Copyright (c) 2025 the National Conference of Bankruptcy Judges
BANKRUPTCY’S REDISTRIBUTIVE POLICIES:
NET VALUE OR A “ZERO-SUM GAME”?
by
Steven L. Schwarcz*
With the assistance of Jack Tiedemann**
Although federal bankruptcy law, epitomized by chapter 11, has a pro-debtor—or at least, anti-liquidation—bias, no scholarship analyzes whether that bias creates net value or merely results in a zero-sum game that redistributes value from creditors to debtors. This article shows that the bias is due more to accidents of history, path dependence, and self-interested lobbying than to any reasoned analysis of value creation. The bias also is inconsistent with many foreign insolvency laws.
The article analyzes whether bankruptcy law should have such a pro-debtor bias. An empirical analysis of that question is not generally feasible because debtor and creditor costs and benefits in bankruptcy cannot be accurately quantified and compared. The article therefore engages in a second-best methodology: it builds on the pro-debtor shareholder-primacy model of corporate governance, which is widely viewed as maximizing value, by stressing that model under the circumstances of bankruptcy. This reveals two critical differences. First, creditors become the primary residual claimants of the firm, whereas shareholders are relegated to secondary residual claimant status. That changes the identity of the beneficiary of the “shareholder” primacy model, whose goal is to favor the firm’s primary residual claimants. Second, the covenants that normally protect creditors become unenforceable in bankruptcy, suggesting the need for additional creditor protection.
Utilizing these differences, the article proposes and assesses a “creditor-primacy” governance model for debtors in bankruptcy. It also examines how such a model could be applied to maximize bankruptcy value by increasing creditor recovery without unnecessarily jeopardizing shareholder return. The article recommends, for example, a threshold viability test that would require debtors that are unlikely to successfully reorganize, and therefore likely ultimately to liquidate, to be liquidated at the outset of a chapter 11 case. That test would save the considerable expenses of proceeding through bankruptcy, which can severely reduce creditor recovery. Such a test also should reduce agency costs and moral hazard. Furthermore, it should help to avoid the sunk-cost fallacy that leads to a disproportionately high number of supposedly reorganized debtors having to subsequently refile chapter 11 cases.
Introduction
Federal bankruptcy law, epitomized by chapter 11 of the Bankruptcy Code, is generally said to have a pro-debtor—or at least, anti-liquidation[1]—bias.[2] No scholarship, however, analyzes whether bankruptcy law should have such a bias.[3] The evolution of federal bankruptcy law indicates that the pro-debtor bias is due more to accidents of history, path dependence, and self-interested lobbying than to any reasoned analysis of value creation.[4] That unsystematic development invites skepticism of whether the pro-debtor bias actually creates net value or, instead, merely results in a zero-sum game that redistributes value from creditors to debtors.[5]
This article attempts to answer that question—whether the pro-debtor bias creates net value or merely results in a zero-sum game—by combining comparative law perspectives and analytical methodology. The methodology begins with the shareholder-primacy model of corporate governance, which is widely viewed as creating net value. It then stresses that model under the circumstances of chapter 11 bankruptcy, taking into account differences such as the primary residual claimants of the firm becoming creditors rather than shareholders and the reality that covenants, which normally protect creditors, are generally unenforceable in bankruptcy.
Based on the foregoing, the article proposes a new “creditor-primacy” governance model for chapter 11 debtors. It also examines how such a model could be applied to increase chapter 11’s net-value creation. In this context, among other things, the article proposes a “threshold viability test” that would require debtors that are unlikely to successfully reorganize, and therefore ultimately likely to liquidate, to be liquidated at the outset of a chapter 11 case. That test would save the considerable but wasteful expenses of proceeding through bankruptcy, which could seriously reduce creditor recovery. It also would help to avoid the sunk-cost fallacy that could drive false findings of viability at plan confirmation hearings, accounting for the all-too-many examples of post-confirmation debtors having to refile chapter 11 cases. Furthermore, a threshold viability test should help to reduce agency costs and moral hazard because a firm’s managers could not confidently take unnecessary pre-bankruptcy corporate risks to try to avoid chapter 11, assured they could fall back on chapter 11 to enable them to keep their jobs.
The article also demonstrates how a creditor-primacy governance model should improve chapter 11 debtor risk-taking. Moreover, the article proposes certain specific changes to provisions of chapter 11 that would help to facilitate the creditor-primacy model.
This article’s approach—grafting a normative analysis to improve net-value creation onto chapter 11’s otherwise widely accepted positive framework—is both pragmatic and has theoretical justification and precedent. Professor Bebchuk has used it, for example, by taking the existence of chapter 11 corporate reorganizations as a given to put forth a suggestion to improve the reorganization process.[6]
The article proceeds as follows. Part I discusses the evolution of the pro-debtor bias, starting with the pro-creditor bias of medieval bankruptcy law, then progressing to reforms based on commercial expansion and economic experimentation, and finally to more modern bankruptcy laws focused on debtor rehabilitation. Part II discusses comparative law perspectives, including European Union insolvency laws that include more pro-creditor biases. Part III then examines the legal, financial, and economic scholarship. It shows that no such scholarship attempts to assess whether a pro-debtor bias creates net value or merely results in a zero-sum game that redistributes value from creditors to debtors.
Part IV of the article engages in an analysis of whether a pro-debtor bias creates net value or merely results in a zero-sum game. It acknowledges the limits of an empirical analysis: one simply cannot quantify, much less accurately compare, debtor and creditor costs and benefits in bankruptcy. Part IV then proposes a second-best analytical methodology, starting by recognizing the existence of an almost universally accepted model for balancing the interests of debtors and creditors: the shareholder-primacy model of corporate governance. The analysis stresses the pro-debtor governance model under the realities of bankruptcy and tests how, if at all, that should change the model. Based thereon, Part IV then derives a normative bankruptcy-governance model, demonstrating that such a model should be more pro-creditor biased than existing law. Thereafter, Part IV pragmatically assesses the pro-creditor model, showing that it would add important positive benefits by reducing the cost of credit without undermining the fundamental benefits of a pro-debtor model.
Finally, Part V applies this pro-creditor bankruptcy-governance model to chapter 11 of the Bankruptcy Code, following the precedent of applying a normative analysis to assess positive bankruptcy law. Based thereon, Part V proposes a threshold viability test that should increase creditor recovery without unnecessarily jeopardizing shareholder return. Part V also shows how the article’s normative model should apply to corporate risk-taking in bankruptcy. Additionally, Part V critiques and suggests improvements to several provisions of the Bankruptcy Code in light of that model.
I. Evolution of the Pro-Debtor Bias
The evolution of the pro-debtor bias reflects a gradual historical shift from a strongly pro-creditor bias, involving debtor punishment and creditor dominance, toward debtor rehabilitation and an aversion to liquidation, sometimes at the expense of creditors.
