The New Bargaining Theory of Corporate Bankruptcy and Chapter 11’s Renegotiation Framework

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

The prevailing theory of corporate bankruptcy law states that its purpose is to vindicate or mimic the agreement that creditors would have reached if they had bargained with each other to write their own rules. That idea – the Creditors’ Bargain theory – has held a central place in the minds of lawyers, judges, and scholars for almost forty years. At the same time, Creditors’ Bargain theorists have struggled to explain what actually prevents creditors from bargaining with each other and how efficient rules that interfere with creditors’ bargained-for rights fit into the theory.

Meanwhile, in other areas of the law, scholars have long recognized the limits of hypothetical contract theories. Notably, scholars have shown that when parties have limited or asymmetric information and incentives to bargain strategically, their contracts will be incomplete in ways that the law cannot remedy with a hypothetical contract. Bankruptcy scholars have never squarely addressed this challenge.

Taking aim at these issues, my article, The New Bargaining Theory of Corporate Bankruptcy and Chapter 11’s Renegotiation Framework, proposes a new law-and-economics theory of corporate bankruptcy. Financial distress routinely presents uncertainty that is not contractible. By its very nature – given the number of parties engaged in strategic bargaining and the number of contingencies – financial distress poses questions that are impossible to predict, define, and negotiate in an ex ante contract. As a result, relationships involving a distressed firm are governed by incomplete contracts that allow parties to hold each other up.

Corporate bankruptcy law’s purpose is to solve this hold-up problem. The problem is familiar in law, but its frequency in the distress context invites a special bankruptcy solution. The noncontractible uncertainty associated with financial distress is a recurring characteristic across all firms. Because every relationship of this type is incomplete and requires judicial intervention upon the occurrence of the same event, a uniform bankruptcy system that deals with those relationships will produce consistency, efficiency, and market predictability.

In Chapter 11 that uniform system takes the form of a structured renegotiation framework. Because of the high level of ex ante uncertainty, the system relies mostly on procedural protection rather than specific substantive prescriptions. The framework allows parties to renegotiate their relationships within a system that imposes prices and burdens on the bargaining process and then subjects the results to high-level judicial oversight. The specifics of this framework are targeted at reducing the worst and most likely instances of hold up that block renegotiation efforts.

Bankruptcy, then, is not about mimicking a hypothetical ex ante bargain. It is about facilitating an actual ex post bargain. The normative claim of my article is that bankruptcy law’s core purpose is to solve the hold-up problem. The descriptive claim is that the ex post renegotiation framework is the fundamental attribute of Chapter 11. The remaining normative question is whether Chapter 11 succeeds at its purpose. This New Bargaining Theory of corporate bankruptcy can help identify the metrics by which to answer that question.

The full article is available here.

Reprofiling Today for a Sustainable Tomorrow: A Unilateral Italian Debt Restructuring

By Emma Cervantes, Victoria Dodev, Shane Ellement, Isabelle Sawhney (Duke University, School of Law)

Italy has €2.4 trillion of debt – an unsustainable level in pressing need of a restructuring. However, traditional avenues for sovereign restructurings cannot be utilized because Italy’s situation is complicated by several factors. First, the massive outstanding bond stock and diversity of bondholders makes a traditional consensual restructuring impractical. Additionally, about 68% of outstanding bonds are held by Italian parties, making any restructuring harmful to the domestic economy. To further add to this complicated situation, the ESM Treaty purports to impose additional restraints on Italy’s ability to restructure through the addition of CACs to approximately 60% of Italy’s bond stock.

Fortunately, there is a loophole in Italy’s bonds that can resolve these problems: Italy can unilaterally extend its maturities without bondholder consent. This power stems from the fact that Italy’s domestic government securities are issued as decrees under the relatively unknown 2003 Consolidated Act, which explicitly grants Italy the power to unilaterally extend bond maturities. Accordingly, 98% of its outstanding bond stock, about €2 trillion, can be restructured without bondholder consent. This strategy could result in the largest sovereign debt restructuring in history being done unilaterally.

This proposal demonstrates that the inclusion of CACs in some of its bonds does not foreclose the use of Italy’s Article 3 power. The proposal also describes the mechanics by which Italy would exercise its right to extend maturities. Unilaterally extending maturities does not require any retroactive utilization of the local law advantage. Nor does it expose Italy to significant legal risks in its domestic courts or under European treaties and conventions.

The full article is available here.

A Sovereign Debt Restructuring Framework for the Euro Area

By Sebastian Grund, Mikael Stenström (European Central Bank)

Our new paper discusses the legal framework for sovereign debt restructuring in the euro area – both de lege lata and de lege ferenda. Sovereign debt restructurings remain exceptional events that come with profound implications for financial stability and monetary policy transmission. However, they may be necessary as part of a financial assistance program to a euro area Member State, as was the case for Greece in 2012. Indeed, the European Stability Mechanism (ESM), the euro area’s lender of last resort to sovereigns, may only lend to countries with sustainable debts. Thus, if debt is assessed as unsustainable, an orderly debt restructuring may be warranted to allow for financial assistance by the ESM.

This paper seeks to contribute to the ongoing policy discussion on how to enhance the functioning of the Economic and Monetary Union (EMU) by exploring the legal aspects of sovereign debt restructuring in the euro area. Drawing upon the International Monetary Fund’s framework for debt restructuring, it analyses whether and how the procedures for sovereign debt restructuring in the euro area can be made more orderly, fair, and predictable by establishing a European Sovereign Debt Restructuring Framework (ESDRF).

We conclude that policymakers may consider the inclusion of enhanced Collective Action Clauses (CACs) as well as certain technical amendment clauses with a view at avoiding holdout inefficiencies. Indeed, the first version of the euro area CAC deviated from the international standard, as it did not allow for full aggregation of bondholder votes across all series. Thus, the euro area always faced a residual risk of holdouts blocking individual bond series, as was for instance the case for certain English-law bonds during the Greek debt restructuring of 2012. Besides CACs, we discuss the potential immunisation of ESM funds from holdout litigation as well as (temporary) stays on debt enforcement actions by opportune investors during restructuring negotiations, also taking account of recent innovations in the context of the Puerto Rican debt restructuring.  Finally, we review broader statutory changes to the current framework. Specifically, two options for a sovereign debt dispute resolution mechanism are discussed: (i) a separate chamber at the Court of Justice of the European Union (CJEU) and (ii) a sovereign debt arbitration mechanism. The rationale behind the establishment of such tribunals would be to centralise dispute settlement in the context of sovereign debt restructurings, thereby forestalling negative externalities from fragmented judicial decisions on bondholder claims.

The paper makes no judgement on the economic or political feasibility and necessity for such changes, but seeks to contribute to the debate by shedding light on the legal aspects to be taken into account in the context of completing Europe’s Economic and Monetary Union.

The full article is available here.