- Email: [email protected]
Is corporate bankruptcy efficient?
Journal
of Financial
Economics
Is corporate
27 (1990) 411417.
North-Holland
bankruptcy
efficient?
Frank H. Easterbrook” United States Court of Appeals for the Secenth Circuit, Chicago, IL 60604, USA Received
May 1990, final version
received
June
1990
Auctions allocate resources to their highest-valued uses. Yet bankruptcy does not use auctions. Instead judges determine a value and parcel out interests on the assumption that this valuation is correct. Errors inevitable in this process lead many persons to conclude that bankruptcy is inefficient. This essay argues that the conclusion does not follow. The costs of error in valuation may be less than the cost of conducting an auction. Legal rules endure because they are efficient or because they transfer wealth. Transfers are an implausible explanation of the current bankruptcy regime, leaving efficiency as the prevailing explanation.
Corporate bankruptcy has two functions: (1) to deliver the penalty for failure by forcing a wrapping up when a business cannot pay its debts and (2) to reduce the social costs of failure. When a business fails, the legal process writes off claims that have become uncollectible, turns out managers and others responsible for the- debacle, and pays the claims for which assets remain. Bankruptcy or a private substitute such as a workout succeeds when this happens quickly (before good money is thrown after bad) and with low transactions costs. Because the process of paying some claims and extinguishing others can lead to a race to carve up the carcass, which may still have a positive cash flow, bankruptcy combines a stay of self-help with a collective forum for the resolution of competing claims. Like the separation theorem of finance, the bankruptcy process divorces decisions about the optimal deployment of assets from decisions about the claims to those assets. If it works well, assets continue to be devoted to their most productive uses.
*I thank Douglas G. Baird, comments on an earlier draft.
0304-405X/90/%03.50
Mark
0 1990-Elsevier
J. Roe,
Science
and
Michael
Publishers
Jensen
(the
editor)
B.V. (North-Holland)
for
helpful
412
F. H. Easterbrook,
Is corporate bankruptcy
eficient?
Bankruptcy certainly writes down claims, and Gilson (1990) finds that it leads to sanctions in the managerial labor market as well. Is the cost worth incurring? Every study of bankruptcy shows it to be expensive, as it is bound to be given creditors’ incentives to stake out competing claims to whatever wealth remains. Weiss (1990) measures costs approximating 3% of the assets in the bankruptcies of substantial firms. Other estimates run between 3.4% and 21% for smaller firms. [See White (1989), collecting studies.] In the process, Weiss finds, bankruptcy courts refuse to enforce some claims in the order provided by contract, despite the ‘absolute priority rule’. (Carrying a grandiose name, the rule means only that contractual allocations of priority in distribution are to be honored. On top of these direct costs are losses from inefficient uses of assets during or after the process, or in anticipation of it as parties maneuver for position. Gilson, John, and Lang (1990) find that private restructuring is superior to bankruptcy. Does this damn the bankruptcy process, or does it show only that people choose restructuring when that is cheaper and choose bankruptcy when the legal process holds the advantage in cost? The Weiss and Gilson-John-Lang papers raise the question: why is there corporate bankruptcy? If it is costly, either in absolute terms or compared with private alternatives, and does not enforce contractual entitlements, what’s the point? One alternative is an auction. After a firm enters bankruptcy, and the automatic stay prevents dismemberment of the assets, the business could be sold as a going concern to the high bidder. This process would yield a pot of cash to be distributed according to contractual entitlements (as modified by statutes implementing other rules, such as priority for taxes or $2,000 of wages per employee). If the assets are worth more when broken up or melted down, the buyer will redeploy them appropriately; the auction yields the highest value available from any future use. Law could assure the buyer that no claims arising out of the firm’s activities before the sale would be honored (other than against the proceeds). Bids then would reflect the full value of the assets, and sunk costs would be disregarded. Auctions are common in moving assets to their best uses, whether they be auctions for art or for offshore oil fields or for targets of tender offers. Investment banks specialize in running auctions for entire corporations, ending in mergers or tender offers or leveraged buyouts. Markets for corporations and their divisions appear to be reasonably thick. Some nations (Germany, for example) auction the whole firm as the first recourse in a corporate bankruptcy. In the United States an auction of the firm is the normal way of disposing of the assets of failed banks, making it seem all the more odd that auctions are rare for other kinds of corporations. Banks to one side, the normal process of bankruptcy calls on a judge to entertain arguments from lawyers and investment bankers. attach a value to the firm’s assets. and then dole out interests in the assets determined to exist.
