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CHAPTER 12

Commentary on "On the nature of bankruptcy": bankruptcy, priority,

and economics*

MARK J. ROE**

I. Exogenous Risks Versus Endogenous Risks:

The Only Relevant Distinction?

Dean Jackson and Professor Scott [referring to Chapter 10 in this volume. Eds.] provide us with a vivid image: the captain of an imperiled ship must decide whether to jettison cargo, to cut off the mast, or to jettison the ship's supplies. If losses fall where incurred and are not shared, the captain would be expected to foster his own interest instead of maximizing the savings of the group. Admiralty's rule of general average reduces the captain's perverse incentive to jettison another participant's cargo when it is cheaper in the aggregate to jettison the ship's own supplies.

Bankruptcy's priority system recreates the imperiled ship scenario. Deviations from the priority system for exogenous risks are analogous to admiralty's rule of general average. The parties could do nothing to avoid the calamity or to mitigate its effects. The costs of bargaining to the value-max- imizing solution are high due to priority. Accordingly, the theoretical justification for respecting priority in a bankruptcy caused by exogenous factors evaporates.

Strategic creditor action, they argue, justifies bankruptcy's sharing rules. Another justification is available - debtor moral hazard: if the owner of a closely held firm fears that his equity interest will be reduced to zero, he has an incentive to abandon the enterprise or to take unwarranted risks to create some possibility of a payback. By giving the entrepreneurial debtor an interest in the ongoing enterprise, sharing rules mute his incentive to gamble with, or to abandon, the enterprise.

A "common risk" is defined as any contingency whose probabilities or effects cannot be influenced by the actions of individual parties. This definition leads to a dichotomy: risks that can be controlled by parties are borne by them; risks that cannot be controlled individually can be and often are shared. But this

*This chapter is an edited version of the article that originally appeared in 75 Virginia Law Review 219 (1989). Permission to publish excerpts in this book is gratefully acknowledged.

**Professor, Columbia Law School.

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definition gives too wide an influence to bankruptcy sharing rules. It excludes a large middle involving disagreement, mistrust, and lack of information.

These explanatory variables - asymmetric information and belief - are fundamental in the financial economics literature. Creditors may not want to share risks because their assessment of the firm's investments differs from that of its stockholders or, more importantly, because the costs of ascertaining the full range and probability of potential outcomes is too high.

Sharing would sometimes require more investigation, and sometimes more subsequent monitoring, than straight priority debt. When investigation is expensive, priority debt facilitates efficient deals.

When the lenders ask what can be given as hostage, the insiders offer full priority in the event of failure. In effect, the entrepreneur is saying, "If the project is not worth enough to pay you in full, I'll give you the machinery, inventory, and factory."

Jackson and Scott's sharing paradigm could destroy this worthwhile bargain: in order to facilitate other relational benefits, the bargain cannot take place in full in the sharing model. The insiders are prohibited from effectively promising the creditors everything in the event of a bankruptcy. Thus, the signaling and informational advantages of debt are undermined by the sharing rule.

Notwithstanding Jackson and Scott's interesting model, the financier and the entrepreneur may not wish to share exogenous risks if sharing requires the creditor to investigate more carefully the sensitivity of the enterprise to those risks. In some instances, worthwhile deals might collapse if a sharing rule is anticipated. But these are deals contractarians should want to go through.

II. Why Not Sharing by Contract?

The common disaster story is consistent with bankruptcy sharing. But, as the authors would surely agree, before bankruptcy sharing is imposed, one ought to have more than a plausible story of why debtors and creditors might want to share risks. Why did the parties fail to share by contract? The authors reject the ability to share by contract, but we should press on beyond that ipse dixit.

This inquiry divides into three parts:

1.the problem of specification;

2.the problem of creditor and debtor coordination; and

3.the comparative advantages of various bankruptcy rules in resolving problems of specification and coordination.

A closely parallel division is this:

1.If there is one creditor, could the exogenous risks be specified and shared between debtor and creditor by contract?

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2.Could several creditors coordinate their actions if they wanted to share risks among themselves?

