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Strategic Bankruptcy

University of California Press

In December 1986, I spent many days sitting through hearings in a lower Manhattan bankruptcy court. The courtroom was filled with scores of lawyers and financial experts discussing capitalization rates, valuation ratios, depreciation values, and other technical financial measurements. As I sat listening to the estimates of the worth of the asbestos manufacturer Johns-Manville, I thought about the man sitting right next to me on the wooden court bench. He was having difficulty breathing through an oxygen mask. On that day at the federal courthouse, he was the only visible reminder of what these technical proceedings were all about. He was dying of asbestosis.

Later I asked him what he thought about the bankruptcy proceeding. He told me: "I'm not sure I really understood all those numbers. I just hope we [asbestos victims] finally get something before we die. We've been through so much. I guess they [Manville managers] had no other choice [than declaring bankruptcy]." The bankruptcy court would later decide his fate and the fate of others injured by Manville's asbestos products.

In June 1983, Continental Airlines' senior vicepresident for flight operations jotted down some notes during a meeting at which the airline's labor troubles were discussed: "I don't believe we can get these [labor] concessions on a voluntary, persuasive basis. We must get an [an] awfully big stick…. Most effective stick might be Chapter 11" (court

testimony, In re Continental Airlines, 3 Bankr. L. Rep. [CCH] [Bankr. S.D. Tex. 1984], and Murphy 1986, 223).

Three months later, Continental declared bankruptcy and abrogated its labor contracts with its unions. Continental's CEO, Frank Lorenzo, began referring to the company as "the new Continental" and to any employee working for the firm after its bankruptcy as a "founding employee" (see Continental Airlines, annual report, 1983). One of the "founding employees" at "the new Continental" found his salary immediately reduced from $45,000 to $30,000 (New York Times [hereafter cited as NYT ], September 24, 1984, D 1), and a ticket agent came to work after the Chapter 11 filing and found that her hourly wage had been cut from $10 to $7.50 per hour (NYT, September 6, 1985, D 2).

Employees wondered how the company could violate labor law without penalty. Union officials complained bitterly that Lorenzo had unilaterally broken legally negotiated contracts. But pro-management observers countered that Lorenzo simply had no choice—he responded to a set of financial conditions beyond his control. Lorenzo was later hailed by Fortune magazine as one of America's "most fascinating business people" (January 5, 1987, 72) and as "an imaginative entrepreneur" (February 17, 1986, 72).

In 1984, a Texas jury ruled that Texaco had illegally interfered with Pennzoil's agreement to acquire Getty Oil. The jury awarded Pennzoil $10.53 billion in damages, the largest court award in history. Texaco refused to pay the award, despite the fact that it had $35 billion in assets and approximately $13 billion in equity. Instead, Texaco declared bankruptcy. Pennzoil charged that Texaco was using bankruptcy to force Pennzoil to accept a lower award. As Time magazine reported at the time, "the U.S. was faced with the spectacle of a healthy corporation sheltering under laws ostensibly intended for the weak and the ailing" (Time, April 27, 1988). The Texas jury probably wondered why it had spent so many days in the courtroom listening to testimony if its decision could be rendered ineffective through a bankruptcy filing.

What is happening in bankruptcy court? We usually think of bankruptcy as something bad—a place that managers try to avoid. Scores of popular books with titles like Turnaround: Avoid Bankruptcy and Revitalize Your Company (Freiermuth 1989) counsel managers on how to steer clear of what is depicted as the ultimate business disaster. According to popular belief, bankruptcy occurs when management's plans go sour. As Freiermuth puts it: "Texaco, Bank of America, LTV, A. H. Robins, … mere mention of the names of corporate giants … evokes a certain image of what can happen to a business when the best-laid plans do not develop as expected" (1989, introduction).

But is this true? Do managers avoid bankruptcy and only accept it when all options are exhausted? Is bankruptcy always an anathema to "good business"? In this book, I shall show that profound changes have occurred in our economic, political, legal, and organizational landscape. Bankruptcy has become a strategic, political device used by large corporations and commercial creditors. Recent cases suggest that firms are beginning to view bankruptcy, not as something to be avoided, but as another weapon in the corporate arsenal.

