Antibankruptcy.

• Author: Baird, Douglas G.

ARTICLE CONTENTS INTRODUCTION I. THE CHANGING FACE OF UNSECURED DEBT A. The Bargaining Dynamic in Chapter 11 B. Claims Trading II. THE TRANSFORMATION OF SECURED DEBT A. The Decline of the Traditional Bank B. The Second Lien Loan C. The Rise of Control III. FINANCIAL INNOVATION A. Derivatives B. Wearing Multiple Hats IV. COALITION FORMATION AND THE PROBLEM OF THE EMPTY CORE CONCLUSION INTRODUCTION

Chapter 11 is now the last firewall protecting many of the country's largest corporations. It may hold. Over the last decade, and especially during the dot-com meltdown, Chapter 11 has been singularly successful. Long gone is the time when the managers of Eastern Airlines could allow it to wither away in bankruptcy with the creditors standing by helplessly. (1) A new breed of bankruptcy judges, lawyers, and turnaround specialists have come on the scene. They do not get caught up in emotion. They can cast a cold eye, harness markets, and make tough decisions. Billion-dollar corporations (United Airlines, Kmart, Budget Rent A Car) overcame financial distress in Chapter is and continued to operate. (2) Even in such fraud-ridden cases as Enron, assets were sensibly redeployed, general creditors received substantial recoveries, and wrongdoers and their fellow travelers were held to account. (3)

There is, however, considerable reason to doubt that reorganization law is up to the challenge it is about to face, at least in the largest cases. (4) The successes of recent years do not readily translate to the current economic environment. The players today are different from those in past downturns. (5) For a long time, the capital structure of a firm in reorganization consisted of a senior bank with a security interest in all the firm's assets and a group of dispersed, but homogenous, unsecured creditors that an active creditors' committee could represent. (6) The bank, the committee, and the debtor's managers bargained with each other against a backdrop of well-developed norms.

Today, we no longer have a single bank and dispersed general creditors. Dozens of constantly changing stakeholders occupy every tranche, each pursuing its own agenda. (7) Some seek long-term control of the business, while others are passive, short-term investors. Others may hold a basket of both long and short positions in multiple tranches and complicated hedges involving other businesses. Their concerns--such as whether a particular action will be a "credit event" in a credit default swap--often have nothing to do with preserving the business or maximizing the value of its assets. Indeed, failure of the business can mean large returns to some creditors. (8) The recent credit contraction has meant that the sale of the company sometimes must be done too quickly and sometimes cannot be done at all. In short, the new world of corporate reorganizations has more heterogeneous creditors whose rights against the business are deeply fragmented.

In the past, the bargains that parties reached among themselves followed a few familiar patterns. While there were many possible deals, the players naturally gravitated toward only a few. (9) In the new environment, with different players holding different stakes, the old patterns no longer apply and new ones have yet to take shape. There are no longer organized groups (like agented lenders or even creditors' committees), but instead investors have "one-off" relationships with the debtor entity (for example, counterparties with individual repos or swaps). The types of institutions vary--from banks and broker-dealers to hedge funds and private equity firms. The current environment is one in which there are no natural leaders (or followers) among the creditors to perform the shuttle diplomacy required to build a consensus. Without familiar benchmarks, there is no shared understanding of what form a plan should take. Coalition formation is harder. (10) Worse yet, in some cases there may be no stable equilibrium at all. To use the language of cooperative game theory, the core may be empty. (11)

In this Article, we review the changes in finance over the last decade and show how each is at odds with basic assumptions of Chapter 11. Our conclusion can be stated simply. The challenge the legal system faces is much like assembling a city block that has been broken up into many parcels. In this scenario, we face an anticommons problem, a world in which ownership interests are fragmented and conflicting. (12) This is quite at odds with the standard account of corporate reorganizations--that it solves a tragedy of the commons, the collective action problem that exists when general creditors share numerous dispersed, but otherwise similar, interests. (13) Bankruptcy has become antibankruptcy.