3.Even if they could not coordinate, is there a better default rule than that of the current regime?

A. Specification

Could exogenous risks be specified ex ante in the contract? True, many exogenous risks are unforeseeable or too difficult to delineate. But many of these risks, although difficult to specify in advance, will manifest themselves as declines in industry price or increases in industry cost. These exogenous risks could plausibly be specified by contract; if they arise the parties would share.

The mechanism for sharing under a background rule of full priority is easy enough to imagine: the contract could provide for no interest in the event of a reorganization. Or the creditor of a public firm would take equity characteristics by taking convertible bonds or bonds with warrants attached.

To tie the sharing to exogenous risks, the contract could trigger the sharing (no interest, payment in stock, or forced conversion to equity) if demand in the industry falls to this level of production or price.

B. Collective action

L Large public firms and financial creditors

Collective action problems would impede the use of a sharing clause. The creditor agreeing to such a clause will often want to be sure that the firm's other creditors do the same but may not be able to force that agreement. This is a rationale for collectivization by legal rule. But before we force collectivization we should question why the collective result is not even attempted by contract. If it is never attempted, maybe that is because it is not wanted.

For example, many public firms do not use security in their credit instruments because they think it is just an expensive shifting of risk. But a financial creditor that does not want security for itself also wants to be sure that no one else comes ahead of him in bankruptcy. Accordingly, the creditor insists that the debtor not secure its assets to anyone else without equally and ratably securing the creditor seeking protection. Some debtors have this type of negative pledge clause in all of their principal debt agreements.

Similarly, one could imagine contractual sharing rules stating that a creditor is obliged to forgo interest if industry-wide prices dip below a specified level, but the obligation would depend on a minimum percentage of the debtor's other creditors also agreeing. True, contractual specification will not be as transactionally efficient as a mandated rule, if that is what the parties

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really want. But at least some firms ought to be able to negotiate to this rule if they really want it. If no one ever negotiates to this contractual provision, then we have two inconsistent explanatory hypotheses. A transactionally costly negotiation is one hypothesis. A spurned sharing of risks because the result is itself undesirable is the competing hypothesis.

If creditors are not sharing by contract when they can, then a creditor-indif- ference or creditor-hostility hypothesis arises to compete with the costly coordination hypothesis: sharing might be unimportant or costly.

2. Smallfirms and trade creditors

I believe that although coordination is plausible among the financial creditors of a large public firm - because the costs of contract arrangement and policing are small in relation to the size of the loans - the cost of coordination among the nonfinancial creditors of smaller firms is larger. For the small firm, coordination costs could justify Jackson and Scott's mandated sharing story.

The sharing thesis takes on special strength in the context of creditors who do not bargain - tort claimants - or those for whom bargaining is very costly - small trade creditors. These creditors, the argument would run, cannot require secured creditors to take characteristics of an equity holder. The plausibility of contract solving the sharing problem diminishes.

But let me offer two critiques in the next two Sections, one weak and one strong. The first is that Jackson and Scott's prototypical capital structure would actually facilitate sharing exogenous risks between financial creditors and trade creditors by contract (compared to other types of capital structures). The second is that if the risks cannot be coordinated by contract, the current set of bankruptcy rules is a relatively poor way to impose the sharing.

3. A single dominant creditorfacilitates the sharing bargain

The Jackson and Scott model firm has a dominant secured creditor that provides most of the firm's financial capital. The general collective action problems for that kind of firm may be in some ways easier to resolve than those of larger firms that nevertheless sometimes succeed through negative pledge clauses.

True, trade creditors typically do not have the financial sophistication to bargain, [or] they lack the time to do so for relatively small shipments. For these reasons, though the efficient rule might be for the secured creditor to share exogenous risks with the trade creditors, they cannot get the contract that they would obtain in a frictionless world.

