Why Bankruptcy Spells Death for Too Many Businesses

Chapter 11 bankruptcy protection is supposed to allow businesses to get out of debt and get a fresh start. Ideally, creditors get back most of what is owed to them when the restructured business begins to turn a profit.

Yet more businesses are liquidated than rebuilt, giving up the second chance for success the law aims to encourage. In the process, these liquidations end up depriving creditors of billions of dollars a year, according to a new study from the assistant professor at Harvard Business School. Samuel B. Antill, who has studied three decades of court records.

“Chapter 11 allows for a reorganization, which seems like such a good thing. People keep their jobs, creditors get equity, and customers don’t lose this business they loved, ”says Antill, whose article Do Good Businesses Survive Bankruptcy? will appear in a future issue of The Journal of Financial Economics.

At a time when the COVID-19 pandemic has hit many businesses hard – some to the point of considering bankruptcy – Antill’s research findings can help business leaders make important decisions to avoid the price high liquidation and choose a reasonable path to follow.

Liquidation is raging

Using case information from Bankruptcydata.com, Bloomberg Law, Moody’s Investors Service, and the Federal Reserve Bank of St. Louis, Antill studied 503 non-financial companies, each with over 50 debt. million dollars at the time of default between 1987 and 2018.

Because the data includes the names of judges on individual cases, Antill was able to determine how specific jurists ruled. He focused on companies that have filed for Chapter 11 bankruptcy, the approach that large companies looking to reorganize or liquidate tend to favor.

Before analyzing court rulings, Antill expected bankruptcy judges to prioritize reorganization over liquidation. “Instead, I was surprised to see that it’s actually the other way around. There is excessive liquidation in the American bankruptcy system, ”he said.

Leaders demand liquidation

One of the reasons for the trend? Senior creditors typically hire outside managers to guide a business through Chapter 11. But instead of reorganizing, the manager often persuades the judge to approve a quick sale of assets. By prioritizing quick resolution rather than beneficial reorganization, managers can steer businesses toward liquidations that hurt junior creditors, employees and customers.

Under Section 363 of the United States Bankruptcy Code, judges can grant this request without the consent of the creditors if the executives present a “business justification” for the move, such as a decline in the value of everything from furniture. to the company itself.

“There are cases where you have a melting ice cube and bankrupt assets that lose value very quickly. It’s ‘if we don’t make the sale now, there won’t be any value left in this business,’ ”says Antill. “[Managers] just need the judge to believe there’s a business rationale, and then they can make this whole sale happen in, like, 30 days.

Restructuring costs less

Rushing the process can be short-sighted for businesses and creditors, costing both parties more in the long run, research shows. Antill points to Sears — the the most expensive bankruptcy in historyry-as an example of value lost through the hasty sale of assets.

According to Antill’s analysis, creditors would potentially earn 52 cents on every dollar owed when a business is restructured instead of liquidated.

In other words, 60% of the liquidations investigated by Antill cost creditors more than a simulated reorganization would have cost. Creditors have also lost more money in the acquisition of certain bankrupt companies than they would have lost in a notional reorganization. Over time, missed opportunities accumulate, with ineffective liquidations and acquisitions costing creditors more than $ 2 billion a year, Antill finds.

This has big implications for businesses large and small. As long as they don’t have excessive debt, companies coming out of bankruptcy can perform well when reorganized, a potential boon to both the business and creditors, according to Antill.

“If you could just get all the creditors to agree to reduce that debt burden, to accept depreciation, then that company’s equity becomes really valuable. Because for some of these companies, really, their only problem was this debt, ”he says.

Creditors, in turn, benefit because they can negotiate stakes in the new business as payment for outstanding debt. This is an asset which, if the reorganization is done well, can grow over time.

“They become partial owners of this business and their equity stake can be very valuable, more valuable than what the liquidation would have been had the business been healthy,” Antill said.

What Should Bankrupt Companies Do?

Antill’s findings may be particularly relevant to small business owners facing the possibility of bankruptcy as the country emerges from the pandemic. Small businesses, especially those in debt or distress, often can’t afford the more expensive Chapter 11 filing and instead file Chapter 7, where they have less control.

Some good news: the 2019 Small Business Reorganization Act seeks to facilitate small business reorganization under Chapter 11, which small businesses should seriously consider, says Antill.

Before going to court, managers considering bankruptcy should meet with major creditors to strengthen their support, Antill advises.

“Get them to sign some sort of restructuring support agreement, maybe even a prepackaged bankruptcy plan before filing,” Antill says. “This allows managers and creditors who have signed the deal to take advantage of one of the coolest features of bankruptcy – you can say to some creditors, ‘I’m only paying you half of what I owe. ”

Meanwhile, creditors should be willing to work more closely with management on a reorganization plan before going to court, especially knowing that many businesses only experience temporary setbacks from the impacts of COVID-19. , Antill said.

“It is important to help creditors understand that this may be an unusual circumstance and that if they could just be patient, accept equity in this business instead of liquidating the assets, that capital could be very valuable after the pandemic, ”Antill said.

About the Author

Rachel Layne is a writer based in the Boston area.
[Image: Pexels/Engin Akyurt]

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