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文/James W. Bowers

SECURITY INTERESTS, CREDITORS

PRIORITIES AND BANKRUPTCY
James W. Bowers
Louisiana State University Law Centre
© Copyright 1999 James W. Bowers

Abstract
The law of creditors’ remedies in developed western economies has a dual
character. This title reviews the law and economics literature which addresses
four principle issues raised by this duality: First, when individualized remedies
are appropriate vs. when collective proceedings are called for; second, should
the remedy system be asset-based, or rather should it be based on claimant type;
third, what explains the first-in-time and last-in-time priority system and the
priority granted to secured creditors under nonbankruptcy law and when should
that law be abandoned in favor of ratable sharing priorities; and finally, what
explains the existence of corporate reorganization law under which investment
contracts are modified ex post. The review points out that the existing
explanations found for the last three questions are all subsets of the answers
given to the first question.
JEL classification: K10, G32, G33
Keywords: Creditors’ Remedies, Priorities, Security Interests, Bankruptcy
Liquidations, Corporate Reorganization.

A. The Development of Creditors’ Remedies: An Introduction

1. Legal Rights and Creditors’ Remedies

Much of the private law of developed economies consists of the law of civil (as
opposed to criminal) obligations. The law of contract, for example, will specify
the legal consequences of the failure to keep promises. Similarly, the law of tort
provides the outcomes when one person’s substandard behavior harms someone
else. The law of property regulates the interactions and relationships between
persons and things and grants certain entitlements to the ‘owners’ of the
property. The resulting private law legal ‘rights’ (to have promises performed,
not to be harmed by others and to control one’s property) naturally imply legal
duties or obligations on the part of the promise breaker, the tortfeasor or the
trespasser. Private law not only describes the shape of these rights and duties,
it also specifies what steps the state is willing to take on behalf of the
right-holder against the persons who owe the resulting duties, in order to see
that the rights are vindicated. The doctrines which describe what steps the state
will take in order that private rights are given effect are known to lawyers as
the law of creditors’ remedies.

The most common legal recourse is substitutionary. Legal rights and
obligations are, most often, expressed in terms of the obligation to pay or the
right to collect money, calculated usually as the amount needed to compensate
the creditor for the difference between the market value of the creditor’s
position in a world in which the debtor performs and the value of that position
after the debtor breaches his or her duty. The creditor’s legal remedy
necessarily involves the use of an agent of the state to seize assets owned by the
debtor. The agent will usually liquidate those assets in some sort of market
(typically a local auction), distributing the proceeds of the liquidation sale to
the creditor, in satisfaction of the debt.

2. The Relevance of Priority

As long as the legal issue involves only a single creditor disputing with a single
debtor, creditors’ remedies can be viewed simply as the teeth which give legal
bite to property rights. In any case, in a world in which each debtor had only
one creditor, the law would have no occasion to provide creditors with the
rights to obtain security for their loans, nor would the issue of priority among
multiple creditors arise. Understanding financial security devices and priorities
as among creditors must thus begin with the intuition that when more than one
creditor has claims against any debtor, there is a potential collective action
problem to be solved (Baird, 1987a). There is, indeed, a substantial literature
which questions whether a serious collective action problem exists in the first
place (Adler, 1994b) and, if so, of just what must it necessarily consist and if
the problem is adequately defined, just how adjusting priorities among creditors
addresses it.

3. Property Theory and Race Priority

In legal theory, once the individual creditors’ remedy process was carried out,
what used to be the debtor’s property had become, in effect, the creditor’s
instead. This logic led, in cases with multiple seizing creditors, to a ‘race’
system of priority. Once the first creditor had made item of property A his in
the process, item A was no longer available to be seized by competing creditors,
because A was no longer the debtor’s property. Later seizing creditors,
accordingly, were left to look to items B ... N or whatever was left in the
debtor’s portfolio in order to satisfy their claims. The creditors’ remedy system
was never designed to take A’s property away from him and to use it to pay B’s
debts. The priority system resulting from the application of the property theory
of the law is ‘the devil take the hindmost’.

4. Contractual Priority

Historically, creditors undoubtedly realized that the one-on-one private
creditors’ remedy of seizure and sale was adequate only in cases when the
debtor had plenty of valuable assets left to be seized. The earliest versions of
secured lending were developed from the legal theory of property by the
creation of simulated sales. The debtor ‘sold’ the collateral to the creditor and
simultaneously signed a side deal under which the property would be
reconveyed to him upon a repayment of the putative ‘repurchase price’ (amount
loaned). Thereafter, the debtors’ other creditors could not seize and sell the
collateral because it now ‘belonged’ to the secured creditor until the
reconveyance price had been paid. On the other hand, the debtor took a
corresponding risk that the collateral could now be seized by the creditor’s
creditors, since it belonged to the creditor until reconveyed.

Lawyers had also developed the property theory of law to permit the
fractionalizing of property interests in any asset. Alphonse and Gastogne, for
example, each could own a half interest in all of Blackacre, rather than each
separately owning the respective north and south halves. At a very early time
lawyers were able to extrapolate on the simulated sale technique by exploiting
the legal notion of fractionalized property rights to guarantee the availability
to their creditor client of assets to seize and sell, without subjecting the debtor
to the risk that the collateral might be lost to the secured creditor’s own
creditors. The ‘mortgage’ interest developed into what was conceived of, in
legal theory, as another sort of fractionalized property interest in the collateral,
a conditional right to seize and sell the collateral unless the loan was repaid
(Nelson and Whitman, 1985). If the debt was not paid, then the creditor could
exercise its particular fractionalized property right in the collateral (the
contingent right to seize and sell the asset upon default) and thus could
liquidate it himself to obtain repayment from the proceeds. Correspondingly,
the debtor as only one of the two co-owners of the aggregate rights in the
property could not convey the collateral to anybody else either, since the
secured creditor owned that important fractionalized interest in it and so the
creditor was assured that the collateral would always be available to look to for
repayment. Earlier seizing creditors could seize the collateral but their seizure
was effective only subject to the secured creditor’s rights because, until the debt
was paid, the fractional interest consisting of the right to seize and sell it was
‘owned’ by the creditor and not by the debtor.

B. From Property Theory to Security to Bankruptcy Law

5. The Regulation of Contractual Priority

The simulated ‘sale’ of the collateral gave rise to some obvious perverse
incentives. After most of the debt had been repaid, for example, the creditor
had an incentive to provoke any default by the debtor so as to be able to assert
a right to the collateral as its owner and to retain any funds actually repaid.
Gradually, courts began to regulate the secured transaction, by requiring the
creditor to foreclose and sell the collateral, refunding any funds collected from
the sale in excess of the balance due on the loan to the debtor. By the nineteenth
century, the legal theory of a mortgage as a conditional property right retained
by the creditor became the ascendent view of the law of secured transactions.
Probably because the creditor community sensed that its members would come
to rely on the apparent ownership of persons in possession of property, it
became a legislated requirement that fractional, conditional interests like the
mortgage not be kept secret, so that the enforceability of the bargain for security
was made contingent on the lender’s giving of a public notice of the existence
of the mortgage interest (Baird, 1983).The legal property rights theory of the
value of security devices described above continues to be the favored
explanation for their existence even today by some commentators (Harris and
Mooney, 1994).

6. The Emergence of Modern Bankruptcy Legislation

Finally, in the United States in the twentieth century, the above described
nonbankruptcy creditors’ remedy system, with its race for priority feature,
became supplemented (and often supplanted) by national bankruptcy legislation
which provided for a collective proceeding to be conducted in which the debtor
and all of his creditors settled the debtor’s affairs in a single case. The federal
1898 Bankruptcy Act was extensively revised in 1938 and then again in 1978,
so the last century has seen much evolution in the legal details of bankruptcy
proceedings. Nevertheless, the conventional legal view is that bankruptcy is
rightfully seen as a staple feature of the background law which establishes the
American capital and asset markets (Warren, 1987).

