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The nature of the bankrupt firm: a response to Baird and Rasmussen's: the end of bankruptcy.

 A. Baird and Rasmussen's Asset by Asset Analysis
 1. Physical assets
 2. Intangible assets
 3. Teams
 B. Baird and Rasmussen's Conception of the Firm
 C. Coase's Conception of the Firm


In The End of Bankruptcy, Professors Douglas G. Baird and Robert K. Rasmussen give this description of the current state of affairs in the bankruptcy courts:
 Corporate reorganizations have all but disappeared. Giant
 corporations make headlines when they file for Chapter 11, but they
 are no longer using it to rescue a firm from imminent failure. Many
 use Chapter 11 merely to sell their assets and divide up the
 proceeds.... Even when a large firm uses Chapter 11 as something
 other than a convenient auction block its principal lenders are
 usually already in control and Chapter 11 merely puts in place a
 preexisting deal. Rarely is Chapter 11 a forum where the various
 stakeholders in a publicly held firm negotiate among each other over
 the firm's destiny. (1)

These assertions are factual, not theoretical. They constitute the foundation for the theoretical analyses Baird and Rasmussen present in their article. Yet Baird and Rasmussen offered no empirical basis for them. (2)

Data I collected over the past two decades show the actual pattern to be different in several respects. Corporate reorganizations are booming. (3) The number of large, public firms reorganizing in 2002 was greater than in any prior year in history. (4) Despite a sudden, recent increase in the numbers of liquidations, (5) most big firm bankruptcies still end in the reorganization of the firm. (6) On average, the emerging firm is about seventy-five percent its prefiling size. (7)

Baird and Rasmussen protest that I have taken the opening sentence of their article too literally. Their claim is not that "corporate reorganizations" have all but disappeared but only that "traditional reorganizations" have done so. (8) The definition I have employed in tracking reorganizations over the past two decades holds that a "reorganization" occurs when a firm files under Chapter 11, obtains confirmation of a plan of reorganization, and emerges as a stand-alone firm that intends to remain in business indefinitely. (9) Baird and Rasmussen do not define "traditional reorganization" explicitly but suggest they would exclude as untraditional at least the following: (1) any case in which the bankruptcy judge presided over an auction that changed ownership of the firm, (10) (2) any case in which the debtor struck a deal with a principal lender before filing, (11) (3) any case in which the company, by Baird and Rasmussen's analysis, seemed to have little going-concern value, (12) and (4) any case in which the dynamic is "utterly different" from what occurred in Chapter 11 cases in earlier years. (13) With so many bases for exclusion, it should not be surprising that the number of cases remaining--in any era--would be small.

Neither they nor I claim to have systematic data showing a change in the number or proportion of "traditional reorganizations" over time. Anecdotal evidence makes clear, however, that "traditional reorganizations" continue to occur. Seven of the thirteen largest firms ever to file under Chapter 11 did so in 2002. (14) The seven are Adelphia Communications, Conseco, Global Crossing, Kmart Corp., NTL, Inc., United Airlines, and Worldcom. All seven firms are using Chapter 11 to reorganize rather than liquidate. Each is a reorganization that will "rescue [the] firm from imminent failure." (15) In only one of the seven cases did the firm have a deal with its major lender when it entered Chapter 11, (16) and in none does the firm intend to sell either itself or its core business. (17) The courts have confirmed plans for four of these firms: NTL, Kmart, Conseco, and Worldcom. None has been sold (though a controlling interest in Global Crossing has) and each continues to operate its business. Each of the seven cases is or has been a "negotiat[ion] ... over the firm's destiny." (18)

In their Reply, Baird and Rasmussen argue from empirical data that few firms, if any, completed "traditional reorganizations" in 2002. The short deadlines in an exchange such as this, however, effectively precluded them from completing the much more extensive data collection that would have been necessary to show that things were different at some earlier time.

Instead, they accept my admittedly imperfect classifications as a starting point and use data from my Bankruptcy Research Database to approximate the decline they assert. Their analysis shows that the proportion of cases I classified as (1) reorganizations and (2) not prenegotiated or prepackaged has fallen from 88% in the 1980s to 24% in 2002. The magnitude of that drop in proportion is dramatic. However, the number of large, public firms completing Chapter 11 cases in 2002 was more that 10 times the annual average number in the 1980s. The 24% of firms completing a nonprenegotiated reorganization in 2002--23 firms--is nearly three times the 88% of firms completing such a reorganization each year in the 1980s--8 firms. (19) The 16% of firms completing nonsale, nonprenegotiated reorganizations by Baird and Rasmussen's count--15 firms--is nearly double the annual average number in the 1980s. Reorganizations have not disappeared since the 1980s, they have doubled or tripled.

Nor, perhaps, is the decline in the proportion of reorganizations since the 1980s what it seems. Two changes in the law--rather than economic factors of the kind Baird and Rasmussen propose--may almost entirely account for that change in proportion. First, several of the reorganizations that occurred in 1980s were tax-NOL driven. Debtors sold all or nearly all of their businesses, then emerged as going concerns, owning little except their NOLs. Because this trafficking in NOLs has since been abolished, these same cases today would be liquidations. (20) Second, in the late 1990s, the courts began to allow debtors to sell their businesses in Section 363 sales, without proposing and obtaining confirmation of a plan of reorganization. This attracted a new kind of liquidation case to Chapter 11, one that previously would not have been in bankruptcy at all. (21) Eliminate the NOL-driven and Section 363 sale cases from the data, and the proportion of reorganizations remains roughly constant from the 1980s to the present. (22)

The second element in the dramatic decline Baird and Rasmussen identify is a decline in the proportion of prenegotiated reorganizations--generally referred to as "free fall" reorganizations. Baird and Rasmussen correctly calculate the decline from the 1980s (when nearly all reorganizations were free fall) to 2002. But that decline did not occur gradually over two decades as their theories would predict. It occurred suddenly, from 1991 to 1993. For the past decade, the proportion of free fall Chapter 11s has increased--from about 59% (23) to about 78%. (24) Thus, the empirical evidence regarding the decline in free-fall reorganizations does not support Baird and Rasmussen's theories. Over the past decade, an increasing proportion of firms have sought reorganization without prenegotiation.

Baird and Rasmussen also assert that "[t]o the extent that any firms contain the necessary ingredients for an old-fashioned 'successful' Chapter 11, they are likely to be small enterprises." (25) In fact, the data show that larger firms reorganize in greater proportions than smaller firms. (26) Old-fashioned successful Chapter 11 is most clearly dominant among the very largest firms.

I agree with Baird and Rasmussen that dramatic changes have recently occurred in the use of Chapter 11. The most striking was the increase in the number of Chapter 11 cases filed by large, public companies from 1997--when only 15 companies filed--to 2001--when 95 companies filed. Most of this increase occurred while the economy was expanding. The putative causes on which Baird and Rasmussen base their theories---changes in firms' going-concern values and improvements in markets and contracting--would operate far too slowly to explain this abrupt increase in filings. Alternative explanations to those offered by Baird and Rasmussen abound. The most promising is that the bankruptcy boom that peaked in 2001 reflects a roughly simultaneous boom of similar magnitude in merger and acquisition activity in the economy as a whole. The merger and acquisition boom peaked in 2000, the bankruptcy boom in 2001. (27) Ill-advised acquisitions (the opposite of the new sophistication in markets for which Baird and Rasmussen argue) may have jerry-built awkward firms that quickly fell apart in bankruptcy. Enron is a prominent example. Another alternative explanation for the boom is that merger and acquisition deals that previously occurred outside bankruptcy were brought into bankruptcy because of the bankruptcy courts' new willingness to permit sales of companies without requiring compliance with the plan process. (28) A third explanation also consistent with the data is that firms now delay their bankruptcies to later stages of financial decline. They negotiate over the firm's destiny in the shadow of bankruptcy and file only when liquidation is imminent. Each of these possible explanations fit the data at least as well as the explanations Baird and Rasmussen proffer.

Most firms that do liquidate in Chapter 11 did not file for that purpose. Only 20% of the 174 large (29) public firms that filed for bankruptcy in 2001 and 2002 indicated at filing that their intent was to sell or liquidate their businesses. (30) Only an additional 4% filed prepackaged cases intended "merely [to put] in place a preexisting deal." (31) Nearly all of the remaining firms filed for the purpose of reorganization and for at least some period of time "negotiated over the firm's destiny." (32) Despite a variety of changes over the past two decades in the types of firms that use Chapter 11 and the ways in which they use it, Chapter 11 remains principally a vehicle for traditional reorganization of firms through the process of negotiation. (33)

In The End of Bankruptcy, Baird and Rasmussen offer three alternative explanations for the supposed disappearance of bankruptcy reorganization. First, they argue that modern firms have no going-concern value. Part I of this Response explains that they find no going-concern value only because they view the firm through a theoretical lens that obscures that value. Second, Baird and Rasmussen argue that advances in bankruptcy contracting made it possible to deliver control rights to investors whose incentives match the interests of the firm--the residual owners--thus eliminating the need for reorganization. Part II argues from empirical evidence that the pattern of bankruptcy contracting Baird and Rasmussen assert is impossible because no single class of residual owners exists in most firms. Even in firms where a single class of residual owners does exist, those residual owners are not the ones receiving control rights by contract. Third, Baird and Rasmussen argue that improvements in the market for firms have made sale as a going concern an effective substitute for reorganization. Part III explains why bankruptcy reorganization would remain necessary even if firms could be sold for their full going-concern value.