Consider some recent bankruptcies. Manville declared bankruptcy to resolve the liability problem created by its harmful asbestos products, despite the fact that it had over $2 billion in assets. A. H. Robins, notwithstanding apparent financial vigor, entered Chapter 11 to create a payment scheme for women injured by its Dalkon Shield intrauterine device. Continental Airlines and Eastern Air Lines, both led by Frank Lorenzo, coupled bankruptcy filings with the abrogation of all of their labor contracts. Texaco, one of the nation's most profitable oil companies, entered bankruptcy to reduce a court-imposed damage award. LTV, a major steel producer, tried to shift the obligation of providing pension funds to retirees to the federal government through bankruptcy. Numerous smaller companies have declared bankruptcy to avoid cleaning up toxic waste sites. These cases

challenge the notion that bankruptcy is contrary to "good business." Instead, it appears that corporations or creditors invoke bankruptcy to achieve a variety of organizational or political goals. Moreover, the usual arbiters of economic health—banks, large insurance companies, bond-rating agencies, and investment bankers—increasingly share the view that bankruptcy is legitimate business strategy.

In this book, I analyze three of the largest of these cases: Manville, Continental, and Texaco. I plan to show that each firm filed for bankruptcy only to accomplish a financial or political objective that it had tried unsuccessfully to achieve through more routine processes. All parties to these cases recognized and operated on the assumption that this limited objective was all that was being pursued. Liquidation of the firm was thus not considered a serious option.

You will see that these companies spent incredible resources and public relations efforts to show their customers and suppliers that they were not "really bankrupt." Perhaps they were more right than we realized. I shall illustrate through these examples that companies can "manufacture" or "construct" a claim to bankrupt status through creative accounting, interpreting the terms liability and assets in novel ways, separating company assets from those of a subsidiary, or shifting assets from one corporate entity to another. I argue that terms such as asset, liability, insolvent, and bankrupt are far from concrete and objective but instead are subjective and open to competing interpretations.

Oddly, academic theories of bankruptcy have missed the significance of these changes. The assumption that bankruptcy is a financial state of affairs that managers loathe still dominates these theories. There has been a tendency to treat bankruptcy as managerial reaction rather than an action . Because these theories ignore the possibility of bankruptcy being a strategy, we are left with a functionalist view of the bankruptcy process: firms enter bankruptcy when they have no other choice. In this study, I turn the assumption of accepted bankruptcy theory on its head. Rather than viewing

bankruptcy as something that is avoided, I consider the possibility that creditors or corporations may choose bankruptcy as a strategy.

While academic theories of bankruptcy seem trapped by their assumptions, some journalists have noted the increasing use of bankruptcy as a strategy (Newsday, April 14, 1987, 43). Unfortunately, these accounts are limited in their consideration of other powerful organizations in this strategic decision-making. Large insurance companies, commercial banks, auditors, and bond-rating agencies all play key roles in the business crises I analyze in this book. These institutional actors continually constrain and shape the options available to management at any given time. While I plan to show that these bankruptcy filings result from strategic decision-making rather than being passive or "natural" responses to market factors, I also argue that we can only understand the choices after accounting for the actions of a wide array of organizations. Thus, viewing the actions of the managers of these firms as either devious or heroic (as many journalists did) misses the fact that other large institutions like financial creditors, insurers, the federal government, and the court have been integral parties to this decision-making.

If I am right that corporations and creditors are coming to view bankruptcy as a strategic weapon, this finding holds wide-ranging implications for the role of the bankruptcy process in society. According to existing theories, bankruptcy is a crucial mechanism in the national economy. It is said to operate both as a neutral forum to collect debt in a fair way and as a neutral market mechanism that discriminates between inefficient firms (which are liquidated) and efficient firms (which are reorganized and continue operating). This book challenges both of these assertions. Despite technical jargon that gives the appearance of objectivity, I view bankruptcy as a political process. As such, we should not be surprised that large organizational players use their legal and societal power to dominate the process. Bankruptcy is about the allocation of scarce resources. In each of the cases discussed,

I chart who won and lost in this allocation. As will be apparent, I question the neutrality of the process.

The Manville, Continental, and Texaco cases involved sharp conflicts between powerful organizations or coalitions of interests: corporations, financial institutions, insurance companies, auditors, health victims, and organized labor. Thus, they provide an opportunity to address important theoretical debates in the areas of economic and political sociology, organizational analysis, the sociology of business, and the sociology of law, as well as bankruptcy analysis. Bankruptcy provides an arena in which to assess the power of competing groups during corporate crises. I hope this study adds to our understanding of how a business crisis is brought about and what types of organizations exercise decisive roles in creating business crises.

Understanding business bankruptcy will also help us understand the larger question of how firms and "the market" interact. Bankruptcy theories are dominated by a market model. Corporations are portrayed as having little impact on the market; they simply react to conditions presented by "the larger business environment." Perhaps this is an apt description of a small firm that has little power to affect the market.1 But, as I shall show, large corporations and commercial creditors have the power to shape what we refer to as "the market." In this study, I detail the levers of power available to corporations and creditors to precipitate or forestall bankruptcy.