F.H. Easterbrook. Is corporate bankruptcy eficient?
413
Think what you want about the ability of investment banks and auctions to generate ‘accurate’ values for whole corporations, it is hard to believe that judges relying on lawyers will be more accurate. Bidders risking their money have every reason to spend the optimal amount to value the assets; those who estimate accurately will prosper, and others will fail. Money generally is wielded by the financially astute. Competition leads to decent (though not perfect) pricing. Judges lose nothing if the value they attach to the firm is inaccurate, and they win the praise of those who would have lost out if the guess had been more astute. Judges are neither selected for ability to value assets correctly nor selected-out on account of poor business judgment. In any contest of real prices (in auctions) against hypothetical prices (in court), real prices will be more accurate. No wonder Baird (1986) has strongly questioned whether corporate bankruptcy makes sense when a cheaper alternative lies at hand. Other scholars, although not taking up a hue and cry for auctions, have proposed methods of increasing the role of market forces in valuing both corporate assets and the claims against them [e.g., Bebchuk (1988), Roe (1983)]. Corporate bankruptcy without auctions or other market valuation devices has been with us for some time. Modern corporate bankruptcy is an outgrowth of the equity receivership, a collective proceeding filed by creditors. Although these often ended in auctions they were thought cumbersome and were replaced by common consent by a statute that does not require auctions. The Federal Deposit Insurance Corporation turned to auctions of failed banks as a cheaper alternative to acquirin g and eventually reselling the banks’ assets, showing the evolution toward auctions is possible. Yet nothing of the kind happens today with other businesses in or out of bankruptcy. Private debt restructurings rarely involve auctions. When creditors meet outside of bankruptcy to readjust claims, they use the same devices they are apt to employ if they meet in court. Sometimes they arrange to sell the firm as a unit, but this is uncommon. And when creditors draft legislation to present to Congress, their agenda does not include a demand that judges put corporate debtors on the block. The Bankruptcy Code of 1978 is largely what creditors wished it to be. No surprise, for corporate bankruptcy is a process of resolving claims among creditors, with few competing interests. Although judicial decisions concerning this code sometimes lead to loud demands for change (demands usually satisfied), there is no comparable demand for a larger volume of auctions. Enduring legal institutions endure either because they are efficient or because they redistribute wealth to concentrated, politically effective interest groups. (Laws also may have moral bases, but these are unlikely explanations for the rules governing corporate bankruptcy.) Market versus hypothetical valuation in bankruptcy has no redistributive effect. Who would be the
414
F. H. Easterbrook.
Is corporate bankruptcy
efficient?
