Bankruptcy: Beyond Failure : Big Business Sees Chapter 11 Shield as a Potent Tool

Harvey Miller is one of the nation’s best-known bankruptcy attorneys. Perhaps too well-known.

Traveling to Texas in 1982 to consult with an energy firm contemplating bankruptcy, Miller was told he had to check into a local hotel under an assumed name.

“The client didn’t want to meet with him publicly in Houston or Dallas,” recalls John H. Laeri, who as investment banking adviser to the company had invited Miller down to discuss the wisdom of its declaring bankruptcy. “He checked in as ‘Harvey Hunt.’ ”

How things have changed in the past five years. “In 1982, it was hard for me even to find people to have dinner with in Houston,” says Laeri, chief of First Boston Corp.’s investment banking unit specializing in aiding distressed and bankrupt clients. “Today,” he says, “we can be seen with almost anybody publicly.”

If not exactly a badge of honor, corporate bankruptcy today has lost a quality once considered its hallmark: the stigma of failure.

For today, not only desperately ill companies are declaring bankruptcy. In 1978, Congress revised the U.S. Bankruptcy Code to make Chapter 11, in which businesses get a suspension of their obligations to creditors while they reorganize their business and debts, a much more flexible and potent tool of corporate planning. Since then, the size and number of corporations taking refuge in its provisions have grown sharply. More notably, the reasons for which companies declare bankruptcy have broadened.

Companies have used Chapter 11 to block court judgments, as did Texaco earlier this year when it was faced with the prospect that a rival oil company would execute a $10.5-billion jury award. They have used the bankruptcy court to overturn labor contracts and terminate pension plans, to fight personal-injury lawsuits and to extricate themselves from responsibility for cleaning up hazardous waste dumps.

Among bankruptcy professionals, these maneuvers are not considered abuses of the Chapter 11 rules because the drafters of the 1978 bankruptcy reform act meant to make bankruptcy more available to companies facing a wide range of problems and not strictly economic ones. But bankruptcy’s greater flexibility has had unanticipated effects on American business.

Chapter 11 is now often used as an offensive weapon by corporate managements against creditors, for a company’s threat to declare bankruptcy is often enough to persuade lenders to renegotiate terms.

Moreover, bankruptcy law now exerts a strong influence on regulatory law, personal-injury cases and other concerns of the federal and state courts because the bankruptcy court’s goal of helping a debtor survive renders most other legal issues secondary.

The new law has given birth to a large number of profitable bankruptcy-related businesses. Many securities traders now specialize in stocks and bonds of companies in Chapter 11, for a declaration of bankruptcy is no longer a signal that a corporation is doomed.

Investment bankers and lawyers specializing in bankruptcy have also proliferated, attracted by huge fees that are by law payable by the debtor with a bankruptcy judge’s approval.

Takeover Candidates

Many businesses and investment funds also specialize in taking over companies in Chapter 11, for once a company declares bankruptcy its management and board cede to a judge the right to approve or reject merger bids. The superior financial condition of many companies in Chapter 11 now, in contrast with pre-1978 days, makes them more attractive targets for such takeovers.

Meanwhile, the greater complexity and expense of Chapter 11 means that it may increasingly become a step available only to the corporate elite, for smaller companies facing genuine economic threats often cannot afford it. “There are lots of little companies I’ve looked at where it just doesn’t pay,” remarks Donald Schupak, an executive who specializes in running distressed companies.

But the roster of big companies that have used Chapter 11 to try to solve their problems is growing.

When Texaco declared bankruptcy in April, its assets were roughly triple its liabilities. But the company faced the threat that Pennzoil, a rival, might begin seizing its assets to secure the $10.5-billion court judgment it had won from Texaco. Manville, the asbestos maker once known as Johns-Manville, declared bankruptcy in 1982 to staunch the flow of personal-liability lawsuits filed by victims of asbestos disease.

