Aggressive Uses of Chapter 11 of the Federal Bankruptcy Code

Aggressive Uses of Chapter

11 of the Federal

Bankruptcy Code

by Walker F. Todd

Walker F. Todd is an assistant gener

al counsel and research officer at the

Federal Reserve Bank of Cleveland.

Substantial contributions to and

useful comments on this article

were provided by Jo hn M . Davis,

Mark Sniderman, and Erica Groshen

of the Federal Reserve Bank of

Cleveland, and by Andrea Berger

Kalodner, member, New York Bar.

Introduction

The filing of a voluntary bankruptcy petition

under Chapter 11 of the Bankruptcy Code of 1978

by the LTV Corporation on July 17, 1986 focused

renewed attention on the recent evolution of

corporate reorganizations under the Bankruptcy

Code. This article reviews that evolution and

offers alternative explanations for the kinds of

uses noted in recent Chapter 11 petitions. To

some observers, a Chapter 11 petition is becom

ing one of the standard financial strategies of

large corporations. In a period of disinflation, the

filing of a Chapter 11 petition is not a completely

unexpected or unnatural response to the need to

reduce corporate obligations.

Alternative legal mechanisms do

exist for the orderly downsizing of corporate

assets and liabilities in the face of a generally fal

ling price level or a significantly reduced demand

in specific markets. Those alternatives include

assignments for the benefit of creditors, corporate

liquidations, and corporate dissolutions and reor

ganizations under state law, as well as contractual

agreements for nonbankruptcy lending ( “work

outs”)- However, those alternatives often are

unsatisfactory because they do not provide a con

venient method for debtors to stay all creditors’

claims automatically or to reject burdensome

contingent liabilities. Thus, corporate reorganiza

tion under Chapter 11 typically is the debtor’s

preferred alternative. Creditors also may prefer

the orderly process of negotiation with a debtor

through creditors’ committees under the supervi

sion of a federal bankruptcy court, instead of

attempts to reorganize the debtor without the

court’s protection and assistance.

A more restrained, and probably

more accurate, view of bankruptcy petitions such

as that filed by LTV is that a Chapter 11 filing may

be helpful in restructuring large claims of secured

creditors and of creditors with the priority claims

described in section 507 of the Bankruptcy Code

(11 U.S.C. section 507). Nevertheless, the use of

Chapter 11 filings as a sword rather than a shield

was not traditionally contemplated under the

1978 Bankruptcy Code or the prior United States

bankruptcy acts.

I. An Economic Perspective

Basic economics textbooks pay little, if any, atten

tion to bankruptcy proceedings as a mechanism

for allocating resources. When an uncompetitive

firm becomes insolvent, economics texts gener

ally assume that its assets w ill be liquidated to

satisfy creditors and that the firm no longer will

exist. Economists call this process “exit from the

market.” Shareholders may suffer large losses,

including the complete loss of their investments.

At times, new investors purchase some of the liqui

dated assets on favorable terms, putting up fresh

capital, and a new firm “enters the market.” Some

former assets are scrapped, some former employ

ees are not re-employed, and some former credi

tors are not paid fully. The new firm generally has

a better chance of succeeding than the old firm be

cause it has some combination of lower costs,

greater productivity, and better management.

Economists describe this market-driven process

as being efficient because investors purchase

1986 Quarter 3

assets or new stock in the firm at market prices.

Those investors could have used their capital for

other purposes.

In practice, corporate reorganiza

tions under the Bankruptcy Code allocate re

sources in a manner that may differ significantly

from an economist’s description of corporate

reorganizations. Under Chapter 11, troubled firms

essentially bargain with creditors’ committees

and, occasionally, with their own employees

regarding the conditions under which they can

remain “going concerns.” Negotiations with

employees typically would cover the restructuring

of executives’ compensation contracts and

unions’ collective bargaining agreements.

The bankruptcy judge acts as a

mediator/arbitrator, following the Bankrupcty

Rules. However, the real power to affect the day-

to-day operations of a debtor is in the hands of

the creditors’ committees. Usually, management

of the bankrupt firm attempts to remain in con

trol of the ongoing operations of the enterprise.

In such cases, management is referred to as the

“debtor in possession.” Often, as was the case

with the LTV filing, bank creditors already have a

functioning committee that has been negotiating

with management before a bankruptcy petition is

filed. Thus, it is not at all inaccurate to describe

the bankruptcy judge as a detached mediator or

referee. Usually, the judge plays only a small role

in preparing a reorganization plan. That plan

ordinarily is drafted by the debtor and must be

ratified by the creditors’ committees. The com

mittees may serve as active, involved co-managers

of the bankrupt firm, and it is not unusual for

counsel for the creditors’ committees to meet at

least weekly with management.

