Get documents about "The Essential Function of Bankruptcy Law
Document Sample
Draft of Monday, August 13, 2001, 8:24 AM; 9,220 words.
The Essential Function of Bankruptcy Law
NICHOLAS L. GEORGAKOPOULOS*
I. INTRODUCTION.................................................................................................................2
II. THE GAPS OF THE COLLECTIVE A CTION EXPLANATION .......................................2
III. THE PRODUCTIVITY JUSTIFICATION OF THE DISCHARGE OF DEBTS...................4
IV. THE PRODUCTIVITY JUSTIFICATION OF REORGANIZATIONS................................8
A. Contemporary Sweden: Sales of Businesses,
Abuse of Junior Creditors..................................................................................9
B. Pre-1938 US: Strategizing to Abuse Junior Creditors......................... 10
C. The Handicap of Junior Creditors: Tight Credit................................... 13
D. The Failure of Forced Auctions................................................................ 13
E. A Simple Model of False Liquidations and False
Continuations ................................................................................................... 16
V. OTHER PRODUCTIVITY REVIVAL ...............................................................................19
A. Tort Liability Priority ................................................................................. 19
B. Mass Tort Trust Funds................................................................................ 21
C. Escaping Non-Compete Obligations....................................................... 22
D. The Validity of Payments on Long-Term Loans..................................... 23
VI. CONCLUSION .................................................................................................................25
Abstract: Bankruptcy law has conventionally
been considered motivated by a desire to prevent
collective action problems between creditors—races to
assets that destroy value when cooperation would
preserve it. This paper argues that bankruptcy law
performs a more important and general function, it
prevents threats to productive capacity that are caused
by insolvency. The macroeconomic importance of
productivity implies that the parties cannot be expected
to take into account all the cost of their failure, refuting
the laissez-faireist attacks on bankruptcy law.
* Professor of Law, University of Connecticut School of Law; Visiting Professor of
Law, Indiana University Law School (Indianapolis), www.NicholasGeorgakopoulos.org. I wish
to thank Michael Alexeev, Daniel Cole, Bob Heidt, Mark Ramseyer, Jeff Stake, Elizabeth
Warren, and Jim Whitman. Special thanks to Chief Judge Richard A. Posner for extensive
discussions regarding this article. I urge you to send your comments to me at
ngeorgak@iupui.edu.
2 Nicholas L. Georgakopoulos DRAFT
I. INTRODUCTION
The economic analysis of bankruptcy law is dominated by the
idea that bankruptcy law resolves collective action problems. This
dominance is false because the collective action explanation only suits
minor provisions of bankruptcy law. The fundamental choices of
bankruptcy law are not explained by microeconomic models. This paper
argues that the fundamental choices of bankruptcy law address threats to
productivity due to insolvency.
First this paper identifies major bankruptcy law provisions that
are not explained as solutions to collective action problems. That
bankruptcy L&Econ scholars argue against these provisions, shows the
dominance of the collective action explanation.
Insolvency threatens the productivity of the economy in two
major ways that correspond to fundamental choices of bankruptcy law.
Crushing debt reduces or eliminates individuals' productivity incentives.
The discharge of debts that has been available since roman times (with
the cessio bonorum) restores productivity incentives.
Firms that cannot meet their debt obligations are at the mercy of
their creditors and may be liquidated. If the firm, however, is viable in the
long-term, its liquidation is false and destroys productive capacity. The
capacity to reorganize reduces the economy's exposure to this error.
Models of these effects of insolvency and their solutions by
bankruptcy law illustrate its effect and the parameters of the choice
involved for society. The same concern for productivity is evident in
other provisions of bankruptcy law.
The arguments for a role of bankruptcy law do not imply that the
microeconomic ramifications of too liberal a discharge policy or a too
easy reorganization threshold should be ignored. Incentives to deter
wasteful economic failure are necessary. Complete freedom of contract,
however, will produce consequences of failure that are too strict from a
social standpoint because of the externalities of the destruction of
productive capacity.
II. THE GAPS OF THE COLLECTIVE ACTION EXPLANATION
When debtors' financial situation deteriorates, their creditors face
a collective action problem. Each creditor can take measures to collect
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 3
their own debt, but these measures may destroy value of the debtor. If
creditors were acting in concert they would avoid value-decreasing
collection tactics, but each individual creditor is not concerned with
maximizing the recovery of other creditors of the same debtor. The
typical example of this collective action problem considers a creditor
choosing between foreclosing on a single machine in a production chain
of the insolvent debtor or acting in concert with other creditors.
Foreclosing against the machine could satisfy this creditor's claim but
reduce the value of the enterprise by a significant amount. The debtor's
insolvency indicates that acting in concert with other creditors promises
to only pay a fraction of each claim. The individual creditor's choice is
between satisfaction by foreclosure or fractional sharing in a concerted
collection. Obviously the first option dominates, even though this
destroys value for the other creditors.
Many provisions of bankruptcy law are seen as solutions to such
collective action problems. A bankruptcy filing bars individual creditors'
efforts to collect. This forces cooperation and a collective solution.
Repayments of debts immediately before a bankruptcy filing are
considered suspect. Such payments are avoidable and can be recovered
for the benefit of all creditors. This eliminates the incentive to require
repayment in anticipation of a bankruptcy filing. Creditors can also not
insert provisions in their contracts that turn on bankruptcy or insolvency
so as to avoid the collective process.
