Anatomy of a Failed Bankruptcy Auction: The Case of TWA
by B. Espen Eckbo
Tuck Centennial Professor of Finance and
Director of the Center for Corporate Governance
On January 10, 2001, Trans World Airlines Inc. (TWA), the nation's eighth largest airline, sought protection from its creditors under Chapter 11 of the U.S. bankruptcy code. The bankruptcy filing-the third for TWA during the past decade-raises interesting issues concerning the optimal mechanism for restructuring a bankrupt firm. As I argue in this article, what essentially represents an aborted bankruptcy auction may have resulted in an inefficient buyout of TWA.
The TWA case is interesting because auctions in Chapter 11 are rare. Rather, the typical Chapter 11 filing is resolved through negotiations between creditors and the incumbent management team, which retains its position in the firm despite just having run the firm into the ground.
For large publicly traded firms, the typical Chapter 11 process takes two years to complete. The capital infusion needed to run the company during this time is obtained through "debtor-in-possession" (DIP) financing-that is, by selling new debt claims that are senior to the old distressed debt, effectively diluting it.
In addition to being "soft" on managers, the rules of Chapter 11 also weaken the priority rules so crucial to the pricing of corporate debt contracts. Frequently, the judge will accept a financial restructuring plan that leaves something for junior creditors even when senior creditors are not paid in full.
It should not come as a surprise that the "soft" constraint on management and "fuzzy" enforcement of creditor priority rights increase the cost of debt financing ex ante. Moreover, there is evidence that firms emerging from Chapter 11 tend to underperform their own industry competitors. Perhaps it is a mistake to retain that old management team after all.
In a recent lead article in Journal of Financial Economics, Professor Karin Thorburn, associate director of the Center for Corporate Governance, provides some first empirical evidence on bankruptcy auctions. Professor Thorburn's evidence raises an important question: Why not systematically auction off firms filing for Chapter 11 in the U.S.? In fact, auctions in Chapter 11 do happen occasionally in response to expressed investor interest, such as in the case of TWA. However, the TWA auction was performed under a set of rules that severely limited the possibility for the auction to result in the most efficient outcome.
The TWA Auction
On January 3, 2001, AMR Corp., the parent corporation of the nation's second largest carrier, American Airlines Inc., offered a $500 million buyout plan for TWA. At that time, TWA had less than $20 million to cover lease payments of $150 million that were due the following week. AMR agreed to buy substantially all of the $2.1 billion assets and assume $3 billion in aircraft leases, hire most of the 20,000 employees, and take over most of the TWA's operations, including its big hub in St. Louis, Missouri.
The AMR bid included retaining TWA's management. Perhaps as a result, TWA agreed to a breakup fee of $75 million. This meant that if any company other than AMR succeeded in buying TWA, that buyer would have to pay AMR $75 million. Moreover, AMR received the right to match any competing bid for TWA.
The AMR offer also included $200 million in urgently needed DIP financing as soon as TWA filed for Chapter 11 protection in the Delaware court on January 10, 2001.
Under normal circumstances, AMR would have effectively locked up TWA with this "prepackaged" Chapter 11 filing. However, Carl Icahn, a former president of TWA who led the firm into bankruptcy in the mid-1990s, objected to the package. Mr. Icahn owned a significant but unsecured claim in the form of contractual access to cheap airplane seats (which he marketed through the Internet, including on Priceline.com) that AMR declared it would not honor.
On the day of the Chapter 11 filing, Mr. Icahn also objected to AMR's $200 million DIP financing offer, alleging it gave AMR an unfair advantage, and he offered his own DIP. The court rejected Mr. Icahn's offer and allowed TWA to tap into the funds offered by American. The court also denied Mr. Icahn a seat on TWA's unsecured creditors committee.
Continental Airlines and Northwest Airlines joined Mr. Icahn in objecting to the AMR buyout. Continental indicated it was willing to offer $400 million for selected TWA assets as part of a plan in which TWA would be reorganized as a freestanding airline. Continental also objected to the AMR DIP financing and to the breakup fee.
In light of these developments, bankruptcy court judge Peter Walsh organized a March 5 auction for the TWA assets. However, no bidder other than AMR met the March 5 deadline for making a formal bid, which included a deposit of $50 million to a trust account, possibly to cover the AMR breakup fee. A motion to extend the deadline was denied. At the time, it appeared known that Jet Acquisitions Group Inc., which included SkyWest Airlines founder J. Ralph Atkins, was willing to offer $889 million in cash.
Mr. Icahn's consortium, the TWA Acquisitions Group, decided to skip the bidding process and offered its own reorganization plan at a court hearing on March 9. This group was backed by one of the TWA employee unions and by Triarc, a cash-rich New York holding company headed by financiers Nelson Peltz and Peter May. The group planned to restructure TWA as an independent airline.
The "auction" ended with the judge accepting a revised AMR offer of $742 million and dismissing all rival offers. In particular, he dismissed a $1.1 billion proposal from the TWA Acquisitions Group. Judge Walsh had earlier stated that he didn't see a realistic "prospect of a successful reorganization of TWA on its own" (The Wall Street Journal, 3/6/01) and characterized the $1.1 billion offer as a "joke" (Financial Times, 3/12/01).
Judge Walsh could have learned several lessons about running an effective bankruptcy auction. First, the single objective should be to sell to the highest bidder. Second, the auctioneer-in this case Judge Walsh-should not discount bids based on his or her own personal opinion as to the quality of the bidder. Third, the initial breakup fee should be disallowed in order to encourage competing bids. Fourth, the auction should be extended to give interested bidders a reasonable amount of time to meet the formal bid requirements. Finally, the buyer in the auction should be free to fire or rehire the old management.
The TWA auction process left open the question of whether AMR was in fact the most efficient buyer of TWA. This is particularly unfortunate since the TWA-AMR combination raises unique antitrust concerns. Antitrust concerns may be overcome if it is possible to argue that a proposed merger creates the maximum possible efficiency gains. Judge Walsh's "auction" failed to resolve this issue.
This article was written by B. Espen Eckbo, Tuck Centennial Professor of Finance and director of the Center for Corporate Governance at the Tuck School of Business at Dartmouth. Professor Eckbo conducts research in corporate finance and capital markets, with emphasis on corporate governance, mergers and acquisitions, investment banking, portfolio management, and performance evaluation. His work has been published in the top international academic finance journals, including Journal of Financial Economics, Journal of Finance, and Review of Financial Studies. His email address is email@example.com.