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The voting prohibition in bond workouts

a workout may be an ex ante advantage, representing a credible commitment at the time of financing to operate the firm well, or suffer the cost of bankruptcy. In a sense, managers offer the firm - or their careers - as hostage to the bondholders. The ex ante agency benefits of prohibiting a vote could outweigh the expected ex post stress costs of a resulting bankruptcy.

3. Tax frictions

Tax frictions could also impede an early workout. As a general rule the exchange of debt for stock whose fair market value is less than the face value of the debt will produce taxable discharge-of-indebtedness income equal to the difference between face and market values.19 Exceptions to and reductions in the impact of the discharge-of-indebtedness income are available but usually not until the eve of, or during, bankruptcy.20 The troubled firm thus could be expected wisely to wait, not seeking a stock-for-debt workout until on the verge of bankruptcy, when the tax penalties will be avoided.21

This suggests a disheartening scenario: When the firm begins to decline it believes a stock-for-debt workout would be operationally useful. But compared to the hard certainty of increasing its current tax bill, the contingency of future financial gridlock seems more remote. Management accordingly might delay seeking a workout. If it miscalculates and waits too long, or if the operational decline is more severe than expected, or if one of the other impeding frictions arises, then the workout fails.

The convoluted institutional structure governing risky public debt is quite ironic. The favored tax status of debt (interest is deductible, dividends are not) encourages widespread use of debt. The prohibition on bondholder votes makes public debt difficult to renegotiate. Furthermore, tax penalties are incurred if a renegotiation is attempted early, before the holdout problem becomes severe: Discharge-of-indebtedness income will be incurred if a stock-for-debt renegotiation is attempted other than on the eve of bankruptcy. The tax penalty is lifted if the firm is in, or on the eve of, bankruptcy. But waiting until the eve of bankruptcy for a full recapitalization increases the buoying-up incentives of holdouts; the prisoners'dilemma of bondholders is exacerbated. If the dilemma induces failure of the workout, bankruptcy is available to end it, by allowing, indeed requiring, collective bondholder action and eliminating the tax penalties to recapitalization. The tax code thereby encourages brinkmanship.

19 I.R.C. sections 61(a)(12), 108(e)(10)(A) (West Supp. 1987); United States v. Kirby Lumber Co., 284 U.S. 1(1931).

20 I.R.C. section 108(e)(10)(B) (West Supp. 1987).

21 A similar tax rule reduces the net operating loss carryforward if a change in ownership occurs, such as by creditors taking a majority of the company's stock. Again, the rule is inapplicable in bankruptcy. I.R.C. section 382(a)(l)(5) (West Supp. 1987).

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4. Summary

Possibly, given agency costs, signalling effects and tax consequences, majority action clauses would not be used even if allowed. However, there seems little reason to prohibit firms from using the clause.

Firms did use the clause intermittently in the United States before it ran into negotiability difficulties and the Trust Indenture Act's prohibition. Prior to prohibition, demand for its use was rising. Firms in Canada and England, countries with financial and legal institutions roughly similar to ours, have used the majority action clause. Preferred stock, a security with nontax features similar to low-quality bonds, often contains voting clauses. Junk bonds with features that relieve some aspects of financial stress are increasingly popular; presumably firms would seek other features that would relieve stress if the legal system gave permission.

IV. Conclusion

As junk bonds proliferate, future workouts to recapitalize declining issuers of junk bonds will be attempted. Some issuers of investment grade bonds will suffer dramatic reversals and also attempt to recapitalize. Yet a firm with a large bond issue can be expected to have a harder time recapitalizing than a troubled firm financed primarily with nonpublic debt.

The legal system creates crucial difficulties for failed bond issues, their holders and their issuing firms. The bondholders cannot act as a class outside of bankruptcy in renegotiating the core terms of their loan to the firm. The legislative history supporting the prohibition is weak because the prohibition's result replicated that of technical regulation under the now-defunct Negotiable Instruments Law.

The individualized bond market of the 1930s - as it was then perceived to be - might have warranted protection from majority votes. But the 1980s market is vastly different. The dominant holders of bonds are not individuals but institutions that understand exchange offers. The structural change is reflected in the 1978 Bankruptcy Code, which allows a two-thirds majority of a creditor class to bind the entire class, both the market and Congress have pulled away the supporting rationales for the prohibition.

