this per- spective, Global Crossing is merely old wine in a new bottle. The technology is different, but the legal challenge is the same. Closer examination, however, reveals fundamental differences be- tween 19th Century railroads on the one hand and Global Crossing and the many casualties of the dot.com era on the other. The rail- roads had to raise capital in bits and pieces. No one source of capital was large enough to build the entire project. Dozens of different types of bonds were secured by different parts of the road. Bond- holders were scattered in New York, London, and Amsterdam. Creditors could not work together to hold a single foreclosure sale. Even if they could, no one buyer would be able to muster the re- sources to bid. The equity receivership allowed diverse investors to coordinate their efforts and confront the special challenges of restructuring in a world with poorly developed capital markets. It developed an elabo- rate mechanism that mimicked a market sale. Old investors ex- changed their old bonds for bonds in the reorganized railroad that 14 / Douglas Baird / were, in principle, worth their share of what they would have re- ceived if the railroad could have been sold for cash.11 Today creditors of insolvent businesses—even those as large as Global Crossing—no longer need a substitute for a market sale. In- stead of providing a substitute for a market sale, Chapter 11 now serves as the forum where such sales are conducted. In the equity receivership, judges protected minority investors when valuations could not be set in the market. To carry out this task, they developed the absolute priority rule. In modern Chapter 11, the judge ensures that sale is conducted in a way that brings the highest price. The emerging case law focuses on lock-up agreements and bust-up fees. In what has become a common pattern in large Chapter 11 reor- ganizations, Global Crossing filed its petition with new buyers al- ready tentatively lined up. In return for $750 million, Singapore Technologies and Hutchison Whampoa would acquire 78% of the equity of the new company. Old creditors would receive the cash and new (and dramatically reduced) debt as well as a minority equity stake. The old equityholders would be wiped out. The job of the bankruptcy judge was to ensure that this deal was in the creditors’ interest. Some creditors objected to this deal and alleged that there were undisclosed connections between the buyer and members of Global Crossing’s board. Other bidders also appeared. At this point, the creditors hoped to be the beneficiaries of a bid- ding war. Global Crossing’s financial condition, however, turned out to be worse than expected. Other bidders retreated, and Singapore and Whampoa took their first offer off the table. Negotiations con- tinued, and after 11 months, Global Crossing reached a new deal with them. Before this deal could be consummated, however, regula- tors balked at allowing a Chinese company to own an important piece of the United States’ technological infrastructure. At the same 11An excellent account of the equity receivership can be found in David A. Skeel, Jr., Debt’s Dominion 48-69 (2001). Robert Rasmussen and I have also offered an account. See Douglas G. Baird & Robert K. Rasmussen, Boyd’s Legacy and Blackstone’s Ghost, 1999 Sup. Ct. Rev. 393, 397-408; Douglas G. Baird & Robert K. Rasmussen, Control Rights, Priority Rights, and the Conceptual Foundations of Corporate Reorganizations, 87 Va. L. Rev. 921, 925-36 (2001). New Face of Chapter 11 / 15 time, Carl Icahn launched a competing bid for the assets. Filing a Chapter 11 petition puts the business in play, and Global Crossing was no exception. In the equity receivership, no actual sale could take place, but as Global Crossing suggests, sales are now part of the warp and woof of Chapter 11 practice. Of the 10 largest Chapter 11s of 2002, eight used the bankruptcy court as a way of selling their assets to the highest bidder, whether piecemeal or as a going concern.12 As with Global Crossing, most of the sales were in the works before the Chapter 11 petition was filed. Budget’s negotiations with Avis were public a month before it filed its petition, and Avis entered into a formal agreement to buy it several weeks later. McLeodUSA’s prenegotiated plan included selling 58% of the equity and control of the business to Forstmann Little. Exodus Communications entered Chapter 11 after its efforts to find a buyer outside had failed. Within weeks, it reached a deal with Cable & Wireless, a buyer whom it had courted unsuc- cessfully several months before it filed. Chapter 11 allows for piecemeal sales when they bring the highest returns. Early on, Global Crossing’s huge operating losses gave rise to speculation that the creditors might shut it down and sell it in pieces. In some cases, liquidation is contemplated from the start. Comdisco reached an agreement to sell one of its principal busi- nesses to Hewlett Packard for $610 million before filing for bank- ruptcy. As has become commonplace, the bankruptcy judge insisted that others have the chance to bid. An auction ensued and this divi- sion was ultimately sold for $835 million to another buyer within several months of the petition. Comdisco then proceeded to find buyers for the rest of its assets. Formed in 1997, UniCapital acquired equipment leases and re- packaged them for sale to banks. It raised $532 million in an initial public offering. But it too was done in by the collapse of the tele- communications sector. Most of its assets were sold and what was not sold was put into a limited liability company that became a wholly owned subsidiary of its principal secured lender. UniCapital 12Global Crossing, Comdisco, XO Communications, McLeodUSA, Budget, Unicapital, Exodus, and Iridium. 