View from New York: Widespread abuses show Chapter 11 is bankrupt

For the first time in nearly a decade, personal bankruptcy is on the decline in the United States - the result of lower interest rates, more sober borrowing practices or, as one cynic suggested last week, the possibility that after 4 million filings in six years America may simply be running out of 'deadbeats'.

Individual deadbeats, perhaps. For while fewer and fewer citizens are claiming insolvency, in corporate America, bankruptcy - or this country's strange form of it, Chapter 11 - is fast becoming a way of life.

Despite economic recovery in the US, the rush among companies to 'reorganise' continues unabated. Half the nation's airlines have sought court protection from their creditors in the past three years; the fifth-largest, Continental, has just re- emerged from the process for the second time, but may soon be replaced by the fourth-largest carrier, Northwest.

Most of New York's well-known department stores, including Macy's and Bloomingdale's, have been in and out of Chapter 11, as have its largest and loudest landlords, Olympia & York and Donald Trump. This year alone, two of Manhattan's three tabloid newspapers will undergo this unique form of debt surgery.

Chapter 11 was designed to save viable companies from premature liquidation. But in America, bankruptcy is not limited to the insolvent. It has been used to escape a dollars 10bn lawsuit (in the case of Texaco), dodge claims by victims of asbestosis (Johns-Manville Corp), cancel labour agreements (Continental Airlines, the first time), shed pension obligations (LTV Steel), avoid compensating women who bought unsafe birth control devices (AR Robbins) and stiff Hollywood stars (Orion Pictures). This month Rupert Murdoch has invoked it in an attempt to bust trade unions at the New York Post.

Chain reaction

Indeed in some industries, Chapter 11 has become an essential competitive tool. Freed from the cost of repaying debts and leases - and from the more general obligation of operating profitably - managers use Chapter 11 as a sort of shelter from which to launch price wars against higher-cost competitors.

One by one, New York's big retailers have succumbed to bankruptcy, only to re-emerge as leaner and lower-cost merchants, setting up a chain reaction. Among US airlines this same phenomenon has created losses of some dollars 10bn in the past three years alone, spawning a bankruptcy virus that is spreading to even the largest, and once healthiest, carriers.

Once a humiliating process regarded as a last resort, Chapter 11 is just another management strategy: new chief executives at General Motors and IBM are rumoured to have considered filings earlier this year as a way to shake up their troubled organisations.

For those with real debt problems, 'pre-packaged bankruptcies' have become common, a sort of Nevada marriage-and-divorce chapel for companies that allows them to slip in and out of Chapter 11 with the prior agreement of creditors who are anxious to avoid the more typical corporate bankruptcy scenario: a long, drawn-out struggle that dissipates assets while legal bills rise into the hundreds of millions of dollars.

It was not supposed to turn out this way. When Washington reformed its Bankruptcy Code in 1978, it was with the intention of preserving productive assets. In a quintessentially American way, the company would be allowed to wipe the slate clean and 'start over again', in the process minimising losses to lenders, owners, suppliers, employees and customers. Unlike the British system of administration, Chapter 11 leaves responsibility for reorganising the company and its debts with its management, sheltering it from the competing claims of creditors while it devises a plan to pay them off.

Because the stigma of bankruptcy was largely lost, and because managers were empowered to file for court protection before a company became technically insolvent, they soon found a variety of competitive uses for debt relief. At the same time, Chapter 11 has made it extremely difficult to kill off chronically ill or over-leveraged companies while there is still some value left to distribute among their victims.

Clever managers, supported by the best lawyers and advisers, can hold creditors at bay for years, bleeding away billions more in operating losses before courts finally order a liquidation. Far from improving the lot of either creditors or shareholders, Chapter 11 filings typically have quite the opposite effect. One study comparing recovery before and after 1978 suggests that bondholders lose 67 per cent more of the investment under Chapter 11, while equity partners - who typically came away with about half the value of their shares - now usually lose it all.

Open-heart surgery

'Bankruptcy,' as one Chicago creditors' lawyer explained it recently, 'is like open-heart surgery - the longer you stay under the knife, the lower your chances of survival.'

Outrage at the abuse of Chapter 11 has reached a new high on Wall Street, with the release of a study suggesting yet another way in which entrenched managers of such firms benefit at the expense of others. Long before they let other shareholders know that their company is headed for bankruptcy court, insiders tend to dump large amounts of their holdings.

The survey, conducted by the University of Michigan, showed that heavy insider selling typically begins as early as two years before bankruptcy but stops 30 days before the actual filing - apparently to avoid regulatory scrutiny. Over the same two-year period, other shareholders lose an average of 75 per cent of their investment.

'Our results indicate that filing for bankruptcy is a strategic, discretionary management decision,' says Michael Bradley, one of the authors. 'Managers, by selling their shares, do not have their interests aligned with shareholders going into bankruptcy or throughout the process.'

Mr Bradley and others have long advocated radical reforms that would replace Chapter 11 with an auction scheme that would give successive classes of shareholders and creditors that chance to buy out the others, stripping existing management of control.

Other proposals - including several being considered by the US Congress - would place strict limits on how long a corporation could remain under the court's wing. With all four of America's biggest airlines headed for bankruptcy, a presidential task force is to report on solutions to the problem next month.

What will replace the current process is far from certain. But Chapter 11 is clearly bankrupt.