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.