"The market" is not an amorphous entity but is made up of lenders, suppliers, and shareholders, many of which have long-standing relationships with their corporate clients. I shall show how corporations, auditors, and creditors play decisive roles in shaping balance-sheet data for strategic advantage. This study suggests, then, that organizations do not

For example, when the market for 8-track audio tapes was replaced by a market for cassette tapes, some small 8-track tape manufacturers declared bankruptcy. The market changed and inefficient firms were swept out of business, to be replaced by more efficient successors.

passively accept market dictates but instead actively work to transform their ties to other organizations that make up the market.

I argue that market models fail to shed much light on the bankruptcies of Manville, Continental, and Texaco because they lend too much credence to balance-sheet data. By accepting balance-sheet numbers as the only objective reality of the firm, market models can logically conclude that Manville, Texaco, Continental, A. H. Robins, and others declared bankruptcy because they had no other choice. But as you will see in the following pages, this view underestimates the extent to which companies and creditors make choices to shape the market data used to legitimate the claim to bankruptcy.

So it is not so much that market-based bankruptcy prediction models are wrong; they simply miss the most exciting part of the story. In the pages to follow, I spend as much analytical energy on what happened before the bankruptcy filing as I do on events subsequent to the filing. My central concerns include: How do liabilities and assets get defined prior to the bankruptcy petition? How do liabilities and assets become "official" liabilities and assets—that is, recognized by courts and government agencies as "real" liabilities and assets? What organizations have the power to influence these seemingly quantifiable, indisputable terms?

I begin with a brief tour through the history of bankruptcy law in chapter 1. My main objective here is to chart the broadening of bankruptcy as an arena in which to handle a larger array of social issues. I show how the Manville, Continental, and Texaco cases emerge from this historical widening of the bankruptcy forum and push the process another step further along. Specifically, I argue that legal changes have led to broader, more contentious definitions of seemingly technical, quantifiable concepts such as debt, liability, and bankrupt . These changes have given powerful institutions increased latitude in defining these terms to suit their interests.

In chapter 2, I discuss a variety of theories of the corporate bankruptcy process and show why they fail to uncover the strategic and political implications of bankruptcy. I focus on the weaknesses inherent in these theories and suggest we move away from the economic functionalism that has thus far dominated bankruptcy analysis. I borrow insights from a variety of fields to develop a framework for better understanding these cases.

Detailed case studies of the Manville, Continental, and Texaco bankruptcies occupy chapters 3, 4, and 5. In these chapters, I focus on the power of institutions to constrain and influence other institutions. I analyze the events leading up to the filing of a bankruptcy petition, as well as events following the filing. In each instance, I show how a Chapter 11 filing was not the only option available to the company, but rather was chosen from a constrained set of options. I detail the levers of power available to institutions both inside and outside the bankruptcy arena. Through these cases, it becomes clear that important social issues, with wideranging implications for the allocation of societal resources, are being decided by the powerful players in bankruptcy court.

In chapter 6, I address the larger theoretical and societal issues raised by my analysis and outline a new way to think about business bankruptcy. Rather than conceiving of the bankruptcy process as punishment, a neutral debt-collection device, or a market mechanism, I suggest that we view the bankruptcy forum as a political arena wherein large organizations attempt to use their power to avoid current financial burdens and shift future financial risk to more vulnerable groups. Conceptualizing bankruptcy in this way raises a set of important questions that have not been adequately addressed in the bankruptcy context: Does Chapter 11 act to facilitate debt collection in a neutral fashion? Does the Chapter 11 process actually fulfill its purported role of ensuring a healthy national economy by weeding out inefficient firms?

As more and more of our largest corporations declare bankruptcy for limited organizational purposes, we need to focus our attention more closely on the bankruptcy arena. Bankruptcy court has become the place where we decide how and when asbestos victims and women injured by the Dalkon Shield will be compensated, whether companies can eliminate unions, and how corporate giants settle takeover disputes. These questions were previously handled in other ways, such as through tort law,2 the collective bargaining process, or by elected representatives in Congress. I hope this book provokes a debate over whether bankruptcy court is the best forum to find solutions to some of the most pressing social and political issues of our time.

A tort is a private or civil wrong, other than breach of contract, for which the court may provide a remedy in the form of damages.

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Excerpted from Strategic Bankruptcy by Kevin J. Delaney Copyright © 1999 by Kevin J. Delaney. Excerpted by permission.
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