If no agreement between the bank

rupt firm and its creditors can be reached volun

tarily, the court, usually acting through a trustee,

can impose a solution. One possible solution is a

complete liquidation of the firm, but such a solu

tion is used in Chapter 11 cases only after a judge

determines that no viable alternative exists. It

would be mere coincidence if a firm reorganized

in a Chapter 11 proceeding had the same assets,

liabilities, capitalization, labor force, wage rates,

and productivity as a market-organized firm.

Indeed, a Chapter 11 proceeding may support, at

least temporarily, the continued existence of a

firm that otherwise would have been liquidated.

Corporate reorganization arguably

is always a smoother process for all concerned

rather than a straight liquidation under Chapter 7

of the Bankruptcy Code. That is why the threat of

filing a Chapter 7 petition serves management as

a strong bargaining tactic in dealing with credi

tors’ committees. Regardless of the outcome of a

Chapter 11 proceeding, all parties theoretically

have a sense of participation and partial control

in a corporate reorganization. If reorganization

produces a new firm that proves to be uncompet

itive, and if further restructuring is required, at

least the affected parties w ill have time to adjust

to the changed circumstances.

Yet, to the extent that a Chapter 11

petition thwarts the discipline of the market

place, the ultimate costs of corporate reorganiza

tion to society may be greater than those of cor

porate liquidation. This can occur because the

court’s judgment as to the viability of the reorgan

ized firm and any arrangement reflecting the

vested interests of the creditors may be wrong.

On the other hand, lawyers seem to believe that

creditors’ lawyers, bankruptcy judges, and trustees

usually assess the possibilities of corporate reor

ganizations accurately because of their repeated

experiences with working out the consequences

of Chapter 11 petitions. Also, the continued pres

ence of corporate management in debtor-in-

possession arrangements under most Chapter 11

plans guarantees that the role of business judg

ment will be significant. Thus, in the end, the

normal result of a corporate reorganization tradi

tionally has not been completely at odds with the

overall lessons o f hum an experience. 21

II. Priorities Among Creditors

Section 507 o f the Bankruptcy Code prescribes a

schedule of the priorities of distribution for

claims of classes of creditors in a bankruptcy pro

ceeding. A simplified listing of the priorities

under Section 507 is as follows:

• Administrative expenses o f the

bankrupt’s estate.

• Postpetition unsecured claims

arising prior to the appointment of a bankruptcy

trustee.

• Up to $2,000 per claimant for

unsecured claims for accrued but unpaid wages,

salaries, commissions, vacation, and sick leave

pay.

• After deducting the $2,000 per

employee above, unsecured claims for up to

$2,000 per claimant for contributions to

employee benefits.

• Unsecured claims of farmers

against grain elevators or of fishermen against fish

processing plants.

• Up to $900 per unsecured claim

ant for security deposits and down payments for

services not rendered or goods not provided.

• Unsecured claims of govern

mental units for taxes, customs duties, and penal

ties accrued but unpaid.

Claims for employees’ wages and

benefits have third and fourth priority in the

schedule. General, unsecured, unsubordinated

1986 Quarter 3

claims, including the balance of claims for wages

and benefits, are given no priority and, thus,

effectively have eighth priority — behind all

other classes of prior claims.

Secured claims are not subject to

the schedule of priorities, but bankruptcy trustees

may restrain secured creditors from realizing upon

their liens in return for providing “adequate pro

tection” to the secured creditors while their claims

are stayed. Unfortunately, one man’s “adequate

protection” may be another m an’s outrageous in

fringement of rights. In practice, secured creditors

often are forced to renew their extensions of cred

it to bankrupt enterprises in order to allow those

enterprises to continue operating for the benefit

of all creditors, both secured and unsecured.

Holders of investment securities

have no priority of claim and generally are paid, if

at all, only after all prior classes of creditors are

paid in full. A normal ranking of security holders

is as follows:

• Subordinated debt holders,

including bond and note holders.

• Preferred shareholders.

• Common equity shareholders.

2 2 Holders of investment securities

are referred to the terms of the relevant legal

documents to determine the relative priority of

different types of investment securities within the

classes of investment security holders.

