Valuation Disputes in Corporate Bankruptcy

Prior scholarship points to disagreements about valuation and judicial valuation error as key drivers of Chapter 11 outcomes. Avoiding valuation disputes and valuation errors is also the underlying driver of most proposed reforms, from Baird’s auctions to Bebchuk’s options. In this paper, we undertake a detailed examination of bankruptcy court opinions involving valuation disputes. Our paper has two goals. The first is to understand how parties and their expert witnesses justify their opposing views to the judge, and how judges decide between them. The second is to provide practical guidance to judges in resolving valuation disputes. We document surprisingly pervasive (and often self-serving) errors in expert testimony. This is particularly true when valuation experts apply the discounted cash flow (DCF) method. The choice of discount rates is frequently unsupported by, and often at odds with, finance theory and evidence. Judges are frequently unable to recognize these problems. We propose simple strategies based in finance theory that judges can employ (such as avoiding the use of company-specific risk premia in discount rates) to reduce the scope for valuation disagreements in Chapter 11. We also recommend that judges rely on the peer reviewed finance and economics literature to assess the scientific reliability of discount rates

Creditor Control and Conflict in Chapter 11

We analyze a sample of large privately and publicly held businesses that filed Chapter 11 bankruptcy petitions during 2001. We find pervasive creditor control. In contrast to traditional views of Chapter 11, equity holders and managers exercise little or no leverage during the reorganization process. 70 percent of CEOs are replaced in the two years before a bankruptcy filing, and few reorganization plans (at most 12 percent) deviate from the absolute priority rule to distribute value to equity holders. Senior lenders exercise significant control through stringent covenants, such as line-item budgets, in loans extended to firms in bankruptcy. Unsecured creditors gain leverage through objections and other court motions. We also find that bargaining between secured and unsecured creditors can distort the reorganization process. A Chapter 11 case is significantly more likely to result in a sale if secured lenders are oversecured, consistent with a secured creditor-driven fire-sale bias. A sale is much less likely when these lenders are undersecured or when the firm has no secured debt at all. Our results suggest that the advent of creditor control has not eliminated the fundamental inefficiency of the bankruptcy process: resource allocation questions (whether to sell or reorganize a firm) are ultimately confounded with distributional questions (how much each creditor will receive) due to conflict among creditor classes

Bankruptcy or Bailouts?

The usual reaction if one mentions bankruptcy as a mechanism for addressing a financial institution’s default is incredulity. Those who favor the rescue of troubled financial institutions, and even those who prefer that their assets be promptly sold to a healthier institution, treat bankruptcy as anathema. Everyone seems to agree that nothing good can come from bankruptcy. Indeed, the Chapter 11 filing by Lehman Brothers has been singled out by many the primary cause of the severe economic and financial contraction that followed, and proof that bankruptcy is disorderly and ineffective. As a result, ad-hoc rescue lending to avoid bankruptcy has been the preferred solution. In this Article, we seek to provide the first careful assessment of the belief that governmental rescues are preferable to bankruptcy. While the interaction of financial firms, systemic risk, and Chapter 11 is complex, our analysis suggests that the widespread belief that bankruptcy should not be used to resolve the distress of financial firms is misguided, and that it has had serious costs in the recent crisis. Although bankruptcy is not always the optimal response to financial distress, it is more effective than is generally realized. In Parts I and II of the Article, we describe the principal problems created by financial distress—debt overhang and creditor runs—and the mechanisms bankruptcy provides for addressing these problems. We then provide historical context in Part III, looking to Drexel Burnham’s bankruptcy in 1990 for further lessons about the efficacy of bankruptcy. In Part IV, we turn to firm-specific bailouts, describing this strategy’s benefits and the distortions it causes. We then shift our focus back to bankruptcy, considering the (legitimate) concern that it may not adequately counteract systemic risk in Part V, and exploring its treatment of derivatives, one of the chief new habitats of systemic risk, in Part VI. Part VII is a brief conclusion

Bankruptcy or Bailouts?

The usual reaction if one mentions bankruptcy as a mechanism for addressing a financial institution’s default is incredulity. Those who favor the rescue of troubled financial institutions, and even those who prefer that their assets be promptly sold to a healthier institution, treat bankruptcy as anathema. Everyone seems to agree that nothing good can come from bankruptcy. Indeed, the Chapter 11 filing by Lehman Brothers has been singled out by many the primary cause of the severe economic and financial contraction that followed, and proof that bankruptcy is disorderly and ineffective. As a result, ad-hoc rescue lending to avoid bankruptcy has been the preferred solution. In this Article, we seek to provide the first careful assessment of the belief that governmental rescues are preferable to bankruptcy. While the interaction of financial firms, systemic risk, and Chapter 11 is complex, our analysis suggests that the widespread belief that bankruptcy should not be used to resolve the distress of financial firms is misguided, and that it has had serious costs in the recent crisis. Although bankruptcy is not always the optimal response to financial distress, it is more effective than is generally realized. In Parts I and II of the Article, we describe the principal problems created by financial distress—debt overhang and creditor runs—and the mechanisms bankruptcy provides for addressing these problems. We then provide historical context in Part III, looking to Drexel Burnham’s bankruptcy in 1990 for further lessons about the efficacy of bankruptcy. In Part IV, we turn to firm-specific bailouts, describing this strategy’s benefits and the distortions it causes. We then shift our focus back to bankruptcy, considering the (legitimate) concern that it may not adequately counteract systemic risk in Part V, and exploring its treatment of derivatives, one of the chief new habitats of systemic risk, in Part VI. Part VII is a brief conclusion

Why Do Distressed Companies Choose Delaware? An Empirical Analysis of Venue Choice in Bankruptcy

