The Examiners: Chapter 11 Doesn’t Guarantee Success

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

An empirical study from New York University Professor Edward Altman concludes that 15% to 18% of reorganized Chapter 11 debtors revisit bankruptcy (sometimes more than once). According to the study, some of the main causes of recidivism are too much leverage and flawed Chapter 11 plan feasibility assessments based on overly optimistic projections. The study concludes that, in a significant number of Chapter 11 cases, a plan of reorganization should never have been confirmed because the debtors had little or no prospect of  succeeding after bankruptcy and were, therefore, quite likely to file for bankruptcy again.

Professor Altman’s study highlights the Bankruptcy Code’s plan feasibility test:  a bankruptcy court should not confirm a plan of reorganization unless confirmation is not “likely” to be followed by the liquidation, or the need for further reorganization, of the debtor or any successor. Making a case for feasibility typically involves the development of financial projections by management often with the input of financial advisers. Projections are sometimes flawed as either overly optimistic or even illusory. In some of those cases, those defects are ignored, downplayed or rationalized because the case dynamic and dominant participants for any number of reasons prioritize a quick exit from bankruptcy over the formulation of an effective (and lasting) solution for the debtor’s problems. Moreover, bankruptcy courts may feel pressure to confirm a plan of questionable feasibility in furtherance of deep-rooted policy considerations favoring reorganization and a “fresh start” over liquidation.

The reasons for repeat bankruptcy filings, however, are not limited to cases involving faulty assessments of a Chapter 11 plan’s feasibility. Other causes of recidivism include, as noted by Professor Altman, major economic downturn, industrial change and product obsolescence, as well as political and regulatory changes. In many instances, these causes are unforeseeable and not susceptible to ascribing blame.

It bears noting that the vast majority of Chapter 11 cases (particularly “mega” cases involving companies with assets valued between $100 million to $500 million or more) are successful. In fact, Prof. Altman’s statistics suggest that more than 80% of public companies reorganized in Chapter 11 do not return to bankruptcy, and a high percentage of the recidivists do not return to bankruptcy for more than five years after confirmation.

Even in a perfect world where debtors and other constituents and their respective professionals do “all the right things,” focusing on an effective financial and operational restructuring supported by reasonable and feasible projections, there is no guarantee of success. U.S. bankruptcy law balances competing policy considerations in this context.  On the one hand, bankruptcy courts should not sanction Chapter 11 plans that amount to “visionary schemes” with little or no chance of success. On the other hand, corporate debtors should be given every reasonable opportunity to reorganize to preserve going-concern value and jobs. Some level of recidivism—hopefully lower than that found by Professor Altman to be the case currently—is the price to be paid for balancing these concerns.

Paul Leake is a partner in Jones Day’s New York office and the global practice leader of the firm’s business restructuring and reorganization practice.