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The strategic choice of Chapter 11: an examination of the critical factors.

Should Chapter 11 be a last resort for firms facing a decline in financial resources and growing environmental adversity? Or should it be considered at an earlier stage and used as a proactive strategy? The recent use of the Bankruptcy Code by various organizations suggests the existence of managerial prerogative in seeking bankruptcy reorganization. This is a strategic option as opposed to imminent financial insolvency. The development in the Bankruptcy Code, and its non-traditional applications by firms show the increasing protective aspect of Chapter 11 for firms faced with an abnormal hostile environment.

This paper focuses on the strategic option of selecting Chapter 11 prior to financial insolvency and develops a framework that can be used by management to identify the appropriate triggering time in order to increase business survival after Chapter 11.

What is the Protective Environment of Chapter 11 ?

The intent of the statute is to provide a business with a temporary protection from creditors to solve a financial crisis. The reforms of the 1978 Bankruptcy Code attempt to speed bankruptcy proceedings and simplify them. Usually the court allows the debtor's management to continue running the business ("debtor in possession"), unless management is considered by the court to be incompetent or untrustworthy, in which case an independent trustee is appointed.

This protection is assumed to save threatened firms from the likelihood of liquidation and increase their survival.(1) The code provides the protective environment by temporary suspension of debt service and renegotiation of burdensome contracts. Due to reducing financial drains and internally generated funds (through reduced production costs), a better financial position is expected to result. An example is the Wheeling-Pittsburgh Steel Corporation which filed in 1985. In 1989, while still in Chapter 11, the operating costs were down to $360 a ton, compared with $471 for the industry average. The company's profitability has soared in the last five years, from $5 for each ton of steel to $59 a ton. The average for other domestic steel makers is $39 a ton.(2)

Prior to bankruptcy, the organization's environment may be characterized by terms such as crises, competitive stress, adversity, decline, or financial insolvency as viewed by constituents (managers, stockholders, and creditors). The Code can be considered an opportunity for new vitality. This revitalization occurs by shaking the firm's routines so that new adjustments to the market may result.

For example, as a result of actions taken subsequent to the filing for Chapter 11 by LTV Steel Company (along with its parent, LTV Corporation) in July 1986,| a downsized steel operation has been created which is more cost efficient. Also, a labor agreement settled in 1987, has enabled the company to reduce costs by approximately $50 million per year without reducing hourly wages. The reduced costs were achieved through combining several craft jobs. Raw material costs were also reduced as a result of replacing or renegotiating burdensome contracts with less expensive contracts. This suggests that Chapter 11 induces management to realize the existence of hidden, potentially productive resources (human, facilities, or financial). These actions have continued to help the LTV company to successfully face foreign competition.

The Strategic Choice of Chapter 11

In both of these cases, i.e. Wheeling-Pittsburgh and LTV, voluntary bankruptcy petitions were submitted prior to financial insolvency. Previously, debtors had to convince the court of their insolvency. Under the revised Code firms are assumed to be filing for relief in good faith. Balance sheet insolvency is no longer a necessary condition for the protection.(4) If the firm can demonstrate to the court real or potential financial troubles, the court will generally accept the petition.(5)

This suggests the existence of managerial prerogative in seeking bankruptcy reorganization as an early strategic option as opposed to imminent financial insolvency. One could suggest that Congress indirectly provides the proposed strategic option by encouraging an early reorganization. Engel6 observed that "Congress relaxed the requirements for filing under Chapter XI,... because it felt that too often in the past, faltering firms waited too long to attempt reorganization and were forced to liquidate." (p. 62)

Accordingly, the use of bankruptcy reorganization as an early proactive choice, is a strategic move that facilitates management's efforts in coping with future threats. If Chapter 11 is adopted at an earlier stage, as part of a grand retrenchment strategy, it may enhance survival in the long run.

The Arguments Against Chapter 11

Although the proactive use of Chapter 11 may be a valid choice in many situations, there may be some arguments raised against the use of Chapter 11. One could argue that many of these actions, such as downsizing or renegotiating burdensome contracts are still available without declaring Chapter 11.