Continental Airlines declared bankruptcy in 1983 to overturn what it contended were fiscally ruinous labor contracts. Wheeling-Pittsburgh, a failing steelmaker, filed to escape the burden of paying tens of millions of dollars in contributions it owed to its own employees’ pension funds.

Bankruptcy has become a popular tool for confounding the collection of legal judgments: In 1986, Smith International, an Irvine-based oil-field service firm, filed under Chapter 11 to block Hughes Tool from collecting a $205-million patent-infringement judgment.

The maneuver was successful in giving Smith the breathing space to settle the case; earlier this year, Smith agreed to pay Hughes $95 million to end the litigation and clear the way for its emergence from bankruptcy protection.

In 1982, the Alton Telegraph, a small Illinois daily newspaper, obtained Chapter 11 protection from a $9.2-million libel judgment rendered virtually unappealable because the small paper could not afford a $10-million appeals bond. (The libel suit was later settled for a much smaller sum, and the paper emerged from bankruptcy, ultimately to be sold to a chain.)

The drafters of the new law fully intended it to be used by big, complex corporations and to encompass the full range of problems that a distressed corporation might face.

“I don’t know that anyone had the foresight to anticipate toxic-tort bankruptcies (like Manville’s),” says Kenneth L. Klee, a Los Angeles lawyer and one of the drafters of the 1978 law. “But it was specifically designed to deal with large questions.”

The 1978 reform altered Chapter 11 with several key provisions. Perhaps the most important was elimination of the so-called insolvency test. Under the 1978 act, a corporation no longer had to have more liabilities than assets to declare bankruptcy. A company did not even have to be losing money before entering Chapter 11.

“The notion behind eliminating the insolvency test was that you ought to be able to file for protection when you still had something left to reorganize,” says Robert Rosenberg, a New York lawyer who counseled the creditor committees of Manville during the first years of its bankruptcy.

Extended Court’s Reach

The change simply redefined the nature of corporate distress, moving away from an accountant’s definition based on a company’s excess of liabilities over assets, to one that recognized the destructive effect of pending or theoretical liabilities.

The lawmakers also gave the debtor an “automatic stay” of all pending civil actions against it. By suspending potentially costly lawsuits, this gave debtors an extremely potent tool with which to diffuse the pressure that legal antagonists can often bring to bear.

But that also sharply extended the reach of the bankruptcy court beyond its traditional jurisdiction over the claims of a corporation’s bondholders, shareholders, customers and suppliers. Now the claims of a company’s retirees or the victims of its negligently manufactured products can come before a bankruptcy judge.

That means that not even a claim awarded against a business by a jury, a state or federal judge, or a regulatory agency is indisputably collectible. For it is subject not only to the rights embodied in contract, retirement or some other law, but also to the question of how the claim will affect the likelihood of a debtor’s reorganization.

The drafters also decided to subject even secured claims--those held by bondholders or by lenders with a right to collateral--to renegotiation under Chapter 11. In the past, secured claims had been sacrosanct; therefore, secured creditors were in a position to block any reorganization plan and force an ailing company to liquidate.

The goal of all the changes was to balance the power of debtor and creditors in Chapter 11 to encourage both sides to negotiate, a process that was thought to bear greater potential for a company’s reorganization.

“The beauty of the new system was that it put both sides at risk,” explains Klee. Creditors knew that if a debtor entered Chapter 11, all claims, secured or otherwise, were subject to modification. Debtors know that under Chapter 11, all their creditors would have some say in how their business would henceforth be run.

The new Chapter 11 was designed to recognize what its drafters saw as the public benefits of keeping even mortally ailing corporations in operation.

The drafters of the reform assumed that the historic stigma of bankruptcy would continue to discourage borderline bankruptcy cases. No one anticipated the creativity of lawyers and managers in finding new applications for the automatic stay or for Chapter 11’s other new benefits.