A. Medieval Bankruptcy Law
Bankruptcy law as we know it has medieval antecedents.[7] Medieval bankruptcy law generally was punitive to debtors, rooted in the belief that financial failure was due to a moral fault, deserving of retribution.[8] In England, the common law allowed creditors to imprison debtors indefinitely, with debtor prisons functioning as a coercive mechanism to compel repayment.[9] This practice prioritized creditor recovery over economic continuity or rehabilitative goals, often consigning debtors to lifelong financial ruin.[10]
The Statute of Bankrupts, enacted in 1542, represented the first formal codification of bankruptcy law in England. It introduced collective proceedings for liquidating a debtor’s estate and distributing the proceeds among creditors.[11] The statute treated bankruptcy as a quasi-criminal offense, offering no discharge or relief to debtors.[12] This approach reinforced the stigma of insolvency without regard for possible harm to debtors and the broader economy.[13]
Nonetheless, despite its harshness, the Statute of Bankrupts introduced the principle of collective creditor action, laying the groundwork for more sophisticated bankruptcy systems.[14] This principle recognized the inefficiencies of creditors individually pursuing remedies, which often led to inequitable recoveries and dissipation of the debtor’s estate.[15] The Statute of Bankrupts empowered authorities, including the Lord Chancellor and other high-ranking officials, to seize debtor assets on behalf of the creditors. The officials then liquidated the assets and distributed the proceeds to creditors on a proportional basis, embodying the pari passu principle.[16]
B. Eighteenth-Century Reforms: Commercial Expansion and Economic Rationality
The rise of trade and commerce during the 18th century exposed the inadequacies of debtor-punitive bankruptcy laws. Financial failures were increasingly seen as exogenous consequences of market forces rather than endogenous moral failings, prompting lawmakers to adopt more debtor-rehabilitative approaches.[17] The Bankruptcy Act of 1705 (England) was a significant milestone, introducing discharge provisions for cooperative debtors who surrendered their assets for distribution among creditors.[18] This innovation marked a shift toward recognizing the economic value of allowing debtors to reenter the productive economy rather than languishing in prison.[19]
The Bankruptcy Act of 1706 (England) (“1706 Act”) introduced even further innovation by allowing honest but insolvent debtors to obtain a discharge of their debts upon full disclosure of assets and compliance with procedural requirements.[20] This statute marked a departure from earlier punitive frameworks that treated bankruptcy primarily as a criminal offense.[21] However, the Act maintained a strong emphasis on creditor protection by imposing rigorous standards for debtor honesty and cooperation.[22]
The Commonwealth of Pennsylvania’s 1730 insolvency statute reflected early American adaptations of English bankruptcy principles. The statute permitted insolvent debtors to obtain a discharge upon the surrender of their assets, provided they demonstrated good faith in their dealings with creditors.[23] Like the 1706 Act, Pennsylvania’s statute balanced relief for honest debtors with safeguards to protect creditor interests.[24]
These statutory reforms were groundbreaking in introducing limited discharge provisions for cooperative debtors, reflecting a nascent recognition of economic misfortune as distinct from moral failure.[25] However, the reforms continued to privilege creditor interests through restrictive provisions and high evidentiary burdens.[26] For instance, the 1706 Act required debtors to surrender all their property and prove compliance with statutory requirements, ensuring creditors retained significant leverage over debt recovery processes.[27] Similarly, Pennsylvania’s 1730 statute permitted discharge only for debtors who could convincingly demonstrate honesty and a complete lack of fraud.[28] Nevertheless, they signaled a growing recognition of the need for a more balanced debtor-creditor approach to bankruptcy.[29]
C. Early U.S. Bankruptcy Law: Experimentation and Adaptation
The United States inherited English bankruptcy law traditions. Early federal bankruptcy statutes, such as the Bankruptcy Act of 1800, of 1841, and of 1867, emphasized debtor liquidation and creditor recovery, mirroring the creditor-centric principles of their English predecessors.[30] These laws provided creditors with significant power to initiate bankruptcy proceedings and seize debtor assets.[31] They offered little relief or discharge for debtors, reflecting a continuing skepticism of bankruptcy as anything other than a personal failing.[32]
Public dissatisfaction with these laws ultimately led to their repeal. Critics argued that liquidation-focused frameworks failed to address the increasingly systemic economic risks posed by the sudden failure and liquidation of huge firms.[33] These risks included widespread unemployment and community destabilization.[34] To try to reduce these risks, states experimented with their own bankruptcy statutes, creating a fragmented, inconsistent, and unpredictable legal landscape that underscored the need for comprehensive federal bankruptcy reform.[35]
In the late 19th century, these concerns gained prominence with a series of large-scale railroad failures.[36] Railroads were the lifeblood of the industrializing American economy, connecting vast regions and enabling the efficient movement of goods, people, and resources.[37] Many railroads struggled under crushing debt loads caused by overexpansion and speculative financing.[38] The cessation of railroad operations threatened to undermine regional economies and paralyze industries dependent on reliable transportation.[39]
The liquidation offered under federal bankruptcy laws was not a viable option for railroads. Dismantling and selling off railroad assets piecemeal would destroy the value of the rail network.[40] Furthermore, liquidation would complicate creditor repayment because many railroad companies were amalgamations of smaller railroads, each with its own creditor groups.[41]
Responding to these challenges, the use of railroad equity receiverships played a foundational role in the development of U.S. bankruptcy law. In a receivership, courts used their equitable powers to appoint, at the request of creditors, a neutral third party to manage the debtor’s assets, allowing the debtor to continue operating while working to satisfy creditor claims.[42] This approach ensured operational continuity and enabled railroads to meet public transportation needs, even in financial distress.[43] Paul Cravath, a prominent attorney of the era, further refined the railroad receivership by standardizing legal frameworks that prioritized both creditor protections and reorganizational efficiency, including using creditors’ committees to centralize decisionmaking and implementing comprehensive plans for reorganizing the railroad’s capital structure.[44]
In parallel with railroad receiverships, informal out-of-court workouts also shaped early U.S. approaches to financial distress.[45] Before federal bankruptcy law offered a reliable restructuring framework, distressed businesses often negotiated directly with creditors to reach partial repayment agreements—so-called compositions—without involving the courts.[46] These arrangements were fragile, as they required unanimous creditor consent, but they reflected a commercial ethos that prioritized business continuity and cooperative adjustment over liquidation.[47] Despite their limitations, such consensual workouts played a meaningful role in preserving viable enterprises in the absence of formal reorganization law.[48]
D. Bankruptcy Laws Focused on Debtor Rehabilitation
