Corporate Reorganization as Labor Insurance in Bankruptcy

By Diana Bonfim (Banco de Portugal; Catholic University of Portugal – Catolica Lisbon School of Business and Economics) and Gil Nogueira (Bank of Portugal – Research Department)

Diana Bonfim
Gil Nogueira

How does corporate reorganization affect labor outcomes in bankruptcy? The existing literature argues that corporate reorganization affects the reallocation of labor because it retains workers in bankrupt firms. In some cases, bankrupt firms remain alive for too long and retain workers inefficiently. In other cases, reorganization reduces the probability of inefficient liquidation.

In this paper we show that resource retention is not the only determinant of labor outcomes in bankruptcy. The decision process in bankruptcy creates a principal-agent problem between firms’ claimholders and other stakeholders (e.g., workers, suppliers). Claimholders decide bankruptcy outcomes but other stakeholders with limited say in the bankruptcy process are also affected by these outcomes. 

Workers are among these stakeholders. They use job contracts with firms as a form of insurance in times of adversity. In the absence of corporate reorganization, workers lose these job contracts and experience persistent costs of job loss. Reorganization improves labor outcomes because it reduces the probability that workers lose the insurance provided by job contracts when the costs of job loss are high.

We test this hypothesis empirically using data from Portuguese reorganization cases. The institutional setting has several features that help design an adequate empirical strategy. First, reorganization cases are randomly allocated across judges. We use this random assignment as a source of variation in the probability of reorganization that is not affected by other factors that also influence workers’ careers. Second, Portuguese firms report financial statements annually, which we use to check whether reorganization affects labor reallocation to more productive or profitable firms. Finally, we link this data to a rich administrative employer-employee matched dataset, which allows us to track workers who eventually change jobs. This dataset is unique because it contains rich job descriptors. We use this data to establish a relationship between corporate reorganization and the scarring effect of bankruptcy on workers’ job functions.

We uncover three main findings. First, we measure the effect of corporate reorganization on the sorting of workers to productive and profitable firms. In five years, only about 20% of the workforce remains in reorganized firms. Many workers from reorganized firms find jobs with new employers. We find no evidence that reorganization affects the reallocation of labor to efficient or profitable firms.

Second, reorganization is an important source of labor insurance against negative productions shocks. In the short term, reorganization increases the probability that workers are employed. In the long term, reorganization increases wages and reduces the scarring effect of job downgrading that is often observed in recessions. Reorganization reduces the probability that workers move to less skill-intensive occupations and increases occupation wage premia. 

Third, we show that reorganization improves job transitions to new employers. Reorganization increases the average time it takes to leave a firm that files for bankruptcy by one year. Reorganization reduces the probability that workers move to low-paying jobs and increases the probability that workers find high-paying jobs with new employers.

Overall, our results show that corporate reorganization is an important source of labor insurance in bankruptcy, thereby mitigating the scarring effect of job loss. The full article is available here.

Hidden Wealth Transfers in Bankruptcy Asset Sales: A Real Option Analysis

By Jordan Neyland (Assistant Professor of Law, Antonin Scalia Law School at George Mason University) and Kathryn St. John (Legal Associate, Supreme Court of Victoria)

Jordan Neyland
Kathryn St. John

One of the most important decisions that firms and courts face in bankruptcy is how to dispose of company assets. The differences between the available options are not trivial. A popular mechanism is contained in §363 of the bankruptcy code, which enables the sale of a firm’s assets with court approval. This allows for a quick sale of a firm without the need for developing and approving a plan of reorganization under Chapter 11, which can save both time and money, as the firm’s assets may otherwise sit idle or depreciate. 

Despite the benefits of a quicker resolution, 363 sales are contentious because certain classes of claimants, particularly shareholders and unsecured creditors, may lose a valuable opportunity to “wait and see” if the value of the assets will increase. Given that unsecured creditors and shareholders are last in line to get paid, they may gain if the asset value increases, whereas secured creditors prefer a quick sale to cash out before any value is potentially lost. But how much shareholder and unsecured creditor wealth is lost as the lottery-like opportunity, or “option” to wait, disappears? Without an active market for these rights, this value is unseen, yet very real.

In a recent article, we investigate the value of this option and how it affects the wealth of the parties to the bankruptcy. We use well-established financial models (i.e., Black-Scholes-Merton) to put a dollar value on how much shareholders lose with the approval of a 363 sale. We take numerical values from the seminal case In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), which provides an ideal case study because most of the firm value was from equity holdings in a publicly traded company. 