winners and losers? There may be winners and losers in particular cases (a violation of the absolute priority rule transfers wealth to the holders of the junior debt), but such transfers ex post do not imply transfers ex ante, given responses to known rules. Suppose current bankruptcy law always falls harshly on junior, unsecured debt, more harshly than a more efficient auction rule that raised larger sums would do. This does not transfer wealth from unsecured claimants to secured claimants; it extinguishes wealth without creating winners and therefore without creating political support. And although such a law creates losers given that a firm becomes a debtor in bankruptcy, it does not create losers ex ante. Unsecured creditors will charge more for money, emerging no worse off across their portfolio of loans. The losers wilI be not the unsecured creditors but the superior firms (and their investors), which must pay the higher price of capital. Investors in these firms - including both secured and unsecured creditors - would be better off if the legal rule were more efficient. So too if existing rules fall harshly on secured creditors by disregarding the absolute priority rule and by indulging optimistic judicial valuations that allow unsecured creditors and equity investors to obtain more than their contractual shares. Again prices adjust, and the anticipation of redistribution ex post means that there is none ex ante. It is at all events unrealistic to suppose that suppliers of capital fall naturally into groups such as secured lenders, unsecured lenders, and equity investors. People have portfolios of investments, and even though some institutions (such as banks) cannot purchase some instruments (such as stock), financial intermediaries are not themselves winners and losers. Real persons supply the capital, and their portfolios are or readily can be diversified across kinds of investment. If an inefficient rule raises the price of unsecured debt, both prices and portfolios will adjust. No one gains ex ante, and all creditors (potentially) lose. The remaining interest group is lawyers. Bankruptcy laws were drafted not by the creditors but by their lawyers. Agency problems are everywhere; maybe the bar figured out how to feather its own nest through extended proceedings at the expense of all creditors’ interests. Such an explanation works, however, only if the bankruptcy bar is closed; free entry would dissipate any rents. Entry is not hard. Lawyers may take up bankruptcy practice freely, and many have done so. Large law firms have greatly expanded their bankruptcy departments in recent years, while other departments such as antitrust have melted away. Because entry is possibIe, and large financial intermediaries have their own teams of lawyers to monitor the work of legislative drafters, rent-seeking is not a plausible explanation of the failure of bankruptcy law to auction off corporate debtors. This leaves efficiency as the likely explanation.
F.H. Easterbrook, Is corporate bankruptcy efficient?
415
Many people find it hard to believe that the judicial system ever operates with lower transactions costs than markets. Baird (1986) expresses justified skepticism on this score. Yet consider that Weiss’s (1990) measurements of the cost of corporate bankruptcy, the best now available, show costs significantly less than those entailed in taking a corporation public. Ritter (1987) finds that the costs of a firm-commitment offering average 14% of the gross proceeds, with a range of 9.3% for placements exceeding $10 million to 19.5% for those of less than $2 million. Private debt placements are less costly, but a bankruptcy auction is more like the sale of equity - for the debtholders in bankruptcy have the residual claims, and the failure of the firm to pay its debts implies substantial risk concerning the success of its future operations. High variability means high costs of sale, for potential buyers rationally spend more evaluating the firm’s prospects and determining whether changes can improve them. Variability is especially high when the value of a firm is linked closely to its managers’ human capital. Managers of firms going public or involved in LBOs usually promise to stay and often are tied by golden handcuffs - stock, often subject to formulaic buy-sell agreements (the departing manager gets only book value for the stock); if the manager is allowed to sell the stock, any diminution in value attributable to the manager’s departure will be reflected in the lower price realized. Managers of firms in bankruptcy are not tied to the firm in this fashion (their stock probably is worthless), and as Gilson (1990) shows, are likely to depart. Auctions of bankrupt firms may well be more costly than IPOs. Although, as Baird (1986, pp. 137-138) observes, flourishing and failed firms may hire the same investment banks to sell the assets, different people set the reservation price and decide when to sell. The residual claimants, who bear the costs of the auction and collect the marginal dollar of receipts, have the right incentives to make decisions about timing and minimum price. When a firm is sound, the equity investors hold the residual claims and make the decisions through the managers. The fabled conflict between debt and equity claimants is a last-period problem. See Easterbrook (1991). When the firm is in default, the managers may still be in control, but the equity claimants they represent no longer hold the residual claims. If the firm’s prospects are volatile, shareholders will want the managers to delay, in the hope of selling when the price is high. On average, however, delay will be costly. Equity claimants have reason to wait too long and to set unrealistic reservation prices, for their claims are worthless unless something unexpectedly good happens. Immediate sale at a realistic price wipes them out; debt claimants bear any erosion of value during a delay, yet have fixed claims and so do not realize the full gain if things turn out well. This is the standard conflict between debt and equity claims, and as usual is substantially aggravated during times of financial distress, when the equity claim is worth little.
416
F.H. Easterbrook.
Is corporate bankruptcy
efficient?