These rules that can be considered procedural. They do not
correspond to the major features of bankruptcy law, which are the
discharge of individuals' debts and the possibility of a reorganization of
debtor firms. These are persistently prominent features of the US
bankruptcy landscape that are widely copied by other jurisdictions. They
are only questioned by L&Econ scholars who see the solution of
collective action problems as the sole role of bankruptcy law, and who
focus on the distortion of incentives that any lenience causes.1
1 Professor Alan Schwartz has repeatedly applied a microeconomic model in
businesses’ contracting around bankruptcy. See Alan Schwartz, A Contract Theory Approach
.
to Business Bankruptcy, 107 YALE L . J 1807 (1998); Alan Schwartz, Contracting about
Bankruptcy, 13 J. L. ECON . & ORG . 127 (1997). Barry Adler, Ben Polack, and Alan Schwartz
study the incentives of consumers to avoid insolvency and recommend that consumers are
allowed to contract about which bankruptcy chapters to use, Regulating Consumer
Bankruptcy: A Theoretical Investigation, 29 J. LEGAL STUDIES 585 (2000). Professor Douglas
4 Nicholas L. Georgakopoulos DRAFT
The US leadership in the dischargeability of individuals' debts is a
historical paradox. The cessio bonorum provided discharge in roman
law from before the beginning of the Modern Era, attributed to either the
times of Julius or Augustus. Paradoxically, the spread of Christianity,
instead of fostering the lenience of cessio, considered non-payment of
debt a sin, morally tainting the exercise of cessio. In a further paradox,
the Napoleonian civil code, despite being an indirect product of the
French revolution, did not include the cessio bonorum. The
consequence was that it disappeared from the Civil Code-based
continental Europe, only to reappear as a result of the unique political
environment surrounding the passage of US bankruptcy law.2
The discharge of individuals' debts and the availability of
reorganizations are the major features of bankruptcy law that are
unexplained by its role as a solver of collective action problems. The next
sections show that these measures are explained as productivity
restoration measures. Insolvency threatens productivity, and bankruptcy
law prevents its destruction. This explanation also fits several other
bankruptcy law provisions, as explained below.
III. THE PRODUCTIVITY JUSTIFICATION OF THE DISCHARGE OF DEBTS
Insolvency may interfere with individuals' incentives to produce.
The incentive to work is a consequence of the ability to appropriate the
fruit of ones' labor. When individuals are deeply insolvent, however, the
proceeds of their labor are subject to their creditors' collection efforts.
The result is that the incentive to produce is muted or destroyed.
The discharge of debts in bankruptcy revives the destroyed
productivity incentives. Individuals who have been unlucky or
Baird argues that failed firms should be auctioned off as going concerns or piecemeal without
the benefit of a reorganization attempt, an issue that this article will discuss extensively below;
Douglas G. Baird, The Uneasy Case for Corporate Reorganizations, 15 J. Legal Stud. 127
(1986).
2 Professor Whitman discusses the medieval treatment of cessio bonorum but does
not pursue its puzzling disappearance, see James Q. Whitman, The Moral Menace of Roman
Law and the Making of Commerce: Some Dutch Evidence, 105 Yale L.J. 1841 (1996). David
Skeel discusses the political landscape that, after several abortive attempts, produced
bankruptcy with permanence. See David Skeel, The Genius of the 1898 Bankruptcy Act, 15
Bankr. Dev’ts J. 321 (1999).
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 5
unsuccessful are able to file for bankruptcy, and restart their financial life
with a clean slate.
From a microeconomic perspective, debtors should be entitled
to bargain over the dischargeability of their debts. Some have credibly
argued that systematic errors and biases distort that exchange.3
Individuals may be systematically overoptimistic and overestimate their
chance of success, with a result of exchanging their discharge on the
cheap. This argument, however, applies to numerous other exchanges—
notably, gambling—that may be regulated but are not prohibited. If,
indeed, fairness of consideration were society's concern, a simple tax or
fee on waivers of discharge could correct the discrepancy. Credit card
companies, for example, that solicit waivers of discharge could be
obligated to pay a fee for each waiver they receive or solicit, inducing
them to give less of an interest-rate break to customers and leading to
correct decisions about the waiver of discharge. A fear of errors does
not explain a policy that prohibits individuals from waiving the benefit of
th bankruptcy discharge.
From the macroeconomic perspective of preserving the
ay
productivity of the economy, however, bargains that m destroy one
party's productivity incentives involve an externality. The subjective
calculation of the costs of their incapacitation by debtors does not take
into account its effect on others. Each productive entity is a nexus in the
web of economic activity. Every transaction gives rise to consumer and
producer surplus. Every transaction accelerates the velocity of money.
And every transaction that exchanges product for cash leads to more
transactions, more productivity, and consumer and producer surplus.
The removal of a productive individual from this economic web has
consequences that match Maynard Keynes' notion about the multiplier.
Just as Keynes held that the restoration of economic activity has an effect
greater than the spending it requires, so the destruction of an individual's
economic activity has an effect greater than the production that does not
occur.
This argument can be easily put into a formal model that
illustrates the effect on consumer and producer surplus. A society
consists of N individuals denoted by i=1...N. Society produces
3 Thomas H. Jackson, T HE LOGIC AND LIMITS OF BANKRUPTCY LAW 225-79
(1986).
6 Nicholas L. Georgakopoulos DRAFT
aggregate product d to satisfy the demand of the members, d/i being
produced by each individual.
The probability of crushing debt is q, implying that without a
bankruptcy discharge, Nq individuals depart from production and do not
contribute to demand. The idle individuals survive by barter.
The reduced demand and reduced supply may have left prices
unchanged but it has had a large impact on the product and the total
producer and consumer surplus. Consider that aggregate demand is a
function D(z, p), where z is the number of economically active individuals
and p is the aggregate price level. Aggregate supply, similarly, is S(z, p),
and the equilibrium price level is the solution for p of D(z, p)=S(z, p). If
bankruptcy law does not offer a fresh start, then the number of
economically active individuals is z=N(1-q). If crushing debt is
dischargeable in bankruptcy, all N members of the society are active and
z=N. We do not know the impact of the reduced economic activity on
prices, but we know that the effect on aggregate surplus, producer and
consumer surplus, is very significant. Although we do not know the exact
shape of the aggregate supply and aggregate demand functions, we
know that they are not horizontal. As the capacity of the economy
changes, supply and demand are reduced, but much more is reduced the
aggregate surplus.
The graphical representation of this is illustrative. Consider a
graph of aggregate production quantity along the x -axis and average
price level on the y-axis, presenting aggregate supply and demand. The
removal of individuals from economic activity initially only reduces
supply, pushing the downward-sloping supply line to the left. The result is
a new equilibrium at a reduced quantity but at a higher price. The
incapacitated debtors, however, are also removed from consumption.
The result is that demand is also reduced and moved left. The equilibrium
is at a yet lower quantity but at a price that may be equal to the initial.
The double reduction in total product is an effect equivalent to Keynes'
multiplier, and is due to the fact that the incapacitated debtors do not
only stop most of their production but also most of their consumption. A
further crucial effect regards total surplus. The total consumer and
producer surplus is significantly reduced.
