Chapter 11 filings by US Airways and United Airlines, and the possibility of other airlines following them into court, bring new attention to bankruptcy reorganization as a management strategy. Is bankruptcy a last-ditch effort to salvage a firm passing through a temporary rough patch, or is it a way to get rid of long-standing pension obligations to employees?
Wharton legal studies professor Richard Shell says bankruptcy typically is used to renegotiate power between a firm and its various stakeholders. He points to Donald Trump’s prepackaged casino bankruptcies that arrived at the courthouse with new financial terms already agreed to by creditors and management.
Yet while creditors are also involved in the recent airline bankruptcies, management has focused on union concessions as the key to reorganization. “What’s going on now is more visible because unions are involved and because some companies are attempting to cleanse their balance sheets of pension and other obligations that have social consequences,” says Shell.
For example, he notes, airlines trying to renegotiate pension promises may ultimately shift those obligations to the already strained government pension guarantee system. In the past, reorganizations have tended to focus more on which creditors will take the biggest financial hits while the company continues to operate with little visible impact on rank-and-file employees or customers.
“If Donald Trump’s casinos go into bankruptcy it doesn’t have the same kind of public policy issues you have when US Airways goes into bankruptcy,” says Shell, author of a recent book on legal strategy entitled, Make the Rules or Your Rivals Will. “US Airways’ use of bankruptcy to handle its pension plans is likely to influence how other companies approach retirement obligations. In a number of industries, bankruptcy could become an even more appealing threat they can use at the bargaining table.”
Meanwhile, Congress may step in and tighten up companies’ ability to use the courts to back away from pension or other obligations, says Shell, particularly if the federal government is left to pick up the tab. Indeed, according to an AP report this week, more than 100 members of Congress have sent a letter to United Airlines stating their opposition to the company’s plan to stop funding its pension plans. The letter, saying that it was “unfair to insist” that employees’ and retirees’ “retirement security be sacrificed,” was signed by 104 House members and eight senators.
Whatever the outcome of that action, “at the end of the day, when a company can’t pay its obligations as they arise, Congress can’t legislate it to be profitable,” says Shell. “There has to be some mechanism for coping with that train wreck.”
A Very Small Pie
Modern bankruptcy laws date back to 1898, and were used relatively infrequently through the 1970s, mostly to cope with cyclical downturns. The Bankruptcy Reform Act of 1978 made it easier for companies to reorganize through the courts, leading to a wave of major bankruptcies in the 1980s and early 1990s: LTV, Eastern Airlines, Texaco, Continental Airlines, Federated Department Stores, and Greyhound.
According to Shell, bankruptcy reorganization – Chapter 11 – basically allows creditors to take over control of the firm for a set period. The downside of bankruptcy for shareholders is that they go to the back of the line behind all creditors. Corporate scandals in the past few years have led to some of the largest bankruptcies ever, most notably Enron, Global Crossing and the largest U.S. bankruptcy to date, WorldCom, which had assets of $103 billion when it went to court, according to BankruptcyData.com. In 2003 there were 35,037 business bankruptcy filings, including 8,474 Chapter 11 reorganizations, down from 38,540 filings and 10,286 reorganizations the year before, according to court statistics.
The theory underlying bankruptcy is that if a company is able to gain concessions from lenders and other creditors through reorganization, it can preserve its ‘going concern’ value and re-emerge as a viable business. This value is lost if the firm goes belly up or is sold off in parts. “Bankruptcy is the last resort of the enterprise when it can’t meet its obligations,” says Shell. “The alternative is liquidation and in liquidation the pie left for creditors is as small as it gets.”
Wharton finance professor Hulya Eraslan has done research that indicates there is a difference of about 5% in the value of a company between liquidation and preserving the firm as a going concern through the bankruptcy process. She, too, points out that her research reflects only the financial value of the firm and does not attempt to calculate a liquidation’s cost to society in lost jobs or pension benefits. “From a policy perspective that is also important,” she says. “If US Airways liquidates and 20,000 jobs are lost, that’s another concern that needs to be added.”
