Reforming Corporate Bankruptcy: Chapter 7 vs Chapter 11

When a company faces financial difficulties, the decision to file for Chapter 7 or Chapter 11 bankruptcy is not straightforward. While bankruptcy law in the US is designed to provide relief to companies, the process can often be fraught with complications. This article explores the challenges in deciding whether a corporation should file for Chapter 7 or Chapter 11, and proposes reforms that could make these processes more equitable for all stakeholders.

The Current Framework

Current bankruptcy laws, specifically Chapter 7 and Chapter 11, are often criticized for not adequately distinguishing between the financial distress of a corporation and a natural person. This distinction is crucial because the financial implications for each are vastly different. While individuals are subject to bankruptcy proceedings, corporations, especially those with separated ownership and management, often present a unique set of challenges.

The existing code fails to fully consider the risks and returns associated with corporate investments. Shareholders, who are typically the risk-takers, argue that their investment should include the potential for total loss. Failure to wipe out these shareholders can lead to unfair outcomes, as creditors are forced to absorb the losses. However, reforms are needed to ensure that this process is fair and that creditors are adequately protected.

Challenges with Current Processes

Chapter 11 is often viewed as a temporary measure to address cash-flow problems. Under the current framework, a corporation can emerge from bankruptcy only after it has a plan to pay all creditors in full, including penalties. However, this process is often far from straightforward. Creditors may be unwilling to accept full payment upfront, as they are often more interested in the company's ongoing viability.

On the other hand, Chapter 7 bankruptcy is often not in the best interest of creditors. The liquidation of a company can result in a significant loss of value due to the inability to utilize the assets as part of a going concern. This is particularly problematic for companies with complex assets or significant ongoing operations.

Proposed Reforms

To address these challenges, it is proposed that both Chapter 7 and Chapter 11 be significantly revised. Chapter 11 should be reformed to serve as a temporary measure to resolve cash-flow problems only. The corporation should emerge with a clear plan to pay all creditors in full. If the corporation cannot emerge from bankruptcy, it should be seized by creditors, rather than liquidated.

Chapter 7, in its traditional form, should be replaced by a process where the entire business is seized and operated by new creditors who are in a priority tranche. This would involve the issuance of new shares while all other junior claims and equity are wiped out. Senior claims should remain undiminished, and the new owners would have limited rights to dividends or stock repurchases until proper provisions are made.

Priority Order of Obligations

To ensure a more just and equitable process, a clear priority order for obligations should be established. This would include:

Third-party fines and tort claims Second-party fines and tort claims Most employee compensation Other operating liabilities Financial liabilities with clear seniority order Director bonuses and union-negotiated promises of future employment Equity

Calls on equity should be honored in full by delivering old stock, which might become worthless. Warehouse receipts should be honored, as they do not belong to the company and should not be seized by creditors.

Case Study: Tracor’s Bankruptcy

A real-world case that illustrates the need for such reforms is the bankruptcy of Tracor, where the management’s actions in handling the crisis are fascinating. Admiral Inman, the CEO, was portrayed as a fool in popular lore, while Jim Skaggs is seen as a master strategist. One story that stands out is when Skaggs sold off a business unit. The bankruptcy court did not allow the creditors to claim the proceeds, as Skaggs used the funds to prop up the company's operations. By showing the creditors the company's assets and offering them the keys, Skaggs managed to convince them that liquidation would be worse than making concessions to keep the company running.

Skaggs’ actions led to a situation where the creditors chose to run the company rather than liquidate it, ensuring the survival of the company. This case highlights the importance of providing options to creditors and ensuring that they do not have to choose between liquidation and concessions.

Conclusion

Reform of corporate bankruptcy processes is essential to ensure a fair and equitable distribution of resources among all stakeholders. By establishing a clearer priority order of obligations and reforming Chapter 7 and Chapter 11, we can ensure that the risks and benefits are more balanced. This will not only protect creditors but also foster a more stable and sustainable business environment.