The Bearish Bankruptcy

Modern bankruptcy practice under Chapter 11presumptively excludes the large and publicly-tradedcorporate debtor's shareholders from the negotiationtable based on a longstanding assumption that theyhave no economic interest to protect because mostbankrupt companies are insolvent. But bankruptcypractice overlooks a shareholder's most importanteconomic interest: the right to enjoy the reorganizedfirm's unlimited upside potential after all creditorclaims are satisfied. This interest, which is essentiallyan option right, is totally ignored in the debtor'shypothetical liquidation analysis. In a similar way,the debtor's upside potential is not fully captured byprevailing enterprise valuation techniques.Of course, the economic uncertainties that drivecompanies into bankruptcy---as well as the risks thataccompany most reorganization plans-also drivedown the value of equity's option right.

In many cases,the benefits to all other stakeholders of an efficientreorganization will far outweigh the negligible value ofthe upside rights. But in the case of commodity-basedfirms that pursue bankruptcy reorganization indeclining or bearishprice markets (what I call "bearishbankruptcies'), economic theory suggests that theupside potential is likely to be substantial. I argue thatby excluding shareholders from the negotiation table,modern bankruptcy practice effectively severs equity'soption right at the outset of the case. Then, bearish debtors use a variety of complex and understudiedcommercial instruments to eliminate uncertainty andconvert, in the earliest days of the case and withminimal judicial oversight, certain creditors' limitedand fixed rights into unlimited upside rights