16 / Douglas Baird / had roughly 500 employees at the time it filed, but only eight by the time it was over. Iridium was a system of low-earth satellites. Built at a cost of bil- lions, millions were needed each month to maintain them in low earth orbit. Its operating losses were so large that the creditors faced the choice of selling the satellites for less than 1% of what it cost to put them in orbit or firing their retrorockets and burning them up in the atmosphere. Of the large publicly traded firms that exited Chapter 11 in 2002,13 the assets of more than half were sold in Chapter 11 or were trans- ferred to a new owner under the plan of reorganization. In some cases, the sales are more or less completed before the fact and the Chapter 11 merely insures that no one else will bid more (Birming- ham Steel). In other cases, the bankruptcy judge conducts an auction in open court. Warren Buffet acquired Fruit of the Loom in this fash- ion. The sale may involve more elaborate negotiations. Sterling Chemical sells half its assets in Chapter 11 and a third party investor acquires control of what is left under a plan of reorganization. In other instances, a going-concern sale is not possible. After its busi- ness plan fails, WebVan enters Chapter 11 in order to allow an or- derly sale of its assets. If we take a snapshot of the business before and after the Chapter 11, we would not be able to tell whether there has been a Chapter 11 or a traditional corporate control transaction. The business may now be folded into another. Even if it is not, the old shareholders are gone as are the old managers and the old board. New managers run a business whose operations have been streamlined and whose work- force has been reduced. The process itself resembles the takeover bat- tles we see elsewhere. Corporate raiders square off against each other in a bidding war, while the board’s independent directors pay careful heed to their Revlon duties. The lawyers shuttle between their offices in New York and a courtroom in Wilmington. Chapter 11 has 13 The data here is taken from Lynn LoPucki’s Bankruptcy Research Da- tabase. Following LoPucki’s convention, a large Chapter 11 is a publicly traded corporation that reports more than $100 million in assets in 1980 dol- lars. For a more detailed account, see Douglas G. Baird & Robert K. Rasmus- sen, Chapter 11 at Twilight, 56 Stan. L. Rev. 673 (2003). New Face of Chapter 11 / 17 morphed into a branch of the law governing mergers and acquisi- tions. There continue to be some Chapter 11 cases in which the sale of the business is never in prospect. In these cases, the embers of the equity receivership still burn. Here again, however, the differences between the equity receivership and modern Chapter 11 are enor- mous. The railroads possessed primitive capital structures. When the Atchison, Topeka, and Santa Fe entered receivership, there were 43 different types of bonds. By contrast, corporations today have far simpler capital structures. Their form is the product of deliberate de- sign. Global Crossing’s capital structure was structured so that it had to return repeatedly to capital markets. A bank group held much of the senior debt and was well-positioned to monitor the business and negotiate with it as its condition deteriorated. The elaborate committee structure of the equity receivership pro- vided investors with a way to communicate with each other that did not exist elsewhere. The ability of creditors to control their debtor and negotiate with each other outside of Chapter 11 is now vastly greater than it was during the equity receivership—or even in Chap- ter 11 just 20 years ago. Often Chapter 11 is needed only to put in place a plan that the key players negotiated before the petition was filed. After Global Crossing, NTL was the largest Chapter 11 that wrapped up in 2002. Most of its creditors agreed on a plan of reor- ganization before the petition was filed. The judge confirmed this plan, with only minor modifications, a few months later. Ninety per- cent of Williams Communications’s bondholders signed on to a pre- negotiated plan before its petition was filed. Of the large businesses whose assets are not sold in Chapter 11, more than half enter Chapter 11 with a prenegotiated plan.14 The judge usually confirms it within several months after only minor modifications.15 These modifications typically are made to appease 14 Again, the figures provided here are from Lynn LoPucki’s database. 15 Of the 25 large businesses that entered with a prepackaged or prenego- tiated plan, the median time was 140 days, and only three took more than 300 days. Of the twenty-two that emerged and entered without a plan, only 4 took less than 300 days and the average was over 400. 18 / Douglas Baird / those junior creditors able to make nonfrivolous (if only barely non- frivolous) claims that the senior lenders are not properly secured or that the business’s assets are worth more than anyone is willing to pay for them. When the financial affairs of the business are murky, confirming the prenegotiated plan may take time. Sunbeam had to contend with a financial mess left in the wake of Al Dunlop’s catastrophic man- agement of the business. From the start, the senior bank group was in control and sought to implement a plan of reorganization in which it received all the equity of the business while the subordinated note- holders and the general creditors were wiped out. Sorting out the finances, regulatory issues with the S.E.C., and lawsuits with ac- countants, insurers, and Dunlop, however, took time. The messy financials gave the subordinated debenture holders some small leverage, which they ultimately converted (through bar- gaining) into 1.5% of the equity of the business. The dynamic of out- of-the-money junior investors gaining concessions because of their power to raise objections in the bankruptcy court is one that we have seen in corporate reorganizations since the time of the equity receiv- ership. But this power is dramatically smaller. The senior lenders are in control of the process. Junior creditors now receive less than what equityholders used to receive. In any event, the time Sunbeam spent having its prenegotiated plan confirmed (almost two years) was more than twice as long as any other large debtor with a prenegotiated plan in 2002. Typical is the six months Guilford Mills spent confirming its prenegotiated plan. In many cases, it does not even take that long to confirm the plan. Chiquita Brands was in and out of Chapter 11 in 100 days; McLeod, a telecommunications giant with thousands of employees and almost $2 billion a year in sales, in only 64. In looking at the large Chapter 11s of 2002, there is one other strik- ing contrast between these businesses and the railroads reorganized