Ever since Polaroid Corp. slipped ignominiously under Chapter 11 bankruptcy protection in October 2001, it has been portrayed as a textbook case of how bankruptcy proceedings can help a failing company emerge with a promising future.

True, the Cambridge, Massachusetts, company, which introduced instant-imaging photography in 1947, still needs to find a way to recover from management errors that caused it to miss most of the digital-photo revolution — while making bad investments and bad recapitalization moves.

But just 10 months after filing, the company had sold all of its assets to Bank One Corp.’s One Equity Partners (OEP) venture-capital arm for an announced $255 million in cash and $200 million in assumed trade liabilities. Secured creditors have been paid off nearly in full, while unsecured creditors are to receive a healthy 35 percent of a new, privately held Polaroid. Former Ford Motor Co. CEO Jacques Nasser has been named Polaroid’s nonexecutive chairman, with responsibility for filling the vacant chief executive spot. (CFO William Flaherty and general counsel Neal Goldman have run the company since CEO Gary DiCamillo resigned last July.)

Officers of the debtor, the original Polaroid, have congratulated themselves for getting the escape from bankruptcy on track so quickly. In the waning days of 2002, Polaroid was close to a final reorganization that would end its case, if approved by the court.

Not everyone has fared so well, of course, including Polaroid shareholders, employees, and retirees. The company has had sweeping layoffs and has discontinued some severance payments. And three days before its filing, it terminated retiree health benefits. Still, both OEP and Judge Peter Walsh, who presided over the case in U.S. Bankruptcy Court for the District of Delaware, have praised the results of the process, which Walsh calls “in the best interest of the estate.”

But some critics are pointing to the Polaroid case as a demonstration of what’s wrong with corporate-bankruptcy reorganization. They say the system is so weighted toward debtors that it fails to encourage the active bidding that could produce fairer, more-lucrative resolutions for creditors and other stakeholders. There are complaints, too, that the courts fail to scrutinize the financial and operational steps that debtors take before their bankruptcy filings.

Ultimately, these critics say, Polaroid provides a look at a system failing miserably even at its stated goal of maximizing returns to creditors and parties in interest. Among the questions emerging from this bankruptcy: Did Polaroid unfairly favor OEP over other bidders? Did it wield too much power over the sale process? In the end, was the price paid too cheap? By some accounts, OEP paid a net amount of less than $80 million, plus assumed trade liabilities, to gain a company with more than 1,000 patents and $1.5 billion­plus in worldwide asset value.

“It’s possibly the worst case I’ve ever seen,” says Lynn LoPucki, a law professor at the University of California at Los Angeles. The bankruptcy court’s job “is to regulate the relationship between debtors and creditors,” he says, but in recent years, debtors and the largest creditors, usually banks, “have taken control of the courts,” and get from judges “whatever they want.” Poorly supervised reorganization plans often result, and less-powerful parties are cowed into approving them — just to get some semblance of a return. “The current system just destroys value,” says LoPucki.

Was It a Fire Sale?

Compared with the explosive wide-screen, Technicolor collapses of Enron and WorldCom, Polaroid’s bankruptcy has been more of a long, slow fade. Yet because of the way it used the bankruptcy courts, Polaroid seems worthy of the same kind of scrutiny that accompanied those other collapses.

In theory, of course, Chapter 11 is designed to provide financially troubled corporations with protection from secured and unsecured creditors while a plan is formulated for paying off debts. A court-approved plan gives creditors first crack — often in the form of equity in a new company — with common shareholders typically receiving little or nothing. Along with the court, creditors themselves serve as watchdogs, making sure the company plays by the book and preserves value.

But in reality, according to LoPucki, the competition for business by bankruptcy courts — especially in Delaware and its closest rival district, New York State — creates “a race to the bottom” that invites venue-shopping by companies. The jurisdictions gain reputations for letting debtors call more of their own shots, he says. And this may contribute to a rate of repeat bankruptcy filings in the Delaware bankruptcy court that is 10 times higher than the average elsewhere, except New York.

Some observers suggest that Polaroid didn’t belong in Chapter 11 in the first place. “OEP got the assets at a fire sale,” says Ulysses Yannas, a Buckman, Buckman & Reid Inc. analyst who has followed Polaroid for 30 years. “It’s a company that should never have died.” In his opinion, “the judge should have forced the company to come up with a plan to run the entire company…properly.” Polaroid’s initial bankruptcy petition, citing a July 1, 2001, filing with the Securities and Exchange Commission, actually listed worldwide assets of $1.8 billion and liabilities of $948.4 million — although Polaroid claimed revenue declines had stifled its ability to pay off or restructure maturing loans and bonds. It blamed the sales fall-off on a weak instant-film market, among other factors, while asserting that high manufacturing costs had penalized earnings.