C. The Four Strands of the Law and Economics Research Agenda

As the above summary of legal doctrine suggests, there are really two systems
of remedies existing concurrently: the nonbankruptcy system which, in the
United States; is a creature of the law of each of the 50 sovereign states and the
Federal law of Bankruptcy. The mission of Law and Economics scholarship is
thus to explain the existence of each of the two systems and justify the shapes
of each. There is also the question of how to coordinate the two systems - the
issue of which system should govern and in what circumstances. Existing law
and economics analysis has tended to focus on four salient features of the
nonbankruptcy system and how its outcomes tend to differ from the bankruptcy
outcomes. The four strands of the literature can be described as follows:

7. Individual vs. Collective Proceedings?

First the nonbankruptcy system can be fairly characterized as a system of
remedies given to individuals. It focusses on a debtor and a creditor and on the
procedures which affect only those two parties. Bankruptcy systems, in contrast,
are inherently collective, involving all of the debtor’s creditors in the same
legal proceedings. Thus it is fundamental to explain how these two
diametrically opposed approaches can both be justified and explained: are there
identifiable environments in which one of these alternative systems is
appropriate and others in which the converse is more likely to yield efficient
outcomes?

8. Asset or Claimant Based Remedies?

Second, the nonbankruptcy creditors’ remedy system focusses on discrete assets
in the debtor’s inventory. Creditors seize only specific assets, which are then
auctioned off. Likewise, security interests convey fractionalized property rights
only in identified assets which are the collateral for the secured loan or credit.
The creation of collective remedies, on the other hand, opens the possibility that
priority ranking could be determined by the characteristics of creditors and
could be applied to all of the debtor’s assets as a group analogously, for
example, to the interests of common and preferred shareholders in a firm. The
issue is then to explain when and how asset-based as against claimant-typebased
systems are appropriate.

9. Justifying Priorities?

Third, the priority system is a mixed one. As among creditors using the
ordinary legal process to enforce their obligations, the first to complete the
process and seize an asset has a priority right to the proceeds of the auction of
that asset over the second to seize. Holders of security interests can finish in the
race system, on the other hand, not in the order in which they seek to enforce
their rights, but rather in order roughly of the times at which they contracted
for those rights. In a collective proceeding, on the other hand, it is
administratively possible to conceive of other priority systems which, to note
the common example, adopt ratable sharing distributions as opposed to
lexicographic priorities. Explaining the contrasting systems, accordingly,
requires the development of theories of priorities.

10. Reconfiguring Contractual Priorities Ex Post

Fourth, Chapter 11 of the US Bankruptcy Code, which is thought to be a model
for collective collection law devices applicable to corporate debtors in the
developed and developing world, features a system which alters contractually
agreed priorities ex post. How can these such devices be justified and
explained?

A complete economic analysis of creditors’ remedies must explain each of these
four features of the existing dual creditors’ remedies system. It is fair to
introduce the literature addressing these problems by observing that much
explaining remains to be done. What the extant literature does contribute to
understanding these features is discussed, issue by issue, below.

D. Should Collection Law provide Individual Remedies or Should it
Provide Collective Proceedings?

11. The Costs and Benefits of Multiple Party Involvement

Nonbankruptcy law’s preference for an individual versus a collective system of
creditors’ remedies is presumably based on the avoidance of unnecessary costs.
Bowers (1990) argues that involving creditors (A, B, C, ..., M) in a dispute
between the debtor and creditor N is likely to be unnecessarily costly. If the
system provides easy means for A, B, C, ..., M to intervene into the Debtor/N
dispute, their failure to intervene is good evidence that involving them would
be wasteful. Thus the historical face-to-face nature of creditors’ remedy law can
be understood. Nevertheless, there may be instances in which economies of
scale exist in the expenditure of collection effort. Kanda and Levmore (1994)
argue in those cases a residual pool of creditors would agree to employ common
agents to pursue collection efforts and likewise agree to share in the costs of
that effort by adopting a pro-rata distributional rule such as is commonly
understood to characterize bankruptcy regimes. The issue thus framed is an
empirical one. The fact that the average recovery by creditors in all bankruptcy
proceedings is effectively zero (one cent on the dollar; LoPucki, 1996) suggests
that the cases in which the advantage rests with collective strategies are few.

12. The Collective Action Problem Model

The most famous law and economics analyst of bankruptcy systems made his
name by arguing that when a single debtor has multiple creditors, the creditors
may have a collective action problem. The individual incentives of each are to
act in ways contrary to the best interests of all (Jackson, 1982). He therefore
proposed that the creation of a mandatory collective remedy, which reflected
the terms of an idealized multiple-creditor contract to cooperate, could be
justifiable as a means of overcoming the collective action problem. Bankruptcy
law could be explained if it actually incorporated the terms of that idealized
‘creditors’ bargain’. The literature developed in three directions from Jackson’s
basic insight.

(a) Does the Law Correspond with the Model?
First, there is a question whether the quest for efficiency (for example providing
a legal solution to the ‘common pool’ problem creditors face under his analysis)
could plausibly be regarded as driving the substance of the actual, existing
bankruptcy doctrine. This first line of inquiry was addressed by Jackson himself
with his collaborator Douglas Baird. They first attempted to apply the creditors’
bargain heuristic to predict the features that an efficient bankruptcy statute
would contain. In a series of pathbreaking articles, however, they discovered
that the manner in which American Bankruptcy Judges were applying the
provisions of Federal Bankruptcy legislation differed from those predicted by
their efficiency hypothesis (Jackson, 1984, 1985; Baird and Jackson, 1984,
1985). Jackson and Scott (1989) attempted to account for the previously
observed inefficiencies as an insurance mechanism, but conceded that the
mechanism was unlikely to prove workable.

 (b) Is There Really a Serious Collective Action Problem after all - Is the Model
Itself Theoretically Sound?
Research in the second direction challenged the soundness of Jackson’s initial
analysis. The ‘Creditors’ Bargain’ logic grew from the premise of an assumed
‘common pool’ problem in which, when the debtor neared insolvency, assets
seized and sold by creditor A tended to directly harm creditor B because
insufficient assets were left behind to satisfy all remaining claims. This premise
is more than simply distributional. Jackson argued, for example, that creditor
A would not take the costs to B, C, ...., N into account in making his decision
to collect. Thus A would not avoid taking actions which destroyed synergistic
values to the assets in the debtor’s portfolio. A creditor owed $100 might take
a valuable earring whose stone could be sold for $100, even when it was a
member of a matched pair worth $300 when kept and sold together. Such losses
were avoidable, under Jackson’s analysis, by forcing all the creditors to act
collectively. Thus, he argued, the nonbankruptcy system had created a system
of perverse incentives which, on the occasion of insolvency, were cured by
switching over to the bankruptcy model.

Influenced by empirical evidence that the adoption of bankruptcy law had
resulted in zero payouts to the supposedly cooperating creditors, Bowers (1990)
argued that the Jackson’s view was one-sided, because it looked only at the
incentives facing the creditors and either ignored the existence of the debtors,
or assumed implicitly that debtors were completely passive. Bowers argued that
debtors had both the means at hand and the incentive to avoid the losses
Jackson predicted would result from perverse creditor common pool incentives.
Among the means available to a debtor under the nonbankruptcy system was
the power to optimally liquidate its assets and, indeed, subsequent empirical
research on the behavior of financially distressed firms (LoPucki and Whitford,
1993b; Gilson, 1996) shows that they do, in fact, conduct substantial asset
liquidations. Once the debtor’s incentives are brought back into the picture, the
hypothesized common pool problem disappears, leaving us once again without
a persuasive economic justification for the adoption of bankruptcy law.

(c) Are there Other, Better Solutions to the Collective Action Problem?
The third line of argument spawned by the Jackson creditors’ bargain thesis
took the law and economics literature in a new direction. It argued that
whatever ex post collective action problem the nonbankruptcy system might
create can be avoided by the use ex ante of optimal credit contracts (Adler,
1993b). Picker (1992), for example, justified the invention of security devices
such as mortgages by showing that the adroit use of security could eliminate
common pool problems. Bowers (1991) argued that the default terms of the
existing nonbankruptcy system of secured and unsecured credit already
provided the terms of optimal credit contracts, which tended to induce efficient
distributions of the distressed debtor’s least critical assets first to its most
vulnerable creditors, thus minimizing the size of aggregate distress losses.
Finally, a number of scholars began to argue that the common pool or other
perverse incentive problems which might occur in the nonbankruptcy system
could be handled by contract (Adler, 1994c). Since corporate debtors probably
dominate the economic impact of the American bankruptcy system, corporate
finance approaches to the problem of understanding bankruptcy law have
argued that borrowing firms are capable of creating new kinds of securities with
attendant options and covenants, which can obviate any common pool problem.
Since this literature tends also to address the issue of alteration of contractual
priorities ex post, it will be discussed below in connection with this last issue.