These quickly became apparent, especially in the severe economic downturn that struck the United States in 1979-80, just as the new rules went into effect. Chapter 11 petitions have nearly tripled since the code was revised in 1978, to 21,370 petitions filed last year from 7,230 in fiscal 1980-81 (the first year in which all petitions were subject to the new code.)

As corporate lawyers were attracted for the first time to bankruptcy practice, they promoted Chapter 11 to clients as an option that a distressed corporation could ignore at its own peril. The big law firms threw all their resources into the big cases, a process that in itself brought new issues before the bankruptcy court.

“The lodestar was the (legal) fees, which grew huge with huge filings,” says Jack Gross of Stroock & Stroock & Lavan, who has been a New York bankruptcy attorney for more than 50 years. “As you got normally esoteric problems in Chapter 11 filings, the bankruptcy practitioner was obligated to surround himself with people knowledgeable in other fields. Here at this firm, we have real estate, securities and corporate disciplines, all of which can get involved in a case.”

Litigator’s Paradise

The new law also engendered a deeper and more costly change in the practice of corporate bankruptcy. As Leon Marcus, a labor attorney involved in many contentious bankruptcies, puts it: “The 1978 act created a litigator’s paradise in bankruptcy court.”

For one thing, the appearance of large, asset-rich companies in Chapter 11 gave creditors much more to fight over, compared to the days when a company declaring bankruptcy generally had scarcely any assets to parcel out. Furthermore, the new law gave bankruptcy judges the authority to rule on almost any legal issue with even indirect bearing on a company’s efforts to reorganize its finances.

The increasing expense of the legal jousting means that Chapter 11, which accommodates debtors with the best prospects for reorganization and the most assets to be restructured, may also become an arena for only big corporations that can afford to survive years of multimillion-dollar legal and investment banking bills.

The presence of so many lawyers in Chapter 11 cases means that even the most trivial questions can be exhaustively contested.

“There was no issue insignificant enough that forests weren’t destroyed to make the point on paper,” remarks Elihu Inselbuch, a New York corporate litigator, of his experience as counsel to the asbestos claimants committee in the Manville bankruptcy. “There seemed to be no constraints on what issues could be tested” under the bankruptcy law.

Chapter 11’s new provisions also put a premium on tactical maneuvering, particularly on the timely exercise of the automatic stay.

The stay, for example, may have saved the life of Mesta Machine, a Pittsburgh manufacturer of steel mill equipment that was crippled by the intractable slump among its customers in the domestic steel industry. Mesta’s banks, including Mellon Bank, the largest in Pittsburgh, had acquired immense influence over the company in 1982, when Mesta’s directors had resisted declaring bankruptcy as a response to its deteriorating financial condition.

Banks Had Control

“The thought was so intolerable to them that they coughed up every single asset the company owned as security to the lenders,” says Putnam B. McDowell, who took over as chairman of Mesta in 1982 and later presided over its emergence from Chapter 11 as Mestek. “The banks had an absolute straitjacket on the company and could dictate its every move.”

That was not enough, and having grown weary of endless dickering over plans to reorganize Mesta’s debt, the banks moved in February, 1983, to seize their security.

“With no warning, in the middle of a routine progress meeting, they pulled the cord,” McDowell recalls. The banks seized all of Mesta’s bank accounts, including even those for employee tax withholding. “They arrived at the door of every plant we had in the United States, demanding the keys,” he said.

The next morning, however, Mesta received an unexpected $1-million royalty payment, virtually its only unpledged asset in hand. It was enough to pay the immediate costs of filing a Chapter 11 petition that afternoon and avert a forced liquidation of the company. Knowing that the automatic stay covered foreclosure actions, McDowell was able to order the company’s plant managers to turn away the bank agents.

“You could make a strong argument we were better off in bankruptcy than out,” McDowell says, adding that Mesta’s having deferred entering Chapter 11 had been an almost fatal error. “In hindsight, I saw that Chapter 11 is an offensive weapon to be used if you’re getting pushed around by your creditors.”

