By Kenneth Ayotte (University of California – Berkeley School of Law) and Christina Scullly (University of California – Berkeley School of Law)
The Nobel laureate Herbert Simon describes a complex system as one “made up of a large number of parts that interact in a nonsimple way.” The modern large Chapter 11 fits this definition quite well. Debt contracts with overlapping provisions lie within capital structures with multiple classes of claims, layered across numerous legal entities. Distressed restructuring transactions give rise to complex litigation over entitlements to the firm’s value. Bankruptcy case governance strategies are driven by intercreditor and restructuring support agreements that are constantly evolving.
Traditional law and economics theory of bankruptcy has little to say about this complexity, except to assume that rational, forward-looking “sophisticated parties” have anticipated it and managed it optimally. Taken to its logical conclusions, this perspective leaves no useful role for bankruptcy law. After all, if some feature of the Bankruptcy Code were useful, sophisticated parties would find a way to put it in their contracts. Mandatory features, even bedrock ones like the automatic stay, become no more than harmful interferences with contractual freedom.
Simplified models that assume omnisciently rational actors are useful tools in corporate finance: they isolate the forces that drive capital structure decisions and generate testable empirical predictions. But as normative models of bankruptcy law design, they are fundamentally flawed. We provide two case studies, one involving a complex contract (J. Crew), and another involving a complex capital structure (Nine West). Taken together, they suggest that it is time for law and economics scholars to take the uncomfortable but necessary step to acknowledge bounded rationality. Bankruptcy law must function not just for the optimal contracts a theorist derives, but also for the “good enough” contracts parties actually write, and the unpredictable interactions these imperfect contracts can generate.
Our first case study recounts the narrative behind the J. Crew restructuring, the most well-known of many “liability management transactions” that have become part of the distressed borrower’s playbook. The J. Crew case illustrates how a complex loan agreement with numerous interacting terms gives rise to loopholes that sophisticated parties can exploit. We describe the two-step transaction by which J. Crew combined multiple provisions in a term loan agreement to transfer the lenders’ collateral to an unrestricted subsidiary to refinance other debt. Though one particular “trap door” provision received the most public attention, our study reveals that other contractual weaknesses, such as the administrative agent’s low-powered incentives as a lender representative, also enabled the collateral transfer.
The growing importance of liability management strategies suggests that the true effect of greater sophistication is not optimal debt contracts, but instead, a magnification of their inevitable flaws. To understand these trends, we first need a model of contracting where such weaknesses can exist. Acknowledging bounded rationality in contracting is a necessary first step toward an agenda that understands the imperfect ways complex contracts evolve. This agenda can help scholars gain an understanding what drives contractual change, why loopholes form and close, and the costs and benefits of contractual complexity.
A second case study, Nine West, illustrates a “butterfly effect” of complex capital structures: small changes can have large and unanticipated effects when a bankruptcy occurs. Sycamore Capital Partners acquired Nine West and related fashion brands in a leveraged buyout in 2014. It reorganized its corporate structure in the process, leaving most of the debt with Nine West and spinning out other brands to itself, free of debt. An eleventh-hour decision to add more debt to the deal, and to make this debt senior through subsidiary guarantees, gave rise to a dizzyingly complex array of entitlement disputes between parent and subsidiary creditors about the uncertain ownership of assets and responsibility for debts across the entities in the Nine West corporate group. These disputes contributed to the exorbitant professional fees incurred in the bankruptcy case that consumed over 20% of the company’s enterprise value.
Insights from the study of complex systems can more realistically inform our models of bankruptcy law design. For example, an important feature of complex systems design is robustness: the system must be able to function effectively under suboptimal conditions. Features like the automatic stay and judicial oversight play a valuable role in preventing imperfections and gaps from propagating. Because interactions across contracts are most likely to lead to unanticipated effects, a perspective based in bounded rationality is also consistent with bankruptcy’s special role as a tool for addressing multiple creditor problems. Overall, we believe there is significant insight to be gained from the recognition that even sophisticated parties are imperfect.
The full article is available here.
