How Efficient is the Chapter 11 Bankruptcy Process?

An efficient bankruptcy system should facilitate the liquidation of bad companies while enabling good firms to reorganize their debts and continue operating. By "bad" companies, I mean those firms whose assets are more valuable in some alternative use, compared to their current use. These firms should sell their assets, return the proceeds to their investors and let them invest the funds in more productive endeavors. "Good" companies are those that create more value as a going concern than they would fetch in a liquidation. These firms may have taken on too much debt, or have a short-term cash flow problem that requires a debt restructuring, but this temporary financial distress does not imply that the firm should liquidate.

Is the U.S. bankruptcy system efficient, in this sense? There are two types of errors that can occur: forcing good firms to liquidate, and allowing bad firms to continue operations. We cannot observe how often the first mistake is made; once a firm has liquidated, there's no way to observe how much value it could have created had it been allowed to continue. Thus, academic research in finance has focused on the second question: Do firms emerge from Chapter 11 as viable enterprises? Some commentators have argued that Chapter 11 biases the reorganization process in favor of the firm's incumbent management. Since incumbent managers have an incentive to save their jobs, it is argued that they have an incentive to reorganize firms that should in fact be liquidated. If this is true, then we should observe that newly reorganized firms, on average, perform poorly.

Studying Post-bankruptcy Performance

Finding that post-bankruptcy performance is typically poor would support the argument that the Chapter 11 process should be overhauled to remove any pro-debtor biases that result in the reorganization of bad firms. At the extreme, some commentators have argued that Chapter 11 should be replaced with an auction system, whereby a bankrupt firm is immediately placed in receivership and auctioned off (either piecemeal or as a going concern) to the highest bidder.

Existing evidence on the post-bankruptcy performance of reorganized firms is mixed. Prior research finds that a typical reorganized firm: 1) earns an operating profit margin that falls short of industry averages; 2) emerges from bankruptcy with a debt ratio that exceeds industry norms and 3) frequently needs to restructure its debt again. Indeed, the term "Chapter 22" has been coined to describe firms that go through Chapter 11 twice. On the other hand, recent research has observed that the common stock of newly reorganized firms, in the first year following emergence from Chapter 11, outperforms the market.

In this article I will describe the results of research that I have conducted with my colleague Michael Alderson at St. Louis University. This research focuses on two issues related to the efficiency of the bankruptcy process. In our first study, (Liquidation Costs and Capital Structure, Journal of Financial Economics 39, September 1995, 45-69) we examine the post-bankruptcy capital structures of reorganized firms. Our second study (Assessing Postbankruptcy Performance: An Analysis of Reorganized Firms' Cash Flows, Financial Management 28, Summer 1999, 68-82) analyzes the postbankruptcy performance of reorganized firms, using methods that differ from other studies.

Capital Structure in Reorganized Firms

In our first study, we examine the relation between the liquidation value of a firm's assets and the firm's post-bankruptcy capital structure. We investigate not only the debt-to-equity ratio chosen by these firms, but also the mix of public and private debt and the terms of the restrictive covenants in the debt contracts. Firms emerging from Chapter 11 have a unique opportunity to select a completely new capital structure, and we observe firms at the point when this choice is made.

Firms that reorganize in bankruptcy must disclose their post-bankruptcy financial structure as well as estimates of the going-concern and liquidation values of their assets. We use these estimates to define "liquidation costs" as the excess of going-concern value over liquidation value. Firms have low liquidation costs if the value of their assets in liquidation is nearly as great as their value in current use. Liquidation costs are high if the value of assets in liquidation is substantially less than their value in current use. High liquidation costs may occur if the assets are specific to the firm, i.e., the assets have no reasonable use outside of their current one. Liquidation costs may also be high if the secondary market for the assets is thin. For example, if the firm's troubles are due to an industry-wide slump, there may be no other firms willing to purchase the assets.

Finance theory suggests that a firm's capital structure should be related to the liquidation value of its assets. Firms with high liquidation costs should avoid high debt, because the assets of these firms will lose value rapidly if the firm becomes financially distressed. Firms with low liquidation costs can afford higher debt ratios since relatively little firm value will be lost should the firm encounter financial distress. In these firms, the benefits of debt (e.g., preventing managers from wasting free cash flow) outweigh the potential costs. Since restrictive covenants in debt contracts may also lead to default, theory also suggests that firms should move from highly restrictive to less restrictive debt contracts as liquidation costs increase.

To illustrate these ideas, consider the cases of American Healthcare Management and Maxicare. Both companies are in the same industry, and both entered Chapter 11 during the period 1988-1990. However, the asset characteristics of the two firms are quite different. American Healthcare primarily owned hospital buildings and land, which have many uses both inside and outside the health care industry. Encountering financial difficulties should not greatly affect the value of a parcel of land that the firm owns. Furthermore, the value of land or a building in one city should not depend greatly on the value of a similar asset in a different location. These factors suggest that American Healthcare should have low liquidation costs — should the firm liquidate, its assets can be fairly easily transferred to an alternative use.