A bankruptcy judge could cure the problem by assigning to the residual claimant not only the right to run the auction but also the obligation to do so within a short time. But this is not possible until the bankruptcy process begins, and managers, knowing that court means a prompt end to their powers, may delay inefficiently before commencing the case [White (1989, pp. 149-1.50)]. What’s more, how does a judge identify the residual claimant when there are several layers of debt? To do this the judge must know the firm’s value - yet the superiority of market over judicial processes in pricing the firm’s assets is the impetus for holding an auction. It is not particularly useful to have borh a judicial and a market valuation process for the same corporation. This means that the court should not itself try to run an auction; how is a judge to set a reservation price intelligently? Not by hiring an investment bank to determine a ‘fair price’ for the assets. Small changes in assumptions about the discount rate and the income stream produce spectacular differences in bankers’ estimates of value [Bebchuk and Kahan (1989)], and the judge has no way to evaluate the wisdom of the bankers’ assumptions. If instead of trying to value the assets the judge invites one group of investors to buy the entitlement to resell the firm as a unit, this is an auction by another name, and it does not solve the question who is to determine timing and reservation price. In comparing the costs of market and judicial valuation, it is important to understand that bankruptcy values the claims as well as the assets. A substantial portion of the measured costs of bankruptcy would exist even if the assets were sold immediately, and the judge dealt only with a pot of cash. Proceedings such as the Manville and Robins bankruptcies were devoted principally to determining the value of contingent claims held by persons injured by the firm’s products. Other cases require valuation of the costs of cleaning up toxic wastes, or of contentions that the debtor committed fraud. Whether the debtor can recover payments made to creditors before bankruptcy (preferences), whether a given debt arises out of a valid contract, and so on, are questions that must be answered by a court even if all assets turn to cash on day one. It is beneficial to resolve in a single forum the extent and priority of all claims to the firm’s wealth. Here lie the principal costs of the process, making the comparison between bankruptcy and IPOs unduly favorable to IPOs. If bankruptcy does well even in such a comparison, it is understandable why there has not been an outcry for a better way. Bankruptcy is a backup, When auctions are superior, creditors will arrange for them in or out of bankruptcy; when they are more expensive, the legal system supplies the method of writing down investments. All investors gain from an agreement to use the more efficient method. Holdouts may prevent the realization of gains from choosing the superior method, and because there are many creditors, holdouts could be a serious problem. Yet the 1978 code makes it hard for a small number of creditors to hold out. The code
F.H. Easterbrook.
Is corporate bankruptcy
efficient?
417
allows a class to compromise its claims by majority vote (two-thirds by value). That rule influences the bargains that can be struck outside of bankruptcy. Solitary holdouts no longer may play the role of spoilers, so it is more likely that creditors as a group will be able to take advantage of superior nonbankruptcy alternatives. When we see creditors resort to bankruptcy, they are telling us that the legal process is superior to market methods available to them. Consider another possibility: the absence of auctions in bankruptcy may be attributable not to tiny comparative advantage of the legal process but to the infrequent bankruptcy of public corporations. Current legal processes may be adequate for closely held firms but inferior for larger entitles. Now that bankruptcy of well-known firms (Texaco, Eastern Airlines, Federated Stores) is more common, creditors may demand a change in the statute. A competing explanation is that bankruptcy of large firms is more common because with the 1978 code bankruptcy became more attractive in comparison with other devices for dealing with financial distress: workouts, mergers, and so on. I am not so sure that bankruptcy of public corporations is more common; railroad bankruptcies in particular have hogged judicial time for more than 100 years. But if it is, an efficiency explanation is at least as attracti\% as an oversight explanation. Survival will distinguish the two, and it will be interesting to see whether in the coming decades the law moves toward a preference for market over judicial valuation of corporate assets.