According to Wharton management professor Raphael Amit, a company filing for bankruptcy as a management strategy takes a big gamble because bankruptcy hands control of the firm to a group of creditors and, ultimately, to a judge. Beyond losing control of the firm, Amit warns that bankruptcy has other business consequences. “More important, your customers are losing faith in you,” he says. “What US Airways needs is to fill those seats that are flying empty all around the world. Any passenger or prospective passenger will be thinking twice about whether to fly an airline that may not be in business when you need it.” Moreover, in the airline industry, customers may be thinking about safety, he adds. “There is a concern over what are they going to cut. Maintenance?”
In the case of US Airways, says Amit, management does not appear to be bluffing. “They are burning cash at a high rate. Unless there is some restructuring in light of the fact that the airline industry is changing and we have a proliferation of new low-cost airlines, the full-fare, full-service airlines need to come to terms with reality. Nobody likes bankruptcy.”
Eraslan says the bankruptcy procedure has been criticized because it takes a long time, ties up the courts and drains firm resources to pay lawyers and other costs. Critics also contend a bankruptcy reorganization transfers wealth from one set of creditors (those with no fixed claims) to those creditors, like banks, that have secured debt. In addition, reorganization can also shore up the position of shareholders, who could be left with nothing if the firm is liquidated in a Chapter 7 bankruptcy filing.
Each group, as well as shareholders, may have incentives to misstate the condition of the firm. “The problem is judges can’t really know that much about the company,” Eraslan says. “Take US Airways. What does a judge know about running an airline company? If you leave it to the creditors, they will have their own incentives to present the situation one way or the other. How can we make sure the right decision is made?”
Filing in Good Faith
Harvey Miller, bankruptcy consultant and a managing director of New York-based Greenhill & Co. investment bank, says companies seem to be using bankruptcy less as a tactical strategy than they did in the 1980s and 1990s. Back then it was often used by real estate companies to walk away from bad assets, or by retailers to abandon weak locations at the expense of their landlords.
In recent years, he says, bankruptcy judges have been more aggressive in making sure companies file in good faith. Rewriting labor contracts is a legitimate issue that is guaranteed by the law. “The bankruptcy code allows you to reject the labor contract,” he says, “although it has to be the result of good faith bargaining.”
In the case of the airlines, he, too, says the bankruptcies appear to be more than a strategic ploy. “It’s a fast-moving economy and unfortunately nobody has the power to project with reasonable accuracy some of the things that may precipitate a failure in and out of bankruptcy. Nobody projected $45 a barrel for oil or the tremendous growth in low-cost carriers.”
Martin Bienenstock, co-head of the business finance and restructuring department at the New York law firm Weil Gotshal & Manges, points to a wrinkle in bankruptcy procedure that has become controversial: the Key Employee Retention Plan (KERP). If approved during a Chapter 11 case, these plans allow companies to pay extra compensation to certain employees during the reorganization. Sometimes, the extras are tied to results, sometimes not. The theory behind a KERP is that when a company’s future is uncertain, employees may jump ship, further weakening the firm’s chances of survival. KERPs give those employees incentives to stay through the bankruptcy proceedings.
“What’s happened is companies whose survival is not in doubt have employees who say they should have a KERP because they heard of other Chapter 11 cases where KERPS were granted. Sometimes in Chapter 11 cases people ask for a KERP when it is really not necessary to retain employees,” says Bienenstock. It can “have the effect of increasing salaries when it would otherwise be unnecessary.”
Bienenstock agrees there are dangers to filing a bankruptcy petition as a strategic device. “These days any company in Chapter 11 is in play,” he says. He also points out that if a trustee or examiner is appointed to oversee the case, everything managers have said to the company’s lawyers is no longer privileged. “Chapter 11 presents a lot of potential exposure, pitfalls, uncertainty and expense. I typically counsel companies that Chapter 11 is a last resort.”
Still, he predicts the courts will continue to see bankruptcy cases as companies try to work out long-term employee agreements and he can imagine, for example, major automakers using the courts, or the threat of bankruptcy, to rewrite retiree pension or healthcare incentives. He also points to a looming financial issue that may bring many companies to bankruptcy court. “The increase in high-yield debt over the past five years has been enormous. It’s hard to predict who, but with the volume of high-yield debt outstanding, you’re going to have defaults.”
In addition, rising interest rates could hurt these companies when investment funds can obtain satisfactory returns without investing in high yield debt, he suggests. “Companies relying on high-yield debt are going to have significant issues as to whether they can stay afloat when the high-yield market suffers diminished liquidity and existing debt can’t be easily rolled over.”