Today, risks analogous to the 1930s rationale for the voting prohibition persist. A principal one is that the institutions voting bonds in workouts will be unfaithful agents of the bonds' ultimate owners. Looking for collateral benefits, these institutions may vote corruptly. Another risk is that a vote might be used for those terms that may be voted upon, and side payments might be offered only to those bondholders that vote favorably. But the question is not whether such scenarios are impossible - clearly they are not - but whether section 316(b) provides serious protection against their occurrence. The protection seems weak.

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The potential for distortion (buoying-up that benefits holdouts or two-tiered offers that hurt holdouts) is substantial, and the fifty-year-old legislation prohibiting all votes on core terms is too inflexible to deal adequately with the new realities. Without a majority action clause, the chance increases that workouts will by stymied because some creditors are subject to disparate expectations, mistrust either other creditors or the issuer, or attempt to gain from strategic action. Furthermore, and most crucially, the buoying-up effect will benefit those creditors who do not participate in a recapitalization at the expense of those who do. This buoying-up may make it necessary that all or nearly all of the creditors agree to the recapitalization. But the prohibition on majority action clauses in public bond issues impedes such near unanimity and provides an incentive to introduce countervailing distortions.

These considerations are speculative. Experiments to measure the benefits of a prohibited bond clause cannot be run. Bond defaults increase as the quality of bond issues declines, but a buoyant economy does not provide the large sample size needed for scientific, statistical comfort. By the time scientific certainty is available, it will be too late: We will then have had failed workouts.

The overall costs of financial stress are difficult to measure, especially because the widespread use of junk bonds is such a new phenomenon. If bankruptcy costs are low - or if whatever bankruptcy costs exist are experienced in the workout anyway - then the repeal of section 316(b) would achieve little in the way of economic efficiency. The important costs of the prohibition are only the difference between the social costs of a workout and those of a chapter 11 proceeding. Some workouts succeed anyway; some would fail no matter what. And for those that are elastic and amenable to manipulation via section 316(b) who knows whether the difference in cost between the two is very much? Bankruptcy costs have not been seen directly (beyond the direct costs of administration); they are presumed to exist and be substantial because the models cannot explain readily observed patterns of debt and equity without them.

Although the efficiency costs of section 316(b) are speculative, the section accomplishes little in the name of fairness and avoided fiduciary breaches. If section 316(b) offers little protection but nevertheless costs little, it may be seen as a symbol of indignation over financial theft that it nevertheless does little to prevent.

If the protective fairness basis seems weak, and if even the efficiency basis has uncertain strength, there may yet be reason to repeal section 316(b). Disputes arise. Enterprises flounder. A decision on recapitalization must be made. In the absence of compelling bases to intervene, a vote can be taken and the company, the parties, and the system can move on to the next problem.

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CHAPTER 28

Financial and political theories of American corporate bankruptcy*

BARRY E. ADLER**

I. Introduction

What explains American corporate bankruptcy, with its time-consuming and expensive reorganization process? Accepted wisdom is that bankruptcy protects an insolvent debtor's assets from its creditors who would otherwise dismantle the debtor in a frenzied attempt to collect on their loans. By providing for an orderly disposition of claims against a debtor firm, bankruptcy law preserves intact the firm's "common pool" of assets available to creditors. In this classic account, creditors willingly bear the costs of bankruptcy because the alternative is worse: a contentious race among creditors and destruction of the firm. Thus, the bankruptcy system is seen as a lesser of evils.

I argue here that the willingness of creditors and other investors to accept the corporate bankruptcy process is as much a political adaptation as an economic decision. The common pool justification for corporate bankruptcy is unsatisfactory. It assumes that without bankruptcy law creditors would destroy insolvent, but viable firms. This assumption is ill-founded. In a legal environment hospitable to all forms of contract, investors could agree efficiently to preserve a firm's value without the aid of the costly, rule-based bankruptcy process. We do not observe such agreements in the United States because political compromises have produced a legal regime that discourages optimal contracts.

II. The Common Pool Illusion

A solution to the supposed common pool problem lies at the heart of existing bankruptcy law. Bankruptcy's proponents argue that creditors of an insolvent firm, left to their own devices, would expend resources first preparing for, then entering, a race to collect limited assets. In the process, they would dismantle the firm, destroying any going-concern surplus over the firm's liquidation value. Bankruptcy replaces the creditors' rights to act individually with a collective regime. This regime is devoted in principle to a

*This chapter is an edited version of the article that originally appeared in 45 Stanford Law Review 311 (1993). Permission to publish excerpts in this book is gratefully acknowledged.

