Commentary: Why Chapter 11 Needs Rewriting

Every company deserves a second chance when it's down on its luck. That, at least, is the theory of Chapter 11 bankruptcy protection: Give companies a respite from creditors so that they can emerge from bankruptcy healthier.

These days, however, many end up sicker than when they went in. Consider Grand Union Co. Last fall, the grocery chain headed to bankruptcy court for the third time in five years. It recently sold all its assets. Likewise, ailing Trans World Airlines Inc. is finally up for sale. On Jan. 10, it announced its third bankruptcy, having already filed for Chapter 11 in June, 1995, and three and a half years before that.

Round-tripping is an ongoing trend in the bankruptcy world, according to BankruptcyData.com. Since 1997, the number of public companies filing each year has more than doubled, to 176 in 2000. Of those, 38 were filing a second or third time. And experts expect the number to grow.

WELFARE PROGRAM. Has bankruptcy court become a kind of corporate welfare program? With first-time corporate bankruptcies on the rise, it's only natural that second-timers--"Chapter 22s and 33s," as they're familiarly known among bankruptcy specialists--will rise, too. "The reason Chapter 22s and 33s are going to increase is that the initial bankruptcies weren't done properly," says F. John Stark III, a principal with Water Tower Capital in Chicago, a financial advisory firm specializing in restructuring.

The trouble is that companies often leave bankruptcy court with too much debt, lousy business plans, or weak management. For example, retailer Bradlees Inc., which filed its second bankruptcy petition in December, was reeling from problems stemming from too much debt that wasn't erased in its first bankruptcy. "It was more highly leveraged than most of its competitors, with the exception of Caldor, which later liquidated as well," says Neil Moses, Bradlees' former chief financial officer.

By the time TWA filed for its third bankruptcy, it had lost money for 12 straight years. "It was never sufficiently capitalized," says TWA attorney James H.M. Sprayregen, a partner at Kirkland & Ellis in Chicago. Why? One reason was that many bondholders refused to exchange their debt into equity in TWA's first and second bankruptcies, leaving the airline with a crippling debt load equaling 553% of shareholder equity. Bondholders feared if they accepted equity in lieu of their bonds, their holdings would be wiped out if TWA went bankrupt again. Which, of course, it did. "It's a chicken-and-egg case. If you come out of bankruptcy with a bad capital structure, it definitely exacerbates the problem," says Henry S. Miller, global head of restructuring at Dresdner Kleinwort Wasserstein. "But in the case of TWA, bondholders were very justified in not having faith in the equity."

So what's to be done? For starters, more scrutiny is needed to determine whether plans whipped up in bankruptcy court are really feasible. By and large, the judge, who is not a financial professional, is ill-equipped to make that decision. "In many cases the plan has been imposed by distressed debt traders who control the creditors' committee. The judge looks down and sees everyone in agreement, so he approves the plan," says Harvey R. Miller, who heads law firm Weil, Gotshal & Manges LLP's business restructuring department. But debt traders are often short-term-oriented. So why not assign an independent party to review the restructuring plan? "It should be someone who can oppose the plan without an ax to grind," says Miller.

Management, too, needs to have a bigger stake in the survival strategies it proffers. Perhaps CEOs' compensation, whether cash or equity, should be held in escrow until plans are successfully implemented. Alternatively, stiff penalties could be imposed on managers who get it wrong again. "At the very least, force management to resign," says Stark. Conditioned responses worked with Pavlov's dogs. Why not CEOs?

By Debra Sparks

Sparks covers corporate finance.

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