Reorganization By Force

In 1978, the United States adopted the Bankruptcy Code and its Chapter 11, which allows companies to restructure their obligations. Chapter 11’s hallmark is that it’s company driven; the company’s management decides if, when, and how it will use Chapter 11 to address its financial distress. To be sure, other stakeholders, such as secured lenders and private equity sponsors, heavily influence those corporate decisions by working in tandem with, and at times taking over, the company’s management. Yet however the company’s management is constituted and whoever decides how to constitute it, it’s the company’s management that initiates and runs the company’s Chapter 11 process.

Despite Chapter 11’s management-centric orientation, the Bankruptcy Code contains a curious oddity: an involuntary Chapter 11, where a group of unsecured creditors can force a company to reorganize through Chapter 11 if they can show that the company owes them a definite, undisputed amount of money¾the current statutory minimum is $18,600¾and either that (a) the company is generally not paying its debts as they become due or (b) a fiduciary was appointed over the company no more than 120 days prior to the involuntary chapter 11 filing.

Bracketing for a moment the question of how the creditors would force the company to reorganize once it’s in Chapter 11, one can ask a more fundamental set of questions: what problem is this system designed to solve and how would it solve it? After all, Chapter 11 was designed to be a management-run system by design because the managers know best (relative to courts and other outsiders of the firm) how to maximize the firm’s value. Institutional investors, such as secured lenders and private equity firms, also bargain for control rights designed to optimize the firm’s management so that the firm can weather its financial distress. And if those tactics don’t work¾if the firm’s management is so entrenched and incompetent that it can’t even come close to guiding the company through its financial distress¾then liquidation will likely maximize the firm’s value. If this line of thought is correct, then what place is there for a compulsory reorganization? Put differently, when would an involuntary Chapter 11 ever be a good idea?

In my latest Article (forthcoming in the California Law Review), I show that this line of thought, while compelling, falls short. The picture painted above encapsulates two kinds of distress. The first is financial distress, which includes things like running out of cash or taking on too much debt such that the company’s going concern value is compromised. Chapter 11, out of court restructurings, and other tactics designed to re-work a company’s capital structure are responses to it. The second kind of distress is what I call “managerial distress,” which is when a company’s management is so deadlocked, absent, or otherwise dysfunctional such that it can’t run the company. Custodianship, receivership, and dissolution proceedings are proper responses to this kind of distress. And institutional investors’ control rights are designed to stave off each kind of distress.

Yet when both kinds of distress set in simultaneously, the usual set of solutions won’t work precisely because they presuppose that the company only faces one kind of distress. To see this, consider financial distress. Tackling it requires that managers be alert, aware, and ready to take decisive action, which is necessarily impossible when the company also faces managerial distress. The company fares no better when it faces managerial distress; litigating whether the company needs a custodian, receiver, or to be liquidated squanders precious time and resources that the company doesn’t have when it is also financially distressed. And when both kinds of distress plague the company, control rights misfire; they don’t do the kind of distress-breaking or distress-mitigating work they were designed to do. When financial and managerial distress concurrently set in, each kind of distress can fuel the other and quickly put the company into a tailspin. What the company needs is to solve both kinds of distress simultaneously.

That’s what the involuntary Chapter 11 system allows the company to do. It allows unsecured creditors to force the company into Chapter 11, which can address both kinds of problems holistically. Once the petition is filed, the automatic stay kicks in, preventing parties from extracting the company’s assets. If the bankruptcy court decides to keep the company in Chapter 11, the court can appoint a Chapter 11 trustee to help resolve the company’s managerial problems in the short term. The Chapter 11 trustee can then help the company use the Bankruptcy Code’s provisions relating to executory contracts, avoidance actions, and sales and leases of assets to maximize its value. Finally, the company can propose a plan of reorganization or a sale of substantially all of its assets in order to put its assets to their highest and best uses and more permanently resolve the company’s managerial distress.

To do this dual-distress breaking work and to prevent parties from abusing it, the involuntary Chapter 11 system would need to be reformed in three key ways. First, additional investors beyond unsecured creditors would have to be able to file involuntary Chapter 11 petitions. There’s little reason to think that unsecured creditors alone, as a class of investors, are uniquely suited to helping a company solve its financial and managerial distress. Consequently, equity holders, as well as secured and unsecured creditors, would be allowed to file involuntary Chapter 11 petitions. Second, petitioning investors would have to show three things: (a) that they jointly hold at least 10% of the company’s outstanding equity or debt; (b) that the company faces financial distress; and (c) that the company faces managerial distress. Finally, a sound involuntary Chapter 11 system would incentivize parties to bring cases where companies face both kinds of distress and disincentivize (and even penalize) parties for trying to bring cases where companies face one, or neither kind, of distress. So reformed, the involuntary Chapter 11 system could be put to its highest and best use by allowing companies that face financial and managerial distress simultaneously to address them in a single, comprehensive forum.

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1. Douglas G Baird and Robert K Rasmussen, ‘Private Debt and the Missing Lever of Corporate Governance’ (2006) 154 University of Pennsylvania Law Review 1209; Vincent SJ Buccola, ‘Sponsor Control: A New Paradigm for Corporate Reorganization’ (2023) 90 University of Chicago Law Review 1.
2. 11 USC § 303.
3. 11 USC § 362.
4. Ibid § 1104.
5. Ibid § 365.
6. Ibid §§ 547-548.
7. Ibid § 363.
8. Ibid §§ 363, 1121-1129.

The authors' paper can be found here. 

Jared Mayer is Lecturer in Law at the University of Chicago Law School.