E. Asset vs. Creditor-type as the Basis for Remedies (Herein of the Law
and Economics of Security Devices)

13. The Legal Justification for Security
Simultaneously with the bankruptcy debate discussed above, the law and
economics literature was also engaged in a vigorous debate about the
justification for granting contracted-for priority rights to secured creditors. The
legal view of the justification, as exemplified in Kripke (1985) and Carlson
(1994) was that security, by reducing the credit risk borne by the secured
lender, tended to make loans available that creditors would not make on any
other basis and so security interests could be justified on the same grounds that
justified the extension of credit itself. In what is, perhaps, the most important
article in the law and economics literature concerning priority and security
issues, Jackson and Kronman (1979) first developed and used the creditors’
bargain theory so influential in the bankruptcy literature, to provide an
economic explanation for the development and use of security devices. They
argued that an aspect of the creditors’ collective action problem was a perverse
tendency for creditors to expend duplicate efforts thus over-monitoring the
debtor. Security, they concluded, if issued to the least efficient monitors,
relieved them of the impulse to monitor, curing the perverse incentive, reducing
unnecessary monitoring costs because only the most efficient monitors would
have any remaining incentive to do so.

14. The Secured Debt Puzzle

In 1981, however, Alan Schwartz (1981) showed that given some typical
theoretical economic assumptions (completely informed, risk neutral creditors,
with homogeneous expectations of the probability of default), the grant of
security to a secured creditor tended to do more than just reduce risk to that
lender (thus reducing the incentive to conduct duplicative monitoring). In fact,
the grant transferred risks onto unsecured creditors who, under these theoretical
assumptions, would demand as much compensation for accepting the transfer
as the secured party was likely to give as a discount on the interest premium for
being granted the security. The corollary as applied to the Jackson and
Kronman monitoring thesis was that to the extent secured creditors could safely
reduce their monitoring efforts, the grant of security correlatively increased the
need for unsecured creditors to monitor, so that the theory could not predict any
savings in aggregate monitoring costs either. Following James Scott (1977),
Schwartz argued security was in theory simply a zero sum game. If the
confection of security interests is costly, then, the mystery is, why would debtors
ever grant them when they stand to gain nothing by it? This analysis, Schwartz
pointed out, was simply an application of the famous Modigliani and Miller
Theorem (1958) of the irrelevance of capital structure. The argument created
what he named and what has since been known as ‘The Puzzle of Secured
Debt’ (Schwartz, 1984). Just as firms obviously invest much energy in
designing and adapting their capital structures, they also issue secured debt in
the teeth of theories which predict they will not. Schwartz concluded, however,
that none of the then-existing theoretical explanations for the employment of
short-term security devices could be squared with the empirical evidence, the
patterns of secured lending actually observed.

15. Possible Efficient Puzzle Solutions

The Schwartz thesis, that granting security is costly to debtors and gains them
nothing is, of course, contradicted by the observation that much secured lending
and borrowing actually occurs. It has been observed (Shupack, 1989) that the
costliness question is relative - that is, the Schwartz argument loses some of its
punch if it is more costly to contract for unsecured lending than to take a
security interest. Nevertheless, any explanation for the grant of security must
probably show that the issuing of security is likely to be efficient, so that some
private gains to the borrower and secured lender must be hypothesized.
Theories which explain the private gain as coming from externalizing risks
onto uncompensated unsecured creditors, of course, are normatively
unattractive. Schwartz (1984) examined several more benign explanatory
answers proposed to his original puzzle, including those of Levmore (1982)
(proposing that secured parties receive priority in payment for the external
benefits their monitoring of the debtor confers on other creditors) and White
(1984) (arguing that creditors differ in their levels of risk aversion so that
security is arguably an efficient means of reducing risk to the most risk averse).
Schwartz dismissed such theories which, by explaining the existence of private
gains to borrowers, however, generate predictions that all borrowing will be
conducted on a secured basis, such that all of every borrower’s available assets
will be encumbered before any unsecured borrowing occurs. All such theories,
Schwartz argued, will be embarrassed by the fact that much unsecured lending
takes place to borrowers with unencumbered assets. It thus seems likely that an
eventual persuasive theory will have to show that security is both costly and
beneficial, or else that unsecured lending achieves previously unknown gains,
in order for it to explain the observed mixture of types of borrowings. A number
of such theories have been proposed, which argue that the institution of security
is likely to be efficient, including Adler (1993a), Bowers (1991), Buckley
(1986, 1992), Kanda and Levmore (1994), Picker (1992), Scott (1986), Stulz
and Johnson (1985) and Triantis (1992, 1994). Without some strong empirical
confirmation of any of the competing theories, however, none has yet
commanded a general level of acceptance in the law and economics
community. Indeed, the current majority view is probably that the debate over
the puzzle of secured transactions has been inconclusive (Scott, 1994).

16. Inefficient Solutions to the Puzzle

The inconclusiveness of the search for ‘benign’ explanations for security
devices, which explain the use of security as justified by the creation of efficient
outcomes, has led to a recent spate of arguments that the institution of secured
credit is not only unproven as an efficient practice, but, on the contrary, is
positively exploitative and thus inefficient. Schwartz (1981) had initially
considered that security devices were employed by lenders and borrowers as
means of exploiting creditors, like tort claimants, or consumers who were
unsophisticated about the impact that security might have on their claims and
who would therefore not increase the risk premiums they charged for becoming
unsecured creditors. The distributive thesis, Schwartz argued, could only be
proven by showing that firms whose creditors were likely to be unsophisticated
were more apt to grant security interests than were borrowers whose other
creditors were less easy to exploit. Such behavior should even be evident and
the fact that it is not led him to dismiss the exploitation hypothesis.
Nevertheless, LoPucki (1994) and Bebchuck and Fried (1996) have recently
proposed that the priority extended to secured lenders be partially or wholly
abolished to prevent the externalization of risk onto unsophisticated unsecured
lenders. Scott (1994) has also suggested that the incentive structures inherent
in the private law-proposing organizations which produced the American
uniform law on security devices may also create perverse legal doctrine. Adler
 (1994a) argues that the Scott hypothesis results from a one-sided analysis.
Harris and Mooney (1994) and Carlson (1986) have urged that in view of the
inconclusive nature of the economic debate, that the institution of secured credit
can be justified by resort to the historical legal theories which have been
accepted by courts and lawyers. None of the exploitative or political theories of
secured lending have yet gained general acceptance among scholars as
explanations for the institution of security. The puzzle, thus, still remains to be
solved, or, to say the same thing in another way, none of the existing theories
which attempt to explain the institution has yet been proven correct.

