Think at London Business School
Bankruptcy might be the end of the road for a business, but it is rarely a fresh start for its employees and assets. It is a time when a business’s obligations and property can be reorganised as a going concern or liquidated.
A question bankruptcy poses is how you do that fairly? Is it best for policymakers to set procedures that protect people and assets, or should the market, through contracts with creditors, be allowed to decide how to protect value?
Julian Franks, LBS Professor of Finance, Alexander M. Knaster Chair and Fellow of the British Academy, has spent a third of his career researching distress and bankruptcy. His interest was piqued, when with co-author Walter Torous, Senior Lecturer at MIT, he set out to find out whether the strict protection rules provided by US Chapter 11 procedures worked.
Chapter 11 dates to when the US government wanted to protect critical railroad infrastructure from mass bankruptcy of its owners. Under Chapter 11 protection, the railroad companies were granted continued control of their assets and significant protection from debtors, while they restructured themselves.
“Chapter 11 was an anathema to English law, which very much puts the onus on contracts to resolve bankruptcy,” recalls Professor Franks. “England doesn’t give breathing space to bankrupt companies, whereas Chapter 11 does. But we found that, under Chapter 11, there was manifest taking advantage of creditors by the borrower”
Professor Franks has also studied codes in the UK, France, Germany, Hungary and US, writing papers on all these countries.
One paper, co-authored with Sergei Davydenko, Associate Professor at Rotman, was a comparison of the bankruptcy codes of France, Germany and the UK. Using data from ten banks, the ratings agency, which sponsored the work, wanted to find out if they should rate countries differently because of their codes.
It showed that legal codes mattered because they significantly shaped bankruptcy outcomes, despite the efforts of banks to take them into account when writing loan contracts.
“The consensus rang alarm bells for me.”
Two new papers add to this body of work, with a reappraisal of fire sale discounts and the idea they lead to a misallocation of assets. These ideas matter because they are justifications for the protections afforded under Chapter 11.
The companion papers, both co-authored with long-time collaborator, Oren Sussmen, Reader in Finance at Said Business School, and two LBS colleagues Vikrant Vig, Professor of Finance, and PhD student Gunjan Seth, focus on the size of fire sale discounts and how bankruptcy is resolved in the airline and shipping industries.
They begin by considering how distress can be resolved in one of two ways. Either a firm enters bankruptcy in Chapter 11 and is then liquidated, or it takes the opportunity to restructure and emerge as a going concern.
Research had pointed to the scale of the fire sale discount as an avoidable loss of value, avoidable under Chapter 11 protection because it allows a more patient sale of assets.
“It’s a pervasive view that fire-sale discounts are large in the US, which is peculiar when you have Chapter 11, and that rang alarm bells for me,” reflects Professor Franks. “You might expect deeper discounts where you don’t have Chapter 11, and you don’t have a patient sale.”
The consensus argument also concluded that large discounts were also driven by a systemic failure; that an industry would likely be in distress when one is in distress, such as you find during a recession. It followed that buyers wouldn’t be peers, who might make efficient use of an asset but an outsider, like private equity or hedge fund, who would be a less specialist, less productive user. It was thought deep fire sales discounts allowed for the fact that assets were misallocated from a productive to less productive user.
This wasn’t Professor Franks’ only problem with the consensus he found it odd that the bankrupt company was considered the high productivity user. In these new papers, they find the opposite. It is the buyers, who are the high productivity users.
This is in part because the discount offered by distressed companies is significantly less than what had previously been calculated. (They also found that the discount is very similar across the airlines and shipping industries, despite Chapter 11 not being available to most shipping companies.)
The key to this breakthrough was successfully calculating the quality of the assets in the fire sale that could account for the depth of fire sale discounts.
The consensus on deep discounts was formed by Todd Pulvino after his 1998 investigation into commercial aircraft transactions.
“Pulvino’s paper has been the go-to reference point on fire sales, and it remains an important and interesting paper,” comments Professor Franks.
“While Pulvino realised there was a quality issue, he didn’t know how to overcome it. John Campbell, in his real estate fire sale paper, discussed the quality issue in considerable detail, but he couldn’t measure this quality discount either.”
In aircraft and shipping, Professor Franks and his colleagues have measured this quality discount. They asked, if your company is going into bankruptcy with an 18-year-old asset, when does the asset die? They found that financially distressed assets die three years earlier than healthy 18-year-old craft. That shorter life is the input and how they measured quality.
“Our paper directly challenges the idea that fire sale discounts are large,” says Professor Franks. “We find them to be half what has been suggested and there is also little if any misallocation.”
“It was also odd that the bankrupt company was considered the high productivity user.”
The ripple effects of bankruptcy can have wide implications, beyond one business or industry. Among these is the impact on the environment, and the situation in shipping is stark.
Boats which have been through bankruptcy fire sales have been significantly undermaintained, as in the extreme case of the MV Rhosus, explode in Beirut.
And if they don’t leak or explode, undermaintained boats with bankrupt owners, can leave crews stranded in legal limbo for months, all the while hulls decay in harbour, increasing the risks of oil spills and other environmental disasters.
Even firms which emerge from Chapter 11 are not free from controversy. Managers can use the protection to reorganise and renegotiate obligations, in questionable ways.
In the case of airlines in distress, they can cut unprofitable routes and cut staff pay. In effect, they are taking money from their employees to pay lenders and shareholders.
Professor Franks says these practices raise the question of who is paying for the gains from restructuring. In some cases, the gains in productivity make up the gap, but sometimes it’s a straight transfer from one set of stakeholders to another.
“There’s controversy over how much we should rely on lenders and borrowers to evolve contracts, which cope with bankruptcy and to what extent should we force bankrupt firms to enter into procedures laid down by the state,” concludes Professor Franks.
“There remains significant tension between finding market solutions and arguing that market solutions just don’t work.”
Professor Franks’ 30-year investigation is not done yet.