There are no strict standards for what companies qualify for protection, which experts claim may be a good thing. “The bankruptcy code is designed to be very flexible,” says Harvard Business School professor Stuart Gilson. “When you base the reorganization on rigid rules and regulations, you can make costly errors. You can get a lot of gaming by management in that case.” Still, of course, there’s no guarantee that companies won’t game today’s system, either.

Current Polaroid executives, and most other principals, generally won’t discuss the case, citing the continuing court proceedings. In his June 28, 2002, sale order to OEP, though, Walsh praised the participants and said unsecured creditors, particularly, had “achieved a significant result in producing value.” Still, steps by the debtor, which unsecured creditors fought until the 11th hour, seem to have led ultimately to sharply lower valuations than might otherwise have been possible.

Anatomy of a Bankruptcy

Early in 2001, Polaroid retained business advisory firm Zolfo Cooper and investment bankers Dresdner Kleinwort Wasserstein to help it restructure debt or complete a nonbankruptcy reorganization — efforts Polaroid abandoned when it defaulted in July and August on $26.3 million in bond payments. That caused the immediate maturity of $575 million in debt securities, magnifying its financial pressure. It then ramped up its efforts to find a buyer. But former Polaroid CFO William O’Neill, a 30-year veteran who left the company in 1999 and now serves on the board of Polaroid unsecured creditor Concord Camera, says chances were slim that then-managers could create a workable reorganization plan. “Where was the credibility of the old management?” asks O’Neill, by way of explaining Polaroid’s financial plight at the time. “The company needed financing, and who was going to loan them money under the old management? The answer was nobody.”

Dire financial straits notwithstanding, Polaroid paid senior executives and directors a total of $6.3 million in bonuses, consulting fees, and lump-sum pension payouts in the months before the filing. Payments included $1.7 million in incentive comp to former CEO DiCamillo, while former CFO Judy Boynton got $300,000 in severance, a $510,000 stock award, and a $638,000 lump-sum pension payout. (Boynton, now the CFO of Royal Dutch/Shell Group, is listed as an unsecured creditor, for an additional severance of $600,000 she is still owed.)

Even after its filing, the company continued trying to enrich senior executives, while lowering asset values. In November, it sought the court’s permission to pay top executives who had stayed through the filing — including Flaherty, Boynton’s replacement — up to $19 million in so-called key-employee retention programs (KERPs), including some proceeds from any future sale of the company. While KERPs are common, Judge Walsh balked at the amount. He eventually capped a total package at $6 million, saying that “to swallow the…program that the debtors put forth, quite frankly, is too much for me.” The following month, when the company asked him to approve the $32 million sale of one profitable Polaroid business, Polaroid ID Systems Inc., to a divisional president, Walsh instead ordered that it be put out for bids.

E.K. Ranjit, CFO of Digimarc Corp., which won the division with a bid of $55 million, says Digimarc expressed interest in the Polaroid ID Systems business before the bankruptcy filing, but “couldn’t work out good economic terms.” When Digimarc heard that a sale to a manager was being arranged, Ranjit says, “we approached them again, but they said, ‘Sorry, we’re selling to management.'” Only after the order for a bidding contest was Digimarc able to compete, he says.

Assets Without Value?

When Polaroid made startling changes in the financial picture it presented to the court, though, Judge Walsh went along. On December 17, 2001, Polaroid filed its official Schedules of Assets and Liabilities, intended as a more-comprehensive summary than the preliminary “First Day” numbers used in seeking Chapter 11 protection. Suddenly, Polaroid claimed a far lower asset base: $714.8 million, compared with the $1.8 billion in the First Day report. (Liabilities were listed as $1.1 billion, up from $948.4 million.)

Most of the $1.1 billion asset change reflected exclusion of cash, real estate, equipment, inventories, and accounts receivable belonging to Polaroid’s foreign subsidiaries, which the company had chosen not to place under court protection. After its bankruptcy filing, Polaroid stopped submitting financial statements for the subsidiaries, which the 2000 annual report listed as generating up to 80 percent of Polaroid’s net income (due in part to the concentration of marketing and R&D costs in the United States).

