Facilitating Successful Failures

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Facilitating Successful Failures

Michelle M. HarnerUniversi ty of Maryland Francis King Carey School of

Law

Jamie Marincic Griff inMathematica Policy Research

No. 2013 - 14

This paper can be downloaded free of charge at:The Social Science Research Network Electronic Paper Collection

http://ssrn.com/abstract=2233348

http://ssrn.com/abstract=2233348http://ssrn.com/abstract=2233348http://ssrn.com/abstract=2233348


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Submission Draft

© 2013 by Michelle Harner and Jamie Marincic Griffin.

FACILITATING SUCCESSFUL FAILURES

Michelle M. Harner *and Jamie Marincic Griffin **

Forthcoming Florida Law Review (2014)

ABSTRACT

Approximately 80,000 businesses fail each year in the UnitedStates. This article presents an original empirical study of over400 business restructuring professionals focused on a critical,arguably contributing factor to these failures—the conduct of boardsof directors and management. Anecdotal evidence suggests thatmanagement of distressed companies often bury their heads in thesand until it is too late to remedy the companies’ problems, a

phenomenon commonly called “ostrich syndrome.” The data confirmthis behavior, show a prevalent use of loss framing, and suggest

trends consistent with prospect theory. The article draws on thesedata and behavioral economics to examine the genesis and contoursof this problem. It then discusses potential changes to applicable lawand introduces a new “meet and confer” process for encouragingtimely restructuring negotiations. The meet and confer process isdesigned to promote meaningful changes in management conduct andto facilitate more “successful failures.” Policymakers should adoptregulations fostering that mentality, rather than rewarding fear orignorance in the face of failure.

* Professor of Law, University of Maryland Francis King Carey School of Law.Professor Harner is the Reporter for the ABI Commission Studying the Reform ofChapter 11. The views set forth in this article are Professor Harner’s personal viewsand do not represent those of the Commission.

** Mathematica Policy Research; University of Nebraska at Lincoln, Ph.D.This project benefitted from the comments of, or discussions with, Daniel Bussel,Maria Chavez-Ruark, Lynne Dallas, Joan Heminway, Kristin Johnson, HonorableDuncan W. Keir, Donald Langevoort, Stephen Lubben, Christopher Mirick,Honorable Randall J. Newsome, Robert Rhee, and Lynn Stout. An earlier versionof this paper was presented at the 2012 Law and Society Annual Meeting. Theauthors also would like to thank the numerous practitioners who provided valuable

input on both the design and substance of the study. In addition, they appreciate theresearch assistance of Jennifer Ivey-Crickenberger and Adrienne Diverte.

Nevertheless, all opinions, errors, omissions and conclusions in this Article are theirown. Finally, the authors would like to thank the University of Maryland FrancisKing Carey School of Law for financial support in connection with this article.


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Submission Draft Forthcoming Florida Law Review (2014)

2© 2013 by Michelle Harner and Jamie Marincic Griffin.

I. I NTRODUCTION .............................................................................. 3 II. FINANCIAL DISTRESS AND MANAGEMENT DECISION -MAKING ...... 8

A. Restructuring Alternatives ................................................... 10 B. Heuristics and Bias in Decision-making ............................. 21

III.

ASSESSING MANAGEMENT DECISION -MAKING IN DISTRESS : THEMANAGEMENT BEHAVIOR STUDY ....................................................... 28 A. Methodology ........................................................................ 29 B. Study Design ........................................................................ 30 C. Key Study Data and Results ................................................ 30

1. General Types and Experiences of Respondents ............. 31 2. What Professionals Say .................................................... 32 3. What Clients Hear ............................................................ 35 4. Does the Dialogue Matter? .............................................. 38

IV. CHANGING THE FRAME TO FACILITATE BETTER R ESULTS ......... 41 A. The Need for Change ........................................................... 42

B.

Encouraging More Hybrid Restructurings .......................... 44

1. Overview of Meet and Confer ......................................... 45 2. The MC Notice and the Parties ........................................ 47 3. The Standstill ................................................................... 49 4. The MCP Exit Plan .......................................................... 50 5. The Potential Benefits ...................................................... 52 6. The Potential Challenges ................................................. 53

V. CONCLUSION …………………………………………………...53 APPENDIX A ........................................................................................ 55


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Failure is simply the opportunity to begin again,this time more intel ligently.

-Henry Ford 1

I. I NTRODUCTION

Almost every company experiences financial distress at one point or another in its life cycle. Start-up companies frequently incursignificant losses for the first several years of operation, and many ofthose companies never realize a profit. 2 For those that do, profits andgrowth are not always maintained over time. 3 Even the most maturecompanies face financial challenges. Why then do some companiesflourish despite (or perhaps because of) those challenges, while otherscollapse under the pressure?

There likely is no single explanation, but one predominantfactor is company management. Playing on the words of JamesCarville during the 1992 presidential race, “It’s the people, stupid.” 4 The timing and substance of management’s decisions in the face offinancial uncertainty are critical to the end result, regardless of whatcaused the distress in the first instance. Yet, relatively little is knownabout that decision-making process other than the loud criticism

1 Scott Allen, Henry Ford – Founder of Ford Motor Company and Assembly Line Innovator , ABOUT .COM : E NTREPRENEURS ,http://entrepreneurs.about.com/od/famousentrepreneurs/p/henryford.htm (lastvisited Dec. 28, 2012).2 See, e.g., U.S. Small Business Administration, Frequently Asked Questions:Advocacy Small Business Statistics and Research (“Frequently Asked Questions”),http://web.sba.gov/faqs/faqIndexAll.cfm?areaid=24 (last visited Dec. 28, 2012)(noting that while seven out of ten small businesses survive their first two years ofoperations, only five out of ten survive more than five years).3 For a general description of business failures in the United States, see D UN & BRADSTREET , D&B U.S. BUSINESS TRENDS R EPORT , Jan. 2011, available at http://www.dnbgov.com/pdf/US_Business_Trends_Jan11.pdf; D UN & BRADSTREET ,D&B U.S. BUSINESS TRENDS QUARTERLY R EPORT , Sept. 2011, available at http://www.dnbgov.com/pdf/US_Business_Trends_Quarterly_Report_Executive_Summary_v3.pdf (last visited Dec. 28, 2012) (explaining status of U.S. business

failures currently estimated at approximately 80,000 per year, and providinghistorical data reflecting similar levels of failure).4 See, e.g., Bill Schneider, Analysis: Could It Be ‘The Economy, Stupid’ Again?, CNN, Nov. 8, 2007,http://www.cnn.com/2007/POLITICS/11/07/schneider.economy.poll/index.html.


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voiced upon failure and the frequently empty praise sung uponsuccess.

This article presents an in-depth analysis of the role ofmanagement and boards of directors in resolving companies’ financial

distress. It uses the results of an original empirical survey ofrestructuring professionals along with behavioral economics toevaluate management decisions and the role of federal bankruptcy lawin those decisions. Although every financial restructuring is unique inone or more respects, the data show common themes that underliemany cases and can guide policy reform in the insolvency context.

No one likes to admit failure. 5 This adage is true for most people, including boards of directors, Chief Executive Officers, andother top executives in corporate America. Understanding this adagecan help us start to understand management’s choices when faced

with financial distress. Indeed, it underlies the “ostrich syndrome”frequently bemoaned by the corporate restructuring community. 6 Ostrich syndrome refers to management’s tendency to stick itscollective head in the sand and ignore the warning signs of financialdistress until it is too late to resolve that distress in an effectivemanner.

Admittedly, the timing for initiating effective restructuringnegotiations is more art than science. It is a sensitive matter subject

5 See, e.g. , Mark V. Pezzo & Stephanie P. Pezzo, Making Sense of Failure: A Motivated Model of Hindsight Bias , 25 S OCIAL COGNITION 147 (2007) (explaining,among other things, two common responses to failure—“defensive processing” and“retroactive pessimism”—both of which deny accountability).6 See, e.g. , John Tribe, Symptoms of Debtor Ostrich Syndrome? , BANKR ., I NSOLVENCY AND CORP . R ESCUE BLOG (Apr. 10, 2009, 8:02 AM),http://bankruptcyandinsolvency.blogspot.com/2009/04/symptoms-of-debtor-ostrich-syndrome-r3s.html (explaining “that those with financial problems do not think they‘need’ debt advice, while those that do seek advice are not always going to the right

places for it”); Michelle M. Harner, Discussing the “B” Word with Corporate Boards, CREDIT SLIPS (June 17, 2010, 9:10AM),http://www.creditslips.org/creditslips/2010/06/discussing-the-b-word-with-corporate-boards.html. As an example, former CEO of Circuit City Alan Wurtzelsaid in an interview after the company’s bankruptcy he wished he had woken upsooner, but instead, “management ushered in the new century with largely the same

strategy” the company had developed during 1980, continuing to provide servicescustomers no longer wanted. Wurtzel commented, “[i]t wasn’t obvious in sales andearnings, but the rot had set in.” Rachel Feintzeig, Lessons From the Death ofCircuit City , WALL STREET JOURNAL BANKRUPTCY BLOG (Oct. 25, 2012, 4:47PM),http://blogs.wsj.com/bankruptcy/2012/10/25/lessons-from-the-death-of-circuit-city/.


