Search

Many current bankruptcy debates—from critical vendor orders to the Supreme Court’s decision last year in Czyzewski v. Jevic Holding Corporation—begin with bankruptcy’s distributional rules and questions about how much discretion a judge should have in applying them. It is a mistake, however, to focus on distributional questions without first identifying the bankruptcy partition and ensuring it is properly policed. What appear to be distributional disputes are more often debates about the demarcation of the bankruptcy partition and the best way to police it. Once the dynamics of establishing and policing the bankruptcy partition are taken into account, there is little room for departures from bankruptcy’s distributional rules. There might be a few rare cases in which maximizing the value of the estate requires it, but these inhabit an exceedingly narrow domain so small and so hard to navigate that they are sensibly handled with a per se rule that prohibits them.

In RadLAX Gateway Hotel, LLC v Amalgamated Bank, the Supreme Court’s statutory interpretation focuses on an emerging theme of its bankruptcy jurisprudence: the proper domain of the bankruptcy judge. While one might expect the Court to approach that question of domain as it has for administrative agencies, that is not the approach taken. This article explores the Court’s approach to bankruptcy’s domain. In doing so, we connect three principal strands of the Court’s bankruptcy jurisprudence. The first strand, embodied in Butner v United States, centers on the idea that the bankruptcy forum must vindicate nonbankruptcy rights. The second, most recently addressed in Stern v Marshall, focuses on the limits of bankruptcy judges in deciding and issuing final judgment on the issues before them. Bankruptcy judges must limit themselves to deciding issues central to the administration of the bankruptcy process. RadLAX is the continuation of a third strand that makes it plain that the Court reads ambiguous provisions of the Bankruptcy Code to narrow the range of decisions over which the bankruptcy judge may exercise her discretion — at least when the exercise of that discretion might impact nonbankruptcy rights. The resulting bankruptcy jurisprudence is in stark contrast with the Court’s approach in administrative law. This paper attempts to make sense of this state of affairs and connect it with the realities of bankruptcy practice today.

Over the last few years, reorganization practice has undergone a massive change. A new device — the restructuring support agreement — has transformed Chapter 11 negotiations. This puts reorganization law at a crossroads. Chapter 11’s commitment to a nonmarket restructuring with a rigid priority system requires bankruptcy judges to police bargaining in bankruptcy, but the Bankruptcy Code gives them relatively little explicit guidance about how they should adjust when a new practice alters the bargaining environment. This essay shows that long-established principles of bankruptcy should lead judges to focus not on how these agreements affect what each party receives, but rather on how they can interfere with the flow of information needed to apply Chapter 11’s substantive rules.

American bankruptcy law provides creditors of a corporate debtor with an alternative way of sorting out their claims to the debtor’s assets. Bankruptcy differs from ordinary avenues of debt collection in that all claims against a common debtor are determined at one time and in one place. Creditors are forced to give up their right to seek repayment on their own. Each creditor must stay its hand while decisions are made about what to do with the firm’s assets and how to recognize the different claims against it. Some creditors who might have been paid in full if bankruptcy had not intervened are worse off. Others, who might have been unaware of the debtor’s financial straits, may be better off. The premise of American bankruptcy law is that sometimes the creditors and others who contributed capital to the firm are better off as a group than they would be if this avenue of debt collection did not exist and creditors had to depend upon their individual remedies under nonbankruptcy law.’ This premise-that the collective interests of the group can be put at risk when individual creditors exercise their rights-brings with it a problem that other legal regimes do not face. Ordinarily, one can depend upon the party that benefits from a particular legal rule to invoke it. Bankruptcy is different. The beneficiaries of bankruptcy law are the creditors as a whole, not individual creditors within the group.? One wants a bankruptcy proceeding to begin when it is in the collective interest of the group, but one must still depend upon someone to initiate it. One must somehow ensure that when a bankruptcy proceeding is in the collective interest of the creditors, it is also in someone’s individual interest as well. Existing bankruptcy law allows creditors to trigger the collective proceeding when three of them with unsecured claims totaling more than $5,000 join in a