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 7
The Multiplier Effect and the Destroyed Surplus
from Economic Incapacitation
Price
Level
Demand
Low Demand
P'
P
Low Supply
Supply
LQ MQ HQ
Aggregate
Product
Quatity
This figure illustrates the effect of discharge on total consumer and producer surplus.
When all members of society are productive, supply is large, illustrated by the Full Supply line.
Since all members are economically active, they are also active as consumers, their demand
being the Full Demand Line. Total production quantity is HQ and the average price level is P.
The economic incapacitation that is caused by non-dischargeable crushing debt implies that
some members will no longer participate in production or consumption. The aggregate supply
after this debt -induced incapacitation is illustrated by the Low Supply dashing line. The
intersection of this with the full demand would be where supply and demand would reach
equilibrium if economic incapacitation did not influence demand. The individuals who no
longer produce, also do not have the funds to engage in consumption. The aggregate demand
drops to one indicated by the Low Demand dashing line. Price (may) remain unchanged at P.
Total quantity produced drops to LQ, even though the direct reduction in production due to
the incapacitation would have only reduced production to MQ and slightly increased price to
P'. The additional reduction in production due to the impact of economic incapacitation on
demand illustrates the effect of the multiplier. In this case, where supply and demand have
equal, albeit of opposite sign, slope, the multiplier has a value of 2, slightly higher than actual
estimates which hover around 1.5.4 The real loss in terms of welfare, however, is the lost
4 See {cite macroeconomics text. Note that the effect of taxes implies that the
multiplier will not be 2 in actuality because individuals do not consume as much as they earn by
8 Nicholas L. Georgakopoulos DRAFT
consumer and producer surplus, the shaded area between the Full and Low lines of supply and
demand. When bankruptcy law provides a fresh start, it returns the crushed debtors to
production, recreates their contribution to supply and demand, and restores the destroyed
surplus to society.
This figure only begins to illustrate the distortions caused by
financial incapacitation. One more very significant consequence regards
optimal allocation of skills in production. The incapacitated individuals
would employ their effort in its highest valued use. When they depart
from production, the market will readjust to still provide at least part of
the same product. This implies, however, that someone else would
deliver that service, who by definition would not be the lowest cost
producer in the highest valued service. The misallocation is a chain
reaction. The individual who fills in for the incapacitated, itself departs
partly its own occupation, causing one more increment of misallocation,
and so on.
IV. THE PRODUCTIVITY JUSTIFICATION OF REORGANIZATIONS
The existence of a reorganization process allows a settlement of
creditors' claims without a piecemeal sale of the businesses' assets.
Ostensibly, this avoids the destruction of the value of the firm as a going
business, if that is greater than the value of its assets. A classical
microeconomic study of this justification for reorganizations finds it
lacking, making reorganizations are a paradox from a microeconomic
perspective.
The microeconomic analysis starts with an examination of the
decision to break up the firm in a bankruptcy process that does not allow
for a reorganization. In absence of a reorganization procedure inside
bankruptcy, the creditors are acting collectively in a bankruptcy process
that must result in liquidation. Nevertheless, the creditors have the option
producing. The fraction that goes into the public fiscus has no effect on demand. This shortfall
from 2 of the multiplier may be due to the fact that it is examined from the perspective of
expansions. But an additional dollar's supply produces less than a dollar's demand because tax
withholdings do not release an entire dollar for consumption. In bankruptcy a other nd
contractions, the effect of the multiplier may be more pronounced and closer to 2 because a
dollar less of production leads to less demand as well as less tax proceeds. Although public
spending is somewhat more inelastic than individual spending, perhaps it is not completely
so—good macroeconomic policy may argue the reverse, additional spending to stave off
recessions, but that is a response only to economy-wide effects, not specific bankruptcies.
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 9
of breaking up the firm and selling its assets, or selling the firm intact as a
going business. In an environment of perfect markets, the creditors or the
trustee who is their representative will make the correct decision.
Consequently, a perfect world would not require a reorganization
process.
The issue becomes to establish why creditors in this imperfect
world fail to preserve the going-concern value of insolvent businesses.
We have two reports from systems without reorganizations about the
reaction of creditors to the insolvency of businesses with going-concern
value. Formal statistical evidence is available from Sweden, which does
not have a reorganization venue in its legal system.5 We can also draw
inferences about the situation in the US before 1938, when the Chandler
Act introduced reorganizations. From a paper by the premier bankruptcy
lawyer of the time, Paul Cravath, we can derive the conflicts that fit his
proposals.6 The two reports present consistent images. A bias appears
because senior creditors, whose claims are secured by the firm's assets,
form an alliance with equityholders. The alliance attempts to deprive from
junior creditors the going-concern value of the debtor firm.
A. Contemporary Sweden: Sales of Businesses,
Abuse of Junior Creditors
The Swedish evidence is straightforward. The study addresses
specifically the question whether there are biases in the firms that stay
intact despite entering bankruptcy in a system without reorganizations.
The first of the two principal conclusions are that not all firms are
liquidated. Firms survive by being sold back to their owners in sales that
are financed by the creditors, usually the senior creditors. This shows
that the absence of reorganizations does not condemn all businesses to
be broken up. Moreover, the frequency of resales to owners increases at
recessionary times with tight credit. This suggests that creditors recognize
the impediment that the availability of credit imposes on buyers and do
5 Per Stromberg, Conflicts of Interest and Market Illiquidity in Bankruptcy Auctions:
Theory and Tests, 55 J. Fin. 2641 (2000).
6 Paul D. Cravath, The Reorganization of Corporations: Bondholders' and
Stockholders' Protective Committees; Reorganization Committees; and the Voluntary
Recapitalization of Corporations, in SOME LEGAL P HASES OF CORPORATE FINANCING,
REORGANIZATION AND REGULATION 153 (1917).
10 Nicholas L. Georgakopoulos DRAFT
overcome it. The evidence cannot speak to the degree with which credit
crunches are overcome. Perhaps creditors distinguish perfectly between
businesses that should be liquidated and businesses that should stay in
operation, but complete perfection is unlikely in an environment of
uncertainty and imperfect information.