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to many contingencies and factors, some of which are beyondmanagement’s control. Nevertheless, delaying restructuringdiscussions can place management in a weaker negotiating positionwith key creditor constituencies and allow short-term investors whoseinterests may not necessarily align with others to amass large holdings

in the company’s capital structure. Management may have feweroptions once it finally starts restructuring discussions, and negotiatingwith your back against the wall rarely produces positive results.

Why is it so hard for individuals to admit mistakes or failure,and what can or should the law do about it? The vast litera ture on

behavioral economics offers some insight into the former, 7 and thegrowing body of literature studying behavioral economi cs incorporate boardrooms has started to influence the latter. 8 This article

7 “Behavioral economics is the combination of psychology and economics thatinvestigates what happens in markets in which some of the agents display humanlimitations and complications.” Sendhil Mullainathan & Richard H. Thaler,

Behavioral Economics (Nat’l Bureau of Econ. Research, Working Paper No. 7948,2000), available at https://www.msu.edu/course/aec/810/clippings/Thaler-

behavioral%20economics.pdf. See also Craig Lambert, The Marketplace ofPerceptions , HARV . MAG., Mar.-Apr. 2006, at 50, available at http://harvardmag.com/pdf/2006/03-pdfs/0306-50.pdf (explaining development of

behavioral economics). But see , e.g. , Richard A. Posner, Rational Choice, Behavioral Economics, and the Law , 50 S TAN . L. R EV. 1551, 1556-57 (1998)(criticizing behavioral economics).8 See generally Donald C. Langevoort, Behavioral Theories of Judgment and

Decision Making in Legal Scholarship: A Literature Review , 51 V AND. L. R EV.1499 (1998) [hereinafter Literature Review ]. See also Antony Page, Unconscious

Bias and the Limits of Director Independence , 2009 U. I LL. L. R EV. 237 (2009);Regina F. Burch, The Myth of the Unbiased Director , 41 A KRON L. R EV. 509(2008); Lawrence A. Cunningham, Beyond Liability: Rewarding EffectiveGatekeepers , 92 M INN. L. R EV . 323 (2007); Oliver Marnet, Behavior and

Rationality in Corporate Governance, 34 J. ECON . ISSUES 613 (2005); Donald C.Langevoort, Resetting the Corporate Thermostat: Lessons from the RecentFinancial Scandals About Self-Deception, Deceiving Others and the Design of

Internal Controls , 93 G EO. L.J. 285 (2004) [hereinafter Corporate Thermostat ];Lynne L. Dallas, A Preliminary Inquiry into the Responsibility of Corporations andTheir Officers and Directors for Corporate Climate: The Psychology of Enron's

Demise , 35 R UTGERS L.J. 1 (2003) [hereinafter Psychology of Enron’s Demise ];Marleen A. O'Connor, The Enron Board: The Perils of Groupthink , 71 U. CIN. L. R EV. 1233 (2003); Kent Greenfield, Using Behavioral Economics to Show thePower and Efficiency of Corporate Law as Regulatory Tool , 35 U.C. DAVIS L. R EV.

581 (2002); Stephen M. Bainbridge, Why a Board? Group Decisionmaking inCorporate Governance, 55 V AND . L. R EV. 1 (2002); Donald C. Langevoort, The

Human Nature of Corporate Boards: Law, Norms, and the UnintendedConsequences of Independence and Accountability , 89 G EO. L.J. 797, 812–13(2001) [hereinafter Human Nature ] (discussing the effect of personal relationships


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further develops this literature by focusing on heuristics (i.e., mentalshort-cuts to facilitate quick decisions) and cognitive bias in thedistressed corporate boardroom. A representative heuristic, over-confidence and optimism biases, and framing effects can impedemanagement’s decisions in distressed situations. Policymakers—as

well as business executives and professionals—need to consider these behavioral traits when designing and implementing federal bankruptcy law. 9

For example, restructuring professionals and commentatorsoften talk about the filing of a bankruptcy case as a distressedcompany’s “option of last resort.” This expression typically is used tounderscore the need for a distressed company to appreciate thesignificance of filing a chapter 11 reorganization case. Such a filinghas broad and potentially negative consequences and should not beundertaken lightly. The chapter 11 process does, however, offer a

distressed company tools not otherwise available outside of bankruptcy, and the utility of those tools frequently turns on thetiming of the bankruptcy filing. Accordingly, most restructuring

professionals use the term “last resort” loosely, not necessarily tomean “use only if all else fails,” but to encourage careful deliberationof the matter.

But is that what a distressed company’s management hears?The term “last resort” typically means “you do it because you can findno other way of getting out of a difficult situation or of solving a

on information sharing between managers and boards); Margaret M. Blair & LynnA. Stout, Trust, Trustworthiness, and the Behavioral Foundations of Corporate

Law, 149 U. PA. L. R EV. 1735 (2001); Donald C. Langevoort, Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market Investors (andCause Other Social Harms) , 146 U. PA. L. R EV. 101 (1997) [hereinafter Organized

Illusions ] (discussing managers various constituencies, motivations to lie and whyregulations do not adequately deter misleading behavior); Lynne L. Dallas, Two

Models of Corporate Governance: Beyond Berle and Means , 22 U. MICH. J.L. R EFORM 19, 73-77 (1988) [hereinafter Beyond Berle and Means ]; James D. Cox &Harry L. Munsinger, Bias in the Boardroom: Psychological Foundations and Legal

Implications of Corporate Cohesion , LAW & CONTEMP . PROBS ., Summer 1985,

at 83, 83-84, 99-108. 9 See, e.g., Hersh Shefrin, Behavioral Corporate Finance , J. APPLIED CORP . FIN.,Fall 2001, at 113, 118; Dan Lovallo & Daniel Kahneman, Delusions of Success:

How Optimism Undermines Executives’ Decisions , HARVARD BUS. R EV., July 2003,at 56, 58 (examining cognitive biases applicable in business decisions).

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problem.” 10 Thus, the phrase “filing bankruptcy should be youroption of last resort” may mean one thing to the restructuring

professional and something completely different to a businessexecutive not trained in bankruptcy parlance. It also might enable anyheuristics and cognitive biases harbored by management, confirming

management’s entrenched views regarding any b ankruptcy filing orthe potential success of its existing business plan. 11

The authors conducted an extensive empirical survey of business restructuring professionals to test a basic hypothesisdeveloped through anecdotal evidence: Management of distressedcompanies often deny the extent of their companies’ distress anddelay discussions of a chapter 11 bankruptcy filing. Over 400restructuring professionals responded to the empirical survey (the“Management Behavior Study”). The survey data confirm the basichypothesis and show some troubling trends. For example, the

overwhelming majority of responde nts use the phrase “bankruptcy asa last resort” with distressed clients. 12 Moreover, respondents usingthe phrase are significantly more likely to have clients who initiallyrefuse to file a ban kr uptcy case and ultimately avoid the bankruptcy

process altogether. 13 That data may suggest those clients successfullyrestructure outside of the bankruptcy process or, more troubling,signal prospect theory at work: Professionals use a loss frame todiscuss bankruptcy, and distressed clients pursue riskier out-of-courtsolutions that either provide only short-term solutions or no solutionat all.

Better understanding management’s decision-making in theface of a company’s distress can lead to better policies and outcomes.This article makes original and meaningful contributions to thisdialogue. Part II of the article provides relevant background

10 COLLINS COBUILD E NGLISH DICTIONARY FOR ADVANCED LEARNERS (4th ed.2003).11 For example, a framing bias may alter what management hears and in turn bolsterany confirmation or overconfidence bias influencing management’s decisions.“[F]raming bias is the tendency to view a given problem in different termsdepending on the perspective from which the problem is viewed.” Ian Weinstein,

Don’t Believe Everything You Think: Cognitive Bias in Legal Decision Making ,

9 CLINICAL L. R EV. 783, 796-97 (2003) (describing the cognitive bias known asframing or anchoring).12 See infra Part III.C.2.13 See id. ; see also Daniel Kahneman & Amos Tversky, Prospect Theory: An

Analysis of Decision Under Risk , 47 E CONOMETRICA 263, 269 (1979).


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information regarding the restructuring alternatives for distressedcompanies and the heuristics and biases that potentially impactdecision-making in this context. The article then presents originalempirical data in Part III and examines these data in light of the

behavioral economics literature and prior studies. Part IV uses these

analyses to evaluate the existing restructuring landscape and suggestlegislative reforms to mitigate heuristics in the distressed companycontext. These reforms include revamping hybrid restructuringoptions for distressed companies to provide incentives and strongerlegislative support for companies that begin restructuring discussionsin a timely manner. 14 The article concludes by encouraging

policymakers, professionals, and business executives to furtherconsider how heuristics might impede successful reorganizations andto integrate countermeasures into both bankruptcy legislation andstrategy discussions to foster more successful failures.

