Bankruptcy’s Endowment Effect

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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.

Beyond Options

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By Anthony J. Casey (University of Chicago Law School) and Edward R. Morrison (Columbia Law School)

Scholars and policymakers now debate reforms that would prevent a bankruptcy filing from being a moment that forces valuation of the firm, crystallization of claims against it, and elimination of junior stakeholders’ interest in future appreciation in firm value. These reforms have many names, ranging from Relative Priority to Redemption Option Value. Much of the debate centers on the extent to which reform would protect the non-bankruptcy options of junior stakeholders or harm the non-bankruptcy options of senior lenders. In a new paper, “Beyond Options,” we argue that this focus on options is misplaced. Protecting options is neither necessary nor sufficient for advancing the goal of a well-functioning bankruptcy system. What is needed is a regime that cashes out the rights of junior stakeholders with minimal judicial involvement. To illustrate, we propose an “automatic bankruptcy procedure” that gives senior creditors an option to restructure the firm’s debt or sell its assets at any time after a contractual default. Under this procedure, restructuring occurs in bankruptcy, but sales do not. Sales are either subject to warrants (which give junior stakeholders a claim on future appreciation) or are subject to judicial appraisal (which forces senior lenders to compensate junior stakeholders if the sale price was too low). Our proposal can be seen as an effort to design a formalized restructuring procedure that borrows from traditional state law governing corporate-control transactions. We show that this procedure minimizes core problems of current law—fire sales that harm junior stakeholders, delay that harms senior lenders, and the uncertainties generated by judicial valuation, which are exploited by all parties.

The full paper is available here.

Bankruptcy on the Side

By Kenneth Ayotte (University of California – Berkeley School of Law), Anthony J. Casey (University of Chicago Law School), David A. Skeel, Jr. (University of Pennsylvania Law School)


Side agreements—such as intercreditor and “bad boy” agreements—are increasingly at the center of major bankruptcy disputes. Litigation around these disputes can be costly and the results of that litigation can dramatically alter the landscape within which the stakeholders bargain over reorganization.

These agreements commonly include a promise by one party to remain silent by waiving some procedural right they would otherwise have under the Bankruptcy Code. Those waivers are invoked at crucial points in the reorganization process, including the approval of debtor-in-possession financing and plan confirmation.

In our new paper, Bankruptcy on the Side, we show that while side agreements have beneficial potential, the parties entering them often impose negative externalities on outsiders. A promise not to extend new financing, for example, can affect the debtor’s reorganization prospects. Similarly, a promise not to object to a reorganization plan can rob the court of information that might benefit the other classes of creditors.

The paper presents a simple model to derive a proposal that is consistent with the intent of the parties to the side agreement but also limits negative externalities. The core of the proposal is that where there is a nontrivial potential for value-destroying externalities, the court should limit a nonbreaching party’s remedy to its expectation damages. On the other hand, if the agreement is unlikely to cause externalities, a court should enforce the agreement according to its terms. Our proposal is different and superior to the approach taken by most courts, which invokes a narrow interpretative standard to invalidate side agreements. We focus instead on enforcing the provisions under normal interpretative doctrines while limiting the use of special remedies like specific performance and stipulated damages.

The insights of our paper also provide a new answer to thorny questions involved in choosing which courts should resolve disputes over intercreditor agreements, and in deciding whether forum selection clauses should be enforced. Specifically, the bankruptcy courts have no specialized expertise for cases where the plaintiff seeks expectation damages. In those cases, the court should defer to default venue rules and forum selection clauses. Where specific performance or stipulated damages are at issue, by contrast, our model suggests that the dispute should be resolved exclusively in bankruptcy proceedings.


The New Corporate Web: Tailored Entity Partitions and Creditors’ Selective Enforcement

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By Anthony J. Casey, University of Chicago Law School

Casey, Anthony_0 (1)Firms often separate assets into distinct entities that have their own legal identity but are commonly owned and together form a large corporate group. While the law-and-economics literature has viewed these legal partitions as either all or nothing, firms have developed sophisticated legal mechanisms to create precisely tailored partitions. The result is a complex corporate web of interconnected legal affiliates.