References Baird, Douglas G., 1986, The uneasy case for corporate reorganization, Journal of Legal Studies 15, 127-147. Bebchuk, Lucian Arye, 1988, A new approach to corporate reorganizations, Harvard Law Review 101, 775-804. Bebchuk, Lucian Arye and Marcel Kahan, 1989, Fairness opinions: How fair are they and what can be done about it?, Duke Law Journal 1989, 27-53. Easterbrook, Frank H., 1991, High-yield debt as an incentive device, International Review of Law and Economics, forthcoming. Gilson, Stuart C., 1990, Bankruptcy, boards, banks. and blockholders. Journal of Financial Economics, this volume. Gilson, Stuart C., Kose John, and Larry H.P. Lang. 1990, Troubled debt restructurings: An empirical study of private reorganizations of firms in default, Journal of Financial Economics, this volume. Ritter, Jay R., 1987, The costs of going public, Journal of Financial Economics 19, 269-281. Roe. Mark J., 1983, Bankruptcy and debt: A new model for corporate reorganizations, Columbia Law Review 83, 527-602. Weiss. Lawrence A., 1990, Bankruptcy resolution: Direct costs and violation of priority of claims, Journal of Financial Economics, this volume. White, Michelle J., 1989, The corporate bankruptcy decision. Journal of Economic Perspectives 3, 129-151.
of Financial
Economics
Is corporate
27 (1990) 411417.
North-Holland
bankruptcy
efficient?
Frank H. Easterbrook” United States Court of Appeals for the Secenth Circuit, Chicago, IL 60604, USA Received
May 1990, final version
received
June
1990
Auctions allocate resources to their highest-valued uses. Yet bankruptcy does not use auctions. Instead judges determine a value and parcel out interests on the assumption that this valuation is correct. Errors inevitable in this process lead many persons to conclude that bankruptcy is inefficient. This essay argues that the conclusion does not follow. The costs of error in valuation may be less than the cost of conducting an auction. Legal rules endure because they are efficient or because they transfer wealth. Transfers are an implausible explanation of the current bankruptcy regime, leaving efficiency as the prevailing explanation.
Corporate bankruptcy has two functions: (1) to deliver the penalty for failure by forcing a wrapping up when a business cannot pay its debts and (2) to reduce the social costs of failure. When a business fails, the legal process writes off claims that have become uncollectible, turns out managers and others responsible for the- debacle, and pays the claims for which assets remain. Bankruptcy or a private substitute such as a workout succeeds when this happens quickly (before good money is thrown after bad) and with low transactions costs. Because the process of paying some claims and extinguishing others can lead to a race to carve up the carcass, which may still have a positive cash flow, bankruptcy combines a stay of self-help with a collective forum for the resolution of competing claims. Like the separation theorem of finance, the bankruptcy process divorces decisions about the optimal deployment of assets from decisions about the claims to those assets. If it works well, assets continue to be devoted to their most productive uses.
*I thank Douglas G. Baird, comments on an earlier draft.
0304-405X/90/%03.50
Mark
0 1990-Elsevier
J. Roe,
Science
and
Michael
Publishers
Jensen
(the
editor)
B.V. (North-Holland)
for
helpful
412
F. H. Easterbrook,
Is corporate bankruptcy
eficient?
Bankruptcy certainly writes down claims, and Gilson (1990) finds that it leads to sanctions in the managerial labor market as well. Is the cost worth incurring? Every study of bankruptcy shows it to be expensive, as it is bound to be given creditors’ incentives to stake out competing claims to whatever wealth remains. Weiss (1990) measures costs approximating 3% of the assets in the bankruptcies of substantial firms. Other estimates run between 3.4% and 21% for smaller firms. [See White (1989), collecting studies.] In the process, Weiss finds, bankruptcy courts refuse to enforce some claims in the order provided by contract, despite the ‘absolute priority rule’. (Carrying a grandiose name, the rule means only that contractual allocations of priority in distribution are to be honored. On top of these direct costs are losses from inefficient uses of assets during or after the process, or in anticipation of it as parties maneuver for position. Gilson, John, and Lang (1990) find that private restructuring is superior to bankruptcy. Does this damn the bankruptcy process, or does it show only that people choose restructuring when that is cheaper and choose bankruptcy when the legal process holds the advantage in cost? The Weiss and Gilson-John-Lang papers raise the question: why is there corporate bankruptcy? If it is costly, either in absolute terms or compared with private alternatives, and does not enforce contractual entitlements, what’s the point? One alternative is an auction. After a firm enters bankruptcy, and the automatic stay prevents dismemberment of the assets, the business could be sold as a going concern to the high bidder. This process would yield a pot of cash to be distributed according to contractual entitlements (as modified by statutes implementing other rules, such as priority for taxes or $2,000 of wages per employee). If the assets are worth more when broken up or melted down, the buyer will redeploy them appropriately; the auction yields the highest value available from any future use. Law could assure the buyer that no claims arising out of the firm’s activities before the sale would be honored (other than against the proceeds). Bids then would reflect the full value of the assets, and sunk costs would be disregarded. Auctions are common in moving assets to their best uses, whether they be auctions for art or for offshore oil fields or for targets of tender offers. Investment banks specialize in running auctions for entire corporations, ending in mergers or tender offers or leveraged buyouts. Markets for corporations and their divisions appear to be reasonably thick. Some nations (Germany, for example) auction the whole firm as the first recourse in a corporate bankruptcy. In the United States an auction of the firm is the normal way of disposing of the assets of failed banks, making it seem all the more odd that auctions are rare for other kinds of corporations. Banks to one side, the normal process of bankruptcy calls on a judge to entertain arguments from lawyers and investment bankers. attach a value to the firm’s assets. and then dole out interests in the assets determined to exist.
