Учебный год 2023 / Bhandari_J__Weiss_L_Corporate_Bankruptcy_Economic_and_Legal_Perspectives_1996

A theory of loan priorities

of the new assets, the cushion of free assets that helps protect the initial lender against default will shrink if, in consequence of the later loan, E{A\) + E(A2)/Li

+ L2 < E(A)/L

The satisfaction of this inequality is a sufficient condition for the value of the initial loan to fall. The smaller the cushion, the more likely asset value will fall below debt value when business reverses occur. Since by the first step the value of the initial loan falls materially when asset value declines below debt value, the increased likelihood that such a decline will materialize results in loan value falling as well.

If the debtor's new project is riskless or if its returns correlate negatively with returns from existing projects, the key inequality is unlikely to be satisfied - the cushion of free assets probably will not be affected adversely. For example, if a new project is profitable in all states of the world in which the old projects' returns fall, taking the new project probably will increase the value of the initial loan. Such projects are difficult to find, however. When a new project's returns correlate positively with returns from existing projects, there is a substantial likelihood that, if the new project is debt financed, the value of the initial loan will fall.

The positive correlation case is illustrated by a department store adding a video section; if demand falls so that fewer consumers visit the store's other sections, video sales probably will decline. In such cases, unless the new project that the later debt funds is very lucrative or creates substantial positive synergies - formally, unless E(A2) is very high relative to L2 - the new project will shrink the cushion of assets that helps protect the initial lender against default. This is evident from the relevant inequality because, if returns from a new project fall with returns from old ones, the likelihood is increased that the new ratio of total asset values to total debt will be lower than the previous ratio. Since positive correlations among projects are very common - firms do related things - this third case is significant. An example will better explain it.

In the example, the initial loan requires the debtor to repay $100 t periods later. When the loan is made, the present value of the debtor's assets - E{A) - is $200. Suppose first that the debtor incurs no new debt and experiences business reverses at time q such that its assets fall in value by $70. Then it is unlikely to default at time t because E{Aq) = $130 while L = $100.

Next let this debtor, before bad times materialize, borrow an additional $100, all of which is devoted to the purchase of new assets for use in a second project. Then a business reverse occurs such that, as before, the old project falls $70 in value and the new project falls $35 in value.

To better understand these declines, realize that, after a debtor purchases assets, their value to it is the higher of the present value of the returns the assets will generate in the debtor's business or the assets' salvage value. If demand falls in the debtor's industry, for example, the former value will fall with it.

21

THE ROLE OF CREDIT

The latter value also will probably decline because the assets' returns in other uses often correlate positively with their returns in the debtor's use. As a consequence, asset values commonly decline with business reverses. And in the example, default is more likely should the reverse occur because then E(Aq{) + E(Aq2) = $195, while Lx +1^ = $200. Thus, debt used to fund a new project can result in the cushion of free assets falling below the level of the total outstanding debt though the new project does not itself increase the likelihood of business reverses and though all of the new debt is used to purchase tangible assets.

Another way to make this point clear is to refer to the previous inequality. Using the figures in this illustration, the left-hand side of the inequality - the post-later-debt ratio of the present value of the borrower's total assets to its total debt - is 1.5 to 1; the right-hand side - the initial asset-to-debt ratio - was 2 to 1. The inequality thus is satisfied, and, as a consequence, this illustration shows business reverses that would not have caused default before the new loan very likely will cause it after. This property of later debt to shrink the cushion of free assets that helps protect the initial lender against default reduces the value of prior loans.

The value reduction that prior debt may experience can be dramatic in two common cases. First, the later debt is not used to purchase tangible assets but, rather, is used to meet operating expenses. Then, in the event of default, the later creditors' claims will be asserted exclusively against assets that otherwise would have been available to the initial creditor; unlike the previous illustration, these claims will not be partly offset by the value of new assets that the later lenders' loans enabled the debtor to buy.

To perceive the effect of this difference, refer again to the illustration and suppose that the later $100 loan is completely paid out as wages. After this, the debtor will have $200 in assets and owe $200; the cushion of free assets that was meant to protect the financer against default has been reduced to zero. Therefore, the borrower likely will default if its assets fall in value by any nontrivial fraction.

