Reorganization without Bankruptcy: Untying the Gordian Knot That Destroys Firm Value

Abstract

This Article presents a new theory for analyzing bankruptcy-reorganization proceedings as well as a reorganization mechanism for public companies that may best meet legislative objectives: maximizing firm value and dividing it according to the claimants’ legal priorities. Called Gordian knot theory, it suggests that there is a strong structural and material connection between reorganization stages, whereby bargaining and litigation between the claimants over the reorganization pie lead to progressive destruction of the firm’s value and infringement on their legal rights. To demonstrate this theory, this Article focuses on reorganization’s allocation and reallocation stages—where the claimants’ original and new rights are determined, respectively—and how the connection between them prevents the legislative objectives from being met. Alternative approaches suggested for attaining these objectives, including Roe’s, Bebchuk’s, Baird’s, Aghion, Hart and Moore’s, and Adler and Ayres’ models, have focused on the firm’s valuation problem and suggested solving it by market mechanisms. The Gordian knot theory suggests, however, that it is impossible to attain the legislative objectives strictly by determining the firm’s value efficiently while leaving allocation problems to bargaining and litigation. This Article further presents a new mechanism for public companies that overcomes this problem by structuring reorganization in a single shot that includes the allocation and reallocation of rights, while eliminating the need for bargaining and court proceedings. It is based on a firm’s going-concern warning that auditors have to issue, explicitly indicating that there is substantial doubt as to whether the firm could remain solvent over twelve months. Under this mechanism, the warning initiates twelve months of voluntary rehabilitation. Then, if the warning is still valid, the junior classes will be able to buy out all of the senior classes at a price of the latter’s claims, similar to Bebchuk’s options model. A successful buy erases the original debt and, if the claimants do not purchase the firm, it is considered insolvent. This Article presents this mechanism—called the reorganization without bankruptcy mechanism—and discusses its advantages: inter alia, in the pre-bankruptcy period, the firm is solvent, it has not breached its contracts, and it is not involved in complex allocation disputes. These advantages bring the reorganization process in line with the legislative objectives, and allow firms to achieve rehabilitation by allowing for funding based on market mechanisms and management’s sole discretion, providing management with incentives for adequate disclosure, and initiating rehabilitation based on objective criteria — all free of bargaining and litigation biases.