Effects of bankruptcy court protection on asset sales

https://doi.org/10.1016/S0304-405X(99)00007-0Get rights and content

Abstract

This paper uses commercial aircraft transactions to determine whether prices obtained from asset sales are greater under Chapter 11 reorganization than under Chapter 7 liquidation. Results indicate that prices obtained under both bankruptcy regimes are substantially lower than prices obtained by non-distressed airlines. Furthermore, there is no evidence that prices obtained by firms reorganizing under Chapter 11 are greater than those obtained by firms liquidating under Chapter 7. An analysis of aircraft sales indicates that Chapter 11 is also ineffective in limiting the number of aircraft sold at discounted prices.

Introduction

When a firm files for protection under Chapter 11 of the U.S. Bankruptcy Code, an automatic stay is imposed on creditors. Payments to creditors and suppliers are suspended until management generates, and creditors approve, a plan of reorganization. This removes much of the pressure to meet principal and interest payments with cash raised via quick liquidation of assets.

Whether the reduction in the pressure to liquidate provided by the automatic stay is desirable has been the subject of debate by both policymakers and academicians. On one side of the debate are those who argue that the current U.S. reorganization law (Chapter 11) fails to provide adequate incentives for managers to sell assets to higher-value users (Bradley and Rosenzweig, 1992; Wruck, 1990). According to this view, distressed firms’ managers faced with the prospect of unemployment have strong incentives to keep their firms operating, whether profitably or not. The complex bargaining process fostered by the current reorganization law creates severe hold-up problems and allows incumbent managers to avoid liquidation, even if liquidation would maximize firm value. Consequently, in addition to direct bankruptcy costs, reorganization (rather than liquidation via Chapter 7) often results in gross investment inefficiencies and substantial wealth transfers from creditors to managers and equityholders (Warner, 1977; Altman, 1984; Weiss, 1990; Wruck, 1990; Weiss and Wruck, 1998; Betker, 1995; Altman, 1993; Franks and Torous, 1994). Some authors argue that immediate cash liquidation of insolvent firms’ assets would result in a superior allocation of resources compared to the allocation obtained by allowing managers to choose the lengthy and potentially costly option of reorganization (Baird, 1986; Thorburn, 1997).

On the other side of the debate are those who argue that forced liquidation of insolvent firms’ assets would result in an inefficient allocation of resources. They point out that forced liquidation can result in the dismantling of economically viable firms. Furthermore, they argue that in the presence of capital market imperfections, assets will not necessarily be allocated to the highest-value users. This will be particularly true when forces that caused the insolvent firm's distress also affect others in the industry. In this case, direct competitors might not be able to pay fundamental value for the insolvent firm's assets. Assets will then be allocated to firms outside the industry who, if the assets are industry specific, are lower-value users. Not only will this result in a socially inefficient allocation of resources, but it can also fail to maximize the amount of cash available for distribution to the insolvent firm's creditors (Shleifer and Vishny, 1992; Aghion et al., 1992). Evidence from commercial aircraft transactions presented in Pulvino (1998) supports these concerns. Outside of bankruptcy, financially distressed airlines receive lower prices when selling assets; they are also more likely to sell to firms outside the industry. Brown (1997) and Strömberg (1998) provide additional evidence that liquidation is costly for distressed firms that have industry specific assets. Conversely, Thorburn (1997) finds no evidence that distressed firms liquidate assets at discounted prices. However, her analysis does not focus on industries with industry specific assets.

This paper makes further use of data on commercial aircraft sales by U.S. airlines to assess the effects of both Chapters 11 and 7 protection on asset sale revenues. Asset sale revenues can be affected by bankruptcy court protection by (1) increasing prices at which assets are sold and (2) reducing the quantity of assets sold at distress-sale discounts. This paper examines both of these effects.

The advantage of using aircraft transactions to assess the effect of bankruptcy court protection on asset sale revenues is that transaction data are readily available. Prior to 1992, prices at which U.S. airlines sold their aircraft had to be disclosed to the Department of Transportation. Thus, both prices and quantities of sales are available. Another advantage of using aircraft transactions is that bankruptcy is common in the U.S. airline industry. Analyses presented in this paper are based on nine bankruptcy filings by major U.S. airlines between 1978 and 1992: Air Florida (July 1984), America West (June 1991), Braniff (May 1982), Continental (September 1983), Continental (December 1990), Eastern (March 1989), Midway (March 1991), Pan Am (January 1991), and TWA (January 1992).

Analyses of transaction prices suggest that prices obtained by airlines reorganizing under Chapter 11 are not significantly higher than those obtained by airlines liquidating under Chapter 7. Bankrupt carriers, whether operating under Chapter 11 or liquidating under Chapter 7, sell assets at discounts that average between 14% and 46%. Because aircraft account for a large portion of airlines’ total assets, the dollar magnitude of this discount can be substantial. For example, net flight equipment (flight equipment less depreciation) accounted for more than $700 million of Braniff Airlines’ $1 billion in pre-bankruptcy assets. An average discount of only 15% would have reduced the amount available for distribution to creditors by more than $100 million. Moreover, because airplanes are among airlines’ most liquid assets, these discounts are likely to underestimate the average discount associated with a complete liquidation of an airline's assets.

Regardless of bankruptcy venue (i.e., Chapter 7 or Chapter 11), prices that bankrupt airlines receive for their used aircraft are generally lower than prices received by distressed but nonbankrupt firms. For example, distressed but nonbankrupt airlines sell aircraft at discounts ranging from 12% to 28%. The magnitude of this discount increases as the rate of aircraft sales increases. Consistent with the literature on the price impact of large-block stock transactions, evidence presented in this paper and in Pulvino (1998) suggests that the price decreases by 1.5% for each additional aircraft sold in the calendar quarter.1 Because it is not uncommon for distressed firms to sell 10 or more aircraft per quarter, this incremental discount can be substantial. However, once bankruptcy court protection is obtained, the sensitivity of the price discount to the number of sales disappears in that bankrupt airlines sell aircraft at substantial discounts regardless of the number of aircraft being sold.