17. Asset-Based Security as an Individual Remedy

Schwartz (1989) attempted to change the focus of the argument he himself had
created by arguing for the grant of first priority over all of the debtor’s assets
in favor of the the borrowing firm’s earliest-to-lend financier. Under his
analysis, the grant of priority, which is the functional equivalent of the grant
of security in all the borrower’s assets, can be an efficient way for firms with
good projects to signal that they differ from firms with poor prospects. Since
the first-in-time priority scheme he proposes resembles the priorities created
under the existing law of secured credit, his argument reduces to a plea that the
priority system cut loose from the asset-based nature it carries under existing
security device law and that a creditor-based priority scheme be substituted
therefore. His argument for this change is based, in part, on his assessment that
the process of tying public notice to particular assets in the current regime is
unduly costly. Bowers (1995) discusses some theoretical reasons why filing
systems might impose excessive costs. Kanda and Levmore (1994), on the other
hand, argue that notice is especially important only in asset-based priority
schemes and is thus not so important if priorities are based on creditor
characteristics as Schwartz proposes. Schwartz does not address the inevitable
aspect of his proposal, however, that it must necessarily trigger some sort of
collective collection proceeding in almost every case of nonpayment. Any
second-to-lend creditor whose contract entitles him to be first to collect (as for
example when a short-term trade creditor is seeking to collect against a debtor
who has financed himself with a relatively long-term loan from the first-to-lend
creditor) must involve the long-term financier as well as the debtor in any claim
that his debt ought to be satisfied out of any of the debtor’s assets, in all of
which, under Schwartz’s proposal, the first-to-lend financier has a priority
interest. Although Schwartz offered his proposal on a conceptual basis only and
so cannot be faulted for not having worked through the multitude of legal
details which its adoption would inevitably necessitate, it is difficult to imagine
that the debtor could even voluntarily pay the second-to-lend creditor with
assets in which the first-to-lend had a superior interest. This look into
Schwartz’s latest proposal, on the other hand, does generate an explanation for
the character of current security device law which is asset-based and not
creditor-based. In an asset-based system, in which all the debtor’s assets are
encumbered, every unsecured creditor must deal with the prior secured lender
in order to realize payment of his claim out of any of the debtor’s assets. In that
kind of case, an asset-based priority system can be seen as requiring a collective
determination of the relative rights of at least two creditors every time only one
wishes to collect. Unlike a creditor-based system, however, an asset-based
system permits debtors to retain some unencumbered assets which creditors can
resort to without having to trigger a collective proceeding. The choice of asset
vs. claimant-based priority rules, then, can be seen as another aspect of the
choice between adopting individualized vs. collective creditors’ remedies.
Particularly when priority rules are claimant- rather than asset-based and
claimants exist in large classes (such as, for example, when there are many
shareholders and many unsecured creditors who share strata of priority), for
any individual member of any class to collect, a legal proceeding almost
necessarily must involve all the members of the claimant’s own class, as well
as all the members of any competing class in the process.

F. The Economic Analysis of Creditor Priorities

18. Nonbankruptcy First-In-Time Priority

As has been previously set out, existing legal doctrine contains two different,
but concurrent priority paradigms. The nonbankruptcy system of individual
remedies is, principally, one of temporal priority. Early lending secured
creditors and early seizing creditors prevail over later ones. There are, however,
exceptions. One of the chief deviations is in favor of later lending secured
parties who are granted a ‘purchase-money’ priority over earlier lenders
claiming security interests in the same collateral. Certain statutory lien
claimants also prevail over earlier perfecting secured lenders. In admiralty,
there are many later-in-time but first-in-priority claims to interests in vessels.
Lawyers probably deem the first-in-time priority as the general rule and the
last-in-time priority cases as exceptional. Probably for that reason, the law and
economics analysis has begun by attempting to understand the general rule
first. Very little progress has been made in explaining the last-in-time priority
cases. Before discussing what there is on that score in the literature, therefore,
we will first address the temporal priority scheme in general.

 (a) Capricious Factors Influencing Racing Outcomes
The outcome of the race among unsecured creditors can be influenced by a
variety of arbitrary factors. Among the most capricious is the variance among
courts in time-lags for obtaining judicial relief. The race is normally won by
successfully completing a lawsuit, after which a judgment can be entered. The
right to seize and sell the debtor’s assets is usually assertable only after
judgement has been obtained. Ceteris paribus, then, creditors suing in
jurisdictions which have a year or more delay between the time a suit is
commenced and the time at which it will be called for trial, will be
disadvantaged in the race as compared with competing creditors who are
capable of maintaining their actions in venues with shorter trial calendars.
Perhaps to eliminate the capricious effects of these arbitrary factors, the
common law developed a set of devices under which a creditor can, at the time
of commencing judicial proceedings, reserve an early place in the order of
finish, conditional only on completing the judicial proceedings.

(b) Finishing-Place Reserving devices and Investments in Collection
The race system’s prejudgment finishing-place reserving devices such as writs
of attachment or sequestration, or notices of lis pendens, if freely available,
would make the race among unsecured creditors more closely resemble the
order in which their causes of action arose and thus susceptible to more reliable
planning at the time credit is initially extended. The creditor making the first
loan to become due would be more likely to become the first-in-line. In the last
30 years, however, the use of prejudgment writs has been restricted in the
United States on constitutional grounds in a series of important US Supreme
Court cases: Snaidach v. Family Finance Corp. 395 US 337 (1967); Fuentes
v. Shevin 407 US 67 (1972); North Georgia Finishing, Inc. V. Di-Chem Inc.
419 US 601 (1975). The court found the writs objectionable, however, only on
grounds that they invaded constitutional interests of the debtor. Their impact
on the priority as among creditors was not attacked and it is conceivable that
constitutional, prejudgement priority-reserving devices could still be designed
to meet that need. Indeed, however, the recording of public notice of a security
interest is an equally effective way of reserving a priority position at the time
credit is extended and thus may have rendered the prejudgement collection
writs superfluous in any case.

Much unsecured credit is extended on a demand basis, however, so that an
initial lending unsecured creditor cannot easily assure himself a head-start in
the race system if he lends for a fixed term. Later demand-basis lenders will
always be able to get the jump on him. Typical loan agreements attempt to
enhance the likelihood of a more nearly even starting time, however, by
permitting lenders to accelerate the due date upon adverse information, for
example the calling in of a demand loan by another creditor. Thus, while one
might argue that the nonbankruptcy priority system has a tendency to favor the
earliest to lend creditor, it is more likely that it favors the earliest to discover
the circumstances putting the debtor in default. This tendency of the unsecured
creditors’ racing system to induce careful creditor monitoring of the debtor has
been regarded in the literature as a mixed blessing. Monitoring tends to reduce
debtor misbehavior, but the system also tends to induce creditors to monitor
each other, a potentially wasteful expenditure in light of the possibilities that
creditors could agree to cooperate rather than compete with each other in
monitoring. Indeed, however, Picker (1992) has shown that the use of security
devices tends to enable creditors to avoid some of the expenses of monitoring
each other. Bowers (1991) on the other hand, has argued that those creditors
who are most vulnerable to losses from debtor default will be apt to invest in
contract terms which permit early starts in the race and will also make the
greatest investment in racing and thus tend to obtain proportionately greater
recoveries than will creditors who are less vulnerable. Thus, it is arguable that
the tournament-like system of the race among unsecured creditors has a
tendency toward efficient outcomes. Those who invest in winning the race are
presumably the more efficient creditors and will be rewarded by the existing
nonbankruptcy system.

(c) Payments as Priorities and the Law of Preferences
The far more promising strategy for unsecured creditors rather than planning
on winning a race through the judicial process, is to create incentives to induce
debtors to voluntarily repay their debts. Credit contracts can and do frequently
contain provisions which are designed to induce a debtor to pay a particular
debt instead of other ones. Discounts for prompt payments and penalty or
late-fees are common such devices. Creditors with whom the debtor does repeat
business are also in positions of leverage, capable of cutting off profitable future
business if past debts remain too long unpaid. The utility companies, by threat
to cut off power and water to their deadbeat customers, are only the most
obvious examples of creditors who can employ such strategies as substitutes for
judicial collection effectively. Nevertheless, even if the collection tournament
includes nonjudicial strategies, it is still arguable that those creditors most
vulnerable to loss will invest the most in designing contractual inducements for
voluntary preferential repayment, and will invest most in post-default collection
activity and are thus likely to be preferred.

One typical structural feature of bankruptcy law, however, is a doctrine that
sets aside preferences. In order to discourage premature dismemberment of
potentially viable firms, it is argued, measures need to be taken to discourage
creditors from ‘opting out’ of the bankruptcy fixed priority scheme in advance
of the bankruptcy proceedings (Jackson, 1986, p. 125). If the tournament-like
results of debtor preferences are likely to produce efficient results (payments to
the most vulnerable creditors first and in such a way as to maximize the value
of the debtor’s remaining portfolio left available to the remaining creditors),
then the need for an efficient collective regime, particularly one to be protected
by preference law, is questionable. What is more, Adler (1995) has shown in
addition that, for corporate borrowers, the existence of a collective action
problem itself impedes the effectiveness of any rules which attempt to prohibit
debtors from making preferential transfers to creditors and that preference
prohibitions may in fact diminish the value of the debtor’s estate available to
satisfy the claims of its creditors.