III. Evolution of the Bankruptcy Code

The power to establish uniform laws on bank

ruptcies was given to Congress under Article I,

section 8, clause 4, of the United States Constitu

tion. Bankruptcy was bound up with controver

sies regarding debtors’ prison under the common

law and, for the first century of its existence, the

United States had no permanent bankruptcy law.1

Congress managed to keep bankruptcy laws on

the books only briefly, during the years 1800-

1803, 1841-1843, and 1867-1878. Disputes regard

ing the availability and liberality of discharges

from debts in bankruptcy proceedings created the

political pressures that caused the repeal of those

early bankruptcy acts. Generally, Jeffersonians,

Jacksonians, and Southern and Western Demo

crats favored liberal bankruptcy laws as a means

of discharging prior debts and granting debtors

fresh starts in life. Naturally, Tories, High Federal

ists, Whigs, and Republicans (that is, the creditor

class) opposed the liberal discharges available to

nonmerchant debtors under bankruptcy laws.2 In

A good overview of the comparative histories of the evolution of

bankruptcy acts in the United State s and the United Kingdom is

Vem Countryman, A History of American Bankruptcy Law, 81 Commer

cial Law Journal 226 (1976 ), from which much of the historical informa

tion in this commentary is taken.

the aftermath of the depression following the

Panic of 1893, the first permanent bankruptcy law

was passed in 1898. That legislation provided

principally for straight liquidations. Then, in fits

and starts between 1932 and 1938, in the throes

of resolving the problems of a time when “so

many were debtors, and so few were solvent,”

the forerunners o f the reorganization provisions

of the present Bankruptcy Code were enacted in

1938. Provisions for corporate reorganizations

(Chapter 10) and corporate arrangements (Chap

ter 11) appeared for the first time as part of the

Chandler Amendments of 1938. Still, bankruptcy

was a defensive measure for corporate debtors,

and the requirement of corporate good faith in

filing bankruptcy petitions, not difficult to estab

lish during the Great Depression, routinely was

enforced by the courts.

The present Bankruptcy Code was

enacted in 1978. Chapters 10 and 11 of the 1938

bankruptcy act were combined in the new Chap

ter 11. Under the new Chapter 11, the stay of

creditors’ claims became automatic upon the fil

ing of the petition. The automatic stay was seen

as a procedural improvement from the debtors’

perspective because, previously, the stay had to

be requested separately, and creditors could re

sist the application for a stay, even after the Chap

ter 11 petition was filed. Also, the requirement of

actual insolvency at the time of filing under the

1938 act was eliminated in the new Chapter 11.

The Bankruptcy Code was

amended in 1984, following a June 1982 United

States Supreme Court decision striking down cru

cial parts of the 1978 Code.3 The 1984 amend

ments primarily were procedural, covering the

jurisdiction and tenure of bankruptcy judges.

However, the 1984 amendments also restricted

the extent of discharges in consumer bankrupt

cies, established standards for judging the reaso

nableness of employers’ rejections of collective

bargaining agreements, reordered the priority of

distributions of stored grain to farmers, and

exempted certain repurchase agreements cover

ing financial instruments from the automatic stay

provisions of the Code.

See Countryman (id) at 229-230. Of course Jeffersonians object

ed when the first bankruptcy act (1800) made discharges availa

ble only to merchants. On the other hand, Hamiltonians found the act

useful. Robert Morris, once the financier of the American Revolution, and

by then “the most daring real estate plunger in the United States,"

financed speculative housing development in the District of Columbia,

beginning in 1796. Unfortunately, in 179 7, a financial panic arose from

the outbreak of the wars between England and revolutionary France.

Morris was ruined and spent more than three years in the Philadelphia

debtors' prison. His discharge in 1801 under the 1800 bankruptcy act

probably was the most famous bankruptcy discharge in the nineteenth

century. See John C. Miller, The Federalist Era: 1780-1801, 252 (1960).

Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458

U .S . 50 (1982).

1986 Quarter 3

Throughout the evolution of the

present Bankruptcy Code, the statutes enacted

have been reasonably clear expressions of the

Congressional view that bankruptcy should be a

defensive, nonroutine measure and should not

be used to advance the financial interests of cor

porate debtors beyond the point that would have

been achieved by competition in a free market

among solvent corporations.

IV. Aggressive Uses of Bankruptcy

A potentially disturbing trend of filings under the

Bankruptcy Code began with the classic “surprise

filing” by the Johns-Manville Corporation in 1982.

