RESEARCH & IDEAS

How Chapter 11 Saved the USEconomyPublished: March 25, 2013Author: Kim Girard

In a relatively short time, much of thecorporate debt that defaulted during the USfinancial crisis has been managed down andcorporate profits have rebounded. Stuart C.Gilson reviews the power of Chapter 11bankruptcy

It's no surprise that Harvard BusinessSchool professor Stuart C. Gilson gave anenthusiastic thumbs-up to the recentlyannounced $11 billion US Airways/AmericanAirlines merger. The deal, which came afterAmerican's parent company, AMR Corporation,declared bankruptcy in November 2011, willallow the airline to work with the court torestructure and unload a significant amount ofits debt, giving an iconic company "a secondbite of the apple," says Gilson.

An unabashed advocate of Chapter 11 anddebt restructuring, Gilson is an expert in thelegal innovations and institutional changes thathave revolutionized their use in practice. Hecontends that both serve the US economy byhelping troubled companies stay viable bygiving them time to find new financing,renegotiate unfavorable leases and supplycontracts, or expedite processes for selling offassets.

Despite these benefits, he says that Chapter11 has suffered an image problem.

"When I first started in this area, I facedchallenges selling this to students," says Gilson,the Steven R. Fenster Professor of BusinessAdministration. "Bankruptcy was seen as thestudy of dead or dying companies."

The truth is anything but— "it's aboutreviving companies," says Gilson, author of the2010 book Creating Value through CorporateRestructuring: Case Studies in Bankruptcies,Buyouts, and Breakups .

Reviving the economyTaking a look at the 2008 financial crisis,

Gilson says that restructuring and Chapter 11played a heroic role in helping the countryrebound. He outlines these ideas in ComingThrough in a Crisis: How Chapter 11 and theDebt Restructuring Industry Are Helping toRevive the US Economy , published in the fall2012 Journal of Applied Corporate Finance.

"Bankruptcy was seen asthe study of dead or dyingcompanies"During the crisis, the "amount of debt that

needed to be restructured posed a seeminglyinsurmountable challenge," he writes in thearticle. At one point, a whopping "$3.5 trillionof corporate debt was distressed or in default.[Between] 2008 and 2009, $1.8 trillion worth ofpublic company assets entered Chapter 11bankruptcy protection— almost 20 times morethan during the prior two years."

A significant portion of the private equityindustry, he says, was "widely believed to be onthe verge of extinction."

Instead, in a relatively short time, much ofthe corporate debt that defaulted during thefinancial crisis has been managed down, massliquidations have been averted, and corporateprofits, balance sheets, and values haverebounded with remarkable speed, he says.Even Lehman Brothers, the largest and mostcomplicated bankruptcy in US history, emergedfrom Chapter 11 with a confirmed plan ofreorganization in only three and a half years.

Because of Chapter 11 and the expertise ofUS restructuring professionals who advisetroubled companies, Gilson says America'seconomic recovery has been far speedier thanEurope's, where bankruptcy laws tend to favorimmediate payback of creditors.

"Many countries around the world havebankruptcy laws that primarily seek to liquidatedistressed companies," he says. "The emphasisis on reimbursing creditors, or protectingparticular stakeholders such as employees,rather than doing what's necessary torehabilitate the business."

According to Gilson, this providescompelling evidence that "US bankruptcy lawsand restructuring practices have played acritical role in driving the economic recoveryand restoring the competitiveness of UScompanies."

Chapter 11's evolutionDespite much criticism of Chapter 11 as too

costly, slow, or inequitable, Gilson saysmanagers and financiers working withdistressed companies in Chapter 11 have"evolved and adapted to deal with large,complex cases."

During the 1970s and '80s, Drexel BurnhamLambert's Michael Milken carved out new waysto restructure large amounts of publicly tradeddebt. Gilson's research suggests that the totalcosts associated with Milken's method ofreorganizing troubled companies were as littleas one-tenth of those associated with aconventional corporate bankruptcy.

In the post-Milken era, Gilson points to ahybrid approach that has blurred the linebetween Chapter 11 and restructuring, offeringalternatives to "free-fall" bankruptcy.Prepackaged and prenegotiated bankruptcycombine the most attractive features of Chapter11 and out-of-court restructuring.