THE Prisoner's Dilemma casts a shadow over all who want to trade. Two parties may desire that a transaction go forward, but each may fear that the other will not perform. The parties may rationally decide either not to make promises or not to keep them, even though each would be better off if both made promises and kept them. Take the simplest case. I have a book that I want to sell for $10; you would like to buy it for $10.' The trade makes each of us better off, but we have conflicting schedules and can never be in the same place at the same time. I must part with the book before I know that you have parted with the $10. Similarly, you must part with the $10 before you know that I have parted with the book. We may not have an incentive to keep our promises. When I decide whether to send the book, you have already decided whether to send the cash, but I do not know your decision. I look at the two possibilities. First, I examine the course I should take if you have already decided to break your promise. In this event, I should keep the book. I do not want to be left without either the book or the $10. I then determine my best course if you have already decided to sent the $10. Here, too, I should keep the book. I am better off with both the book and the $10 than I am with just the $10. Whether I part with the book has nothing to do with whether you part with the $10. Keeping the book is the optimal strategy

Bankruptcy law does not exist in a vacuum, yet one cannot spend much time reading in the field without noting that few judges or scholars have taken this observation to heart.' Too many seem to think that a bankruptcy proceeding provides, in the main, an essentially unlimited opportunity to do what appears at the moment to be good, just, or fair without regard to the reasons for having a system of bankruptcy laws in the first place.2 A close study of the present controversy over the adequate protection of secured creditors illustrates the shallowness of much of the recent discussion of bankruptcy law and the consequences of a failure to

In a Chapter 11 reorganization, senior creditors are entitled to insist upon being paid in full before anyone junior to them receives anything. In practice, however, departures from such “absolute priority” are commonplace. Explaining these deviations has been a central preoccupation of reorganization scholars for decades. By the standard law-andeconomics account, deviations from absolute priority arise because well-positioned insiders take advantage of cumbersome procedures and inept judges. In this paper, we suggest that a far simpler and more benign force dominates bargaining in reorganization cases. “Deviations” from absolute priority are inevitable even in a world completely committed to respecting priority as long as asset values are uncertain. Uncertainty accompanies any valuation procedure. Bargaining in corporate reorganizations takes place in the shadow of this uncertainty, and standard models of litigation and settlement show that valuation uncertainty alone can explain many of the departures from absolute priority we see in large corporate reorganizations. Even where rational and well-informed senior investors expect the absolute priority rule to be strictly enforced, they must account for the uncertainty associated with any valuation. The possibility of an unexpectedly high appraisal will cause them to offer apparently out-of-the-money junior investors contingent interests in the reorganized business. The debate over absolute priority, the central principle of modern corporate reorganization law, has been misdirected for decades. It has failed to recognize that a substantive rule of absolute priority does not lead to an absolute priority outcome. A coherent account of absolute priority must incorporate relative priority. It must take account of the option value implicit in the junior investors’ right to insist on an appraisal. This paper offers an explanation for one of the most important and persistent puzzles in corporate reorganizations. In a Chapter 11 reorganization, senior creditors are, in principle, entitled to insist upon “absolute priority.” They have a right to be paid in full before junior investors receive anything. This “fixed principle” has been the foundation of our corporate reorganization laws for decades. In practice, however, departures from ab

Traditional approaches to corporate governance focus exclusively on shareholders and neglect the large and growing role of creditors. Today’s creditors craft elaborate covenants that give them a large role in the affairs of the corporation. While they do not exercise their rights in sunny times when things are going well, these are not the times that matter most. When a business stumbles, creditors typically enjoy powers that public shareholders never have, such as the ability to replace the managers and install those more to their liking. Creditors exercise these powers even when the business is far from being insolvent and continues to pay its debts. Bankruptcy provides no sanctuary, as senior lenders ensure that their powers either go unchecked or are enhanced. The powers that modern lenders wield rival in importance the hostile takeover in disciplining poor or underperforming managers. This Essay explores these powers and begins the task of integrating this lever of corporate governance into the modern account of corporate law.