However, the provisions of the Code seem to provide more backing and support to managerial actions. Under normal circumstances, debt agreements often restrict the extent to which downsizing and restructuring (selling of assets) can be used.(7&8) Also, the downsizing strategy is not successful if it stands alone without being supported by improvement in economic or competitive conditions.(9) Without this external environmental change, a troubled firm may use Chapter 11 to provide a transitional period away form environmental pressure.

A second argument is that the interference of the bankruptcy court and creditors' committees will impose bureaucratic constraints and delays on management's actions and decision making process. While Nelson(10) argues management under Chapter 11 may have a better chance to make desired changes, since problems are brought out into the open and cash flow increases (as a result of the cessation of heavy financial obligations), yet the burden and restraints of creditors scrutinizing business decisions made by a debtor should not be underestimated. Also, court approval of changes is not automatic rather than it should be argued for by management. These challenges place additional burden on upper management to defend their strategic proposal.

As discussed later, it is critical for upper management of Chapter 11 organizations to constantly work with constituencies to maintain support the bankruptcy choice and management's right to continue in control. This was not evident when Frank Lorenzo of Eastern Airlines was forced out as CEO in favor of a trustee. The approval by the various constituencies of management's reorganization plan is considered to be a necessary condition to succeed and to avoid liquidation. Unless a firm can show that successful reorganization means to emerge with stronger core businesses after it comes out of bankruptcy, it may be forced into Chapter 7 liquidation. D'Aveni(11) strongly argues that highly educated, well connected, competent, and trustworthy leaders have better chances of successful reorganization under Chapter 11, of providing more flexibility with creditors due to their influence, and of supporting management's right to continue in control.

A third argument is about the stigma of bankruptcy. This stigma resulted from the traditional view associating bankruptcy with organizational and managerial failure. Another cause of this stigma is the potentially unethical aspect of bankruptcy. The unethical and political motivations of some of the filings have been mentioned frequently since some of these cases represent abusive uses of the Code. For example, it can be used to reject contracts, terminate or extract cash from employee pension funds, avoid the payment of employment bonuses, and avoid litigation.

The revised Code assumes that the bankruptcy judge assesses the severity of the firm's problems and determines if it is advisable to allow for the protection. The law has provisions for assessing the amount of penalty a firm will incur in disavowing a contract. Also, the union can appeal to the bankruptcy court, stating that the company's filing had been made in bad faith (e.g, the Continental Airlines' union). In addition, recent federal regulations limit the percentage of pension fund assets that can be invested in company stock or real estate.

Yet, the stigma represents a serious challenge to management and should be addressed by them when considering Chapter 11. Negative reactions from constituencies along with suggested remedies are discussed later in more detail.

Chapter 11 as a Retrenchment Strategy

Strategies for declining businesses provide some insight into the choice of Chapter 11. Retrenchment strategy alternatives include shrinking selectively, extracting cash for investment in other businesses, and divestment.(12) While these strategies result in generating cash, they differ in terms of their intentions. Divestment of the whole business is an "end game" strategy and it may be done via selling or liquidation of business. Under the strategy of extraction of cash for investment in other business, cash is generated from the troubled business mainly via budget and cost contraction. In both strategies, the intention of management is to quit the troubled business.

In the shrinking selectively strategy (SSS), cash is generated via downsizing (contraction of size or divesting some operations). In contrast to the other two strategies, management should feel positive about the future of the industry and their company's ability to exploit a niche for a competitive edge. The strategy of shrinking selectively then means "retrieving the value of investments in some parts of the market while reinvesting in other parts... because some niches of industry demand will continue to be profitable while demand for other uses shrivels, the firms objective is to capture the desirable niches."(13)A firm which chooses the shrink selectively strategy, should have some internal competitive advantages which it hopes to preserve. Thus, it may prefer to retain some part of its former businesses by shrinking rather than divesting, because of the possible advantages it had built up through the years.