The second observation applies directly to the abuses due to the
lack of a reorganization chapter. The evidence examines the terms of the
resales to the old owners. The resales are more favorable to senior
creditors at times of tight credit. Moreover, senior creditors benefit at the
expense of junior creditors. The evidence does not reveal why tight
credit hurts junior creditors in Sweden. Some evidence about the
bargaining position of junior creditors can be inferred from the strategies
that Paul Cravath describes.
B. Pre-1938 US: Strategizing to Abuse Junior Creditors
The US was forced to confront the problem of reorganizations
with the case of failing railroads. The assets of the railroads tended to be
suited exclusively to their business. Engines and coaches could be sold to
other railroads. The long strips of land, however, which comprised of the
railroads' network, could not be used in any other business but a
railroad. Liquidations were avoided in the process of equity receivership,
which took place before the federal courts, ostensibly in order to enforce
creditors rights in other jurisdictions and stem a destructive race to the
assets.
The practice that Paul Cravath describes revolves around a
liquidating auction, in which the entire group of assets of the debtor firm
are sold to a new corporation. The new corporation is organized by the
debt and equity claimants in the original corporation. Typically, the claims
in the new corporation would be held predominantly by the senior
creditors of the first. The senior creditors, however, usually were not in
the business of running corporations. As a consequence, they needed to
obtain the service of management who was aware of the debtor firm's
mode of operations and who had some institutional memory. In essence,
senior creditors needed the cooperation of the equityholders of the old
firm, because management tended to own significant equity stakes. Thus,
the new corporation would be formed by claimants of the old one, and it
would purchase at auction the assets of the old firm.
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 11
The principal legal challenge in this process which Cravath
addresses has two perspectives. The first was the propriety of the size of
the bid at the auction and the second was the propriety of the structure
of the claims in the new firm. Cravath advises (at 201-02) to set the
foreclosure sale price high enough to avoid claims of unfairness by
dissenting junior creditors, but low enough to minimize payments to
dissenters.
The claim structure that Cravath advocates involves three tiers of
equity. It is a response to the Boyd opinion,7 which prohibited the
distribution of value to any claimants (read equityholders) of the old firm
unless the immediately more senior claimants (read its junior creditors)
were either paid in full or received the balance of the liquidation value.
This requirement has survived in bankruptcy jurisprudence as the
"absolute priority rule." The three-tiered structure is proposed by
Cravath as a solution to the problem of giving participation to the old
equityholders without violating the absolute priority rule.
Cravath proposes that the new corporation issue common stock,
junior preferred stock, and senior preferred stock. The holders of the
common stock benefit by enjoying any increases in the value of the firm,
but are exposed to any declines. The holders of the senior preferred
stock enjoy relative security because they only suffer from declines after
they wipe out both common and junior preferred. Neither class of
preferred participates in increases of the firm value. It is important to
note that the position of junior preferred holders is not enviable. They
neither participate in the upside potential, and are wiped out early in
cases of declines.
Cravath proposes (at 196-97) that junior creditors are given
junior preferred, and that equityholders are given both senior preferred
and common. This way, equityholders enjoy the best of both worlds,
while junior creditors are squeezed out of both upside potential and
downside protection.
An example illustrates how Cravath's stratagem might subvert the
spirit of Boyd to the detriment of unsecured creditors. Suppose the failed
firm has $100m of assets that produce $20m annually in an environment
with a 10% discount rate. This implies that the value of the firm as a
going concern is $200m and that the firm should not be liquidated but
7 Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913).
12 Nicholas L. Georgakopoulos DRAFT
reorganized. The secured claims are $150m, and the unsecured are
$100m. Going-concern value was not well understood at that time.
Therefore, the plan would start from the premise that the firm is worth
$100 and that only the secured creditors' claims were "in the money."
The abuse Boyd sought to stem must have been that the secured
creditors would propose a plan valuing the firm at $150m and, after
raising $10m new capital from the old equityholders, the firm would
reinstate the secured creditors' $150m secured claim and give all the
equity to the old equityholders. Today that we understand going-concern
value, we recognize that such a plan freezes the unsecured creditors out
of $50m of value to which they are entitled: what would remain after the
secured credit of $150m were subtracted from the going-concern value
of $200m.
Cravath's answer to Boyd would probably produce a plan along
the following lines. Again the firm would be valued at $150m and it
would raise $10m from not only the old equityholders but probably also
the old unsecured creditors. Suppose each group would contribute $5m.
After raising the $10m it would issue the three classes of equity. The
senior preferred would be issued at a discount, so that the first, say, $4m
of the equityholders' contribution would buy $32m of senior preferred.
The unsecured creditors might receive some amount of junior preferred,
suppose that is $10m for their $5m contribution, and the common stock,
worth $200 value +10 contribution -150 secured claims -32 senior
preferred -10 preferred=18m, would be bought with the remaining $1m
contribution of the equityholders. This plan would give value to the
unsecured creditors, who appeared to be out of the money, upholding
the letter of Boyd. Nevertheless, the treatment of unsecured creditors is
in no way generous. They were "in the money" to the tune of the $50m
that would remain after subtracting the $150 secured debt from the
going-concern value of $200m, but they receive in the reorganization
value of $5m by being given a claim worth $10m after paying $5m for it.
The equityholders were "out of the money" not only in appearance, but
also in substance—after accounting for the full going-concern value.
Nevertheless, they would receive value of $45m, $32m in senior
preferred equity and $18m in common for both of which they would pay
$5m.
Cravath's narrative shows how equity receivership could used by
the senior creditors to strip the claims of unsecured creditors while letting
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 13
the equityholders maintain control in the reorganized firm. The court
opinions that we have—from Boyd and Allers in the Supreme Court and
down to other courts—show that this potential was put into full effect.
C. The Handicap of Junior Creditors: Tight Credit
The Swedish evidence and Cravath's stratagems point to the
weakness of junior creditors. For junior creditors to overcome their
predicament, they must prevent an inamicable sale of the firm. The sale is
financed by the senior creditors and is abusive to junior creditors
because it undervalues the firm at their expense. Junior creditors can
prevent such a sale by buying the firm themselves for a greater price.
This requires that they raise new capital (note that secured creditors are
able to largely bid on credit, against the claims that they already have
against the firm). At times of tight credit, raising large amounts of capital
becomes less likely. As the Swedish evidence indicates, the abuse of
junior creditors becomes correspondingly more likely.
