Bankruptcy’s Endowment Effect

posted in: Cramdown and Priority | 0

By Anthony J. Casey (University of Chicago Law School)

The notion of endowments and entitlements has a powerful effect on corporate bankruptcy policy. Scholars and lawyers generally assume a creditor endowed with a right outside the bankruptcy system must receive the equivalent of that right when its debtor is within the bankruptcy system. Proponents of this idea often assert that the result is required by the foundational theory of bankruptcy.

In a forthcoming essay, “Bankruptcy’s Endowment Effect,” I demonstrate that this is false. The idea of sacred creditor endowments is an untenable position that misunderstands the fundamental principles of bankruptcy. Corporate bankruptcy is, at its core, a system that alters nonbankruptcy endowments according to a hypothetical bargain that all creditors of a firm would have entered if bargaining were costless. The entire point of that hypothetical bargain is to suspend and alter some nonbankruptcy endowments to maximize the value of the bankruptcy estate and the firm as a whole. Indeed, if every stakeholder retained all of its nonbankruptcy endowments, the Bankruptcy Code would have no provisions at all.

Of course, altering nonbankruptcy endowments can impose costs. Foremost among those costs is the risk of opportunistic behavior that is costly for the estate as a whole. Bankruptcy policy will, therefore, be designed to maximize estate value while minimizing opportunistic bankruptcy behavior. Thus, the guiding principle for optimal bankruptcy design should be not the preservation of nonbankruptcy rights but rather the minimization of opportunistic behavior that reduces the net value of a firm.

With that principle in hand, we can resolve many difficult questions of bankruptcy policy. In the essay, I focus on applying the principle to the debate over what interest rate a senior creditor should get in a chapter 11 cramdown. In particular, I analyze the dispute in In re MPM Silicones, LLC (“Momentive”), where the bankruptcy court mistakenly reached its final decision by importing a creditor-endowment framework from consumer bankruptcy law (where the framework might make more sense). I show that an optimal rule for corporate bankruptcy supports a cramdown interest rate based on the prevailing market rates for similar loans, which reduces the risk of opportunistic behavior by both debtor and creditor.