COMMENT: While Chapter 11 stops destruction of value it has its critics, writes Chris Giles.

Events have been moving quickly since President George W. Bush in effect added irresponsible corporate executives to his "axis of evil".

Within a few weeks Congress passed the Sarbanes-Oxley Act, ushering in wide reform of US corporate governance, and prosecutors began to arrest those accused of corporate wrongdoing. Scott Sullivan, WorldCom's former chief financial officer, and David Myers, its former chief controller, were the first to feel the long arm of the law.

The judicial effort has been to punish the bad apples; the legislative focus has been on trying to ensure that similar corporate malfeasance cannot happen again. Both are reasonable responses to the discovery of big problems in US corporate governance and they should improve the system. But they do little for those left stranded by the bankruptcies at WorldCom, Enron and others. Few have much faith in US bankruptcy procedures to sort out the claims of creditors efficiently or satisfactorily.

When it filed for Chapter 11 protection from its creditors last month, WorldCom became the largest bankruptcy in US corporate history. "At the end of the day, it became the only realistic option to keep the company whole," said Mr John Sidgmore, WorldCom's new chief executive. At the time, banks and bondholders had already started fighting over the company's assets in the courts. But being WorldCom's only chance of remaining intact does not necessarily make it right.

Chapter 11 of the US bankruptcy code was designed to stop creditors trying to seize a distressed company's assets and get out. Such a land grab would tend to lead to liquidation and the cash raised would often be less than the value of the whole company.

Under Chapter 11, a stay is put on creditors' claims, which stops all attempts to collect a company's debts. Those with a claim on the company's assets are put into groups according to the seniority of their claim, with secured creditors at the top and shareholders at the bottom. A judge supervises negotiations among creditors to draw up a plan for the company and the division of the remaining assets. In the meantime, the existing management runs the company.

While Chapter 11 stops the destruction of value that can occur in a rapid liquidation, the procedure is not short of critics. It is time-consuming and costly, with lawyers and bankruptcy advisers gaining at the expense of creditors. As the incumbent management is still in charge, the procedure is also accused of being too friendly to those who have failed. And competitors complain that, while the haggling over restructuring takes place, the bankrupt company can compete on unfair terms because it does not have to service its debts.

From an economist's perspective, the outcome of Chapter 11-style bargaining is potentially even worse because it can generate inefficient outcomes: bad companies can be saved and good companies liquidated.

Prof Oliver Hart of Harvard University cites an example of a company whose debts are approximately equal to its liquidation value. Creditors would push for a speedy liquidation (to get their money back) while shareholders would hold out for a reorganisation (to get a chance of some return). The outcome would depend not on economic efficiency but on who held the pivotal votes.

But if economics can describe the flaws inherent in Chapter 11, it has more difficulty in offering an better alternative. That said, the dismal science can provide some principles for all bankruptcy procedures. First, the outcome should be efficient. The value of a bankrupt company should be maximised so it can be distributed to the interested parties.

Second, bankruptcy must involve punishment to provide a strong incentive for companies to pay their debts. Senior managers should not, therefore, expect to stay in their jobs after filing for bankruptcy.

Third, the priority of claims on a bankrupt company should be preserved so creditors remain willing to lend. But creditors may want to reserve a small proportion of the assets for shareholders to avoid management (acting on their behalf) taking excessive risks once bankruptcy looms.

In place of structured bargaining procedures among parties with different objectives such as Chapter 11, Prof Hart suggests that economic efficiency would be best served if those with a legitimate claim shared the same incentives.

This requires that a company's debts are first cancelled and the former creditors receive the equity in the restructured company. After the debt-for-equity swap, the new shareholders can vote on the outcome of the company.

Shareholdings would be determined by the level and seniority of the debt held, with perhaps a small proportion reserved for former shareholders.

Clearly the debt-for-equity swap would be a tricky process but no more so than current bankruptcy negotiations. The advantage is that once it is complete, the new shareholders share the same incentives, namely to pick the most efficient outcome for the company.

None of this can help the pensioners, bondholders or shareholders of WorldCom or the other companies that have recently gone bust. But if US lawmakers and those in other countries want to improve the workings of capitalism, they should have a close look at their bankruptcy procedures. - (Financial Times Service)