For example, an asset that is placed in one legal entity may serve as collateral guaranteeing the debts of another legal entity within the corporate group. The assets of the two entities are separate for some purposes but integrated for others. Conventional theories of corporate groups cannot explain the tailored partitions in this corporate web. This article develops a new theory of selective enforcement to fill that gap.

When a debtor defaults on a loan, that default may signal a failure across the entire firm or it may signal a project-specific failure. Tailored partitions provide monitoring creditors with a valuable option to choose between project-specific and firm-wide enforcement depending on the information signal provided. Thus, firm-wide risks and failures can be addressed globally while the effects of project-specific risks and failures can be locally contained when necessary.

These concepts of selective enforcement and tailored partitions reveal important implications for theory and practice. They provide a cohesive justification for the web of entity partitioning and cross liabilities that characterize much of corporate structure today and inform the analysis of holding-company equity guarantees, fraudulent transfers, and ipso facto clauses.

The full version of this article is available here.

The Article III Problem in Bankruptcy

By Anthony J. Casey and Aziz Z. Huq, University of Chicago Law School

Casey, Anthony_0Huq Aziz 2009-06-18

The Supreme Court has struggled for the last three decades in defining the permissible scope of bankruptcy courts’ power. This question poses difficult federalism and separations-of-powers problems under Article III of the Constitution. Divided opinions in Northern Pipeline Construction v. Marathon Pipe Line, and more recently, in Stern v. Marshall, have produced confusion and litigation for practitioners and lower courts. This is true in large part because the Court’s Article III decisions lack any foundational account of why bankruptcy judges implicate a constitutional problem. As the Court prepares to confront the issue once again later this term, Aziz Huq and I provide such an account in a new article. This account more concretely identifies the precise stakes in this debate. We argue that a tractable, economically sophisticated constraint on delegations to the bankruptcy courts can be derived from what should be an obvious source: the well-tested creditors’ bargain theory of bankruptcy. Working from this account of bankruptcy’s necessary domain minimizes Article III and federalism harms while also enabling bankruptcy’s core operations to continue unhindered. To illustrate its utility, we then apply our framework to a range of common bankruptcy disputes, demonstrating that many of the Court’s existing jurisprudence is sound in result, if not in reasoning.

The article is forthcoming in the University of Chicago Law Review, and is available here.

Bankruptcy Step Zero

Authors: Douglas G. Baird and Anthony J. Casey

In RadLAX Gateway Hotel, LLC v Amalgamated Bank, the Supreme Court’s statutory interpretation focuses on an emerging theme of its bankruptcy jurisprudence: the proper domain of the bankruptcy judge. While one might expect the Court to approach that question of domain as it has for administrative agencies, that is not the approach taken. This article explores the Court’s approach to bankruptcy’s domain. In doing so, we connect three principal strands of the Court’s bankruptcy jurisprudence. The first strand, embodied in Butner v United States, centers on the idea that the bankruptcy forum must vindicate nonbankruptcy rights. The second, most recently addressed in Stern v Marshall, focuses on the limits of bankruptcy judges in deciding and issuing final judgment on the issues before them. Bankruptcy judges must limit themselves to deciding issues central to the administration of the bankruptcy process. RadLAX is the continuation of a third strand that makes it plain that the Court reads ambiguous provisions of the Bankruptcy Code to narrow the range of decisions over which the bankruptcy judge may exercise her discretion — at least when the exercise of that discretion might impact nonbankruptcy rights. The resulting bankruptcy jurisprudence is in stark contrast with the Court’s approach in administrative law. This paper attempts to make sense of this state of affairs and connect it with the realities of bankruptcy practice today.

The article is available here on SSRN.