In the second common case, the initial loan is unsecured and the later debt is secured. Secured loans exacerbate the effects just described. The loan itself increases the likelihood of default when bad states materialize and the security interest will actually reduce the assets available to the initial creditor in the event of default when, as often happens, the lien attaches to existing assets as well as to new ones. Later secured loans also can disadvantage initial financers when both the initial loan and the later loan are secured but the later creditor has a "superpriority" that places it ahead of the prior secured creditor.

Debtors have an incentive to pursue (or at least not refuse) projects that will disadvantage prior lenders. Two factors incline them to act in this way.

22

A theory of loan priorities

First, the ability of shareholders to diversify their portfolios tends to make them risk neutral respecting the performance of particular firms; they want each firm they hold only to maximize expected returns. Second, limited liability creates an incentive for these shareholders to weight more heavily the prospect of gains than the prospect of losses, thereby creating a shareholder preference for firms to take risky projects. A final example will show how these factors work.

A firm first borrows money to pursue a project; the debt is to be repaid in full t periods later, and the value of the firm is just the present discounted value of the return stream the project's assets generate. Before period t is reached, the debtor borrows money from a second lender to pursue a new project, also to be repaid in full at period t. The returns from both projects are a function of the debtor's efforts, which are assumed to be optimal, and an exogenously determined social state whose probabilities are known before the loans and that materializes at period q < t. The debtor will repay both loans in good states but default in bad states. If the debtor defaults, the two lenders share pro rata in the debtor's assets.

Lest this be thought too abstract, suppose the borrower is a manufacturer and the two projects are the making of two distinct but related types of machine. The social state is world demand for the machines, which is not known ex ante but is revealed after the debtor has borrowed the money to make both machines and has begun to manufacture them. See Tables 3.1 and 3.2.

Column 1 in each table is the probability of a particular social state materializing. Column 2 is the value the project will have should this state occur. Each amount in column 3 is the expected value of the borrower's assets in each of the possible social states - column 1 or column 2 - so column 3 sums to the present value of the borrower's assets when the loans is made - E(A). Column 4 is the debt taken to support these projects - $120 for the old and $180 for the new. Each amount in column 5 is the value of the project to the borrower's shareholders in each of the possible social states (zero if project value is less than the debt; otherwise [col. 2 - col. 4] col. 1), so column 5 sums to the present value of the project to the borrower's shareholders.

The borrower in this example has an incentive to take the new project as well as the old because the new project's net present value to shareholders is $106, but taking it reduces the cushion of free assets. After the initial loan, the ratio of the present value of the borrower's assets to its debt was 1.33, while after the second loan, the ratio of total present value of assets to total debt shrank to 1.25; the relevant inequality again is satisfied.

As an example of the possible consequences, let state three (see Table 3.1, row 3) materialize. Had the borrower not taken the new project, it likely would not default on its initial $120 loan; in state three, E(Aq) - L = $130-$120 =

23

THE ROLE OF CREDIT

Table 3.1. "Old" project.

a Note: See text for column definitions.

Table 3.2. "New" project

a Note: See text for column definitions.

$10. When the borrowing firm is composed of both projects, and should state three materialize, it probably would default in period t\ for in state three, E(Aq2) + E(Aq2) = $230, while Lx+L2 = $300. Since the new project does not reduce the probability that any of these social states will occur taking the new project increases the likelihood of default and thus reduces the value of the initial loan.

24

PART II

Bankruptcy as a reflection of the creditors' implicit bargain

The chapters included in Part I explain why some firms include debt in their capital structures and others prefer to have debt with heterogeneous levels of priority. The chapters in this part explain the problems debt financing creates and the role of bankruptcy law in addressing those problems.

To understand the problems created by debt financing, imagine a firm that manufactures copper wire at a time when technology dictates that fiber optics will replace most uses of copper wire. The advent of fiber optics makes obsolete much of the manufacturers equipment and requires that the manufacturer substantially retool if it is to stay in business.

This obsolescence and the prospect of retooling significantly reduces the value of the firm compared to its value prior to the introduction of new technology. Such a reduction in value would not precipitate a financial crisis if the firm were financed purely by equity. The equity owners directly or through the firm managers acting as equity agents would simply assess the viability of the firm in the new world of fiber optics. The shareholders or their agents would then decide whether to continue the firm or to wind it up. If the firm continued, it would use existing capital or raise new capital to retool. If the firm wound up, it would liquidate and divide its assets ratably among the shareholders. In either case, the process could be orderly.