Baird and Rasmussen begin by correctly noting the traditional justification for bankruptcy reorganization: Reorganization preserves the bankrupt firm's going-concern value. (34) They continue the argument as follows:
 We have a going-concern surplus (the thing the law of corporate
 reorganizations exists to preserve) only to the extent that there
 are assets that are worth more if located within an existing firm.
 If all the assets can be used as well elsewhere, the firm has no
 value as a going concern. In the next two Parts, we show that such
 assets are increasingly hard to find. (35)

Elsewhere in the article, Baird and Rasmussen elaborate. "[Going-concern surplus] comes from assets that are dedicated to a particular purpose." (36) "[T]he need for a law of corporate reorganizations ... depends crucially upon specialized assets that need to reside in a particular firm." (37) "Chapter 11 can play its traditional role only in environments in which specialized assets exist." (38) Today's firms rarely have firm-specific or dedicated assets, Baird and Rasmussen argue, so there is "nothing to reorganize." (39) From this argument, they conclude that few firms warrant preservation by bankruptcy reorganization. (40)

Baird and Rasmussen's premise that going-concern value can exist only in conjunction with firm-specific assets is wrong. Going-concern value resides principally in relationships. (41) Those relationships can be among people, among assets, or between people and assets. (42) Large reorganizing firms typically employ thousands of people who maintain millions of relationships with people inside and outside the firm, including creditors, customers, suppliers, regulatory agencies, and others. The employees use literally millions of assets ranging from retail stores to jet aircraft, computer software, and pencil sharpeners. Together, the number of potentially valuable relationships that constitute a large, public firm is at least in the billions. The firm incurred costs in creating each of them. Only with time do these relationships coalesce in a smoothly operating, competitive firm. (43) This harmony constitutes the going-concern value that reorganization seeks to preserve. If the firm is demolished and another built in its place, many of the costs must be incurred again.

A. Baird and Rasmussen's Asset by Asset Analysis

Baird and Rasmussen examined the relationships that constitute the firm only obliquely, through the lens of an ideology that regards the firm as merely a pool of assets. (44) They considered three types of assets--physical assets, intangible assets, and employee teams--for evidence of firm-specificity. They found none and concluded that the modern firm lacks going-concern value.

1. Physical assets.

Baird and Rasmussen argue that increasing standardization has made physical assets interchangeable and thus incapable of supporting going-concern value. (45) They assert that "It]he hard assets of modern businesses tend to be even less dedicated to a particular firm than those of these cotton mills. Retailers rent space in a shopping center. Manufacturers lease space in an industrial park.... Retailers can acquire standardized shelving, cash registers, and furniture." (46)

Contrary to Baird and Rasmussen's premise, assets need not be unique, firm-specific, or dedicated to a purpose for the relationship between them to have substantial value. The relationship between completely fungible assets can have substantial value. The facts of In re 26 Trumbull Street (47) illustrate. The debtor in that case closed a restaurant, leaving the Chapter 7 estate with two assets: a long-term lease and the restaurant's equipment and furnishings. The court found that, sold separately, the lease was worth $60,000 and the equipment and furnishings $21,500. The trustee sold the two together for $165,000, more than twice their separate values. The case contains no suggestion that either asset alone was anything but fungible: The "standardized shelving, cash registers, and furniture" that Baird and Rasmussen claim can harbor no going-concern value. (48) The value of the relationship between these assets did not depend on the uniqueness of either, nor even on the existence of a firm. Rather, it derived from the fact that a purchaser of the equipment and furnishings alone would have had to remove them from the leased premises and sell them to someone who would then have had to find a place to use them. The purchaser of the lease alone would have had to install new equipment and furnishings. Selling the assets together saved these costs, and that savings was the measure of the value of the relationship between the two assets. Substantial going-concern value can exist in the relationship between even completely fungible assets. (49)

Going-concern value can also reside in the relationship between fungible inventory and the going concern. In an empirical study of secured lending practices, Professor Ronald Mann found lenders reluctant to repossess business inventories because they believed "debtors almost universally could sell the collateral for more than the lender." (50) The difference was that the debtor could sell the inventory from a going concern; the lender could not. If the debtor's business closed, value disappeared. (51) That value is going-concern value.

2. Intangible assets.

Baird and Rasmussen recognize that "know-how," expertise, business plans, and other intangibles constitute most of the value of the modern firm. (52) Their argument that those intangibles harbor no going-concern value begins by categorizing the intangibles at issue as either intellectual property or know-how and expertise. Baird and Rasmussen then dismiss the intellectual property category as composed merely of non-firm-specific assets. (53) Then they dismiss the know-how and expertise category as worthless because the firm is in economic distress. (54) As an empirical matter, this dismissal is unwarranted. Numerous firms have suffered economic distress and recovered through bankruptcy reorganization. (55)

Baird and Rasmussen's discussion recognizes only a small part of a firm's business know-how and expertise: essentially the high-level business formats franchisors provide to franchisees. (56) The range of know-how and expertise that constitutes going-concern value is far broader. It includes such low-level expertise as the store clerk's knowledge of the store's inventory, a supervisor's knowledge of the personal quirks and abilities of the people working under her, an administrator's knowledge of the firm's bureaucratic procedures, or the close working relationship between a service representative and a key customer. These kinds of expertise can continue to have value even when "another firm has an operating plan that is both better and scalable." (57) Simply by itself adopting a better operating plan, the reorganizing firm can save its low-level, firm-specific knowledge and expertise.

3. Teams.

Baird and Rasmussen's argument as to employee teams goes similarly astray. They recognize that value inheres in the relationships among team members, and among team members and other firm assets. But in The End of Bankruptcy, they conceptualize the teams not as the entire workforces of the firms but instead as small, elite groups of key employees.

Baird and Rasmussen's examples reveal that the employees referred to are only a minute portion of the workforce. The following is a complete list: seven people making films with Woody Allen, (58) the team of developers Henry Ford acquired from Keim Mills, (59) "the great investment banks," (60) the lawyers at Cravath, the animators at Disney in the 1940s, the engineers at NASA in the 1960s, the software writers at Microsoft in the 1990s, (61) particular practice groups within a law firm, (62) and the string section of the Philadelphia Orchestra. (63) These teams have what the distressed firm does not: "value over and above the value that each worker brings to the enterprise." (64) To paraphrase Baird and Rasmussen: Firms don't have going-concern value, teams do. (65)

In fact, the going-concern value of a firm inheres in a tremendous number of relationships, both within the firm and between firm employees and outsiders. Any employee can be replaced, but only at a cost. Once a firm shuts down, its employees disperse. Rarely does such a firm resume operations; the cost of replacing the employees is prohibitive. By confining their consideration to merely a few elite employees, Baird and Rasmussen miss the bulk of the firm's potential for going-concern value.

B. Baird and Rasmussen's Conception of the Firm

The essence of Baird and Rasmussen's argument against the existence of going-concern value is that a distressed firm's assets can be separated from the distressed firm, without loss of asset value. (66) Reading Baird and Rasmussen literally, the "firm" from which the assets can be separated is the legal entity. (67) Thus viewed, however, their argument quickly self-destructs. Legal entities are of no economic significance. If the people, assets, and organization of the firm are "reassembled in whole" (68) in a new legal entity, few would doubt that the firm has been preserved. (69) The relationships among the people and assets are the firm.

Perhaps what Baird and Rasmussen mean to assert is that particular combinations of assets or people might need to remain together, but, on the whole, the modern firm is readily broken down into numerous pieces without the loss of significant value. (70) But if that assertion were true, we would expect to see not only more complete liquidations during bankruptcy cases but also more partial liquidations, as teams depart from reorganizing firms and non-firm-specific assets are redeployed. Empirical evidence shows an opposite trend over the past two decades: Reorganizing firms have exhibited increased internal coherence.

