Lipson on The BS That Didn’t Bark: Why Didn’t (Doesn’t) Bear Stearns Go Into Bankruptcy

lipson.JPGMy colleague, Jonathan Lipson, is an incredibly astute observer of bankruptcy law and practice. I was talking with him the other day about Bear’s bailout, and he offered some characteristically interesting thoughts. I invited him to share them in written form with our audience, and will be posting his comments in two parts today and tomorrow.

What’s so bad about bankruptcy?

Today’s New York Times reports that both shareholders and lock-up acquiror JP Morgan-Chase have threatened to put the financial firm into bankruptcy if the other doesn’t blink.

But, if bankruptcy is the only thing both sides agree on, why doesn’t the board authorize a chapter 11 filing?

Two classes of arguments have been made against a BS bankruptcy, one about market disruption, the other about value maximization. The cost, delay and uncertainty of bankruptcy could bring the whole system down, the theory goes. In any case, it would wipe out shareholders’ entire interest.

These are, of course, possible outcomes. But they’re not as likely as people think. In any case, the important question is not whether bankruptcy would do this, but whether ex ante we think bankruptcy would be worse than the current deal.

There is some reason to think bankruptcy might actually be better. If so, then something else may explain why BS, JPM and the Fed would rather spend the next couple of years in Delaware Chancery Court than the U.S. Bankruptcy Court for the Southern District of New York.


Market Disruption

Consider first the claim that a BS bankruptcy would irreparably disrupt fragile capital markets. A domino effect is possible, of course: First BS, then Lehman, then JPM, then Citigroup, until only Goldman remains to drool over the carcasses. Bear Stearns is, the thinking goes, simply “too big to fail.”

But this position loses force if we actually think about a how bankruptcy would likely play out.

First, bankruptcy would simply not touch at least some BS entities and many of their larger, system-sustaining transactions. Entities that are banks or insurance companies generally cannot be debtors under the Bankruptcy Code. While this would not keep the public parent company out of the tank, it would appear that at least some subsidiaries would be outside the reach of bankruptcy.

So, too for the major swap, derivative or repo transactions to which the company was party if it went into bankruptcy. These were the sorts of deals that were thought “too big to fail.” A BS bankruptcy would surely disrupt these trillion-dollar deals, the claim goes, thereby annihilating the economy and all of civilization.

But the reality is that’s not how it would work. In 2005, large financial institutions succeeded in having complex “netting” provisions added to the Bankruptcy Code (or expanding ones that already existed) precisely so that the bankruptcy of a major financial institution—e.g., Bear Stearns—would not otherwise disrupt the larger capital markets. These provisions do this by permitting non-debtor parties to close (“net”) out their positions without risk of the cost or delay of a bankruptcy. It would be as though bankruptcy never happened so far as those deals, and those counterparties, were concerned.

In any case, while the too-big-to-fail mantra may have resonance when applied to major commercial banks, it didn’t (at least in the past) send the Fed to rescue non-bank financial firms. Drexel Burnham was too big to fail, too, remember? But we seem to have gotten through their bankruptcy.

Second, to the extent that BS subsidiaries were statutory broker-dealers, bankruptcy would have to be a comparatively quick liquidation under special provisions of chapter 7, not the longer, more drawn out “reorganizations” we typically think of when we think of business bankruptcy.

True, a BS bankruptcy would probably halt future deal flow. But didn’t events leading up to (and including) the announcement of the JPM deal kill that activity? Bankruptcy can’t kill a dead dog twice.

Value Maximization

If bankruptcy law exempts truly system-critical transactions, and those were much of what BS did, what would a BS bankruptcy add? The answer is value maximization—or at least competitive valuation of some sort for those portions of the business that would go through bankruptcy, including the parent company.

This goes to the second argument usually advanced against a BS bankruptcy–it would kill shareholder value. Often, that’s true. But given the appallingly low price offered—even $10/share is a small fraction of its recent close—it is not surprising that many shareholders would prefer a gamble in bankruptcy.

Why? Because in bankruptcy, any major deal to sell or reorganize the company would likely result in some sort of competitive process that would drive the price closer to market. Committees of creditors (and probably) equity holders would vet any deal and object to a process that seemed to dampen value. For example, they might challenge the so-called “Bear Put”, which appears to permit JPM to keep the deal in play until shareholders finally give up. It might also put BS’s valuable real estate on the auction block, rather than give it to JPM no matter what, even as a breakup fee.

Because bankruptcy is increasingly a venue for the sale of assets—rather than traditional reorganizations—a court may well approve a controlled liquidation of the company. But it would almost certainly require a meaningful market test, to assure that the assets received the highest and best price. Today, even with JPM sweetening its offer, we have no idea what the real market value of the company is. The JPM process appears designed to make sure we never find out.

A related argument is that bankruptcy is a costly and time-consuming process. But here, too, there is less than meets the eye.

Those who would make this claim cite Enron, which took several years and hundreds of millions of dollars in professional fees. But the important question is not whether bankruptcy is costly—it is. Rather, the important question is whether, ex ante, it appears to cost more than the current deal.