If the firm includes debt, however, there is no assurance of an orderly process. Creditors are different from shareholders in one important respect. Acreditor has the right individually to collect his investment from a firm at some predetermined "maturity" or due date. In contrast, a shareholder's investment in a firm does not mature at any predetermined date. A shareholder may collect his investment only through the combined action of the shareholders collectively.

This difference could prove to plague any creditors of the illustrative copper wire manufacturer. Assume that the manufacturer borrowed large sums of money from a dispersed group of creditors well before anyone anticipated the advent of fiber optics technology. At the time of the borrowings, all may have anticipated that the firm would generate income sufficient to repay all its debts. But imagine that the new technology so reduces the manufacturer's value that it no longer had any hope of repaying its debts in full, that is, the firm is now hopelessly insolvent.

25

BANKRUPTCY AS A REFLECTION OF THE CREDITORS' IMPLICIT BARGAIN

One could suppose that the creditors would be the new owners of the firm, and as the new owners they would gather to decide the firm's fate, much as the shareholders would if the firm were a pure equity firm. But collective action on the part of the creditors would be difficult because, by hypothesis, they are dispersed and because each of them has the opportunity to defect from negotiations and collect on his own debt.

The first consequence of the creditors' coordination problem is that each creditor may expend excessive resources positioning himself to win any race to an insolvent firm's assets. That is, each creditor may anticipate the difficulties of negotiation and may plan to defect before other creditors do. This planning may include monitoring the debtor so that the creditor has good information about when the race to grab assets is to begin. One could argue that the creditors collectively might prefer to forego the expense of this monitoring and agree instead to share all assets ratably with other creditors of the same priority. Such an arrangement would increase the aggregate value of the creditors' investment by the aggregate expenses of the avoided race. But the costs of creditor coordination make such mutually beneficial agreement difficult at best.

A second consequence of the creditors' coordination problem is that the creditors' race to an insolvent firm's assets may have significant indirect costs. Assume that despite the advent of fiber optics technology and the firm's consequent insolvency, the hypothetical copper wire manufacturer deserves to stay in business because it is well managed, has a highly skilled work force, and could, after retooling, compete effectively in the manufacture of fiber optics.

Presumably, then, the creditors would collectively decide to permit the firm to stay in business and reduce the firm's obligations so that it could expect to meet those obligations in the future. Individually, however, each creditor has an incentive to exercise his right to collect the debt owed him. If a creditor is successful in winning the race to grab the firm's assets, that creditor might receive full repayment while the other creditors would be left with less, even if the other creditors succeeded in restructuring the firm's obligations. As a result, fearful that other creditors will begin and win the race, every creditor might race, dismember the firm and destroy any hope of a successful restructuring in the process. Collectively, the creditors would lose the firm's going concern surplus over its piecemeal liquidation value.

Bankruptcy law stays the creditors' individual right to collect, guarantees ratable distribution of asset value among creditors of the same contractual priority, and provides a forum for debt restructuring. Thus, as some scholars theorize, bankruptcy law is useful because it solves the creditors' coordination problem and allows the creditors to save the direct and indirect costs of a race to grab assets. Put simply, these scholars argue that bankruptcy law imposes

26

BANKRUPTCY AS A REFLECTION OF THE CREDITORS' IMPLICIT BARGAIN

on the creditors the bargain that they would have reached but for their coordination problems.

The chapters included in this part explain more fully the nature of the creditors' hypothetical bargain and the implications of such a bargain for the theoretical framework of bankruptcy law.

The first chapter is Douglas G. Baird's "A world without bankruptcy." In this chapter, Baird imagines a world without bankruptcy. He concludes that in such a world neither business firms nor debtor-creditor relationships would vanish from the landscape. In fact, he argues, most firms would look much as they do now. The sole important difference, he suggests, is that at the time of financial distress a firm would be subject to a creditors' race and the consequent costs of such a race. He focuses attention, therefore, on bankruptcy law's efficacy as a means of overcoming the creditors' coordination problem.

