The economics of prepackaged bankruptcy

A new kind of bankruptcy has emerged in the last few years. It can be thought of as a “hybrid” form—one that attempts to combine the advantages (and exclude the disadvantages) of the two customary methods of reorganizing troubled companies: workouts and bankruptcy.

In a workout, a debtor that has already violated its debt covenants (or is about to do so) negotiates a relaxation or restructuring of those covenants with its creditors. In many cases, the restructuring includes an exchange of old debt securities for a package of new claims that can include debt, equity, or cash. Informal reorganizations take place outside the court system, but typically involve corporate officers, lenders, lawyers, and investment bankers. And though such negotiations are often contentious and protracted, informal workouts are widely held to be less damaging, less expensive, and, perhaps, less stressful than reorganizations under Chapter 11.1

Recently, however, a number of firms that have had most or all of the ingredients in place for a successful workout outside the courtroom have filed for bankruptcy anyway. In such cases, the distressed firms file a plan of reorganization along with their filing for bankruptcy. And largely because most creditors have agreed to the terms of the reorganization plan prior to the Chapter 11 filing, the time (and presumably the money) actually spent in Chapter 11 has been significantly reduced.2

Kroy, Inc., an Arizona-based maker of low-tech office labeling equipment, is a good example. After undergoing a leveraged buyout in 1986, the company suffered a slump in sales and profit margins that left it unable to meet its debt obligations. The company's primary lenders were the Minneapolis First Bank and Quest Equities Corporation. Both were receptive to a pre-negotiated bankruptcy reorganization. With a pre-negotiated plan in place, the company filed its plan of reorganization along with its bankruptcy petition on May 15, 1990. The company emerged from bankruptcy proceedings 89 days later. Such an untraditional reorganization has been dubbed “prepackaged bankruptcy.”3

The appearance of this new mechanism for corporate reorganization gives rise to a number of questions: How are they structured? Are they motivated by real economic gains and, if so, what are the sources of such gain? What are the particular circumstances in which a prepackaged bankruptcy is more sensible than an informal reorganization outside the courts? What does the future hold for prepackaged bankruptcy reorganizations?

The first major corporation to undergo a prepackaged bankruptcy reorganization was Crystal Oil Company, an independent crude oil and natural gas exploration and production company headquartered in Louisiana. The company filed for bankruptcy on October 1, 1986 and emerged less than three months later, its capital structure completely reorganized. The total indebtedness of the firm was reduced from $277 million to $129 million. In exchange for giving up their debt claims, debtholders received a combination of common stock, convertible notes, convertible preferred stock, and warrants to purchase common stock. Little time was spent in Chapter 11 because most major creditors had already agreed to the plan of reorganization.

The original reorganization proposal had been presented to creditors three months before the Chapter 11 filing. It was accepted by all classes of public debtholders. Within each class, more than half of the debtholders, representing more than two thirds in value of the outstanding debt, accepted the proposal. The initial plan was not accepted, however, by Crystal Oil's most senior creditors: Bankers Trust and Halliburton Company. Both of these creditors’ claims were securitized by a lien on the company's oil and gas properties. Bankers Trust accepted a revised plan, but Halliburton never gave in.4 Eventually, the bankruptcy court “crammed down” the revised plan on Halliburton.

Since its reorganization, Crystal Oil has returned to profitability and it has been able to further reduce its debt burden and continue its operations on a smaller scale.

One potential problem that can arise when a firm initiates a prepackaged bankruptcy can be illustrated with the case of Southland Corporation. In 1987, Southland, the firm that operates the 7-Eleven convenience stores, underwent a leveraged buyout to thwart a hostile takeover attempt by Samuel Belzberg. By 1989, the company could not service its $4 billion of debt and sought to restructure these claims. After 9 months of unsuccessful negotiations with creditors, Southland management concluded that the company would have to reorganize through the bankruptcy process. A prepackaged bankruptcy was proposed to resolve the impasse and Southland sent solicitations to its debtholders in early October. The bankruptcy petition was filed on October 24. Southland claimed that a sufficient number of debtholders had accepted the plan for confirmation by the court. The voting procedure, however, was challenged by a number of debtholders who were not satisfied with the outcome. Three basic objections to the voting process were raised: (1) the debtholders did not have sufficient time to cast their votes; (2) brokers often voted for their customers; (3) votes were not counted properly. The judge ruled in favor of the dissidents and the voting process was invalidated.

The Southland case illustrates that a prepackaged bankruptcy always entails the risk that dissident creditors will challenge the legitimacy of the voting process. But such challenges are not necessarily a major obstacle to prepackaged bankruptcies. Southland later sweetened its offer, which was then accepted by the majority of the debtholders. The company ended up emerging from bankruptcy in March of 1991 after a stay of only four months.

Prepackaged bankruptcy can facilitate a successful, and relatively low-cost, reorganization by forcing holdouts to accept the plan of reorganization. It also provides a means of circumventing two relatively new obstacles that have substantially dampened out-of-court exchange offers: the LTV ruling and the change in the tax code penalizing debt forgiveness.

To make use of this new “hybrid” form of bankruptcy, however, a significant fraction of creditors must be able to reach agreement outside of the court. A prepackaged bankruptcy cannot be forced on a significant number of reluctant creditors. Nevertheless, given the possibility of a pre-negotiated bankruptcy reorganization, a greater fraction of creditors may be willing to agree to the plan precisely because holdouts can be forced to participate by filing Chapter 11.

This new development has in some sense been anticipated by financial economists. Reviving and expanding upon an argument presented by Robert Haugen and Lemma Senbet in the late 70s, Michael Jensen recently suggested that the bankruptcy process can be expected to undergo a “privatization.” According to this line of thought, because private reorganizations are likely to be much less expensive than formal bankruptcy, workouts can be expected to replace bankruptcies—that is, barring major tax and legal obstacles.

Although economists did not foresee the new obstacles to workouts, the rise of prepackaged bankruptcies can be viewed as evidence in support of this privatization argument. As we suggested earlier, firms that have succeeded in prepackaging their bankruptcies have most of the elements in place necessary to reorganize successfully outside of court. Indeed, several of the prepackaged bankruptcies, including those of Republic Health and JPS, were filed after first achieving considerable progress toward an out-of-court settlement. Based on these and a growing number of other “success stories,” it seems likely that prepackaged bankruptcies will significantly speed up the process of reorganization— but, again, provided that a reasonable degree of creditor consensus can be reached informally.