The Bankruptcy Game

By John Greenwald

ACCORDING TO THE AMERICAN capitalist gospel, it is no sin to go belly up. Quite to the contrary, U.S. firms enjoy the most liberal bankruptcy laws on earth -- a privilege strengthened by a provision of the code known as Chapter 11 that holds creditors at bay while often allowing sick firms to bleed new buckets of red ink and still operate for years.

Congress added the Chapter 11 provision to the federal bankruptcy code in 1978 so companies could stay in business while working out repayment plans. But a national debate has now sprung up over whether the country would be better off if sick firms were allowed to die. Last year nearly 21,000 firms filed Chapter 11 petitions, the most since 1986. More significant, many of the new cases are mammoth, involving such familiar names as Macy's, TWA and Orion Pictures. While few large companies entered Chapter 11 before the mid-1980s, more than a dozen with assets exceeding $5 billion have taken refuge there in the past three years.

A growing body of critics charge that Chapter 11 has become a tool that wily managers can now use to stiff creditors and preserve their own jobs. Moreover, they argue, companies in Chapter 11 can take advantage of the fact that they pay no interest on part of their debt by slashing prices and wreaking havoc on their competitors. Most companies that take refuge in Chapter 11 ultimately fail anyway, critics say, leaving creditors with even fewer assets than if the firms had been liquidated in the first place. Says Sam Zell, a Chicago financier: "It isn't good for the economy to prop up cripples and hand them unfair advantages that allow them to bleed income and help destroy the healthy competition."

Horror stories are easy to find. Eastern Airlines had a net worth of more than $1 billion when it entered Chapter 11 in 1989. But there was little left for creditors by the time Eastern exhausted $400 million trying to remain aloft before it quit flying last year. Manville Corp. filed a 1982 petition solely to escape $2 billion of liability suits brought by defendants who claimed to have been harmed by the firm's asbestos products. The next year Frank Lorenzo steered Continental Airlines into bankruptcy, allegedly to break union contracts. But the tactic could not save Continental -- now minus Lorenzo -- from returning to Chapter 11 in 1990.

Alarmed by such abuses, Congress is considering reforms. The Senate Judiciary Committee has called for a blue-ribbon panel to study whether the entire 1,568-page bankruptcy code should be overhauled. The panel would also consider speedy alternatives to Chapter 11 proceedings, which last about two years on average and force companies to expend vast sums of scarce cash on legal and accounting fees.

Many experts agree that changes in Chapter 11 are sorely needed. "Nobody thought it would ever come to this," says Sam Giordano, executive director of the American Bankruptcy Institute, a clearinghouse for bankruptcy information. "The law was meant to keep people employed and allow companies to be good corporate citizens, not allow bankruptcy to be a shield for purposes for which it was never intended. Right now," Giordano says, Chapter 11 "is just a hodgepodge that's being decided on a case-by-case basis. It's probably time to revisit the law itself."

A recent Yale Law Journal article called for junking Chapter 11 altogether and letting sick companies die. The authors studied 326 publicly traded firms that had filed bankruptcy petitions between 1964 and 1989 and found that only 20% had managed to emerge successfully. At the same time, the article said, bondholders lost 67% more of their investments on average when companies failed in Chapter 11 than under previous law. "If stock- and bondholders were worse off, what in the hell was going on here?" demands co-author Michael Bradley, a law and finance professor at the University of Michigan. "If the purpose of Chapter 11 was to protect corporate assets and shareholders, we found just the opposite."

Like any hotly contested issue, Chapter 11 has its share of champions. "On balance, Chapter 11 has been positive for the economy," says Edward Altman, a finance professor at New York University's Stern School of Business. "It conserves the assets and values of firms that have temporary problems but can be rehabilitated." Altman and doctoral student Edith Hotchkiss conducted a study that found that at least half the 1,096 firms entering Chapter 11 between 1979 and 1991 emerged successfully and have managed to stay out. That study focused exclusively on publicly held companies in Chapter 11.