19. First-to-Perfect Priority Among Secured Creditors

The first-wins priority scheme for secured creditors is explainable on a more
straightforward basis. In it, each creditor can fix his or her place in the race for
the debtor’s assets at the time credit is extended. Those making later loans will
be on notice that they will come in second in the race and can thus adjust the
amount they choose to lend and the terms of their credit contracts to account
for that fact. The expenses of earlier lenders in accounting for later creditors is
likely to be exorbitant since the facts about later loans cannot be learned at the
time the contracts are entered into. Thus, the basic secured creditor priority
system can be explained as the one which permits the creditors to adjust to each
other most cheaply. To the extent that this rationale is explanatory, however,
it also makes the few instances in which last-to-lend creditors are given
priority, even more mysterious.

20. Nonbankruptcy Later-in-Time Priorities

The earliest attempt to provide an economic explanation for a later-in-time
priority involved the so-called ‘purchase-money priority’ of lenders who take
as collateral, the very assets purchase which their extensions of credit financed.
In an asset-based lending system, this transaction might be viewed as a
first-in-time transaction because the taking of security in the asset occurs at the
very first instant at which the collateral became part of the debtor’s estate. The
American Uniform Commercial Code, however, contemplates that borrowers
can grant security interests to earlier lenders in after-acquired assets. The
priority of the purchase-money lender, consequently, simply means that the
purchase-money financier prevails over the after-acquired property interest of
the earlier lender. Thus, what looks like a last-in-time priority may also be seen
as nothing more than a limitation on the powers of debtors to pledge and of
lenders to take security in future assets. None of the investigations to date,
however, has asked whether there are efficient limits to the pledge of
after-acquired assets. Jackson and Kronman (1979) addressed purchase-money
priority as if it were a preferred default clause in the credit contract which
created the earlier security interest in after-acquired collateral. Unless it could
grant purchase-money priority to future lenders, they argued, the debtor was
effectively committed to obtain all future financing from the initial lender.
Since few debtors would willingly grant situational monopolies to lenders
without asking for significant other concessions, they hypothesized that the
parties to the initial credit contact would choose a purchase-money escapehatch
clause in their contract and were saved the expenses of doing so by the
priority provisions of the Code. Schwartz (1989), in his proposal to permit first
priority to the first significant financier in all of the debtor’s assets, also argues
that the parties might bargain for purchase-money priority exceptions for
sufficiently insignificant after-acquired asset purchases.

The latest attempt to explain later-in-time wins priority provisions is
Levmore and Kanda (1994). They begin by espousing the recent trend in the
law and economics literature to assume that existing doctrine was intended to
address the problems of corporate borrowers. They then argue that the basic
first-in-time gets priority rule is justifiable as a means of protecting early
lending creditors from the perverse incentives which attract the equity owners
of corporate borrowers to overinvest in excessively risky projects. Not all
investments in the firm necessarily exacerbate the overinvestment incentive,
however and, Levmore and Kanda surmise, later lenders have an informational
advantage over earlier lenders about new investments the firm is undertaking.
When, then, the informational advantage is significant and the environment is
such that overinvestment is not likely to to be a serious risk, they argue, one
might expect to see a later-in-time priority rule to displace the basic scheme as
a means of encouraging investment in the firm’s latest prospects by
well-informed lenders. This approach to explaining the mystery of late-in-time
priority rules seems promising. On the other hand, the argument that each
existing later-lender-gets-priority rule can be explained as being confined to an
environment in which overinvestment risk is minor, is empirically speculative.

21. Liquidation Bankruptcy Priority

The shape of the asset-based, first-in-time nonbankruptcy priority system
conforms to the underlying assumption that the collection of obligations should
be regarded as an individual matter, strictly between the debtor and the
creditor. They are free to write credit contracts which meet their individual
needs and to pursue the remedies they have bargained for on the basis of their
individual circumstances. Particularly, however, once the debtor nears
insolvency, the actions taken by any individual creditor arguably create a risk
of external impacts on the welfare of competing creditors. Nothing in the
contracting system in which the extension of credit is bargained for requires
any creditor to modify the terms of his contract in order to coordinate his
contract rights, or his ultimate legal remedy, with others who may have an
interest in the debtor’s fortunes. American lawyers intuit that on the occasion
of insolvency some sort of coordination among creditors is required, and on that
basis have built their basic understanding of the justification for bankruptcy
law.

The basic priority system in the collective regime is complicated by the fact
that, in theory, bankruptcy is designed to partially enforce the rights creditors
acquire in the nonbankruptcy system. Thus, for example, secured creditors are
technically entitled to recover the value of the collateral securing their debt to
the extent that it is less than or equal to the amount owed. The extent to which
this entitlement is enforced in actual bankruptcy proceedings, however, depends
on whether the particular bankruptcy is a reorganization or a liquidation case.
Reorganizations are discussed in Part G below. Since the legal priority rules
which nominally create the baselines for distributions in reorganizations are the
priorities which prevail in liquidation cases, it is useful to discuss these rules
first.

(a) Class-Based Distribution
The archetypical bankruptcy proceeding is Chapter 7 of the US Bankruptcy
Code. It can be initiated by either the debtor or a group of creditors and once
the proceedings commence, all individual collection activity by all creditors is
stopped by the issuance of an automatic injunction. Almost immediately the
bankruptcy trustee, an agent to represent all the claimants, is appointed and
given control over all of the debtor’s assets. The trustee then liquidates the
assets, either in the ordinary course of the debtor’s business, or else by auction,
converting all of them into cash. The proceeds from the sale of collateral are
paid to secured creditors. The remaining cash is distributed to various creditors
according to the Chapter 7 priority scheme, which first sets up a set of several
classes of creditors holding ‘priority claims’. The claims of the first priority are
paid in full and only in the event there is cash remaining are distributions made
to the next class and so on until all claims are paid. Creditors in the last class
for whom the assets are sufficient for a distribution, but not enough to satisfy
all the claims in the class, receive partial payments of the sum left undistributed
in the debtor’s estate, but are paid among themselves in proportion to the size
of their claims - the so-called ‘pro-rata equality’ formula.
The literature has not addressed the question whether the existing fixed
priority scheme of liquidation bankruptcy regimes can be economically
explained. The first priority class are so-called ‘administrative priority’ claims.
The preference shown to these claims can probably be understood best as
answering the need that the costs of the collective proceeding must be paid if
there is to to be any proceeding, but in fact the bulk of all US bankruptcy cases
are those of individual debtors whose assets have no remaining distributable
value once they enter bankruptcy. Bowers (1990) argues that debtors attempting
to maximize the value of their assets will self-liquidate before their creditors
force them to do it involuntarily and that the result of such self-liquidations will
be that only highly-specialized assets and those which have the highest
transaction costs to liquidate will remain in the debtor’s inventories as of the
time they are surrendered to creditors. The fact that the bankruptcy estates of
individual debtors are basically empty can thus be explained.

(b) Sympathetic Classes
The remaining classes of priority claims are more difficult to justify on
efficiency grounds. Unpaid employees, certain farmers and fishermen and some
consumers having made deposits on undelivered merchandise are sympathetic
creditors who might to be expected to find favor in the legislative arena in
which bankruptcy legislation has traditionally been crafted. Tax collectors get
priority for similar easy-to-understand political reasons, even if they do not
merit much sympathy. The existing list of priority creditors does not exhaust
the list of possibly sympathetic claimants. The omissions inspire demands that
tort-victims of the debtor be given priority, even over the claims of secured
creditors (for example, see LoPucki, 1994).