in the 19th Century. The railroads generated substantial operating profits. Value would be lost if the railroad did not stay intact. The value of keeping the business intact is far less obvious with busi- nesses in Chapter 11 today. To be sure, WebVan’s customized ware- houses, Iridium’s satellite system, and Global Crossing’s fiber optic cables, have relatively little value if broken up piecemeal. But they may not have much value kept together either. New Face of Chapter 11 / 19 WebVan’s business had no value as a going concern. Its business model could not generate any revenue given the tiny margins in the industry and the competition from conventional grocery stores, WalMart, and other on-line grocery businesses. Iridium’s market niche was very small in a world in which it could not compete in price or reliability with ordinary cell phone subscribers in most mar- kets. Its potential market was largely limited to workers on ocean oil drilling rigs, employees of the Central Intelligence Agency, and oth- ers with similarly specialized needs. Even in Global Crossing, the value of keeping the assets together has not always been self-evident. Global Crossing has to compete in a market in which one can create networks through contract. As long as these contracting costs are low, Global’s ability to offer direct connections between Tokyo and London may not be worth much. A pulse of light can be transferred between multiple carriers much more easily than rail freight. The value of what is being preserved by keeping the business intact is much smaller than in the case of railroads. The difference between the receivership and the large businesses in reorganization today is even more manifest in other large busi- nesses in Chapter 11. Outside the telecommunications sector, they often lack large infrastructure investments. Some, such as Chiquita Brands and NTL, are holding companies. Their operating subsidiar- ies were not in Chapter 11. Chapter 11 provides a relatively cheap way to put a new capital structure in place, but the value being pre- served is only that of the holding company. The worst thing that would happen in the absence of a reorganization would be for the equity of the operating companies to be spread among diverse credi- tors. In many other large Chapter 11s, particularly those in which there was neither a prenegotiated plan nor an asset sale, the corporation is a collection of discrete businesses, such as movie theaters (Carmike Cinema), nursing homes (Sun HeathCare, Carematrix, and Mariner Post-Acute Network), or hotels (Lodgian). What is at risk is the syn- ergy gained from putting these different discrete businesses under one umbrella. This synergy itself, however, is often of recent vintage. The business itself was formed through the same highly leveraged acquisitions that precipitated the financial distress and the need to reorganize. Unlike a railroad, the synergy that these businesses pos- sess is intangible and often quite small. 20 / Douglas Baird / Lodgian exploits the synergies that exist when one company runs a Holiday Inn in Mertle Beach, a Hilton in Fort Wayne, and a Radis- son in Phoenix. Independent of Lodgian, each enjoys the services various franchisors provide, including national reservation systems and marketing and advertising programs. Lodgian does have some- thing to offer the hotels in addition to what their various franchisors provide. Lodgian can enter into single contracts with food, telephone and software vendors. It can provide centralized accounting, tax, and payroll services. It can help train employees. But the individual ho- tels are separate corporations that stand on their own. A creditor of Lodgian can foreclose on the equity Lodgian holds in the corporation that runs the Holiday Inn in Richfield, Ohio, and the Holiday Inn still remains a Holiday Inn employing the same people and serving the same community.16 When we ask what value Lodgian has that Chapter 11 might pre- serve, we have to identify the value of the business over and above the value of the underlying assets. The hotels employ 5,000 people and generate $400 million of revenue a year, but they are not the lo- cus of Lodgian’s value as a going concern. Lodgian proper is a busi- ness employing the 118 people in Atlanta who oversee a portfolio of 97 hotels. Sun HealthCare tells a similar story. It acquired a number of nurs- ing homes and put them under its management. Each nursing facility can stand on its own or, if cut loose from Sun HealthCare, join an- other. Sun HealthCare takes advantage of the economies of scale that exist from owning multiple homes. Like Lodgian, its problems arose from its aggressive acquisitions in the late 1990s. Its debts were re- structured as it encountered financial distress. A group of senior lenders now had a security interest in all its assets. They agreed on a plan of reorganization before the petition was filed, but the plan fell apart when the valuations on which the restructuring was premised proved inaccurate. Creditors argued that the guarantees subsidiaries had given the senior lenders were not supported by reasonably equivalent value and were therefore suspect. In the end, the senior 16 As part of its reorganization plan, Lodgian cast over several hotel properties, including its Holiday Inn in Richfield in Ohio. It remains a Holi- day Inn. New Face of Chapter 11 / 21 lenders settled on a plan that gave them 90% of the common stock of the business as well as 8 of 9 seats on the board. The ninth seat was the CEO who was hired by representatives of the secured creditors during the Chapter 11. Of all the large cases that concluded in 2002, the one most resem- bling the traditional Chapter 11 was that of Pillowtex, the manufac- turer of Cannon and Royal Velvet towels and Fieldcrest sheets and pillows. It cost millions to build the factories, hire thousands of em- ployees, and create all the relationships that made Pillowtex’s busi- ness work, but these have no value as a going concern in a world in which the towels, pillows, and sheets can be made under the same labels for less off shore. The Chapter 11 from which Pillowtex emerged in 2002 only postponed the inevitable. It filed for Chapter 11 again in July 2003, and its factories were closed and it remaining as- sets sold