Chapter 11, in which bankrupt companies are allowed to reorganize and continue doing business under the protection of the bankruptcy court, generally serves little productive purpose, harms the interests of secured creditors, and should be abolished or greatly modified.
Proponents of Chapter 11 argue that it embodies both good business and social policy. The facts, to the extent they are known, present a different picture.
While the ability to reorganize a failed enterprise may do some localized good, the practice is harmful in the aggregate as it interferes with the efficient distribution of capital in the marketplace. As has been amply demonstrated by the collapse of Eastern Europe, state interference in the economy often has significant unintended consequences, most of which are bad.
Why does Chapter 11 persist? Take a look at who wins and loses in the Chapter 11 process.
The chief defenders of Chapter 11 are lawyers and judges. This should come as no surprise. Bankruptcy practices at most major commercial law firms (including mine) tend to be made up primarily of Chapter 11 work, which can be quite lucrative.
Judges almost certainly prefer presiding over high-profile Chapter 11 proceedings to glumly overseeing a trial on whether some poor debtor has defrauded a bank when he submitted a credit card application. Employees and suppliers of the bankrupt company are also thought to benefit from reorganization and are a powerful political constituency.
The losers in Chapter 11 cases almost always include secured creditors and banks, who are frequently forced to take a writedown on their investments. The systemic effects are even more pernicious because bankruptcy law may cause lenders to increase their rates to all borrowers simply to compensate for its costs.
By adding to the cost of credit, Chapter 11 discourages business activity at the margin, dampening overall economic growth and perhaps contributing to higher levels of unemployment.
In a free-market economy, any analysis of Chapter 11 should be entirely utilitarian: Do the benefits outweigh the costs?
While no truly comprehensive study of the matter exists, such evidence as is available argues strongly against the efficacy of Chapter 11.
For example, nationwide, only 10% to 15% of all Chapter 11 cases result in a confirmed reorganization plan, and according to one study, about 40% of confirmed plans are not fully carried out.
This means that most companies filing for protection under Chapter 11 end up in liquidation anyway but only after a potentially lengthy and expensive trip through bankruptcy court.
In the interim, creditors are forced to hire their own attorneys to defend their interests, and assets that might have been liquidated and redeployed more efficiently have languished and perhaps eroded in value.
To be fair, the difficulty of arguing for or against Chapter 11 is increased by the fact that so little is known about it. As a result, a few high-profile cases, which may have had favorable outcomes, attract most of the attention and define much of what people think they know about bankruptcy.
As it happens, however, the overwhelming majority of Chapter 11 filings involve small, nonpublic entities.
Few statistics document the success or failure of these cases. In fact, there is no recognized definition of success.
In general, the economy and the interests of secured creditors would be better served by the more widespread use of Chapter 7 of the bankruptcy code. Under Chapter 7, insolvent companies go immediately into liquidation under the supervision of a court-appointed trustee.
Creditors are able to take possession of their collateral and redeploy their assets much more quickly-often in a matter of months rather than the several years it can take for the courts to rule in Chapter 11.
That those immediately affected by a liquidation would suffer is undeniable and unfortunate. However, to argue that Chapter 11 should be an instrument of social policy-in effect a vehicle for maintaining employment- is to burden the law with a load of freight it was never meant to carry.
Social policy, including the protection of displaced workers, should be addressed directly by the government, not by levying a "stealth" tax on the secured and unsecured creditors of Chapter 11 debtors.
While liquidation is to be preferred in the vast majority of cases, a few exceptions to this rule make reorganization the most sensible course. For example, prepackaged Chapter 11 plans-in which a majority of creditors agree to a restructuring and then use Chapter 11 to carry out their agreement and bind any dissenting minority-provide a workable mechanism for the quick disposition of assets. Mass tort cases are another possible exception.
But the criticisms of Chapter 11-delay, expense, and debtor control-are not met by this narrow category of cases in which creditors wish to reorganize the debtor quickly. For in these instances the process carries out the wishes of a majority of creditors, who are of course the true owners of nearly all Chapter 11 debtors.
In general, Chapter 11 remains an inefficient mechanism for protecting and reallocating assets. Its costs, measured by the distortion introduced into the marketplace and the burdens inflicted on creditors, label it an expensive failure and suggest that drastic reform is needed.