II. F INANCIAL DISTRESS AND MANAGEMENT DECISION -MAKING

Companies experience distress for a variety of reasons, bothsystemic and idiosyncratic. 15 Systemic risk generally affects entire

14 See infra Part IV.B (discussing new concept of “meet and confer” process, or anMCP, that provides a more effective quasi-judicial option for distressed companies).15 See, e.g. , Dean Anderson & Elliot A. Fuhr, Diagnosing Distressed Companies: APractical Example , AM. BANKR . I NST . J., Oct. 1994, at 9 (“Major warning signs offinancial distress include: declining net income, decreasing or inadequate margins,creditors unwilling to advance credit, loss of a major supplier with special creditterms, reduction in lines of credit, excessive receivables over 90 days, default on

payment by a major customer, excessive payables unpaid over 90 days, inability tomake timely deposits of trust funds such as employee withholding taxes, inability toservice long-term debt requirements, excessive re-negotiation of broken loancovenants, unusual or extraordinary litigations and events not customarilyencountered in the industry, loss of key financial officers or key personnel, cashmanagement becoming a primary activity at the expense of traditional managementfunctions, new long-term financing proceeds applied to pay off debts rather thanacquisition of assets, poor record keeping or inadequate financial records, lack of

basic controls, such as perpetual inventory record keeping, and significantdiscrepancies between actual and projected results over the prior three years.” The

company Dun & Bradstreet uses several of these indicators in providing creditscores and supplier evaluation risk summaries regarding businesses. D UN & BRADSTREET I NSTRUCTIONAL GUIDE ,https://www.dnb.com/sassmo/help/InstructionalGuide.htm (last visited Dec. 28,2012).

https://www.dnb.com/sassmo/help/InstructionalGuide.htmhttps://www.dnb.com/sassmo/help/InstructionalGuide.htmhttps://www.dnb.com/sassmo/help/InstructionalGuide.htm


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industries or markets, and it is not unique to a particular company. 16 The economic turmoil and resulting recession in 2008 highlighted theglobal instability at times triggered by systemic risk. Idiosyncraticrisk refers to internal factors often specific to a particular company,such as its business lines, capital structure, or management activity or

inactivity.17

Moreover, systemic risk can accelerate idiosyncratic riskand compound a company’s distress and restructuring efforts.

Notably, when a company undertakes either an in- or out-of-courtrestructuring, management focuses on the systemic and externalfactors causing the company’s distress. Press releases frequently touta weak economy and softening customer demand as k ey drivers

behind a company’s decision to file a chapter 11 case. 18 Rarely doesmanagement identify idiosyncratic factors or, more pointedly, risksattributable to their own decisions or strategic objectives as anunderlying cause.

Management’s reluctance to acknowledge responsibility for acompany’s distress may be a natural human response; peoplegenerally are reluctant to take ownership of their mistakes. 19 This

16 “A common factor in the various definitions of system risk is that a trigger event,such as an economic shock or institutional failure, causes a chain of bad economicconsequences – sometimes referred to as a domino effect. These consequencescould include (a chain of) financial institution and/or market failures. Lessdramatically, these consequences might include (a chain of) significant losses tofinancial institutions or substantial financial-market price volatility. In either case,the consequences impact financial institutions, markets, or both.” Steven L.Schwarcz, Systemic Risk , 97 G EO. L.J. 193, 198 (2008).17 See, e.g. James C. Spindler, IPO Liability and Entrepreneurial Response , 155 U. PA. L. R EV. 1187, 1189, fn. 2 (2007) ( “ ‘Idiosyncratic,’ ‘unique,’ ‘firm-specific,’ or‘diversifiable’ risk is risk that is particular to that specific firm.”); Robert Ackerman& Elizabeth Chorvat, Modern Financial Theory and Transfer Pricing , 10 G EO. MASON L. R EV. 637, 671 (2002) (discussing one way idiosyncratic risk can work in

practice by comparing inventory assets in the hands of a distributor as opposed to alocal retailer).18 Aff. of Richard Golden in Support of First Day Motions and Applications at ¶ 15,

In re UFood Restaurant Group, Inc., No. 12-BK-19702 (Bankr. D. Mass. Dec. 14,2012) (“[D]ue to economic downturn, the Debtors’ slow recovery therefrom, andcertain other factors, certain of the company-owned UFood Outlets are strugglingand are a drag on the Debtors’ businesses”); Aff. of Antoinette P. McCorvey at ¶ 10,

In re Easte Kodak Company, No. 12-10202 (Bankr. S.D.N.Y. Jan. 19, 2012)(“Since 2008, despite Kodak’s best efforts, restructuring costs and recessionaryforces have continued to negatively impact the Company’s liquidity position…”).19 See, e.g. Eugene Szwajkowski, Accounting for Organizational Misconduct , 11 J. BUS. ETHICS 401, 402 (1992) (describing the literature on the failure-to-take-


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reaction may be reinforced by heuristics; several studies haveexplored the impact of co nf irmation and over-confidence biases onCEO and board decisions. 20 These potential management flaws can

be fatal to a distressed company. They may skew management’s perception of the company’s financial health and delay necessary

operational and restructuring activities. A distressed company’s professionals may further enable these biases in how they frame anddiscuss the company’s restructuring alternatives with management.

This part of the article explains the basic legal and behavioraleconomics arguments pertinent to analyzing management decision-making in the distressed company context. It first outlines therestructuring alternatives for a distressed company by summarizingthe in- and out-of-court options likely available to a distressedcompany. It then considers the behavioral economics literature andits relevance to corporate boardrooms.

A. Restructuring Alternatives

A troubled company may be experiencing financial distress,economic distress, or both. Financial distress generally refers to thefinancial condition of the company, including its leverage, fin ancialobligations to creditors, and ability to meet those obligations. 21 Economic distress, on the other hand, suggests that the company’s

primary weakness lies in its business model and operations. 22 Although economic distress can lead to financial distress, the reverse

progression also occurs and may cause the untimely demise of a

responsibility phenomenon and noting how the discovery of organizationalmisconduct creates a predicament for a manager because the event may “cast[]undesired aspersions on the lineage, character, conduct, skills, or motives” of themanager, which are potentially damaging to the social and professional standing ofthe individual).20 See, e.g. , Burch, supra note 8; Cunningham, supra note 8; Psychology of Enron's

Demise , supra note 8; Beyond Berle and Means , supra note 8; Greenfield , supra note 8; Corporate Thermostat , supra note 8; Human Nature , supra note 8, at 812– 13; Organized Illusions , supra note 8; Oliver Marnet, supra note 8; Anthony Page,supra note 8.21 Lemma W. Senbet & Tracy Yue Wang, Corporate Financial Distress and

Bankruptcy: A Survey , at 7 (2012), available at SSRN:http://ssrn.com/abstract=2034646 or http://dx.doi.org/10.2139/ssrn.2034646.22 Id . See also Michael L. Lemmon, Yung-Yu Ma & Elizabeth Tashjian,

Restructuring and Post Emergence Performance of Bankrupt Firms: Evidence fromthe Post-1991 Period , at 12 (2009).


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profitable business model. In both cases, the substance and timing ofmanage ment’s decisions are critical to the company’s ultimatesuccess. 23

What constitutes success in the restructuring context is subject to

debate. Some commentators focus on maximizing value while othersemphasize rehabilitating the busine ss, with the attendant preservationof jobs and economic development. 24 The optimal restructuringstrikes a balance between these competing goals and facilitates thereorganization of economically viable firms. Economic viability mayresult f rom deleveraging and, in some cases, revamping the businessmodel. 25 Again, both outcomes are largely dependent onmanagement’s restructuring path.

Most commentators agree that management should pursue out- of -court restructuring options before undertaking a bankruptcy filing. 26

23 See Lemma W. Senbet & James K. Seward, Financial Distress, Bankruptcy and Reorganization, in Handbooks , in O PERATIONS R ESEARCH AND MANAGEMENTSCIENCE , Vol 9 (R.A. Jarrow, et al. ed. 1995) at 951-53 (discussing how managerialability and decision-making are important determinants of firm value both generallyand when the firm is in distress).24 See James H.M. Sprayregan, et al., Chapter 11: Not Perfect, but Better Than the

Alternatives , 14 J. BANKR . L. & PRAC . 6 (2005) (noting two perspectives amongstchapter 11 scholars, the “rehabilitationists” who view the rehabilitative aspects ofchapter 11 as valuable and those who think the current process is not useful); Hon.Leif M. Clark, et al., What Constitutes Success in Chapter 11? A Roundtable

Discussion , 2 A M. BANKR . I NST . L. R EV. 229 (1994); In re Central Ice Cream Co.,836 F.2d 1068, 1072 (7th Cir. 1987) (Judge Easterbrook suggests that valuemaximization should be the goal of Chapter 11).25 See Lemmon, supra note 22 at 10, 12 (noting that firms classified as financiallydistressed have “fundamentally sound business models” and high leverage is thedominant source of distress, whereas firms classified as economically distressed arecharacterized by “a business model with fundamental problems” and operating

performance is the dominant source of distress); F INANCIER WORLDWIDE , BANKRUPTCY & R ESTRUCTURING COMPENDIUM 2012, at 152 (2012) (discussinglarge-scale bank deleveraging), available at http://www.arnstein.com/attorneypublications/FW_2012-Bankruptcy-Restructuring-Compendium.pdf; id . at 60 (discussing business model changes in the airlineindustry).26 See Karen M. Gebbia-Pinetti, First Report of the Select Advisory Committee on

