Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE EFFECT OF EXISTING RULES ON REORGANIZATION VALUE

The existing bargaining-based process appears to fall substantially short of the goal of maximizing total reorganization value. This happens both because value is often dissipated during the process and because the ultimate outcome of the process might not be value-maximizing.

(i) The dissipation of value during the reorganization process: The reorganization process under the existing rules takes substantial time (see White, Lopucki and Whitford, Weiss, and Gertner and Scharfstein ). During this time, substantial value might be dissipated. To begin with, the Chapter 11 process involves substantial administrative costs. Indeed, the fees paid to lawyers, accountants, and other professionals in a Chapter 11 reorganization of a publicly traded company are often on the order of tens of millions dollars. (In one recent reorganization of a major corporation, for example, the administrative expenses of the company and of the creditors committee came to $3.5 million per month — see Cutler and Summers ).

Second, and more importantly, the company under reorganization might incur substantial “indirect” costs from functioning inefficiently during the reorganization process. Because the incentives of management during the process are generally not well aligned with the maximization of reorganization value, the management decisions during the process are likely to be distorted. And because of the insolvency cloud hovering over the company, potential business partners may be reluctant to deal with the company or may demand especially favorable terms.

(ii) Potential inefficiencies in the structure emerging out of the process: There are reason to suspect that inefficiency costs might continue to be incurred even after the reorganization process ends, because the structure emerging out of the process might not be optimal. White suggests that the existing process is biased in favor of continuation – that is, the company is likely to continue as a going concern even if the most efficient route would be liquidation. And Roe suggests that the nature of the existing bargaining process often leads to an inefficient choice of structure for the reorganized company — and, in particular, to excessive debt in the capital structure. Both arguments are consistent with the empirical evidence that a large fraction of the companies emerging out of reorganization go through a financial restructuring within the subsequent few years (see Hotchkiss ).