D. The Failure of Forced Auctions
The review from these two systems of forced auctions with no
possibility of reorganization is revealing. Forced auctions do not
uniformly result in break-ups of insolvent businesses. Therefore, justifying
reorganizations as a means to prevent break-ups is simplistic. Despite the
forced auctions, however, actual auctions appear to be the exception in
these systems. The forced nature of the sale, the environment of tight
credit, and the mass of information necessary to value a complex
business suggest a shortage of high bidders. An actual auction would
likely result in a sale to the secured creditor at an unreasonably small
price. What we observe, in both Sweden and pre-1938 US, is buyouts
financed and structured by the senior creditors, who bring in the
equityholders for managerial continuity and skill. The senior creditors
dictate a bid as low as the law will tolerate, and these low bids are the
source of the abuse of junior creditors.
Reorganizations are not necessary to prevent break-ups, but by
eliminating the alternative of the forced auction, reorganizations change
the character of the interaction between senior and junior creditors. We
do not know about Sweden, but in the US in both forced auctions and in
reorganizations, the court must approve of a valuation. In the case of
14 Nicholas L. Georgakopoulos DRAFT
equitable receivership, Cravath reports that the court must not find the
bid inadequate. In the case of reorganizations §1129 of the Bankruptcy
Code requires the court to compare the claims distributed by the
reorganization plan to the value of the firm both as a going business and
in liquidation. The difference may be as stark as estimating the value of
the assets at an auction compared to estimating the value of the going
concern in an orderly sale. In the case of the forced auction, the court
must estimate the price at a current auction, while in the case of a
reorganization, the court must estimate the valuation of a going business
and its claims in a long-term basis. By escaping the implicit threat of an
immediate auction, reorganizations allow the court to try and escape the
environment of the tight credit and value the firm in a regular setting.
By valuing the insolvent firms as going businesses, the economy
receives the benefit of more accurate decisions regarding break-ups of
firms and deployment of assets. Recessions and credit crunches are
inescapable. Recessions make some firms unable to meet their debt
obligations and credit crunches reduce the likelihood that the highest-
valuing users of these insolvent firms will be able to finance a purchase.
This is not an environment where the market is likely to make the right
decisions about which firms to liquidate, and which firms to let survive. A
reorganization regime—compared to forced auctions, where the
liquidation decision rests in essence with the senior creditor—is biased in
favor of letting businesses survive.
The environment of recessions and tight credit must be
contrasted with times of growth and ample credit. In such a favorable
environment, solvency and long-term viability are likely to be much more
correlated as viable businesses would have easy sales and could find
credit in case of temporary financial difficulties. Even in the cases that
they could not, the firm is in little danger of false liquidation because
buyers who can run the firm as a going business face favorable
conditions for financing a bit to acquire the entire firm. All creditors
would, of course, welcome such a bid. Both senior and junior creditors
receive the largest possible payment on their claims. Therefore, at times
of growth and ample credit, the lack of a reorganization procedure is
least likely to cause any false liquidations.
The lack of a reorganization procedure a times of growth and
ample credit forces breakups. Firms that cannot raise funds and cannot
attract bidders despite the favorable environment, will be liquidated.
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 15
Errors are still possible, but they are least likely to occur. A
reorganization procedure is likely to have the opposite effect. During the
good times, a reorganization procedure will allow even non-viable firms
to reorganize and try again.
Society is not concerned with the distribution of value between
senior, junior creditors, and equityholders. If the total performance
remains constant, the division only influences the returns and values of the
different types of securities. The return of their aggregate remains
constant and equal to the return of the firm. Society's lot improves by
preventing false liquidations and ensuring that non-viable enterprises do
get broken up. Releasing resources from moribund to growing industries
is crucial for growth.
The capacity for reorganizations, in other words, may likely
prevent some false liquidations during recessions but likely cause some
false continuations at times of growth. The two do not cancel out,
because of the macroeconomic effects of liquidations during recessions.
The idleness of the firm's assets, temporary as it may be, aggravates the
recession. Of course, postponing liquidations during growth implies that
they may occur during recessions, depressing prices and possibly
triggering more liquidations. This fear is exaggerated. Not only should
bankruptcy courts err against reorganizations at times of growth, but they
are also going to take into account the possibility of a snowballing selling
cascade and delay liquidations during crises.8
The point that preventing false liquidations at times of recessions
and tight credit is desirable does not close the inquiry into the desirability
of reorganization law. Perhaps the cost of false continuations more than
compensates, implying that, on balance, an economic system is better off
without a reorganization chapter in its bankruptcy law. A simple model
illustrates the parameters of this comparison.
8 A court has explicitly acknowledged this role:
[T]he solution [to the plethora of real-estate filings in this recession] is
not to make every reorganization ... into a liquidation by denying equity
holders the right of participation... Refusing to permit [them] an
opportunity to invest destroys any incentive which might exist for
capital contributio n. Without fresh capital infusion, little hope exists for
reorganizing deflated assets in a bad market.
In re Woodscape L.P., 134 Bankr. 165 at 177 (Bankr. D. Mary. 1991).
16 Nicholas L. Georgakopoulos DRAFT
E. A Simple Model of False Liquidations and False Continuations
The model of the importance of reorganizations is similar to the
model of the benefits from the discharge of individuals’ debts. Consider
an economy with N identical firms, which become uneconomical with
probability p, in which case they are also insolvent, and become unable
to meet their debt service obligations with probability q despite being
profitable in the long run. At any given point, N(p+q) firms are in
bankruptcy, and a fraction q/(p+q) of those should not be liquidated.
Acquirers obtain funds for acquiring insolvent businesses out of
bankruptcy with a probability that is determined by the availability of
credit. The availability of credit is a random variable a. The probability of
obtaining credit to acquire an insolvent but sound business is g(a), which
can be set for simplicity to g(a)=a with values ranging from 0 to 1,
inclusive. Accordingly, a fraction 1-a of sound insolvent businesses are
not acquired as businesses and are falsely liquidated. The fraction of
bankruptcies that result in false liquidations is (1-a)q/(p+q). Calling the
aggregate loss in productivity from a false liquidation s, we can establish
the cost of not having reorganizations in terms of false liquidations. We
ll
know that a fraction p+q of a N firms enter bankruptcy, a fraction
q/(p+q) of the firms in bankruptcy should be reorganized, and that 1-a of
the sound firms in bankruptcy will not be bought as firms subjecting the
economy to loss s from their false liquidation. Thus, the economy which
does not provide reorganization capacity loses s(p+q)N(1-a)q/(p+q),
which simplifies to sN(1-a)q.
