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.

Activist Investors, Distressed Companies, and Value Uncertainty

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Authors:  Michelle M. Harner, Jamie Marincic Griffin, and Jennifer Ivey-Crickenberger

Hedge funds and other private investment funds often play a key role in chapter 11 cases.  They may hold the debtor’s prepetition secured debt or provide postpetition financing to the debtor.  They also may buy and trade the debtor’s secured and unsecured debt both before and after a chapter 11 filing.  These activities can provide much-needed liquidity to a debtor and foster a robust secondary market for creditors looking to exit the credit.  A fund’s participation in a case, however, sometimes generates litigation and, arguably, both delays the resolution and increases the cost of the case.  Consequently, many commentators and practitioners debate the utility of funds in restructurings.

In our most recent article on funds in chapter 11, we conduct an original empirical study of funds as purchasers of chapter 11 debtors.  Specifically, the study analyzes cases where a fund (individually or as part of a group) acquires control of a debtor through the chapter 11 process by purchasing either substantially all of the debtor’s assets or a majority interest in the reorganized stock.  In the stock acquisition context, we were concerned only with the investment of new capital.

Overall, the data suggest that funds have the potential to provide value in chapter 11.  But neither the participation of funds nor the chapter 11 process itself is a panacea, and more empirical and traditional case studies are needed to understand fully the impact of funds on corporate restructurings.  We hope our study encourages further research.

The full-length article can be found here.