Academic journal article Financial Management

Streamlining the Bankruptcy Process

Academic journal article Financial Management

Streamlining the Bankruptcy Process

Article excerpt

The current Chapter 11 bankruptcy process suffers from two major problems: 1) it is quite costly (Altman, 1984; John, 1993; Betker, 1997; and Branch, 1997), and 2) nonviable firms are often reorganized (Hotchkiss, 1996). In this paper, I propose reforms designed to address both problems. First, the process would be shortened dramatically by eliminating the need for interest holders to negotiate with each other to reach a consensual plan. Rather, an automatic mechanism would parcel out value according to the contractual priorities but allow the market sufficient time to discover the reorganized entity's going-concern value. Second, the bankrupt firm's creditors would elect a new board of directors, who would then decide whether, and if so how, the firm should be reorganized.

I. Chapter 11's Deficiencies

Its credit agreements call for a bankrupt firm's value to be parceled out according to the absolute priority of claims principle. In a Chapter 7 liquidation, assets are liquidated and payments are made to each creditor class strictly according to its priority. The task is more complex in a Chapter 11 reorganization, where the value of the reorganized firm and its post-reorganization securities are uncertain (Beranek, Boehmer, and Smith, 1996; and Eberhart and Senbet, 1993). Moreover, a "consensual" reorganization that preserves the firm's going-concern value may yield more value for claimants than a straight liquidation (Alderson and Betker, 1996). Lower-priority claimants will assert entitlement to at least part of this difference in value. In Chapter 11, disputes between junior and senior claimants almost always arise.

Anyone who has served on a creditors' committee in a large bankruptcy will understand the contentious nature of the current process. The debtor is likely to be suspicious of the creditors and reluctant to share nonpublic information. Different creditor groups are suspicious of each other and the debtor. Lawyers are hired to check the work of other lawyers. Accountants are hired to check the work of other accountants. Investment bankers look over each other's shoulders. Everyone negotiates for maximum individual advantage. Making the pie larger gets lost in the process of fighting over how to divide it.

The direct cost of administrating a typical bank-ruptcy includes legal, accounting, investment banking, and debtor-in-possession fees and expenses. A substantial additional indirect cost in the form of disruption and lost business is generally incurred (Wall Street Journal, 1991; and Opler and Titman, 1994). Claimants are also likely to bear their own bankruptcy-related costs (e.g., legal, monitoring, and advocacy). The total amount of these bankruptcy-related costs average 10% to 20% of the debtor's prefiling value (Altman, 1984; John, 1993; Franks and Torous, 1994, and Branch, 1997). Bearing these expenses and losses reduce what would otherwise be available to distribute to the claimants. Dealing with these failures also imposes costs on society at large: the relevant portions of the budgets of the US Trustee's office, bankruptcy courts, and other courts that deal with bankruptcy-related claims and administration; losses imposed on various noninvestor stakeholders (employees, government agencies, etc.); adverse impacts on customers, markets, suppliers, and local communities as well as lost tax revenues (Jog, Kotlyan, and Tote, 1993; and Branch, 1997). While most of these social costs result from the business failure itself, a significant part stems from the costly and lengthy process of dealing with the failure.

Reducing the cost of going through the current bankruptcy process could offer substantial benefits. The creditors benefit if greater value is available to distribute, resolution is quicker, and the outcome is more certain. The bankrupt firm's employees benefit to the extent that less business is lost, and thus more and better jobs are preserved. The bankrupt firm's customers and suppliers benefit in that they can deal with a healthier firm that emerges from bankruptcy more quickly. …

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