Business Reorganization , 57 B US. LAW . 163, 179 (2001); Conrad B. Duberstein,

Out-of-Court Workouts , 1 A M. BANKR . I NST . L. R EV. 347, 365 (1993) (noting thatout-of-court workouts, when successful, are typically more beneficial to all partiesthan when utilizing the bankruptcy courts); Stuart C. Gilson, Kose John & LarryH.P. Lang, Troubled Debt Restructurings: An Empirical Study of Private

Reorganizations of Firms in Default , 27 J. FIN. ECON . 315, 319 (1990). See also


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Bankruptcy can be a lengthy and expensive process. 27 Nevertheless,each option has particular advantages depending on the company’scircumstances and deserves independent consideration. Managementmust understand and be open to all restructuring options in order tomaximize the utility of any. As described below, the prospects of a

chapter 11 case might encourage an out-of-court restructuring orstreamline the bankruptcy process through a pre-packaged bankruptcycase. 28

1. Out-of-Court Restructurings

An out-of-court restructuring typically involves a consensualagreement among the company and its major creditors to adjust thecompany’s capital structure. It also may accompany or facilitate anoperational restructuring. The key attributes of most successful out-of-court restructurings include a concentrated creditor group and a

good working relationship between the company and its creditors,vendors, and suppliers. Although simple in concept, achieving a private, consensual resolution can be challenging and often derailed by just one dissenting creditor.

Randolph J. Haines, Bankrupting the Opposition , 21 L ITIG . 38, Summer 1995, at 38,40 (“Out-of-court workouts, even if they mean accepting pennies on the dollar, areusually quicker and cheaper than any bankruptcy, and therefore likely to returnmore to creditors. Moreover, the out-of-court workout probably stands a greaterchance of permitting the debtor to remain in business, and thus be a valuablecustomer in the future.”); Bettina M. Whyte & Patricia D. Tilton, Turnarounds:Pursuing a Dual Path , AM. BANKR . I NST . L. J., Nov. 1995, at 28 (“Generallyspeaking… an out-of-court workout is preferable to reorganizing under the Codedue to the cost, image, drain or resources, impact on morale, etc. of a bankruptcy.”).27 See Gebbia-Pinetti, supra note 26, at 183-84 (noting that the many expensesassociated with bankruptcy restructuring – filing fees, costs associated withcompliance and reporting requirements, attorney’s fees, and costs associated withappearing in court – can be excessive). See also , Charles J. Tabb, The Future ofChapter 11 , 44 S.C. L. R EV. 791, 799-800 (1993) (discussing multiple studiesregarding the large costs of chapter 11); Robert H. Mnookin & Robert B. Wilson,

Rational Bargaining and Market Efficiency: Understanding Pennzoil v. Texaco,75 V A. L. R EV. 295, 299 (1989) (arguing that “the process of reorganization,especially if protracted, can destroy value”).28 See W. HOMER DRAKE , JR . & CHRISTOPHER S. STRICKLAND , CHAPTER 11 R EORGANIZATIONS § 12:3 (2d 2011) (providing a general overview of how

prepackaged plans work generally); Gebbia-Pinetta, supra note 26 at 183-84(“[B]oth the National Bankruptcy Review Commission and the NationalBankruptcy Conference have formally recommended that efforts be made to reduceunnecessary costs and delay in Chapter 11 restructurings by facilitating andexpediting prepackaged chapter 11 reorganization cases.”).


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The power of the dissenting or “hold-out” creditor stems largelyfrom provisions in a company’s prepetition debt instruments and theIndenture Trust Act of 1939. For example, a credit facility orindenture might require a super-majority or unanimous voting

threshold for the waiver of certain defaults, forbearance, or otheractions that might be necessary to achieve the desired restructuring. 29 Likewise, the Indenture Trust Act of 1939 provides that an indenturemay not affect an individual bondholder's right to receive the“payment of the principal of and interest ... on or after the respectivedue dates ... or to institute suit for the enforcement of any such

payment” without the consent of the bondholder. 30 Accordingly, anindividual creditor may have significant influence over the extent andsuccess of a company’s out-of-court restructuring efforts.

An out-of-court restructuring may take a variety of forms. A

company may attempt to exchange its existing debt for new noteswith more favorable repayment terms or for common stock, therebyreducing the company’s overall leverage. 31 It may engage in a

program of asset disposal within the bounds of debt covenants. It mayseek a strategic partner with some financing backing. It may also usea combination of these and other recapitalization options, includingthe infusion of new capital or new investors into the capital

29 See Mark J. Roe, The Voting Prohibition in Bond Workouts , 97 Y ALE L.J. 232,251 (1987) (discussing the legislative history of the Act and noting that Congressand the SEC knew that this holdout problem could frustrate some out-of-courtworkouts).30 15 U.S.C. §§ 77aaa, 77ddd(a) (2006); see also George W. Shuster, Jr., The Trust

Indenture Act and International Debt Restructurings, 14 A M. BANKR . I NST . L. R EV.431, 437 (2006).31 See, e.g. , Saybrook Successfully Completes the Out-of Court Restructuring ofFoster Wheeler, Ltd. , BUSINESS W IRE (Nov. 4, 2004, 6:05AM),http://www.businesswire.com/news/home/20041104005211/en/Saybrook-Successfully-Completes-Out-of-Court-Restructuring-Foster-Wheeler (last visitedJan. 9, 2013); Jennifer Weitzman, J. Crew Downgraded by Standard & Poor’s ,WOMEN ’S WEAR DAILY , Apr. 15, 2003, at 14; Continental Global Group, Inc.,Form 8-K, Exh. 99.1 (July 23, 2004), available at http://www.sec.gov/Archives/edgar/data/1039785/000095015204005565/0000950152-04-005565-index.htm . See also , Gina Gutzeit & John Yozzo, Distressed Debt

Exchanges: You Can Run, But You Can’t Hide , AM. BANKR . I NST . J., Mar. 2010, at

46 (discussing how distressed debt exchanges, whereby a troubled borrower offers acreditor different securities in exchange for the debt claim, increased dramatically in2009); Edward I. Altman & Brenda Karlin, The Re-Emergence of Distressed

Exchanges in Corporate Restructuring , 5 J. CREDIT R ISK 43 (2009), available at http://ssrn.com/abstract=1469130.

http://www.sec.gov/Archives/edgar/data/1039785/000095015204005565/0000950152-04-005565-index.htmhttp://www.sec.gov/Archives/edgar/data/1039785/000095015204005565/0000950152-04-005565-index.htmhttp://www.sec.gov/Archives/edgar/data/1039785/000095015204005565/0000950152-04-005565-index.htmhttp://www.sec.gov/Archives/edgar/data/1039785/000095015204005565/0000950152-04-005565-index.htmhttp://www.sec.gov/Archives/edgar/data/1039785/000095015204005565/0000950152-04-005565-index.htm


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structure. 32 Such restructurings are not, however, free from cost. Thecompany likely will have to pay significant fees and may be requiredto make concessions regarding operations and any futurerestructurings.

Management concessions in the face of an out-of-courtrestructuring may appropriately discipline management or,alternatively, unduly impede management’s ability to return acompany to profitability. For example, management’s agreement tosell non-core assets or retain a Chief Restructuring Officer might helprightsize a business. The Chief Restructuring Officer may, however,

be beholden to the creditors and encourage a company to forego projects that do not align with the creditors’ investment horizons orthe interests of other constituents. 33 Similarly, restrictive covenantsand creditor veto rights in the restructuring documents may hinderfuture operations. 34 Management must tread carefully through theout-of-court restructuring negotiations.

In this vein, management’s openness to a chapter 11 bankruptcy process might hold value in restructuring discussions. Management’sability to explain creditors’ rights in, and the landscape of, anychapter 11 case for the company allows all parties to appreciate thechoices at hand and may provide management with some leverage in

32 See, e.g. , Dan Trigoboff, XM Radio Gets $450M Infusion , BROADCASTING & CABLE 6 (Dec. 2002), available at http://www.broadcastingcable.com/article/145257-XM_Radio_Gets_450M_Infusion.php.33 See John Wm. Butler, Jr., Chris L. Dickerson & Stephen S. Neuman, PreservingState Corporate Governance Law in Chapter 11: Maximizing Value ThroughTraditional Fiduciaries , 18 A M. BANKR . I NST . L. R EV. 337, 356 (2010) (noting thatwhile some expertise believe independent, third-party chief restructuring officerscan be beneficial, the use of CROs raise serious conflict of interest issues because,CROs can be “predisposed to favor only one entity involved in the debtor’schapter 11 reorganization: the creditor who was responsible for getting him hired”).34 See, e.g. , Harvey R. Miller & Shai Y. Waisman, Does Chapter 11

Reorganization Remain a Viable Option for Distressed Businesses for the Twenty-First Century? , 78 A M. BANKR . L.J. 153, 198 (2004) (discussing the expanding

power of secured creditors in the Chapter 11 process, due in part to the use of

restrictive covenants and rights of control provisions in credit facilities); Martin J.Whitman, et al., A Rejounder to “The Untenable Case for Chapter 11” , 2 J. BANKR . L. & PRAC . 839, 856-57 (1993) (discussing restrictive covenants such as cashsweeps and prohibitions on future borrowing that can impair the reorganization

process).


