A weak economy, continued curbs on credit, and curtailed consumer spending are taking their toll, driving American companies to file for bankruptcy at a record rate. As business bankruptcies surge to their highest levels in nearly a decade—up 54% to 43,546 in 2008, from 28,322 in 2007 according to the latest figures from the American Bankruptcy Institute—some observers are asking if a Chapter 11 bankruptcy has become a new kind of competitive advantage.
A Chapter 11 filing contemplates reorganization, unlike a Chapter 7 filing that leads to liquidation. It may or may not let a company gain a leg up on competitors, say faculty from Emory University. For some industries, a bankruptcy filing may carry some long-term negative effects.
“Given today’s economy, I wouldn’t be surprised if Ford Motor Company viewed the Chapter 11 filing of its competitors [Chrysler LLC and General Motors Corp.] as giving those carmakers a competitive advantage,” says William Carney, a professor of corporate law at Emory University’s School of Law. “Revised union agreements are yielding lower labor and pension costs, plus the debt relief and other advantages they will receive under the Chapter 11 could put Ford in a corner.”
Stung by high labor costs and falling sales, Chrysler LLC filed for Chapter 11 bankruptcy protection on April 30 as part of a plan to sell most of its assets to a group led by Italian automaker Fiat Group SpA. Facing similar issues and a “do or die” ultimatum from the federal government, GM filed for Chapter 11 on June 1.
A company that files for Chapter 11 reorganization generally gets temporary protection from creditors that are trying to collect on existing debt. The company filing for bankruptcy also gets broad powers to renegotiate costly contracts and reject unprofitable lease and other agreements, subject to court approval. Stockholders and bondholders may lose their entire investment, or see the value fall to pennies for each dollar originally invested.
“At one time there may have been a certain amount of stigma associated with a commercial bankruptcy filing,” notes Carney. “But the negative connotation has dissipated somewhat ever since Federated Department Stores [a department store holding company now known as Macy’s Inc. that owns Macy's and other brands] filed for bankruptcy in January 1990 in order to keep getting merchandise delivered and emerged from it about two years later.”
Even so, a company may not come out of a bankruptcy smelling like roses, Carney cautions.
“Banks that have to write off huge amounts of debt they extended to the now-bankrupt company may not be too keen on lending money to the firm in the future,” he notes. “Similarly, bondholders that get hosed may not be quick to buy the company’s debt after it emerges from bankruptcy.”
The kinds of goods and services rendered by a company may also help determine whether or not its customers continue to deal with it during the Chapter 11 process.
“When a company like Federated enters Chapter 11, there’s not much of an impact on its retail customers,” Carney explains. “For the most part they’re buying clothes, electronics, furniture and other relatively low-cost goods that essentially involve a single interaction with the seller store. If I buy a shirt, for example, I’m probably not going to care if the store’s still around in six months or a year, since there’s little chance the retailer will be asked to perform any kind of service on the garment beyond the initial sale.”
Carney points to his own experience with Delta Airlines, an Atlanta, GA-based carrier that filed Chapter 11 in September 2005 and emerged in April 2007.
“As a frequent flier I was not worried about Delta’s bankruptcy filing,” he says. “The airline industry is highly regulated, so I wasn’t concerned about safety, and if the company did go belly up, my losses would have basically been limited to the cost of any outstanding plane tickets, assuming of course that another airline would not have honored the tickets.”
But the issues may be different when it comes to a big-ticket item like a car.
“When a person buys a vehicle, there are relatively long-term considerations that go far beyond the initial purchase,” Carney says. “A potential car buyer may wonder who will stand behind the warranty work if the automaker goes under, and whether vehicle parts will continue to be available. It’s a whole different situation.”
When Delta Airlines and Northwest Airlines [which was purchased by Delta in 2008] and United Airlines spent time in Chapter 11, some competitors complained the filing gave the bankrupt airlines an unfair advantage, notes Frederick Tung, a corporate and securities professor at Emory's School of Law.