Johns-Manville, facing an unpredictable amount

of claims for damage thought to be caused by

asbestos, proposed a Chapter 11 reorganization

under which all present and future asbestos claim

ants would be reimbursed from a separate fund

created by Johns-Manville. Meanwhile, the normal

business operations of the corporation continued,

comparatively unimpeded by the claims of asbes

tos victims. The victims’ fund is to receive up to

$2.5 b illion over 25 years, including the contribu

tion of at least 50 percent of the comm on voting

equity shares of the corporation. The Johns-

Manville case has been questioned in some of

the bankruptcy literature as lacking the elements

of a good-faith filing, but at this writing it appears

that the settlement will stand.4

Other potentially disturbing bank

ruptcy decisions soon followed in the wake of

the Johns-Manville case. In February 1984, the

United States Supreme Court decided, 5-4, in

National Labor Relations Board v. Bildisco & Bil-

disco, Inc., that employers undergoing Chapter 11

reorganizations unilaterally may abrogate or m od

ify collective bargaining agreements that are

seriously burdensome to the employer when, on

balance, the equities of the case favor modifica

tion of burdensome terms.5

See, e.g., Mark J , Roe, Bankruptcy and Mass Tort, 84 Columbia

La w Review 846 (1984); No te, The Manville Corporation bank

ruptcy; an abuse of the judicial process? 11 Pepperdine L aw Review 151

(1983); Note, Manville: good faith reorganization or "insulated" bank

ruptcy? 12 Hofstra La w Review 121 (1983); N ote , Manville corporation

and the "good faith” standard for reorganization under the Bankruptcy

Code, 14 University of Toledo La w Review 1467 (1983); Note , Manville

bankruptcy: treating mass tort claims in Chapter 11 proceedings, 96 Har

vard La w Review 112 1 (1983).

A thorough account of the Bildisco decision, 465 U .S . 513 (1984),

and the enactment of the collective bargaining provisions of the

Bankruptcy Code Am endments of 1984 is Thomas R. Haggard, The Con

tinuing Conflict Between Bankruptcy and Labor Law -The Issues that

Bildisco and the 1984 Bankruptcy Amendments Did Not Resolve, 1986

Brigham Young University L aw Review 1. See also, Benjamin Weintraub

and Alan N . Resnick, Bankruptcy La w Manual, Problems with Labor

Unions: Rejecting Collective Bargaining Agreements, paragraph 8.11 (9)

(1986). See In re Bildisco, 682 F.2 d 72 (3d Cir. 1982).

The Bildisco case illustrates the way

that bankruptcy courts usually resolve fundamen

tal conflicts between provisions of the Bankruptcy

Code and other provisions of federal law: Bank-

rupcty provisions prevail. It is only natural for

bankruptcy courts to consider the creation of via-

bly reorganized entities as their paramount duty

in Chapter 11 cases. The remedy for those dis

tressed by such tendencies on the part of the

bankruptcy courts is to petition Congress for

amendments to the Bankruptcy Code that would

specifically address such conflicts. However, as is

noted below, the bankruptcy courts have modified

somewhat their tendency to elevate bankruptcy

procedures above other considerations of federal

or state law only in environmental pollution cases.

Labor leaders lobbied Congress to

overturn the effect of the Bildisco decision, and

Congress did so in the July 1984 amendments to

the Bankruptcy Code (11 U.S.C. section 1113,

“Rejection of collective bargaining agreements”).

Although they still allow employers to reject col

lective bargaining agreements, these amendments

establish standards for judging the reasonable

ness of the rejection in light of good-faith efforts

to negotiate modification o f the agreements. In 23

the first court test of the 1984 amendments, In re

Wheeling-Pittsburgh Steel Corp. (W.D. Pa. 1985),

the district court sustained an employer’s rejec

tion of wage provisions of a union contract under

section 1113, even though it was arguable that

the employer had not bargained in good faith on

the wage concessions. The union was holding

out for further bank lenders’ concessions before

agreeing to the wage concessions. Upon appeal

(May 1986), the Third Circuit Court of Appeals re

manded the case to the district court, finding that

the standards for rejection established by section

1113 of the Bankruptcy Code had not been met.6

In the Daikon Shield (intrauterine

device) litigation, a Chapter 11 filing by the AH.

Robins Company (March 1986) was intended to

forestall future product liability claims against the

company. At the date of filing, Robins had settled

9,300 claims for $517 m illion, with 5,000 more

claims still pending. As in the Johns-Manville case,

the Robins filing was intended to cut off future

product liability claims and to enable the rest of

the company to continue operating without the

burden of those claims. However, enough allega

tions of high-level corporate malfeasance emerged

in the Robins case that the court appointed a spe

cial m onitor to review the ongoing operations of

senior management. Management remains in

control of the company at this writing.7

Wheeling Pittsburgh Steel Corp. v. United Steelworkers of

America, 791 F.2d 1074 (3d Cir. 1986).