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negotiations. 35 Nevertheless, this approach also requires managementto confront its own failings and the possibility of airing those failingsin a very public forum—a thought often repugnant to management.Consequently, the chapter 11 option often enters the discussion, if atall, too late in the process.

2. Bankruptcy Restructurings

A distressed company may file a chapter 7 liquidation case or achapter 11 reorganization case under the Bankruptcy Code. In achapter 7 case, a bankruptcy trustee replaces the company’smanagement and works to sell the company’s assets to repay itscreditors. 36 In a chapter 11 case, the company’s managementgeneral ly stays in control of the company and its reorganizationefforts; 37 the company operates as a “debtor in possession” withessenti ally the same rights, duties, and powers as a bankruptcytrustee.38 A company can sell some or all of its assets in a chapter 11case, 39 and creditor s can request the appointment of a chapter 11trustee or examiner. 40 Notably, the actual app ointment of a chapter11 trustee is the exception rather than the rule. 41

35 See, e.g. , JOHN C. DIDONATO & DANIEL P. W IKEL , MANAGING TRADITIONALCHAPTER 11 R EORGANIZATIONS : A PRIMER FOR DIRECTORS AND OFFICERS ONBANKRUPTCY FUNDAMENTALS 1 (2010) (“Sometimes the best weapon, andstrongest negotiation tactic with creditor constituents, is to play the ‘bankruptcycard’. Most parties are aware that filing for protection affords companies ‘time out’from their creditors and the precious time to regroup…”), available at http://www.huronconsultinggroup.com/en/Insights/Perspective/Financial/~/media/Insights-Media-Content/Bankrupcy_Fundamentals.pdf.36 See generally 11 U.S.C. §§ 701-727 (general Chapter 7 provisions of BankruptcyCode); id . at §§ 701-704 (discussing selection of trustee and duties of trustee).37 See generally id . §§ 1101-1146 (general Chapter 11 provisions of BankruptcyCode).38 Id . § 1107 (discussing duties of company as a debtor in possession).39 Id . § 363 (permitting sales of a debtor’s assets in the ordinary course of businessor, with prior notice and approval, outside of the ordinary course of business). Seealso Ali M.M. Mojdehi & Janet Dean Gertz, The Implicit “Good Faith”

Requirement in Chapter 11 Liquidations: A Rule in Search of a Rationale? , 14 A M. BANKR . I NST . L. R EV. 143, 152-53 (2006) (discussing history, scholarship, and caselaw in regard to companies using chapter 11 to liquidate and sell assets rather thanto reorganize and re-emerge); Douglas G. Baird & Robert K. Rasmussen, Chapter11 at Twilight , 56 S TAN . L. R EV. 673 (2003) [hereinafter Twilight ] (discussing how

the asset sales in chapter 11 of today are inconsistent with past conceptions of bankruptcy reorganization).40 Id . § 1104 (discussing appointment of trustee or examiner); see also Jonathan C.Lipson, Understanding Failure: Examiners and the Bankruptcy Reorganization of

Large Public Companies , 84 AM. BANKR . L.J. 1 (2010); Kelli A. Alces, Enforcing


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Not surprisingly, most companies prefer to file chapter 11 cases if bankruptcy is necessary. As noted above, the company—through itsmanagement—stays in control of the process and can continue tooperate its business. In addition, the Bankruptcy Code offers

management a number of useful restructuring tools. For example, the bankruptcy filing triggers the automatic stay, which prevents partiesfrom pursuing prepetition actions or attempting to collect prepetitiondebts against the company. The debtor has the unilateral ability todecide to keep or reject most types of contracts and leases and has asignificant period of time to make this decision. The debtor may sellsome or all of its assets free and clear of most claims, liens, andencumbrances. It also has an initial exclusive period in which to file a

proposed plan of reorganization. Moreover, the Bankruptcy Codegives the debtor assistance in negotiating and structuring postpetitionfinancing.

Nevertheless, management of a distressed company may haveoperational and reputational concerns relating to a chapter 11 filing.Although originally characterized by some as a pro-debtor forum, 42 amendments to the Bankruptcy Code have reallocated power in manychapter 11 cases, allowing prepetition lenders, landlords,counterparties, and other constituencies to significantly influence the

Corporate Fiduciary Duties in Bankruptcy , 56 U. K AN. L. R EV. 83 (2007)(commenting that the “conventional wisdom” that chapter 11 trustees should almostnever be appointed is wrong); Stuart C. Gilson & Michael R. Vetsuypens, CreditorControl in Financially Distressed Firms: Empirical Evidence, 72 W ASH. U. L.Q.1005, 1012 (1994).41 See Lipson, supra note 40, at 50 (noting that while examiners are more likely toappear in larger cases, they are still rare – even for those larger cases); Alces, supra note 40, at 84 (noting the appointment of a trustee in bankruptcy is very rarely

pursued).42 See, e.g., Lynn M. LoPucki, The Debtor in Full Control—Systems Failure UnderChapter 11 of the Bankruptcy Code? First Installment , 57 A M. BANKR . L.J. 99, 101(1983) (noting that debtor companies were generally successful in dictating theterms of the reorganization to their creditors); Lynn M. LoPucki, The Debtor in FullControl—Systems Failure Under Chapter 11 of the Bankruptcy Code? Second

Installment , 57 A M. BANKR . L.J. 247-48 (1983) (noting that creditors historically

took little interest in bankruptcy proceedings because the bankruptcy legislation didnot “provide a means to exercise meaningful control or to make their participation

profitable.”); see also DAVID A. SKEEL , DEBT ’S DOMINION : A HISTORY OFBANKRUPTCY LAW IN AMERICA 212-32 (2001) (explaining historical aspects to pro-debtor perception).


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process. 43 For example, the Bankruptcy Abuse Prevention andConsumer Protection Act of 2005 (BAPCPA) shortened a debtor’sexclusive period to file a reorganization plan and limited the types ofretention and severance benefits available to a debtor’s topmanagement. 44 BAPCPA also truncated the debtor’s time to assume

or reject commercial real estate leases and elev ated the priority ofvendor’s reclamation claims against the debtor. 45 In addition, variousamendments have broadened the protections afforded counterpartiesunder certain types of derivatives and financial contracts with adebtor, potentially causing a debtor to lose significant value on thefirst day of a bankruptcy case. 46

The constant power struggle in chapter 11—played out inamendments to the Bankruptcy Code and in bankruptcy courtsthroughout the United States—is counterproductive to the commongoals of the debtor and all of its constituencies, i.e., maximizing valueand rehabilitating viable businesses. Neith er a pro-debtor nor a pro-creditor system achieves an optimal result. 47 As such, the current

power balance that arguably favors various creditor constituenciesoften causes a distressed company to forego chapter 11, or delay any

43 See Twilight , supra note 39, at 675 (describing creditor control as the dominanttheme in modern chapter 11 cases).44 Pub. L. No. 109-8, 119 Stat. 23 (codified as amended in scattered sections of title11 of the United States Code); see also 11 U.S.C. §§ 503(c), 1121(d).45 See Robert N.H. Christmas, Designation Rights – A New, Post-BAPCPA World ,AM. BANKR . I NST . J., Feb. 2006, at 10 (noting the new timing limitation will have adramatic effect on debtors); David L. Woods, Reclamation Under BAPCPA: Model

for Uniformity? , AM. BANKR . I NST . J., July/Aug. 2007, at 40 (discussing how theBAPCPA provisions expanded the ability of a seller to reclaim goods from aninsolvent buyer).46 Michael H. Weiss, Using Derivatives to Create Bankruptcy Proof Loans , 30 C AL. BANKR . J. 207, 268 (2010) (describing how BAPCPA effectively removes largenumbers of transactions from the bankruptcy process (which is historically designedto treat creditors in an orderly and fair manner)); Rhett G. Campbell, Financial

Markets Contracts and BAPCPA , 79 A M. BANKR . L.J. 697, 712 (2005) (describinghow Congress must have concluded “that expanded [protections for counterparties,etc] will promote the stability of worldwide capital markets and that this publicgood (reducing systemic risk) justifies preserving less value for creditors in a single

bankruptcy proceeding.”); Edward R. Morrison & Jeorg Riegel, FinancialContracts and the New Bankruptcy Code: Insulating Markets from Bankrupt

Debtors and Bankruptcy Judges , 13 A M. BANKR . I NST . L. R EV. 641 (2005).47

See, e.g. , Preface to R EPORT OF THE NATIONAL BANKRUPTCY R EVIEWCOMMISSION , at i (October 20, 1997) (“A bankruptcy system that doesnot balance the interests of creditors and the interests of debtors will have neithertheir confidence nor, of even greater importance, the confidence of the American

people.”).