“The suspension of debt payment and other tools provided to a debtor reorganizing under Chapter 11 can confer some significant competitive advantages,” he says. “But the filing can also send warning messages to a variety of constituents. A Chapter 11 filing sends a signal, in a very transparent way, that a company is in trouble.”
Suppliers and employees alike may get nervous, and that can have a negative effect on operations, Tung adds, noting that nervous workers may look for other employment, and suppliers may decline to deliver goods or services unless they’re paid cash on delivery.
“Management is also affected to some degree,” Tung says. “The bankruptcy court and creditors committee are likely to keep a close watch on the company’s activities while it’s in Chapter 11, and although management may be able to continue ordinary business operations, it will likely have to seek court approval to make any significant investments in new lines of business or product lines. So there are positive effects to a Chapter 11 bankruptcy, but there are also negative ones.”
In general, it’s not clear that automakers gain a significant competitive advantage from a bankruptcy filing, notes Tung.
“In this case, a bankruptcy filing clearly benefitted Chrysler’s sale to Fiat, since the Italian car company wanted to wrap up the deal fairly quickly,” he notes. “Chrysler’s bankruptcy sale was made under Section 363 of the U.S. Bankruptcy Code [which allows a company to enter a court-supervised process to sell assets relatively quickly], which let the ailing carmaker meet the Fiat requirement of a speedy sale.”
The bankruptcy filing also made it easier and less costly for Chrysler to shed dealer franchises that the manufacturer deemed to be unprofitable, but as a strategy, Tung observes, it carries some risks as well.
“Even though the federal government appears to be guaranteeing warranty work on Chrysler vehicles, what happens if dealership closures make it inconvenient for certain car buyers to get to a dealer?” he wonders. “If Toyota, Ford or other competitors maintain a more robust network of dealers, consumers may avoid Chrysler.”
In fact, any competitive advantage that Chrysler gains through lower labor costs and other contractual agreements are already being matched at Ford, Tung adds.
“All of the parties involved know what the economy is like and what has happened to car sales,” he says. “Ford expects equal treatment by its unions so as not to be at a competitive disadvantage relative to its U.S.-based rivals.”
Ray Hill, a finance professor at Emory’s Goizueta Business School, also says that when one or more companies gain a competitive advantage through a bankruptcy filing, other companies in their industry may have to seek similar structural gains.
“There is a sense in which bankruptcy has always been a source of competitive advantage for a business enterprise, although not for the owners-shareholders, who usually lose everything,” Hill says. “In general, a company goes into bankruptcy because it has taken on obligations it cannot satisfy while remaining a viable enterprise.”
While this is the case for GM and Chrysler and their obligations to the United Auto Workers union and its retirees, and to the companies’ dealer network, “in the long run, in order to remain competitive, Ford will need to obtain some of the same concessions through voluntary negotiation that GM and Chrysler can achieve in bankruptcy.”
One example of this domino effect may be seen in GM’s negotiations with the Canadian UAW.
“The head of the Canadian union originally said it was ‘unrealistic’ for GM to achieve the same labor costs as Honda because Honda was a younger company and didn't have the same legacy costs,” Hill notes. “But the Canadian UAW, like its North American counterpart, eventually agreed to new contract terms with lower costs, since GM can only be viable if it gets its costs down to the level of its competitors, just like any company in a competitive market.”
In many cases, a Chapter 11 filing can generate an economic advantage, says Professor Michael Broyde, a law professor at Emory School of Law. But he says the stigma of failed management and an unsuccessful business plan may wipe out the economic advantages of the filing.
Broyde distinguishes between companies that have a sound business model but were crippled by taking on too much debt in the go-go years preceding the 2008 pullback.
“The market may be willing to forgive companies that went on a debt spree and then got caught up in the credit crunch,” he says. “But if the business plan itself is not sound, a Chapter 7 liquidation is likely to lie ahead.”
For GM and Chrysler, he says, the question is whether or not they can design cars that really matter to consumers.
“If they can’t make cars that people want to buy, the U.S. carmakers are in trouble,” says Broyde. “If that happens, it won’t matter how many times they reorganize. In that case they’re likely to simply fail.”
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