1986 Quarter 3

In other aggresive filing develop

ments under the Bankruptcy Code, a new line of

cases is evolving that might limit corporations’

capacity to cut off liability for toxic waste pollu

tion of the environment by filing Chapter 11 peti

tions. In January 1986, the United States Supreme

Court decided, 5-4, that bankruptcy trustees may

not abandon corporate property under 11 U.S.C.

section 554 (a) that is burdensome to the bank

ruptcy estate if the abandonment causes envir

onmental damage that contravenes state laws or

health and safety regulations. The case decided in

January 1986 was Midlantic Bank v. New Jersey

Department of Environmental Protection, which

was an appeal of two 1984 Third Circuit cases

involving Quanta Resources Corporation.8 It is

noteworthy that, in the

Midlantic case, Justice

Rehnquist wrote the dissenting opinion which

stated, in relevant part:

The Bankruptcy Court may

not, in the exercise of its equitable powers,

enforce its views of sound public policy at

the expense of the interests the Code is

designed to protect. In these cases, it is

undisputed that the properties in question

24 were burdensome and of inconsequential

value to the estate. Forcing the trustee to

expend estate assets to clean up the sites

would plainly be contrary to the purposes

of the Code.

The Midlantic case involved a

liquidation, but comparable concerns would arise

in Chapter 11 cases if abandonment of contami

nated property seemed essential to achieving a

financially successful corporate reorganization. In

the future, it is not inconceivable that corpora

tions would attempt to cut off toxic waste liability

by filing Chapter 11 petitions with the intent to

abandon contaminated property. At present, the

weight of court decisions appears to be against

such aggressive use of Chapter 11 petitions.9

The original bankruptcy court order

in the Bildiscocase was issued in 1981. Since

then, Bildisco has had two progeny worthy of

note: Wilson Foods and Continental Air Lines. In

See A.H. Robins Co. v. Piccinin, 788 F.2 d 994 (4th Cir. 1986). The

Fourth Circuit upheld a preliminary injunction staying all claims

arising from Daikon Shield litigation against personally named co

defendants (typically, officers and directors of Robins) once the Robins

Chapter 11 petition w as filed. This decision is viewed as an affirmation

of the broad injunctive powers of a bankruptcy court to stay all claims

involving a debtor reorganizing under Chapter 11.

Midlantic, 474 U .S

___________

88 L.Ed .2 d 859 (1986). The

Supreme Court made a similar finding in the case of Ohio v. Ko-

vacs, 469 U .S

__________

, 83 L.Ed .2 d 6 49 (1985). In Kovacs, the

Supreme Court held that a discharge in bankruptcy was allowed for a

debtor whose property w as seized by a state receivership which began

to clean up a toxic w aste site and then ordered the debtor to pay for the

clean-up. The Supreme Court left for another ruling (Midlantic) the reso

lution of the issue of allowing bankruptcy trustees to abandon contami

nated property.

April 1983, Wilson, then the fifth-largest meat

packer in the United States, filed a Chapter 11 pe

tition in Oklahoma. W ilson then unilaterally re

jected collective bargaining agreements covering

two-thirds of its employees and reduced wages

by 40 to 50 percent. W ilson’s petition showed an

estimated positive net worth of more than $67

m illion. After reducing wages, Wilson was re

ported to have obtained a new line of credit for

$80 m illion from a New York City bank.10

In September 1983, Continental,

then the eighth-largest airline in the United States,

filed a Chapter 11 petition in Texas. Continental

had been bargaining with its employees for wage

concessions as part of a corporate strategy for be

coming an efficient, low-cost carrier in a deregu

lated environment. After the filing, Continental

unilaterally rejected contracts with several unions,

including the pilots’ union. All employees tempo

rarily were laid off. A few days later, one-third of

the employees were recalled, but new wages were

reduced from former levels by more than half in

some instances. Although Continental had a

heavy debt burden at the time of filing, net worth

still was positive. The reorganized Continental,

together with low-cost affiliates such as New York

Air, is a strong competitor over major airline

routes in the United States and on certain interna

tional routes; furthermore, it is usually mentioned

as a potential acquirer o f other, troubled airlines.

During the spring and summer of 1986, Conti

nental’s parent company, Texas Air, was involved

in negotiations to acquire Eastern Airlines and

People Express. At this writing, it appears that

those acquisitions will be consummated.