But there are intermediaries. In some industries, trade creditors make crude credit decisions based on the evaluation of a credit-rating agency. Presumably, if the sharing rule were really important, the debtor would attach the sharing clause to the financial statements it forwards to credit agencies. These superior

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sharing terms would then find their way into superior credit recommendations. Since the sharing model is designed to deal with the overreaching of a dominant secured lender, communication of crucial terms should be fairly easy. I do not argue that the contractual frictions noted previously would necessarily be easy to overcome. I do argue that they are at least worthy of investigation.

C. More efficient default rules

A more serious difficulty faces the assertion that the trade (and similar tort, consumer, and nonbargain) creditors cannot coordinate and bargain. How much have we shown if we demonstrate that a sharing rule is consistent with efficiency? We used to think that priority was consistent with efficiency. Maybe it still is. Jackson and Scott's sharing theory now shows us that sharing is consistent with efficiency. The importance of that showing should not be underestimated. Are we now to think, as we must, that priority, sharing, and all hybrids are consistent with efficiency? Isn't the next task, the tougher task, to go beyond the existence theorem and to show how one set of rules is superior to another set of rules?

Could the relational explanation be buttressed by explaining why alternative legal rules are not better? Why wouldn't priority in reorganization for trade creditors or tort claimants be better than the hybrid results we now have? A rule of priority for nonbargain creditors seems efficient.

Or why not have a rule that prohibits secured creditors from seizing security to the ratable disadvantage of nonbargain creditors? Under this rule, the secured creditor would "share" with these nonbargain creditors, but would retain priority over the other financial and bargain creditors. This result parallels that of typical subordination arrangements in public firms.1 It also is consistent with efficiency. Although this rule may have some defects, it does seem to be a plausible first response to the problem of strategic action by the dominant secured creditor.

Such a rule might be superior to the current sharing hybrids for another reason. The current rules have a ratchet-like effect. Once imposed, the parties cannot reverse them even if they can overcome the bargaining and coordination costs. For example, interest does not accrue on many claims in bankruptcy, even if the parties want it to accrue.

The point of this discussion is that sharing by contract is possible under current rules and even more plausible under alternative rules. Those attempting to

1 Public firms tend not to use secured debt. See M. McDaniel, "Are Negative Pledge Clauses in Public Debt Issues Obsolete?," 38 Business Lawyer 867 (1983). The subordination arrangements have trade and nonfinancial creditors "outside" of the intercreditor priority rearrangement. The outsiders "share" with the financial creditors, who reallocate priorities among themselves. See American Bar Foundation, Commentaries on Model Debenture Indenture Provisions, 560-1 (1971).

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justify mandated sharing ought to show why contract mechanisms or other baseline rules are inadequate to the task. It would be helpful to the sharing theory to show some substantial contractual efforts (even if incomplete) that were motivated by sharing and strategic concerns. Identifying a possible contractual breakdown in the current legal framework is insufficient in itself to justify jumping to a mandatory rule; one has to know why contract fails and why an alternative baseline, nonmandatory rule could not do better.

If creditors are not contractually making the common disaster/endogenous risk distinction that Jackson and Scott posit to be important, there are several competing explanatory hypotheses to consider:

1.the distinction is unimportant;

2.the distinction, although important, is overshadowed by more important considerations like informational signaling; or

3.the relevant parties cannot get together to make the distinction by contract.

III.Do Existing Examples of Sharing Reflect the Exogenous/Endogenous Risk Distinction?

A. Reorganization under chapter 11

Reorganization under chapter 11 is characterized by a broad-based sharing of risks. How well does it comport with the contractarian framework?

1. Idiosyncratic value and the common disaster

Is risk sharing the central reason for value shifts during small firm reorganization or is the idiosyncratic value invested in the enterprise by its individual owners the primary justification? The two concepts are different. Exogenous risk sharing is justified as a means of reducing perverse incentives to collapse or expand probability distributions or to engage in self-interested maneuvers. Idiosyncratic value is an economist's term for distributional considerations. It does not fit well with the distinction between exogenous and endogenous risks that is central to Jackson and Scott's thesis.