The second chapter is Thomas H. Jackson's "Bankruptcy, nonbankruptcy entitlements, and the creditors' bargain." In this chapter, Jackson defines the creditors' hypothetical bargain as a bargain about collection rights. He notes that bankruptcy's cure for the creditors' coordination problem need not alter the relative priority among claimants to an insolvent firm's assets. Jackson explains in some detail how the bankruptcy process provides a collective procedure that can restructure claims and still honor the claimants' relative entitlements; which, he notes, substantive nonbankruptcy law properly establishes. By honoring nonbankruptcy entitlements, Jackson observes that bankruptcy law can allow the parties to reap the benefits of free contracting. Thus, he concludes, bankruptcy law should be and largely is procedural. It increases the "pie" to be divided by protecting creditors from their own avarice, but leaves largely intact the nonbankruptcy entitlements to shares of the pie.

The third chapter is Thomas H. Jackson's "Translating assets and liabilities to the bankruptcy forum." In this chapter, Jackson focuses on the real world complexities associated with the simple model developed in the prior selection. He describes the difficulty of translating multifarious claims to comparable forms for the purposes of allocation. He notes, for example, that in addition to distinguishing between ordinary unsecured loans and typical high-priority loans - such as secured loans - the bankruptcy forum must quantify and compare claims of various maturities, claims arising from executory contracts, and claims arising from contracts that offer specific performance as a remedy for breach. Jackson concludes that these translations are difficult but necessary. He reiterates that bankruptcy law, to the extent possible, should be merely procedural.1

1 There are additional articles, not included here, that discuss difficulties in translating nonbankruptcy entitlements into bankruptcy claims or interests. See, for example, Jay L. Westbrook, "A Functional Analysis of Executory Contracts," 74 Minnesota Law Review 227 (1989); Thomas H. Jackson, "Avoiding Powers in Bankruptcy," 36 Stanford Law Review 775 (1984).

27

BANKRUPTCY AS A REFLECTION OF THE CREDITORS' IMPLICIT BARGAIN

The fourth chapter is Elizabeth Warren's "Bankruptcy policy." Warren challenges the central notion underlying the creditors' bargain model - that bankruptcy law should be neutral as to claimants' relative priorities. She notes that social policies may favor asset distributions that are in some respects independent of the recipients' contractual entitlements. She observes, for example, that an insolvent firm's employees may be particularly ill-suited to bear the costs of firm failure, and that bankruptcy policy, therefore, may consider rationally the effects on employees of strict adherence to nonbankruptcy entitlements. Bankruptcy policy, Warren concludes, is not as simple as the creditors' bargain model suggests.

The fifth and final chapter in this part is Douglas G. Baird's "Loss distribution, forum shopping, and bankruptcy: A reply to Warren." In this chapter, Baird summarizes the creditors' bargain heuristic and, as the title suggests, responds to Warren. He concedes that Warren may well identify legitimate social policies favoring some firm constituents over others. He argues, however, that no such policy is a legitimate bankruptcy policy. He asks, for example, why bankrupt firms should have a special obligation to protect their employees if firms outside bankruptcy do not. If social policy rationally favors workers, legislation could favor workers in all firms not just those that are unable to meet their debt obligations or find themselves in bankruptcy for some other reason.

He emphasizes, moreover, that a consequence of one set of rules for firms in bankruptcy and another set for others could be wasteful forum shopping by constituents that prefer one set over the other. Thus, he finishes where he and Jackson began, defining the proper scope of bankruptcy law as a procedural solution to the creditors' coordination problem, and as little more.

28

CHAPTER 4

A world without bankruptcy*

DOUGLAS G. BAIRD**

I. Introduction

At the Constitutional Convention in 1787, the only objection to giving Congress the power to pass uniform laws on the subject of bankruptcies was that bankrupts were occasionally put to death in England and that no similar fate should await debtors in this country. The answer to this objection at the Convention - and one fully borne out over the last two centuries - was that there was little danger of such abuse.