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chapter 11 filing, to its detriment. Anecdotal and empirical datasuggest that ma nagement fears losing control and losing valuablecontract rights. 48

A distressed company’s management also may fear losing face.

Once a company files for chapter 11 bankruptcy, it basically operatesinside a public fishbowl. 49 The company is required to discloseextensive information concerning its prepetition and currentoperations and obligations, and various parties, including a statutorycommittee of unsecured creditors, have rights to review andinvestigate management activities. 50 Empirical studies also documenta high turn over in top management of bankrupt companies, perhapscausing so me to worry about job security if bankruptcy options arediscussed. 51 Moreover, bankruptcy often carries the stigma of fa ilureand is a very public recognition of a management’s deficiencies. 52

On balance, in the current legislative environment, managementof a distressed company may be reluctant to consider bankruptcy as

48 See infra Part III; see also A. Mechele Dickerson, The Many Faces of Chapter11: A Reply to Professor Baird , 12 A M. BANKR . I NST . L. R EV. 109, 133-34 (2004)(discussing how managers of insolvent or nearly insolvent firms make biaseddecisions and also experience fear that he or she is about to lose their job).49 Brad B. Erens & Kelly M. Neff, Confidentiality in Chapter 11 , 22 E MORYBANKR . DEV. J. 47, 48 (2005) (describing how bankruptcy court filings are publiclyavailable and how the public forum is often not in the best interest of the companyor its creditors).50 See, e.g. , FED. R. BANKR . P. 2015(a)(1)-(5) (providing the DIP or trustee must:file and transmit a report containing a complete inventory of the property of thedebtor; keep a record of receipts and the disposition of money and propertyreceived; file reports and summaries statutorily required, which must includeadditional information if payments are made to employees; and provide quarterlyreports regarding any disbursements and any fees payable for that quarter); F ED. R. BANKR . P. 2015.3(a) (providing the DIP or trustee must file “periodic financialreports of the value, operations, and profitability of each entity that is not a publiclytraded corporation or debtor in a case under title 11, and in which the estate holds asubstantial or controlling interest”); 11 U.S.C. § 308 (discussing the reportingrequirements applicable to small business cases).51 See Dickerson, supra note 48, at 133-34; see also Ramesh K.S. Rao, DavidSimon Sokolow & Derek White Fiduciary Duty a la Lyonnais : An EconomicPerspective on Corporate Governance in a Financially-Distressed Firm , 22 J. CORP . L. 53, 67 (citing to empirical studies by Stuart Gilson, Lynn LoPucki, and

their colleagues, regarding high turnover amongst management and directors priorto and during bankruptcy).52 See, e.g., Dickerson, supra note 48, at 134 (noting that directors of insolvent firmstake into account the anticipated reputational harm and public scrutiny they mayface if or when the company files for bankruptcy).


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an available restructuring option. Ignoring this option, however, mayweaken management’s position in out-of-court restructurings andinhibit hybrid r estructuring efforts, such as a prepackaged plan ofreorganization. 53 A company must be willing to consider bankruptcy,however, to assess the utility of any hybrid restructuring plan.

3. Prepackaged Restructurings

A prepackaged plan of reorganization, akin to most hybridrestructuring tools, typically involves a private restructuringarrangement implemented through a judicial process. 54 It has the

potential to mitigate some of the concerns frequently voiced about afull-blown chapter 11 case. 55 It is not a restructuring option,however, for every distressed company, and its current structureconfines the types of distress successfully resolved through the

process.

For the most part, prepackaged plans are governed by non- bankruptcy law and represent a privately negotiated contract solutionto a company’s distress. 56 This aspect of the process subjects it toseveral of the limitations discussed above in the context of pure out-of-court workouts. For example, the company does not receive the

benefit of an automatic stay, and it may have difficulties i dentifyingand bringing the necessary parties to the negotiating table. 57 It also iscommonly limited to resolving only bank and funded debt claims

because of collective action problems and challenges to creatingrepresentation for unsecured creditor s, vendors, employees, and

shareholders at the negotiating table.58

This may leave the companyexposed to ongoing vulnerability either because of its failure to truly

53 JOSE M. GARRIDO , THE WORLD BANK , OUT OF COURT DEBT R ESTRUCTURINGS 48-49 (2012).54 Id . at 48-49.55 See generally Conrad B. Duberstein, Out-of-Court Workouts , 1 A M. BANKR . I NST . L. R EV. 347, 365 (1993) (“Since the prepackaged plan is negotiated before theChapter 11 case starts, it can take advantage of all the benefits available under theCode without the detriments of a prolonged and expensive proceeding…” (quotingMarc S. Kirschner, et al., Prepackaged Bankruptcy Plans: The Deleveraging Toolof the 90s in the Wake of OID and Tax Concerns , 21 S ETON HALL L. R EV. 643, 663(1991))).56

Michelle M. Harner, The Corporate Governance and Public Policy Implicationsof Activist Distressed Debt Investing , 77 F ORDHAM L. R EV. 703, 739 (2008).57 See id . at 739-40 (“The consensual nature of an out-of-court restructuring limitsits usefulness.”).58 Harner, supra note 56, at 768.


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deleverage the balance sheet or because of the new burdens imposed by the only c onstituencies at the table—i.e., typically banks and bondholders. 59

In a pure prepackaged plan scenario, the company solicits

acceptances of the proposed plan from the debtholders whose claimsare being modified or impaired under the plan outside of the bankruptcy process. This solicitation must comply with applicablenon-bankruptcy law, including f ederal securities law for any publicsecurities involved in the plan. 60 If the level of plan acceptancecomports with the requirements of the Bankruptcy Code, the companythen commences a chapter 11 case to confirm and impleme nt the

prepackaged plan. 61 This can be a relatively quick process. 62 If thecompany does not receive acceptable support for the plan, it can startthe process over or commence its chapter 11 case as a prearranged

plan case. In the prearranged plan scenario, the company may refine

the prepetition plan and re-solicit acceptances of the plan through theforma l solicitation and confirmation procedures under the BankruptcyCode. 63

Both prepackaged and prearranged plans are alternatives to a long,contentious bankruptcy case, but they are only two of a distressedcompany’s options and, as currently structured, provide only limitedrelief. Moreover, if a company is unwilling to discuss bankruptcy-related tools, they may discount or ignore any hybrid restructuringoptions. The challenge then is to foster a meaningful dialogue withmanagement concerning the company’s distress and all of its

restructuring options at a time that still permits full exploitation ofthose options. The heuristics and related cognitive biases potentiallyconfounding this discussion are discussed below.

59 See, e.g., Lynn M. LoPucki & Sara D. Kalin, The Failure of Public Company Bankruptcies in Delaware and New York: Empirical Evidence of a “Race to the Bottom,” 54 V AND . L. R EV. 231, 252 (2001) (finding that that companies emergingfrom prepackaged bankruptcies after 1990 were more likely to refile than werecompanies emerging from non-prepackaged cases during the same period).60 Harner, supra note 56, at 739.61 Harner, supra note 56, at 740.62 According to BankruptcyData.com, the quickest pre-negotiated or prepackaged

bankruptcy since 2009 was for Baseline Oil & Gas Corp, which was filed Aug. 28,

2009 and was confirmed 28 days later. BankruptcyData.com Reveals Largest &Quickest Prepackaged Bankruptcies , BANKRUPTCY DATA .COM (Aug. 16, 2011);http://www.bankruptcydata.com/product_files/PR_081611.pdf . See also BaselineOil & Gas Corp., No. 4:09-bk-36291 (Bankr. S.D. Tex. Aug. 28, 2009).63 Harner, supra note 56, at 740-41.

http://www.bankruptcydata.com/product_files/PR_081611.pdfhttp://www.bankruptcydata.com/product_files/PR_081611.pdfhttp://www.bankruptcydata.com/product_files/PR_081611.pdf


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B. Heuristics and Bias in Decision-making

Business decisions are complex, time-sensitive and, i n the

distressed context, almost always subject to controversy.64

Even themost skilled executives need input and support in making thesedecisions. Many exec utives find this support in their colleagues and

professional advisers. 65 The value of that support to the company,however, may turn on t he heuristics and cognitive biases of thedecision-maker herself. 66

1. Examples of Heuristics and Biases

64 See generally In re Loral Space & Comm’ns Inc., Nos. 2808-VCS, 3022-VCS,2008 WL 4293781 (Del. Ch. Sept. 19, 2008) (after company emerged fromchapter 11, minority shareholders brought a derivative action on behalf of thecorporation against the dominant shareholder (a company “whose business modelinvolved taking control of distressed companies and positioning itself to reap the

benefits of control for itself and its investors”) and its directors, alleging unfairnessin connection with the financing transaction which had occurred during the

bankruptcy); In re Loral Space & Comm’ns Ltd., 342 B.R. 132 (S.D.N.Y. 2006).When a company is experiencing financial distress, a number of differentconstituencies, including lenders, may place pressure on management. See, e.g. ,Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever ofCorporate Governance, 154 U. PA. L. R EV. 1209, 1236-38 (2006) [hereinafter

