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Web posted and Copyright © September 1, 2004, American Bankruptcy Institute.

This month's Update contains excerpts from the testimony of Prof. Lynn LoPucki (UCLA Law School) before the House Judiciary Committee on July 21, 2004. Prof. LoPucki testified about his research on the effect of so many large public companies' decisions to file for bankruptcy in either the District of Delaware or the Southern District of New York. Prof. LoPucki's research and controversial findings are in part funded by a grant from the ABI Endowment Fund.

he bankruptcy courts of the United States have inadvertently been thrown into competition for big bankruptcy cases. That competition is changing bankruptcy law and practice in ways not contemplated by Congress and corrupting those courts.

By "corrupting," I mean that a substantial number of bankruptcy judges are deciding particular matters not as they believe they should, but as they believe they must, to maintain the flow of cases to their courts. I can identify no particular decision as corrupt, but I can show a pattern of decisions by the bankruptcy courts for which corruption by the pressures of court competition is the most reasonable explanation. I can also show that the competition is having an adverse effect on reorganizing companies. Specifically, companies that reorganized in the courts most successful in attracting cases were two to 10 times more likely to fail after bankruptcy than were comparable companies reorganized in other courts.

Why Bankruptcy Courts Compete for Big Cases

Bankruptcy judges want large cases for at least three reasons:

1. For the judge, a large bankruptcy case is a career opportunity. The judge will be able to work with the nation's leading bankruptcy professionals, and the proceedings will be followed by the media and the bankruptcy community as a whole. Judges who attract numerous large cases are likely to become celebrities.

2. The cases are of economic importance to the judges' communities. The court-awarded professional fees in a single, large bankruptcy case are almost invariably in the millions of dollars, and may be as high as a billion dollars. In most large cases, most fees paid will go to local professionals. Thus, attracting the case of a large company to the bankruptcy court in a city brings substantial revenues to the bankruptcy professionals in that city. Attracting all of the big bankruptcies in the United States to a single court—as the Delaware Bankruptcy Court nearly succeeded in doing in 1996—could bring billions of dollars to a local economy annually.

3. The loss of cases to other courts humiliates the bankruptcy judges, lowers their standing in their communities and may even cost them their jobs. Most—but not all—large, bankrupt companies are linked in the minds of the public to the city in which they have long maintained a national headquarters. Examples are Enron with Houston and Polaroid with Cambridge, Mass. The bankruptcy court at that location is a sort of "natural venue" where the company is expected to file. The company that files in Delaware or New York is seen as rejecting the local court. That rejection often leads to criticism of particular bankruptcy judges for failure to take what action was necessary to retain "their" cases. To illustrate the scope of the problem, of the 24 companies headquartered in the Boston area that filed for bankruptcy since 1980, only four (17 percent) filed in the Boston Bankruptcy Court. For Alexandria, Va., the number is two of 13 (15 percent). Some cites, including Philadelphia, West Palm Beach, Fla., and Ft. Lauderdale, Fla., have lost all of their cases.

In some cases, the criticisms appear warranted. One or more of the local judges may have poor skills or temperament. In other cases, the criticisms are unwarranted. The judge is simply following laws and rules the court-selecting lawyers and executives prefer to avoid.

Bankruptcy judges are not Article III judges and do not enjoy life tenure. They serve 14-year terms and must apply for reappointment to continue in office. A recent study by Bankruptcy Judge Stan Bernstein of the Eastern District of New York found that more than 8 percent of the bankruptcy judges who applied for reappointment during the period from 1998 to 2002 were not reappointed. Bernstein, Stan, The Reappointment of Bankruptcy Judges: A Preliminary Analysis of the Present Process (unpublished manuscript, Oct. 15, 2003). Other bankruptcy judges won reappointment, but only after their competence had been challenged and they had been, in Judge Bernstein's words, "put through the wringer." Because the appeals courts usually seek the opinions of local bankruptcy lawyers as part of the reappointment process, bankruptcy judges are probably more sensitive than Article III judges as to how they are viewed in their communities.

Historical Roots of the Problem

In 1974 and 1975, the Bankruptcy Rules Committee liberalized the venue rules for cases under chapters X and XI of the Bankruptcy Code. The new rules gave corporations the option to file their bankruptcy cases at (1) the corporation's domicile or residence (later interpreted to mean its state of incorporation), (2) the corporation's principal place of business (essentially, its headquarters), (3) the corporation's principal assets in the United States or (4) the location at which the case of an affiliated corporation was already pending. Committee members believed that if their liberal venue rules were abused, the bankruptcy courts would exercise their broad power to transfer cases to the most appropriate venues. 28 U.S.C. §1412.