off piecemeal.17 Some features of the traditional corporate reorganization are still in evidence. The substantive changes in the rights of real property lessees from the nonbankruptcy baseline are a major component of a number of large Chapter 11s, such as Kmart and United Airlines. Even here, however, a new dynamic is at work.18 The senior lenders are the ones usually in control. Fundamental changes are afoot. Chapter 11 is performing a new role. During the 1980s, nine of ten large businesses entered Chapter 11, crafted a plan of reorganization there, and then emerged intact. In 2002, this was true in fewer than one in four. Today the vast majority of the cases—three-quarters or more—fit the two patterns I have identified. Most often, Chapter 11 17We see a similar pattern in Glenoit. After leaving bankruptcy, Glenoit moved most of its production to China and used remaining sites in the United States primarily as warehouses and distribution centers. See Claudia H. Deutsch, Burlington Made to Order for Investor Seeking a Test, New York Times, August 14, 2003, Section C, Page 1. 18 United’s success in making enormous changes in its collective bargain- ing agreements was due in large measure to the way in which the postpeti- tion lenders were able to impose financial covenants that tied the managers’ hands. For an examination of the control creditors now exercise inside of bankruptcy and out, see Douglas G. Baird & Robert K. Rasmussen, Corpo- rate Governance, State-Contingent Control Rights and Financial Distress (first draft October 2002). 22 / Douglas Baird / is merely one way in which a business is sold. It is liquidated or merged with or acquired by another. Alternatively, the bankruptcy judge merely puts in place a restructuring of debt that the major in- vestors have settled upon outside of bankruptcy and the Chapter 11 is over within a few months. The disappearance of the traditional reorganization stems not from changes in the law, but from changes in the economy that have been underway for a long period of time.19 The equity receivership of the 19th Century railroad was desirable because of a conjunction of a number of different conditions. There was a huge capital investment in a particular business and the assets were worth far more if kept together than if sold off piecemeal. The creditors were scattered across the globe and could not effectively control the railroad or shape its future outside the kind of collective forum that the receiver- ship provided. Finally, the capital markets were not liquid enough to have a sale of the railroad as a going concern. Any one of these conditions can still exist today, but each is less likely. Moreover, the conjunction of all of them at the same time is increasingly improbable. Most important, the going-concern surplus is less evident now than in the time of the great railroads. Few busi- nesses today center around specialized long-lived assets. In a service- oriented economy, the assets walk out the door at 5:00. Today the costs of starting a business are those involved in creating and imple- menting a business plan. Millions are spent training staff, building a client base, and cementing relationships with suppliers. But these investments are fundamentally different from those involved with building a railroad. The most salient characteristic of a railroad is low operating costs relative to the initial capital investment. Railroads of the 19th Century generated at least enough revenue to cover their op- erating expenses. By contrast, a new business venture may be unable to cover its expenses if it is only just a little worse than a rival busi- ness. The hundreds of millions spent trying to establish WebVan were worthless once its business model failed. 19These ideas are set out in greater detail in Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751 (2002). New Face of Chapter 11 / 23 III. Dynamics of Absolute Priority In this part, I focus on the vanishing species that is the prototypi- cal Chapter 11. We have a large business that, for one reason or an- other, cannot be readily sold. In contrast to the railroads, the typical large business in Chapter 11 has a comparatively simple capital structure. A group of banks may hold the senior debt and a group of public bondholders may hold junior debt that is structurally and con- tractually subordinate to the senior debt. In the typical case, the banks monitor the debtor and do not allow matters to deteriorate to a point at which the business lacked a value, on a going-concern basis, that exceeds the amount of its secured debt.20 Hence, the large busi- ness is usually administratively solvent. It enjoys a cash flow that can more than cover the administrative expenses associated with any bankruptcy proceedings. The banks enjoy a priority position that is watertight, the bankruptcy judge is completely committed to the ab- solute priority rule, and the junior investors have relatively little abil- ity to stall for its own sake. We want to understand the dynamics in this environment, the prototypical environment of the large corpo- rate reorganization. It might seem that in such a case, an effective bankruptcy system would be one in which the junior creditors should not receive any- thing unless and until the senior creditors are paid in full. The ques- tion, however, is considerably more complicated. There are two al- ternative ways to sort out distributional priorities between junior and senior investors in connection with the reorganization of a financially 20 When the business manifestly lacks sufficient assets to pay the senior creditors in full, the dynamic today is different from what is described here and what it was only a few years ago. The banks would control the cash col- lateral. The debtor would be unable to find a dip financer willing to take a priority position behind the secured party and modern bankruptcy judges would be unwilling to give the dip financer a lien that primed the secured creditor. Under these circumstances, the secured lender would be able to keep the debtor on a tight leash and dictate the course of the case. The in- ability of the debtor to support itself renders the junior creditors powerless. A speedy sale is the usual outcome. 