Even though the foreign subsidiaries were not in bankruptcy, the company was required to list the value of its stock in them. Polaroid, however, called that value “undetermined,” meaning that the subsidiaries were recorded at an effective value of zero in the asset schedule.

In court, shareholder representatives and others raised questions about this valuation of foreign assets and other items for which Polaroid listed the value as undetermined — including trademarks, patents, and a 24,000-piece art collection. Said Walsh at one point: “I’m not sure the revenue produced by the patents and copyrights are all that important in evaluating the company’s affairs.” It was a comment some in the courtroom considered strange, since Polaroid’s entire revenue stream is generated by patented product lines. (Future revenues will also rely heavily on brand licensing deals, according to a Polaroid spokesman.)

Asked by attorneys for Stephen Morgan, leader of a shareholder group, why the foreign subsidiaries weren’t valued, CFO Flaherty said they were part of “Mother Polaroid,” and were essentially worthless if the parent ceased to be a going concern. Any book value for the subsidiaries, art, patents, and trademarks, he added, would be misleading. The judge concurred, ruling that the best way to value assets was in a “fair and open” bidding process.

A Creditors’ Plan

Last April, the company drew up a “placeholder” reorganization plan premised on the sale of all of the company’s assets foreign and domestic to OEP, part of a so-called stalking-horse bid. This bid is a lead offer against which other offers are supposed to compete. (Polaroid’s choice of OEP as the stalking horse reflected a search since “early 2001,” according to testimony from Dresdner Kleinwort Wasserstein, Polaroid’s investment bank.) The April plan allowed for competing bids to be received at a June auction, along with OEP’s initial bid of $265 million, plus $200 million in assumed trade liabilities. But the bidding procedures, allowing the debtor to determine which prospective bidders got access to proprietary data, among other debtor privileges, drew numerous complaints from the U.S. Trustee counsel, Mark Kenney, engaged in the proceedings as an observer.

The procedures, according to a written objection filed by Kenney, “vest the debtors with excessive and inappropriate authority to control the bidding process” and “to chill the bidding to ensure that the subject assets are sold to their handpicked buyer.” He also noted that the committee of unsecured creditors had vehemently opposed the sale, and said he believed that Polaroid’s plan was “to liquidate in a transaction that is primarily for the benefit of the secured creditors.”

Indeed, the unsecured creditors and shareholder Stephen Morgan, along with the Polaroid Retirees Association, had opposed the bidding on numerous grounds, saying that Polaroid had dramatically undervalued its assets and should instead be reorganized.

At a May hearing on the bidding procedures, a month before the auction, the judge overruled all objections, but changed some bid procedures and extended the auction date several weeks to allow the unsecured creditors to present a reorganization plan as a competing bid to the OEP deal. (Kenney indicated, without explanation, that these changes satisfied his concerns.)

Backed by financing from Congress Financial and Deutsche Bank, the unsecured creditors prepared their plan. It didn’t contain a dollar value, since it was in the form of a reorganization. But it gave unsecured creditors 100 percent of the new company, after paying off the secured creditors, and raised the possibility of retaining the pension plan — which wasn’t included in the OEP bid.

The June 26 auction, to determine who would eventually run Polaroid, presents one of the best examples of how Polaroid and its secured creditors seemed to control the bankruptcy process. Both OEP and the unsecured creditors’ committee presented their offers, the only two in the auction. Polaroid attorney Gregg M. Galardi, however, disagreed with financial projections made by the committee, and said it lacked sufficient “exit financing” to get the company out of bankruptcy protection. The auction was recessed. The committee returned with an oral commitment for exit financing, but said it needed three days to get a written term sheet. Polaroid and secured creditors, however, were unwilling to delay the proceedings. Further, Galardi said they still preferred a sale to a reorganization, suggesting that unsecured creditors would be out of the running in any event.

Seeing the writing on the wall, the unsecured creditors dropped out, agreeing instead to participate with OEP. For its part, OEP increased the participation for unsecured creditors from the original 6 percent to 35 percent, while lowering the total of the offer to $255 million, plus trade-debt assumption.

Getting Cash Back

Walsh approved Polaroid’s sale to OEP on June 28, after hearing testimony from Dresdner Kleinwort Wasserstein that the bidding had been open and fair. Because the unsecured creditors had withdrawn their bid, the judge didn’t analyze the proceeding transcripts before making his ruling. “There is absolutely no testimony to support the conclusion that anything was withheld from the market in [this transaction],” he ruled. On July 31, Primary PDC Inc., as the “old Polaroid” shell is known, received a check from OEP for $186.7 million, along with 35 percent of the stock of the new company, to be distributed to unsecured creditors. OEP received all of Polaroid’s assets, including all of its nonbankrupt foreign subsidiaries.