In the context of a large, public company that operates through subsidiaries in all parts of the United States, the effect of these liberal venue rules has been to allow the company to file in the bankruptcy court of its choice. The Enron case serves as an illustration. Enron Corp. was incorporated in Oregon. Enron's headquarters, and the bulk of its 25,000 employees, were in Houston. Enron chose to file its bankruptcy in the New York Bankruptcy Court. (References to the New York Bankruptcy Court are to the Manhattan Division of the U.S. Bankruptcy Court for the Southern District of New York.) To accomplish that, Enron directed its New York subsidiary, a corporation with 157 employees, to file a bankruptcy petition with the New York Bankruptcy Court. A few minutes later, Enron filed in New York on the basis that the New York court was a court "in which there [was] pending a case...concerning [Enron's] affiliate." Numerous creditors joined in a motion to transfer Enron's cases to Houston. The New York bankruptcy judge denied the motion.

Through the 1980s, the rate of forum shopping (defined as filing away from the company's headquarters) in large public company bankruptcies rose from about 20 percent to 40 percent. Most of the shopping was to New York. During that decade, the Delaware Bankruptcy Court had the case of only one large, public company. That company, Phoenix Steel, had both its headquarters and its operations in Delaware. The one-judge Delaware Bankruptcy Court began attracting cases in 1990. Delaware attracted four big cases in 1991 and six in 1992. In 1992, Congress awarded the Delaware court a second bankruptcy judgeship. The Delaware court's market share rose steadily until 1996, when 87 percent of the large, public companies filing for bankruptcy in the United States (13 of 15) chose the Delaware court.

In 1996, the National Bankruptcy Review Commission adopted a recommendation designed to end the rampant bankruptcy forum shopping. That recommendation was to delete the provisions of the venue statute that authorized filing at the debtor's place of incorporation or where the case of an affiliate was pending.

In 1997, a study requested by the Judicial Conference of the United States and conducted by the Federal Judicial Center revealed that Delaware's chief bankruptcy judge routinely had ex parte contacts (for scheduling purposes) with representatives of large, public companies that intended to file in Delaware, and in the course of those contacts, identified the judge that would be assigned to the case once it was filed. Seventeen days after the release of the Federal Judicial Center's report, the Delaware District Court took the unprecedented step of revoking the reference to the bankruptcy court of all newly filed chapter 11 cases. Although the district court asserted that its action was taken merely to assist the bankruptcy court with its heavy docket, the action was widely interpreted as a rebuke to the bankruptcy court. Large, public-company bankruptcy filings in Delaware declined in 1997, but resumed their rise in 1998.

By 1998, it was apparent that Congress would not act on the recommendation of the National Bankruptcy Review Commission. Over a period of two or three years, bankruptcy lawyers in at least a dozen cities, including New York, Chicago, Houston, Dallas, Los Angeles and Miami, approached their local bankruptcy judges to request that the judges make their courts more competitive with Delaware by liberalizing their awards of professional fees and mimicking other Delaware practices. Beginning in 1999 and 2000, nearly all of the courts responded by making changes in local rules and practices, including those regarding the award of professionals' fees.

By 2000, an unprecedented rise in the number of big case bankruptcy filings nationally had overwhelmed the resources of the Delaware Bankruptcy Court. The Delaware court had been awarded its second bankruptcy judge on the basis of six big cases in 1992. In 2000, the Delaware court attracted 45 big cases. The effect of the overload was to make Delaware a less-attractive venue. Most of the overflow went to New York. Since 2000, the Delaware Bankruptcy Court has captured 34 percent of all large, public-company filings in the United States, and the New York Bankruptcy Court has captured 20 percent.

Adverse Effect on Reorganizing Companies

Evidence suggests that the court competition has resulted in the destruction of many large, public companies that otherwise could have been saved. In a study of all 98 large, public companies filing for bankruptcy and emerging as public companies from 1991 through 1996, Joseph Doherty and I found that 42 percent of Delaware-reorganized companies filed a second bankruptcy case within five years of the confirmation of their plans, as compared with 19 percent of New York-reorganized companies, and only 4 percent of companies reorganized in other courts.1 Roughly twice as high a proportion of the Delaware and New York-reorganizing companies (25 percent) went out of business while in financial distress during that five-year period.


These changes were not preceded by congressional action, appellate decisions or even policy discussions. They evolved because the case placers wanted the changes, and the bankruptcy courts stretched or broke the law to accommodate them.