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

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court-supervised distribution of assets or asset value to claimants in order of contractual priority and ratably among those with equal priority. If the firm is more valuable as a going concern than in piecemeal liquidation, the court can provide for the firm's survival by distributing new interests in the firm, rather than assets, to satisfy the creditors' claims. In this way, bankruptcy eliminates what its proponents contend would be an inefficient competition among creditors.

Bankruptcy's protection of the debtor's assets - the "common pool" of value available to creditors - is beneficial, of course, only if creditors cannot simply agree among themselves to forego individual action in favor of a collective process. Bankruptcy's proponents argue that such agreement is often prohibitively expensive given a large number of creditors that lack temporal proximity in extending credit and that harbor incentives for strategic, self-in- terested behavior.

Bankruptcy's solution to the common pool problem, however, rests on a faulty premise: that there is a common pool problem. In theory, each creditor could appoint management as its agent to enforce a mutual and irrevocable agreement among creditors to accept only a collective default remedy. In this manner, a firm's equity investors and creditors could contract for the form of collective remedy provided by bankruptcy law without also accepting bankruptcy's rule-bound legal regime.

III. Chameleon Equity

While no insolvency process is completely costless, a better solution to the problem of expensive insolvency exists. This solution, Chameleon Equity, would not require an auction or a separate postinsolvency capital structure. Rather, it would give a firm the flexibility to issue a single set of unbundled residual and fixed obligations. A Chameleon Equity firm would closely resemble a traditional firm, except that fixed-obligation Chameleon Equity holders would replace creditors. Such a Chameleon Equity holder would possess the same right as a creditor to set payments from the firm, but it would not be permitted to collect individually on an obligation in default. Instead, if the firm defaulted and remained in default on a fixed Chameleon Equity claim, the holder would gain a portion of the firm's residual claim and of voting control over the firm. In essence, a Chameleon Equity firm would retain the benefits of fixed obligations but would bear neither the costs that accompany a race to assets.

To maintain investor certainty about the firm's structure and internal insolvency resolution system, the investors would adopt the Chameleon Equity

1 11 U.S.C. sections 362, 725, 726, 1129 (1988).

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structure at the firm's outset or, if a traditional firm wished to convert, immediately upon the creditors' exchange of debt for Chameleon Equity interests. Once the terms of Chameleon Equity contracts became common, these costs would be no greater than the costs of drafting "boilerplate" default provisions in traditional debt contracts.

A. Tiered structure

To avoid restructuring costs, a Chameleon Equity firm would establish a multitiered priority hierarchy by issuing claims in tranches. Traditional equity would comprise the initial residual class, subject to the fixed obligations of any higher-priority Chameleon Equity class. Should a Chameleon Equity firm be unable to meet all of its fixed obligations, it would retain, unaltered, obligations to any higher-priority class of investors with claims the firm could satisfy, convert to traditional equity the highest-priority class whose obligations the firm could not fully pay on time, and extinguish the claims of all lowerpriority classes. No asset valuation would be necessary.

Implicit in the multitranche Chameleon Equity structure is the prohibition against issuing fixed obligations with acceleration-on-default clauses that would apply to any class having claims that could survive a transformation of a lower class. Acceleration clauses grant a creditor the right to demand repayment of its entire principal amount in the event of a payment default or some other contractual breach. Such clauses protect traditional creditors from residual claimants who attempt to cure current defaults with small contributions of new capital or with some conversion of the firm's assets. Acceleration clauses deprive equity of the opportunity to invest the firm's assets in risky ventures at a time when, equity as the residual class has everything to gain and little to lose from a gamble.

Traditional acceleration clauses would not serve the same purpose in a Chameleon Equity firm. If, as determined by Chameleon Equity contract, a default were sufficiently significant or prolonged to trigger a transformation, the firm would automatically extinguish both the equity class and the fixed claims of at least the class with the next lowest priority. Thus, holders of surviving fixed claims could rely on the equity "cushion" of a new residual class as a substitute for principal acceleration. The new equity class would be less likely than the old to permit extraordinary risks, because unlike the extinguished equity class, the new equity class of the now solvent firm would be risking its own significant investment in any gamble the firm took.