Missing Lever ]; David A. Skeel, Jr., Creditors' Ball: The "New" New CorporateGovernance in Chapter 11, 152 U. P A. L. R EV. 917, 918 (2003). Moreover, at leastone commentator suggests that this pressure and influence exists even outside of thedistressed context. See Frederick Tung, Leverage in the Board Room: The Unsung

Influence of Private Lenders in Corporate Governance , 57 UCLA L. R EV. 115, 120(2009) (“Lender influence is pervasive. Empirical research documents the regularitywith which banks constrain fundamental managerial decisions even in the ordinarycourse of business.”).65 See, e.g. , The Corporate Laws Committee, ABA Section of Business Law,Corporate Director’s Guidebook – Sixth Edition , 66 B US. LAW . 975, 989 (2011)(discussing the board’s options for staying informed and finding support).66 For a general discussion of heuristics and biases, see B EHAVIORAL LAW ANDECONOMICS (Cass R. Sunstein ed., 2000); Inga Chira, et al., Behavioral Bias Withinthe Decision Making Process , J. B US. & ECON . R ESEARCH , August 2008, at 11

(behavioral finance “draws on the psychology and cognitive science literatures toexamine why individual decision-making often deviates from rational choices insystematic ways”); Literature Review , supra note 8; Roger G. Noll & James E.Krier, Some Implications of Cognitive Psychology for Risk Regulation, 19 J. L EGALSTUD . 747 (1990).


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The concept of heuristics suggests that individuals use mentalshortcuts to facilitate quick and deci sive action, often ignoringrelevant information in that process. 67 These shortcuts—also referredto as “decision-making strategies”—rely on factors easily accessible

by the decision-maker, such as prior experiences (e.g., representative

heuristics) and emoti ons (e.g., confirmation, over-confidence, andloss aversion biases). 68 Corporate managers may invoke any numberof these mental strategies to respond wi th the speed and efficacydemanded by stakeholders and markets. 69 A few are particularlyrelevant to the distressed context.

The representative heuristic suggests that individuals draw on pastexperiences and “perceived similarity to a particular known group orevent” in making decisions in the face of uncertainty. 70 This heuristiccan be useful and help managers avoid becoming paralyzed bydifficult decisions. It also, however, can create false assumptions that

67 See Gerd Gigerenzer & Wolfgang Gaissmaier, Heuristic Decision Making ,62 A NNUAL R EV. PSYCHOL . 451, 454 (2011) (“A heuristic is a strategy that ignores

part of the information, with the goal of making decisions more quickly, frugally,and/or accurately than more complex methods.”).68 See Eyal Ert & Ido Erev, The Rejection of Attractive Gambles Loss Aversion, andthe Lemon Avoidance Heuristic , J. ECON . PSYCHOL . 715, 718 (2008) (discussingloss aversion bias in heuristic decision making); Cass R. Sunstein, Hazardous

Heuristics , 70 U. CHI. L. R EV. 751, 766 (2003) (discussing the use of priorexperience in heuristic decision making); Larissa Z. Tiedens & Susan Linton,

Judgment Under Emotional Certainty and Uncertainty: The Effects of Specific Emotions on Information Processing , 81 J. PERSONALITY & SOC. PSYCHOL . 973,973 (2001) (discussing emotions and moods in heuristic decision making).69 Jaana Woiceshyn, Lessons from “Good Minds”: How CEOS Use Intuition,

Analysis and Guiding Principles to Make Strategic Decisions , 42 L ONG R ANGEPLANNING 298, 299 (2009) (“Studies have found systematic, rational analysisinsufficient to deal effectively with complexity. The overall conclusion of theresearch so far is that experienced decision makers… rely on intuition tosupplement, or at times even to substitute for, rational analysis… Studies suggestthat many corporate executives use more intuition than formal analysis in makingdecisions.”); T.K. Das & Bing-Sheng Teng, Cognitive Biases and Strategic

Decision Processes: An Integrative Perspective , 36 J. MGMT . STUD. 757, 773(1999) (noting that heuristics and biases are often valuable and indispensable foreffective decision making – perhaps particularly so for strategic decisions); but seeid . at 760 (describing potential negative consequences of heuristics on strategicdecision making) . 70

Mark R. Kebbell, et al., Understanding and Managing Bias , in DEALING WITHU NCERTAINTIES IN POLICING SERIOUS CRIME 87-97 (Gabriele Bammer ed. 2010); see also Amos Tversky & Daniel Kahneman, Judgment Under Uncertainty:

Heuristics and Biases , 185 S CIENCE 1124 (1974) (general discussion of cognitive bias in decisionmaking).


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cause errors in judgment. 71 For example, a CEO or director whoknows of colleagues having lost their jobs or suffered reputationaldamage when their companies filed for bankruptcy might factor thatinto her decision. Likewise, she might reference the frequentlynegative media coverage of companies in chapter 11, such as

headlines reading, With A123’s Bankruptcy, Amer ica’s Battery BizGoes Dead, and Ding Dong, Are Twinkies Dead? 72 Theserepresentations likely will taint her assessment and conclusionsregarding the appropriate path for her distressed company.

In addition to discounting a bankruptcy or restructuring alternative based on a representative heuristic, a manager also might honestly believe that she is exceptionally skilled and equipped to turn aroundher company where others could not. Such an overconfidence biasdistorts a decision-maker’s assessment of achieving the desired goal.Those affected by an overconfidence bias “overestimate their abilities,

believe that they know more than they in fact do, and suffer from an‘illusion of control,’ believing that they exert more control overresults than they actually do.” 73 Commentators have considered

potential issues with CEO’s overconfidence in the context of mergersand acquisitions, inve stment decisions, risk assessment, and corporategovernance generally. 74 These issues include over-estimating the

71 See Tversky & Kahneman, supra note 70, at 1124 (“In general, these heuristicsare quite useful, but sometimes they lead to severe and systematic errors.”); T.K.Das & Bing-Sheng Teng, supra note 69, at 760; Sunstein, supra note 68, at 766-67,775 (noting how emotions and overconfidence can negatively interfere withdecision making).72 Michael V. Copeland, With A123’s Bankruptcy, America’s Battery Biz Goes

Dead , W IRED .COM (Oct. 16, 2012, 6:18PM),http://www.wired.com/business/2012/10/a123-bankruptcy/; Associated Press, Ding

Dong, Are Twinkies Dead?, CHARLESTON GAZETTE (Nov. 16, 2012),http://wvgazette.com/News/Business/201211160143; see also Tiffany Kary,

Borders Files Bankruptcy, Is Closing Up to 275 Stores , BLOOMBERG .COM (Feb. 16,2011, 12:12PM), http://www.bloomberg.com/news/2011-02-16/borders-book-chain-files-for-bankruptcy-protection-with-1-29-billion-debt.html.73 Troy A. Paredes, Too Much Pay, Too Much Deference: Behavioral CorporateFinance, CEOs, and Corporate Governance , 32 F LA. ST. U.L. R EV. 673, 689(2005).74 See id . (arguing that corporate governance should be adjusted to manage CEOoverconfidence); Ulrike Malmendier & Geoffrey Tate, Who Makes Acquisitions?

CEO Overconfidence and the Market’s Reaction , 89 J. FIN. ECON . 20-43 (2008)(studying confidence in CEOs for M&A transactions, financial investmentdecisions, and risk assessments); Bernard S. Black, Bidder Overpayment inTakeovers , 41 S TAN . L. R EV. 597, 624-25 (1989) (discussing optimism andoverpayment in corporate takeovers); Richard Roll, The Hubris Hypothesis of


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value of projects and the likelihood of positive outcomes and apply inthe distressed context as well. Indeed, a distressed company mayexperience more significant negative consequences because theCEO’s unfounded belief that the distress is temporary or that she canhelp the company overcome may cause her to forego important

restructuring opportunities.75

In theory, other managers and directors should be a check to

counter any representative heuristic or overconfidence bias impairingdecision-making by the CEO or other manager. In practice, however,an optimism bias may limit the effectiveness of this check.Individuals working with the decision-maker may fear appearingdisloyal or as an outlier if they dissent to a proposed course of action.As Dan Lovallo and Daniel Kahneman explain:

Organizations also actively discourage pessimism,which is often interpreted as disloyalty. The bearers of

bad news tend to become pariahs, shunned and ignored by other employees. When pessimistic opinions aresuppressed, while optimistic ones are rewarded, anorganization’s ability to think critically is undermined.The optimistic biases of individual employees becomemutually reinforcing, and unreali stic views of thefuture are validated by the group. 76

Accordingly, management may talk each other into a frenzy ofagreement on an ill-fated course of action. Moreover, managementmay draw on the support of colleagues and the negative perception of

bankruptcy to confirm the substance of their deci sion, therebyintroducing a confirmation bias into the equation. 77

A fellow manager or director is not the only individual who canenable or validate a decision-maker’s errors in judgment.

