Commentary: Bankruptcy Reform Won't Fix Telecom

Here we go again. The economy is stagnating, prices are falling, capacity is languishing--and executives are starting to grumble about the bankruptcy system. Their complaint: Rather than kill weak companies, the law allows too many poorly managed outfits to return to life with sharply reduced costs. The latest example: telecommunications, where dozens of bankrupt companies are trying to remain alive, even though there is at least 50 times too much long-distance capacity. These unfairly advantaged competitors, the story goes, drive prices to unrealistically low levels, prevent the reduction in capacity needed to restore the industry's economic health--and frequently wind up going out of business anyway.

Sounds like a reasonable argument, doesn't it? Already, managers in some troubled industries are calling for a reform of bankruptcy laws. But the notion that there's something fundamentally wrong with the bankruptcy code is one most independent economists and legal experts dismiss. While the American system does allow too many corporate losers to limp along for way too long--and that, in turn, results in weak pricing--there's little evidence this hurts the economy.

Instead, more competition means consumers spend less, while corporate rivals shed costs. As a result, there's virtually no momentum for legislation that would rewrite the laws of corporate bankruptcy. Companies "cloak their critique of the bankruptcy law in this broad social welfare argument," says Harvard University economics professor Oliver Hart. "But it just isn't believable."

But don't expect the debate to die out. The statistics on bankruptcy are sobering. According to Lynn M. LoPucki, a bankruptcy professor at the University of California at Los Angeles law school, about one-quarter of all companies that reorganize under Chapter 11 go into liquidation, merge in distress, or refile for bankruptcy within five years. The Chapter 11 rules "will actually lengthen the time period for [the telecom] industry to recover," says Evercore Partners Vice-Chairman Michael J. Price, a veteran telecom investor. On Oct. 1, he told the Senate Commerce Committee: "Management teams that have overextended themselves get to wipe out their debt in Chapter 11 and start with a cost-advantaged capital structure. This means that capacity does not go away."

Indeed, nowhere will the debate reverberate more in the coming months and years than in the troubled telecom sector. Several bankrupt companies are likely to reemerge from Chapter 11 even though they are unlikely to thrive. Global Crossing Ltd., for one, will come out of bankruptcy with much less debt, but critics say it is overly dependent on the long-distance and international phone markets, which already suffer major overcapacity. Besides, the brand is in tatters because of allegations of accounting shenanigans dogging company founder Gary Winnick.

As for WorldCom Inc., the apparent strength, so proudly trumpeted by ex-CEO Bernard J. Ebbers, has been shown to be illusory. But it has enormous capacity under its wing, and many creditors would like to see all of its debt wiped out so that it, too, can get a fresh start. The danger is clear: that these and other kamikaze companies could depress prices for so long the entire sector's health will be imperiled. Critics say this will retard innovation and lead to unnecessary job losses. "It's as if companies are coming back to life as zombies," says telecom analyst Susan Kalla of investment company Friedman, Billings, Ramsey & Co. "We need the zombies to die."

Such arguments are old hat for air carriers, which debated the issue extensively when Eastern, Continental, and America West were attempting to reorganize in the early 1990s. In a 1993 speech, Robert Crandall, then American Airlines Inc. (AMR ) CEO, attacked "the truly bizarre U.S. bankruptcy system, which permits failed carriers to operate indefinitely under protection of the courts--and has transformed excess capacity from a problem to a disaster."

Problem is, his scare stories didn't come true. All the apparent overcapacity in the early 1990s was put to good use in the booming economy that came later. And in one of the few academic studies ever to consider whether companies in Chapter 11 harm their rivals, University of California at Berkeley economist Severin Borenstein debunked many of Crandall's arguments. His 1995 analysis "found no evidence that carriers competing with bankrupt airlines cut their prices."

That may not hold true in telecoms, where prices have already been slashed. Still, it isn't clear how Chapter 11 should be fixed. A main premise of the law is that the best arbiters of a company's viability are its creditors. If they're willing to put more money into a business, then it makes little sense for a judge to stop them. The only alternative is to encourage the men and women in robes to block more reorganizations--a "reform" that would require jurists to make judgments about market structure and, in essence, turn them into regulators. "We have a free-market process," says Harvard Law School professor Elizabeth Warren. It is founded on the idea that "the self-interest of creditors will get the economy to the right place."

Of course, things don't always work out that way. Creditor committees and managers of bankrupt companies often are too optimistic. Their bad decisions harm rivals and may even slow down the economic rationalization of some industries. But the alternative--encouraging judges to block more Chapter 11 reorganizations---would clearly be worse.

By Mike France

With Wendy Zellner in Dallas and Steve Rosenbush in New York

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