Shrinking selectively as a repositioning strategy (i.e., matching market niche with distinctive competence) combined with Chapter 11 protection, often results in renewed vitality. For example, Allegheny International (which filed for protection in early 1988) continued concentrating on its consumer products business including small appliances, patio furniture, scales and measuring instruments (mainly through its leading brand names such as SunBeam), while selling non-related businesses including real estate, credit and finance, metal, and engineering subsidiaries, which were not consistent with Allegheny's long term strategy. Similarly, the LTV steel company's decision (after filing in 1986) to concentrate on "flat rolled" steel products, while divesting other steel operations, reflects the intent to maintain a leadership position in production of high-quality, value-added steel for critical engineering application. But, again, when management chooses Chapter 11 as a strategic alternative they should believe in the future of their industry and their company.

Chapter 11 fulfills the shrink selectively strategy because previous financial commitments to creditors are suspended. This increases the positive cash flow and helps overcome barriers to downsizing the organization or divesting idled facilities and subsidiaries. As mentioned earlier, downsizing, without Chapter 11, may face opposition from creditors. Also sometimes exit barriers (from the market) may result from psychological and managerial career considerations. For example, managers in the troubled business units may ignore or filter the bad news in order to keep their preferred businesses or to protect their own career." This is expected to be lessened as a result of the high pressure in the bankruptcy's environment for disclosure of financial performance or mistakes. For instance, management is expected to obtain more information about the internal operations once the company is in Chapter 11 because all transactions will be formalized and documented. There is also the stakeholders' (including the court) demand for the reorganization plans.

Factors Related to Organizational Survival/Decay

We suggest that organizational survival/decay is a function of environmental adversity (external opportunities and threats), and internal adversity (organizational positive and negative aspects). Organizational decay (and eventually death) resulted from high environmental adversity and high organizational negative aspects.

A. Environmental Adversity. Environmental adversity may be viewed as an overall measure of the firm's difficulty in coping with the environment. The higher the level of adversity encountered by the organization, the more difficult it is to achieve its goals. This results in organizational decay (decline). Among a sample of troubled firms, Nelson(15) found that low adversity produced more appropriate adjustments and motivated the firm to pursue a defensible niche. Severe adversity produced mixed results between adaptation and maladaptation. However, most organizational decisions, in the severe adversity group, were short term/stop gap responses made at the expense of the long term. The lesson from this research is that proactive organizations, which exercise strategic options, before reaching a very high level of adversity, are significantly more able to reduce threats from the environment.

B. Organizational Decay. Organizational decay (decline) is the slow, long term deterioration of the firm's operations caused by the inability to change and adapt. Decay is mostly associated with high environmental adversity and shrinking financial resources, profitability and market demand. Decay can be defined more specifically as at least a real 5% drop in revenue over several years.(16) An example of this decay is evident in the period before LTV declared bankruptcy. LTV's financial difficulties included reduced steel orders as a result of an increase in the level of steel imports (to 20% per year), a decrease in domestic automobile sales (LTV's sales of the flat rolled steel products to GM Corporation represented approximately 14% of its 1986 sales), and high price competition from national and local producers, especially in the bar steel products. Also, profit had deteriorated as a result of the high costs of raw materials and the low productivity of labor. These conditions reduced the availability of trade credit and long-term financing.

C. Organizational Negative Aspects .These are conditions that organizations experience in decline or on the brink of bankruptcy.

1. Psychological and Behavioral Reactions to De - cline

When employees and management recognize organizational decay and scarce resources, they experience low morale (because few needs are met) and may withdraw their confidence in or blame (scapegoating) top management. Other negative responses to decay include: a) conservatism, rejection of new alternatives, and risk aversion; b) competition and infighting for acquiring scarce resources; and c) turnover (the most competent leaders tend to leave first, causing leadership anemia).(17)

2. The Stigma of Bankruptcy

Sutton and Callahart(18) found that Chapter 11 is a discrediting label that causes key constituents (buyers and suppliers) to have negative reactions toward the firm, including: a) severing business ties if possible; b) reducing the quality of engagements (e.g. bad supplies); c) bargaining for more favorable terms than in earlier relationships; and d) assaulting the credibility of the company and its leaders.