24 / Douglas Baird / distressed firm.21 The first is “absolute priority” and the other “rela- tive priority.” Absolute priority embodies the familiar idea that sen- ior creditors must be paid in full at the time of any reorganization before those junior to them received anything. By contrast, under relative priority, junior investors retain some residual rights against the reorganized business, even when the assets of the business might not ultimately be worth enough to pay the senior creditors in full. Unlike absolute priority, relative priority recognizes the option value of junior claims against the reorganizing business. The junior inves- tors do not receive cash, but rather rights against the firm (such as equity or stock options) that might have value if the business ulti- mately succeeds. 22 21 James C. Bonbright & Milton M. Bergerman, Two Rival Theories of Priority Rights of Security Holders in a Corporate Reorganization, 28 Colum. L. Rev. 127, (1928). 22 To get one’s bearings on absolute and relative priority, one can start with a simple case. Imagine a venture has a senior and a junior investor. The venture has a definite terminus. When it comes to an end, the senior inves- tor is entitled to be paid first. But an unexpected event comes midstream. This event requires changing the rights of the investors. The original con- tract, for example, provided for interim payments to creditors, but the cash- flows fall short of projections. The amount of money the venture will make ultimately is unknown, but it is less than expected. Indeed, the expected value of the venture today is less than what the senior lender is owed. Any restructuring must take account of the venture’s inability to make interim payments, as well as the right of the senior investor to be paid in full at the end of the day. There are two possible approaches. The absolute prior- ity rule would assume that the restructuring is the day of reckoning, as though the venture is being wrapped up. It is a realization, a recognition event in which all future possibilities are collapsed to present value. In a world in which the senior investor has priority over the junior investor, the senior investor should take everything if, at the time of the restructuring, the expected income over time, discounted to present value, is worth less than it is owed. A restructuring, however, does not have to collapse future possibilities to present value. One can restructure the rights of creditors mid-stream and at the same time take into account the possibility that the junior interest can still have value if things go better than expected by the time the venture comes to an end. If there is a 10% chance that, at the end of the venture, New Face of Chapter 11 / 25 In 1939, the United States Supreme Court squarely and unequivo- cally adopted a rule of absolute priority and has regularly reaffirmed it and strengthened it ever since, most recently in 1998.23 Relative priority, however, has not disappeared. Notwithstanding the unam- biguous commitment to absolute priority as a matter of law since 1939, a commitment that has only increased over time, negotiated plans of reorganization regularly adopt relative priority. Senior creditors agree to accept something less than certain payment in full, while those junior to them receive participation rights. Relative prior- ity regularly emerges out of bargaining conducted in the shadow of a rule of absolute priority. The persistence of relative priority bargains in a world of absolute priority is the great and largely neglected puz- zle of the law of large corporate reorganizations.24 Where unsecured creditors have a meaningful chance of recover- ing part of their claims, the interaction between the classes represent- ing the large bulk of the debtor’s prepetition obligations becomes the there will be $100 left after the senior investor is paid in full, then the junior investor could be given contingent rights today that have an expected value of $10 and that take a form that will have value only if the venture proves successful ultimately. In short, a restructuring can preserve the option value of the junior investor’s rights, the possibility that the venture will be worth more than what senior investor is owed and at the same time recognize that the junior investor’s claim is recognized only if the senior investor is paid in full. This approach to resolving the rights of senior and junior investors is what Bonbright and Bergerman called “relative priority.” To say that one investor has priority over another is not the same thing as saying that the enterprise value must be established and allocated among claimants when- ever rights must be restructured midstream. 23For example, in Bank of America National Trust Savings Association v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999), the Court insisted on valuations that were market-tested in order to ensure that absolute prior- ity was respected when junior investors participated in the restructured business by virtue of new contributions of capital. 24The history of the ideas of relative and absolute priority can be found in Douglas G. Baird & Robert K. Rasmussen, Control Rights, Priority Rights, and the Conceptual Foundations of Corporate Reorganizations, 87 Va. L. Rev. 921, 925-36 (2001). That paper’s discussion of relative priority focuses on the role it can play in small cases. By contrast, our focus is upon the im- portance it continues to enjoy even in the largest corporate reorganizations. 