This cost must be compared with the costs of reorganizations.
The costs of reorganizations are the errors of the courts in attempting to
reorganize firms w hich should be liquidated and liquidating firms which
should be reorganized. Courts are probably biased in favor of
reorganizing, so that different error rates should be used in the two
settings. Judges erroneously reorganize a fraction r of the firms that
should be liquidated, and erroneously liquidate a fraction d of the firms
that should be reorganized. The cost of not reorganizing, i.e. of false
liquidations, we saw above, is s. Calling the cost of reorganizing a
business that should be liquidated o, the cost of a reorganization system
is ropN+dsqN. Judges falsely liquidate r firms with cost o of the pN
firms that should be liquidated and falsely liquidate d firms with cost s of
the qN that should be reorganized.
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 17
A reorganization system is desirable if
sN(1-a)q>ropN+dsqN , or, dividing both sides by N
and canceling, if
s(1-a)q>rop+dsq
if, namely, the cost of false liquidations without a reorganization
venue exceeds the sum of false liquidations and false reorganizations in a
reorganization system.
The juxtaposition of this theoretical result with the arguments
used in the debate regarding reorganization law is instructive. Those who
argue against reorganizations claim reorganization law produces few if
any false liquidations and numerous false continuations, while a forced
auction system would produce no false liquidations and allow unimpeded
continuations. The evidence from the two forced auction system
discussed above suggests that some false liquidations may occur, and
that forced auctions also produce continuations, some of which may also
be false. A term for false continuations is not included in the left side of
the above inequality because the model assumes forced auctions
invariably lead to liquidations. The evidence does not preclude the likely
idea that senior creditors may feel they will do better if they continue the
business until the recession or credit crunch is over. The substantive
similarity of the two regimes—that both produce continuations as well as
liquidations with some errors—indicates that reorganizations are an
economic reality that occurs regardless of the existence of reorganization
law. Reorganization law simply tries to improve the performance of the
economic reality.
A different interesting juxtaposition compares judicial accuracy
with economic slack. Economic slack is the ease with which a productive
opportunity can be realized in an economy, and is inversely related to
competitiveness. In a very competitive economy, opportunities are more
difficult to identify and the race to realize them erodes their gains.
Economic slack should correlate with overregulation, bureaucracy, and
corruption. Slack may imply that a false liquidation is not as costly for the
economy, because opportunities give full returns to entrepreneurs, who
will fill any gaps created by false liquidations. Corruption and
bureaucracy should also correlate with judicial inaccuracy. As a result,
reorganization law may not be desirable in developing economies, where
overregulation and corruption are endemic. This conclusion agrees with
18 Nicholas L. Georgakopoulos DRAFT
the observation that developing economies are less lenient toward
debtors than developed economies.9
The analysis also shows that this static model is inadequate.
Forced auctions present few problems at times of economic expansion.
Reorganization law is most valuable during recessions, credit crunches or
selling cascades, when forced auctions become problematic. This implies
that judges can use a simple yardstick that improves the performance of
reorganization law. Err in favor of liquidation at times of economic health
and err in favor of reorganizations at times of recession, credit crunches,
or selling cascades. The false continuations at bad times cost little. The
dearth of economic activity indicates they do not compete with growth
industries for scarce resources, and if the reorganized firm is
uneconomical it may still fail later at a time when its liquidation will be
more easily absorbed by the economic system. By contrast, at times of
economic health, the cost of false liquidations is mitigated by the ability of
high-valuing users to raise the funds necessary to buy the firm as a going
concern. An assessment of reorganization law must not ignore this
dynamic variation in its contribution.
In sum, reorganization law seeks to prevent the destruction of
productivity—the capacity of the going business—in recessionary
circumstances of tight credit, when insolvency has the greatest likelihood
to cause a false liquidation. As a side benefit, reorganization law also has
the capacity to interrupt selling cascades, to stop, in other words, the
snowballing effect of liquidations that depress prices leading to more
liquidations. Both services are very valuable to the economy and outside
the calculation of costs and benefits by borrowing firms or their creditors.
V. OTHER PRODUCTIVITY REVIVAL
The liberal discharge of individuals’ debts and the liberal capacity
to attempt to reorganize insolvent businesses are the cornerstones of
modern bankruptcy. That they are unexplained as solutions to collective
action problems should be enough to show that bankruptcy law is not
only or mostly about resolving creditors’ collective action problems.
Both discharge and reorganizations revive productivity. But these are not
9 LaPorta, Schleifer, Silanes, et al, Law & Finance, 106 J. POL . ECON . 1113
(1998).
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 19
exceptional measures. Productivity revival is a recurring phenomenon in
bankruptcy law. Several provisions, not nearly as visible as the main
policy choices of discharge and reorganizations, perform the same
function. The treatment of tort claims offers two examples. First, tort
claims during the bankruptcy process need to have priority to prevent a
destructive erosion of the incentives for care. Second, mass tort claims
that produce a false incentive to liquidate a productive business are
addressed in a trust fund that prevents the pointless destruction of
productive capacity. The third setting resonates with the justifications of
the fresh start; individuals who have incurred non-compete obligations
which hamper their productivity, are allowed to avoid them in
bankruptcy. The last illustration regards the avoidability of long-term loan
payments. When regular payments on long-term loans are not avoidable,
the long-term lender has an incentive to anticipate the debtor’s failure
and induce bankruptcy by using trigger clauses in the loan agreement.
Avoiding the anticipatory bankruptcy serves the economy as well as the
creditors. This point also shows that the solution of a collective action
problem is also a productivity reviving tool.
A. Tort Liability Priority
Tort claims are treated no differently than other claims by
bankruptcy law in principle. As a result, tort claims in U.S bankruptcies
are part of the general unsecured claims. Tort claims that arise during, as
opposed to before, the bankruptcy process pose the question of
transition, namely whether they are pre-bankruptcy or post-bankruptcy
claims.