The law of corporate reorganizations is conventionally justified as a way to preserve a firm’s going-concern value: Specialized assets in a particular firm are worth more together in that firm than anywhere else. This paper shows that this notion is mistaken. Its flaw is that it lacks a welldeveloped understanding of the nature of a firm. Initially, it is easy to confuse size with specialization and overstate the extent to which assets are dedicated to a particular enterprise. Even when such dedicated assets exist, they often do not need to stay in the same firm. As Coase taught us, as the costs of contracting go down, so too does the value of keeping assets in a particular firm. But even when specialized assets must be kept inside a firm, two other forces limit the need for a traditional law of corporate reorganizations. Capital structures are increasingly designed with financial distress in mind. For these firms, control rights shift from one set of investors to another as the firm encounters difficulty. Such firms either never file for bankruptcy, or, if they do, it is only to vindicate the predetermined allocation of control rights. Even where control rights are not sensibly allocated, a quick sale of the firm restores order. When firms can be sold as going concerns, the need for the traditional negotiated plan of reorganization disappears. The vast majority of firms in financial distress never enter bankruptcy. Today the Chapter 11 of a large firm is an auction of the assets, followed by litigation over the proceeds. To the extent we understand the law of corporate reorganizations as providing a collective forum in which creditors and their common debtor fashion a future for a firm that would otherwise be torn apart by financial distress, we may safely conclude that its era has come to an end. * Harry A. Bigelow Distinguished Service Professor, University of Chicago Law School. Forthcoming in the Stanford Law Review. ** Associate Dean for Academic Affairs and Professor of Law, Vanderbilt Law School. We thank Barry Adler, Marcus Cole, Michael Hilgers, Richard Levin, Alan Littmann, Eric Posner, Mark Ramseyer, and David Skeel for their help. Prior versions of this Article were presented at the University of Chicago Law School and the Annual Meeting of the American Law and Economics Association. For his support and insight throughout this project, we are especially grateful to our colleague Edward Morrison. We also thank the John M. Olin Foundation, the Sarah Scaife Foundation, the Lynde & Harry Bradley Foundation, and the Dean’s Fund at Vanderbilt for research support. Baird & Rasmussen, page 2

A BANKRUPTCY proceeding is a day of reckoning for all parties with ownership interests in an insolvent firm. Ownership interests are valued, the assets are sold, and the proceeds are divided among the owners. Bankruptcy proceedings take one of two forms, depending on whether ownership rights to the assets are sold on the open market to one or more third parties or whether ownership rights to the assets are transferred to the old owners in return for the cancellation of their prebankruptcy entitlements. The first kind of bankruptcy proceeding, a liquidation, is governed by Chapter 7 of the Bankruptcy Code; the second kind, a reorganization, is governed by Chapter 11. A bankruptcy proceeding always involves a sale of assets followed by a division of the proceeds among the existing owners. In a Chapter 7 proceeding the sale is real; in a Chapter 11 proceeding the sale is hypothetical.' An analysis of the law of corporate reorganizations should properly begin with a discussion of whether all those with rights to the assets of a firm (be they bondholders, stockholders, or workers) would bargain for one if they had the opportunity to negotiate at the time of their initial investment.2 Properly understood, a bankruptcy proceeding itself can be

defaults, he will require a higher interest rate from the debtor.' In order to reduce this uncertainty, and thereby to facilitate secured credit, the Uniform Commerical Code normally requires a creditor either to take possession of the property or to make a public filing, if he wants a security interest in his debtor's property that is effective against competing property claimants.2 This requirement, coupled with a simple "first-in-time" rule, enables a creditor who wants to lend money on a secured basis to assume that, if the property in question is in the debtor's possession and if no other creditors have filed a financing statement, his claim to that property can have priority over those of other existing and future creditors. The Code assumes that this benefit outweighs the costs imposed upon secured parties by the requirement that they take possession or file.3