2. Moral hazard and implied contract

Amoral hazard explanation for the failure of contract does not fit well with the contractarian paradigm, as can be seen by asking why the entrepreneur with idiosyncratic value does not get his creditors to share some of the risk ex ante. Idiosyncratic value should lead the entrepreneur to seek third-party insurance against a decline in value of the firm. Such insurance, however, would lead to the risk that the insured will be sloppy with her property once someone else

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bears the financial burden of its loss. Presumably, this moral hazard is so great that the insured cannot pay for the insurance out of expected idiosyncratic losses. In other words, contract fails.

But if these moral hazard costs deter third-party insurance, then they must also be embedded in the two-party insurance that bankruptcy sharing represents. The moral hazard does not disappear simply because the morally hazardous term is written into the contract by bankruptcy law rather than through contract negotiation. The debtor would be subject to the same moral hazard, the same propensity to be sloppy in the management of the business, whatever the source of the insurance.

3. Adverse selection

The distributional considerations that underlie idiosyncratic value in closely held firms theoretically might justify a risk-sharing redistributional result on contractarian terms.

The owner with her name on the door gets special value from running her own firm. She makes specific investment of human capital, is precluded from alternative actions if the business goes bad, and often cannot readily diversify the financial, idiosyncratic, and human capital she has invested in the firm. Thus, she would want financial creditors to accept some of the enterprise risks. Again the contractarian question arises: Why can she not contract for insurance with her creditors, specifying, for example, that upon declines in cash flow or industry price levels of a specified amount interest will be reduced or forgiven?

Perhaps one deductive contractarian justification for mandated risk sharing due to idiosyncratic value is not moral hazard, which will exist no matter who writes the insurance, but is embedded in the signaling information contained in debt. In other words, the problem might be one of adverse selection. Beginning there, Jackson and Scott could argue that adverse selection would be cured by a mandated result.

If, at the time of loan, the owner has the best estimate of the firm's value, creditors may hesitate as soon as she asks for the insurance. Although she is willing to pay for the insurance, the very request for the insurance changes the creditors' estimate of the value of the loan.2 For her to get the loan at all (or to get it with actuarially fair insurance terms), she must be prohibited from signaling the quality of the project by her acceptance of contingent destruction of her position. With the signal prohibited, the argument runs, she can obtain insurance because the creditor will not be able to use full priority as a signal of creditor quality.

2 See G. Akerlof, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," 84 Quarterly Journal of Economics 488 (1970); J. Stiglitz and A. Weiss, "Credit Rationing in Markets with Imperfect Information," 71 American Economic Review 393 (1981); J. Stiglitz and A. Weiss, "Credit Rationing: Reply," 77 American Economic Review 228 (1987). The argument is similar to that made in favor of mandated medical insurance for certain risky groups.

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Whether this adverse selection story really justifies mandated sharing is another question. The parties must be able to turn to a substitute form of signaling that does not have severe idiosyncratic value costs. If the substitute is almost as good a signal, mandated sharing would be wealth-maximizing and consistent with a contractarian framework.

In addition, there are many firms whose owners do not need to share risks, but who would be forced to do so under a mandated sharing rule unless a screening device were constructed. This forced risk sharing will in turn produce the moral hazard costs discussed above. In sum, the contract story is as follows: if most firms are subject to the adverse selection problem, if their owners have significant idiosyncratic investment or are risk averse, and if the next-best selection mechanism is almost as good as priority, then forced risk sharing at some level would be justified by implicit contract.

But to tell this adverse selection story would contradict the common disaster heuristic. Once we admit adverse selection into the model (to justify sharing of idiosyncratic risks), we must of course recognize that some firms may actually have no idiosyncratic value problems and may need to give full priority in order to signal the value of their projects and the insensitivity of their expected cash flow to exogenous risks. Thus, when adverse selection is fully considered, the common disaster model involves a much more complicated tradeoff.

Jackson and Scott may just be suggesting that efficient risk sharing is the best justification for these bankruptcy anomalies. But could happenstance, institutional lags, misconception, and mistake be better historical explanation of the rules than relational efficiency? Jackson and Scott might not at all disagree that to get a richer understanding of the bankruptcy process we may have to examine noncontractarian paradigms.

