Adam Smith's "Invisible Hand" proposes that individuals working to advance their economic interests in an open market will ultimately specialize, focus on their comparative advantage, and trade goods and services among themselves. As a result, the individuals and society will be better off. Smith concluded that competing interests in an open market achieve superior economic and social results.¹

In the context of chapter 11, the same holds true: The more disclosure, the more opportunity to negotiate and/or adjudicate in a fair and open forum, the more equitable and superior the result. Conversely, a rush to confirm a plan of reorganization (plan) or a quick pre-packaged plan may promote the misallocation of existing value, leading to suboptimal results and the potential need for future restructuring. Examples of misallocation include (1) the junior classes of claimants receiving too much value and a reorganized company that has not sufficiently deleveraged, or (2) the misappropriation of value from junior classes to senior classes where senior classes realize recoveries substantially in excess of the economic value of their claims. Other areas with the potential to misallocate value include key employee retention and critical vendor payment programs²—programs that are specifically designed to contravene the absolute priority rule. In order to prevent such potential misallocations, it is critically important to allow for an open process with full disclosure to all parties-in-interest.

Ideally, chapter 11s should accomplish the following:

1. Fix the business operations. Eliminate or transform uneconomic operations, contracts, warranty agreements or other operating related liabilities or loss-producing operations.
2. Fix the capital structure. Deleverage the balance sheet and/or source new financing to fund the business transformation or payments to creditors. New financing may result in an absolute change of control or a sale of the company to a third party.

While full disclosure and adequate time to negotiate and/or adjudicate matters is desirable for the long-term viability of the reorganized company, that luxury may not always be available. Business is more challenging now than a decade ago, principally as a result of changes in information technologies. The cost of information has essentially become zero, compressing the time by which companies must react to changing business conditions. Accordingly, companies in chapter 11 must actively manage their public relations, among other items, as news regarding their financial condition and viability is swiftly broadcast to the market, principally by non-chapter 11 competitors. This imperils the ability of chapter 11 debtors to realize all the benefits that may be available from an extended reorganization process.

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The Sarbanes-Oxley Act of 2002 naively requires senior company officials to vouchsafe their SEC disclosures and stand by their financial reporting. This is not enough.

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The ramifications of the quick-fix chapter 11 are clearly illustrated by LoPucki and Kalin,³ where they demonstrate that the clogged bankruptcy courts in Delaware and New York facilitate expedited chapter 11 plans of public companies—a consequence of which is that refiling rates for these public companies is six to seven times greater than those of other bankruptcy courts. LoPucki and Kalin "presuppose that refiling constitutes a failure of the bankruptcy process and that the rush of debtors to Delaware is inefficient and socially undesirable."⁴ Stated another way, refiling demonstrates the misallocation of value to junior classes of claimants resulting from a reorganized company that was not sufficiently deleveraged.

Greater judicial intervention may be important in reviewing whether proposed plans adequately allocate value and lead to better results thereby reducing refiling rates and improving overall social and economic utility. Ideally, proposed plans must be fair and equitable and achieve the other requirements necessary to confirm chapter 11 plans.

Beyond Chapter 11

Having determined that a more transparent and participatory chapter 11 process yields better social and economic outcomes, are there other arenas where sunshine and greater participation could furnish superior results? With the travails of WorldCom, Enron and a host of other high-profile business failures and chapter 11 filings, perhaps companies with publicly traded debt and equity securities should revisit their public disclosures and the openness of their economic and governance processes.

There is already one relatively efficient mechanism influencing corporate behavior—the trading prices of various publicly traded debt and equity securities. But there also need to be effective mechanisms providing oversight and proper governance. One is a company's board of directors. They are supposed to oversee the operations of management and have fiduciary obligations to shareholders and even creditors. Another is the company's auditors. Notwithstanding recent well-known audit failures, independent public accountants can and must be effective watchdogs. A third is the Securities and Exchange Commission (SEC). The SEC is the ultimate regulatory body responsible for reviewing public disclosures and financial reports of SEC filers. Their scrutiny of such filings needs to be improved.

The Sarbanes-Oxley Act of 2002 naively requires senior company officials to vouchsafe their SEC disclosures and stand by their financial reporting. This is not enough. Only with the full participation of a company's board, its auditors and a strong SEC oversight function, will public company disclosures reach a level that will serve to improve the efficiency of financial markets.

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Footnotes

¹ Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776. Return to article

² A key employee retention program is designed to incentivize management to work through a chapter 11 reorganization and to compensate management for the associated opportunity cost and risk. A critical vendor payment program is designed to ensure the continuity of critical vendor support during a chapter 11 by preemptively paying some or a portion of pre-petition vendor claims. Return to article

³ See LoPucki, Lynn M. and Kalin, Sara D., "The Failure of Public Company Bankruptcies in Delaware and York: Empirical Evidence of a 'Race to the Bottom,'" Vanderbilt Law Review, Vol. 54:2:231. Return to article

⁴ Vanderbilt Law Review, Vol. 54. Return to article