Yet few experts dispute that Chapter 11 cases can run up huge -- and often excessive -- legal and professional fees, especially when big companies are involved. LTV Corp., a steel and aerospace conglomerate, which had sales of $6 billion last year, has forked out more than $100 million in legal fees since it entered Chapter 11 in 1986 yet remains mired in debt. As the megacase grinds on, LTV's bills are piling up at the astonishing rate of $2.5 million a month.

But owners and managers of companies in Chapter 11 can do very well for themselves, thank you, even as creditors take a beating. William Farley put his $3 billion empire, which includes Fruit-of-the-Loom apparel, into Chapter 11 last year. But analysts say Farley could keep as much as $100 million of his personal fortune and homes in Chicago, Aspen and Maine. In Washington, real estate developer Dominic Antonelli Jr. has reached agreement with his creditors in a $700 million Chapter 11 case that would allow him to keep, among other things, $1.9 million in cash along with stock, cars and possessions valued at $2.1 million. If the deal goes through, the creditors could get as little as 17 cents on the dollar.

Inside ailing companies, Chapter 11 filings can lower morale and strain already tense relations between bosses and employees. Some TWA workers question owner Carl Icahn's motives for placing the airline in Chapter 11 in January. Instead of striving to clean up the company's finances, they say, Icahn's real goal may be to use Chapter 11 as a shelter from which to conduct fare wars like his current battle with American Airlines. "Chapter 11 can be a good opportunity for a company to cleanse itself of past mistakes," says Bill Compton, chairman of the pilots' union local at TWA. "But how do you do that when you have the same managers and employees who created the problems in the first place?"

Federated Department Stores emerged from two years of Chapter 11 proceedings in February after new managers shed $5 billion of the $8.2 billion of debt that previous owner Robert Campeau had accumulated. Federated -- the parent of Bloomingdale's, Rich's, Burdines and other chains -- spent much of the Chapter 11 period reorganizing its finances and closing weak stores. Macy's also got a new-management look last month when chairman Edward Finkelstein resigned after filing Chapter 11 papers in January. Finkelstein had come under increasing fire since using debt to achieve a $3.7 billion buyout of Macy's in 1986 and another $1.1 billion to acquire Bullock's and I. Magnin stores.

Some firms have found that the best way to survive Chapter 11 is to escape it as swiftly as possible. The Days Inns motel chain brought 1,200 franchises out of Chapter 11 in January after a relatively brief 17-month stay. "A lot of bankruptcies just go on forever," says John Snodgrass, who heads the franchise operations. "But the judge made sure we didn't get bogged down and drawn out. It really serves no one but attorneys to continue in bankruptcy for a lengthy period of time. It can't be healthy for a business to do that."

This commonsense approach is already working for small North Carolina companies. Under a fast track that U.S. bankruptcy Judge A. Thomas Small installed in 1987, firms file their reorganization plans within 90 days and average just six months in court. Spector Molding, a $3 million plastics company, made an even quicker getaway; it was in and out of Small's court in less than two months. "Cases like this are why the code was written," says Trawick Stubbs, the firm's attorney. "Congress has said, and I agree, that it's preferable to have reorganization and rehabilitation rather than liquidation."

Experts say big firms should speed through Chapter 11 in the same no- nonsense way. Chicago investor Zell would give companies an "absolute deadline" of one year to reorganize or go out of business. "By having little discipline, you create a huge playing field for a lot of ghouls to make a living," he says. "They're all feeding at the trough." For all the richness of his metaphors, Zell has a point. Tight deadlines could curb Chapter 11 abuses by encouraging companies to get out of court quickly and return to the business of surviving in the marketplace without life support. Or, if that's impossible, to close up shop and allow their creditors to split the remaining assets.

With reporting by Bernard Baumohl/New York, Julie Johnson/Washington and William McWhirter/Detroit