University of Rochester Roundtable on Bailout vs. Bankruptcy: The Case of GM

In an event staged at Rochester’s Geva Theatre in the midst of the global financial crisis in 2009, Tom Jackson, one of the world’s two most highly regarded bankruptcy scholars (the other is Doug Baird) as well as a former President of the University of Rochester, begins by explaining why the U.S. Chapter 11 reorganization process is well suited to resolving the problem of excess capacity that has long plagued the U.S. auto industry. As Jackson has noted elsewhere, thanks to both academic research and the efforts of legal and corporate practitioners to implement the findings of this research,

The current Chapter 11 process is a dramatic improvement over the world of 1985. In those days, our system put the bankruptcy judges—people who generally do not have a great deal of financial sophistication—in the impossible position of deciding among the conflicting claims of parties whose incentives were to provide biased information. The great thing about the auction process that is now routinely used by the ABI—and which wasn’t being used anywhere in the bankruptcy process 20 years ago—is that we’re likely to get more reliable information from people who are putting up their own money…[and so] backing their projections of future performance and value with cash. This has the great benefit of taking the judges out of a role for which they have neither the proper training or experience—or the right incentives… [As a result of recent reforms,] what we have today is a much more streamlined process. Sale mechanisms are more likely to be used, exclusivity periods are less likely to be extended, and it has begun to look a lot like the auction or M&A model that some of us proposed years ago.

This relatively new reliance on an M&A-type auction process is reassuring because, as Cliff Smith points out,

One of the biggest challenges in bankruptcy is determining the value of the firm, or the size of the pie that can end up being divided among the creditors. And this means that before you start divvying up the firm’s assets, it’s critically important to get reliable answers to questions like: How valuable is this business under the current management? And how valuable could it be if we allowed the ownership to change? Judges don’t have a comparative advantage in answering these questions because they simply don’t have the specific knowledge to make this kind of determination. Using the auction system in a market setting is likely to generate much more reliable answers.

Besides preserving value for creditors, a better informed and more efficient reorganization process can also have the critically important effect of removing excess capacity in industries that are weighed down by it. And as Smith goes on to say,

Financially troubled companies that will not be viable under any management team and are therefore worth more dead than alive are clearly candidates for Chapter 7, and the job of the bankruptcy courts is to get them there as expeditiously as possible. Liquidate the business and free those assets to move to higher-valued uses… Take the case of the airline industry. Although keeping extra carriers in business through prolonged stays in Chapter 11 may help keep airfares down, these artificially low fares are also likely to discourage even profitable competitors from investing in the future. And this ends up working against the long-run interest of the industry and the general public.

In sum, bankruptcy has at least two potentially important roles to play in a well-functioning economy. First is distinguishing companies that should survive and remain intact from those that should be pulled apart. In cases of chronic overcapacity in which companies are clearly worth more dead than alive, the firm’s assets should be sold, either piecemeal or in their entirety, to the highest bidders. But for all economically viable businesses, there are two general outcomes: In cases where a competent management team is the victim of external circumstance—and perhaps the wrong capital structure—the likely outcome is an LBO-type transaction in which outsiders provide new funding for the current team. But in those cases where the current management is viewed as part of the problem, the system is designed to shift control to new owners and management—and as quickly as possible. Such a process can be expected to contribute to long-run economic growth by helping ensure that industries end up with the right amount of capacity, neither too much nor too little.