These lessons—avoiding harsh liquidations and allowing the debtor to continue operating while working to satisfy creditor claims, standardizing legal frameworks to prioritize both creditor protections and reorganizational efficiency, using creditors’ committees to centralize decisionmaking, and fostering the negotiated settlement of comprehensive plans for reorganizing the debtor’s capital structure—heavily influenced the drafting of the Bankruptcy Act of 1898 (“Bankruptcy Act”), the first federal statute focused on rehabilitating business entities.[49] Drawing directly from the equity receivership model, the Bankruptcy Act introduced provisions for corporate reorganization generally with the goal of allowing debtors to restructure their indebtedness while preserving the value of their businesses.[50] The Chandler Act of 1938 reinforced this evolution by amending and supplementing the Bankruptcy Act to respond to the economic and political pressures of the Great Depression.[51] As so amended and supplemented, the Bankruptcy Act created a more formal structure for corporate reorganization, further prioritizing business survival over liquidation.[52]
The Bankruptcy Reform Act of 1978[53] codified the Bankruptcy Code, including its focus on rehabilitating business entities, represented by chapter 11.[54] Chapter 11 is said to have a pro-debtor bias,[55] allowing firms to continue operating in bankruptcy while attempting to restructure their indebtedness and also significantly expanding debtor protections, introducing provisions such as the automatic stay which provides debtors with breathing room to reorganize while maintaining operational continuity.[56] Proponents of chapter 11 argue that these protections help to preserve jobs and preserve economic stability, thereby avoiding the destructive consequences of liquidation.[57]
Critics of chapter 11 contend, however, that its approach is inefficient, incentivizing mismanagement and delaying necessary liquidations, often to the detriment of creditors. Critics such as Professors Bradley and Rosenzweig argue, for example, that chapter 11 creates agency costs because a firm’s managers can use it to keep their jobs, even in bankruptcy.[58] They also argue that chapter 11 fosters moral hazard because it incentivizes managers to take unnecessary pre-bankruptcy corporate risks to try to avoid bankruptcy, confident they could keep their jobs if the risks fail.[59] Additionally, critics contend that the pro-debtor bias can benefit insiders—managers and equity holders—at the expense of creditors.[60]
Critics also observe that the enactment of the Bankruptcy Code was heavily lobbied by self-interested parties, including lawyers and other members of the bankruptcy bar.[61] Although these parties argued that chapter 11’s pro-debtor provisions were crafted for economic efficiency,[62] their arguments masked the professional and financial benefits those provisions conferred on the bankruptcy bar.[63] For example, lawyers advocated for the automatic stay provision (§ 362), ostensibly to protect debtors and preserve the status quo during reorganizations; the real purpose, however, may have been to require creditors to initiate costly litigation to modify or lift the stay, ensuring greater demand for legal services.[64] The debtor-in-possession framework under chapter 11 was justified on the grounds of operational continuity, claiming that existing management could better guide a struggling firm through reorganization; in practice, though, it allowed debtor-side lawyers to maintain lucrative relationships with entrenched management.[65]
Similarly, the debtor exclusivity period to file a plan of reorganization (§ 1121) was initially proposed as necessary to give debtors time to craft viable reorganization plans without interference from competing creditor proposals.[66] Some suggest, however, that this provision was intended to significantly shift leverage to debtors, enabling them to delay negotiations and prolong bankruptcy proceedings at the expense of creditors.[67] Extending the timeline would give debtor-side lawyers the opportunity to increase their billable hours and overall fees.[68]
Critics also could have observed that chapter 11’s pro-debtor orientation has been somewhat path dependent, developing from the historical quirk that the modern formation of bankruptcy law arose in connection with preserving the railroad network, which was vital to the industrializing American economy.[69] One might argue that railroads then, like systemically important financial institutions (“SIFI”s) today,[70] constitute a special case that should be protected by bespoke alternative resolution mechanisms.[71]
II. Comparative Law Perspectives
The foregoing transformation from pro-creditor to pro-debtor bias does not necessarily reflect the development of bankruptcy law outside of the United States. Many advanced economies have developed bankruptcy—often called “insolvency”[72]—regimes that more evenly balance debtor and creditor interests. A comparison with those laws calls into question the legitimacy of the U.S. pro-debtor bias.
For example, Germany and the United Kingdom adopt balanced approaches that prioritize early intervention and creditor protection. Germany’s recently enacted Act on the Stabilization and Restructuring Framework for Companies[73] allows for preventative restructuring measures outside formal insolvency proceedings.[74] This framework emphasizes early creditor engagement, enabling parties to address financial distress proactively while avoiding court-imposed resolutions. By shifting the focus toward negotiated solutions, it seeks to preserve value without granting debtors undue advantages.[75]
Similarly, the UK’s Corporate Insolvency and Governance Act 2020 introduces restructuring mechanisms that blend debtor flexibility with creditor oversight.[76] The cross-class cramdown provision[77] allows restructuring plans to bind dissenting creditor classes, but only if the plan satisfies rigorous judicial scrutiny.[78] The “no creditor worse off” test ensures that dissenting creditors receive at least as much as they would in liquidation.[79] These requirements prevent debtors from exploiting the restructuring process, while still allowing for value-maximizing reorganizations.[80] The UK Act thus illustrates a middle ground, prioritizing equitable treatment for creditors while recognizing the potential benefits of reorganization.[81]
The European Union’s Restructuring Directive (Directive 2019/1023)[82] also provides EU member states with significant flexibility to tailor insolvency restructuring frameworks based on their legal traditions and economic needs.[83] This flexibility underscores a core difference between the U.S. and European approaches: whereas U.S. bankruptcy law tilts heavily in favor of debtors, the EU promotes more flexibility to balance creditor and debtor interests.
III. Existing Scholarship
As next discussed, no scholars have seriously attempted to analyze whether U.S. bankruptcy law’s policies, which favor debtor rehabilitation over creditor recovery, create net value or instead result in a zero-sum game that merely redistributes value from creditors to debtors.
A. Legal Scholarship
Bankruptcy scholars have long grappled with the competing priorities of liquidation and reorganization, examining such normative objectives as promoting efficiency, fairness, and economic stability.[84] The literature is largely confined, however, to describing those objectives and other relevant considerations and examining how bankruptcy might affect them. No legal scholars have analyzed whether favoring debtor rehabilitation over creditor recovery actually creates net value.
Professor Warren, for example, emphasizes that debtor rehabilitation can preserve jobs, stabilize communities, and mitigate the broader economic consequences of firm failure.[85] She frames corporate reorganization as a societal imperative, claiming that its benefits often extend beyond the immediate stakeholders to include local economies and national economic stability.[86] Her work, however, assumes that these benefits can outweigh the costs to creditors without providing any proof.