There are at least two reasons that bankrupt airlines receive lower prices for their aircraft than distressed but non-bankrupt carriers. First, bankruptcy status attracts `low-ball’ bids from opportunistic buyers. Second, the structure of the bankruptcy law encourages managers to accept these low bids. For 120 days after filing for Chapter 11, incumbent management has the exclusive right to propose a reorganization plan. Acceptance of the plan requires approval by each impaired creditor class (including shareholders) or a decision by the bankruptcy judge to force the plan on dissenting classes (commonly referred to as a `cram down'; see Section 1126 of Chapter 11 of the U.S. bankruptcy code for a complete discussion of the conditions under which this option is viable). As Wruck (1990, p. 441) points out, the fact that only impaired creditors and shareholders vote means that `the plan determines who votes and which claimants vote together'. Thus, managers interested in securing their jobs have a strong incentive to raise capital so that they can satisfy certain claims (within the confines of the bankruptcy code), thereby selecting the most favorable voters to pass judgment on the reorganization plan.

Furthermore, proceeds from asset sales can be used to finance operations. Weiss and Wruck (1998) describe Eastern Airline's use of asset-sale proceeds to fund operations while operating under Chapter 11 protection. Bankrupt firms that are severely cash constrained can avoid immediate shutdown by accepting low bids, even if doing so fails to maximize firm value.

The rate of asset sales provides additional evidence that Chapter 11 is ineffective in helping distressed firms search for high-value buyers for their assets. Rather than decreasing, the rate of asset sales increases after firms file for Chapter 11 protection. This is particularly true for firms that eventually liquidate under Chapter 7. These firms experience very high rates of asset sales in the two years preceding Chapter 11 filing, and an increased rate of sales after the filing date. For firms that eventually emerge from bankruptcy, the rate of asset sales is low in the two years preceding bankruptcy and increases slightly after bankruptcy court protection is obtained. Results from both this analysis and the pricing analysis suggest that providing sellers with time to find high-value buyers for their assets is not a benefit provided by Chapter 11 protection.

The remainder of this paper proceeds as follows. Section 2 describes the sample of aircraft transactions used in the empirical analyses. Section 3 examines the effect of bankruptcy court protection on prices that airlines receive for their assets. Section 4 presents an analysis of the effect of bankruptcy court protection on the rate of asset sales and Section 5 concludes.

Section snippets

Data description

Department of Transportation and Federal Aviation Administration records of used commercial aircraft transactions between 1978 and 1991 are used to examine asset sales in bankruptcy. These data were collected by Avmark, Inc., an aircraft appraisal firm, and consist of transaction date, aircraft model, serial number, transaction price, engine type, seller identity, and buyer identity.

Using aircraft transactions has a number of advantages. First, bankruptcy filings are common in the U.S. airline

Effect of bankruptcy court protection on asset prices

The analysis presented in this section assesses the degree to which bankruptcy laws affect prices that distressed sellers receive for their assets. If reorganization laws like Chapter 11 of the U.S. bankruptcy code are better at promoting orderly dispositions of assets than are liquidation proceedings such as Chapter 7, then we should observe smaller price discounts for asset sales conducted under Chapter 11 than for those conducted under Chapter 7. Furthermore, because the bankruptcy code's

Effect of bankruptcy court protection on the rate of sales

The rate of asset sales provides further evidence that bankruptcy court protection is ineffective in helping distressed firms conduct orderly dispositions of their assets. Although firms reorganizing under Chapter 11 receive prices that are no greater than prices received by firms liquidating under Chapter 7, Chapter 11 protection may help airlines limit the number of aircraft sold at discounted prices. The number of aircraft sales in a given calendar quarter for firms operating under Chapter

Conclusions

This paper uses a sample of commercial aircraft transactions to assess the effects of reorganization and liquidation proceedings on revenues from asset sales. The evidence indicates that neither protection under Chapter 11 of the bankruptcy code nor court-supervised liquidation under Chapter 7 of the code are effective at eliminating distress-sale discounts. Airlines operating under supervision of the bankruptcy court sell assets at greater discounts than do distressed but nonbankrupt carriers.

References (33)

  • E. Altman

    A further empirical investigation of the bankruptcy cost question

    Journal of Finance

    (1984)
  • Altman, E., 1993. Corporate Financial Distress and Bankruptcy, second ed., Wiley, New...
  • P. Asquith et al.

    Anatomy of financial distress: an examination of junk-bond issuers

    Quarterly Journal of Economics

    (1994)
  • D. Baird

    The uneasy case for corporate reorganizations

    Journal of Legal Studies

    (1986)
  • B. Betker

    Management's incentives, equity's bargaining power, and deviations from absolute priority in Chapter 11 bankruptcies

    Journal of Business

    (1995)
  • M. Bradley et al.

    The untenable case for Chapter 11

    Yale Law Journal

    (1992)
  • Cited by (0)

    I am grateful to George Baker, Ben Branch, Charles Calomiris, Miguel Cantillo, Richard Caves, Ken Froot, Bill Schwert (the editor), Andrei Shleifer and Jerry Warner (referee) for helpful comments. I would also like to thank Chris Allen for helping with data collection. Financial support from the Harvard Business School Division of Research is gratefully acknowledged.

    View full text