Professor William C. Whitford and I studied the 29 firms that emerged from bankruptcy as public companies from January 1, 1982, to March 15, 1988. On average, they emerged at 44% of their prefiling size. (71) Later, Joseph Doherty and I studied the 98 firms that emerged from bankruptcy as public companies from 1991 through 1996. (72) On average, they emerged at 77% of their prefiling size. (73) In preparation for this Response, I studied the eighteen firms that emerged from bankruptcy as public companies in the most recent year for which data was available, 2001. (74) On average, they emerged at 75% of their prefiling size. (75) The difference between the 1980s cases and the later cases is statistically significant. (76) The forces that hold firms together appear to have become stronger instead of weaker. (77)

C. Coase's Conception of the Firm

Early in their Article, Baird and Rasmussen chide corporate reorganization scholars for not treating Ronald Coase's article, The Nature of the Firm, as their starting point. (78) But Baird and Rasmussen themselves make precisely that error. They conceive the firm to be essentially a collection of assets. Coase's concept of the firm barely makes reference to assets. It focuses instead on the relationship between the entrepreneur and the employees who have agreed to obey the entrepreneur's directions. In the following passage, Coase distinguishes the legal relationship of master and servant--employer and employee in modern terminology--from the looser relationship of principal and agent, and makes clear that the very existence of the firm depends on that distinction:
 Of course, it is not possible to draw a hard and fast line which
 Determines whether there is a firm or not. There may be more or less
 direction. It is similar to the legal question of whether there is
 the relationship of master and servant or principal and agent. (79)

Coase later chided himself for having made "the employer-employee relationship" the "archetype of the firm" in The Nature of the Firm. (80) The employment relationship (the "firm"), he said, competed with the "price mechanism" (the "market") in organizing production. (81) In those realms where the employment relationship was more efficient than market transactions, the firm existed.

The essential quality of the Coasian firm that justified its continuing existence was the efficiency with which the firm could transact for resources. Coase split the firm's transacting relationships into two categories: relationships with labor and relationships with commodities. (82) He saw the firm's relationships with labor as the more important of the two because the contracting was more complex and the transaction costs accordingly greater:
 A firm is likely therefore to emerge in those cases where a very
 short term contract (for a resource) would be unsatisfactory. It is
 obviously of more importance in the case of services (labour) than
 it is in the case of the buying of commodities. In the case of
 commodities, the main items can be stated in advance and the details
 which will be decided later will be of minor significance. (83)

As discussed earlier, (84) Baird and Rasmussen saw elite teams as mere assets of the firm, not attached to the firm in any meaningful way. The entrepreneur's relationships with the general workforce were of minimal, if any, significance:
 [W]orkers at Keim Mills were foolish enough to think that they were
 essential to the production of the Model T and went on strike.
 Within three days, Henry Ford shut down the plant, and moved both
 the stamping presses and the key managers to Detroit. The ownership
 of these machines and the loyalty of those in charge had value, but
 neither depended upon Keim Mill's existence as a going concern. (85)

Coase, by contrast, made clear that his equation of employment to the firm extended to the entire workforce. (86) In defining the "entrepreneur" who acted as employer in The Nature of the Firm, Coase later said he meant "the hierarchy in a business which directs resources and includes not only management but also foremen and many workmen." (87) As "entrepreneur," those people would have an employment relationship with virtually every worker in the firm.

Asset-specificity is at the heart of Baird and Rasmussen's concept of the firm. (88) During his preparations for writing The Nature of the Firm, Coase actually considered whether to include that concept in his theory. There is "no trace of the argument about asset-specificity" in that article, Coase later wrote, because he was "skeptical" of it. (89) In short, a Coasian theory of the bankrupt firm would seek going-concern value principally in the entrepreneur's relationship to the workforce, not in the firm-specific or dedicated nature of the firm's assets.

Baird and Rasmussen demonstrate that conceptualization of the firm as a collection of assets leads to the conclusion that distressed firms rarely have going-concern value. It follows that reorganization (particularly large firm reorganization) would be rare. The boom in large firm reorganization proves Baird and Rasmussen's conclusion wrong and so casts doubt on their conceptualization.


In The End of Bankruptcy, Baird and Rasmussen argue that corporate reorganization is obsolete because investors now contract for lender control in the event of insolvency. (90) "[I]t is the lender," they say, "and not the Bankruptcy Code or the bankruptcy judge, that is deciding how long the managers will have to make a go of things [during bankruptcy]." (91)

Lending contracts that can put the lender in effective control of a reorganizing firm are nothing new. (92) Baird and Rasmussen may well be correct in thinking the use of such contracts is on the increase. But they err in thinking that those contracts predominate (93) or can "allocate control rights among investors in a way that ensures coherent decisionmaking" in bankruptcy (94) and so solve the bankruptcy governance problem.

Baird and Rasmussen correctly identify that problem:
 The traditional conception of corporate reorganizations starts with
 the belief that when a firm is in distress control rights will not
 be vested in the hands of someone who exercises them sensibly. Once
 the firm defaults on one or more loan covenants, creditors acquire
 control rights and may have the power to shut the firm down. It is
 the fear of the improper exercise of such power that lies at the
 heart of reorganization law. (95)

"Under this view," they continue, "legal processes ... are needed because exogenous events create a mismatch between incentives of the individual investors that possess control rights and what is in the best interests of the firm as a whole." (96) To put it more simply, the contract needed to solve the bankruptcy governance problem is one that would keep control in the hands of investors whose interests are identical with those of the firm as a whole.

Baird and Rasmussen believe that investors recently solved this contracting problem by inventing contracts that shift control (including the ability to shut down the firm) to the right lender at the right time. "If [control] rights are allocated sensibly," they say, "the shutdown decision will reside in the hands of those with the best information and the appropriate incentives to exercise it correctly." (97) They contemplate that the hands will be those of a single investor, (98) and they do not suggest the development of any mechanism other than corporate reorganization for sharing control among investors. They believe the investor with the appropriate incentive is "the senior lender who will not be paid in full," (99) the mythical "residual owner" of law and economics bankruptcy theory.

The residual owner of a firm is the investor who will reap the marginal dollar of gain or suffer the marginal dollar of loss from the firm's activities. (100) If such an investor exists, it is the perfect person to control the firm. Its interests and the firm's interests are identical.

Baird and Jackson were the first to assert that a single such owner exists in insolvent firms. In 1988, they argued that "the law of corporate reorganizations should focus on identifying the residual owner, limiting agency problems in representing the residual owner, and making sure that the residual owner has control over the negotiations that the firm must make while it is restructuring." (101) Less than a year later, Jackson distanced himself from the idea, (102) but Baird and Rasmussen continue to promote it.

Critics of the residual owner theory have long maintained that no single residual owner exists in most distressed, large, public firms. (103) Large, public firms generally have multiple layers of debt and equity, each with a different priority in the assets of the firm. Several factors combine to cause investors at more than one level of priority to share in the typical firm's marginal gains and losses and so share residual owner status. (104) Because these investors have different priorities, their interests conflict with those of each other and those of the firm. Senior classes unduly favor risk minimization and liquidation; junior classes unduly favor risk taking and reorganization. None alone has the correct incentives to make decisions regarding sale, shutdown, or investment policy.

I recently confirmed the existence of these incentive mismatches in a study of 78 large, public firm reorganizations from 1991 to 1996. (105) In 48 of the 78 cases (62%), investors at more than one priority level shared residual owner status in such a manner that the interests of investors at each level were in material conflict with those of investors at each other level, and so in conflict with the firm's interests. In 10 additional cases (13%), shareholders were the sole residual owners of the firm. Even if contracting could put "the senior lender who will not be paid in full" (106) in control of the firm, that would not solve the contracting problem. That lender's interests conflict with the firm's interests in the large majority of cases.

More than a decade ago, Professor George Triantis had already grasped the impossibility of identifying a single residual owner, and the implications for bankruptcy contracting:
 The most enduring problem, however, is that even if successful, the
 shift in decisionmaking authority to the residual owners does not
 eliminate financial agency problems. Unsecured creditors are
 residual owners only at the margin. Their participation in the
 company's fortunes is bounded on both sides: they share gains with
 shareholders and losses with the more senior creditors. Therefore,
 conflicts of interest between the residual owner who holds
 decisionmaking authority in bankruptcy and these other groups will
 persist. In particular, the more senior creditors will not have the
 protection of covenants and the accompanying rights to accelerate
 and enforce. Therefore, bankruptcy rules that replace the controls
 of covenants will still have a role to play. (107)

Baird and Rasmussen contend that sophisticated contracting now shifts control rights dynamically to keep those rights in the appropriate hands. Control rights, they say, "change as the firm's fortunes change, typically in ways that ensure that ... mismatches [between incentives of the individual investors that possess control rights and what is in the best interests of the firm as a whole] do not occur." (108)

Baird and Rasmussen do not offer any description of the contracts that supposedly accomplish this remarkable feat. (109) Contracts that shift control of the board of directors among investors based on some measure of the changing value of the firm theoretically could do it, but Baird and Rasmussen do not suggest that such contracts exist. Professor Stephen Lubben demonstrates that the kinds of contracts that are in widespread use (contracts providing for remedies on default) do not shift control to a single creditor but instead give numerous creditors varying degrees of hegemony over the debtor and each other. (110)

In their Reply, Baird and Rasmussen seek to reduce their reliance on the single-residual-owner point saying, "Nor does the mechanism even have to entrust this decision to a single person. A variety of mechanisms can be put in place outside of bankruptcy to induce value-maximizing decisions." (111) Baird and Rasmussen allude to the possibility of "a mechanism" that would work "by forcing those in control to return to capital markets to keep [their business] running" (112) but they do not say what it is. The mechanisms by which Baird and Rasmussen assert that creditors with conflicting interests share control of reorganizing firms remain unspecified.