(c) Behavior Invariant Loss Sharing Rules
The principally important feature of the statutory priority system, however,
including the catch-all pro-rata formula for the bottom priority creditors, is that
it is fixed in advance and, thus, will not vary with creditor behavior. In the
nonbankruptcy race system, for example, a creditor stands to make gains from
obtaining information earlier than competing creditors so as to get a head-start
in the race for the debtor’s assets. The payouts in the collective regime,
however, are fixed in advance and will not vary much according to creditors’
investments in monitoring or collection efforts. A creditor who carefully
monitors the debtor thus must share with the other creditors the gains from
early detection if a collective proceeding ensues. If over-monitoring is a
potential problem (Jackson and Kronman, 1979), or if racing costs are viewed
as potentially wasteful (Jackson, 1982), then the fixed priority system imposed
by bankruptcy law might be justified as a cure for the adverse effects of those
perverse incentives. On the other hand, it has been shown in other contexts that
mandatory equal sharing rules can block co-owned assets from being moved to
higher valued uses (Easterbrook and Fischel, 1991, p. 118; Harris and Raviv,
1988; Kahan, 1993). The sharing regime gives some creditors incentives to
free ride on the efforts of other creditors to monitor and force an ultimate
liquidation. In the face of empirical complaints that bankruptcy proceedings
might thus not be initiated soon enough, there are proposals in the literature to
pay a bounty to the creditor who triggers the collective proceeding (Jackson,
1986; LoPucki, 1982). Of course, bounties are difficult to design and may give
rise to races for the bounty, over-monitoring so as to to be able to win the race
to the bounty, and so on. The perfectly designed, happy medium liquidation
bankruptcy structure which avoids both sets of perverse incentives, however,
has not yet been developed in the literature.

G. Corporate Reorganization Bankruptcies and Ex Post Modification of
Contractual Priorities

22. The Problem of the Corporate Borrower

The most heavily studied aspect of the issues raised in this chapter, is the
question of what should be done when corporate borrowers incur financial
distress. Although the bankruptcy code applies to individuals and other kinds
of entities which become borrowers, the law and economics literature on this
question has typically attempted to explain bankruptcy solely as a means of
solving the collective action problem which corporate investors will forseeably
face. Until recently, the literature has assumed that the archetypical corporate
bankruptcy law was Chapter 11 of the US Bankruptcy Code. The collective
action problem is seen as the result of the content of the borrower’s ex ante
credit contracts and the nonbankruptcy law of creditors’ remedies which
permits creditors to race for, seize and sell the firm’s assets. Bankruptcy law
could be justified and understood if it addresses the collective action problem
by refusing to enforce the suboptimal prebankruptcy market credit contracts and
altering their terms ex post so that the set of post-reorganization claims against
any debtor firm will more closely approximate an optimal capital structure.
Recently, however, the companion literature on comparative corporate
governance has raised the interesting possibility that corporate reorganization
might be just an American problem. Roe (1994, Ch. 11) has shown that
German and Japanese firms, for example, are subject to a great deal of
management control by their financing banks, who also wield influence with
the firm’s other suppliers and customers. The relational lending regimes which
result have the potential to essentially privatize the process of reorganizing
financially distressed firms. Roe points out that the relational techniques have
been politically outlawed in the US which might explain the American
preoccupation with corporate bankruptcy law.

23. The Illusive Problem of Optimal Capital Structure Design

Presumably since any given firm’s optimal capital structure cannot be specified
in advance, the law of corporate reorganization replaces the nonbankruptcy and
liquidation bankruptcy result of predetermined priorities with a
non-predetermined scheme. The priority rights in the reorganized firm are not
spelled out in the statute. Rather, it provides an extensive set of procedures
under which a ‘plan of reorganization’ is developed and adopted for each
bankrupt firm. The actual priorities awarded the claimants holding
prebankruptcy contracts, then, is specified only ex post in the plan. It is well
understood that the procedures under which such plans are developed dilute the
value of contracts which provide for the claimant to receive high priority and,
correlatively, enhance the distributions to those whose contracts called for them
to have the lowest priorities. What is not so well understood, however, is how
altering the prebankruptcy priority contracts contributes to the solution of any
collective action problem (Adler, 1992).

From a law and economics viewpoint, the efficacy of this legal strategy for
avoiding the collective action problem depends on whether we have developed
a comprehensive theory of optimal capital structure for any given type of firm
in the first place. If a firm’s optimal capital structure is determinable, on the
other hand, the coherence of the bankruptcy scheme must rest on some
unarticulated explanations for why the investors’ contracts cannot be expected
to have already provided for the optimal outcome such that the resulting
contracted-for priorities should not be enforced in the bankruptcy
reorganization. As the law and economics literature has refined its definition
of the issues needed to understand bankruptcy’s corporate reorganization
provisions, it has become increasingly obvious that these questions have not yet
been answered. The answers are likely to come from the subfield of corporate
finance.

24. Nonbankruptcy Organizational Solutions to the Structural Problem

To begin with, firms need incur the prospect of collective action problems only
by choice. Business projects can be organized in all-equity entities or those
which are solely owned by a single investor and which pursue whatever projects
that controlling investor deems most efficient (Baird, 1994). It is even probable,
based on the beginnings of relational theory in the literature (Scott, 1986; Eric
Posner, 1996; Bowers and Bigelow, 1996), to suppose that relational behavior
can solve all the parties’ collective action problems. Multiple investors who are
also actively relationally involved with each other can join together in a
business partnership venture and function as if they were a sole investor, so
long as the necessary acts of relating reduce transaction costs sufficiently
among them as to invoke the Coase Theorem (Coase, 1960). Since most
corporate reorganizations in the United States are of small firms (Bufford,
1994) which are thus arguably unlikely to face significant collective action
problems, it is probable that US Corporate Reorganization law cannot be
justified and explained by the need to solve small firms’ problems.

25. The Contributions of Well-Functioning Capital Markets to the Problem
of Capital Structure Design

The law and economics literature has focussed almost entirely on the optimal
capital structure problems of firms of significant size and thus has assumed that
Corporate Bankruptcy Reorganization law must be intended to address the
problems of such firms for whom serious collective action problems are likely
to exist. The debate over the significance of these problems has been recounted
earlier in Section D discussing the justifications for development of collective
remedy systems. Nevertheless, early in the debate Douglas Baird (1986) argued
that the existence of well-functioning markets largely mitigated the possibility
of any serious collective action problems for large, listed firms. The debate over
what purposes corporate reorganization bankruptcy might serve has been
conducted ever since between groups who, on the one hand, believe that almost
all market results are inferior to bureaucratic decision making (LoPucki, 1992;
Warren, 1992a) and those, on the other hand, who are persuaded that the
existing capital markets function fairly well (Bowers, 1993). The latter scholars
have concluded from the data that Chapter 11 of the Bankruptcy Code has been
punishing to investors (Bradley and Rosenzweig, 1992), without obviously
assisting other recognizable groups of claimants (Bowers, 1994b).

26. The Valuation Problem with Bureaucratic Solutions

The logic underlying the corporate reorganization provisions of the US
Bankruptcy Code (‘Chapter 11’) has always been that firms, even those in
financial distress, have so-called ‘going concern’ values which are lost if the
firm is broken up by having its assets sold off piecemeal. The collective action
problem is seen as the incentives of individual creditors to race to dismember
the firm on the first suspicion that it is headed for insolvency thus possibly
destroying that going concern value (Baird, 1987a; Eisenberg and Tagashira,
1994). The structure of Chapter 11 is consistent with this explanation. When
a firm files for Chapter 11 relief, all individual creditor actions to seize any of
the bankrupts’ assets are automatically enjoined and the assets are never, in
fact, liquidated. Instead, the firm is recapitalized, with its old creditors
becoming its new shareholders. Stock in the reorganized firm is swapped for
the original debt. This result cannot obtain in legal theory, however, unless the
equities distributed to the former creditors exceed the estimated value the
creditor would have obtained in a hypothetical liquidation bankruptcy. In other
words, the expectation is that the claimants’ new interests in the firm will
exceed the liquidation value of their interest in the unreorganized firm,
presumably by the amount of the saved going concern surplus.