In contrast, Maxicare owned little tangible property; it is a health maintenance organization, which is a network of contracts between physicians, hospitals and employers for delivery of health care services to enrollees. A single contract would have little value outside of this network. Furthermore, the value of Maxicare's assets was sensitive to the firm's financial condition — members of the health care network, perhaps fearful that the firm would not be around to honor its contracts, would have an incentive to seek other health insurers if Maxicare became financially distressed. These arguments suggest that Maxicare's liquidation costs should be relatively high.

We estimated that only 12 percent of the value of American Healthcare would be lost in liquidation, compared to 76 percent for Maxicare. These estimated liquidation costs reflect both the firm-specific nature of the firms' assets and the liquidity of the secondary market for the assets. We, therefore, expected to see differences in the amount and type of debt used by the reorganized firms. In fact, American Healthcare reorganized with a ratio of long-term debt to assets of 88.8 percent. The new debt was 85 percent secured bank debt and 15 percent secured public debt. Maxicare reorganized with long-term debt to assets of 43.5 percent; new debt consisted entirely of unsecured, public debentures. Not only did Maxicare reorganize with less debt than American Healthcare, but the debt that it did have placed fewer constraints on the firm's post-bankruptcy operations.

The conclusions suggested by this example are borne out in our full study of 88 large, publicly traded bankrupt firms. We find that firms with high liquidation costs use less debt compared to firms with low liquidation costs. Furthermore, the debt of these firms is more likely to be public and unsecured. Firms with high liquidation costs are less likely to be constrained by debt covenants that prohibit dividends, restrict capital expenditures and prohibit changes in corporate structure. These firms are also less likely to have to prepay their debt out of excess cash flow. Firms with high liquidation costs are also much more likely to attract new equity capital as part of their reorganization process.

The results of this study support finance theories that relate asset characteristics to capital structure. The study also supports the notion that Chapter 11 leads to efficient outcomes: firms choose capital structures that make sense, given their asset characteristics. Thus, it does not necessarily follow that a "Chapter 22" filing, or even a subsequent liquidation, indicates that the first reorganization was a mistake. For firms whose assets are worth nearly as much in liquidation as they are in their current use, high debt levels allow creditors to closely monitor the firm. If the firm fails to perform well after emerging, creditors have a means to quickly force the firm back into Chapter 11 or into liquidation. Far from being a sign that the first reorganization failed, this is a sign that the firm's creditors chose the debt level of the reorganized firm wisely.

Post-bankruptcy Performance of Reorganized Firms

In our second study, we examine the post-bankruptcy performance of 89 large firms by evaluating the cash flows produced by the firms' assets. These firms, as a group, produced weak operating margins in the post-bankruptcy environment. Operating margins do not tell the whole story, however, because they omit consideration of post-reorganization asset sales and other transactions that cause accounting earnings to differ from cash flow. Thus, rather than focusing on accounting profitability, we evaluate the rate of return received by investors who owned all the debt and equity claims on the firm as it emerged from bankruptcy.

Claim holders of a bankrupt firm have two choices: either vote to allow the firm to reorganize and accept new claims on the reorganized firm, or vote to liquidate the firm. A logical benchmark against which to assess post-bankruptcy performance is, therefore, the return that could have been earned by liquidating the firm and placing the proceeds in an alternative investment of similar risk.

Estimating what the firms' assets would have fetched in liquidation is problematic. We used two estimates: the liquidation value of the assets as estimated in a firm's disclosure statement, and the going-concern value (market) value of the assets as the firm emerged from bankruptcy. The first figure likely understates the liquidation value of the firm, since the debtor may have an incentive to understate liquidation values in order to pass the "best interests" test. However, the second figure likely overstates the firm's liquidation value since it ignores the "fire sale" discount that may occur in a liquidation. We therefore treat these figures as lower and upper bounds on the firm's true liquidation value.

The results of our study, in contrast to prior studies, indicate that reorganized firms neither over-perform nor under-perform. Instead, we show that the total cash flows produced by the reorganized firms, and returned to both debt and equity holders, provided a return that was competitive with returns on alternative investments of similar risk.

Additional results in this study indicate that firms that avoid second restructurings and those that are acquired after emerging exhibit superior post-bankruptcy returns. We also find that post-bankruptcy performance is affected by the firms' investment opportunities. Firms with valuable investment opportunities generate superior returns when their net investment expenditures exceed the industry median. In contrast, firms with few valuable investment opportunities do not produce superior returns by investing more heavily than their competitors.

Summary

The Chapter 11 process is surely not a perfect one. There are, no doubt, cases in which viable firms are liquidated, and cases in which firms are allowed to reorganize when liquidation is the preferred alternative. My research suggests, however, that these cases are not the norm. A typical large firm emerges from Chapter 11 with a capital structure that is appropriate, given its asset characteristics, and then offers investors a rate of return that is competitive with alternative investments of similar risk. These results support the argument that the Chapter 11 process is generally efficient.