Conclusion

The heuristic suggested by Dean Jackson and Professor Scott works. They have set out to show an existence theorem, and they have shown it. Parties might want to share common disaster risks, and contract might fail to allocate these risks.

To complete their argument Jackson and Scott might want to press on to ask: Why does contract fail to do the same crude job that judicially mandated sharing rules provide? Why do not many of the exogenous risks reduce themselves into declines in industry demand or increases in cost? If they can be so reduced, exogenous risks could sometimes be specified in terms of benchmark prices of industry output or input. Furthermore, if sharing rules based on such benchmarks do not appear, why don't they? Adverse selection cost is one alternative hypothesis to Jackson and Scott's coordination-cost explanation. Unimportance of sharing is another. And if coordination costs are the answer,

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as Jackson and Scott suggest, then we might ask whether alternative judicial rules - such as a default baseline rule of priority or equality for nonbargain creditors that could be modified by contract - would accomplish the sharing norm more effectively.

It is not necessarily so that exogenous risks would be shared even if they could be specified and even if the creditors could overcome the problems of creditor coordination. The parties might decline to share exogenous risks because of the investigation and signaling costs sharing would entail. If that is so, mandated sharing cannot be readily reconciled with a contractarian framework.

The bankruptcy institutions offered as examples of bankruptcy sharing of exogenous risks are less convincing than they first seem. Lien-feeding problems and the strong-arm example are responsive to perceived creditor misfeasance, not to common risk problems.

Next, if our task is to explain why bankruptcy's sharing rules have developed, should we rest upon the conclusion that the distinctions Jackson and Scott draw are the most satisfying or should we press on to find other reasons for adoption of these rules? It may be that administrative justifications, deepseated moral aversion to interest, or sentiments that favor giving losers another chance were the real reasons for the original adoption of these sharing rules. It is also possible that society wants a collective proceeding for the bankruptcy but that the polity cannot ascribe the character of executioner to the bankruptcy system.

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CHAPTER 13

Bankruptcy and risk allocation*

BARRY E. ADLER**

I. Introduction

Bankrupt business firms distribute property to low-priority investors even though the firms do not fully repay high-priority investors. That bankruptcy in this way alters contractual priorities effectively reallocates among investors the risk of business insolvency. Commentators have roundly criticized such reallocation as an impediment to efficient business practice. Recently, however, a "risk-sharing" defense of bankruptcy reallocation has appeared in both the law and finance literature. Risk-sharing theorists argue that all investors in a business debtor - equity investors and creditors alike - would choose to share the risk of loss from the debtor's insolvency. These theorists surmise that investors cannot agree to share such risk, because a risk-sharing agreement is prohibitively expensive to negotiate. Therefore, the theorists conclude, bankruptcy reallocation furnishes a mutually beneficial hypothetical bargain to which investors would expressly agree but for transaction difficulties.

Though ostensibly plausible, risk-sharing theory must overcome a formidable obstacle: the actual bargain among investors is not silent on how to allocate insolvency risk. That bargain, in the form of equity and creditor contracts, expressly allocates insolvency risk to the low-priority, or "junior," investors (i.e., to equity investors and general unsecured creditors). Thus bankruptcy reallocation appears to conflict with the parties' express intent.

Moreover, one cannot properly attribute contractual priority to transaction costs. Contractual priority reflects a bargain struck within the network of contracts that comprises every firm. As part of the investors' contractual network, equity investors purchase residual claims subordinate to those of creditors. In return, these equity investors gain both control of the firm and the right to any value in excess of the amount the firm owes creditors. Among the firm's creditors, general creditors invest in rights to repayment that are subordinate to rights of high-priority, usually secured "senior" creditors. As a result, the firm, if able, pays interest to general creditors at a risk-enhanced rate greater than that the firm pays the more senior creditors. In sum, this collective scheme

*This chapter is an edited version of the article that originally appeared in 77 Cornell Law Review 439 (1992). Permission to publish excerpts in this book is gratefully acknowledged.

**Sullivan and Cromwell Research Professor of Law, University of Virginia.

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