Professor Baird critiques bankruptcy law’s emphasis on debtor rehabilitation, arguing that liquidation often can reallocate corporate resources to more productive uses.[87] He contends that by entrenching failing firms, chapter 11’s pro-reorganization policies can waste valuable resources that should be redirected to more viable enterprises.[88] As with Professor Warren, however, Professor Baird’s arguments are descriptive without rigorously weighing costs and benefits.
B. Financial and Economic Scholarship
Although financial and economic scholars have also contributed to the debate over the pro-debtor bias of U.S. bankruptcy law, their analyses often focus narrowly on specific policy outcomes. Professor Jackson, for instance, has studied the importance of bankruptcy law in resolving collective action problems among creditors.[89] Other financial and economic scholarship has attempted to quantify the costs associated with protracted corporate reorganizations, but fails to assess whether any benefits offset, much less exceed, those costs.[90] Similarly, the scholarship on job preservation and economic stability focuses on benefits without attempting to compare costs.[91] Moreover, that scholarship tends to examine localized effects.[92]
Some financial and economic scholarship offers additional perspectives on the more balanced views of foreign bankruptcy regimes. For example, studies on Germany’s Act on the Stabilization and Restructuring Framework for Companies[93] and the UK’s Corporate Insolvency and Governance Act[94] highlight the economic benefits of early intervention and creditor engagement.[95] These studies, however, focus primarily on quantifying creditor recoveries without attempting to assess whether those recoveries justify the pro-creditor bias.[96] Moreover, these German and UK statutes appear to be moving to more of a pro-debtor bias,[97] so any comparison of those laws with chapter 11 is imprecise at best.
In short, the existing legal, financial, and economic scholarship fails to address whether U.S. bankruptcy law’s pro-debtor bias, or even whether foreign insolvency law’s occasional pro-creditor bias,[98] creates net value or instead results in a zero-sum game that merely redistributes value from creditors to debtors. This article seeks to engage that analysis.
IV. Analysis
As subpart A below shows, there is a reason why scholars have not quantified the costs and benefits of U.S. bankruptcy law’s pro-debtor bias: there are practical limits to performing such an empirical analysis. This Part IV therefore attacks the problem more obliquely by analyzing how to design a bankruptcy-governance model that maximizes the expected value of corporate reorganizations. This focus accords with normative decision theory, that good social policy should maximize expected value—in this case, aggregate monetary value.[99]
The analysis proceeds by a second-best methodology. The article recognizes the existence of an almost universally accepted model, “shareholder primacy,” for generally balancing the interests of debtors and creditors. The article then stresses that model under the realities of bankruptcy. This methodology shows, at least in theory, that a pro-creditor bankruptcy-governance model should maximize the expected value of corporate reorganizations more than a pro-debtor model. The article then pragmatically assesses a pro-creditor model, showing that it should provide important positive benefits by reducing the cost of credit without undermining the fundamental benefits of a pro-debtor model.
A. Limits to an Empirical Analysis
A perfect analytical methodology would be empirical.[100] The problem, though, is that it is impossible generally to quantify, much less accurately to compare, debtor and creditor costs and benefits in bankruptcy.[101] One cannot even compare the costs and benefits of debtors and creditors that go through chapter 11 bankruptcy with those of debtors and creditors that go through a more pro-creditor-biased bankruptcy proceeding: such a more pro-creditor-biased but otherwise federal-bankruptcy-comparable system simply does not exist.
The closest empirical analysis of the costs and benefits of a pro-debtor bankruptcy system comes from Poland, which in the last decade changed the pro-creditor bias of its bankruptcy proceedings to pro-debtor.[102] Several finance scholars attempted to assess the impact of this change through what they identified as “the major determinants connected with the effectiveness of bankruptcy law,” including the rate of debt recovery, funds obtained by the receiver, costs of bankruptcy proceedings, and efficiency ratio measured by recovered debts divided by costs of bankruptcy proceedings.[103] They concluded that “the new pro-debtor model of bankruptcy proceedings implemented in Poland from 1 January 2016 is less effective than the pro-creditor model of bankruptcy proceedings was,” and that “the pro-creditor model of bankruptcy proceedings had a higher efficiency ratio than the pro-debtor model of bankruptcy proceedings now has.”[104] They caution, however, that their analysis has numerous limitations, and that the “research undertaken in this area should be continued and further discussed, because the presented model of insolvency is quite new.”[105]
B. Proposing a Second-Best Analytical Methodology
This article proposes a second-best analytical methodology.[106] It starts by recognizing the existence of an almost universally accepted model for generally balancing the interests of debtors and creditors: the shareholder-primacy model of corporate governance.[107] Under that model, managers are expected to govern the firm solely for the best interests of its shareholders[108]—who stand in for the debtor.[109] Universal acceptance evidences a presumption that the model maximizes value.[110]
In subpart C below, the article stresses this governance model under the realities of bankruptcy and tests how, if at all, that should change the model. The changed model arguably would balance the interests of debtors and creditors to maximize value by increasing creditor recovery without unnecessarily jeopardizing shareholder return. This approach of grafting a normative analysis onto a widely accepted positive framework has strong precedent.[111]
C. Using the Methodology to Derive a Bankruptcy-Governance Model
The realities of bankruptcy would stress the shareholder-primacy governance model in at least two ways. As next shown, these stresses remove both justifications—that shareholders are the firm’s primary residual claimants, and that creditors are protected by covenants—for favoring a firm’s shareholders over its creditors. Furthermore, these stresses cause creditors to become the debtor-firm’s primary residual claimants by subordinating shareholder residual claims to creditor residual claims.
1. In bankruptcy, creditors become the firm’s primary residual claimants. A significant justification for the shareholder-primacy governance model is that shareholders are the firm’s primary residual claimants.[112] This means that shareholders are primarily motivated to engage the firm in positive expected-value projects because every dollar of profit would first redound to their benefit.[113] The realities of bankruptcy would reverse that justification.
Because virtually all firms in bankruptcy are either insolvent or illiquid (or both),[114] creditors replace shareholders as the firm’s primary residual claimants.[115] Creditor claims—to which shareholder claims are subordinated[116]—become residual claims until the debtor regains solvency and liquidity,[117] which normally does not occur until confirmation (at or towards the end) of the bankruptcy case.[118] Until confirmation, creditors are the parties primarily motivated to engage the firm in positive expected-value projects because every dollar of profit would first redound to their benefit.[119]
2. In bankruptcy, creditors are no longer protected by covenants. The other important justification for the shareholder-primacy governance model is that creditors often are contractually protected by covenants.[120] The realities of bankruptcy would also reverse, or at least remove, that justification.
Bankruptcy excuses firms from complying with financial covenants, such as covenants to maintain solvency or otherwise achieve a targeted financial condition.[121] Firms in bankruptcy also no longer need to comply with many covenants in loan or other financing agreements.[122] Absent covenant protection—again, this article’s normative analysis starts with certain positive assumptions as to bankruptcy[123]—a bankruptcy-governance model should treat shareholders and creditors neutrally as investors, other than regarding their status as residual claimants of the debtor.