The results are dramatic. Under certain conditions, shareholders stand to lose value worth more than one quarter of total firm assets from a 363 sale. That is, by forgoing the “wait and see” option, shareholder value decreases from around one quarter of the firm’s assets to close to zero. In the Lionel case, where the value of the firm’s assets was about $170 million, this decline in value equates to wiping out nearly $45 million in shareholder wealth. Higher priority claimants capture that value.

Even under more conservative estimates, we show that shareholder and lower-priority creditor wealth is dramatically affected by the loss of the “wait and see” option. Large amounts of wealth may be transferred from shareholders to creditors by bringing forward assets sales by just a few months.

We identify factors that are likely to influence the magnitude of the “hidden” shareholder and lower-priority creditor wealth loss. These include the volatility and value of the asset to be sold, in addition to the difference between the time required to arrange an asset sale and the time it may take to finalize a plan of reorganization. We note that the current common law rules governing 363 sales do not require consideration of this set of factors, which are potentially more value-relevant than factors, such as asset depreciation, that courts currently use to determine whether a business justification for a sale exists.

We suggest that courts consider the factors identified in our analysis and the “hidden” wealth effects when deciding whether to approve a 363 sale. This consideration should improve courts’ understanding of parties’ stakes and incentives, leading to better informed decision-making.

The full article is available here.

Fiduciary Duties in Bankruptcy and Insolvency

By John A. E. Pottow (University of Michigan Law School).

Although discussed nowhere in the U.S. Bankruptcy Code, fiduciary duties play a central role in guiding the administration of an insolvent debtor’s assets. Regulatory oversight of trustees is only loosely circumscribed by statute, but significant lacunae exist regarding specification of the duties of loyalty.  In assessing what fiduciary obligations are owed to secured creditors, unsecured creditors, and debtors, some courts build upon the general principle that the trustee’s fiduciary duty of loyalty flows to all creditors. Other courts, though, work from the premise that secured creditors are better situated to look after themselves and that a trustee’s primary obligation is to unsecured creditors, perhaps especially non-priority general creditors. The Supreme Court has also weighed in, stating that a DIP’s fiduciary duties run directly (if somewhat delphically) to “the corporation.” How then does a trustee choose between beneficiaries of the estate, and what remedies are there for losing parties disappointed with this allegiance decision?  This book chapter explores the fiduciary obligations of trustees (including DIPs) under both statute and common law. There is a special focus on the intrinsic conflicts that arise within the “menagerie of heterogeneous creditors” that constitute the claimants of a bankruptcy estate.  A single normative theory seems unlikely to explain the results (so much for the “residual fiduciary beneficiary”!).  What does seem clear is that trustees are “more fiduciary” for some constituencies than for others.  Fortunately, U.S. bankruptcy courts are accustomed to shifting allegiances and disalignments of interest. Thus, the bankruptcy system may be well-suited to handle the endemic conflicts of interest between corporate constituencies through various bankruptcy-specific mechanisms, such as the institution of the Creditors Committee and the norm of engaged judicial oversight.

The full article is available here.

Equitable Mootness Doctrine Persists in Bankruptcy Appeals

By Shana A. Elberg, Amy Van Gelder, and Jason M. Liberi (Skadden, Arps, Slate, Meagher & Flom LLP)

In recent years, some courts have become critical of the doctrine of equitable mootness, a judicially created abstention doctrine — unique to the corporate bankruptcy world — that allows appellate courts to dismiss appeals from a bankruptcy court’s confirmation order if the relief sought on appeal threatens to unwind a complex debtor reorganization previously approved by the bankruptcy court. The doctrine promotes finality of confirmation orders, encourages the global consensual resolutions often crucial to complex reorganizations, and protects third parties that have justifiably relied upon the bankruptcy court’s confirmation order or transactions effectuated pursuant to that order.

Despite significant concerns expressed by courts regarding the impact of the doctrine on parties’ fundamental appellate rights, equitable mootness persists in some form within every circuit that has jurisdiction over bankruptcy appeals. Thus, plan proponents and objectors alike must be aware of its implications on contested plan confirmation proceedings and prepared to act quickly to advance their interests following plan confirmation.

This article provides a brief overview of the doctrine of equitable mootness, its application by appellate courts, and key considerations for bankruptcy and non-bankruptcy practitioners faced with contested plan confirmations and subsequent appeals.

The article is available here.