Bankruptcy for Banks: A Tribute (and Little Plea) to Jay Westbrook

By David A. Skeel, Jr. (University of Pennsylvania Law School)

Over the past several years, Congress has considered various versions of a legislative reform that would amend the Bankruptcy Code to facilitate the prompt reorganization of systemically important financial institutions (“SIFIs”). The reform would adapt the “Single Point of Entry” strategy devised for use under Title II of the Dodd Frank Act to bankruptcy. In each context, the assets, short term liabilities, and secured debt of the troubled SIFI would be transferred to a newly created bridge institution, leaving behind its stock and long-term debt. The newly recapitalized bridge institution would be fully solvent, and could contribute liquidity to the troubled subsidiaries as necessary. Although the bankruptcy for banks legislation appears to have strong support in Congress, its reception among bankruptcy scholars has been mixed.

In this short essay, I take the opportunity of a celebration of the work and influence of Jay Westbrook to explore his and his fellow critics’ opposition to bankruptcy for banks. I begin the essay by surveying Jay’s wide-ranging contributions to bankruptcy scholarship. Jay’s functional analysis has had a profound effect on scholars’ understanding of key issues in domestic bankruptcy law, and Jay has been the leading scholarly figure on cross-border insolvency. After surveying Jay’s influence, I turn to the topic at hand: bankruptcy for banks. Jay has been a strong critic of the proposed reforms, arguing among other things that financial institutions need to be resolved by regulators and an administrative process, not bankruptcy. After addressing these and other objections, I ask Jay if he might reconsider his opposition if the legislation were amended to respond to several of his primary concerns.

The essay is available here.

The Effect of Creditor Rights on Capital Structure, Investment, Profitability, and Risk: Evidence from a Natural Experiment

By Aras Canipek (University of Konstanz), Axel Kind (University of Konstanz; University of Basel; University of St. Gallen), and Sabine Wende (University of Cologne)

Supply-side scholars have argued that laws which mandate managers to leave upon bankruptcy filing and which grant secured creditors strong power to quickly seize their collateralized assets lead to higher recovery rates, lower interest costs, and relaxed financial constraints, and that these consequences ultimately foster economic growth. In contrast, a more recent demand-side view raises the concern that borrowers can feel threatened by such liquidation-oriented regimes. Threatened borrowers may take (economically undesirable) actions to reduce the likelihood of having to bear high distress costs.

We find evidence in favor of the demand-side view by using Germany’s bankruptcy reform (ESUG) of 2012 and studying the causal effects of an exogenous downward shock to creditor rights on firms’ financial and investment policy. ESUG limited the rights of secured creditors by strongly facilitating firm continuation and allowing the manager to stay in unrestricted corporate control. In the study, we show that high-tangible-asset companies – which the reform predominantly affected – turned away from being overly risk-averse at the cost of profitability, relative to low-tangibility control firms. Specifically, weaker creditor rights motivated affected firms to increase financial leverage and to prefer the more flexible unsecured debt. Moreover, affected firms reduced unprofitable but risk-lowering expansions and sold off less profitable but easily-marketable assets that are useful in downturns by providing the liquidity that can prevent bankruptcy. Our results suggest that weaker creditor rights encourage firms to eliminate protection mechanisms formerly constructed to contract around liquidation-oriented bankruptcy provisions. This view is supported by the increased profitability and higher risk of treated firms after the reform.

The stronger pre-ESUG creditor rights not only produced ex post deadweight losses in terms of inefficient liquidation, but also discouraged firms to make profitable investment decisions. This reveals ex ante inefficiencies of creditor rights, an aspect largely ignored in the extant literature.

The article can be found here.