It is true that the pretransformation firm could be so deeply insolvent that the posttransformation equity class would retain the residual interest in a still insolvent or barely solvent firm. The new equity class could then be in a posi-

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tion only to gain from a gamble. This could occur if a firm defaulted on current obligations to its lowest-priority fixed claimants at a time when the firm had so declined in value that it could not repay or could barely repay full principal even to the next-to-lowest-priority class.

High-priority claimants could minimize this risk, however, by requiring the firm to include relatively "thick" low-priority classes and to issue substantial ongoing obligations. Under these conditions, it would be unlikely that a firm would lose the entire value of its lowest-priority fixed class before it defaulted on some of its obligations. These safeguards would minimize the possibility that a firm could slip insolvent through more than one class at a time and would generally protect capitalization.

B. Secured finance

The Chameleon Equity structure easily could accommodate incidental arrangements such as secured finance. A Chameleon Equity firm would offer collateral only to its highest-priority consensual claimants. So long as these claimants never became the residual class, secured claimants would receive payment in full, and collateral would prove unnecessary. If the highest-priori- ty class ever became the residual class, then any secured claimant in that class would have the right to foreclose on its collateral unless the investors agreed otherwise.

A foreclosure right need not seriously impair a Chameleon Equity firm's ability to preserve going-concern surplus. A firm could structure its claims so that only if the firm were ripe for piecemeal liquidation would it likely become subject exclusively to a residual claim. Investors could protect the firm's going-concern surplus in other ways. For example, the firm could require that if the highest-priority class became the residual class, the firm could be liquidated only by majority or supermajority vote. In sum, Chameleon Equity contracts could provide all the advantages of secured credit under bankruptcy law, and would offer flexibility not available within the bankruptcy regime.

C. Subsequent capital

The adoption of a Chameleon Equity structure need not restrict the firm's ability to raise capital. Just as a traditional firm may issue new obligations subject to any restrictions agreed on by existing investors, a Chameleon Equity firm could issue new obligations subject to contractual restrictions. Initial investors could permit subsequent issuances of obligations in all, some, or no classes, and could provide the terms by which their initial decision could be amended.

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Even financially unsophisticated trade creditors could fit easily into this structure by signing a standard form contract placing them either entirely in one priority class or partially in multiple classes.

Another issue to consider is a Chameleon Equity firm's ability to raise new capital despite financial distress. Under current bankruptcy law, a court can grant special administrative priority to claims that insolvent firms incur after the bankruptcy process begins. This provision may aid firms in bankruptcy that would otherwise be unable to gain the new investment needed to survive as a going concern. If such a firm could issue only ordinary unsecured debt, it would have to issue such debt either discounted to reflect the firm's insolvency or at extraordinarily high interest rates. Under these conditions, management might forego even a valuable project if the best available credit terms left the firm with no hope of solvency regardless of the project's ultimate success or failure.

Whatever the needs of a traditional debtor, a Chameleon Equity firm likely would not benefit from bankruptcy's special priority provision. The ability of a bankruptcy court to grant new lenders special priority aids prebankruptcy creditors only if the firm cannot grant new lenders priority in ordinary course. Thus, bankruptcy's special provision provides a benefit when management wishes to have the firm pledge unencumberable going-concern surplus over the value of the firm's encumberable assets. By contrast, if Chameleon Equity contracts were fully enforceable and replaced bankruptcy distribution rules, Chameleon Equity investors could initially authorize the future sale of new obligations to a high-priority class. This authorization would not require the presence of free encumberable assets, the later consent of other claimants, or intervention of a court.

D. Capital retention

Firms in financial distress can find retaining capital to be as difficult as raising new capital. To address this problem, the Bankruptcy Code voids most nonpriority loan payments made just prior to bankruptcy3 and requires court approval for any postbankruptcy loan repayments. These provisions protect a traditional firm from creditor collection or coercion based on threats of legal action. In a Chameleon Equity firm, however, no claimant would possess the individual right to collect a fixed obligation and the related coercion could not occur.

E. Agency costs

Although Chameleon Equity would significantly reduce the expense of insolvency, it would not cure all conflicts among investors or between investors and man-

211 U.S.C. section 364.

311 U.S.C. section 550 (1988). The ordinary period for voidable payments is 90 days prior to bankruptcy. 11 U.S.C. section 547.