In the first years after enactment of the reform code, companies throughout the country tested Chapter 11’s capabilities as an offensive weapon. Among the first targets were labor unions, especially at companies where negotiations over union concessions had proven fruitless.

One of the most celebrated such cases involved Continental Airlines. Continental’s attempt to extinguish its contracts with machinists and pilots led to a yearlong court battle over whether the airline had declared bankruptcy solely to break its unions--in which case the bankruptcy filing could be thrown out on grounds of bad faith--or because the contracts were genuinely instrumental in causing the airline’s heavy losses.

The unions had argued that Continental had overstated the seriousness of its condition in order to justify a bankruptcy declaration, and therefore it must have had ulterior motives.

An appeals court finally ruled that Continental qualified thoroughly as a bankrupt. Had it not declared bankruptcy when it did, the court said, “it would not have been flying for very much longer, its 6,000 remaining employees would now be out of a job or working elsewhere and its ability to reorganize would have been further impaired.”

Although Continental won that case and its emergence as a low-cost, competitive carrier has propelled its parent company, Texas Air, into its position as the nation’s largest airline, the long fight demonstrated the disadvantages of attacking unions through bankruptcy.

The case showed that under such circumstances the unions retain--and in Continental’s case, exercised--the right to strike. Union complaints, furthermore, inspired a Federal Aviation Administration investigation of the airline’s safety practices.

Since then, other companies have discovered that aiming bankruptcy’s gun at union contracts is often more trouble than it is worth. Wheeling-Pittsburgh, a hobbled steelmaker, suffered a devastating 98-day strike after it moved to terminate its labor contracts following its declaration of bankruptcy in 1985. No major company in bankruptcy has moved against its unions since.

Can Increase Profit

Still, Chapter 11 has effectively allowed companies to sharply pare their fixed costs. By suspending a debtor’s obligations to lenders, suppliers and other creditors, Chapter 11 can also give profit a jolt. This has had a great effect in the steel industry, where domestic manufacturers have been hamstrung by billions of dollars in contractual obligations to lenders and bondholders and pension obligations to present or retired workers.

In this way, LTV Corp., one of the domestic industry’s weakest manufacturers, has temporarily transformed itself into one of the steel business’s best performers. LTV was able to so sharply cut its costs after declaring bankruptcy in July, 1986, that it rang up a profit of $101.1 million in the first three months of this year, compared to a loss of $60.1 million in the same period a year earlier.

Contributing to the change was LTV’s ability under bankruptcy to cancel its pension payouts to retirees; that saved $355 million on an annual basis. (The benefits were covered by the federal Pension Benefit Guaranty Corp., which insured the pension funds.) LTV was also permitted by the bankruptcy court to cancel several old contracts requiring it to buy raw materials at historically high prices.

Finally, because interest payments on bonds and bank loans are suspended during Chapter 11, LTV kept more than $70 million it would otherwise have had to pay out. Investing that accumulated cash made the company $8.4 million in interest, more than it had in the first quarter of 1986--more than offsetting the $4 million it paid to the regiments of lawyers and investment advisers hired specifically to see it through bankruptcy.

Yet Chapter 11 is no garden party. With bankruptcy specialists, creditors and the court scrutinizing every major corporate transaction and many trivial ones, companies in Chapter 11 inevitably find that day-to-day life is unpredictable and trying. Executives are subject to dismissal; crucial corporate expenditures can be overruled by sometimes dilatory, distracted or inattentive judges.

Often Second-Guessed

“I never knew a company that wanted to be in Chapter 11 or a client who was correct in his assessment of the consequences,” Laeri says.

Mestek’s McDowell found his every decision being second-guessed by hostile attorneys. “What I found most difficult and distasteful was not the law or the court,” he says, “but the way creditors and their lawyers treat management. Overnight, the assumption is that you’re a crook or stupid or venal.”