As subparts 1 and 2 above show, bankruptcy reverses the justifications for the shareholder-primacy governance model, replacing shareholders with creditors as the primary residual claimants and the parties needing protection. In theory, therefore—and as this article later shows, in practice too[124]—creditor-primacy should be the appropriate bankruptcy-governance model.
D. Articulating a Creditor-Primacy Bankruptcy Governance Model
Under a creditor-primacy bankruptcy-governance model, directors should manage the debtor to engage in positive expected value risk-taking that increases creditor recovery (creditors being the primary residual claimants) without unnecessarily jeopardizing shareholder return (shareholders being the secondary residual claimants).[125] In a different, but related, context in the “vicinity of insolvency” a firm’s directors should “scrutinize actions that increase shareholder return by impairing creditor claims,” the “more insolvent the corporation is or would become, the more the fiduciary obligation shifts from shareholders to creditors, in a continuum,” and in “balancing this fiduciary obligation, directors should have latitude to make their own good faith balancing of benefit and harm, recognizing that harm to creditors may well be more significant than benefit to shareholders; and therefore the benefit might have to considerably outweigh the harm, or at least provide a compelling case, to be justified.”[126] In a bankruptcy context, that balance should shift even more to creditors.
Applying that balancing to the bankruptcy context yields the following model:
1. Directors should manage the debtor to engage in positive expected value risk-taking that increases creditor recovery.[127]
2. Directors should nonetheless give regard to protecting shareholders by scrutinizing actions that could increase creditor recovery by unduly impairing shareholder return. This recognizes that, if and when creditors are paid, shareholders again become the residual claimants.
3. Directors should have latitude provided by the business-judgment rule to make their own good faith balancing of benefit to creditors and harm to shareholders. Directors nonetheless should recognize that human nature tends to weigh harm more heavily than benefit. They therefore may wish to demonstrate that the expected benefit of an action should at least materially exceed the harm.
E. Pragmatically Assessing the Model
This article has theoretically derived a creditor-primacy bankruptcy-governance model. Theory may be inadequate, though, if using the model could be harmful in practice, such as by causing unnecessary job loss. This subpart E pragmatically assesses the model, showing that it should provide important positive benefits by reducing the cost of credit without undermining the fundamental benefits of a pro-debtor biased model.
1. The Model should help to reduce the cost of credit. A creditor-primacy bankruptcy-governance model should help to reduce the uncertainty created by bankruptcy law’s pro-debtor bias.[128] Under that bias, pre-petition creditors cannot always expect to be able to enforce their contractual and commercial law rights.[129]
Uncertainty can increase the cost and reduce the availability of credit.[130] The National Bureau of Economic Research has found, for example, that “uncertainty has a direct effect on investment” and that “greater uncertainty tends to make investment less desirable”[131] and “exerts a strong negative influence on investment.”[132] Courts also have expressed concern. The United States District Court for the Southern District of New York has observed that uncertainty “would both impair bank financing and increase the costs of obtaining such financing.”[133] The Seventh Circuit likewise has observed that investors influenced by the uncertainty of debt recovery might prefer not “to lend or invest in the future,” causing “the cost of credit [to] rise for all.”[134] Uncertainty also creates a deleterious impact on “households’ access to small credit”[135] and “leads to higher loan interest rates and default probabilities.”[136]
A creditor-primacy bankruptcy-governance model should reduce uncertainty by making it more likely that pre-petition creditors can enforce their contractual and commercial law rights.[137] That, in turn, should help to reduce the cost and possibly also increase the availability of credit.
2. The Model should not undermine the fundamental benefits of a pro-debtor bias. A creditor-primacy bankruptcy-governance model would reverse bankruptcy law’s pro-debtor bias. Proponents of that bias argue, however, that it helps to preserve jobs and economic stability by avoiding the liquidation of firms.[138]
Admittedly, avoiding the liquidation of a firm would help, at least temporarily, to preserve the jobs associated with the firm. The problem, though, is that if the firm is not otherwise economically viable, it is likely ultimately to fail (causing a loss of those jobs).[139] Furthermore, as Professor Baird observes, avoiding, or perhaps even delaying, the liquidation of a non-viable firm could waste valuable resources that should be redirected to more viable and productive enterprises.[140] Reversing bankruptcy law’s pro-debtor bias therefore should not, at least in the long run, necessarily reduce jobs.
Nor should reversing bankruptcy law’s pro-debtor bias impair, much less relate to, economic stability. In response to the global financial crisis of 2008, Congress enacted the Dodd-Frank Act,[141] which mandates the designation of SIFIs.[142] It also exempts SIFIs from the Bankruptcy Code and provides alternative resolution mechanisms that are intended to preserve systemic economic stability.[143] This article’s proposal for a creditor-primacy bankruptcy-governance model would not, therefore, apply to SIFIs.
This article does not purport to critique the merits of the Dodd-Frank Act’s alternative resolution mechanisms for SIFIs, nor does it examine what governance models apply, or should apply, to those mechanisms.[144] The article merely points out that the exclusion of SIFIs from the Bankruptcy Code removes an important rationale for retaining debtor-primacy.
V. Applying the Creditor-Primacy Bankruptcy-Governance Model
This article has shown that a creditor-primacy bankruptcy-governance model should have both theoretical and pragmatic justification. Next, the article considers how such a model should apply in practice. To that end, subpart A introduces a new concept, a “threshold viability test,” which could significantly facilitate the goals of a creditor-primacy bankruptcy-governance model. Subpart B examines how creditor-primacy should apply to a debtor’s risk-taking in bankruptcy. Finally, subpart C examines specific provisions of the Bankruptcy Code that should be reconsidered in light of creditor-primacy.