The theory behind the provisions, however, has failed the test of practical
applicability. Since the going concern value is necessarily the present market
value of the firm minus the amount the assets would have sold for if liquidated
and the firm is never presently sold on the market nor are its assets ever
liquidated, the going concern value for any firm in Chapter 11 is simply a
hypothetical construct. Hypothetical liquidation values estimated for use in the
proceedings, in particular, are quite problematical because they are apt to to be
extremely context contingent. If you ask me to estimate how much I can sell
General Motors for, but specify that I must sell it in the next five minutes, its
liquidation value is equivalent to my estimate of the maximum amount of cash
in the heaviest purse of the 23 persons within hailing distance. Prebankruptcy
holders of the lowest priority claims (usually common equity) have an incentive
to overstate the hypothetical going concern value of the firm so as to buttress
their claim to have part of the reorganized firm distributed to them. They
likewise have a strong incentive to understate the liquidation value of the firm’s
assets because that minimizes the baseline distributional entitlements of the
creditors in the reorganized firm. The costs of trying to value the firm, without
conducting any actual market transactions, are thought to to be extremely high
(Altman, 1984; Bhagat, Brickley and Coles, 1994; Opler and Titman, 1994).
The actual values which the bankruptcy judge might determine the assets would
have sold for and what the reorganized firm will be worth, are sufficiently
uncertain that the multiple claimants are not inclined to want to litigate them.
Since management representing the common shareholders remains in control
of the firm while the renegotiation of its capital structure is ongoing, Chapter
11 confers on management and common equity something akin to a legal right
to engage in holdout behavior. As a consequence, it is common knowledge that
the interests in the reorganized firm are not distributed to the claimants in
accordance with their prebankruptcy contract priority rights. Those empowered
to hold out commonly improve their ex ante contractual priority at the expense
of creditors (Eberhart, Moore and Roenfelt, 1990; LoPucki and Whitford, 1990;
Warner, 1977; Weiss; 1990).

27. Proposals for Curing the Valuation Problem

Much scholarly creativity has been thrown into the effort to develop a better
way to avoid the collective action problem and at the same time cheaply and
accurately value the firm, or avoid the incentives to engage in ex post
rent-seeking built into the current Chapter 11. Roe (1983) proposed an initial
public offering of a small portion of the securities intended to to be distributed
to claimants in the reorganization as a more accurate way of evaluating whether
the securities being swapped for debt had incorporated any real going concern
value. Bebchuck (1988) proposed instead that each claimant be granted an
option to buy the rights of the next most superior priority level at their face
value or else lose their interest in the firm. Thus, the lowest priority level not
bought out would end up holding the residual claims to the firm. Merton (1990)
offered a similar proposal. Aghion, Hart and Moore (1992, 1994) proposed still
another refinement on the Bebchuck scheme. They suggested that the Chapter
11 court, once having identified the appropriate holders of the residual interest
in the firm from the exercise of the Bebchuck-type options, thereafter permit
them to vote on new capital structure proposals offered by competing
management groups. Baird (1986) proposed that instead of elaborate and
expensive recontracting, that the firm simply be auctioned off in Chapter 11,
with the auction proceeds being distributed in accordance with priorities fixed
in the claimants’ pre-bankruptcy investment contracts. Whatever going concern
values the firm had would presumably be saved by being included in the price
the winning bidder was willing to pay, buying the firm as an intact unit. Since
the auction proceeds could be distributed in accordance with all the claimants’
prebankruptcy priority contracts, the auction argument also showed that the
solution to the collective action problem did not necessitate ex post
modifications of those contracts. Auctions are, nevertheless, known to entail
their own transaction costs and imperfections ( Baird, 1993; Cramton and
Schwartz, 1991; French and McCormick, 1984).

Adler (1993b) and Bradley and Rosenzweig (1992) both proposed that firms
might issue new types of securities which automatically erase the lowest
priority claims upon a default of an obligation to the next higher priority class
and simultaneously place that next-higher class in control of the firm. Adler’s
proposal also was to eliminate the individual collection rights of holders of any
of the contingent securities, thus eliminating any right and therefore any
incentive for individual creditors to take action to dismember the debtor, and
powerfully eliminating any justification for Chapter 11 if it was designed to
ameliorate the collective action problem which arises when creditors have
rights to act individually.

All of these proposals to reform Chapter 11, on the other hand, seem
implicitly to accept that permitting individual creditors to enforce their credit
contracts under nonbankruptcy law creates such significant collective action
problems that a mandatory collective type proceeding is required as a solution.
Some proposals offer the possibility that hybrid collective/individual type
processes might improve on Chapter 11. Baird and Picker (1991) propose that
a collective stay be imposed on smaller creditors while permitting a single
major financing creditor to individually decide whether to liquidate or continue
the firm. Perhaps the most comprehensive proposals were those of Rasmussen
(1993) and Schwartz (1993) under which individual firms would be obliged to
specify the details of the collective program claimants against them would be
required to adhere to.

All of these proposals share the strategic presupposition that firms
themselves can, in the design of their credit contracts or securities, also include
contract terms which will ameliorate the collective action problems which
might arise thereafter, by specifying a collective procedure in which the claims
would to be processed (Adler, 1994b). The fact that firms never seem to have
attempted to use these devices then gives rise to some interesting empirical
inferences. Perhaps the theoretically alarming collective action problem is not,
in practice, as dreadful as armchair theorists and congressmen have feared.
Adler (1993a) argues that automatically recapitalizing securities, at least, may
not have been adopted for a variety of unrelated tax, tort and corporate law
reasons. A recent study (Gilson, 1996) showed the most astonishing difference
between failing firms which recapitalized using Chapter 11 and those
recontracting outside of a regulated bankruptcy proceeding was that the
net-operating-loss carry forwards (NOLS) of the chapter 11 firms were nearly
5 times larger than those which recapitalized privately. This suggests that
Chapter 11 may provide a technique for obtaining favorable corporate income
tax treatment, a justification far afield from those currently speculated about.
It is not easy to see, however, why a distressed firm should to be required to
undergo the details of a Chapter 11 reorganization before being entitled to these
particular tax benefits. Such an understanding would have to proceed first by
elaborating on the desirability of the creation of NOLS in the first place.

28. Bankruptcy and Investment Incentives

As the previous discussion showed, the collective action problem faced by a
firm’s creditors can be addressed without altering the investors’ prebankruptcy
priority plans ex post (Schwartz, 1994b) and Rasmussen (1994b) proposed that
refusing ex post to honor investors’ prebankruptcy priority contracts might be
explained by their affects on the firm’s near-insolvency investment incentives.
They both concluded that none of the proposed contractual means of addressing
the potential collective action problems could be judged better on this a priori
basis, however. The inconclusiveness of these affects they deemed as a strong
argument for giving individual firms their own ability to choose among a
‘menu’ of different possibilities for the proposal which best suited the concerns
of that particular firm.

Even if a one-size-fits-all bankruptcy regime could be improved upon by
allowing each firm to tailor-make its own procedure, however, in the absence
of a comprehensive understanding of how to create an optimal capital structure
it is not easy to know how investors could value the differing choices on the
resulting menus. The theoretical difficulties of knowing why capital structures
might even matter raised by the Miller/Modigliani irrelevance theorem (1958)
have begun to be overcome, largely as an offshoot of the theory of agency costs
has developed (Jensen and Meckling, 1976). It is now understood that debt in
a firm’s capital structure contributes to the firm’s value by imposing discipline
on managers whose personal incentives do not coincide with the desires of their
principals, the equity investors. Fixed obligations impose a measurable task on
management either to operate the firm profitably enough to raise the cash
needed to meet the fixed obligation, or else to subject themselves to the
discipline of the financial market in order to obtain the funds they need to
operate the business (Easterbrook, 1984; Grossman and Hart, 1982; Jensen,
1986; Triantis, 1994). Since only firms with debt can incur financial distress,
the overall expected gains from reduction of management misbehavior must be
greater than the prospective losses which the existence of debt may create.