We analyze a sample of large Chapter 11 cases to determine which factors motivate the choice of filing in one court over another when a choice is available. We focus in particular on the Delaware court, which became the most popular venue for large corporations in the 1990s. We find no evidence of agency problems governing the venue choice or affecting the outcome of the bankruptcy process. Instead, firm characteristics and court characteristics, particularly a court\u27s level of experience, are the most important factors. We find that court experience manifests itself in both a greater ability to reorganize marginal firms and in reorganizing such firms faster. Delaware is similar to other high-experience courts in terms of the likelihood of reorganization controlling for firm characteristics, but is a standout in terms of speed. We estimate that a Delaware bankruptcy requires approximately 40% less time to complete than an equivalent case in another court

Ernst Freund as Precursor of the Rational Study of Corporate Law

Gindis, David, Ernst Freund as Precursor of the Rational Study of Corporate Law (October 27, 2017). Journal of Institutional Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2905547, doi: https://dx.doi.org/10.2139/ssrn.2905547The rise of large business corporations in the late 19th century compelled many American observers to admit that the nature of the corporation had yet to be understood. Published in this context, Ernst Freund's little-known The Legal Nature of Corporations (1897) was an original attempt to come to terms with a new legal and economic reality. But it can also be described, to paraphrase Oliver Wendell Holmes, as the earliest example of the rational study of corporate law. The paper shows that Freund had the intuitions of an institutional economist, and engaged in what today would be called comparative institutional analysis. Remarkably, his argument that the corporate form secures property against insider defection and against outsiders anticipated recent work on entity shielding and capital lock-in, and can be read as an early contribution to what today would be called the theory of the firm.Peer reviewe

No Exit? Withdrawal Rights and the Law of Corporate Reorganizations

Bankruptcy scholarship is largely a debate about the comparative merits of a mandatory regime on one hand and bankruptcy by free design on the other. By the standard account, the current law of corporate reorganization is mandatory. Various rules that cannot be avoided ensure that investors’ actions are limited and they do not exercise their rights against specialized assets in a way that destroys the value of a business as a whole. These rules solve collective action problems and reduce the risk of bargaining failure. But there are costs to a mandatory regime. In particular, investors cannot design their rights to achieve optimal monitoring as they could in a system of bankruptcy by free design. This Article suggests that the academic debate has missed a fundamental feature of the law. Bankruptcy operates on legal entities, not on firms in the economic sense. For this reason, sophisticated investors do not face a mandatory regime at all. The ability of investors to place assets in separate entities gives them the ability to create specific withdrawal rights in the event the firm encounters financial distress. There is nothing mandatory about rules like the automatic stay when assets can be partitioned off into legal entities that are beyond the reach of the bankruptcy judge. Thus, by partitioning assets of one economic enterprise into different legal entities, investors can create a tailored bankruptcy regime. In this way, legal entities serve as building blocks that can be combined to create specific and varied but transparent investor withdrawal rights. This regime of tailored bankruptcy has been unrecognized and underappreciated and may be preferable to both mandatory and free design regimes. By allowing a limited number of investors to opt out of bankruptcy in a particular, discrete, and visible way, investors as a group may be able to both limit the risk of bargaining failure and at the same time enjoy the disciplining effect that a withdrawal right brings with it

Disagreement and Capital Structure Complexity

Corporate bankruptcies often involve complicated, fragmented capital structures with many layers of debt and legal entity structures with many subsidiaries. Why do capital structures evolve this way, given that they make distress more costly to resolve? I suggest an answer based in investor disagreement about the value of assets that back loans. When investors disagree, firms have the incentive to exploit the disagreement by issuing asset-backed claims to optimists about those assets. This capital structure fragmentation minimizes the borrower’s cost of funds ex ante by maximizing creditors’ perceived recoveries, but it also creates costly valuation disputes in bankruptcy. I show that disagreement about collateral values can cause inefficient liquidations. Reorganization, in which prebankruptcy creditors receive securities in the ongoing firm, allows parties to agree to disagree about the value of their entitlements. This promotes settlement and reduces costly litigation over valuation relative to a going-concern sale for cash

Disagreement and Capital Structure Complexity

Corporate bankruptcies often involve complicated, fragmented capital structures with many layers of debt and legal entity structures with many subsidiaries. Why do capital structures evolve this way, given that they make distress more costly to resolve? I suggest an answer based in investor disagreement about the value of assets that back loans. When investors disagree, firms have the incentive to exploit the disagreement by issuing asset-backed claims to optimists about those assets. This capital structure fragmentation minimizes the borrower’s cost of funds ex ante by maximizing creditors’ perceived recoveries, but it also creates costly valuation disputes in bankruptcy. I show that disagreement about collateral values can cause inefficient liquidations. Reorganization, in which prebankruptcy creditors receive securities in the ongoing firm, allows parties to agree to disagree about the value of their entitlements. This promotes settlement and reduces costly litigation over valuation relative to a going-concern sale for cash

Governance in financial distress and bankruptcy

This chapter provides a survey of law, economics, and finance scholarship at the intersection of corporate governance and financial distress. In financial distress, both inside and outside of bankruptcy court, formal and informal control rights are paramount. Thus, we organize our review around the major constituencies that exercise control rights in distressed firms: shareholders, managers and boards; senior and junior creditors; and the law, courts and judges. Broadly, our review suggests that an understanding of the incentives of these constituencies is crucial to explaining outcomes. Our review also documents the paradigm shift in the bankruptcy literature, away from the “safe haven” view of Chapter 11as a slow, manager and shareholder-controlled reorganization process. Chapter 11 case outcomes are increasingly steered by sophisticated activist investors, generating faster resolutions that are more creditor-controlled. We suggest some directions for future research in light of these developments