When Congress created Chapter 11 bankruptcy procedures in 1978, the intent was to avoid having assets of temporarily insolvent companies auctioned off hastily. Congress figured that giving management time to restructure financial claims under court supervision was better than forcing a corporate takeover. Now new research indicates that Chapter 11 may be inefficient relative to auctions.
Tuck professor B. Espen Eckbo and colleague Karin Thorburn at the Norwegian School of Economics and Business Administration came to that conclusion after comparing outcomes from Chapter 11 with those of the Swedish bankruptcy system, which mandates that bankrupt companies are put up for auction. There the winning bidder alone determines whether a bankrupt company will continue in business or be liquidated. The research shows that, unlike under Chapter 11, a substantial majority of auctioned companies survive as going concerns and perform at par with their competitors. And there is little evidence that auctions produce fire-sale prices.
"There has been a lot of speculation around why U.S. courts should avoid auctions to resolve bankruptcy," says Eckbo. "Our research shows that the Swedish system leads to more efficient outcomes and that Chapter 11 proceedings would benefit from greater use of auctions."
Fully three-quarters of the 263 auctioned companies investigated by Eckbo and Thorburn survive as going concerns, a greater survivorship rate than firms entering Chapter 11. And while the post-bankruptcy operating profitability of the Swedish firms matches that of their industry rivals, two-thirds of the U.S. firms underperform relative to the competition.
In Sweden, filing for bankruptcy automatically terminates all labor contracts, including those of senior management. The conventional assumption is that the prospect of being fired will lead CEOs of insolvent firms to take excessive risks—gamble with creditors' money—to avoid bankruptcy. The assumption is so strong that it has become a core tenet of classical corporate finance theory. But the researchers found no evidence of such risk-shifting.
"The explanation for this surprising result," says Eckbo, "may simply be that CEOs are looking ahead to the possibility of being rehired by the buyer in the auction. In order to be rehired, you can hardly be seen as having risked the company prior to filing. Classical theory may be placing too much emphasis on the danger of risk-shifting."
Will the auction mechanism work for large American companies with their complicated capital structures? "Why not?" asks Eckbo. "An auction is nothing but a corporate takeover, and size is evidently not an obstacle to takeovers of large U.S. firms." He cites Chrysler's recent government-arranged marriage with Fiat as an example of how the lessons from Sweden could have offered Chrysler's security holders better protection. Several potential suitors indicated they would have been willing to compete for Chrysler's hand, potentially driving up the purchase price. But none were allowed to bid.
Eckbo says his and Thorburn's research is designed to bring bankruptcy auction evidence to the attention of American business leaders and the legal community. A chief obstacle to increased use of auctions in the United States is a combination of traditional thinking and vested interest in the status quo. "By helping to debunk many of the myths surrounding auctions," says Eckbo, "this sort of research will likely accelerate the use of auction processes also in the United States. Ultimately, neither the U.S. Bankruptcy Court nor America's top managers can ignore the fact that auctions protect investors better."
Eckbo E, Thorburn K, "Auction as a Bankruptcy Process: Lessons from Sweden," Journal of Applied Corporate Finance, forthcoming
This article appears in the November 2009 issue of Tuck Forum.