These significant and potentially devastating negative reactions continue through the bankruptcy reorganization process. Stigma often creates negative perceptions and potentially "spoils" the image, self-esteem, and reputation of the organization and its management. These increase the probability of: a) organizational death; b) damaged managerial careers; and c) an accelerated chance of managerial succession.(19)

In order to lessen the stigma pressure on the bankrupt firm, Sutton and Callahan=0 suggest some programs that can be used by CEOs. These include a) acknowledging the situation but blaming adverse external factors or b) acknowledging the situation and relying on defining it via educational programs. Nelson(21) strongly argues that management should address the stigma threats to their constituents by asserting that Chapter 11 reorganization does not mean liquidation. A recent example is a one page ad in the New York Times [Jan. 16, 1990] signed by both the chairman and the president of A&S department store. A few days after A&S went in Chapter 11 along with its parent company, the Campeau Corporation of U.S., these executives openly discussed their reasons for filing for protection and asserted to their customers that their stores were operating (quality of service, merchandise adjustment, and return policies) as usual. In another part of the ad, the company stated that:

"...there may be cases where an advertised item is not available. If this happens, we'll do our best to offer you a comparable value, or to let you know when the merchandise you want does arnve." [p. A5]

Other remedies(22) include management's attempt to obtain acquiescence from constituent groups instead of imposing their will through Chapter 11 power. Perhaps before filing, management may negotiate improved contracts and obtain additional concessions by means of threatening bankruptcy or providing information which suggests that failure is inevitable. Also, since employees are not represented by any committee in the bankruptcy proceeding (which may impose an extraordinary burden on the human resource manager) an executive with a proven record of concern for employees should be placed among top positions in Chapter 11 firms.

D. Organizational Positive Aspects. Positive aspects are critical financial and human resources that are associated with organizational survival in a declining business.

1. Organizational Slack

Slack is uncommitted or committed (but under utilized) resources that are at the disposal of the organization. The existence of uncommitted slack (especially in the form of cash and liquid assets) is considered a necessary strategic factor for the survival of the declining organization because during decline, there are not enough sales to generate sufficient cash. In contrast, slack may not serve as a strategic factor at time of growth and it may represent a high opportunity cost causing a drag on performance. While organizations in decline require high discretion and flexibility in using slack, in more stable or growing markets, high levels of slack (especially in the form of cash) may reduce performance-(23)

Critical to the choice and the timing of filing for Chapter 11, and the likelihood of survival, is the amount of slack within the organization. Specifically, using Chapter 11 as a strategic option, when critical slack still exists, will give the organization more flexibility in dealing with internal and external adversity.

2. Leadership

The lack of leadership has been identified as one of the most significant causes of business failure.(24) A critical success factor for American companies facing high adversity and unpredictability created by competition, is the existence of leaders who can create an agenda for change and build and effective implementation environment.= If the organization is in Chapter 11, it is critical for its leaders to alter the organizational philosophy, defining success as lower growth and smaller size and to persuade constituencies to support the bankruptcy choice.

Organizations may want to recruit prestigious leaders prior to filing. The lack of leadership may exist due to managerial incompetence or managerial succession. As mentioned earlier, the succession occurs because qualified managers seek alternate employment before they become associate with any potential stigma. While in Chapter 11, prestigious leaders with an access to elite groups and other networks can a) provide more flexibility with creditors, stockholders, and the government, b) influence creditors to support the management's right to continue in control, and c) provide additional capital more easily and on better terms.(26) A recent example is the selection of William Miller, a former Treasury Secretary and Federal Reserve chairman, to head the Campeau Corporation's American retailing operations, right after the corporation went into Chapter 11. Highly educated, well connected, competent, and trustworthy leaders have better chances of successful reorganization under Chapter 11.(27)

3. Managerial Control

In successful organizations, managerial depth provides better coordination and control(28) and it contributes to environmental scanning.(29) However, organizations in decline often choose to cut back their managerial staff especially at the middle levels of management. Creditors may also force cutbacks in staff or reduction in management compensation. Excess reduction in managerial depth may eliminate critical functions and decrease survival. Organizations may have the option, however, to replace personnel involved with coordination and control functions by applying appropriate information technology. In order for organizations to cope with high complexity in the environment and the firm itself, firms will need to increase their usage of information and communication processing technology.(30)

When Does Management Select Retrenchment Strategies?

