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THE CHOICE BETWEEN LIQUIDATION AND REORGANIZATION

Here is an idealized view of the bankruptcy decision. Whenever a payment is due to creditors, management checks the value of the firm. If the firm is worth more than the promised payment, the firm pays up (if necessary, raising the cash by an issue of shares). If not, the equity is worthless, and the firm defaults on its debt and petitions for bankruptcy. If in the court`s judgment the assets of the bankrupt firm can be put to better use elsewhere, the firm is liquidated and the proceeds are used to pay off the creditors. Otherwise, the creditors simply become the new owners and the firm continues to operate.

In practice, matters are rarely so simple. For example, we observe that firms often petition for bankruptcy even when the equity has a positive value. And firms are often reorganized even when the assets could be used more efficiently elsewhere. The nearby box provides a striking example. There are several reasons.

First, although the reorganized firm is legally a new entity, it is entitled to any taxloss carry-forwards belonging to the old firm. If the firm is liquidated rather than reorganized, any tax-loss carry-forwards disappear. Thus there is an incentive to continue in operation even if assets are better used by another firm.

Second, if the firm`s assets are sold off, it is easy to determine what is available to pay the creditors. However, when the company is reorganized, it needs to conserve cash as far as possible. Therefore, claimants are generally paid in a mixture of cash and securities. This makes it less easy to judge whether they have received their entitlement.

For example, each bondholder may be offered $300 in cash and $700 in a new bond which pays no interest for the first 2 years and a low rate of interest thereafter. A bond of this kind in a company that is struggling to survive may not be worth much, but the bankruptcy court usually looks at the face value of the new bonds and may therefore regard the bondholders as paid in full.

Senior creditors who know they are likely to get a raw deal in a reorganization are likely to press for a liquidation. Shareholders and junior creditors prefer a reorganization. They hope that the court will not interpret the pecking order too strictly and that they will receive some crumbs.

Third, although shareholder and junior creditors are at the bottom of the pecking order, they have a secret weapon: they can play for time. Bankruptcies of large companies often take several years before a plan is presented to the court and agreed to by each class of creditor. (The bankruptcy proceedings of the Missouri Pacific Railroad took a total of 22 years.) When they use delaying tactics, the junior claimants are betting on a turn of fortune that will rescue their investment. On the other hand, the senior creditors know that time is working against them, so they may be prepared to accept a smaller payoff as part of the price for getting a plan accepted. Also, prolonged bankruptcy cases are costly (the Wickes case involved $250 million in legal and administrative costs). Senior claimants may see their money seeping into lawyers` pockets and

therefore decide to settle quickly.

Fourth, while a reorganization plan is being drawn up, the company is allowed to buy goods on credit and borrow money. Postpetition creditors (those who extend credit to a firm already in bankruptcy proceedings) have priority over the old creditors and their debt may even be secured by assets that are already mortgaged to existing debtholders. This also gives the prepetition creditors an incentive to settle quickly, before their claim on assets is diluted by the new debt.

Finally, profitable companies may file for Chapter 11 bankruptcy to protect themselves against “burdensome” suits. For example, in 1982 Manville Corporation was threatened by 16,000 damage suits alleging injury from asbestos. Manville filed for bankruptcy under Chapter 11, and the bankruptcy judge agreed to put the damage suits on hold until the company was reorganized. This took 6 years. Of course legislators worry that these actions are contrary to the original intent of the bankruptcy acts.