The increasing sophistication of corporations entering Chapter 11, as well as their creditors, has imposed an immense strain on the system itself. Because bankruptcy judges’ pay, benefits and prestige are so low compared to other federal judges, the bench tends to attract attorneys who are often young and inexperienced in the law, much less in the intricacies of operating a big business.

Additionally, the explosion in cases throughout the bankruptcy system has left many judges hopelessly backlogged.

“Our judge told us a year ago that if he devoted equal time to each of the cases he had on his docket then, each one would get 15 minutes a year,” says Jerry C. Martin, chief financial officer of Global Marine, an oil-field service company that entered Chapter 11 in early 1986, after the collapse of oil prices put an end to its attempts to restructure its burdensome debt.

Any single large case can tie up much of a single judge’s time for years as the judge attempts to structure negotiations and mediate disputes.

The enduring model for complex Chapter 11 cases is Manville, whose five-year sojourn under the protection of the court has been marked by dissension between creditor groups, as well as within committees of ostensibly allied creditors.

In the process, almost every major management decision, and some minor ones, has been the subject of dispute among the interested parties and come before Bankruptcy Judge Burton Lifland for his consideration.

Inselbuch, the asbestos committee’s counsel, found when he joined the case that the bitterness and suspicion with which traditional creditors viewed one another in conventional Chapter 11 cases was exacerbated by the presence of a category of unique creditors: the asbestos-disease victims.

This group eventually grew to include a group of claimants who had never before been granted standing in a bankruptcy case--”future” victims, those whose asbestos-caused symptoms, traditionally latent for decades, have not yet manifested themselves. Their inclusion itself generated litigation, including appeals by other claimants that appear destined to reach the Supreme Court sometime next year.

Yet finally, under pressure from Judge Lifland, the creditors worked out a radical solution to the quandary of how to accommodate millions of dollars in potential injury claims against Manville: the establishment of a trust fund, secured by most of the corporation’s stock, that would pay future injury claims out of Manville’s profit. In effect, the victims of asbestos disease, now and in the future, would own Manville.

It was a solution that could have been reached only in bankruptcy court, the only arena in which the competing claims of bondholders, shareholders, banks, customers and victims could be balanced and adjusted.

“People ask me if it isn’t a bad precedent” to allow a company to seek refuge in bankruptcy law from such serious claims, Inselbuch says. “I tell them it’s a good precedent because you couldn’t settle the issues of asbestos injury in court with one damage case here or there around the country.”

Because settling complex disputes involving asset-rich companies often involves finding innovative ways to redistribute those assets, most major Chapter 11 cases now count investment bankers among their most important participants.

Because the investment bankers’ fees are paid out of the bankruptcy estate, that has added considerably to the expense of operating under Chapter 11.

“Our fees aren’t cheap,” says Laeri, whose unit at First Boston is the busiest and best-known group of reorganization specialists on Wall Street. First Boston charges between $100,000 and $200,000 a month for its advice, plus as much as a $2.5-million “success fee” for participating in a successful reorganization.

Yet investment bankers are now considered almost indispensable in devising the securities that often comprise the payouts to creditors in big cases.

“Today, when a major case is filed, as important as the retention of a lawyer is the retention of an investment banker--so that he’s not retained by the other side,” says Gary Blum, a New York bankruptcy lawyer.

In Manville, the investment bankers performed the additional role of evaluating the company’s management for the creditors. “One thing they told us is that Manville was doing very poorly as a company in the industry,” Inselbuch says. “They were at the bottom of every measure that First Boston could give them. That reinforced our feeling that we could risk putting pressure on them; the report card, plus the management’s attitude, led us to the point where we didn’t have confidence in them.”

In the end, Manville’s reorganization was accompanied by the departure of the old management, including Chairman John McKinney, whose obduracy toward the asbestos victims’ lawyers had interfered with negotiations for many years.