A. Threshold Viability Test
This subpart’s proposal for a threshold viability test could significantly facilitate the goals of a creditor-primacy model. If (as this article argues) the purpose of bankruptcy law should be to increase creditor recovery without unnecessarily jeopardizing shareholder return,[145] debtors that are unlikely to successfully reorganize should be forced to liquidate at the outset of a bankruptcy case. That would save the considerable expenses of proceeding through bankruptcy, of which the direct costs alone have been estimated at “1-2 percent the value of a debtor’s assets in larger cases and 4-5 percent in smaller cases.”[146] In chapter 11, the debtor directly or indirectly pays virtually all of these expenses, which seriously reduces creditor and, if applicable, shareholder recovery.[147] Requiring such liquidation would, of course, undercut bankruptcy’s current anti-liquidation bias and jeopardize shareholder return.[148] Nonetheless, that requirement would be reasonable and would not unnecessarily jeopardize shareholder return[149] if, as above proposed, it is limited to debtors that are ultimately likely to liquidate.[150]
Ironically, the Bankruptcy Code technically allows bankruptcy judges to convert a chapter 11 reorganization to a chapter 7 liquidation at any time during the bankruptcy case, for cause.[151] “Cause” includes “substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation.”[152] In theory, therefore, this conversion option already should help to avoid the costs of a non-viable debtor continuing to operate in chapter 11. In practice, though, judges are highly reluctant to convert a chapter 11 reorganization to a chapter 7 liquidation if the debtor objects.[153]
To implement a threshold viability test, bankruptcy law could require chapter 11 debtors to demonstrate at the outset of the case that they are likely—or at least, not unlikely—to successfully reorganize.[154] The Bankruptcy Code already has a viability (sometimes called feasibility) test as a condition precedent to plan confirmation.[155] However, confirmation normally occurs at or towards the end of the case, which can be extremely costly if the debtor, in retrospect, is not viable.[156] A threshold viability test should help to avoid these costs.
Furthermore at the time of plan confirmation,[157] the already invested costs can create a sunk-cost fallacy: the “tendency to continue investing in a losing proposition because of what it’s already cost us.”[158] This fallacy can distort findings of viability, accounting for the disproportionately high number of post-confirmation debtors having to refile chapter 11 cases (jokingly often called “chapter 22s” or, in the rare example (like Continental Airlines) of filing for a third time, “chapter 33s”).[159] A threshold viability test also should help to avoid that fallacy.[160]
Moreover, a threshold viability test should help to reduce agency costs and moral hazard.[161] It should reduce agency costs because a firm’s managers cannot, as Bradley & Rosenzweig suggest,[162] be confident in using chapter 11 to keep their jobs. It should reduce moral hazard because managers would be reluctant to take unnecessary corporate risks to try to avoid bankruptcy if their jobs would likely be lost at the outset of a chapter 11 bankruptcy filing that fails the threshold viability test.[163]
Debtors that represent a “good company, bad balance sheet” should successfully pass a threshold viability test.[164] This means that the debtor has an inherently good business but too much debt.[165] Chapter 11 is a valuable tool to help financially troubled firms reorganize their capital structure—for example, reduce their debt in exchange for issuing new equity—in order to become financially viable.[166] In contrast, a debtor with an inherently bad business ultimately will be likely to fail even if it is temporarily able to reduce its debt.[167]
That raises at least two questions: (i) Who should perform the threshold viability test?; (ii) Who should assess the outcome of the test? For the first question, private for-profit valuation and investment banking firms like Houlihan Lokey may well be able to perform a viability test. These types of firms routinely assess a debtor’s asset values, financial stability, and feasibility under § 1129(a)(11),[168] the plan confirmation viability test.[169] Experience shows that parties are often able to assess a debtor’s viability at the outset of a chapter 11 case.[170] For example, rating agency Fitch recommends that a lender consider providing debtor-in-possession (“DIP”) financing only if the lender determines, at the outset of the bankruptcy case when DIP financing is needed, that although the debtor has a bad balance sheet, it has an inherently good business—in other words, the “good company, bad balance sheet.”[171]
One might ask why markets themselves do not effectively provide a threshold viability test. After all, according to the Fitch criteria, a bad-company, bad-balance-sheet debtor should not qualify for DIP financing.[172] Absent post-petition financing, many debtors with limited or restricted liquid assets may be unable to meet post-petition obligations as required to continue operating in bankruptcy and would have to liquidate.[173] At least part of the answer is that lenders do not always hew to the good-company, bad-balance-sheet DIP-lending ideal. The Bankruptcy Code offers lenders high degrees of repayment priority, including superpriority claims and liens, to induce them to extend DIP financing.[174] The Bankruptcy Code also assures DIP lenders, if acting in good faith, that these superpriority claims and liens cannot be compromised.[175] DIP lenders thus have strong repayment protection, even if the debtor ultimately liquidates. Furthermore, a bad-company, bad-balance-sheet debtor may well be able to obtain DIP financing if it pays a high enough interest rate to offset the liquidation risk.[176]
For the second question, who should assess the outcome of the threshold viability test, the bankruptcy judge is likely best situated and, by experience, most able to make that determination. As an alternative, the United States Trustee Program (“UST Program”)—civil servants within the Attorney General’s office of the U.S. Department of Justice who are appointed to “supervise the administration” of chapter 11 cases[177]—could be tasked with assessing the outcome of the threshold viability test. U.S. Trustees already conduct an initial viability analysis of small businesses that are in bankruptcy under subchapter V of chapter 11 based primarily on information provided by the debtor.[178] Preliminary studies indicate, at least in that context, that their supervision can help to assure that only firms with viable businesses proceed with chapter 11 reorganization.[179] While the UST Program employs financial analysts to assist with their statutory duties, a wholesale evaluation of the viability of each chapter 11 case would likely be beyond the capacity of the program as currently constituted (even if, as under subchapter V, the viability analysis were based solely on information provided by the debtor).
The implementation of a threshold viability test, which likely would require an amendment to the Bankruptcy Code, almost certainly would face political challenges.[180] Lawyers and other members of the bankruptcy bar[181] might oppose it because it would reduce the number of active chapter 11 cases, and thus impact their livelihood. Strict traditionalists might oppose it if they believe that even economically non-viable debtors should be kept operating in order to preserve jobs and support local communities.[182] From a social policy standpoint, however, that political opposition would be unjustified to the extent it protects net negative value bankruptcy outcomes.[183]
Another possible objection to a threshold viability test might be that it could introduce delay at the beginning of the case, which could be worrisome for cases that need a rapid resolution. In those cases, however, the parties could consider proceeding via a pre-packaged bankruptcy under § 1126(b) of the Bankruptcy Code, which is designed for rapid resolution.[184] That approach should avoid the requirement for a viability test because it bypasses the debtor’s need to operate in chapter 11. Rather, in a pre-packaged bankruptcy (or “pre-pack”), the debtor negotiates the terms of a reorganization plan with its creditors—at least with those creditors whose claims are proposed to be restructured in the plan—and then solicits their votes on the plan in accordance with applicable securities laws, before filing a bankruptcy petition.[185] If and when the plan receives votes that satisfy the § 1126 supermajority voting necessary to approve the plan in bankruptcy,[186] the debtor files its bankruptcy petition accompanied by the proposed plan and voting documentation.[187] Bankruptcy courts typically confirm a pre-pack plan in the first two months of the bankruptcy filing.[188]
B. Corporate Risk Taking
The next consideration is how the creditor-primacy bankruptcy-governance model would apply to a debtor’s risk-taking in bankruptcy. In many cases, a chapter 11 debtor operates in bankruptcy as a going concern,[189] with the ultimate goal of reorganizing to become financially viable.[190] It therefore should consider taking business risks—not unlike a firm outside of bankruptcy—in order to gain profitability.[191] This can create difficult choices depending on the chances of success and failure and the benefits and costs of each risk-taking engagement.
