Creditors' Ball: The 'New' New Corporate Governance in Chapter 11

Abstract

For well over a year now, the papers have been filled with hand-wringing about the sorry state of American corporate governance. We read that Wall Street's watchers-the securities analysts and auditors especially-were so riven with conflicts of interest during the stock market boom that the only thing they watched was their own bank accounts. The former chairman of the SEC is barnstorming the country as I write this, telling everyone that he tried to warn us back in the 1990s. The SEC needed more money, he says, among many other complaints, and more freedom from political interference in order to do its job. 2 For the companies that epitomized the governance crisis, bankruptcy is now where the action is. Nearly all of them-Enron, WorldCom, Adelphia, Global Crossing-are currently doing their business in Chapter 11. An observer who followed the bankruptcy literature (and the occasional New York Times or Wall Street Journal article) in the 1990s and who'd lost touch 3 For discussion of the concerns, and a critique of the principal proposals to replace Chapter 11 with an alternative regime, see, e.g., David A.

Hedge Funds and Chapter 11

“…Our default measure for hedge funds playing the LTO strategy, HFLTO , takes a value of one if any of the following situations applies: 11 (i) a hedge fund identified from a list of the largest unsecured creditors or the unsecured creditors committee members is matched to major shareholders from 13D and 13F filings within one year after bankruptcy, or (ii) bankruptcy reorganization plans confirmed by the court show that the classes of claims held by a hedge fund receive equity distribution. In recent years, DIP financing has become creditors' new power tool of corporate governance in Chapter 11 (Skeel (2003)) because DIP lenders are able to take control of the bankrupt firm by bargaining for seats on the board of directors and receiving shares in the newly reorganized company. As a result, our alternative measure, HFLTO _ DIP , takes a value of one if conditions (i) or (ii) above, or (iii) a hedge fund is the provider of DIP financing, holds.…”

“…Bharath et al (2007), while reporting an almost identical overall frequency, document a dwindling trend in the formation of equity committees after 1990. The declining role of shareholders in the Chapter 11 process is apparently matched by the rising importance of creditors in the process (Skeel (2003), Ayotte and Morrison (2009)). However, we note that, during the most recent years (2005 to 2007), hedge funds are present on all equity committees when there is one.…”

“…This effect manifests in higher probabilities of the debtor's loss of exclusive rights to file a reorganization plan, CEO turnover, and adoptions of key employee retention plans (KERP), and in higher probabilities of emergence and payoffs to junior claims. While the bankruptcy process was traditionally classified as either “management driven” (Franks and Torous (1994), Berkovitch, Isreal, and Zender (1998)) or “senior creditor driven” (Welch (1997), Baird and Rasmussen (2003)), hedge funds have driven the transformation of the restructuring process into one that is best characterized as “management neutral” (Skeel (2003), Harner (2008a)), where managers facilitate and implement the distressed firm's restructuring plans but do not control the restructuring process.…”

Optimal Debt and Equity Values in the Presence of Chapter 7 and Chapter 11

“…Aghion and Bolton (1992) and Dewatripont and Tirole (1994) emphasize the importance of switching control from equity to debt in bad states. Skeel (2003) points out that the recent trend in practice is 19 In Section IV, we explicitly address negotiation over d.…”

“…Nevertheless, as Skeel (2003) points out, in practice creditors are able to inf luence decision making in distress by placing their officers on the firm's board and by using executive compensation contracts to align the incentives of managers with theirs. In the next section, we introduce a stylized way to transfer control in bad states.…”