The organization is able to stop its decay and increase its survival by adopting an appropriate retrenchment strategy (including Chapter 11) at the appropriate time. The following propositions provide guidelines for the timing of retrenchment strategies. The choice of a specific strategy is a function of the level of environmental adversity and the level of organizational slack.

Proposition I: Condition of Moderate Adversity. Firms with low slack should consider an early bankruptcy strategy when faced with moderate adversity because alternatives are limited. In the context of strategic planning, Chapter 11 reorganization may include the shrink selectively strategy, discharging some debts while restructuring others, reducing stigma, and shifting the organizational philosophy to define success as accepting lower growth and size. It is important to trigger Chapter 11 while talented top management is still in the organization and still feels positive (moderate adversity) about their business and its future.

When slack is moderate, the organization should focus on profitable or promising businesses in which it has distinctive skills and experience. This strategy may take the shape of a combination of an "extracting cash strategy" and a "shrink selectively strategy".

Firms with high slack are able to withstand a moderate level of adversity. High slack enables the organization to maintain its strategic direction through the use of uncommirred or under utilized (committed) assets.

Proposition 2: Condition of High/Severe Adversity. Small firms are more likely to stop operations (i.e. liquidation) if they file for Chapter 11. Specifically, 1987, 70% of small firms (under $25 million in sales) were forced to discontinue operations after filing for Chapter 11.(31) Apparently small organizations lack slack resources, thus increasing the probability for failure. Large firms have greater physical and financial capacities to hold excess resources and are expected to have more slack than small firms.

Therefore, it is proposed that: small firms or firms with low levels of slack, faced with high/severe adversity, may select to sell off assets outside of its strategic focus (i.e. SSS) or to accept a leverage buyout (divest). These altematives are proposed in lieu of being forced into Chapter 11, suggesting a non-strategic alternative. The leveraged buyout choice is a successful approach for keeping threatened firms out of liquidation.(32)

When moderate slack exists in high adversity, Chapter 11 choice is appropriate for the troubled firm. ln addition to slack, the organization should possess (or acquire) a competitive edge.

When high slack exists, adding to the organization's leadership and managerial control is suggested. The coordination and control provided by managerial depth could take the form of establishing a computer based reporting and budgeting system linked with the strategic planning system.

The Challenge and Opportunity of Chapter 11

The challenge of Chapter 11 is that managers should be proactive in terms of triggering bankruptcy at the appropriate time while distinctive competencies still exist (e.g. prestigious leadership, skilled personnel, liquid assets, and other measures of organizational vitality. Management should persuade creditors, shareholders and constituent groups to approve of the proposed reorganization plan and support management's position.

Another challenge is that bankruptcy is not a risk free choice. In fact there are high costs and other potential perils that management should be aware of. Management should consider the monetary and psychological costs associated with the bankruptcy filing. Major costs involved include the administration and legal costs of filing and operating under court protection. The reactions of stakeholders (including the psychological and economic consequences of the bankruptcy stigma) must also be considered as well as the risk of a forced Chapter 7 liquidation.

In his discussion of corporate current practices, Byrne(33) sees Chapter 11 as an effective, albeit trendy way to side step labor contracts and deal with liability lawsuits. In the context of strategic planning, Chapter 11 reorganization may include the shrink selectively strategy, discharging some debts while restructuring others, reducing stigma, and modifying the organizational philosophy to define success as a lower rate of growth and smaller size. The protection serves as a temporary buffer from the threats of environmental and competitive forces. Some companies which used Chapter 11 in a non-traditional manner have gained admiration from the business community for a successful turnaround.(34)


1. For citation of successful bankruptcy cases see for example Kulp, S. "Life After Bankruptcy: For Some Companies and Their Shareholders It Can Be Exciting." Barron's. February 8, 1982, pp. 8,9.

2. The New York Times, July 19. 1990, pp. DI &D5.

3. LTV steel company and Allegheny Corporation were used through out the paper as case illustrations. Information were drawn companies' repons. Dow Jones News Retrieval Services, and business publications.