A firm outside of bankruptcy should consider engaging in a risk-taking project that has a positive expected value to its shareholders, the primary residual claimants.[192] In bankruptcy, though, the debtor-firm’s creditors are its primary residual claimants. Logically, therefore, as articulated in Part IV.D, a debtor-firm should consider engaging in a risk-taking project that has a positive expected value to its creditors. Nonetheless, because the debtor-firm’s shareholders are also residual claimants (albeit with lower priority), fairness should require the project to either benefit or at least not impair the firm’s shareholders.[193]
For example, consider an insolvent chapter 11 debtor with $100 of assets and $150 of liabilities. The debtor is considering investing $75 in a project that has a 60% chance of success, which would yield a $120 return. The project’s failure would lose the full $75. The expected-value calculation would be as follows[194]:
Expected Value (EV) = (0.60 x $120) + (0.40 x $-75) = $72 – $30 = $42.
This project yields a positive expected value overall. Thus, it would primarily benefit the debtor’s creditors, being the primary residual claimants. Furthermore, the project either should benefit or at least not directly impair the debtor’s shareholders. If the project is successful, it would benefit those shareholders because the $120 return would make the debtor solvent.[195] If the project fails, it should not directly impair those shareholders because the debtor was insolvent to begin with. This analysis—that a project that yields a positive expected value overall should benefit, or at least not directly impair, the debtor’s shareholders—should apply for most debtors because virtually all firms in bankruptcy are either insolvent or illiquid, or both.[196]
That raises a question, though, whether—and if so, the extent to which—making the debtor more insolvent should be regarded as indirectly impairing shareholders.[197] Prior to the project, the debtor was $50 insolvent ($100 assets minus $150 liabilities). If the project fails, the debtor would become $125 insolvent ($100 assets minus $75 loss on the project minus $150 liabilities). This article proposes that managers should have discretion to balance the benefit to creditors and potential benefit to shareholders with any such impairment of shareholders, and that managers should be protected by the business-judgment rule so long as they act in good faith.[198]
In exercising that discretion, some managers might wish to compare the expected value of the project to the shareholders alone, taking into account any direct or indirect impairment. A positive expected value would then even more clearly justify the project. For the above example, the expected value of the project to the shareholders could be calculated as follows:
EV to Shareholders = (0.60[199] x ($120[200] – $50[201])) + (0.40[202] x $-75[203]) = $42 – $30 = $12.
That positive expected value to the shareholders should clearly justify the project.
For another example, consider a slightly solvent chapter 11 debtor with $100 of assets and $95 of liabilities. The debtor is again considering investing $75 in a project that has a 60% chance of success, which would yield a $120 return, but the project’s failure would lose the full $75. The overall expected-value calculation would yield the same result:
Expected Value (EV) = (0.60 x $120) + (0.40 x $-75) = $72 – $30 = $42.
Again, this project yields a positive expected value overall and thus would primarily benefit the debtor’s creditors. However, the project’s failure would actually impair the debtor’s shareholders because it would wipe out their $5 residual claim ($100 assets minus $75 loss on the project minus $95 liabilities = $-70). It also could be regarded as indirectly impairing those shareholders by making the debtor $70 insolvent. In contrast, though, the project’s success would benefit those shareholders by increasing their equity value from $5 to $125 ($100 assets plus $120 return minus $95 liabilities = $125). As before, this article proposes that managers should have discretion to balance the benefit to creditors and potential benefit to shareholders with any direct or indirect impairment of shareholders, and that they should be protected by the business-judgment rule so long as they act in good faith.[204] Furthermore, in exercising that discretion, some managers might wish to compare the expected value of the project to the shareholders alone, taking into account any impairment. For this example, the shareholder expected value would be calculated as follows:
EV to Shareholders = (0.60 x ($120 return – $0[205])) + (0.40 x $-75 loss of assets) = $72 – $30 = $42.
That positive expected value to shareholders should justify the project.
In addition to considering possible indirect impairment of shareholders (by making the debtor more insolvent), managers might also consider possible indirect benefit of shareholders (by making the debtor less insolvent). Although shareholders do not directly benefit until the debtor gains solvency, they could be said to indirectly benefit from every dollar that creditor claims are paid because that pro tanto reduces the insolvency.[206] Managers should have discretion not only to take indirect impairment but also indirect benefit into account.
Managers also should exercise discretion in assessing the impact of an expected-value calculation. For example, unless a positive expected-value project makes the debtor more of a “good company,”[207] any profit from a project might merely improve the debtor’s balance sheet, which would be restructured anyway in a chapter 11 plan.[208] Profit from a project should nonetheless provide more direct value to the extent it reduces the amount of DIP financing that the debtor needs to borrow. This is because the debtor must repay DIP financing as a priority obligation.[209]
The need for managers to exercise these discretions provides all the more reason why they should be protected by the business-judgment rule so long as they act in good faith in the exercise thereof.[210]
C. Statutory Changes
This subpart C examines specific provisions of the Bankruptcy Code that should be reconsidered in light of the author’s proposed creditor-primacy bankruptcy-governance model. This article does not, however, disagree with all provisions of the Bankruptcy Code that exemplify a pro-debtor bias.[211]
Section 362.[212] Section 362 of the Bankruptcy Code[213] automatically stays, or suspends, all enforcement and related actions against the debtor or its property in bankruptcy. Although the stay prevents creditors from enforcing their claims, it generally is needed to avoid so-called creditor “grab races,” which not only can wastefully eviscerate the debtor’s assets but also unfairly favors the first-mover enforcers.[214]
Nonetheless, on a case-by-case basis, creditors should have the right to enforce their claims notwithstanding bankruptcy if such enforcement is neither wasteful nor unfair. Subsection (d)(2) of § 362 technically gives creditors this right: “On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay . . . if— (A) the debtor does not have an equity in such property [that is the subject of the enforcement request]; and (B) such property is not necessary to an effective reorganization.” In practice, however, the problem with this exception from the stay is that (at least in the author’s experience) debtors routinely respond that they will not know, until the end of the case when there is a plan of reorganization, whether the property will be “necessary to an effective reorganization.” It is rare for bankruptcy courts to grant this relief from the stay in a chapter 11,[215] especially in the early stages of a case.[216]
A compromise would be for § 362(d) to clearly give debtors the burden of proof to show that the property that is the subject of the motion for relief will be “necessary to an effective reorganization.” Although § 362(g)(2) already technically imposes that burden on the debtor, it is not always applied this way in practice.[217] That tendency may well reflect the debtor bias of chapter 11 and the discretion granted bankruptcy judges by the Bankruptcy Code as courts of equity.[218] Applying a creditor-primacy model to the existing Bankruptcy Code language should make it more likely that courts would more routinely apply the § 362(g)(2) debtor’s burden of proof.
