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Unknowingly Cut From the Same Cloth: The Strategic Overlap of Chapter 11 Bankruptcy and Private Equity To Re-energize Hidden Value of Companies

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If you were to ask the average MBA or Law student fresh from graduation to name the overlapping, free market benefits of Chapter 11 bankruptcy and private equity, you would likely receive a blank stare.  However, private equity investments and Chapter 11 bankruptcy transactions share the same foundational tenet of redeploying economic resources to their most efficient and rewarding use.

Although, the Chapter 11 process is not without legitimate concerns from critics–myself included–there are those who unnecessarily root for the abolishment of the United States bankruptcy system. Similar to those who incorrectly condone the private equity system as “vulturistic” and counter-intuitive to capitalism (as former Republican presidential candidate and Governor of Texas Rick Perry claimed on the campaign trail), those who look at the United States bankruptcy system as also undercutting capitalism fail to fully appreciate the value that the Chapter 11 process can unlock. Only the Chapter 11 process permits a fiscal amnesty for assets and business operations hopelessly trapped in a corporate entity.

Private equity firms, along with public investment banks, play a significant role in ensuring that our capitalist system continues to redirect economic resources to their most productive use. By example, the concept of strategic bankruptcy has been criticized among others by the Cato Institute, an organization I highly respect and usually intellectually champion.

The improper use of Chapter 11 bankruptcies to consummate transactions that would not take place without the existence of a federal Bankruptcy code should not render the existence of Chapter 11 improper. On the contrary, the sanctity of contracts and private property is inherently valuable in a free-market economy, both in common law and statutory law. In the simplest sense, the Chapter 11 process is a means of maximizing economic value within the economy.

In my opinion, the Chapter 11 Bankruptcy process does not by its mere existence reward or even incentive “gross financial mismanagement” (although grossly mismanaged companies often end up in chapter 11 bankruptcy – which is provides the exact type of transparency and judicial oversight that such a financial situation needs).  Rather, the Chapter 11 Bankruptcy creates a more stabilized forum and thus the opportunity for the utilization of capital infusions and forward-looking strategic risk taking that might not otherwise occur that as an end results keeps a company viable.

According to critics at Cato Institute, the benefits of strategic bankruptcy are outlined as “[benefiting] the creditors by keeping the assets of the insolvent corporation together as a going concern” and avoid quarrel among the creditors. However, the critics at the Cato Institute further argue that “Although the bankruptcy code requires management to gain court approval for extraordinary transactions, most bankruptcy reorganization provisions increase management’s ability to behave strategically to the detriment of creditors.”

My experience has led me to disagree.  Chapter 11 bankruptcies, permitting a reorganization of corporate debt, place the rights of creditors in a place where collecting on those debts is possible.  During the reorganization period, the court will adjust or even cancel certain debts – but all with any eye towards ensuring that “impaired” creditors (i.e. those whose rights are being altered by the reorganization plan) receive more than they would receive in a liquidation of the company. See 11 U.S.C 1129(a)(7).  This legal quid pro quo is necessary in order to ensure that the company has the capacity to revive.

While corporation bankruptcy may weaken a company temporarily, if done for the right business reasons, strengthens the company for future business endeavors, including that of making creditors whole or as close to whole as possible.  Often people think of Chapter 11 as a bankruptcy filing for larger companies, but many smaller companies successfully use Chapter 11 bankruptcy as a means to an end of strengthening the company while removing debt. Were it not for the reorganization process, creditors would likely, in my experience, more often than not lose more under the current Chapter 7 bankruptcy liquidation process.  Instead of focusing on reviving a business, they would be left with a business corpse.  This is not to say that some businesses, small and large, should not die or that some businesses should not be in Chapter 7 instead of Chapter 11 – but that is a different question and debate.  But, the benefit of the existence of a Chapter 11 system extends from small private businesses to large public corporations.  The exact same can be said for private equity.

As my law partner, Chris Manderson outlined recently, describing the recent strategic bankruptcies done by Sun Capital involving Fluid Routing System and Friendly’s ice cream parlor chain: “For many sponsors, contributing more capital to an underwater investment seems like throwing good money after bad. But a savvy sponsor may be able to recapitalize a distressed portfolio company using the bankruptcy process — wiping out debt and unfavorable contracts and leases — all for a modest additional investment.”

Neither the bankruptcy process nor the private equity system are simple or free from danger for all parties involved.  However, the strategic business options available through chapter 11 bankruptcy to reorganize debt, postpone and not discharge debt are a good thing, just as the deployment of capital infusions by private equity firms can assist in shepherding an ailing company through a down-cycle (even if it means the loss of some jobs, as the loss of some jobs is better than the loss of all jobs at a company . . . think chapter 7 bankruptcy for instance).  Thus, both Chapter 11 bankruptcy and private equity can be used effectively and in many cases in concert with one another to bring a company back to health.  If properly managed, the process can even make creditors whole as well.

A topic for further discussion, but of importance to note here, the use of well-versed advisors in shepherding corporate management teams through the process is a critical component that can result be the difference maker between a failure and a win-win for all parties involved – something the critics of the chapter 11 process and private equity should be focusing on more, instead of attacking the system as a whole.


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