4. Cifelli, A. "Management By Bankruptcy." Fortune. October 31, 1983. pp. 69-71.

5. Wright, A. "Bankruptcy." Coal Age, October, 1984, pp. 7882.

6. Engel. P. "Bankruptcy A Refuge for all Reasons." Industry Week, March 5, 1984, pp. 61-65.

7. Smith. C. and Warner. J. "On Financial Contracting: An Analysis of Bond Covenant." Journal of Financial Economics, Vol.

7. 1979, pp. 117-61.

8. Jensen. M. and Clifford S., Jr. "Stockholder. Manager. and Creditors Interests: Application of Agency Theory" in Edward, E and Suberahmanyam, M (Eds.). Recent Advances in Comparative Finance. Homewood, IL.: Dow Jones-Irwin, 1985, pp. 93-131.

9. D 'Aveni, A.R. "Dependability and Organizational Bankruptcy: An pplication of Agency and Prospect Theory." Management Science, Vol. 35, No. 9, 1989, pp. 1120-138.

10. Nelson, P. Corporation in Crisis. New York: Praeger, 1981. p. 13.

11. D'Aveni, A., 1989 (Endnote No. 9).

12. For a discussion of retrenchment strategies see Hamgan. K. and Porter, M. "End-Game Strategies For Declining Industries." Harvard Business Review, July-August, No. 24, 1983. Also Hamgan. K. Strategies For Declining Business. Lexington, Mass.: D.C. Heath.,1980. It should be noted that some other strategies such as merger or vertical integration have been used to survive a declining market. However they are not categorized as retrenchment since retrenchment by definition is not a growth strategy.

13. Ham gan, K. 1980, p. 16 (Endnote No. 12).

14. Porter, M. "Please Note Location of Nearest Exit," California Management Review, Vol. 19, 1976. pp. 21-25.

15. Nelson, P., 1981 (Endnote No. 10).

16. Cameron, K., Whetten, D. & Kim, M. "Organizational Dysfunctionals of Decline." Academy of Management Journal. Vol. 30, No. 1, 1987, pp. 126-138.

17. Sutton. R. & Callahan, A.L. "The Stigma of Bankruptcy: Spoiled Organizational Image and its Management." Academy of Management Journal, Vol. 30, No.3, 1987, pp. 405436.

18. Ibid.

19. Ibid.

20. Ibid.

21. Nelson, P., 1981, p. 38 (Endnote No. 10).

22. See Sharplin. A. and Hall. J. "Serving HRM Purposed Through Chapter 11" Personnel Administrator. February, 1985, pp. 103-111.

23. Sharfman. M., Wolf, G., Chase, R. & Tansik, D. "Antecedents of Organizational Slack." Academy of Management Review. Vol. 13. No. 4, 1988. pp. 601-614.

24. Stanley, D. & Girth, M. Bankruptcy Problem. Process, and Reform. Washington, D.C.: Brookings Institution. 1971.

25. Kotter, John P. The Leadership Factor. New York: The Free Press, 1988.

26. Fower, E. "Managerial Presitge and Bankruptcy." The New York Times, March 21, 1989, p. D5. The artticle is based on an interview of Richard A. D'Aveni

27. Ibid.

28. McKinley. W. "Complexity and Administrative Intensity: The Case of Declining Organizations." Administrative Science Quarterly, Vol. 32, No. 1. 1987, pp. 87-105.

29. Huber, G. "The Nature and Design of Post Industrial Organizations." Management Science, Vol. 30, No. 8. 1984. pp. 928951.

30. Ibid.

31. Brown, B. "For Small Firms, Penis Lie in Chapter 11 .. The Wall Street Journal, Section 2, 14 July, 1988. p. 29.

32. Jensen, M.C. "Is Leverage an Invitation to Bankruptcy? On the Contrary It Keeps Shaky Firms Out of Court." The Wall Street Journal, Feb. l, 1989, p. AI 3.

33. Byrne, J. "Business Fads: What's In and Out" Business Week, 20 January, 1986, pp. 52-61.

34. Gainson, S. & Mason, W. "An Examination of Non'Traditional Bankruptcies." Review of Business, Vol. 10, No. 3, 1988, pp. 20-22.
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Title Annotation:Bankruptcy Code of 1978
Author:Farid, Mamdouh I.; Flynn, David M.
Publication:Review of Business
Date:Mar 22, 1992
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