Bankruptcy’s Cathedral

What good can a corporate insolvency regime do in the modern economy? The question bears asking because the environment in which distressed companies find themselves is so markedly different from the environment of just twenty years ago—to say nothing of the days when equity receiverships and schemes of arrangement were dreamed up. The most important changes are well known: increased depth and liquidity of financial markets and, especially, increased capacity of financial contracting to say ex ante how distress will be resolved ex post. Recent efforts in the US to take stock of contemporary bankruptcy practice, most notably the American Bankruptcy Institute’s Chapter 11 reform project, grapple implicitly with the significance of a changing environment. But by leaving the matter implicit, they underscore a lacuna about what the law’s marginal contribution to the economic order might be.

In a forthcoming article, ‘Bankruptcy’s Cathedral’, I hazard a general answer and elaborate its implications for a few prominent uses of bankruptcy in today’s practice. 

The characteristic function of bankruptcy law, I say, is to recharacterize the mode in which an investor’s relationship to a distressed firm is governed. In particular, bankruptcy frequently toggles the protection of an investor’s economic interests from a property rule, in the Calabresi and Melamed sense, to a liability rule. It swaps out the investor’s unilateral right upon default to withdraw her investment, when such a right would ordinarily prevail, in favor of a judicially mediated procedure designed to give her the official value of her right. Chapter 11’s automatic stay furnishes an example. It extinguishes a secured creditor’s power to repossess and sell collateral, and supplies instead a right only to what the bankruptcy judge determines to be ‘adequate protection’ of its interest in the collateral.

This toggling function can be useful. Property rules are often more efficient during a company’s financial health than during distress. A state-contingent meta rule that switches between the two thus might be optimal. But what about financial contracting? Why can’t investors stipulate state-contingent meta rules if indeed they can maximize surplus by doing so? The short answer is that in some cases contract is sufficient, but in other cases legal or practical impediments are insuperable. The marginal contribution of bankruptcy law, then, is to supply toggling rules where investors cannot practically do so on their own.

One implication of my approach is to index the justifiable scope of bankruptcy to contingent facts about the efficacy of financial contracting. In environments where it is difficult for investors to specify state-contingent toggling rules, whether because of legal prohibition or practical impossibility, the compass for bankruptcy law is wider. As contract becomes more efficacious, bankruptcy’s brief grows correspondingly shorter.

This normative schema can be used to assess one-by-one the many actual interventions of bankruptcy laws. I scrutinize three uses of bankruptcy that are important in today’s practice: to confirm prepackaged plans, to effect going-concern sales, and to take advantage of the automatic stay. I find plausible justifications for a legal institution to bind holdout creditors and to extinguish in rem claims against a debtor’s assets. The automatic stay, on the other hand, is harder to justify. (The curious must read within to find out why.) More generally, though, my approach shows how one can weigh the contributions of a bankruptcy regime against its redundant or even counterproductive components in light of contracting innovations.

The article is available for download here.

Vincent Buccola is Assistant Professor of Legal Studies and Business Ethics at the Wharton School, University of Pennsylvania.