The first English bankruptcy statutes gave the creditors of a merchant, as a group, rights they did not have individually.1 These rights arose when a debtor committed certain specified acts. These "acts of bankruptcy," as they were called, focused not on the financial difficulties of the debtor per se, but rather on actions, such as fleeing to "parts unknown," that were thought to thwart the conventional efforts creditors used to obtain repayment. If a merchant committed a specified act of bankruptcy, creditors could petition the Lord Chancellor to appoint a commission that had the power to gather the debtor's assets together and sell them. The commission would then distribute the proceeds "to every of the said creditors a portion, rate and rate alike, according to the quantity of his or their debts." If creditors were not paid off in full, "then the said creditor or creditors, and every of them, shall and may have their remedy for the recovery and levying of the residue of their said debts or duties ... in like manner and form as they should and might have had before the making of this act."2

Bankruptcy law in England began as a debt-collection device for creditors and the early English statutes were all directed at strengthening the hand of the creditors and increasing their chances of being paid, not at providing relief for debtors. The Statute of 4 Anne, which introduced the concept of discharge to

*This chapter is an edited version of the article that originally appeared in 50 Law and Contemporary Problems 173 (1987). Permission to publish excerpts in this book is gratefully acknowledged.

**Professor of Law, The University of Chicago. I thank Frank Easterbrook, Daniel Fischel,

Thomas Jackson, and John McCoid for their help.

1 34 & 35 Henry VIII, ch. 4 (1542). A brief review of the history of bankruptcy law may be

found in D. Baird and T. Jackson, Cases, Problems, and Materials on Bankruptcy 20-30 (1985). 2 13 Eliz., ch. 7, section X (1570).

29

BANKRUPTCY AS A REFLECTION OF THE CREDITORS' IMPLICIT BARGAIN

bankruptcy, is a good example. Titled "An act to prevent frauds frequently committed by bankrupts," the statute was an attempt to reduce the problems creditors had in locating their debtor's assets by rewarding those debtors who helped creditors locate and gather their assets and punishing those who did not.3 The Statute of 4 Anne provided that those debtors who cooperated fully would be discharged and would take 5 percent of whatever assets were gathered. Debtors who did not meet with their creditors, who lied to them, or who refused to reveal the whereabouts of all their assets would be hanged.4

Congress's exercise of the bankruptcy power was far from inevitable. Indeed, for much of the nineteenth century, there was no federal bankruptcy statute at all.5 That we might live in a world without bankruptcy law or any similar collective procedure is not as farfetched or as ridiculous as it might seem at first glance. This chapter will take problems that have been the focus of much of the recent debate in bankruptcy law and ask how these issues would be approached if no bankruptcy law existed.

The reason for engaging in this thought experiment is not that it is either wise or at all likely that we abandon bankruptcy law. Rather, the point of the exercise is to isolate bankruptcy issues from other issues. One of the most troublesome aspects of most modern discussions of bankruptcy law, both academic and judicial, is the reliance upon unarticulated notions of "bankruptcy policy." Imagining the world without bankruptcy law gives us an opportunity to identify precisely what it is that bankruptcy law adds to our legal regime and hence what bankruptcy policy is or should be.

This chapter will show that much of what is usually thought of as "bankruptcy policy" is not bankruptcy policy at all, but rather an issue of general concern that must first be grappled with before the special problems that arise by virtue of a bankruptcy proceeding are confronted. Recognizing that a problem involves the rights of tort victims or the hazards of toxic wastes and not bankruptcy policy does not make the problem go away, but it does identify with greater clarity the relevant stakes.

34 Anne, ch. 17 (1705). The preamble to the statute reads: "Whereas many persons have and do daily become bankrupt, not so much by reason of losses and unavoidable misfortunes, as to the intent to defraud and hinder their creditors of their just debts and duties to them due and owing, for the prevention thereof, be it enacted...."

4The capital punishment provision in 4 Anne, ch. 17 (1705) is contained in the provision of the statute that uncooperative debtors would "suffer as a felon without the benefit of clergy," the eighteenth-century term of art for the death penalty. This is not, of course, to suggest that all debtors who were the least bit uncooperative were executed. Nevertheless, a number of debtors were in fact executed under the Statute of Anne.

5 The Bankruptcy Act of 1800, 2 Stat. 19, was repealed in 1803. The Bankruptcy Act of 1841, 5 Stat. 440, was repealed after only eighteen months. Congress passed another bankruptcy statute in 1867, 14 Stat. 517, and repealed it in 1878. The Bankruptcy Act of 1898 survived, with substantial amendments, until 1979. For a history of bankruptcy law in this country, see Warren, C,

Bankruptcy Law in United States History (1935).

30