A bankruptcy system is believed necessary to solve a coordination problem among the creditors of a distressed firm. The firm may be economically distressed – it cannot make a go of it in the market place – or financially distressed – it would survive under a reduced debt load. To understand the coordination problem, let the illustrative firm have a large number of symmetric creditors, each of whom holds a debt share that is small in relation to the total owed. As a consequence, no creditor could internalize enough of the gain from restructuring the firm were it viable. Rather, creditors pursue their individual collection remedies.In the likely equilibrium, all firms are liquidated, whether they are viable or not. Bankruptcy law automatically stays these private collection efforts, and then the bankruptcy court coordinates an investigation into the firm’s economic status, saving viable firms and liquidating the rest.

Bankruptcy law also restricts the ability of creditors and the debtor to contract about bankruptcy procedures in order to preserve the viability of a law that solves the coordination problem.For example, a contract clause permitting a supplier to end a contract if the firm becomes distressed is unenforceable: if every supplier were to exact such a clause from buyers, it is believed, even a financially distressed buyer would die. My essay, ‘Bankruptcy Related Contracting and Bankruptcy Functions’[1] shows that bankruptcy law’s contractual restrictions, such as the illustrative supplier/customer clause, are broader than the assumed need for them requires.

More importantly, the coordination problem that is said to justify the law is largely mythic. The problem is thought often to arise because firms’ typical capital structures are assumed to have equity and a set of symmetric small creditors. Capital structures are endogenous, however, so the question is why it would be optimal for a borrower to create a structure that makes it impossible privately to restructure its debt, and so makes bankruptcy inevitable. Not only is there no good answer to this question; the assumed capital structure is not found in nature. Rather, the theoretical capital structure literature predicts that common capital structures concentrate the senior debt. Lending agreements contain loan covenants whose primary function is to shift control of the firm to the senior creditors when a debtor becomes liquidity constrained. Creditors with such control have an incentive to liquidate any firm whose assets equal or exceed their debt. Optimal capital structures therefore impair the senior debt: the seniors hold collateral that would bring only a fraction of their claims. Impairing the senior debt gives the seniors a stake in the continuation value of the firm. Hence, the seniors have incentives to liquidate economically distressed firms but also to restructure borrowers whose continuation value exceeds their liquidation value. The theory thus predicts that much debt will be efficiently and privately restructured. This Essay then surveys the empirical capital structure literature, to show that the theory predicts what is observed: senior creditors are concentrated and impaired; loan covenants are ubiquitous; loans are frequently renegotiated; private restructurings are common; and a very small percentage of insolvencies eventuate in proceedings under the US bankruptcy code.

Theory and data thus raise two related, and largely novel, questions: Empirically, are the debtors that use the bankruptcy code, or the circumstances of those debtors, systematically different from the debtors and circumstances that obtain when the code is not used? Normatively, if there is no coordination problem, what problems should a bankruptcy law solve? This Essay introduces these questions but does not attempt to answer them, though it speculates briefly about the normative query. Rather, the Essay’s central claim is that bankruptcy scholarship should expand to consider what functions it is necessary for a corporate bankruptcy system to perform in light of the capital structures that actually exist.

Alan Schwartz is Sterling Professor of Law and Professor of Management at Yale University.

 


[1] This Essay is a draft chapter that has been accepted for publication by Edward Elgar Publishing in the forthcoming Handbook on Corporate Bankruptcy (Barry Adler Ed.) due to be published in 2017. Barry E. Adler, Douglas G. Baird, Alvin Klevorick, Robert Rasmussen, David Skeel and Mark Roe made helpful comments on a prior draft.