F.H. Easterbrook. Is corporate bankruptcy eficient?
413
Think what you want about the ability of investment banks and auctions to generate ‘accurate’ values for whole corporations, it is hard to believe that judges relying on lawyers will be more accurate. Bidders risking their money have every reason to spend the optimal amount to value the assets; those who estimate accurately will prosper, and others will fail. Money generally is wielded by the financially astute. Competition leads to decent (though not perfect) pricing. Judges lose nothing if the value they attach to the firm is inaccurate, and they win the praise of those who would have lost out if the guess had been more astute. Judges are neither selected for ability to value assets correctly nor selected-out on account of poor business judgment. In any contest of real prices (in auctions) against hypothetical prices (in court), real prices will be more accurate. No wonder Baird (1986) has strongly questioned whether corporate bankruptcy makes sense when a cheaper alternative lies at hand. Other scholars, although not taking up a hue and cry for auctions, have proposed methods of increasing the role of market forces in valuing both corporate assets and the claims against them [e.g., Bebchuk (1988), Roe (1983)]. Corporate bankruptcy without auctions or other market valuation devices has been with us for some time. Modern corporate bankruptcy is an outgrowth of the equity receivership, a collective proceeding filed by creditors. Although these often ended in auctions they were thought cumbersome and were replaced by common consent by a statute that does not require auctions. The Federal Deposit Insurance Corporation turned to auctions of failed banks as a cheaper alternative to acquirin g and eventually reselling the banks’ assets, showing the evolution toward auctions is possible. Yet nothing of the kind happens today with other businesses in or out of bankruptcy. Private debt restructurings rarely involve auctions. When creditors meet outside of bankruptcy to readjust claims, they use the same devices they are apt to employ if they meet in court. Sometimes they arrange to sell the firm as a unit, but this is uncommon. And when creditors draft legislation to present to Congress, their agenda does not include a demand that judges put corporate debtors on the block. The Bankruptcy Code of 1978 is largely what creditors wished it to be. No surprise, for corporate bankruptcy is a process of resolving claims among creditors, with few competing interests. Although judicial decisions concerning this code sometimes lead to loud demands for change (demands usually satisfied), there is no comparable demand for a larger volume of auctions. Enduring legal institutions endure either because they are efficient or because they redistribute wealth to concentrated, politically effective interest groups. (Laws also may have moral bases, but these are unlikely explanations for the rules governing corporate bankruptcy.) Market versus hypothetical valuation in bankruptcy has no redistributive effect. Who would be the
414
F. H. Easterbrook.
Is corporate bankruptcy
efficient?
