Should companies lose the freedom to choose where to file for bankruptcy?

Large, public companies such as Enron, Worldcom and Lehman Brothers can choose their bankruptcy courts. They should lose that freedom for three reasons:

• They were never intended to have it.
• It harms the companies and their investors.
• It is corrupting the bankruptcy courts.

This “freedom” comes from a law that allows a debtor to file at its “domicile” or “where the case of an affiliate is pending.” The drafters didn’t anticipate that a company such as the Tribune Company — whose headquarters and principal operations are in Chicago — could use the law to file in Delaware, its state of incorporation, where its only connection is the filing of a piece of paper and the payment of a small fee once each year.

Nor did the drafters anticipate that a company such as Winn-Dixie — which operates in the Southeast — could form a shell New York corporate subsidiary, assign some debt to it, put it in bankruptcy in New York, and then, 12 days after the farce began, put Winn-Dixie in bankruptcy in New York on the ground that “the case of an affiliate is pending” there.

Empirical studies show this “freedom” harms, rather than benefits, the companies. Managers choose courts that let them take big bonuses or shield them from personal liability. Bankruptcy lawyers recommend courts that will award them higher fees. Bank lenders insist on courts that will let them charge outrageously high fees for financing the bankruptcy and have “drop dead” control over the companies. One study showed that companies choosing Delaware — the court most often chosen — were seven times more likely to be back in bankruptcy within five years.

Reorganizing big, bankrupt companies is a glamorous, multibillion-dollar industry. Some courts compete for that industry by favoring the positions of parties who can bring the court more cases — corrupt or failed executives, bankruptcy advisers and bankruptcy financiers. The losers are all the other parties to the bankruptcy case — creditors, shareholders, employees, landlords, suppliers and customers.

The Delaware bankruptcy court has six judges even though the state doesn’t generate enough bankruptcy cases internally to keep one judge busy. To protect their own jobs, those judges must rule in ways that keep the cases coming. That is not fair to other parties. The lesson to draw is that one side in litigation should not be choosing the court. Companies should be limited to filing at their headquarters or the location of their principal assets.

The next great wave of corporate bankruptcies is upon us. Current law provides companies with extraordinary flexibility in choosing which court to handle their Chapter 11. That flexibility should be maintained. It ensures that experienced courts confront the challenges that the next few years will bring.

No one disputes that companies use the freedom they have under the Bankruptcy Code to select where to file their cases. Roughly 60 percent of large, publicly held companies filing for Chapter 11 in the last five years have selected either the Delaware or Southern District of New York bankruptcy courts.

Many benign reasons explain this preference. Companies choose courts with experience. Overseeing the reorganization of a large corporation is no ministerial task. Judges have to create an environment where the parties can decide on the proper course for the company. They need to know when to intervene and when to let the parties craft a solution. Delaware and the Southern District of New York have been handling a predominant share of large cases for over 15 years.

Today’s large corporations have complex capital structures. New financing instruments such as second-lien loans and credit-default swaps complicate the restructuring efforts. A Fortune 500 company does not want to be a learning experience.

All agree that companies pick courts strategically. The crucial question is the extent to which decision-makers’ interests align with maximizing the value of the company. Gone are the days when Chapter 11 could provide a refuge for those who had steered the company into distress. Turnaround experts have often been put in place before a company files for bankruptcy. The company often must consult with its lenders over venue. These lenders, who often will end up with a large share of any reorganized company, will be slow to endorse a venue that consumes value.

In bankruptcy as in life, it is often better to make the pie bigger than to fight over the size of the slices. Claims that the data show that current practice is corrupt miss the mark. These assertions rest on debatable assumptions, and one needs to attend to the limits of available evidence.

Each wave of corporate restructurings since the time of the railroads has brought new sets of challenges. We cannot predict the nature of what bankruptcy judges will confront in the coming years, but we are best served by allowing companies to take the most difficult cases to courts that have gained the confidence of those with money on the table.