Taking the Chapter 11 baton from

Continental is Frontier Airlines, a unionized carrier

serving the western United States that was

acquired in 1985 by the ultimate low-cost air car

rier, People Express. Facing a heavy debt burden

and expanded price competition over most of its

domestic routes, People Express offered Frontier

for sale in the late spring of 1986. One potential

acquirer, United Airlines, was close to completing

the purchase of Frontier but, as of this writing,

has not done so.

One of the obstacles to United’s ac

quisition of Frontier was its inability to negotiate

In United States v. Maryland Bank & Trust Co.,

______

F.Sup p.

______

(D. M d „) slip op. Apr. 9, 1986), the environmental protec

tion laws were extended to enable the Environmental Protection Agency

to maintain lawsuits against innocent parties foreclosing on contami

nated property and to require them to pay for the costs of cleaning up

the property. It is believed that such precedents will complicate Chapter

11 proceedings in the future by raising the spectre of unscheduled liabili

ties in amounts that, if not stayed or discharged, would disrupt the

orderly reorganization of companies operating under Chapter 11 in cases

involving infringement of environmental protection laws.

1 Graeme Browning, Using Bankruptcy to Reject Labor Con-

U tracts, 70 American Bar Association Journal 60 (Feb. 1984).

1986 Quarter 3

a mutually satisfactory transitional salary scale for

Frontier’s pilots, who generally earned less than

United’s pilots. Other potential acquirers of Fron

tier apparently were w illing to purchase it only if

the collective bargaining agreements with the

principal Frontier unions were rejected. People

Express apparently threatened to file a Chapter 11

petition for Frontier in order to induce Frontier’s

unions to be more forthcoming. Thus, the Fron

tier case illustrates another variation of the

aggressive use of Chapter 11 filings: The threat to

file becomes a bargaining chip in labor negotia

tions. United’s negotiations regarding Frontier

were interrupted by the filing of a Chapter 11

petition for Frontier on August 28, 1986.11

One debtor that has shown real

initiative following a bankruptcy reorganization is

Wickes Corporation, a California-based building

supply company that filed its Chapter 11 petition

in April 1982, shortly before the upturn from the

1981-82 recession began. Reorganized under

strong management, Wickes reduced operating

expenses, closed unprofitable stores, and renego

tiated or rejected a number of building leases for

its stores. Wickes emerged from Chapter 11 in

early 1985. A year later, in April 1986, Wickes

attempted to acquire the National Gypsum Cor

poration for approximately $1.2 billion. After that

takeover attempt failed, during August 1986,

Wickes mounted a new hostile tender offer for

Owens-Coming Fiberglas Corporation, Toledo,

Ohio. Wickes apparently intended to finance the

tender offer with an issue of so-called “junk

bonds” and with the planned post-acquisition

sale of Owens-Coming operations not closely

related to the core operations o f Wickes. The

tender offer was valued at $2.1 billion. O n August

29, 1986, Wickes terminated the offer, but analysts

estimated that Wickes had a net gain of at least

$30 m illion from the increased value of Owens-

Coming shares acquired during the takeover

attempt. It is significant that a company that not

long ago filed a Chapter 11 petition, apparently in

good faith, has been able to mount hostile tender

offers for multi-billion-dollar corporations within

little more than a year after ceasing to operate

under the supervision of a bankruptcy court.

V. Implications for the Bankruptcy System

The sequence of all the cases cited above is a

signal that something might be wrong in the

bankruptcy system. For bankruptcy specialists,

and for economists generally, those cases are like,

in the words of Thomas Jefferson, a “fire-bell in

the night

...

[W] e have the wolf by the ears, and

we can neither hold him, nor safely let him go.

Justice is in one scale, and self-preservation in the

other.”12 Jefferson was writing about the perni

cious effects of slavery on the preservation of the

Union and about the controversies raised by the

Missouri Compromise. The message of those

words, however, for defenders of the notions of a

free market and of market discipline in American

enterprise, is that actions currently taken under

Chapter 11, while perfectly legal under the pres

ent Bankruptcy Code, may be moving inexorably

in the direction of a race to the courthouse to

enable solvent, albeit troubled, corporations to

gain positive advantages over competitors. Such a

race for competitive advantage through the legal

process eventually undermines the free-market

system, as well as the other laws overridden by

the Bankrutpcy Code, such as environmental pro

tection or labor laws.

Yet, competitors in any line of bus

iness “have the w olf by the ears” in that they

cannot safely renounce the use of Chapter 11 fil

ings as a means of reducing operating costs

unless

all significant competitors in that line of 25

business refrain from filing as long as they are

solvent. Thus, justice (fair play) demands that all

solvent competitors refrain from filing, but self-

preservation demands that all competitors retain

the capacity to file as long as any significant com

petitor has that capacity.