winners and losers? There may be winners and losers in particular cases (a violation of the absolute priority rule transfers wealth to the holders of the junior debt), but such transfers ex post do not imply transfers ex ante, given responses to known rules. Suppose current bankruptcy law always falls harshly on junior, unsecured debt, more harshly than a more efficient auction rule that raised larger sums would do. This does not transfer wealth from unsecured claimants to secured claimants; it extinguishes wealth without creating winners and therefore without creating political support. And although such a law creates losers given that a firm becomes a debtor in bankruptcy, it does not create losers ex ante. Unsecured creditors will charge more for money, emerging no worse off across their portfolio of loans. The losers wilI be not the unsecured creditors but the superior firms (and their investors), which must pay the higher price of capital. Investors in these firms - including both secured and unsecured creditors - would be better off if the legal rule were more efficient. So too if existing rules fall harshly on secured creditors by disregarding the absolute priority rule and by indulging optimistic judicial valuations that allow unsecured creditors and equity investors to obtain more than their contractual shares. Again prices adjust, and the anticipation of redistribution ex post means that there is none ex ante. It is at all events unrealistic to suppose that suppliers of capital fall naturally into groups such as secured lenders, unsecured lenders, and equity investors. People have portfolios of investments, and even though some institutions (such as banks) cannot purchase some instruments (such as stock), financial intermediaries are not themselves winners and losers. Real persons supply the capital, and their portfolios are or readily can be diversified across kinds of investment. If an inefficient rule raises the price of unsecured debt, both prices and portfolios will adjust. No one gains ex ante, and all creditors (potentially) lose. The remaining interest group is lawyers. Bankruptcy laws were drafted not by the creditors but by their lawyers. Agency problems are everywhere; maybe the bar figured out how to feather its own nest through extended proceedings at the expense of all creditors’ interests. Such an explanation works, however, only if the bankruptcy bar is closed; free entry would dissipate any rents. Entry is not hard. Lawyers may take up bankruptcy practice freely, and many have done so. Large law firms have greatly expanded their bankruptcy departments in recent years, while other departments such as antitrust have melted away. Because entry is possibIe, and large financial intermediaries have their own teams of lawyers to monitor the work of legislative drafters, rent-seeking is not a plausible explanation of the failure of bankruptcy law to auction off corporate debtors. This leaves efficiency as the likely explanation.
F.H. Easterbrook, Is corporate bankruptcy efficient?
415
Many people find it hard to believe that the judicial system ever operates with lower transactions costs than markets. Baird (1986) expresses justified skepticism on this score. Yet consider that Weiss’s (1990) measurements of the cost of corporate bankruptcy, the best now available, show costs significantly less than those entailed in taking a corporation public. Ritter (1987) finds that the costs of a firm-commitment offering average 14% of the gross proceeds, with a range of 9.3% for placements exceeding $10 million to 19.5% for those of less than $2 million. Private debt placements are less costly, but a bankruptcy auction is more like the sale of equity - for the debtholders in bankruptcy have the residual claims, and the failure of the firm to pay its debts implies substantial risk concerning the success of its future operations. High variability means high costs of sale, for potential buyers rationally spend more evaluating the firm’s prospects and determining whether changes can improve them. Variability is especially high when the value of a firm is linked closely to its managers’ human capital. Managers of firms going public or involved in LBOs usually promise to stay and often are tied by golden handcuffs - stock, often subject to formulaic buy-sell agreements (the departing manager gets only book value for the stock); if the manager is allowed to sell the stock, any diminution in value attributable to the manager’s departure will be reflected in the lower price realized. Managers of firms in bankruptcy are not tied to the firm in this fashion (their stock probably is worthless), and as Gilson (1990) shows, are likely to depart. Auctions of bankrupt firms may well be more costly than IPOs. Although, as Baird (1986, pp. 137-138) observes, flourishing and failed firms may hire the same investment banks to sell the assets, different people set the reservation price and decide when to sell. The residual claimants, who bear the costs of the auction and collect the marginal dollar of receipts, have the right incentives to make decisions about timing and minimum price. When a firm is sound, the equity investors hold the residual claims and make the decisions through the managers. The fabled conflict between debt and equity claimants is a last-period problem. See Easterbrook (1991). When the firm is in default, the managers may still be in control, but the equity claimants they represent no longer hold the residual claims. If the firm’s prospects are volatile, shareholders will want the managers to delay, in the hope of selling when the price is high. On average, however, delay will be costly. Equity claimants have reason to wait too long and to set unrealistic reservation prices, for their claims are worthless unless something unexpectedly good happens. Immediate sale at a realistic price wipes them out; debt claimants bear any erosion of value during a delay, yet have fixed claims and so do not realize the full gain if things turn out well. This is the standard conflict between debt and equity claims, and as usual is substantially aggravated during times of financial distress, when the equity claim is worth little.