Baird and Rasmussen offer WebVan as an example of the new success in bankruptcy contracting. (113) Without describing the contract used, they assert that "[f]rom beginning to end, control of WebVan's assets rested with those in the best position to make the strategic decisions." (114) What they apparently mean is that the venture capitalists who founded WebVan hired a CEO and left him in unfettered control because he was in the best position to make the shutdown decision. What that CEO actually did was burn through the shareholders' entire $1.2 billion cash investment in two years, closing the business only when it lacked sufficient cash to continue. (115) The venture capitalists had been attracted to WebVan in the first place because (unlike in other venture capital opportunities) they could strike it rich without having to risk much of their own money. WebVan could go public almost immediately, and from then on, the public shareholders and unsecured creditors would bear the risk. (116)

By the time WebVan liquidated, it was apparent that the unsecured creditors (who never got control of WebVan) had been the firm's residual owners in the closing months of operations. They got about forty-eight cents on the dollar if they extended credit to WebVan or six cents on the dollar if they extended credit to WebVan's subsidiary. (117) Nothing in the WebVan story suggests that its control rights were coherently allocated or shifted dynamically. (118) WebVan is not the paradigmatic example of bankruptcy contracting's success but merely another variation on its failure.

Contracts currently in use have no mechanism for identifying the residual owner beyond the crude assumption that debtors only default to residual owners. (119) That assumption is unwarranted. Most lenders contract to receive control before their own interests are significantly at risk, not while they are significantly at risk. (120) If such a contract achieves its intent, the lender receives control before it becomes the residual owner--a time when the lender has nothing to lose by insisting on immediate liquidation. As Baird and Rasmussen acknowledge, "It is the fear of the improper exercise of such power that lies at the heart of reorganization law." (121) Reorganization constrains exercise of that power, which may partly explain reorganization's continued vitality.

In their Reply, Baird and Rasmussen abandon the assertion that contracts give control to investors with incentives that match the interests of the firm. Instead, they argue that it usually will not matter whether seniors or juniors make the decisions because the same decisions will be in the interests of both. (122) All the decisionmaker needs is "the skill and the incentive to make [the particular decision] correctly." (123) This new, fuzzy theory of control rights is not empirically testable. It rests heavily on Baird and Rasmussen's a priori conviction that the contracting parties are sophisticated market players, so their contracts must provide a coherent control scheme. (124) What Baird and Rasmussen miss is that the contracts are not intended to put creditors in control of reorganizing businesses or to provide a scheme for bankruptcy decision making. The contracts contemplate and permit reorganization under the control of the debtor's board of directors. The parties intend the contracts only to provide creditors with blunt leverages by which they will seek to influence the board.

Constraining creditors with the wrong incentives does not alone solve the bankruptcy governance problem. Someone must affirmatively govern the firm. Bankruptcy reorganization solves the governance problem by leaving the directors in control of the firm and imposing on them fiduciary duties to all parties in interest. Under the loose supervision of a disinterested judge, the directors impose their decisions on the usually hopelessly conflicted parties. Bankruptcy reorganization's regulatory solution is not ideal, but Baird and Rasmussen have not yet demonstrated the existence of a coherent contract alternative.


Baird and Rasmussen's third alternative argument for the irrelevance of bankruptcy reorganization is that improvements in markets have made it possible to sell firms rather than rehabilitate them. (125) The buyers, they say, can best do the rehabilitating. (126)

Substantial improvements in markets may have occurred over the past two decades. (127) Nevertheless, the number of reorganizations is growing, and the proportion of distressed firms reorganizing remains high. (128) Although I have no data on the point, my impression is that creditors force few bankruptcy liquidations. Firms liquidate in bankruptcy only after their boards conclude that the firms could not survive even if bankruptcy relieved them of all their unsecured debt. So long as distressed firms can survive on their own, they exhibit an overwhelming preference for reorganization over liquidation.

The strength of that preference suggests that reorganization value in excess of liquidation value (going-concern value) is not the only significant force driving reorganizations. Even in the absence of going-concern value, those in control of the firm may rationally prefer reorganization for at least two other reasons. To understand those reasons, one must first realize that, contrary to Baird and Rasmussen's claim, (129) boards of directors rather than DIP lenders control most large, public firms in reorganization. (130) The board, acting on behalf of the debtor-in-possession, makes the sale or shutdown decision. In doing so, the board is protected by the business judgment rule, (131) meaning that the board can do whatever it believes is in the interests of the firm. (132)

The first reason board-controlled, viable firms prefer to avoid sale is that sale collapses the probability distribution of possible firm values. The effect is a transfer of wealth from shareholders to creditors. To understand that effect, consider the example of a firm with debt of 100 that by confirmation of a plan may be worth 90 (a 50% probability) or 110 (a 50% probability). In reorganization, the shareholders of this firm have an expectancy of 5. (133) If the directors sell this firm as a going concern during the bankruptcy case, the sale will be for a price of 100. (134) A sale will resolve the uncertainty as to firm value and so collapse the probabilities. The absolute priority rule requires that the proceeds of sale go entirely to creditors. Equity will not share. Thus, a sale extinguishes the shareholders' expectancy and gives a windfall to the creditors. (135) That violates the implicit understanding under which the production team came together, formed the firm, and entrusted the directors with control. The understanding was essentially that the probability distribution would not be collapsed until the firm was no longer viable. (136)

Baird and Rasmussen respond that parties could contract to solve the probability-collapse problem by adopting a relative priority rule in place of the absolute priority rule. (137) What Baird and Rasmussen miss here is that the parties actually contracted to solve this problem in a different, and so presumably more efficient, manner. At the founding of the firm, the shareholders and creditors agreed to cede power to a board of directors that would remain in office in the event of bankruptcy, seek reorganization instead of liquidation, and provide reasonable protection for shareholder interests should liquidation occur. The routine sales of firms entering Chapter 11 that Baird and Rasmussen advocate would deprive the shareholders of that bargained-for protection.

The second reason board-controlled, viable firms prefer to avoid sales is closely related. The beneficiaries of the implicit understanding just referred to include not only creditors and shareholders but also other members of the production team who invested in the firm in reliance on the understanding. Those other members may include employees, managers, suppliers, customers, and communities. (138) Sale often would adversely affect them because the buyer will install a new board that was not a party to the understanding. The new board members may not consider themselves bound by that understanding. (139) Managers may be replaced, employees may lose seniority or even their jobs, relational contracts with suppliers and customers may be disavowed, and the reliance investments of communities may be ignored. (140) Enforcement of the understanding may be efficient because it is the contract under which the production team voluntarily came together. (141) To avoid breaching it, boards generally decline to sell the firm so long as it remains viable--even if the price offered modestly exceeds the firm's reorganization value. (142)

Baird and Rasmussen respond that "[h]owever desirable it might be to have a reorganization law that uses a board to preserve relationships, current Chapter 11 as practiced does not do this, at least not by the time the case is over." (143) The description they offer is one in which many board members resign during reorganization and creditors exercise influence over the selection of their replacements to take control of the firm.

The resignation and replacement process that Baird and Rasmussen describe may indeed make the board more responsive to the interests of creditors. That responsiveness should not, however, be confused with creditor control. Creditors seek to boost their influence over the board precisely because the board remains in control. Regardless of the amount of influence creditors may have in a given case, generally speaking, new members can join the board only if elected by the existing members. The new members are more often selected for stature and independence from the old, failed management than for fealty to creditors. Once in office they owe fiduciary duties not to the creditors alone but to "the entire community of interests that sustains the corporation." (144) If the firm survives the bankruptcy, the new directors will govern in the postbankruptcy period. If the emerging firm remains public they will likely do so with the same kind of independence from the new shareholders that their predecessors had from the prior shareholders.

Board turnover in the WorldCom case--one of three cases Baird and Rasmussen selected as representatives of their position--illustrates the nature of the process. Two members of WorldCom's twelve-member board--Bernie Ebbers and Scott Sullivan--had been forced out before WorldCom filed for bankruptcy in July 2002. To replace them, the WorldCom board hired former U.S. Attorney General Nicholas Katzenbach and Dennis Beresford, the "squeaky clean" University of Georgia accounting professor who had formerly been chairman of the Financial Accounting Standards Board. (145) A month into the bankruptcy case, the board added C.B. Rogers, a former Chairman and Chief Executive Officer of Equifax. (146) Two months into the bankruptcy case, the board hired Michael Capellas, then President of Compaq Computers, as CEO of WorldCom and made him the fourth new member of the board. In the meantime, two additional Ebbers-era members resigned from the board. Seven Ebbers-era members remained on the board and constituted a substantial majority until they resigned en masse December 17, 2002--five months into the case. Their resignations left only the four new directors in office. As WorldCom prepared to emerge from bankruptcy in August 2003, the four new members chose five additional new members. Nothing reported in the press suggests that creditors played any part in the selection of those five. With the board already at nine members, the debtor announced that it would permit the creditors' committee to nominate three additional directors "subject to appropriate background clearance and compliance with the Company's corporate governance standards." (147) The twelve-member board thus selected is expected to govern after WorldCom emerges from reorganization.