When this question reached the U.S. Supreme Court, the court
used simple economic analysis. Tort liability outside of bankruptcy seeks
to induce optimal care. Similarly, in bankruptcy interpretation the
question is to ensure that the insolvency and the bankruptcy process do
not distort the incentives for care that the tort system provides.
Two are the candidates for the treatment of tort claims during
bankruptcy. They can be grouped with pre-bankruptcy unsecured
claims, or given priority. Giving tort claims priority is the analogous to
treating them as post-bankruptcy claims because they would burden the
new owners of the firm who would be the unsecured creditors. If tort
claims do not receive priority, then they will be paid in the same
20 Nicholas L. Georgakopoulos DRAFT
proportion as other unsecured claims. The additional liability will reduce
the proportion of claims that unsecured creditors will receive, but the
aggregate reduction will be less than the additional liability, because the
liability will be prorated. The cost of care, however, would come at the
full expense of unsecured creditors. Thus, the decision to take an
incrementally costly measure of care, juxtaposes its full cost with the
s
avoidance of a diluted obligation. Care that i desirable from a social
standpoint, because it prevents more injury than it costs, may not be
taken.
If the tort claim receives priority, unsecured creditors will bear
the full burden of the additional liability. The priority of the tort claim
implies that it is paid before unsecured claims. The funds available for
distribution to unsecured creditors are reduced by the full amount of the
tort claim. This cures the distortion we saw above. When incremental
measures of care are considered from the perspective of unsecured
creditors, the full cost of care is compared to avoiding the entire liability
for the injury. The bankruptcy trustee and the unsecured creditors whom
the trustee serves, make their calculations regarding care in a way
identical to society. Measures of care that cost less than the injuries they
prevent are desirable.
With an analysis that was not far from the above, the Supreme
Court concluded that tort claims arising during bankruptcy should have
priority. Accordingly, the term "administrative expenses," which receive
priority, was interpreted to include tort claims that arise after the
bankruptcy filing.10 Notice that, once again, there is no issue regarding
collective action problems guiding bankruptcy interpretation. Insolvency
distorts and dilutes incentives for care. The economic system is exposed
to avoidable accidents because of insolvency. Bankruptcy law corrects
the error and prevents the destructive effect of insolvency.
B. Mass Tort Trust Funds
As tort liability expanded in the U.S. to product liability and as
technology advanced, old products were found to be dangerous and to
lead to massive liability. Mass tort liability appears in bankruptcy law
because some of the liable manufacturers are firms that sound as going
10 Reading v. Brown , 391 U.S. 471 (1968).
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 21
businesses. In the most perplexing cases of asbestos liability,
manufacturers would be forced to file for bankruptcy without being
presently insolvent. Their insolvency was a result of the estimated future
liability to tort victims who would be injured in the future from asbestos
manufactured in the past.
The accumulating future tort liability poses a difficult problem for
bankruptcy law. No reorganization will result in a viable firm if the future
liability is not addressed. Even if a firm is reorganized with a 100% equity
structure by converting all claims into equity, the firm will eventually
become insolvent again due to new tort claims. Those claims would be
created by asbestos manufactured many years ago.
This vicious cycle of reorganizations is undesirable from a social
perspective. Its cost and its disruptive effect may be notable, but the
effect is much more than a periodic administrative expense. The
prediction of future insolvency produces an incentive for false
liquidations.
The future insolvency of the manufacturer is expected with
certainty after the first reorganization. The firm's equityholders,
consequently, know that the value they hold will be eliminated. The only
way that the equityholders can receive more than just a few years of
dividends, is to break up the firm and sell its assets in a voluntary
liquidation. Selling the firm as a going business would not answer,
because according to successor liability law the buyer would be
burdened with the tort liability. Thus, although the firm is more productive
as a going business, the future insolvency produces a false liquidation
incentive.
The solution was to create trust funds for future tort victims.11
The trust funds were funded with shares of the debtor. Future asbestos
tort victims were barred from turning against the manufacturer and would
be satisfied exclusively from the trust.
This solution posed fundamental constitutional questions.
Unknown individuals' rights were adjudicated and settled without so
much as a notice. Nevertheless, eliminating the danger for productivity
was the choice that the legal system made. The constitutional concerns of
11 The court opinion that elaborates on the quandary posed by asbestos claims is
written by none other than Judge Richard Posner. See In Re UNR Industries, Inc., 725 F.2d
1111 (7 th Cir., 1984).
22 Nicholas L. Georgakopoulos DRAFT
the future claimants received little more than lip service and receded
before the economic concern. Again, in this crucial choice of the
bankruptcy system, collective action problems are absent.
C. Escaping Non-Compete Obligations
The filing of a bankruptcy petition has no effect on injunctive
obligations of the debtor. With the exception of injunctions to perform
contracts, injunctive obligations are treated as property rights that the
debtor has transferred.12 Obligations not to trespass, not to stalk
(approach a person with some distance), or not to compete will
ordinarily survive bankruptcy. They only survive bankruptcy, however, if
they do not interfere with productivity.
An obligation to TV studio not to perform for a competitor’s
show is a non-compete obligation. It is often undertaken by actors during
the run of the show for which they perform. It is part of the contractual
exchange and the actor is compensated for the limitations that it imposes.
An attempt to file for bankruptcy and use the “rejection” provisions of
§ 365 to claim that the obligation is “rejected” typically fails in the
courts.13 It is consistent with the notion that the actor’s productivity is
not hurt by the non-compete obligation because acting is still an available
occupation in various other venues, such as live theater.
Contrast to this situation one in which an individual has promised
not to conduct a business in competition with the counterparty and the
individual does not have the capacity to employ his individual skills
outside the confines of the contractual limitation. The productive capacity
of the individual is now hampered. Instead of remaining in the most
productive occupation, the individual is forced in a less productive
occupation. When non-compete obligations pose such a threat to
productivity, the courts allow the debtors to “reject” the non-compete
obligation and return to the activity in which they are most productive.14
12 See, generally, Jay Lawrence Westbrook, A Functional Analysis of Executory
Contracts, 74 Minn. L. Rev. 227 (1989).
13 See, e.g., In re Carrere, 64 Bankr. 156 (1986) (Actress Tia Carrere could not
avoid her obligation not to perform in another show during her contract with ABC for the
show General Hospital).