26 / Douglas Baird / key to the restructuring process. The question is how Chapter 11’s distributional rules, in particular the absolute priority rule, affect this interaction. The negotiations that take place are not among widely dispersed creditors, but rather a small group of creditors and their experienced professionals. Trading of claims in Chapter 11 has be- come so commonplace that all those at the bargaining table are likely to be professional investors that can be counted upon to cast a cold eye on the business and the likely course of any litigation. The negotiations likely center on the value of the business. In cir- cumstances such as these, both the banks and the bondholders may find it is in their mutual interest to strike a bargain with each other rather than invoke the judicial process to put a value on the business. The debtor needs to confirm a plan of reorganization sooner rather than later. It may live in an industry in which long-term supply con- tracts are an essential part of the business.25 Unless it can convince buyers that its financial problems are behind it and that it will be around for the long haul, its ability to improve earnings are com- promised. The environment in which the senior and junior creditors find themselves is quite foreign to most academic accounts of the absolute priority rule. There is no plausible claim that the ex ante bargain called for anything other than absolute priority. The negotiations are between professionals, not among tort victims or workers or any other nonadjusting creditors. The subordination of the bondholders to the banks was established through contract. Every bondholder knew at the outset the nature and the extent of the banks’ priority. Nor is this is a case in which there is an owner-manager who must be kept on board or who possesses valuable private information. Nor do the business’s managers have incentives that lead them to delay. They are newly hired turnaround specialists. Their incentives are aligned with the banks and the bondholders. Moreover, the parties to the negotiations are equally well-informed. The banks and the lend- 25 The need to leave bankruptcy earlier rather than later may stem from a number of different factors. In Conseco, for example, the debtor needed to regain it AM Best rating for the insurance businesses to be viable. To do so, the holding companies had to emerge from Chapter 11 with a strong bal- ance sheet. New Face of Chapter 11 / 27 ers may have different beliefs about the value of the business, but none has information denied to the other. Conventional accounts of corporate reorganizations do not ex- plain departures from absolute priority in such cases. The ability of the junior investors to extract value through delaying tactics is muted. Nor is there any fuzziness about the banks’ priority position. The banks must bargain with the bondholders because there is in- stead a genuine disagreement over the value of the business. A sim- ple model can capture the essence of the bargaining environment in which the banks and the bondholders find themselves and attempts to account for the possible bargain they might strike. Firm has two creditors, Bank and Lender. Bank has lent $250 and Lender $200. Bank has a security interest in all of Firm’s assets. Firm’s future prospects are well known to Bank and Lender, but not to outsiders. Both believe that Firm is worth more than $250 million. At the moment, however, no outsider is willing to pay that much for Firm’s business. The industry as a whole is depressed. Moreover, if Bank and Lender wanted to sell Firm, they would have trouble con- vincing potential buyers that they were not trying to foist off a busi- ness that was even worse than it appeared.26 In two years time, the uncertainties surrounding Firm will have disappeared and a market price for investment positions in it will already exist. But such a mar- ket does not exist now. If Bank and Lender conclude they can both do better if the busi- ness is not sold, either can insist on a process in which the bank- ruptcy judge decides Firm’s value for the purpose of allocating Firm’s securities between them. This process imposes costs on both Bank and Lender. Alternatively, Bank and Lender can avoid these costs by entering into a mutually beneficial bargain that obviates the need for a hearing in which the judge fixes a value on the business. In the simplest case, Bank and Lender share the same view the business’s prospects and the way in which the bankruptcy judge will assess them. In this world, we can expect a settlement in which Bank and Lender divide between themselves the value of the business in accordance with their priorities and allocate between them the sav- ings realized from bypassing the valuation process. These include the 26 Bank and Lender face a standard lemons probem. 28 / Douglas Baird / direct costs of the process itself and the indirect costs of delaying the business’s emergence from bankruptcy. A more interesting bargaining dynamic arises when Lender and Bank have different beliefs about the value the bankruptcy judge will attach to Firm.27 Bank believes that the judge will share its own view of Firm’s value and find that, in two year’s time, Firm will be worth either $225 with 80% probability or $375 with 20% probability. Col- lapsing these possibilities yields an expected valuation of $255. By contrast, Lender believes that the judge will share its view that, in two year’s time, Firm will be worth $225 with 20% probability or $375 with 80% probability. This results in an expected value of $345. A valuation hearing costs Bank $20 and Lender $15.28 Under these assumptions, Lender expects to receive $80 if it con- tests valuation. (The bankruptcy judge will find that Firm is worth $345 and will give Lender a share in the reorganized firm that is worth $95. Less the $15 cost of the litigation, Lender realizes $80.) Bank, by contrast, expects to receive $230 after a valuation hearing. (Again, it believes that the bankruptcy judge will agree with its valuation and hold that Firm is worth $255. Because Bank is owed $250, the judge will give it virtually the entire reorganized firm. After spending $20 on the valuation hearing, it is left with $230.) Lender and Bank cannot reach a cash settlement with each other. Lender believes it will realize $80 if it fails to reach a deal with Bank. 27 This model of settlement negotiations uses the standard model in which parties to the negotiations have different beliefs about the outcome of the litigation. See, e.g., William M. Landes, An Economic Analysis of the Courts, 14 J. L. & Econ. 61 (1971). Alternative models of settlement are based on bargaining in the face of private information. In the environment we con- front there, however, there is no private information. 