Creditors did not take control of WorldCom through this evolutionary process. The persons with the strongest influence on the selection of each new board member (except for the last three chosen) were the persons already on the board.

Theoretically, creditors could contract for greater control of reorganizing firms and use that control to force sales-as-going-concerns. In practice, they do so infrequently. The relative dearth of going-concern sales in Chapter 11 suggests either that firms cannot operate efficiently at the point of their lead lender's bayonet or that the lenders holding the bayonets do not think going-concern sales are in their own interests. (148)


Big-case bankruptcy reorganizations have not ended. They are booming. Their survival casts doubt on the theories that Baird and Rasmussen present in The End of Bankruptcy. But those theories fail for reasons more basic than the theories' inability to account for the pattern of dispositions in the bankruptcy courts.

Baird and Rasmussen's view of the bankrupt firm as merely an asset-owning entity misses the firm's essence. (149) Coase's view of the bankrupt firm as a relationship among people captures it. (150) Baird and Rasmussen's firm has no going-concern value and so it makes no sense to reorganize it. Coase's firm may have going-concern value, and so it makes sense to reorganize it if the relationships are working or can easily be fixed. Baird and Rasmussen's firm does not fit the data; Coase's firm does.

Law and economics scholars have long maintained that contracts could and should replace bankruptcy reorganization. (151) In their article, Baird and Rasmussen split with law and economics tradition to acknowledge that bankruptcy contracting can be accomplished without a change in the law (152) and to claim that bankruptcy contracting has already replaced bankruptcy reorganization. The claim is empirically wrong, and the theory from which Baird and Rasmussen derived it is defective. The problem is the same one that doomed earlier efforts to prove the viability of bankruptcy contracting: The theorists can specify no mechanism by which the claimed contracts could operate. (153)

Baird and Rasmussen's assertion that the market for distressed firm is improving may be correct. But that assertion is only one of several possible explanations for the sharp increase in the number of liquidating bankruptcies since 1998. (154) If the assertion is correct, it raises the question why large reorganizations continue to occur in record numbers. The answer may be that firm resist their own sale for reasons that scholars have only recently begun to explore. The End of Bankruptcy's most important contribution may be as a catalyst to that exploration.

(1.) Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 STAN. L. REV. 751, 751-52 (2002) (footnotes omitted).

(2.) They cite only newspaper articles reporting the liquidation of specific firms. See, e.g., id. at 751 (TWA); id. at 751-52 (Enron); id. at 752 (Budget Group); id. (Polaroid); id. at 752 n.5 (Dade Behrning); id. at 767-68, 781 (WebVan); id at 768, 783-84 (Iridium); id at 787 n.161 (Global Crossing); id at 787 (Qualitech Steel). Baird and Rasmussen have remedied this defect by making a plausible and much more extensive empirical defense of their assertions in a Reply published in this issue. Douglas G. Baird & Robert K. Rasmussen, Chapter 11 at Twilight, 56 STAN. L. REV. 673 (2003).

(3.) Lynn M. LoPucki, The Bankruptcy Boom 2 (2003) (unpublished manuscript, on file with author).

(4.) Id. (showing that 47 firms that filed bankruptcy as public companies each with assets exceeding approximately $218 million emerged in 2002, surpassing the prior record of 36 firms in 1992).

(5.) Riva D. Atlas, Enron's Collapse: The Options; A Trend Toward Liquidation, Not Company Reorganization, N.Y. TIMES, Nov. 30, 2001, at C1 (seeking to explain the increase in liquidation cases). Ironically, after serving as the exemplar of the trend toward liquidation, Enron recently reversed its plan to liquidate. Rebecca Smith, Enron May Split Off Pipeline Units, WALL ST. J., Mar. 20, 2003, at A8 (reporting that Enron would spin off its core businesses rather than sell them because Enron was "not satisfied [it was] getting full value for [its] properties at auction"); LoPucki, supra note 3, at 7 (showing that 41 firms that filed bankruptcy as public companies each with assets exceeding approximately $218 million liquidated in 2002, although no more than 8 such firms did so in any year prior to 1999).

(6.) LoPucki, supra note 3, at 12 (showing 53% of large, public company case dispositions to be by reorganization rather than liquidation).

(7.) Infra note 75 and accompanying text.

(8.) Baird & Rasmussen, supra note 2, at 699 (stating that "[t]raditional reorganizations are all but gone").

(9.) Lynn M. LoPucki, Protocols for the Bankruptcy Research Database 8 (Nov. 12, 2003) (unpublished manuscript, on file with the author).

(10.) Baird & Rasmussen, supra note 2, at 677 (counting Global Crossing as a sale of the company because the plan "consisted primarily of a purchase agreement under which the prebankruptcy suitor would receive 60% of the equity in exchange for several hundred million in cash").

(11.) Id. at 679 (counting cases as "prenegotiated" merely because the confirmed plans "adhered to the basic contours of the deal brokered before the petition was filed, albeit with some alterations").

(12.) Id. at 680-84 (reviewing 15 firms that successfully completed reorganizations in 2002 and concluding that none of them were traditional reorganizations because none had going-concern value).

(13.) Id. at 684-85 (stating that Worldcom, Adelphia, and United Airlines cannot "be considered paradigmatic reorganizations either" because they "have a dynamic utterly different from what we saw only a few years ago").

(14.) Lynn M. LoPucki's Bankruptcy Research Database, available at (last visited Nov. 29, 2003). Case size was measured by assets reported on the firm's last 10-K filed before bankruptcy, adjusted for inflation to current dollars. There have been only six other cases as large: Enron (2001), Pacific Gas & Electric (2001), First Executive Corp. (1991), Texaco (1987), First Republic Bank Corp. (1988), and Baldwin-United Corp. (1983).

(15.) Baird & Rasmussen, supra note 1, at 751 ("Giant corporations ... are no longer using [Chapter 11] to rescue a firm from imminent failure.").

(16.) NTL, Inc., Form 8-K filed May 8, 2002 (indicating a "'prearranged' joint plan of reorganization under Chapter 11 to convert $10.6 billion of debt into equity of two newly formed companies"). The designation "prearranged" indicates that creditors had not yet voted on the plan. Another, Conseco, had reached an "agreement in principle with representatives of its banks and bondholders." Conseco, Inc., Form 8-K filed Dec. 17, 2002, at 1. These kinds of understandings are at most alliances between parties to the reorganization case. They fail far short of making Baird and Rasmussen's case that the "principal lenders are usually already in control and Chapter 11 merely puts in place a preexisting deal." Supra text accompanying note 1.

(17.) At the time it filed, Global Crossing had signed a letter of intent to sell a majority interest in the firm to two investors for a $750 million cash investment. Global Crossing Ltd., Form 8-K filed Feb. 7, 2002. The deal was renegotiated during the Chapter 11 case, resulting in a sale of the majority interest for one-third the letter of intent price. Global Crossing Ltd., Form 8-K filed Jan. 30, 2003 (confirming a reorganization plan providing for sale of a majority interest for $250 million).

(18.) Baird & Rasmussen, supra note 1, at 752 ("Rarely is Chapter 11 a forum where the various stakeholders in a publicly held firm negotiate among each other over the firm's destiny.").

(19.) LoPucki, supra note 14.

(20.) LoPucki, supra note 3, at 12.

(21.) Id. at 13-14.

(22.) Id. at 14 (graph showing adjusted liquidations to be a roughly constant percentage of Chapter 11 cases from the 1980s through 2002).

(23.) LoPucki, supranote 14 (based on all 71 cases filed from 1993 through 1996).

(24.) Id. (based on all 272 cases filed from 2000 through July 2003).

(25.) Baird & Rasmussen, supra note 1, at 788.

(26.) Based on its survey of the empirical studies, the National Bankruptcy Review Commission concluded that "only a small fraction of the Chapter 11 cases filed nationwide end in confirmation of a plan of reorganization. The vast majority are dismissed or converted." NAT'L BANKR. REVIEW COMM'N, FINAL REPORT: BANKRUPTCY: THE NEXT TWENTY YEARS 610 (1997). By contrast, the data for the largest firms show more than half emerging from reorganization as going concerns. LoPucki, supra note 3, at 12 fig.5 (showing at least 53% of large public companies emerging from bankruptcy in every year since 1983).

(27.) MERGERSTAT REVIEW 2 (2003) (table showing the number of net merger and acquisition announcements climbed from 3510 in 1995 to peak at 9566 in 2000).

(28.) See supra notes 20-21 and accompanying text.

(29.) A "large" firm is a firm reporting more than $100 million in assets, measured in 1980 dollars, in its last 10-K filing before bankruptcy. That amount is approximately $220 million in current dollars.

(30.) LoPucki, supra note 3, at 7-8.

(31.) Baird & Rasmussen, supra note 1, at 752 ("Even when a large firm uses Chapter 11 as something other than a convenient auction block ... Chapter 11 merely puts in place a preexisting deal."); LoPucki, supra note 3, at 2-3 (empirical study finding that only 4% of cases filed by large, public firms in 2001 and 2002 were prepackaged).