14 In Re Register, 95 Bankr. 73 (Bankr. M.D. Tenn., 1989) (Silk flower maker
could reject non-compete obligation).
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 23
The treatment of non-compete obligation strengthens the
productivity consequences of the fresh start. Not only are individuals’
general productivity incentives maintained by the fresh start, but
individuals appear entitled to maintain their most productive occupation
by rejecting noncompete obligations. Thus bankruptcy law does not only
protect against the elimination of productivity, it also prevents incremental
reductions of productivity.
D. The Validity of Payments on Long-Term Loans
Bankruptcy law prevents debtors from favoring some of their
creditors at the expense of others. An attempt to repay creditors when
bankruptcy is imminent is avoidable by the trustee. The avoided payment
is returned to the estate to be shared pro rata among the creditors. The
existence of the rule that such preferential payments are avoidable
prevents creditors from trying to obtain preferential repayment and
accelerating the failure of the debtor. This appears to be rule to prevent a
collective action problem, to prevent races to assets and allow the
debtor to weather temporary difficulties to the benefit of all creditors.
Regular payments on long-term loans, however, pose a special
problem. If the regular payments are avoidable, then the long-term lender
has the opposite incentive from the usual creditor who seeks his capital in
anticipation of bankruptcy. Instead of an incentive to give the debtor one
more chance, the long-term lender sees the debtor’s continued existence
as a threat. The longer the debtor survives, the more distant is the
possibility of repayment of the lender’s principal. Being forgiving might
have been worthwhile if the lender could retain the periodic payments on
the debt, but if they are treated as avoidable preferences, the long-term
lender receives no compensation for waiting.
Long-term lenders attempted to escape this predicament by
arguing that regular payments should be included in the “ordinary course
of business” exception to avoidable preferences. Conventional
interpretation had the ordinary course of business exception serve a
specific narrow role. It safeguarded repayments of minor periodic
indebtedness, such as the payment of utilities bills, suppliers, or
employees. Extraordinary long-term loans did not fit with the concept of
ordinary course of business.
24 Nicholas L. Georgakopoulos DRAFT
The Supreme Court, noting the reversed incentives on the long-
term lender, considered that the ordinary course of business exception
should be expanded to include long-term loan payments.15
A closer look, however, reveals that the principal function of
treating long term loan payments as not preferential, is productivity. First,
the setting is not one where collective value is being destroyed by the
lender. For a collective action problem to exist the long term lender must
feel compelled to invoke a loan acceleration clause in order to prevent
another creditor from obtaining a superior right in the debtor’s assets.
This is true in the pure race to the debtor’s assets, because if one
creditor does not attach the few valuable assets, another will.
Accelerating a loan is not attachment, however. If the loan is secured, its
acceleration has no effect of excluding other creditors; they are already
excluded from the collateral by virtue of the security interest or mortgage.
Accelerating an unsecured loan is insufficient because acceleration must
be followed by foreclosure.
Lenience gives the debtor a chance to recover, but it also allows
the debtor to take further risks with the creditors' money. Putting an
earlier end to debtor's decline does not destroy creditors' aggregate
value and may well preserve it. Taking away this chance is not equivalent
to foreclosing on one of the machines in a chain of production. For the
long-term lender's incentive to produce a value-destroying race it must
influence yet another creditor to make a value-destroying move. That is a
different reaction that should not confuse us here. It should be prevented
by the web of bankruptcy provisions that resolve collective action
problems. Thus, the long-term lender’s decision to accelerate does not
mesh as perfectly with the collective action problem as its proponents
claim it does.
The purpose of postponing the debtor's failure, thus, is not so
much to resolve creditors' collective action problem. Justice Stevens
stated that avoiding the creditors' race also promotes equal distribution,
the competing interest that also argues in favor of avoidability.16 The
15 Union Bank v. Wolas, 502 U.S. 151 (1991).
16 After noting that by avoiding races, an exception from avoidance does promote
the interests of all creditors by enhancing their collective value, the court further notes:
Thus, … we must recognize that [availability of the ordinary course of
business exemption] does further the policy of deterring the race to the
1997 ESSENTIAL FUNCTION OF BANKRUPTCY LAW 25
intuitive leaning of the court in favor of giving the debtor an extra chance
can be explained more persuasively as an effort to avoid anticipatory
bankruptcies, i.e., financial failures caused, not from true failure, but that
are a result of creditors anticipating a future financial failure. The
productivity justification for avoiding anticipatory failures is obvious: the
cost of a bankruptcy process should only be incurred in cases of true
failures.
VI. CONCLUSION
Provisions of bankruptcy law have been explained as solutions to
the collective action problem of creditors. Carrying this reasoning to an
extreme, scholars have argued that bankruptcy law should be analyzed
exclusively from the perspective of the parties, as if it contains no
externality. This article argued that this view abuses the “micro” of
microeconomics. Individuals and firms cannot be expected to take into
account the full impact of their failure for society. Bankruptcy law is
about preventing insolvency-induced threats to productivity. It meshes
seamlessly with conventional macroeconomic tenets generally, and in
particular John Maynard Keynes’ multiplier. The concern with
productivity is not limited to exceptional issues, and there is nothing
exceptional about the discharge of debts and reorganization law. Just as
bankruptcy law preserves productivity in those major policy choices, it
also preserves productivity in numerous lesser choices that we have
seen. The avoidance of creditors’ races to assets is itself an expression
of the same phenomenon, as races to assets threaten the economy with
false insolvencies of viable firms and economic destruction of productive
capacity. Creditor races are one more threat to productivity that
bankruptcy law, consistently, prevents.
Macroeconomics teaches us that economic activity—
production—has a multiplier. Contractual arrangements about the
eventuality of economic incapacitation, similarly, regards the
incapacitation of more than that entity’s productive capacity. Thus, when
firms waive the protection of the reorganization chapter or individuals
waive the dischargeability of their debts, we cannot expect them to take
courthouse and … may indirectly further the goal of equal distribution as
well.
Union Bank v. Wolas, 502 U.S. 151 at 162 (1991) (Stevens, J.).
26 Nicholas L. Georgakopoulos DRAFT
into account ex ante the full social impact of their failure. Bankruptcy law
should keep preventing agreements about financial failure and keep
restoring the productivity of failed debtors.
Related docs