28 There is uncertainty about the extent to which Lender will bear the costs of the valuation hearing in an actual case. If the creditors’ committee carries the burden of the valuation proceeding and if the junior creditors are paid in contingent rights of participation, part of the cost of the process will shift from the junior creditors to the senior creditors. (In bad states of the world in which junior creditors have options that are out of the money, the costs of the bankruptcy borne by the debtor are borne by the senior credi- tor.) Of course, if all payouts are in cash at the end of the case, then the jun- ior creditors bear the costs whenever the debtor is administratively solvent. New Face of Chapter 11 / 29 Bank, however, believes it stands to gain no more than $25 by reach- ing a deal.29 The highest offer Bank will make is much less than what Lender will accept. There is no cash Bank will offer Lender that makes each better off than they think they will be after a valuation proceeding. Because Bank and Lender cannot avoid the valuation process with a settlement, they will look to other alternatives. In a world in which Lender faces no liquidity constraints, Bank and Lender could reach a deal in which Lender simply bought Bank out. Bank believes that a valuation process will bring it only $230. Hence, it will accept any take-it-or-leave-it offer that is greater than $230. Moreover, the amount it is owed ($250) caps the amount it can demand. Because Lender believes that the business is worth $345, it will be better off making a deal with Bank for some amount between $250 and $230. If those in Lender’s position generally face no liquidity constraints, the law of corporate reorganizations could simply provide that Bank succeeds to the entire Firm unless Lender were willing to pay it the face amount of its loan.30 Lender, however, is likely subject to liquidity constraints. By buy- ing out Bank’s position, it would expose itself to nondiversifiable risk. Recall that Bank and Lender find themselves facing a bank- ruptcy court valuation only because Firm itself is not readily market- able. The circumstances that give rise to bargaining are inconsistent with the assumptions underlying a rule that solves the priority prob- lem by forcing Lender to buy out Bank. Bank and Lender, however, can still find common ground. Con- sider, for example, a settlement in which Firm acquires an all-equity capital structure. Bank acquires all the equity in Firm, but Lender en- joys the right to buy the equity of Firm from it in two years time for $275. Bank and Lender do as well with such a bargain as they would 29 Bank believes the judge will give it a share of Firm worth $250 and that Firm is worth only $255. Hence, it is willing to give up only the $5 that Lender will receive in valuation hearing and $20 that Bank would spend in such a hearing. 30 Lucien Bebchuk was the first to make this point. See Lucian Arye Bebchuk, A New Approach to Corporate Reorganizations, 101 Harv. L. Rev. 775 (1988). 30 / Douglas Baird / by going through a valuation process. This plan gives Bank an ex- pected return of $235, $5 more than it would receive in a valuation hearing.31 The plan gives Lender an expected return of $80. It expects to receive nothing in 20% of the cases and an option worth $100 in 80%, an amount equal to what it expects to receive in a valuation procedure.32 The liquidity problem that Lender faces today will not exist in 2 years time, as by then the market for the securities will have established itself and Lender will be able to borrow the money needed to exercise the option or it will be able to sell the option to someone else. Bank and Lender therefore enter into a deal in which, in many states of the world, Bank is paid less in full and Lender enjoys upside in the event Firm does well. Once one takes the costs of the valuation proceeding into account, the outcome is consistent with the absolute priority rule. The costs of valuation generate the relative priority out- come. In the example, we assumed that the debtor was administra- tively solvent. Once we take into account that possibility that it might not be (and that the bankruptcy judge would recognize this at the valuation hearing), relative priority can emerge in second way. Once again, let us assume that Bank is owed $250 million. At the valuation hearing, the bankruptcy judge rigorously applies the abso- lute priority rule and gives an unbiased estimate of the business’s value. Bank and Lender both believe that the actual value of the business is $250 and that the judge will value the business as being worth somewhere between $200 and $300, all with equal probability. Lender has the right to insist on a valuation hearing. A valuation hearing imposes costs of $2.50 on Lender and Bank. Under these assumptions, Lender will accept a take-it-or-leave-it offer from Bank of $10, but turn down any offer that gives it less. 31 Bank believes that Firm will be worth $225 eight cases in ten. Under these conditions, Lender will not exercise the option, and Bank will remain the sole owner of Firm. One time in five, Firm will be worth $375. In these cases, Lender will exercise its option and Bank will receive $2750. Hence, the expected value of Bank’s share under the plan is worth (0.8 * 225) + (0.2 * 275) = 235. 32When Firm proves to be worth $375, the right to buy it for $275 is worth $100, and Lender believes this event will happen 80% of the time. New Face of Chapter 11 / 31 Even though the absolute priority rule applies with full force and the business is worth only enough to pay it in full, the uncertainty of the valuation process itself gives Lender an option. When the bankruptcy judge finds that the business is worth less than $250, Lender receives nothing. But in half the cases, the bankruptcy judge will find that the business is worth more than $250. In these, Lender will receive the difference between the value the bankruptcy judge applies to the business and $250. This difference will vary between $0 and $50 and will average $25. The value of capturing this differential half the time is worth $12.50. Less the costs of litigating value, the “cram up” op- tion that Lender enjoys is worth $10. In short, departures from absolute priority in negotiated plans of reorganization arise naturally even where unbiased judge rigorously enforce absolute priority in a world in which there is no private in- formation and no agency costs of any kind. Valuation uncertainty alone leads to relative priority plans, even in a world of absolute pri- ority. Hence, the ability of the junior lender to invoke a