(32.) Baird & Rasmussen, supra note 1, at 752 ("Rarely is Chapter 11 a forum where the various stakeholders in a publicly held firm negotiate among each other over the firm's destiny.").

(33.) See, e.g., David A. Skeel, Jr., Creditors' Ball: The "New" New Corporate Governance in Chapter 11 (2003) (unpublished manuscript, on file with author) (arguing that corporate reorganization responded to changing conditions and continues to do so).

(34.) Baird & Rasmussen, supra note 1, at 758 (referring to going-concern value as "the thing the law of corporate reorganizations exists to preserve").

(35.) Id.

(36.) Id. at 754.

(37.) Id. at 768.

(38.) Id. at 788.

(39.) Id. at 767.

(40.) Professor Charles Adams made essentially this same argument more than a decade earlier. Charles W. Adams, An Economic Justification for Corporate Reorganizations, 20 HOFSTRA L. REV. 117, 133 (1991) ("[M]ost assets are probably not highly firm-specific, and so, most insolvent corporations will not have substantially greater going-concern than liquidation values and, consequently, will not be good candidates for an effective reorganization.").

(41.) Richard V. Butler & Scott M. Gilpatric, A Re-Examination of the Purposes and Goals of Bankruptcy, 2 AM. BANKR. INST. L. REV. 269, 281 (1994) (concluding, based on application of Coase's The Nature of the Firm to bankruptcy, that "part of the going-concern surplus represents the value to the firm of the relationships which it has established with factor owners. The rest reflects the value to it of its relationships with customers, regulators, and other interested parties.").

(42.) As Professor Ronald Coase put it in explaining why firms exist, "contracts [must be] made with people and for things which cooperate with one another." R.H. Coase, The Nature of the Firm: Influence, in THE NATURE or THE FIRM 61, 64 (Oliver E. Williamson & Sidney G. Winter eds., 1991).

(43.) Consider, for example, this list of "minor glitches" in the first operating days of interact grocer WebVan:
 Too few vans because the vendor was late in delivering the vehicles
 Webvan had ordered. Assignments of sequential deliveries that could
 never have been executed when promised without a helicopter. Parking
 nightmares in San Francisco that made it impossible for drivers to
 park legally and still make their deliveries on time. The driver who
 tried to take his ten-foot-tall van through an eight-foot-high


(44.) See, e.g., Baird & Rasmussen, supra note 1, at 754 ("There is no special magic beyond transaction costs in accounting for any particular collection of assets assembled within a single firm."); Thomas H. Jackson, Avoiding Powers in Bankruptcy, 36 STAN. L. REV. 725, 728 (1984) ("This creditor-oriented justification for bankruptcy--the 'creditors' bargain' theory--rests on the notion that with any given set of entitlements creditors would prefer a system that kept the size of the pool of assets as large as possible."); id at 763 ("[A]t bottom, bankruptcy is designed to maximize a pool of assets for the collective good....").

(45.) See, e.g., Baird & Rasmussen, supra note 1, at 777 ("For a particular firm to be an integral part of the value of the team, it has to contribute unique assets to the mix.").

(46.) Id. at 762.

(47.) 77 B.R. 374 (Bankr. D. Conn. 1987).

(48.) See supra note 46 and accompanying text.

(49.) In their Reply, Baird and Rasmussen provide a fascinating, detailed account of the history of the 26 Trumbull Street property: a restaurant that succeeded until it was sold, a succession of failures, and then finally another success. See Baird & Rasmussen, supra note 2, at 685-89. The extended story further illustrates the point I make here. The value of the collection of fungible assets at 26 Trumbull Street was much higher to a buyer who contemplated using them together than to buyers who would separate them.

(50.) Ronald J. Mann, Strategy and Force in the Liquidation of Secured Debt, 96 MICH. L. REV. 159, 179 (1997).

(51.) Id at 178 (noting that the lender failed to recover its full principal and interest in only one of 23 cases and that case was the only one in which the debtor "was not able to liquidate the collateral in the ordinary course of its business").

(52.) Baird & Rasmussen, supra note 1, at 763-68 (discussing the importance of these attributes); id at 763 ("In an industry where assets are fungible, what creates value in a firm is the ability to use assets better than one's competitors.").

(53.) Id. at 763 ("Intellectual property is an even more important part of modern firms. Such assets, however, are not necessarily locked inside a particular firm.").

(54.) Id at 763-68; id at 765 ("Any expertise that even a large firm possesses becomes worthless when its business model fails.").

(55.) Each of the following is an example of an economically distressed firm; that is, a firm that experienced operating losses at the time of bankruptcy. Each recovered through bankruptcy reorganization and is operating successfully at least 10 years later. The year given is the year of the firm's bankruptcy filing: Cherokee, Inc. (1993); Continental Airlines (1983); Greyhound Lines (1990); Hexcel (1993); National Gypsum (1990); NVR, Inc. (1992); Revere Copper and Brass (1982); Wickes Companies (1982) (renamed Collins and Aikman Group); Zales (1992). These are only a few of many.

(56.) Rather than being the essence of the firm, McDonald's Corporation's business format is merely a commodity that the firm rents to its franchisees for a price. A McDonald's franchisee could prosper while McDonald's failed, or vice versa. In addition to the commodified expertise McDonald's Corporation rents to its franchisee, each firm, franchisor, and franchisee has its own, internal expertise. Each might preserve its internal expertise through reorganization.

(57.) Baird & Rasmussen, supra note 1, at 764 ("Know-how locked up in any individual bookstore, however, is not worth saving in a world in which another firm has an operating plan that is both better and scalable.").

(58.) Id. at 773 n.113.

(59.) Id. at 774-76.

(60.) Id. at 775.

(61.) Id.

(62.) Id. at 776.

(63.) Id.

(64.) Id. at 775.

(65.) Id. at 773 ("The synergy of the team makes it valuable, but the value may be independent of any firm.").

(66.) Id. at 758 ("If all the assets can be used as well elsewhere, the firm has no value as a going concern.").

(67.) Baird and Rasmussen state:
 The law clearly demarcates which assets belong to which legal
 entities. A Chapter 11 petition raises the question whether the
 assets that legally belong to this firm should remain with this
 firm.... [R]eorganization law ought to begin by ascertaining the
 value of keeping particular assets together inside a given firm.
 (The alternative is for these assets be returned to the market,
 where they may be reassembled in whole or in part in another firm.)

Id. (footnotes omitted). If "firm" were intended to mean anything other than "legal entity" in this passage, it would be impossible for assets to be reassembled "in whole ... in another firm." Other passages confirm that Baird and Rasmussen regard the legal entity as synonymous with the firm:
 Even with respect to teams, however, one must be careful to
 distinguish the team from the firm. The organizational form and the
 team are independent of one another. The Keim Mills team contributed
 to the success of the Model T over many years, both when they worked
 for Keim and when they worked for Ford. Their identity as a team was
 independent of the legal entity that employed them and independent
 of that entity's relationship to the Model T.

Id at 776. The same usage occurs in other passages. See, e.g., id at 771 ("Products may have intangible goodwill associated with them, but nothing requires that a particular entity survive in order for such assets to survive."); id. at 773 ("But the entity that created the film will disappear regardless of whether the film succeeds or fails."); id ("It has nothing to do with whether a particular firm continues as a discrete legal entity.").

(68.) The phrase is Baird and Rasmussen's. See supra note 67.

(69.) Reassembly may result in different treatment with respect to taxes and successor liability.

(70.) Baird & Rasmussen, supra note 1, at 758 ("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 existing firm, or whether they are moved to an altogether different one."); id at 777 ("To link the need to preserve a team with preserving a particular firm that is in financial distress, one needs to posit that the firm has assets that the team needs in order to flourish.").

(71.) Lynn M. LoPucki & William C. Whitford, Patterns in the Bankruptcy Reorganization of Large, Publicly Held Companies, 78 CORNELL L. REV. 597, 615 (1993) (listing firms individually).

(72.) Lynn M. LoPucki & Joseph W. Doherty, Why Are Delaware and New York Reorganizations Failing?, 55 VAND. L. REV. 1933 (2002) (reporting study).

(73.) Lynn M. LoPucki & Joseph W. Doherty, Excel file 1 (used in paper), column K, available at

(74.) Most firms emerging in 2002 did not file the Form 10-Ks that divulge the post-bankruptcy values of their assets until March 2003, and some will not file them until the end of 2003.

(75.) LoPucki, supra note 14.

(76.) T-test, p < .05 (meaning there is less than a 5% probability that the difference occurred by chance).

(77.) During the 1980s, tax considerations may have caused firms that otherwise would have liquidated to reorganize at a fraction of their former size. But if so, those tax considerations artificially reduced the number of complete liquidations during those years, which presents a similar challenge to Baird and Rasmussen's theory.

(78.) Baird & Rasmussen, supra note 1, at 753 ("In other words, rather than beginning with Modigliani and Miller's irrelevance propositions and Black-Scholes option pricing, scholars of corporate reorganization should start with Ronald Coase and The Nature of the Firm.").

(79.) R.H. Coase, The Nature of the Firm, in AM. ECON. ASS'N, READINGS IN PRICE THEORY 331, 337 n.21 (1952).

