The Examiners: Are Chapter 22s Really So Bad?

When a company files for Chapter 11 protection a second, third or even fourth time, who’s to blame?

Bankruptcy recidivism has a bad name. The best data points to one out of six restructured companies refiling for bankruptcy not long after getting a Chapter 11 plan of reorganization confirmed. If blame needs to be handed out, one could point to the judge who is charged under the Code with independently concluding that the plan is not likely to lead to a further restructuring of the company.  But blaming the judge would be harsh, because the statutory standard of ‘not likely’ doesn’t require a “guarantee,” just a likelihood. The data suggests that most—more than 80%—don’t refile.

One could also blame the creditors who kept too much debt in the plan for the firm because some creditors aren’t set up to take an ownership interest, or because bargaining in bankruptcy makes a deal easier by keeping more of the old debt in place. And tax rules incentivize reorganizing companies to keep more debt than is often operationally best.

Now look at the refiling problem another way. True, maybe a restructuring plan that turns more debt into equity would be better from an operating perspective for some of restructured companies. But if achieving that would require another six months of negotiation, then the less stable, but faster, plan could well be a better option. For many firms, pushing through the bankruptcy process and out the bankruptcy door with a confirmed but less-than-perfect plan is often better than a longer stay in bankruptcy with a more stable plan. There are tradeoffs in lowering the recidivism rate further.

Is a Chapter 22 refiling so costly? Imagine that half of the firms come out of bankruptcy with weak capital structures that put the firms at risk of re-filing. But consider the possibility that two-thirds of those firms then stumble a bit before steadying their operations after the bankruptcy. Because they get through bankruptcy quickly, they grow and prosper. The remaining one-third does not grow. If a zero-tolerance bankruptcy policy would put the good two-thirds at risk in a longer bankruptcy proceeding, maybe zero tolerance isn’t a good idea. And if the one-third that need another restructuring don’t die in bankruptcy but just do the job better the second time, then recidivism costs aren’t much to really complain about.

There is one plausible justification for a zero-tolerance bankruptcy policy. The bankruptcy system has an overall interest in promoting wide acceptance that a firm that exits Chapter 11 is in good shape, to deter customers, vendors, new lenders, and others dealing with recently bankrupt firms from inappropriately shunning them. A Chapter 22 redounds to the detriment of all Chapter 11 filers, the strong as well as the weak. If that reputation for post-bankruptcy viability is important to keep the whole bankruptcy system functional, then one would want to revisit the analytics in the prior paragraphs—that a few Chapter 22s, maybe even at 15% of the total—isn’t so bad.

Of course, that’s an uphill argument to make and the statute seems to have the standard right: “not likely” to be followed by another Chapter 11 or restructuring. It can happen; it just shouldn’t happen usually. And it that’s the way it is—it happens, but it’s not the usual result.

Mark Roe is a professor of law at Harvard Law School in Cambridge, Mass.