Bankruptcy Law as a Liquidity Provider

posted in: Claims Trading | 0

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.

Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain

posted in: Cramdown and Priority | 0

Post by Frederick Tung, Professor at Boston University School of Law

In “Breaking Bankruptcy Priority:  How Rent-Seeking Upends the Creditors’ Bargain,” recently published in the Virginia Law Review, Mark Roe and I question the stability of bankruptcy’s priority structure and suggest a new conceptualization of bankruptcy reorganization that challenges the long-standing creditors’ bargain view. Bankruptcy scholarship has long conceptualized bankruptcy’s reallocation of value as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of statutory and agreed-to contractual priorities.

In “Breaking Priority,” we propose an alternative view. No hypothetical bargain is ever fully fixed because creditors continually attempt to alter the priority rules, pursuing categorical rule changes to jump ahead of competing creditors. These moves are often successful, so creditors must continually adjust to other creditors’ successful jumps. Because priority is always up for grabs, bankruptcy should be reconceptualized as an ongoing rent-seeking contest, fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps.

We highlight a number of recent and historical priority jumps. We explain how priority jumping interacts with finance theory and how it should lead us to view bankruptcy as a dynamic process. Breaking priority, reestablishing it, and adapting to new priorities is part of the normal science of Chapter 11 reorganization, where bankruptcy lawyers and judges expend a large part of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.

The paper is available here.