(80.) Coase, supra note 42, at 64. He referred to this as "one of the main weaknesses" of his article and sought to qualify it to say that "the full firm relationship will not come about unless 'several such contracts are made with people and for things which cooperate with one another.'" Id.

(81.) Coase, supra note 79, at 336-38 (describing the advantages and disadvantages of the price mechanism in this competition).

(82.) Id. at 337-38.

(83.) Id. Coase later withdrew from his characterization of the difficulties of contracting regarding commodities as "minor" but not from his relative ranking. Coase, supra note 42, at 68.

(84.) See supra Part I.A.3.

(85.) Baird & Rasmussen, supra note 1, at 772. A more plausible explanation might be that the employees realized they were not "essential" to the production of the model T, but, if they struck, it would be cheaper for Ford to increase their wages than to shut the plant down and move it. Ford may have shared their assessment but decided to take a loss in order to establish a reputation that would enable him to extract rents in other situations.

(86.) R. H. Coase, The Nature of the Firm: Meaning, in THE NATURE OF THE FIRM, supra note 42 at 48, 58-59.

(87.) Id.

(88.) See supra notes 35-40 and accompanying text.

(89.) Coase, supra note 42, at 70.

(90.) Baird & Rasmussen, supra note 1, at 785 ("Their investment contracts ensure that when the firm approaches financial distress, its continued operations depend on the willingness of the lender to continue the financing of ongoing operations.").

(91.) Id. Baird and Rasmussen's acknowledgment that debtors and their creditors have the ability to contract around bankruptcy represents an important shift in law and economics thinking. Earlier theorists maintained that such contracting was impossible. See, e.g., Alan Schwartz, A Contract Theory Approach to Business Bankruptcy, 107 YALE L.J. 1807, 1833 (1998) ("Because bankruptcy contracts are currently illegal, there is no data about real contracts that could support this argument. The goal here is to render plausible the view that bankruptcy contracting would occur if it were permitted."). But see Barry Adler, A Theory of Corporate Insolvency, 72 N.Y.U. L. REV. 343, 377-78 (1997) (arguing that bankruptcy courts would respect a well-drafted liquidation agreement).

(92.) See, e.g., LYNN M. LOPUCKI & ELIZABETH WARREN, SECURED CREDIT: A SYSTEMS APPROACH 112 (4th ed. 2003) (describing the 1981 bankruptcy reorganization of McLouth Steel, in which a group of institutions lenders were "virtually in control of the company").

(93.) Stephen J. Lubben, The Ambiguity of Control: Why the Third Lesson of Enron is Wrong 10-24 (Aug. 15, 2003) (explaining why many contracts that appear to put the firm's lead lender in control in fact do not), at (last visited Nov. 29, 2003).

(94.) Baird & Rasmussen, supra note 1, at 778 ("Most large firms now allocate control rights among investors in a way that ensures coherent decisionmaking throughout the firm's lifecycle.").

(95.) Id. at 779.

(96.) Id. at 781 (emphasis added).

(97.) Id. at 778.

(98.) See, e.g., Douglas G. Baird & Robert K. Rasmussen, Four (or Five) Easy Lessons From Enron, 55 VAND. L. REV. 1787, 1805 (2002) (footnote omitted):
 In the case of a large firm in bankruptcy, we find that, at the
 moment Chapter 11 is filed, a revolving credit facility is already
 in place that entrusts decisionmaking authority to a single entity.
 This entity will often step in and replace management. It will make
 the necessary operational decisions before Chapter 11 begins.

Baird and Rasmussen regard lack of control by a single investor as a malfunction. Baird & Rasmussen, supra note 1, at 785 ("To be sure, a firm might find itself caught up in a sudden crisis, and no single investor may be able to take control. But these cases are increasingly rare.").

(99.) Baird & Rasmussen, supra note 1, at 785.

(100.) Douglas G. Baird & Thomas H. Jackson, Bargaining After the Fall and the Contours of the Absolute Priority Rule, 55 U. CHI. L. REV. 738, 761 (1988) ("The dollar that is won or lost because of good or bad negotiating by definition is felt by the residual owner."),

(101.) Id. at 775.

(102.) Thomas H. Jackson & Robert E. Scott, On the Nature of Bankruptcy: An Essay on Bankruptcy Sharing and the Creditors' Bargain, 75 VA. L. REV. 155, 159 (1989):
 The problem of transferring decision-making power from the equity
 owners ... is compounded by the associated problem that no other
 class may sufficiently reflect the interests of the claimants taken
 as a whole. Thus, the objective of the collective is never entirely
 congruent with the objective of any of the constituent parts.

(103.) See, e.g., Lynn M. LoPucki & William C. Whitford, Corporate Governance in the Bankruptcy Reorganization of Large, Publicly Held Companies, 141 U. PA. L. REV. 669, 771-76 (1993); George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 CAL. L. REV. 1073, 1100 (1995) ("Even at the best of times, it is difficult to establish a governance process that aligns managerial incentives with the collective interests of all stakeholders. No single investor or class of investors can represent the collective interest of all stakeholders of an insolvent firm.").

(104.) Those factors include: (1) subordination agreements that do not include all unsecured creditors, (2) uncertainties regarding firm value, and (3) governance decisions large enough to affect investors at multiple priority levels. Lynn M. LoPucki, The Myth of the Residual Owner 18-19 (2003) (unpublished manuscript, on file with author).

(105.) Id.

(106.) Baird & Rasmussen, supra note 1, at 785.

(107.) George G. Triantis, A Theory of the Regulation of Debtor-in-Possession Financing, 46 VAND. L. REV. 901,916 (1993).

(108.) Baird & Rasmussen, supra note 1, at 782.

(109.) Baird and Rasmussen cite Kaplan and Stromberg for the idea that "[h]igh tech firms ... have sophisticated contracts expressly designed to ensure that control rights lie in the appropriate hands," id. at 781 (citing STEVEN N. KAPLAN & PER STROMBERG, FINANCIAL CONTRACTING THEORY MEETS THE REAL WORLD: AN EMPIRICAL ANALYSIS OF VENTURE CAPITAL CONTRACTS 1-2 (Nat'l Bureau of Econ. Research, Working Paper No. 7660, 2000)), but that study is not of large public companies and does not report contract provisions in sufficient detail to show whether the contracting parties were even attempting to shift control to residual owners.

(110.) Lubben, supra note 93, at 13-14 (citing examples that show that numerous creditors typically have varying types and degrees of control simultaneously).

(111.) Baird & Rasmussen, supra note 2, at 695.

(112.) Id.

(113.) Baird & Rasmussen, supra note 1, at 781 ("To see how contracts can allocate control rights coherently in a failing enterprise, consider the demise of Webvan.").

(114.) Id.

(115.) Compare Neil Irwin, Dot-Corn Relics Scoot on; Buyers Misty-Eyed for Kozmo, Webvan and Other Flops, WASH. POST, Aug. 9, 2001, at E01 (stating that Webvan burned through $1.2 billion investment), with WebVan Group, Inc., Form 8-K filed Sept. 5, 2001 (showing WebVan to have only $20 million in cash--about enough to pay the bankruptcy lawyers--when it filed bankruptcy), and Kathleen Pender, Webvan Rolled in Luxury, S.F. CHRON., Oct. 28, 2001 at E1 ("Webvan estimates that when it is finished liquidating, its four divisions combined will have about $44 million available for distribution to creditors.").

(116.) STROSS, supra note 43, at 39-40 (The author recounts a discussion among the venture capitalists in which one said, "The beauty of this business [WebVan] is--I don't think this is a four-round financing. There is not another venture round." Another replied, "And it's not our money....").

(117.) Pender, supra note 115, at E1.

(118.) Id ("Shareholders won't get anything.").

(119.) Baird & Rasmussen, supra note 1, at 778-85 (discussing contracts that allocated control rights).

(120.) Loan agreements commonly provide that the debtor's failure to maintain a cushion of equity beyond the value necessary to repay the loan constitutes a default. See, e.g., Cent. La. Elec. Co. v. Dolet Hills Mining Venture, 116 F. Supp. 2d 726, 732 (W.D. La. 2000):
 Section 20.7(b) of the Lignite Mining Agreement (the "LMA") and
 Section 5.3 of the Option and Security Agreement between CLECO and
 SWEPCO ("Project") and Miner each require the Miner to maintain a
 debt to equity ratio of 2.8 to 1.0. Failure to do so is an event of
 Major Default under Section 23.1(b) of the LMA.

(121.) Baird & Rasmussen, supra note 1, at 779.

(122.) Baird & Rasmussen, supra note 2, at 696 ("Large businesses do not ordinarily find themselves in situation in which the senior creditors want to shut them down, while the junior ones do not."); id. (noting that in Enron "there was almost no disagreement with respect to the single most important decision at the start of the case").

(123.) Id.

(124.) Id. at 695-96 ("To the extent that unsecured creditors would tend to shut the business down at the wrong time, one should not expect them to have the power to do so."); id. at 696 ("The investment contracts in the typical large case are the product of careful design.").