The high failure rates for Delaware and New York-reorganized companies cannot be explained by any salient differences in the companies choosing to reorganize in those courts. On a variety of measures, the Delaware and New York-reorganizing companies were not in worse financial difficulty than those reorganizing in other courts. The Delaware and New York-reorganizing companies were somewhat larger than the other court-reorganizing companies, but the larger companies in our study did not fail more frequently than the smaller ones. We found no significant differences by industry among the two sets of cases.

We found several indicators that the reorganization process was less effective in Delaware and New York. Although the firms filing in Delaware and New York had pre-bankruptcy earnings no lower than those of the firms filing in other courts, the firms filing in Delaware and New York had sharply lower earnings than the firms filing in other courts during the five years after they emerged from bankruptcy. Average post-bankruptcy earnings for firms emerging from Delaware reorganization were -9 percent. The corresponding average for firms emerging from New York reorganization was -3 percent. For firms emerging from other court reorganizations, the corresponding average was 1 percent. Delaware and New York reorganizations were significantly quicker than reorganizations in other courts, and quicker reorganizations were generally more likely to fail. Even though the Delaware and New York-reorganizing companies were larger than the other court-reorganizing companies, the plans in Delaware and New York reorganizations divided the creditors into fewer classes, suggesting possible superficiality in the reorganization process.

Adverse Effect on Court Processes

In addition to its obvious adverse effect on the integrity of the bankruptcy courts, the competition for big cases is also having an adverse effect on court processes. The choice of a bankruptcy court is made by the top executives of a debtor corporation. Those executives usually have little experience with bankruptcy courts and so are heavily dependent on information and advice furnished by the bankruptcy attorneys retained to represent the corporation. In some cases, financial institutions that will make post-petition loans to the debtor corporation may also play a role in selecting the bankruptcy court. Generally speaking, however, pre-petition creditors are excluded from the court-selection process.

It follows that courts wishing to attract cases must appeal to the debtor's executives, attorneys and post-petition lenders. (I refer to them collectively as the "case placers.") To make this appeal, the judges are under pressure to favor case placers on a number of key issues in the court's cases generally. The court must establish a reputation for generosity with professional fees and tolerance for the professionals' conflicts of interest. The court must approve the compensation proposed for the top executives, even when that compensation includes huge "retention" loans and bonuses for the same executives that caused the company's failure. The court cannot appoint a trustee to replace corrupt management, even in such extreme cases as Enron, WorldCom, Global Crossing and Adelphia. The court must be willing to approve provisions in the reorganization plan that release the case placers from liability for the case placers' own wrongdoing. A judicial panel that did not yield to these pressures would not be attractive to case placers and would not get future filings.

Over the past 15 years, the pressures of competition have resulted in major changes in the operation of the bankruptcy system. These changes were not preceded by congressional action, appellate decisions or even policy discussions. They evolved because the case placers wanted the changes, and the bankruptcy courts stretched or broke the law to accommodate them. These are three examples of such systematic changes:

1. Thirty-day pre-packaged cases. Pre-packaged cases are specifically authorized in the Bankruptcy Code. A debtor "pre-packages" its case by distributing a plan and disclosure statement to creditors prior to filing the bankruptcy case, and obtaining a sufficient number of votes in favor of the plan to meet the requirements of the Bankruptcy Code. Only then does the debtor file a bankruptcy case and submit the plan, disclosure statement, and ballots to the court for approval. The court can confirm a pre-packaged plan only if the court first determines that the disclosure statement provided information adequate for informed voting, the plan complies with the provisions of the Bankruptcy Code and the vote is sufficient for approval. To assist the court in that process, the Code requires that the U.S. Trustee appoint a creditors' committee and convene a meeting of creditors after the filing of the case.

Under the pressures of competition, some bankruptcy courts have dispensed with these two requirements—even though they have no legal authority to do so—and rubber-stamp whatever pre-packaged cases are submitted to them. The creditors in these cases receive no official representation, even though there may be an unofficial committee purporting to represent their interests. By so doing, those courts make it possible for a debtor to obtain confirmation of its pre-packaged plan in slightly over 30 days from the date of filing. Some of these courts have adopted local rules or guidelines directing that confirmation hearings be set 30 days after filing (Los Angeles). One court has adopted a local rule authorizing the cancelling of the meeting of creditors required by Congress in the event it cannot be completed by the confirmation hearing (New York).

Before confirming a reorganization plan, the court is required to determine that "confirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor...." 11 U.S.C. §1129(a)(11). In our study, Doherty and I found that confirmation of a pre-packaged plan by the Delaware Bankruptcy Court was followed by a distress liquidation or further financial reorganization in nine of 14 cases (54 percent).