(a) Entrenchment
Aside from the ex post collective action problems supposedly met by Chapter
11, it is also known that the existence of debt in the firm’s capital structure has
some downsides. First, just as debt is thought to reduce agency costs by
controlling management’s powers over the firm’s free cash flow, it is also
recognized that the existence of debt gives rise to the positive probability of a
financial default. Managers may fear that if the firm is to to be liquidated upon
default, they will lose their valuable positions, including some firm-specific
investment in human capital. This reasoning gives rise to the perverse incentive
known as management entrenchment. When the firm has issued debt, managers
will tend to warp the firm’s investment decisions in favor of those projects in
which managers can make themselves indispensable, even though these
projects are not necessarily those with the highest net present values to
investors (Morck, Shleifer and Vishny, 1989; Bebchuck and Picker, 1993).

(b) Overinvestment
Second, it is now well understood that especially as the firm nears insolvency,
that low priority claimants have a perverse incentive to gamble with the firm’s
assets, since they can pay off the higher priorities with the winnings and keep
the profits for themselves, but all the losses will be imposed on the higher
priority claimants. This set of perverse incentives is known as the Jenson and
Meckling (1976) ‘overinvestment’ problem. The current bankruptcy regime is
sometimes thought to ameliorate this incentive by refusing to enforce the
investors’ ex ante contracts which require that equity to be totally subordinated
to debt claimants. If, as is known to to be the case, Chapter 11 distributions
deviate from the absolute priority rule, then the managers and equity may be
gambling with some of their own money when they undertake risky projects
and will be less inclined to do so. Insofar as these risky investments were likely
to be in negative net present value projects, then the deviation from absolute
priority might even be applauded as a means of avoiding socially detrimental
wasteful investment decisions. On the other hand, it has also been shown that
priority redistributions in bankruptcy creates a classic case of moral hazard for
solvent firms. By insuring management and equity against losses if insolvency
eventuates, it is likely to aggravate the tendency of equity-holders and their
managers to undertake undue risk during the periods when the firm is solvent
(Adler, 1992).

(c) Underinvestment
The third perverse incentive known to haunt capital structures which contain
debt is the so-called debt-overhang, or Myers’s (1977) ‘underinvestment’ risk.
If the firm is nearly insolvent and is presented with a promising investment
opportunity, equity (and management, their agents) may decided to forgo
investing in it because the payoffs are likely to to be captured entirely by the
higher priority creditors. In that way, the existence of debt may cause the firm
to forgo the opportunity to invest in positive net present value projects. For
firms with investable internal funds, then, eliminating the claims of the higher
priority creditors ex post in order to make distributions to the lowest priority
claimants (equity) is a way of permitting equity to share in the returns from
those valuable projects (Rasmussen, 1994b). Once in bankruptcy proceedings,
the bankruptcy judge may approve subordinating senior claims to those of new
financiers in order to overcome this underinvestment incentive (Triantis,
1993a).

Nevertheless, Schwartz (1994b) has shown that if the firm must resort to the
capital markets in order to obtain the financing for positive net present value
projects, then the failure to enforce pre-bankruptcy priority contracts creates an
underinvestment incentive even for solvent firms and exacerbates those
incentives for nearly insolvent firms. Generally, he argues, outside financiers,
aware that their nonbankruptcy priority will not be honored in a Chapter 11,
will insist not only on market returns for their investments, but also will insist
on extra returns for being forced to bear the costs of the bankruptcy
redistribution. The extra returns they will insist upon will render otherwise
positive net value projects not worthwhile to undertake at the margins. It is thus
an empirical issue whether the extra underinvestment risks which bankruptcy
reorganization imposes on solvent firms and on those who must resort to the
capital markets to finance their projects and are near insolvency, are
outweighed by the mitigation of those risks to nearly insolvent firms with
internal investable capital.

In summary, the current American corporate reorganization scheme has not
yet been satisfactorily explained. In the first place, the collective action
problems it seems designed to address may not be so serious after all, and in the
second place, even if they are serious, they are capable of being addressed more
cheaply by altering the contractual terms of credit contracts and securities.
Finally, corporate reorganization’s failure to honor prebankruptcy contractual
priorities does not seem to address management entrenchment, the first set of
perverse incentives which inhere in corporate capital structures. The impact of
denying enforcement to prebankruptcy contractual priority is, at best,
ambiguous with respect to both the overinvestment and underinvestment
perverse incentives.

29. Structures with Preplanned Liquidations

Adler (1997) has recently suggested that the failure of law and economics
scholarship to develop a satisfactory explanation for corporate reorganization
bankruptcy may to be due to a flawed initial premise generated by a faulty ex
post point of view. He suggests that asking why and how investors would like
to to be able to salvage going concern values, as looked at from the point in
time when the debt obligations of the firm go into default themselves, ignores
a significant feature of any business’s necessarily prior decision to select its
capital structure. The ex ante point of view, from the time the structure is
designed, he suggests might offer a more fruitful perspective. Investors at the
time the firm is structured may purposely design the firm so that it experiences
financial distress whenever it is also likely to become economically inviable.
Bowers (1991) had, in a similar vein, proposed that firms might employ
security interests in a manner which would build self-executing optimal
liquidating plans into their capital structures.

Firms whose projects have no economic value ought not to be reorganized.
Instead their assets ought to to be redeployed to higher and better uses. It is a
commonplace that, ex post, managers (Rose-Ackerman, 1991) and lower
priority claimants (Bebchuck and Chang, 1992) have an incentive to fuzz the
distinctions between economic and financial viabilities simply to milk the
higher priority creditors for the last available dime before the firm must cease
business, and that they apparently succeed in doing so (White, 1994a, b).
Describing the optimal moment at which management’s control over the assets
should be eliminated is a formidable task (Buckley, 1992). Even if the initial
capital structure design does not perfectly separate the economically from the
merely financially inviable firms ex post, however, the gains from
rehabilitating a few firms may not be worth the losses from attempting to save
a multitude of unsalvageable ones. Chapter 11’s record for rehabilitating firms
is not a stellar one (Hotchkiss, 1996). The potential for an out-of-court workout
also provides a failsafe mechanism if the capital structure turns out, ex post to
have been an especially bad predictor (Fitts, et al., 1991; Gilson, John and
Lange, 1990; Haugen and Senbet, 1988).

30. Nonbankruptcy Law’s Responses to Perverse Investment Incentives

This insight might in fact explain the nonbankruptcy creditors’ remedy system
in which, if creditors are unpaid, they can trigger a liquidation which will send
the firm’s assets back into the market to to be reallocated to better uses. The
nonbankruptcy system also can address some of the perverse incentives built
into typical capital structures having a debt component. The overinvestment
incentive is addressed by permitting creditors to seize the assets of the firm.
Once the assets are seized, equity and its management can no longer gamble
them on risky ventures. Furthermore, even management entrenchment can be
resisted under the nonbankruptcy system. Creditors who can effectively
precommit to a version of the ‘grim’ strategy, to seize and sell whatever assets
the managers invest in, can eliminate the incentives of managers to invest in
them even if such investments owe a lot of their value to information which is
private to the managers. It is only the prospect of a job in the reorganized
project which permits the entrenchment incentive to operate. An absolute
commitment to liquidate rather than reorganize thus makes entrenchment
prospectively unprofitable. In that sense, then, one of the most serious of the
perverse incentives is created by the law of bankruptcy reorganization..

The final perverse incentive that arises under capital structures which
include debt, so-called underinvestment, may also not be of the sort which can
easily be resolved by altering the terms of credit contracts. The potential
positive net present value project which might not be exploited in the future, is
difficult for the initial investors to describe in their present contracts. The
underinvestment incentive is not addressed by corporate reorganization
bankruptcy doctrine either. The problem, thus, may be practically intractable.
In that case, the investors may conclude that if the firm suffers distress, its
assets ought not to to be deployed in any new projects in a firm still laden with
the old capital structure. The best alternative may to be to liquidate the old firm
and to structure a new one in order to pursue the new investment opportunities.
It seems unlikely that a satisfactory explanation and justification for any sort
of corporate reorganization law will be possible until such time as a generally
acceptable model of optimal initial organization is developed. While the shape
of such a model might be inferable from the actual behaviors of investors and
executives, the empirical literature to date has not succeeded in distinguishing
the essentials from the noise. Nor has the theory of corporate financial structure
yet advanced to the point of offering a satisfying understanding.

 


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