(125.) Baird & Rasmussen, supra note 1, at 786-88.

(126.) Id. at 786 ("[T]he buyer of the assets takes them and applies a new capital structure.").

(127.) Baird and Rasmussen present no evidence but merely assume the point.

(128.) LoPucki, supra note 3, at 1-2.

(129.) Baird & Rasmussen, supra note 1, at 785 ("In other words, it is the [DIP] lender, and not the Bankruptcy Code or the bankruptcy judge, that is deciding how long the managers will have to make a go of things.").

(130.) "DIP lenders" are financial institutions that make loans to reorganizing debtors at the inception of bankruptcy cases. DIP lenders sometimes are in effective control of reorganizing firms. But that is not their usual role. DIP lenders are ordinarily asset-based lenders. That is, they contract for sufficient collateral or priority that they will not be at risk from the business. See, e.g., Robert Manor, Lenders Embrace Bankruptcy Concerns." Sour Economy Proves Sweet for 'DIP' Financing, CHI. TRIB., Jan. 9, 2002, at N1 ("[DIP 1]enders take a long and expert look at company assets, whether a fleet of planes or a portfolio of patents, to determine if the collateral is sufficient to repay a loan."). The board must work within cash constraints fixed by the firm's contract with the DIP lender. But for all practical purposes in most cases, the board remains in control.

Boards sometimes agree that failure to sell the firm within a fixed period of time (often 120 days) will constitute a default under the DIP lending arrangement. But even such a default does not put the DIP lender in control. First, the DIP lender is not making the decision whether to liquidate or reorganize. The board made that decision when it sought financing conditioned on sale. Second, default under such an agreement does not give the DIP lender the ability to make future decisions. It gives the DIP lender only the option to foreclose.

(131.) 3 COLLIER ON BANKRUPTCY [paragraph] 363.02[1][g] (15th ed. 2002) ("In determining whether to approve a proposed sale under section 363, courts generally apply standards that, although stated variously [sic] ways, represent essentially a business judgment test.").

(132.) See, e.g., Lawrence E. Mitchell, Conversations from the Warren Buffett Symposium, 19 CARDOZO L. REV. 719, 741 (1997) ("The law sets such wide parameters that the board can do what it wants.").

(133.) That is, there is a 50% chance that the firm will be worth 110. If it is, shareholders will receive 10 and creditors will receive 100.50% * 10 = 5.

(134.) A 50% chance of 110 is worth 55 and a 50% chance of 90 is worth 45, indicating a total firm value of 100.

(135.) Collapsing the probabilities as to value before confirmation thwarts the expectations of the parties because the debtor's bargain allowed for reorganization. The debtor and its creditors could have contracted out of bankruptcy but chose not to do so. See supra note 91 and accompanying text.

(136.) See Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA. L. REV. 247, 275-79 (1999) (arguing that public companies are based on implicit understandings that differ from the formal contracts with team members and that team members entrust boards of directors to enforce those understandings); Andrei Shleifer & Lawrence H. Summers, Breach of Trust in Hostile Takeovers, in CORPORATE TAKEOVERS: CAUSES AND CONSEQUENCES 33 (Alan J. Auerbach ed., 1988) (arguing that corporate stakeholders enter into implicit contracts based on trust and that takeover premiums result principally from breach of those trusts); Lynn M. LoPucki, A Team Production Theory of Bankruptcy Reorganization, 57 VAND. L. REV. (forthcoming April 2004) (explaining bankruptcy reorganization in terms of team production theory).

(137.) Baird & Rasmussen, supra note 2, at 693 ("Hence, alternatives to the absolute priority rule (such as relative priority) may make more sense."); id. at 693 & n.66 (advocating the use of Bernstein's financial instruments in liquidations as well as in reorganizations). Elsewhere Baird and Rasmussen have argued that the change should not be made by law, because parties are free to contract for it. Douglas G. Baird & Robert K. Rasmussen, Control Rights, Priority Rights, and the Conceptual Foundations of Corporate Reorganizations, 87 VA. L. REV. 921, 940 (2001) ("There seems to be little reason for departing from absolute priority in modern publicly traded firms.").

(138.) Blair & Stout, supra note 136, at 253 ("[B]oards exist not to protect shareholders per se, but to protect the enterprise-specific investments of all the members of the corporate 'team,' including shareholders, managers, rank and file employees, and possibly other groups, such as creditors."); Shleifer & Summers, supra note 136, at 38 ("Although these [implicit] long-term contracts are usually thought of as covering managers or employees, they also commonly apply to customers and suppliers.").

(139.) Essentially the same problem occurs in hostile takeovers. Shleifer & Summers, supra note 136, at 41 ("As the incumbent managers are removed after the takeover, control reverts to the bidder, who is not committed to upholding the implicit contracts with stakeholders. Shareholders can then renege on the contracts and expropriate rents from the stakeholders.").

(140.) Margaret M. Blair & Lynn A. Stout, Director Accountability and the Mediating Role of the Corporate Board, 79 WASH. U. L.Q. 403,422 (2001) (citation omitted):
 The adoption of antitakeover provisions at the initial public
 offering stage makes sense, however, as a means of encouraging team
 production by reassuring that firm's managers and employees that
 their futures rest in the hands of the board of directors, rather
 than with shareholders who might be tempted to sell them out in the
 "market for corporate control."

(141.) See, e.g., Blair & Stout, supra note 136, at 305 ("[A] shareholder decision to yield control rights over the firm to directors ex ante--that is, when the corporate coalition is first formed--can induce other participants in the team production process to make the kind of firm-specific investments necessary to reap a surplus from team production in the first place."); Shleifer & Summers, supra note 136, at 38 ("The [implicit] contracts are beneficial both to stakeholders and to shareholders, as they split the ex ante gains from trade.")

(142.) Firms seldom make explicit reference to the implicit understanding, but there are exceptions. Sterling Chemicals Holdings, Inc., Form 8-K, (July 17, 2001):
 The Chapter 11 filings will allow the Company to access additional
 working capital and significantly reduce its overall debt, while
 continuing to operate its business in the ordinary course and in
 compliance with its long-standing commitment to the health and
 safety of its employees and the communities in which it operates.

(143.) Baird & Rasmussen, supra note 2, at 697-98 n.80.

(144.) Credit Lyonnais Bank Nederland, N.V. v. Pathe Communs. Corp., No. CIV.A. 12150, 1991 Del. Ch. LEXIS 215, at * 109 (Dec. 30, 1991) ("But the MGM board or its executive committee had an obligation to the community of interest that sustained the corporation, to exercise judgment in an informed, good faith effort to maximize the corporation's long-term wealth creating capacity."); id. ("[C]ircumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.").

(145.) Kathy Brister, UGA Professor Takes Tough Job: WorldCom Turns to New Leadership, ATLANTA J.-CONST., July 27, 2002, at IF.

(146.) Barnaby J. Feder, WorldCom Drafts a Roster of High-Profile Directors, THE INT'L HERALD TRIB., Sept. 1, 2003, at 11.

(147.) Notice of Designation of Reorganized WorldCom Board of Directors at 1, In re Worldcom, Inc., 296 B.R. 115 (Bankr. S.D.N.Y. 2003) (Case No. 02-13533) (announcing new directors and prospective creditors' committee nominations).

(148.) Shleifer & Summers, supra note 136, at 40 ("[I]t is essential to see that shareholders deliberately choose as managers individuals for whom value maximization is subordinate to satisfaction of stakeholder claims, and then surrender to them control over the firm's contracts.").

(149.) See supra Part I.A.

(150.) Id.

(151.) See, e.g., Robert K. Rasmussen, Debtor's Choice: A Menu Approach to Corporate Bankruptcy, 71 TEX. L. REV. 51 (1992) (advocating a change in bankruptcy law to offer debtors and their creditors a menu of bankruptcy options from which they would select by contract). For a review of the literature, see Susan Block-Lieb, The Logic and Limits of Contract Bankruptcy, 2001 U. ILL. L. REV. 503.

(152.) See supra note 91 and accompanying text.

(153.) Lynn M. LoPucki, Contract Bankruptcy: A Reply to Alan Schwartz, 109 YALE L.J. 317, 317 (1999) ("Since the publication of Professor Robert Rasmussen's landmark article in 1992, the central focus of bankruptcy scholarship has been to discover a practical method of contracting for bankruptcy procedure.").

(154.) See supra notes 27-28 and accompanying text.

Lynn M. LoPucki, Security Pacific Bank Professor of Law at the UCLA School of Law. I thank Steve Bainbridge, Frances Foster, Dan Keating, Ken Klee, Bill Klein, Stephen Lubben, Ronald Mann, David Skeel, Lynn Stout, and Elizabeth Warren for comments on earlier drafts and Joseph Doherty of the UCLA School of Law's Empirical Research Group for assistance with statistical testing.
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Title Annotation:response to Douglas G. Baird and Robert K. Rasmussen, Stanford Law Review, vol. 55, p. 751, 2002
Author:LoPucki, Lynn M.
Publication:Stanford Law Review
Date:Dec 1, 2003
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