Last year, 22,634 American businesses filed for reorganization under Chapter 11, an economic safety net established by the revised 1978 Bankruptcy Code.
While prior bankruptcy law permitted reorganizations, Chapter 11 greatly broadened the ranks of eligible companies by granting access to those not yet insolvent and permitting existing management to stay on and have the first shot at proposing a reorganization plan.
The underlying logic of Chapter 11 is that, where feasible, business reorganization is preferable to liquidation as a means of saving jobs and maintaining the value of capital assets, to the overall benefit of the U.S. economy.
Alarmingly, despite the economy's lackluster condition, and without considered deliberation, one just-enacted and two pending legislative proposals would effectively repeal Chapter 11 availability for thousands of American businesses.
Forced into Chapter 7
The threat is real that many companies otherwise able to successfully reorganize in chapter 11 will be forced into unwarranted Chapter 7 liquidation. Unless Congress reverses course, the economy will be the big loser.
The first threat to Chapter 11 is posed by an esoteric tax provision enacted in July as part of the budget package. It repealed the "stock-for-debt exception" enacted as part of the Bankruptcy Tax Act of 1980, which conformed the tax laws to the then new Bankruptcy Code.
This action was taken without any hearings on its prospective economic consequences. Repeal was included in the tax package not for sound policy reasons, or even for necessary deficit reduction, but simply to counterbalance changes in the bill - such as dropping the proposed BTU tax - which diminished expected revenues.
Lost Tax Revenues
The Senate Finance Committee claimed this will raise $622 million over five years, a highly suspect guess more than double its own 1992 estimate.
In reality, the repeal will surely be a revenue loser, as taxable exchanges facilitating Chapter 11 reorganizations will simply not occur, and the businesses consequently forced into liquidation will cease to generate both corporate and employee income taxes.
The stock-for-debt exception allows troubled companies to convert their debt burden into an equity cushion without losing other favorable tax treatments. As a result, they have increased cash flow with which to meet operating expenses and repay remaining obligations.
Tax bill conferees - made aware of the detrimental effect that repeal would have on Chapter 11 by a unified lobbying coalition of business, labor, and lenders - provided a short-term "transition rule."
The repeal, rather than taking immediate effect, will instead commence on Jan. 1, 1995; companies filing for Chapter 11 prior to Jan. 1, 1994, will however have an unlimited period in which to transfer stock-for-debt.
Rise in Filings Expected
In practical terms, this will encourage an upsurge in Chapter 11 filings late this year; companies filing after spring 1994 will generally not be able to utilize such exchanges, given the time required to develop a reorganization plan.
While the transition rule buys time for companies currently on the brink of bankruptcy, and for congressional reconsideration, it leaves in grave doubt the future availability of Chapter 11 for many firms.
Ironically, government agencies with significant claims in bankruptcy, such as the Pension Benefit Guarantee. Corp. and Environmental Protection Agency, are among the largest recipients of new stock in Chapter 11 reorganizations, and will therefore suffer a major blow from increased business liquidations.
Financial institutions will also be hit hard, and this will inhibit general credit availability and sustained economic growth.
Senate Measures
The other two Chapter 11 killers are contained in a pending Senate bankruptcy reform bill, which also contains many salutary provisions and which would establish a National Bankruptcy Reform Commission to recommend broader changes.
The first misguided provision attempts to partially shield the Pension Benefit Guarantee Corp. from the tens of billions of dollars of unfunded pension obligations that it, and U.S. taxpayers, may ultimately be asked to make good on.
It would require a debtor company attempting reorganization to make set funding contributions to employee pension benefit plans. Contrary to its aim it would substantially destroy the company's prospects for successful reorganization and thereby increase the likelihood of obligations being dumped on the PBGC.
This proposal is opposed by lenders and organized labor, which fears that the PBGC's dollars will come out of the pockets of current and retired workers.
Retiree Benefits
The second well-intentioned but ultimately detrimental proposal would require the debtor company to use any cash on hand, or any new credit, to make payments for retiree health and insurance benefits.
A 1988 provision of the Bankruptcy Code enacted by a sympathetic Congress promised retirees greater procedural protection of such benefits. But, while Congress made the promise, someone else must write the check to fulfill it.
The unfortunate reality is that Chapter 11 is a trail of broken promises, starting with the debtor's pledge to fully repay its lenders.
When a company enters into Chapter 11 reorganization, the first few days are critically important. Creditors must be swayed to either release their security interests and/or provide a new line of credit if the company is to pay its workers, assure suppliers of continuing payments, and satisfy other financial obligations.
Priorities Out of Order
Yet no prudent lender will agree to provide such funds if their lawfully mandated first use is for a purpose, such as funding pensions or retiree benefits, which does not address these operating priorities and thereby generate essential income to keep the company operating. Further, by front-loading reorganization with these explosive issues, the chances of fatal labor-management disputes greatly increase.
Bankruptcy law is not a logical or effective means for addressing looming PBGC obligations. And it is the least appropriate place to address retiree problems, as existing federal pension and tax laws, plus financial accounting
standards, all discourage adequate funding of retiree benefits.
As supplementary health insurance constitutes the majority of these benefits, the best context for congressional action would be in the upcoming debate on national health care.
Weak Firms in Jeopardy
These Bankruptcy Code changes will not only prevent most American businesses from having access to Chapter 11 financing, but will also have a detrimental impact on the cost and availability of credit to companies not yet in reorganization but experiencing financial difficulty and burdened by substantial pension and benefit obligations.
As an example of the very large exposures that lenders must be wary of, the estimated unfunded pension liability of General Motors Corp. is $20 billion, and its postretirement health care liabilities stand at $43 billion.
These three changes constitute a muddled and conflict-ridden shift in bankruptcy policy. repeal of the stock-for-debt exception will not raise new revenues, but does place the Tax Code and Bankruptcy Code in direct conflict and will increase governmental losses through the PBGC and EPA.
And attempting to give higher priorities to both the PBGC and to retiree health benefits will place those interests in conflict in the zero-sum game of bankruptcy reorganization.
A successful Chapter 11 process is a triumph of delicate negotiation. By statutorily attempting to predetermine outcomes, Congress will greatly undermine the overall chances of reorganization success.
Whatever its current shortcomings. Chapter 1 at least has the virtue of establishing the same ground rules for all troubled companies.
Can anyone doubt that if all these disastrous proposals become law and Chapter 11 moves out of reach for most businesses, large troubled companies with political clout will push for targeted bailouts such as those extended in the 1970s to Penn Central, Lockheed, and Chrysler?
Those rescues occurred before Chapter 11 unleashed the private sector's ability to assist American business to successfully reorganize.
Chapter 11 has been subject to some justified criticism. To the extent that complaints about Chapter 11 rules, procedures, and policy bear up under scrutiny, they can be addressed.
Unemployment Toll
Reasonable Chapter 11 reforms will not jeopardize the broad availability of reorganization to thousands of business worth more as going concerns than in a liquidation sale, or unnecessarily throw tens of thousands of workers onto the unemployment rolls.
Despite its campaign pledge to focus on the economy like a laser beam, the Administration has not yet been heard from regarding these pending threats to credit flows and jobs.
One can only hope it will speak up before it is too late. And that Congress will refrain from killing Chapter 11 in advance of considering its reform.