If efficiency in the market is

achieved most easily by becoming a low-cost

producer under the protective umbrella of a

Chapter 11 filing, why should any corporation

exert itself to achieve efficiency by bargaining

and by open competition in a free market? Before

1978, a showing o f insolvency was a prerequisite

of a Chapter 11 filing, but that requirement was

dropped in the present Bankruptcy Code.13 The

question now presented is whether the benefits

that were supposed to flow from the removal of

the requirement of insolvency have been out

weighed by the deficiencies — if they are, in fact,

deficiencies — of the present statute. After all, in

the words of one bankruptcy expert,

Chapter 11 is supposed to be

rehabilitative,... a device “which can be

used to cure a company that’s ill or hemor

rhaging.” It is better to apply the cure while

a company “has strength and vitality left —

before letting it die.”14

Press reports in early September 1986 indicated that Armco,

a major producer of steel, also allegedly w as using the threat

of a Chapter 11 filing to induce its employees’ union to make wage con

cessions. In fact, the union agreed to the concessions and no Chapter 11

petition was filed.

" I ^ Letter from Thom as Jefferson to Jo hn Holm es, April 2 2,18 2 0,

L d in The Portable Thomas Jefferson 567, Merrill D . Peterson

ed. (19 75 , reprinted 1980).

Browning, supra note 10.

1986 Quarter 3

Thus, it is important to remember

that not all observers believe that the present

uses of Chapter 11 are all bad. The issue of good

faith in filing could be addressed satisfactorily by

scrutinizing Chapter 11 filings in light of the

question: “Is this company financially troubled

enough to justify the filing?” By that standard,

some of the recent Chapter 11 filings (for exam

ple, Wickes, LTV, and Frontier) might not be par

ticularly troublesome.

VI. Summary

The law of bankruptcy has been intended since

1898 to grant debtors relief from claims of unse

cured trade creditors, bank lenders, and the like,

but not to affect substantially the claims of em

ployees for accrued, but unpaid, wages and bene

fits, or the claims of governmental units for taxes.

Such claims were, and still are, given priority in

the distribution of assets of bankruptcy estates.

Since 1982, a new trend has emerged in which

aggressive bankruptcy filings are used to achieve

the greater financial objectives of the corporations

filing Chapter 11 petitions. The 1984 amend-

2 6 ments to the Bankruptcy Code were intended to

rein in perceived abuses of the corporate capacity

to disavow employment contracts. Some may

argue that the July 17, 1986 filing by LTV Corpora

tion was yet another corporate effort in the direc

tion that was opposed by the 1984 amendments.

It is possible to contend that the filing was

designed to enable LTV to modify its collective

bargaining agreements substantially or to reject

future liability for employee benefits, including

pension or insurance liabilities. O n the other

hand, LTV clearly was having financial troubles,

and issues regarding the good faith of its failing

still have to be resolved by the bankruptcy court.

The cases described above fall into

three broad categories:

1. Contingent products liability or environ

mental protection

Johns-Manville (1982)

AH. Robins (1986)

Midlantic (1986) (Chapter 7)

2. Executory collective bargaining agreements

Bildisco (1981-1984).

Wilson Foods (1983)

Continental Air Lines (1983)

Frontier Airlines (1986)

3. Restructuring and downsizing corporate

liabilities

Wickes (1982)

Z7V(1986).

The Supreme Court thus far seems to be sustain

ing the primacy o f bankruptcy considerations in

the second and third categories of cases, while

continuing to sustain the primacy of environmen

tal protection laws in cases that do not involve

mass tort litigation.

In any case, it is clear that compan

ies with the benefit of the protection afforded by

Chapter 11 filings have advantages in corporate

financial structure that are not available to sim

ilarly situated, but presumably solvent, com peti

tors who do not file. Thus, it is reasonable to

predict that, in a disinflationary environment, an

increased number of aggressive Chapter 11 filings

will occur in any industry in which a significant

competitor alters its costs of production by filing

a Chapter 11 petition. In the absence of a more

orderly, formal procedure for downsizing corpo

rate assets and liabilities in the United States, such

a use o f Chapter 11 is neither illogical nor com

pletely unforeseeable. The remedy for aggressive

uses of Chapter 11, if a remedy becomes desira

ble as a matter of public policy, is to be found by

following the traditional path of Congressional

enactment of corrective amendments of the

Bankruptcy Code.