In prepackaged bankruptcy, companiesnegotiate restructuring plans with creditors,gathering formal votes prior to filing forbankruptcy so they can enter Chapter 11 with areorganization plan and disclosure statementalready in place. (In 2009, "prepackagedbankruptcies accounted for $124 billioncorporate assets filing for Chapter 11, includingCIT Group, Six Flags, Lear Corp., and CharterCommunications," Gilson writes.)

In a prenegotiated Chapter 11, firms don'tformally solicit votes but rather ask keycreditors to sign a "lock-up" agreementpromising to vote for the plan once the firm isin Chapter 11.

The advantage of either type of filing is thatit allows companies to avoid steep costsassociated with spending months in bankruptcycourt and to take advantage of Chapter 11's"more lenient voting rules, minimizing theholdout problem that can frustrate attempts torestructure out of court," Gilson writes.

Companies also increasingly using Chapter11 to expeditiously sell off assets. Section 363of the US Bankruptcy Code allows a bankruptcompany to sell assets in a competitive auctionoverseen by the court; assets purchased this wayare also less vulnerable to subsequent legalchallenges. This option has always existed,Gilson says, but it's been used more often inrecent years so asset-rich companies that are

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cash poor can raise money. In 2001, AmericanAirlines acquired the assets of bankrupt TWAusing this approach. More recently, Section 363sales played a key role in some of the largestand most complex bankruptcies of the financialcrisis, including General Motors and LehmanBrothers.

"The amount of debt thatneeded to be restructuredposed a seeminglyinsurmountable challenge"Chapter 11 gives troubled companies other

valuable options for raising cash, Gilson says.While operating in Chapter 11, a company isfreed from paying interest on its pre-bankruptcydebts. Section 365 of the Bankruptcy Codeallows the company to reject unprofitableleases. And through so-calleddebtor-in-possession (DIP) financing, newlenders are given priority in the capitalstructure. This is a critical incentive because itspurs banks and other creditors to lend tocompanies in Chapter 11 by giving them seniorstatus, effectively letting them stand in front ofpre-existing creditors. (American did not needsuch debtor-in-possession financing. United andDelta together raised almost $3.5 billion in DIPfinancing in their bankruptcies.)

Some argue that putting earlier investors at

the back of the line is unfair, but Gilson saysthat giving a distressed company access to newcash can increase its chances of paying backmore investors overall. "It's about increasing thesize of the pie available to all the firm'sstakeholders," he says.

Not a universal solutionBut Chapter 11 isn't the answer for all

companies, Gilson says.It might yield big benefits for commercial

airlines and retail chains, which typically leasea large fraction of their assets, and for steel- andautomakers that have large unionizedworkforces, which will give them greaterleverage to renegotiate collective bargainingagreements. But Chapter 11 will be lessbeneficial for companies where the "stigma" ofbankruptcy is apt to scare off customers andsuppliers, or for banks and other financial firmsthat have large liabilities under derivativescontracts, which, unlike most debts, are notfrozen by a bankruptcy filing.

Realogy Corp., featured in Gilson's article,is an example of a company that chose to dealwith its financial problems outside ofbankruptcy court.

One of the world's largest real-estatecompanies, Realogy was acquired in the springof 2007 by the private equity firm ApolloManagement in a $7 billion leveraged buyout.The buyout came at the peak of the US housing

boom, and the company was struggling tomanage its $6 billion debt load. As the housingand mortgage market collapsed, Realogyscrapped to pay more than $600 million inannual interest. With a total debt of $6.6 billionin 2010, the company decided to restructure outof court instead of filing for Chapter 11 forseveral reasons, Gilson says.

First, most of Realogy's operating cashflows were from franchise agreements withlocal real-estate agencies, and a Chapter 11filing could have critically damaged relationswith the agencies. Second, its workforce wasnot unionized. Finally, the appearance of"giving up" through bankruptcy could have senta signal to Apollo's limited partners—and to itscompetitors—that the firm wasn't "willing tosupport its less successful investments,undermining future fund-raising efforts or itsability to restructure other portfolio companies,"Gilson writes.

While the jury is still out on therestructuring, Gilson says Realogy is seekingopportunities to grow the business, and"operating improvements made during therestructuring have positioned the company totake full advantage of any recovery inreal-estate values."

About the authorKim Girard is a writer in Brookline,

Massachusetts.

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