2. "Critical vendor" orders. The Bankruptcy Code prohibits the preferential payment of some creditors over others when both have the same legal rights. The opinions of the appellate courts are pretty much uniformly in accord. But in the mid-1990s, under the pressures of competition, some bankruptcy courts began approving preferential payments to so-called "critical vendors"—suppliers whose cooperation was needed for reorganization and who would not provide it unless the debtor paid its pre-petition debt to the supplier in full. In their early years, critical vendor orders were rare and covered only small numbers of creditors. But by 2002, critical vendor orders were being approved in most large public company cases. In some, the orders authorized preferential distributions of hundreds of millions of dollars to hundreds or even thousands of creditors. In the Kmart case, for example, the Chicago Bankruptcy Court permitted the distribution of $200 million to $300 million in preferential payments to 2,300 supposedly "critical vendors" selected by the debtor. The bankruptcy court's order was reversed on appeal, but the damage was in large part irreversible because the money had already been distributed.

3. Section 363 sales. The Bankruptcy Code specifically authorizes the use of chapter 11 to sell a company. The appeals courts held that debtors may do so pursuant to a reorganization plan after adequate disclosure to creditors and a vote or, if the debtor has "sound business reasons" for doing so, under §363 of the Bankruptcy Code without a plan, adequate disclosure or a vote. Until the courts began competing for cases in the 1990s, §363 sales of entire companies were rare.

In the 1990s, such sales became common. The competing courts so frequently and easily waived the requirement of "sound business reasons" that debtors began arranging sales and announcing those sales prior to even filing the debtors' bankruptcy cases. Since 1997, the Delaware Bankruptcy Court has given final approval to sales of seven large public companies, each in less than 50 days of the filing of the company's case. Once the bankruptcy court has finally approved a §363 sale, the sale is final. Section 363(m) of the Bankruptcy Code prohibits the reversal of that approval on appeal.

Section 363 sales of large public companies now routinely occur without adequate disclosure to creditors or the opportunity for creditors to vote on a plan.

The §363 sale procedure is fraught with potential for abuse. The case placers often have interests in the sales that conflict with those of the creditors, employees, suppliers and taxing authorities of the debtor. The top managers may be purchasers or they may expect to be employed by the buyer. Some of the managers receive large stock bonuses from the buyer after the sale is complete. Investment bankers retained as financial advisors often recommend sales that will result in large fees to themselves; they may steer the debtor to a court that will approve the sale without question. Discovery of such abuses is difficult because the sales occur quickly, in near secrecy, and there is no legal avenue for review.

Solutions

In addition to the serious adverse effects described in the preceding section, the competition for big bankruptcy cases has also had some positive effects on the bankruptcy courts. The Delaware court pioneered the development of the omnibus hearing that reduced travel expenses and inconvenience for out-of-town lawyers. That court also set a new standard for judicial availability, achieved an unprecedented level of judicial experience and expertise in the handling of large cases, and has perhaps the best-functioning PACER web site in the country. Unfortunately, these benefits are far outweighed by the accompanying problems.

The essence of the court competition problem is that only a few of the many parties interested in the outcome of the case select the court. To attract cases, the courts must cater to the interests of those few at the expense of the debtor, the creditors and other interested parties. Allowing those other parties to participate in case selection is not practical because so much activity occurs in the first few days of the bankruptcy case. To achieve a reasonable level of efficiency in the handling of a big bankruptcy case, the issue of venue must be settled no later than on the day the case is filed.

The simplest solution would be to amend the bankruptcy venue statute to require that debtors file in their local bankruptcy courts—that is, the courts where they have their headquarters or their principal assets. Such an amendment would not eliminate all forum shopping because firms could move their headquarters or assets in the period before filing. Complete elimination of forum shopping is not, however, necessary to solve the problem. Forum shopping need only be reduced to a level at which the loss of cases by a court no longer constitutes a serious threat to the judges of that court. The integrity of the judges can take care of the rest.

An alternative solution would be to assign three or four regional courts to handle large bankruptcy cases. The law would require that all large debtors file their petitions with a single judge, along with a simple statement of facts relevant to venue. Based on that statement, the judge would assign the case to the most appropriate of the regional courts on the same day the case was filed. The advantage of this solution is that it would permit the development of large-case expertise among the judges, without forcing them to compete for the cases.2


Footnotes

1 LoPucki, Lynn M. and Doherty, Joseph W., "Why Are Delaware and New York Bankruptcy Reorganizations Failing?," 55 Vanderbilt Law Review 1933 (2002). Return to article

2 Each of the subjects discussed in this statement is also discussed in greater detail in the manuscript of my book, Courting Failure: How Competition for Big Cases is Corrupting Bankruptcy Courts. The book will be published by the University of Michigan Press in January 2005. Return to article



 

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