At the same time, the purpose of

the 1978 revisions of Chapter 11 should be kept

in mind: The rehabilitation of ailing companies

should be effected before they become termi

nally ill. If nothing concentrates the m ind like the

prospect of being hanged, then the opportunity

for a debtor to file a Chapter 11 petition before its

case is terminal ought to serve a constructive

purpose: It should encourage lenders,

employees, and the company’s other constituent

groups to cooperate in attempting to improve the

chances for restoring the company’s competitive

viability in order to avoid the filing. The same

spirit of cooperation should prevail if a filing

occurs despite everyone’s best efforts.

" I / Roy Carlin, Esq., bankruptcy counsel for Wilson Foods,

J L I quoted in Browning, supra note 10.

1986 Quarter 3

Economic Commentary

A Correct Value for the Dollar?

by Owen F. Humpage and

Nicholas V. Karamouzis

January 1, 1986

Bank H olding Company Voluntary

Nonbanking Asset Divestitures

by Gary Whalen

January 15, 1986

Ju nk Bonds and Public Policy

by Jerome S. Fons

February 1, 1986

Can W e Count on Private Pensions?

by James F. Siekmeier

February 15, 1986

Am erican A utom obile Manufacturing:

It’s Turning Japanese

by Michael F. Bryan and Michael W. Dvorak

March 1, 1986

Should W e Be Concerned About the

Speed o f the Depreciation?

by Owen F. Humpage

March 15, 1986

The Government Securities Market

and Proposed Regulation

by James J. Balazsy,Jr.

April 1, 1986

A Revised Picture: Has O ur View

of the Economy Changed?

by Theodore G. Bernard

April 15, 1986

Monetary Policy Debates Reflect

Theoretical Issues

by James G. Hoehn

May 1, 1986

How G ood Are Corporate Earnings?

by Paul R. Watro

May 15, 1986

The Thrift Industry: Reconstruction

in Progress

by Thomas M. Buynak

June 1, 1986

The Emerging Service Economy

by Patricia E. Beeson and Michael F. Bryan

June 15, 1986

Domestic Nonfinancial Debt: After

Three Years o f Monitoring

by John B. Carlson

July 1, 1986

Equity, Efficiency, and

Mispriced Deposit Guarantees

by James B. Thomson

July 15, 1986

Target Zones for Exchange Rates?

by Owen F. Humpage and

Nicholas V. Karamouzis

August 1, 1986

W ill the D ollar’s Decline Help

O h io Manufacturers?

by Amy Durrell, Philip Israilevich,

and KJ. Kowalewski

August 15, 1986

Im plications of a Tariff on O il Im ports

by Gerald H. Anderson and KJ. Kowalewski

September 1, 1986

Alternative Methods for Assessing Risk-Based

Deposit-Insurance Premiums

by James B. Thomson

September 15, 1986

1986 Quarter 3

Economic Review

Quarter I 1985

Beauty and the Bulls: The Investment Character

istics of Paintings

by Michael F. Bryan

The Reserve Market and the Information Con

tent of Ml Announcements

by William T. Gavin and Nicholas V. Karamouzis

Quarter II 1985

Vector Autoregressive Forecasts of Recession

and Recovery: Is Less More?

by Gordon Schlegel

Revenue Sharing and Local Public Expenditure:

Old Questions, New Answers

by Paul Gary Wyckoff

Quarter III 1985

The Impact of Bank Holding Company Consoli

dation: Evidence from Shareholder Returns

by Gary Whalen

The National Debt: A Secular Perspective

by John B. Carlson and E. J. Stevens

The Ohio Economy: A Time Series Analysis

by James G. Hoehn and James J. Balazsy, Jr.

Quarter I 1986

The Impact of Regional Difference in Unionism

on Employment

by Edward Montgomery

The Changing Nature of Regional Wage Differ

entials from 1975 to 1983

by Lorie Jackson

Labor Market Conditions in Ohio Versus the

Rest of the United States: 1973-1984

by James L. Medoff

Quarter II 1986

Metropolitan Wage Differentials:

Can Cleveland Still Compete?

by Randall W. Eberts

and Joe A Stone

The Effects of Supplemental Income

and Labor Productivity on Metropolitan

Labor Cost Differentials

by Thomas F. Luce

Reducing Risk in Wire Transfer Systems

by E.J. Stevens

Quarter IV 1985

Stochastic Interest Rates in the Aggregate Life-

Cycle/Permanent Income Cum Rational Expec

tations Model

by Kim J. Kowalewski

New Classical and New Keynesian Models of

Business Cycles

by Eric Kades

1986 Quarter 3