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agers. Afirm's equity investors like the firm to take risks that claimants with fixed obligations prefer it avoid. This is particularly true when the firm is at or near insolvency and the residual claimants face a complete loss of their investment unless they can enhance the firm's value. Equity holders might accept gambles including payments of current obligations to continue a firm that should be liquidated. Conversely, fixed obligation investors prefer to avoid risky investments or even continuation because their share in the success of a venture is limited by the amount of their claims. To mitigate this conflict of interest, the initial equity and fixed obligation investors typically allocate control of management among themselves through contractual restrictions on equity's otherwise plenary right to control the firm. The conflict cannot be fully eliminated, however, and it would exist in a Chameleon Equity firm as it does in a traditional firm.

Management discretion creates another agency problem common to all firms that separate ownership and control. When making business decisions, managers' personal incentives may conflict with the goal of maximizing firm value. For example, regardless of equity's interest, managers may try to protect their jobs by concealing firm difficulties and implementing strategies that ensure the firm's ability to meet its short-term obligations. Their aim is to ensure that if the firm becomes insolvent and survives, its new owners will have strong reasons to retain existing management.

A Chameleon Equity firm's susceptibility to these agency problems is not, however, a valid criticism of Chameleon Equity as an insolvency process. Each of these problems would be no greater in a Chameleon Equity firm than in a traditional firm of similar structure. A Chameleon Equity structure would save insolvency expenses without imposing any additional agency costs.

IV. An Inhospitable Legal Environment

Investors prefer traditional firms and bankruptcy to Chameleon Equity because legal rules create incentives that make the latter untenable. Most prominent among these rules is the provision of a nonwaivable bankruptcy option. But the importance of such an option is dubious. Other rules include the corporate income tax, commercial and corporate law limitations on free contracting, and insufficient priority for tort victims. Standardization of the bankruptcy process presents an additional obstacle. Because of these previously unrecognized but significant ntf/ibankruptcy impediments to an efficient insolvency process, prior scholarship on the insolvency process is misdirected in its assumption that amendment or repeal of bankruptcy law alone can solve the problem of expensive insolvency.

A. Waiver of bankruptcy

Chameleon Equity contracts would provide a substitute for bankruptcy and would include an explicit waiver of any investor's or manager's right to file a

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bankruptcy petition. This waiver would be important because, whether to protect their jobs as agents, their principal, or their own equity investments, managers of a Chameleon Equity firm could have an incentive to file for bankruptcy just before default triggered a transformation of investor classes and elimination of the equity class that voted management into power.4 Once in bankruptcy, management could use the threat of prolonged and expensive reorganization to extract concessions from high-priority claimants just as if the debtor were a traditional firm, and the Chameleon Equity structure would have served no purpose.

Alan Schwartz argues that bankruptcy law forbids bankruptcy option waivers such as those that would be required in a Chameleon Equity firm. Schwartz accurately notes that legal precedent suggests a firm may not waive its right to file for bankruptcy. And if this rule could force a Chameleon Equity firm to endure the bankruptcy process, the advantages of the Chameleon Equity structure would be lost. But Schwartz misplaces his focus on the nonwaivability of the bankruptcy option. Whether management could initiate a bankruptcy case is unimportant. What matters is whether management could sustain the bankruptcy process. In the case of a Chameleon Equity firm, a court would quite likely dismiss a bankruptcy case filed by management contrary to prior agreement because contractual insolvency procedures would leave no issue for the court to resolve.

Perhaps Frank Easterbrook is correct, then, when he suggests that investors choose firms subject to bankruptcy because they are satisfied with that form of insolvency process.5 However, the theoretical appeal of Chameleon Equity raises the possibility that investors prefer bankruptcy to all preinsolvency arrangements other than Chameleon Equity and do not choose Chameleon Equity because other legal impediments constrain their choice.

B. Corporate income tax

The corporate income tax is probably the greatest single impediment to Chameleon Equity. The Internal Revenue Code permits a firm to deduct interest but not dividends from taxable income.6 Because a Chameleon Equity firm would grant holders of fixed obligations a contingent right to control the firm

Under bankruptcy law, managers representing the "debtor" have an unconstrained right to file for bankruptcy on behalf of the firm. There is no requirement that the firm be in default 11 U.S.C. section 301 (1988).

5 See Frank H. Easterbrook, "Is Corporate Bankruptcy Efficient?" (reprinted in this volume as Chapter 26).

61.R.C. section 163(a) (1988) allows "all interest paid or accrued within the taxable year on indebtedness" to be deducted from the taxable income of the payor corporation. There is no similar provision for general deductions of payments to holders of equity interests, though public utilities may deduct dividends on preferred stock. See I.R.C. section 247.

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