Part I examines how the prototypical general creditor has changed. It is no longer a small player holding a claim much like everyone else's. Moreover, this group changes constantly throughout the course of the case. Part II examines the changed nature of the secured creditor and, especially, the way in which it now enjoys much more control than it had even a decade ago. In Part III, we focus on financial innovation and the way that derivatives and the ability to hedge alter the dynamics of Chapter 11. Part IV draws on the lessons of cooperative game theory to show how in combination these changes are toxic. They undermine the coalition formation process that is central to Chapter 11.

1. THE CHANGING FACE OF UNSECURED DEBT

   1. The Bargaining Dynamic in Chapter 11

      Bankruptcy law developed in a world of limited financial instruments. Secured debt (generally held by banks), unsecured debt (comprised of private debt, bonds, and trade credit), and publicly traded stock largely exhausted the types of investments that comprised the capital structure of large businesses. (14) The action lay at the level of the general creditors. The bankruptcy was for the benefit of the general creditors. Hence, the drafters of the Bankruptcy Code provided that administrative expenses be paid after the secured creditors, but before the general creditors. (15)

      The creditors of the typical financially distressed business, whether bondholder or supplier, enjoyed at bottom the same legal right: the ability to sue and reduce their claim to judgment. If each were left to her own devices, they might tear the business apart. The Bankruptcy Code worked its magic by forcing the group to work together as one. The Code turned every variety of right against the debtor into a "claim." (16) A loan at ten percent due in five years was treated the same as a loan at five percent due in ten years. (17) Someone who had a breach of contract action had a claim for the damages she would have received under nonbankruptcy law.

      Because they held the same kind of legal right subject to the same treatment, all had the same incentive to maximize the value of the estate. Every claim entitled the stakeholder to exactly the same thing--a pro rata share of the bankruptcy estate. (18) A small committee of the largest creditors could thus look after everyone's interest. (19) The general creditors as a group bore the expenses of the committee. (20) Dispersed general creditors with small claims were spared the expense of vindicating their rights on their own. Because everyone had the same legal rights and received identical pro rata treatment, we could safely allow the decisions of the group as a whole to bind the dissenters. (21) There was no need to fear a tyranny of the majority. The plan had to treat those similarly situated in the same way. (22)

      By the standard account, general creditors were dispersed. (23) Whereas the secured debt was primarily concentrated in the hands of a single institution, various parties held unsecured debt. The problem was one of collective action. As a group, the unsecured creditors would have been better off by taking concerted action, but no one creditor was willing to take the laboring oar. The costs of participation fell on those who participated, but the benefits were distributed to all creditors. While for creditors as a group the best course of action was to participate in the reorganization discussions, for each individual creditor the rational thing to do was stay passive. The nonbankruptcy rights were insufficiently tailored to allow them to act in a way that was mutually beneficial. Just as the agency issuing fishing licenses or regulating drilling in an oil field attempts to maximize value, those charged with overseeing the reorganization took steps to preserve the value of the estate on behalf of general creditors, who were presumptively similarly situated and entitled to equal treatment.

      In addition to the incentive towards passivity, unsecured creditors also lacked the information necessary to participate in the reorganization. (24) A central issue in most reorganization cases was valuation--the amount the company would be worth if liquidated and the amount if kept together. While creditors might have been able to piece together information on liquidation values from publicly available sources, putting a price on the company as a going concern was a more difficult endeavor. One had to know the future plans for the company and what the plausible projections were for the future revenue stream. These both required information that the company had but that outsiders did not. Indeed, the creditors had no legal entitlement to such information. (25)

      The answer to these problems was to give a central role to a committee to represent the interests of the unsecured creditors. (26) The committee would be staffed with creditors, presumptively those holding the seven largest claims against the debtor. (27) The existence of the committee provided a mechanism by which private information could be shared with the creditors. The committee would negotiate on behalf of the unsecured creditors as a group. Moreover, the committee would be able to collect the...