Corporate Takeovers , J. BUS. L., Apr. 1986, at 197, 199-200 (discussingoverconfidence – or “hubris” in the context of mergers and acquisitions).75 See infra Part III.C.4; see also Michelle M. Harner, Barriers to Effective Risk

Management , 40 S ETON HALL L. R EV. 1323, 1354 (2010) (discussing how CEOsand executives overestimate their abilities and believe they are the exception ratherthan the rule).76

Lovallo & Kahneman, supra note 9, at 56, 60-61. 77 In addition, a related bias—commitment bias—may prevent management fromchanging their decision even after the error in judgment is recognized. See, e.g. ,IRVING L. JANIS & LEON MANN , DECISION MAKING : A PSYCHOLOGICAL A NALYSISOF CONFLICT , CHOICE AND COMMITMENT (1977).


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Professionals (lawyers, financial advisers, accountants) advisingcorporate management also can play such a role in a variety of ways.For example, an adviser may provide information suggesting certainadvantages to the decision-maker’s proposed action. Even if theadviser also explains the disadvantages, the decision-maker likely will

latch on to the positive to confirm her belief. Advisers may softentheir advice to try to please the client and contribute to an optimism bias. Advisers, by their words, tone and phrasing, also may frame issues in a manner that affects a client’s decision-making process. 78

2. The Framing Bias and Restructuring

Studies show that people’s perceptions are affe cted by howquestions and issues are communicated or framed. 79 The followingdata from the work of Amos Tversky and Daniel Kahneman illustratea framing bias:

“Imagine that the United States is preparing for theoutbreak of an unusual Asian disease, which is

78 See Jeffrey J. Rachlinski, Gains, Losses, and the Psychology of Litigation , 70 S. CAL. L. R EV. 113, 122-23 (1996) (explaining framing bias); X.T. Wang, Framing

Effect: Dynamics and Task Domains , 68 O RGANIZATIONAL BEHAV . & HUMANDECISION PROCESSES 145 (1996) (same); Katherina Glac, Understanding Socially

Responsible Investing: The Effect of Decision Frames and Trade-Off Options , 87 J. BUS. ETHICS 41, (2008) (describing the operation of framing bias in a clear andrelatively detailed manner); Richard W. Painter, Convergence and Competition in

Rules Governing Lawyers and Auditors , 29 J. C ORP . L. 397, 404 (2004) (discussingframing bias in corporate context); Robert B. Thompson, Securities Regulation inan Electronic Age: The Impact of Cognitive Psychology, 75 W ASH. U. L.Q. 779,784 (1997) (explaining framing bias in investment decisions).79 “[F]raming bias is the tendency to view a given problem in different termsdepending on the perspective from which the problem is viewed.” Ian Weinstein,

Don’t Believe Everything You Think: Cognitive Bias in Legal Decision Making ,9 CLINICAL L. R EV. 783, 797 (2002). See also Theresa M. Marteau, Framing of

Information: Its Influence Upon Decisions of Doctors and Patients , 28 B RITISH J. SOC . PSYCHOLOGY 89 (1989) (discussing a study of doctor and patient decision-making regarding undergoing certain medical treatments and how the presentationof options and probabilities regarding the treatment influences those decisions);Michael J. Hiscox, Through a Glass and Darkly: Attitudes Toward InternationalTrade and the Curious Effects if Issue Framing, 60 I NT’L ORG. 755 (2006)(reporting findings from a study aimed at measuring the impact of issue framing on

individuals’ attitudes regarding international trade); William A. Boettcher, III, Military Intervention Decisions Regarding Humanitarian Crises: Framing Induced Risk Behavior , 43 J. CONFLICT R ESOL . 331 (2004) (discussing a study of howframing effects public opinion regarding U.S. military intervention in humanitariancrises).


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expected to kill 600 people. Two alternative programsto combat the disease have been proposed. Assumethat the exact scientific estimates of the consequencesof the programs are as follows:

If Program A is adopted, 200 people will be saved If Program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved”

In this version of the problem, a substantial majority ofrespondents favor Program A, indicating risk aversion.Other respondents, selected at random, receive aquestion in which the same cover story is followed bya different description of the options:

“If Program A’ is adopted, 400 people will die

If Program B’ is adopted, there is a one- third probability that nobody will die and a two-thirds probability that 600 people will die”

A substantial majority of respondent s now favorProgram B’, the risk-seeking option. 80

Many commentators sugge st that phrasing issues in a loss frame produces risk-seeking conduct. 81 This effect—also discussed in terms

of prospect theory—“argues that the value of gains and losses areexperienced differently; for example, people are more likely to takerisks in the domain of losses because of diminishing sensitivity tolarge losses, producing a convex portion of the value function.” 82 Atleast one study suggests that an individual’s desire to avoid surelosses and be more risk-seeking in a loss frame intensifies if that

80 Daniel Kahneman, Maps of Bounded Rationality: Psychology for Behavioral Economics , 93 A M. ECON . R EV. 1449, 1458 (2003) (emphasis in original) (quotingAmos Tversky and Daniel Kahneman, The Framing of Decisions and thePsychology of Choice , 211 S CIENCE 453 (1981)).81 See Rachlinski, supra note 78, at 119; Chris Guthrie, Prospect Theory, Risk

Preference, and the Law , 97 NW. U. L. R EV. 1115 (2003) (agreeing with the generalhypothesis regarding framing and presenting an overview of much of the legalliterature on the subject).82 Cameron Anderson & Adam D. Galinksy, Power, Optimism, and Risk-Taking ,36 E UR . J. SOC. PSYCHOL . 511, 520 (2006) (citations omitted).


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individual also is placed in a high-power position. 83 That studytheorizes a link between the optimism bias often present inindividuals holding positions of power and framing effects—i.e.,

powerful individuals are more risk-seeking when faced with certain loss (a loss frame) because they believe that they will beat the odds. 84

This effect has direct and significant application to managementof distressed companies. A CEO who perceives bankruptcy as failurelikely will be more risk-seeking to avoid that result and likely believesshe will succeed in her efforts. Likewise, the CEO who receives

professional advice that “bankruptcy should be considered only if allother options fail” or that “bankruptcy is a last resort” likely will

behave in a similar manner. Accordingly, management of distressedcompanies may be foregoing or delaying viable restructuring optionsrelating to bankruptcy in the hopes of hitting the proverbial home run.

The potential ramifications of heuristics and biases on decision-making in the distressed company context raise several importantquestions: Do CEOs and management really hold such negative viewsof chapter 11 bankruptcy and, if so, are these views reinforced by

professional advisers? Do those views affect management’s decisionsconcerning distressed companies? Does the conversation surroundingdistress and restructuring need to change?

The authors conducted the Management Behavior Study toexplore these and related questions. The study is described below andsuggests a need for further research and re-evaluation of howmanagement and professionals think about and discuss restructuringalternatives.

83 Id . at 520-21.84 Id . at 521 (“ This suggests that activating high-power drove individuals to be morerisk-taking, but that activating low-power did not lead individuals to be more riskaverse.”); see also Ziva Kunda, Motivated Inference: Self-Serving Generation and

Evaluation of Casual Theories , J. P ERSON . & SOC . PSYCHOL . 636-647 (1987)(discussing the theory of motivated inference and presenting four studies suggestingthat people “generate theories that view their own attributes as more predictive ofdesirable outcomes, and they are reluctant to believe in theories relating their ownattributes to undesirable events”).


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III. A SSESSING MANAGEMENT DECISION -MAKING IN DISTRESS : THE MANAGEMENT BEHAVIOR STUDY

We probably did take longer (to file for Chapter 11)than we should have because you never want to have t hat

feeling of failure and you always want to fight it out.85

Anecdotal evidence suggests that business executives hold anegative perception of chapter 11 bankruptcy and delay consideringthat restructuring option, often at the expense of the company and itsstakeholders. 86 Moreover, business bankruptcy commonly isdescribed as “an option of last resort” in the commen tary and

professional advisory materials on the subject matter. 87 Yet, nostudies thoroughly analyze these factors or their impact on corporatevalue or successful restructurings in any meaningful detail. 88 TheManagement Behavior Study fills that void.

As more fully described below, the Management Behavior Studyoffers valuable insight on key components of management’s decision-making process in the distressed context. The data include responsesfrom over 400 restructuring professionals and uncover interestingtrends in client advising and decision-making. Overall, the datasuggest a need for policymakers, business executives, and

professionals to re-evaluate the dialogue and incentive structuresurrounding chapter 11 business cases.

85 Chelsea Emery, CEOs Wait Too Long Before Filing Bankruptcy ,R EUTERS .COM ((Apr. 2, 2009, 4:12AM) (quoting Joseph Vicens, chief operatingofficer of 1800mattress.com), http://www.reuters.com/article/2009/04/02/us-

bankruptcy-psychology-idUSTRE5310AY20090402.86 Robert K. Rasmussen & Randall S. Thomas, Timing Matters: Promoting ForumShopping by Insolvent Corporations , 94 N W. U. L. R EV. 1357, 1396-97 (2000)(noting that in facing bankruptcy, “managers will seek to preserve their control ofthe firm despite the costs to investors, even if they only are abl

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