Document Type

Article

Publication Title

Cornell Law Review

Abstract

Part I of this Article first describes the basic creditors' bargain heuristic. This model is the standard justification for bankruptcy's general supplantation of private contract rights, most notably the right to collect unilaterally on a debt obligation in default. The creditors' bargain model suggests that creditors of an insolvent debtor prefer bankruptcy's collective proceeding to individual collection actions because a collective proceeding preserves a more valuable debtor to divide among the claimants. Bankruptcy is necessary, the heuristic reveals, because creditors would find it difficult collectively to reach this efficient outcome. Part I next explains how bankruptcy law reallocates contractual priorities among claimants, and argues that the basic creditors' bargain model cannot extend to justify this reallocation. Principal among bankruptcy's reallocative provisions are compulsory reorganization rules that grant junior claimants practical control over the bankruptcy process and allow such claimants to coerce concessions from senior claimants. Moreover, court bias in favor of junior claimants exacerbates this strategic advantage, and other provisions directly deny a senior claimant's priority in whole or in part. Part II describes how risk-sharing theory attempts to justify bankruptcy's reallocative provisions in a way that the basic creditors' bargain model cannot. In theory, one source of reallocation's benefit is insurance against a firm's failure from a "common disaster." This insurance guarantees that no claimant bears too large a share of the losses from such a disaster. Risk-sharing theory adds an additional hypothesis, that reallocation produces benefits by reducing investors' conflict on or after the "eve" of bankruptcy. On the eve of an insolvent debtor's bankruptcy, junior claimants have little to lose and much to gain if they invest the debtor's assets in a risky venture. Thus the junior claimants have an incentive to take untoward risks with the troubled firm's assets. Senior claimants, in contrast, bear the risk that such an investment will fail and do not share the junior claimants' incentive. Risk-sharing theory presumes that bankruptcy reallocation reduces the junior claimants' perverse incentive, because reallocation grants junior claimants a stake in the insolvent debtor. Part III begins a critique of risk-sharing theory by discussing the potentially enormous costs that bankruptcy reallocation can impose. Because all investors bargain with full knowledge of bankruptcy's reallocative provisions, reallocation does not force a wealth transfer from or to any investor. Bankruptcy reallocation, however, does impose efficiency costs that are commonly underestimated. First, researchers have traditionally focused too narrowly on direct bankruptcy costs such as attorneys' and accountants' fees, while they ignore costs from delay and uncertainty, which may dwarf the direct costs. Second, commentators underestimate total bankruptcy costs when they myopically attribute to reallocation positive insolvency incentives, while failing to recognize that reallocation creates perverse incentives that precede, and can cause, financial distress. These perverse incentives exist when the debtor is solvent, because bankruptcy reallocation makes the prospect of insolvency less onerous to junior claimants. Third, descriptions of bankruptcy costs exclude costs incurred by firms that adopt inefficient capital structures in response to bankruptcy's reallocative provisions. In its conclusion, Part III identifies two reasons why the collective benefits from bankruptcy reallocation cannot outweigh its collective costs. First, the benefits from bankruptcy reallocation accrue only to junior investors that are undiversified or relatively more sensitive to insolvency risk than are a debtor's senior investors. Risk sharing theory overstates this class of beneficiaries because it misapplies risk-aversion analysis. Second, contractual and less pervasive compulsory alternatives to bankruptcy's actual reallocative provisions can produce all plausible risk-sharing benefits at lower cost. Thus the Article concludes that bankruptcy's reallocative provisions, including bankruptcy reorganization, its most pernicious real location vehicle, lack justification and that Congress should abolish them. The abolition of bankruptcy reorganization and kindred provisions would greatly simplify and reduce the price of the insolvency process. Alternatively, courts properly sympathetic to contractual priorities should interpret extant law to remove bankruptcy's reallocative bias.

First Page

439

Volume

77

Publication Date

1992

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