Jon Henes: Failure is an Option—The Brilliance of our Corporate Restructuring Regime
“Failure is not an option.” Gene Kranz, lead flight director for Mission Control for Apollo 13.
In a moment of brilliance, Congress, in 1978, recognized that, in business, failure is not only an option, but the inevitable outcome of economic growth.
Why is this?
Risk is required for growth. While, today, risk has become a four letter word due to the economic debacle, without it, we would not have our greatest businesses, products and technologies. In fact, without it, we would not have become the dominant economy in the world over the last century.
But, with risk can come failure (as well as reward).
So, Congress recognized that we needed a corporate bankruptcy regime that did not punish risk-taking, but provided a framework to enable a company to get back on its feet after being knocked down.
Enabling a company to get back on its feet, however, could not be forced or supported by the government.
This would only result in the state supporting failed businesses.
Rather, the corporate bankruptcy regime needed to provide tools for businesses and investors alike to use if a company deserved to stand back up.
And this is the brilliance of chapter 11 of the Bankruptcy Code.
A company finding itself in financial distress - unable to pay its bills as they become due or stuck with an oppressive capital structure - can seek the protection of bankruptcy to catch its breath and determine whether it can survive by putting its assets to productive use on a going concern basis. But, the company cannot do it alone. Management - which remains in place - can prepare a new business plan, determine its debt capacity and market itself to its stakeholders as a new and improved business if able to emerge from chapter 11. The new business plan, debt capacity and marketing story are all reviewed by the company’s board of directors, which also remains in place and continues to owe fiduciary duties to the corporate enterprise. But, while the company’s management and board remain in place to captain the ship, the company’s stakeholders (at least some of them) need to believe and, in many cases, be willing to significantly reduce their claims or invest new money into the company for it to emerge from chapter 11 as a going concern. This agreement, if reached, is accomplished through hard-nosed negotiations and extensive due diligence, and, then, it must be approved by the bankruptcy court after any non-consenting stakeholders have the chance to object and let their voices be heard. Agreements, nonetheless, are not always reached. Stakeholders do not always believe in the business model and, as a result, would rather see the company liquidated (as opposed to rehabilitated).
Indeed, again this is the brilliance of our corporate bankruptcy system. The free market - the free will of investors (who, generally, are very sophisticated) - determines the fate of the distressed business.
In 2009, we witnesses the free market up-close. Certain businesses didn’t make it. For instance, Circuit City, the huge electronics retailer, shut its doors and liquidated. The question its stakeholders must have asked themselves was “how many electronic retailers do we need?” The answer - especially with the economic world imploding - was not many. But, other large companies did make it, as their stakeholders believed in their business models and long term prospects. Masonite (one of the largest door manufacturers), ION Media (the largest independent television station operator), Wellman, Inc. (manufacturer of polyester resin and fibers) and Hawaiian Telecom (the state of Hawaii’s incumbent telecommunications provided) - just to name four - emerged from chapter 11 as going concerns, with strong balance sheets, with the support of their stakeholders and, today, are poised to compete and succeed in their respective markets. The determination by the management teams, boards of directors and, ultimately, the stakeholders of these and other companies to continue operating or shut down was made based on the strength (or lack of strength) of their business plans and business models on a long-term basis. The free market allows the wheat to be separated from chaff and the strong to survive.
As we head into 2010, we will see more “failures” due to risk-taking - risk-taking we encourage due to the tremendous rewards achieved when the risk (the investments) pays off. For those that fail, the ultimate outcome - i.e., remaining down for the count or the able to bounce back - will be decided by the stakeholders of these companies, which will be based on whether the stakeholders view the company more valuable as a going concern or being liquidated. Because Congress recognized that failure is an option, these companies and their stakeholders, working together, have the framework to decide the best way to move forward and maximize value for all.
Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.