A Viable Alternative to Chapter 11
American companies having trouble servicing their debt typically resort to reorganization under Chapter 11 of the U.S. Bankruptcy Code (as opposed to liquidation under Chapter 7). Increasingly, other industrial countries are adopting the Chapter 11 model. Sweden is not among them. Despite pressures for change, that country continues to rely on bankruptcy auctions, in which failing companies are sold to the highest bidder, either as going concerns or piecemeal. It's a system that Professor Karin Thorburn believes should be preserved.
Thorburn has conducted the first empirical study of the outcomes in an auction bankruptcy system. In a detailed report, recently published in the Journal of Financial Economics, she compared 263 small businesses auctioned off in Sweden between 1988 and 1991 with their counterparts under Chapter 11. The study looked at costs, debt recovery, and survival rates (the proportion of businesses that continue to operate at the close of bankruptcy proceedings). After controlling for such factors as size, financial health of the industry, and ownership structure, she found surprisingly few differences in firm survival and creditor recovery rates, a result that Thorburn says establishes the auction system as a viable alternative to Chapter 11.
But Thorburn finds the differences between the two systems of even greater importance.
Chapter 11 reorganizations are protracted affairs, often involving contentious disputes over valuation of the firm, judicial imposition that forces deviations from creditors' priority, and recovery in the form of stock and new debt claims in the reorganized company rather than cash. The proceedings take on average two years to resolve, compared with two months under the auction system. The differential correlates directly with greater direct and indirect costs, such as legal fees, reduced product demand, diversion of managerial focus, and erosion of suppliers and key personnel.
In the auction system, in contrast, value is determined automatically by whatever the highest bidder is willing to pay, and creditors are recompensed from the cash proceeds according to absolute priority rules. In the Swedish auctions, creditor priority is fully protected, while in Chapter 11, senior creditors may receive less so that all stakeholders can receive something. "It's all in how you define fairness," says Thorburn.
But perhaps the major difference between the two systems is that under Chapter 11 the same CEO that presided over the company's decline is allowed to remain in control (albeit under court supervision) until final resolution-a system that Thorburn believes promotes delay and encourages managers to shift resources to protect themselves at creditors' expense. Indeed, she says Chapter 11 is expressly designed to protect equity holders, creating an uncertainty in the resolution of distressed debt claims and, she believes, fostering weakness in the companies allegedly being protected.
"Under Chapter 11, the patient waits in pain as his condition deteriorates while everybody argues about the treatment. In the Swedish auction system, the patient quickly undergoes a rough treatment and walks away with no further delay."
Karin S. Thorburn is assistant professor of business administration and associate director of the Center for Corporate Governance at the Tuck School of Business at Dartmouth. Professor Thorburn conducts research in takeovers, corporate restructuring, and bankruptcy. Her work has been published in the top international academic finance journals, including Journal of Financial Economics and Journal of Financial and Quantitative Analysis. Her email address is firstname.lastname@example.org.
This article originally appeared in Tuck Forum, V(2), Spring 2001, published by the Office of Publications at Tuck.