416
F.H. Easterbrook.
Is corporate bankruptcy
efficient?
A bankruptcy judge could cure the problem by assigning to the residual claimant not only the right to run the auction but also the obligation to do so within a short time. But this is not possible until the bankruptcy process begins, and managers, knowing that court means a prompt end to their powers, may delay inefficiently before commencing the case [White (1989, pp. 149-1.50)]. What’s more, how does a judge identify the residual claimant when there are several layers of debt? To do this the judge must know the firm’s value - yet the superiority of market over judicial processes in pricing the firm’s assets is the impetus for holding an auction. It is not particularly useful to have borh a judicial and a market valuation process for the same corporation. This means that the court should not itself try to run an auction; how is a judge to set a reservation price intelligently? Not by hiring an investment bank to determine a ‘fair price’ for the assets. Small changes in assumptions about the discount rate and the income stream produce spectacular differences in bankers’ estimates of value [Bebchuk and Kahan (1989)], and the judge has no way to evaluate the wisdom of the bankers’ assumptions. If instead of trying to value the assets the judge invites one group of investors to buy the entitlement to resell the firm as a unit, this is an auction by another name, and it does not solve the question who is to determine timing and reservation price. In comparing the costs of market and judicial valuation, it is important to understand that bankruptcy values the claims as well as the assets. A substantial portion of the measured costs of bankruptcy would exist even if the assets were sold immediately, and the judge dealt only with a pot of cash. Proceedings such as the Manville and Robins bankruptcies were devoted principally to determining the value of contingent claims held by persons injured by the firm’s products. Other cases require valuation of the costs of cleaning up toxic wastes, or of contentions that the debtor committed fraud. Whether the debtor can recover payments made to creditors before bankruptcy (preferences), whether a given debt arises out of a valid contract, and so on, are questions that must be answered by a court even if all assets turn to cash on day one. It is beneficial to resolve in a single forum the extent and priority of all claims to the firm’s wealth. Here lie the principal costs of the process, making the comparison between bankruptcy and IPOs unduly favorable to IPOs. If bankruptcy does well even in such a comparison, it is understandable why there has not been an outcry for a better way. Bankruptcy is a backup, When auctions are superior, creditors will arrange for them in or out of bankruptcy; when they are more expensive, the legal system supplies the method of writing down investments. All investors gain from an agreement to use the more efficient method. Holdouts may prevent the realization of gains from choosing the superior method, and because there are many creditors, holdouts could be a serious problem. Yet the 1978 code makes it hard for a small number of creditors to hold out. The code
F.H. Easterbrook.
Is corporate bankruptcy
efficient?
417
allows a class to compromise its claims by majority vote (two-thirds by value). That rule influences the bargains that can be struck outside of bankruptcy. Solitary holdouts no longer may play the role of spoilers, so it is more likely that creditors as a group will be able to take advantage of superior nonbankruptcy alternatives. When we see creditors resort to bankruptcy, they are telling us that the legal process is superior to market methods available to them. Consider another possibility: the absence of auctions in bankruptcy may be attributable not to tiny comparative advantage of the legal process but to the infrequent bankruptcy of public corporations. Current legal processes may be adequate for closely held firms but inferior for larger entitles. Now that bankruptcy of well-known firms (Texaco, Eastern Airlines, Federated Stores) is more common, creditors may demand a change in the statute. A competing explanation is that bankruptcy of large firms is more common because with the 1978 code bankruptcy became more attractive in comparison with other devices for dealing with financial distress: workouts, mergers, and so on. I am not so sure that bankruptcy of public corporations is more common; railroad bankruptcies in particular have hogged judicial time for more than 100 years. But if it is, an efficiency explanation is at least as attracti\% as an oversight explanation. Survival will distinguish the two, and it will be interesting to see whether in the coming decades the law moves toward a preference for market over judicial valuation of corporate assets.
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