Given the litigation that the JPM deal is likely to spawn, it is not clear why a well-managed (a big caveat, that) bankruptcy would be any worse. Is one or more roundtrips through Delaware Supreme Court likely to be quicker and cheaper than time on Bowling Green? Perhaps. But more than a half-dozen years of Disney litigation does not bode well.

A final (somewhat incongruous) argument is that bankruptcy would scare off JPM and/or the Fed, who have thrown a lifeline to BS. That may be, but given the deal’s reception, it looks more like an anchor than a float was at the receiving end of the line.

More important, there is simply no reason JPM and the Fed could not have walked into bankruptcy court, arm in arm with BS, proposing the exact same deal that was inked March 16. The only difference would be that it would be subject to court approval. The fact that JPM head Dimon now “threatens” bankruptcy suggests he may understand this.

Indeed, the fact that this didn’t happen is especially baffling when you think about how much bankruptcy might actually benefit JPM. If they really were offering the best deal around—one that a competitive auction in bankruptcy would confirm—then they would also get the benefit of a discharge of most pre-bankruptcy BS liabilities. This means they would not have to worry about unanticipated liabilities—like lawsuits–haunting them after the fact. True, JPM agreed to guarantee a variety of BS obligations in connection with the acquisition. But that could all have been part of the deal run through—and approved by—the bankruptcy court. If it was the best deal going.

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9 Responses

  1. Mike says:

    Terrific post. A lot of interesting content. However, I’m not sure I follow your point about the swaps/repos. I think those transactions were the precise problem. In a bankruptcy, the automatic stay – one of chapter 11’s most valuable protections – would not help Bear. Counterparties to repo contracts could seize Bear’s assets. The chapter 11 would thus not have stopped Bear’s meltdown, because creditors would be free to grab Bear’s assets. Am I missing something? To me, this is one of the most critical reasons Bear didn’t file. Chapter 11 simply doesn’t work as well with large financial institutions as debtors.

  2. John says:

    Terrific post. A lot of interesting content. However, I’m not sure I follow your point about the swaps/repos. I think those transactions were the precise problem. In a bankruptcy, the automatic stay – one of chapter 11’s most valuable protections – would not help Bear. Counterparties to repo contracts could seize Bear’s assets. The chapter 11 would thus not have stopped Bear’s meltdown, because creditors would be free to grab Bear’s assets. Am I missing something? To me, this is one of the most critical reasons Bear didn’t file. Chapter 11 simply doesn’t work as well with large financial institutions as debtors.

  3. pwb says:

    Doesn’t common stock frequently go to (near-) zero in the event of bankruptc?

  4. c.o. says:

    “Doesn’t common stock frequently go to (near-) zero in the event of bankruptc?”

    Absolutely. While shareholder interests are a company’s top priority during solvency, it drops to the bottom of the list upon the filing of a bankruptcy petition. So, it might be safe to say that shareholders definitely get a better deal with an out-of-court restruturing with JPM than they would if BS filed for Chapter 11 protection.

  5. Jonathan Lipson says:

    Re: Mike’s comments: Yes, certain creditors would have been able to grab certain assets under the netting provisions. But I have seen no evidence that they didn’t do this already. In any case, there is no requirement that those entities go into bankruptcy at all. Moreover, in bankruptcy, the Fed could have provided whatever assurances were in fact provided to calm that corner of the financial market. The only difference would be that today we have little reliable information on what actually happened. A bankruptcy would likely force some of that into the open.

    Re: pwb’s question on the value of shares in bankruptcy. The shares are already junior in priority as a matter of both corporations law and common law rules on priority. Bankruptcy doesn’t cause that to happen-state law does. That said, nothing in bankruptcy strips shareholders of whatever equity there is. Thus, the fight in Johns-Manville was over the value of equity’s share. At least historically, LoPucki and Whitford’s work has shown, equity retained some interest more than general rules on solvency and priority would predict. So, if the “real” market value of BS common is $30, and JPM is paying $10, then bankruptcy transaction costs would have to eat $20/share to eliminate shareholders’ equity. Certainly not impossible, but not guaranteed, either.

    Having interferred with the operation of the “market”–as that term includes the procedure known as bankruptcy–the Fed has assured that we will likely never know.

  6. Rick says:

    If the common stock goes down to 0 during a Chapter 11 bankrupsy, how does that help the company going bankrupt? or does it?

  7. Rick says:

    If the common stock goes down to 0 during a Chapter 11 bankrupsy, how does that help the company afterwards that went Chapter 11 bankrupt? or does it?

  8. Rick says:

    If the common stock goes down to 0 during a Chapter 11 bankrupsy, how does that help the company afterwards that went Chapter 11 bankrupt? or does it? Also, what happens in the same situation if the company fails?

  9. Rick says:

    If the common stock goes down to 0 during a Chapter 11 bankrupsy, how does that help the company afterwards that went Chapter 11 bankrupt? or does it? Also, what happens in the same situation if the company fails?