Of the $255 million total to be paid, $50 million went directly to prepetition lenders. Other terms of the deal, however, allowed OEP to reduce its price by $18 million. OEP got all of Polaroid’s cash except for $45 million that Primary PDC kept for administrative claims and other costs. Neither OEP nor Polaroid has revealed how much cash was transferred in the deal (the judge allowed a filing of many sale disclosures under seal), but unsecured-creditor estimates show the company having at least $200 million in cash at closing. If the estimates are accurate, the $237 million in OEP payments would have returned it $164 million in cash (plus about $1.5 billion in other assets), for a net cost of $73 million.

Polaroid retirees had feared the results of a sale to OEP, and that fear was justified. After June 28, the company’s cash balance plan was terminated and handed over to the federal Pension Benefit Guarantee Corp., meaning many retirees had their pension payments slashed. Employees on long-term disability received letters informing them that they would not be hired by the new company and that their benefits were being terminated. Indeed, the Massachusetts attorney general’s office had difficulty convincing OEP, as owner of the new Polaroid, to sponsor the retirees’ supplemental Medicare plan, even though that sponsorship costs nothing except time spent keeping the books.

An appeal has been filed in the U.S. District Court in Delaware by shareholder representative Morgan. (Shareholders never received official status in court, because the judge ruled Polaroid’s assets were insufficient to pay them anything.) Several retirees and shareholders have requested that the judge appoint an independent examiner to investigate their claims that Polaroid engineered the bankruptcy filing in bad faith.

Retirees retain the right to sue the company’s directors’ and officers’ insurance policy to cover claims. But Derek Jarrett, a former Polaroid corporate vice president of international operations and now a member of the 2,600-member Polaroid Retirees Association, says retirees are resigned to ending up with nothing, even though the fight continues. “The attitude of the retirees is simple,” he says. “We’ve lost our ESOP shares, health benefits, life insurance, but we are going to get these people that robbed us of the respect for the company that we felt part of.”

While most issues still in the appeals process relate to pro-debtor rulings in the bankruptcy court, a number of questions about the bankruptcy process itself will go unanswered. They include: How can a debtor’s sealed financial documents and valuations be verified when contested? What checks can prevent the debtor — sometimes more interested in controlling the process than in winning top dollar — from abusing its authority to decide who gets access to proprietary information? Should judges place so much faith in asset sales as a way to maximize estate value? In short, how can the process, while granting corporate debtors protection from creditors, still hold those debtors to a high degree of public scrutiny and accountability?

As a private company now, Polaroid is no longer required to file financial reports with the government. But Jarrett and others from the once-great camera concern see a liquidation ahead. “OEP knows that it’s worth so much more as a break-apart for them,” he says. “People on the inside that I’ve talked to say the situation is very bad.”

Former CFO O’Neill, while more optimistic, is hedging his bets. “They’ve got great assets and opportunities,” he says. “They will either run it well and succeed, or run it poorly and fail.”

Sadly, LoPucki’s research indicates the odds are on failure. Of the companies that emerge reorganized in Delaware bankruptcy court, he reports, 54 percent fail within five years, either by refiling, distress-merging, or liquidating, compared with an 18 percent failure rate for all other district bankruptcy courts combined.

Kris Frieswick is a staff writer at CFO.

The Next Corporate-Reform Drive?

If bankruptcy reform catches on this year in Washington, D.C., Polaroid Corp. could well be the rallying cry.

Although Sen. Charles Grassley’s bankruptcy bill died in Congress last fall, the Iowa Republican is expected to pursue legislation again this year. The bill focused mainly on consumer bankruptcies, but sought also to reduce the ability of companies to stay in the driver’s seat, limiting the debtor’s exclusive reorganization period to 18 months.

At least three government agencies are reported to be conducting investigations into the Polaroid case, which certainly contains fodder for legislative debate.

One congressman sure to be active in reforms is Massachusetts Democrat William Delahunt. At one point, the congressional delegation for Polaroid’s home state wrote to buyer One Equity Partners, requesting that it retain the Polaroid pension plan. The letter went unanswered. Delahunt’s own legislation last session, which also failed, would have required companies to file where they are headquartered. —K.F.