Section 364. Section 364 of the Bankruptcy Code[219] facilitates so-called DIP financing to a debtor in bankruptcy. It incentivizes lenders to consider extending credit by giving them priority of repayment over the claims of pre-petition creditors. In general, this is a fair balance; DIP financing enables otherwise viable debtors to successfully reorganize,[220] and pre-petition creditors have the right to notice and a hearing to oppose an inappropriate extension of DIP financing.[221]
A problem can arise, though, when a debtor needs DIP financing to reorganize but lacks sufficient unencumbered assets to borrow the amount needed. In these cases, the court “may authorize the [DIP financing to be] secured by a senior . . . lien on property of the [debtor] that is subject to a [pre-petition] lien only if— (A) the [debtor] is unable to obtain such credit otherwise; and (B) there is adequate protection of the” pre-petition lienholder.[222] This sounds fair, but (as next explained) ambiguity in the definition of “adequate protection” can undermine creditor protection.
Section 361(3) of the Bankruptcy Code[223] defines adequate protection to include “the realization by [the pre-petition lienholder] of the indubitable equivalent” of its pre-petition lien. Coined by Judge Learned Hand in a different context,[224] the term indubitable equivalent sometimes has been used by bankruptcy judges to provide very poor substitutes to formally satisfy the adequate protection standard.[225]
As with the exception to the automatic stay, § 364(d)(2) technically imposes the burden of proof on the debtor to demonstrate that the pre-petition lender receives adequate protection but bankruptcy courts tend to ignore it.[226] Reinterpreting bankruptcy law under a creditor-primacy model should make it more likely that courts more routinely apply the § 364(d)(2) debtor’s burden of proof.
Section 363. Section 363 of the Bankruptcy Code[227] authorizes bankruptcy judges, “after notice and a hearing,” to authorize a debtor to sell assets. Originally envisioned to authorize the occasional sale of assets and broadened in interpretation to reasonably authorize emergency asset sales,[228] bankruptcy courts have used § 363 to facilitate the sale of all or substantially all of a debtor’s assets outside of a plan of reorganization.[229] In ordinary circumstances, that type of sale should be effectuated as part of a formal plan of reorganization.[230] Using § 363 to effectuate that sale bypasses the procedural creditor protections that are contemplated by § 1129 of the Bankruptcy Code,[231] which governs confirmation of a reorganization plan.[232]
The General Motors and Chrysler bankruptcies demonstrate the risks of using § 363 to bypass the procedural protections of § 1129. In the Chrysler bankruptcy, the court approved a § 363 sale transferring Chrysler’s key assets to a new entity, heavily influenced by government intervention.[233] The transaction disproportionately benefited certain unsecured creditors, including labor unions, while allowing secured creditors to receive only a fraction of their claims, undermining the Bankruptcy Code’s priority rules.[234] In the GM bankruptcy, the § 363 sale of substantially all of GM’s assets bypassed the § 1129 creditor protections. Specifically, a portion of the sales proceeds went to pay certain secured lenders and provided unions with a stake in the “new GM,” while many other creditors, including bondholders and suppliers, were left in “old GM” with minimal recovery.[235]
To address these concerns, courts (if not Congress) should adopt more rigorous standards for evaluating § 363 sales. Some advocate, for example, a stricter “sound business purpose” test that requires detailed factual findings from courts to ensure that § 363 sales align with creditor protections and do not circumvent the priority rules established under § 1129.[236] Others advocate a “rough rule of thumb” to “distinguish true § 363 sales from bogus ones that are really reorganizations that squeeze out one or more creditor layers,” namely “if the new balance sheet has creditors and owners who constituted more than half of the selling company’s balance sheet, but with some creditors left behind, or if a majority of the new equity was drawn from the old capital structure, then the transaction should be presumed not to be a sale at all, but a reorganization.”[237] Furthermore, § 363 sales should only be authorized when the debtor demonstrates a compelling business purpose and the sale does not unduly harm creditors’ statutory entitlements.[238]
Section 1124. Section 1124 of the Bankruptcy Code[239] defines what it means for a claim to be impaired.[240] The significance is that holders of impaired claims are protected under § 1129 of the Bankruptcy Code, which governs confirmation of a reorganization plan.[241] Holders of claims that are not impaired[242] have no such protection.[243]
Debtors have used § 1124 to prejudice creditors whose contractual interest rates have declined below market interest rates.[244] In many cases, debtors, who normally have the exclusive right to propose a plan of reorganization,[245] write plans that keep those below market interest rates in place even after the debtor reorganizes and exits bankruptcy.
Section 1124(2) of the Bankruptcy Code gives chapter 11 debtors a valuable tool for use in situations where long-term prepetition debt carries a significantly lower interest rate than the rates available at the time of emergence from bankruptcy. Under this section, in a chapter 11 plan, the debtor can “cure” any defaults under the relevant agreement and “reinstate” the maturity date and other terms of the original agreement, thus enabling the debtor to “lock in” a favorable interest rate in a prepetition loan agreement upon bankruptcy emergence.[246]
Under a creditor-primacy bankruptcy-governance model, Congress might consider amending § 1124 to include defining a claim with a below market interest rate as being impaired.
Conclusion
This article is the first to attempt to analyze whether federal bankruptcy law’s pro-debtor bias creates net value or merely results in a zero-sum game that redistributes value from creditors to debtors. Because an empirical analysis of that question is not generally feasible,[247] the article engages in a second-best methodology, building on the pro-debtor shareholder-primacy model of corporate governance which is widely viewed as maximizing value. The article stresses that model under the circumstances of bankruptcy, revealing two critical differences: creditors become the primary residual claimants of the firm whereas shareholders are relegated to secondary residual claimant status, and the covenants that normally protect creditors become unenforceable.
The article utilizes these differences to derive a creditor-primacy governance model for debtors in bankruptcy. It then pragmatically assesses this model, showing that it would add important positive benefits by reducing the cost of credit without undermining the fundamental benefits of a pro-debtor biased model.
The article also shows how the creditor-primacy model could be applied to maximize bankruptcy value by increasing creditor recovery without unnecessarily jeopardizing shareholder return. For example, a threshold viability test would require debtors that are unlikely to successfully reorganize to be liquidated at the outset of a chapter 11 case, thereby significantly increasing creditor recovery without realistically impairing debtor rehabilitation. Such a test should also reduce agency costs and moral hazard and help to avoid the sunk-cost fallacy that wastefully causes numerous supposedly reorganized debtors to have to refile bankruptcy cases.
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