A Functional Analysis of SIFI Insolvency

By Stephen J. Lubben (Seton Hall University School of Law)

Since the disgrace of Lehman, the question of how to handle failing SIFIs has been quite vexed.   On the one hand, governmental rescue of shareholders and other investors is beyond annoying, and there is some intuitive sense that if management does a poor job, they and their investor backers should face the consequences, just like any other firm.   That bank managers would have the temerity to pay themselves large bonuses shortly after a taxpayer rescue only emphasizes the point.

On the other hand, there is a widespread understanding that a large bank, or a sufficiently interconnected one, is not quite like Kmart, Enron, or even American Airlines, in that when the bank fails, it tends to take a large chunk of the economy along with it.   Pre-failure regulation can mitigate some of the effects, but by the time we get to insolvency—or “financial distress”—the regulatory string has pretty much played out.   And in the end, we have trouble deciding if we really mean to treat large financial institutions like normal failed firms.

In A Functional Analysis of SIFI Insolvency, I argue that we need to consider what it is that we are trying to achieve in a bank insolvency case, and how that compares with bankruptcy law in general.  Bank insolvency, I submit, is all about special priorities: both ordinal and temporal.  The Bankruptcy Code, on the other hand, takes an “equality is equity” approach to priorities as a baseline, mostly using state law to draw the claim-asset border.

Financial insolvency law expressly rejects this model; it instead is all about protecting some favored group from the effects of insolvency.   There is no equality here, and it was never intended that there would be equality.   And thus it is time to stop pretending SIFI insolvency is “normal” corporate insolvency but bigger.

The full article is available here.

Bankruptcy Law as a Liquidity Provider

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Authors: Kenneth Ayotte & David Skeel

Since the outset of the recent financial crisis, liquidity problems have been cited as the cause behind the bankruptcies and near bankruptcies of numerous firms, ranging from Bear Stearns and Lehman Brothers in 2008 to Kodak more recently.  As Kodak’s lead bankruptcy lawyer explained to the court on the first day of the case: “We’re here for liquidity.” In this Article, we offer the first theoretical analysis of bankruptcy’s crucial role in creating liquidity for firms in financial distress.

The dominant normative theory of bankruptcy (the “Creditors Bargain theory”) argues that bankruptcy should be limited to solving coordination problems caused by multiple creditors. Using simple numerical illustrations, we show that two well-known problems that cause illiquidity–debt overhang and adverse selection– are more severe in the presence of multiple, uncoordinated creditors.  Hence, bankruptcy is justified in addressing them.

We discuss the Bankruptcy Code’s existing liquidity-providing rules, such as the ability to issue new senior claims, and the ability to sell assets free and clear of liens and other claims.  In addition to identifying this function in a variety of provisions that have not previously been recognized as related, our theory also explains how the recent trend toward creditor control in Chapter 11 cases can be explained as an attempt to create illiquidity for strategic advantage.  Although bankruptcy’s liquidity providing rules are essential, especially in the current environment, they also carry costs, such as the risk of “continuation bias.”  To address these costs, we propose qualitative principles for striking the balance between debtor liquidity and respect for nonbankruptcy rights.

University of Chicago Law Review, Vol. 80, Fall 2013.  A draft is available on SSRN.

Essential Corporate Bankruptcy Law

Authors:  Oscar Couwenberg & Stephen J. Lubben

In every economy, the question of what to do with financially distressed businesses is a matter of concern.   The United States has a long history of corporate restructuring law, starting with the reorganization of railroads in the nineteenth century and continuing through chapter 11 in its current form.   This naturally leads to a tendency to adopt chapter 11, or something like it.

But why?  In particular, chapter 11 is a rather ornate system of corporate reorganization, and it has been adorned with elements that reflect little more than particular creditors’ ability to lobby Congress.

We reexamine chapter 11 to understand its core.  In short, what, if any, are the essential elements of corporate bankruptcy law?

We point to two facets of chapter 11:  asset stabilization and asset separation.  These two aspects of chapter 11 could not be established other than by statute, and jurisdictions looking to reform their corporate bankruptcy processes should focus there.

Asset stabilization is the ability to temporarily protect assets as a coherent whole.  It includes obvious things like the stay on individual creditor collection, provision of post-bankruptcy liquidity and delays on termination of contracts with the debtor.

Asset separation captures the ability to separate assets from their concomitant liabilities.  This might take the form of a discharge, but is not necessary.  Essential is that the system provides clean title to a new owner of the assets, which may or may not be the post-bankruptcy firm.

As this is the core of any sensible corporate insolvency system, features beyond that are a matter of policy, and politics.

The full article can be found here.