valuation proceeding has value even when there is no disagreement about value and the bankruptcy judge’s valuations are completely unbi- ased. This option value that arises from the possibility of overvalua- tion is worth something even in a strict regime of absolute priority. A rational senior creditor will take the value of this option into account in making any settlement offer. A senior creditor’s willingness to “buy” this option from the junior creditor will also naturally lead to relative priority plans.33 To a far greater extent than commonly appreciated, the departures from absolute priority come from valuation uncertainty. Negotia- tions in large reorganizations are, of course, fact-dense and plans of reorganization are complicated, but the bargaining dynamic is the same and the basic features of the plans are consistent with the idea that valuation uncertainty explains the central contours of the plan. 33 The observation we make here—that an ex ante agreement for absolute priority will in fact yield something less than absolute priority ex post— raises a second set of questions. If the efficient investment contract in fact would provide for absolute priority ex post, we should ask whether devices are available to investors to allow ex ante contracting that would in fact yield absolute priority. To frame things differently, is there a way to write an ex ante absolute priority contract that is renegotiation proof? 32 / Douglas Baird / IV. Lessons from Chapter 11 The recent experience of large businesses in Chapter 11 provides a few lessons that may transcend the archaic structure of Chapter 11 and the parochial practices that have developed under it. What mat- ters most is whether legal institutions exist that allow for the efficient reconfiguration of ownership rights in bad states of the world. We should not underestimate the power of markets to help facilitate the restructuring of distressed businesses. The illiquidity of capital mar- kets that gave rise to the equity receivership has largely disappeared. Markets for the assets of large firms exist in a way they did not at the time the law of corporate reorganization came into being. Shortly before it filed for chapter 11, Enron controlled 25% of a trading volume that measured many billions of dollars. Its working capital itself ran in the billions. But it could cease its trading opera- tions without creating even a ripple in the marketplace. When the trading operation that had purportedly generated billions in profits was put up for sale, no cash bidders appeared. The absence of a cash bid for its trading operations did not raise concern about the liquidity of markets, but rather new doubts about the underlying value of En- ron’s operation. As suggested in the previous part, liquidity con- straints still matter in some large reorganizations, but much less than once supposed. Recent experience in the United States also underscores the im- portance of focusing upon control rights. A law of corporate reor- ganizations is needed only when the investors cannot make sensible decisions when the firm encounters trouble. When control rights are allocated coherently, no legal intervention is needed to ensure that decisions about the firm’s future are made sensibly. Most large firms now allocate control rights among investors in a way that ensures coherent decisionmaking throughout the firm’s life cycle. Just as modern cars are designed to take account of the possibility that they might crash, modern capital structures are designed with the possi- bility of financial distress in mind. For most firms, there is a coherent contract among investors that keeps financial distress from destroying the firm. As the cost of con- tracting over control rights—the rights to deploy a firm’s assets— continues to fall, we should expect the risk of costly internecine fights among investors to matter even less. In other words, the ability of investors to contract among each other over the control of a firm’s New Face of Chapter 11 / 33 assets further limits the value of a law that ensures that a firm’s as- sets remain together. The basic decisions in a reorganization ought to begin with an ex- amination of the way in which control rights are allocated. Their co- herence, or lack of coherence, tells us how much work the legal sys- tem must do. When the rights are coherently allocated, or the assets are conventional and easy to identify, there is little work to be done. Often, the judge, receiver, or other official need only follow the lead of those who have bargained for control. These individuals have greater knowledge and incentives to ensure that assets are put to their highest valued use. In such cases, work for the legal system, to the extent it exists at all, involves allocating the assets among com- peting claimants and vindicating prohibitions on fraudulent conduct. Most importantly, it is all too easy, inside of bankruptcy and out, to assume that any particular business has an enormous going- concern surplus. The extent to which a firm as a whole has value above and beyond the sum of the highest value of its discrete assets is easy to overestimate. In a world in which transaction costs are rap- idly declining, the value created by simply bringing assets into the firm is likely to decrease over time. Long ago Ronald Coase asked the question of what explained whether a transaction would be located in a firm or in the market. In the same spirit, reorganization law ought to begin by ascertaining the value of keeping particular assets together inside a given legal entity (or a successor entity). The alternative is for these assets to be re- turned to the market, where they may be reassembled in whole or in part. We have a going-concern surplus (the thing the law of corpo- rate reorganizations exists to preserve) only to the extent there are assets that are worth more if located within an existing business. If all the assets can be used as well elsewhere, the business has no value as a going concern. Such assets are increasingly hard to find. Even if certain assets are best used together with other assets, it often does not matter whether these assets are used in conjunction with other assets in a particular legal entity, or whether they are moved to an altogether different one.