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Why Chapter 11 Needs To Be Rewritten


Finance: Commentary

WHY CHAPTER 11 NEEDS TO BE REWRITTEN

Bankruptcy is great for business these days. That is, great for lawyers, investment bankers, and consultants. And all too often, for corporate managers, who get to keep their failed enterprises alive--along with their salaries and bonuses. It's not so great for creditors, who often end up with very little.

No wonder Chapter 11 is appealing to the management of troubled companies. It allows a financially strapped business to hold creditors at bay while it tries to turn itself around. More than 70,000 businesses filed for bankruptcy in the past year, including 125 publicly held companies with total assets of more than $80 billion.

The problem is that bankruptcy courts allow these cases to drag on for years, depleting assets. And one major reason cases go on forever is that bankruptcy judges are often asked to deal with issues such as labor disputes, pension-plan financing, and environmental liability.

Manville Corp., for example, got into trouble when it began losing lawsuits claiming that contact with the company's asbestos caused illnesses and deaths. In 1982, Manville filed for bankruptcy, which lasted six years. In the end, it was a bankruptcy judge who decided how much the plaintiffs would collect.

A bankruptcy court's inability to resolve a complex pension dispute among LTV Corp., its workers, retirees, and the federal government has kept the company in Chapter 11 since 1986. During this time, the Dallas-based conglomerate has spent $162 million on fees to lawyers and consultants. Meanwhile, under the latest reorganization proposal, creditors would get 4 to 53 on the dollar.

TIME LIMITS. Too frequently, bankruptcy judges allow managers to drain a company's remaining assets in an ultimately futile effort to save it. In 1989, Eastern Air Lines Inc. used Chapter 11 to try to bust its unions. A bankruptcy judge allowed Chief Executive Officer Frank Lorenzo to run the airline for another year, during which it lost more than $1 billion. A court-appointed trustee took over the next year, and most of the remaining assets dwindled away. The once proud carrier was liquidated in 1991.

Before 1978, most bankruptcies ended in rapid liquidation. Then, Congress rewrote the law in an attempt to keep insolvent companies alive, believing that this was best for managers, employees, and creditors alike. It hasn't worked out that way. Before the reform, 90% of Chapter 11 filers were liquidated. Now, up to 80%, mostly small businesses, die. Large public corporations with the ability to hire high-priced legal help have the best chance of making it.

A system that hurts creditors and shareholders while benefiting lawyers, consultants, and managers needs fixing. What should an overhaul of bankruptcy law aim for? One valuable change would be limiting the time a business has to file a reorganization plan, the most important step toward restoring a company to health. A debtor is supposed have only 120 days, but the deadline is rarely enforced for companies with sharp lawyers. As disputes drag on, assets are depleted and negotiating positions harden. It might make sense to set a deadline of six months or a year, then stick to it. "Bankruptcy is like open-heart surgery--the longer you stay under the knife, the lower the chance of success," says James E. Spiotto, a creditors' lawyer with Chapman & Cutler in Chicago. "We should be shooting for a quick, efficient way to give companies a fresh start."

COSTLY DISPUTES. Another needed change is removing broad social questions from the bankruptcy process. Congressional failure to grapple with such issues as product liability, pension reform, and environmental cleanups has dumped these tangled and costly disputes onto bankruptcy judges' dockets. If lawmakers want to correct the underfunding of retirement plans, they should do it by fixing federal pension laws.

And bankruptcy judges have to realize that some sick companies should simply be allowed to die--and quickly. Maintaining them on life support ultimately serves no one's interest.

Radical reformers aren't satisfied with tinkering. In a controversial Yale Law Journal article, University of Michigan Finance Professor Michael H. Bradley and Atlanta lawyer Michael Rosenzweig say the current system of judicial protection and supervision should be trashed. Instead, they propose a kind of auction, in which shareholders and creditors would be given an opportunity to gain control of the company by raising the cash needed to pay the bills. Says Bradley: "When you get into Chapter 11, the question is: Is this more valuable alive than dead? The market is a better judge of that than a bankruptcy judge."

Such remedies would surely run into heavy opposition. But Chapter 11 is bankrupt. Unless confidence in the system is restored, radical change may be the only solution.Howard Gleckman


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