Corporate bankruptcy: Costly and often worthless

FORTUNE -- Unsecured creditors of Lehman Brothers may have choked last week when Harvey Miller, the lead attorney on the bank's bankruptcy, told Congress that the final bill to unwind its sprawling claims would likely hit $2 billion and take two more years to settle. He also said some of those creditors might only collect twenty cents on the dollar for approved claims.

To some, Lehman is an example of bankruptcy costs run amuck, driven higher by $1000-an-hour lawyers and pricey consultants out to line their pockets at creditors' expense. Such costs have also come under scrutiny during the mega-bankruptcies being unwound at General Motors, Chrysler and Washington Mutual -- the latter a hobbled bank that just passed the $100 million mark in reorganization fees.

History is replete with similarly expensive tales of woe. The tab for parsing Enron topped $750 million, while WorldCom's hit $657 million and Pacific Gas & Electric's (PCG, Fortune 500) was $462.5 million. In comparison, UAL's (UAUA, Fortune 500) more recent three-year slog through bankruptcy -- at $330 million -- seems almost too cheap to compare.

But some bankruptcy experts argue that those eye-popping figures aren't really that large, given the complexities involved in unwinding institutions such as Enron or Lehman Brothers, or when the sums are compared with the assets held by such bankrupt concerns. In fact, the most egregious and most costly problem with the bankruptcy system may be something else entirely -- that too many companies emerge from bankruptcy only to find themselves distressed again.

Good times for turnaround specialists

That's not to say that bankruptcy costs couldn't come down. Bankruptcy rules make it easier for companies to obtain financing and sweat out their creditors while restructuring, say critics, adding that the executives running the companies are unfazed by the fees because the creditors will end up eating the cost. They also argue that fee applications are generally too voluminous and too difficult to truly challenge, and that judges and creditors' lawyers are generally too timid to question them anyway.

Stephen French, whose company, Legalbill, helps businesses manage the costs of outside counsel, says companies in bankruptcy can see a 15% to 20% reduction in legal costs when they put oversight controls in place. But UCLA Law professors Lynn LoPucki and Joseph Doherty recently wrote that "meaningful objections to fee requests are few, and judges are shirking the duty to review fees absent objection." The professors added that their data indicates only about 1% of all fee requests are cut down and that such fees increased at a rate greater than 10% per year between 1998 and 2007 -- more than twice the rate of inflation.

However, it can often be hard to say which bankruptcy fees are truly excessive. As Professor Stephen J. Lubben, a bankruptcy expert at Seton Hall University's School of Law, noted in one of his own studies, "the idea of professionals receiving millions from a company that is ostensibly 'broke' strikes more than a few as peculiar, or worse," but deciding "exactly how much it should cost to reorganize a corporate entity is a matter of surprising elusiveness."

In the end, he says, the excessive Chapter 11 cost, "like pornography, is recognized by whatever shocks a particular commentator."

The depth of the most recent recession focused attention on those fees again, as a string of high-profile bankruptcies has again fattened the wallets of bankruptcy lawyers and their consultants. Nine of the 20 largest corporate bankruptcies to occur in the last three decades were filed in 2008 and 2009. Last year marked the highest number of billion-dollar bankruptcies ever recorded. And corporate bankruptcies have continued at an elevated clip, with about twice the number of businesses filing for bankruptcy protection in the 12 months ending June 2010, as they did during the same span of time in 2008, 2007 or 2006.

But despite the headline-grabbing string of expenses emanating from the Lehman case and others -- $500 a day limo fees, a few hundred for dry cleaning, or a few million a month in billable hours -- experts say that such costs are not only hard to judge, but relatively small.

Lawyers aren't paid a dime in about 35% of all Chapter 11 bankruptcies, generally because the cases are dismissed or the firm is liquidated. And with the average time spent in bankruptcy in decline, the higher billable hour may be a wash, say some experts.

Bankruptcy's hidden costs

Far more important than a bankruptcy's legal and consultant fees are its indirect costs -- lost sales and profits due to the firm's uncertainty and its financial distress. These can add up to between 10% and 15% of a firm's value; in contrast, lawyer and consultant fees generally amount to only about 1% or 2% of a large company's asset value, or 4% to 5% of the asset value of the smallest firms.

In the end, the cost of lawyers and consultants on a bankruptcy is "trivial," says Professor Edward Altman, an expert on bankruptcy at NYU's Stern School of Business who believes the focus on legal fees in bankruptcy masks a greater and more debilitating danger within the system, one that affects about one-third of all public companies seeking bankruptcy reorganization. The problem? Within four or five years, they find themselves back in a distressed restructuring again.

Despite the bankruptcy code's order that judges independently confirm that a reorganization plan "is not likely to be followed by the liquidation or the need for further financial reorganization of the debtor," these companies are routinely allowed to leave bankruptcy with the same operating issues and over-leveraged balance sheets that caused their original death rattle. Among the recent repeat offenders are Polaroid, Sun Country Airlines, Spiegel/Eddie Bauer Holdings, Filene's Basement, and Firstplus Financial Group.

Some of these companies probably should have never been allowed to reorganize, and been liquidated instead. Others, Altman argues, could have survived with more nurturing. Instead, they were pushed through the reorganization process too quickly and left with too much leverage by investment bankers wanting to collect fees and equity-averse senior creditors wanting to cash out. If the creditors are on board, he says, the courts too often refuse to look at the efficacy of the reorganization plan and refuse to judge the likelihood that financial stress will bow the company gain.

Too many firms come out of bankruptcy but they are not really cured, says Altman, adding that he's much more concerned with the fact that companies can't stay out of bankruptcy than that reorganization costs may seem a little high here or there.

After all, what's more expensive than a corporate bankruptcy? A second one.