Bankruptcy and the State

• Publication year: 2022
• Citation: Vol. 38 No. 1

Bankruptcy and the State

Adam Feibelman

BANKRUPTCY AND THE STATE

Adam Feibelman^*

Abstract

Anticipating a wave of bankruptcies caused by the economic and financial effects of the COVID-19 pandemic, numerous commentators proposed measures to expand the institutional capacity of the bankruptcy system. A number of these proposals would represent dramatic and systematic government involvement in the U.S. bankruptcy system. Such involvement by the government in the bankruptcy system is a topic that is largely ignored in the literature on bankruptcy. Where it is observed, it is generally criticized. Among other things, it sits uneasily with dominant theories of bankruptcy that assume the bankruptcy system should be driven by the interests of direct stakeholders in particular cases. This Article argues that involvement or influence by government actors in the bankruptcy system is, in fact, broadly consistent with bankruptcy theory and with the structural relationship between bankruptcy law and other legal and regulatory components of the state. This relationship is subject to some basic ordering principles. Bankruptcy law constrains and adjusts other legal regimes to some extent, but it generally incorporates non-bankruptcy law and yields to government's regulatory actions. These ordering principles reasonably extend to ad hoc government actions or "activism" in the bankruptcy system. In other words, government actors do not contravene bankruptcy policy when they employ the system to advance non-bankruptcy policies within their authority, even when doing so enables the government to take actions and achieve goals that it could not outside of the system. In some circumstances, however, the regulatory policies or concerns motivating government involvement in the bankruptcy system may be too diffuse or attenuated to justify the extent of its intervention, especially if the effect is to discourage use of the bankruptcy system.

This Article develops these claims by focusing in particular on the relationship between bankruptcy and financial regulation. Bankruptcy is part of the architecture of financial markets in a modern economy, and the influence of financial regulators on the bankruptcy system should be viewed as the product

[Page 2]

of overlapping regulatory functions, which require a logic of ordering. Such regulatory influence generally operates in the deep background, yet macro-prudential and systemic concerns will sometimes require more direct government intervention and may override the efficiency concerns or stakes of a particular bankruptcy case. This Article describes three episodes of regulatory intervention in the bankruptcy system: (1) "regulatory bankruptcy" during the 2008-09 financial crisis; (2) the efforts by the Reserve Bank of India to force some large commercial firms into India's new insolvency system; and (3) the Chrysler bankruptcy. The ordering principles advanced in this Article generally justify the government involvement in these cases and, to some extent, in the COVID-era proposals as well. However, the degree of regulatory involvement in the bankruptcy system envisioned by some of these recent proposals may be disproportionate to, or attenuated from, their underlying regulatory goals. If so, they may fall beyond the scope of justified government involvement in the bankruptcy system.

TABLE OF CONTENTS

Introduction.................................................................................................3

I. A Very General Theory.................................................................10

A. Qua Bankruptcy.......................................................................... 11
B. Overlaps and Ordering............................................................... 15

1. Interactions........................................................................... 15
2. Ordering Principles.............................................................. 18

II. Financial Regulation and Bankruptcy......................................25

A. The Relationship......................................................................... 26
B. Three Episodes ........................................................................... 28

1. Commercial Real Estate and the Financial Crisis of 2008-09 ................................................................................ 29
2. The Chrysler Bankruptcy ...................................................... 31
3. The "RBI 12" ....................................................................... 35
4. Summary............................................................................... 41

C. Criticism ..................................................................................... 41
D. Recent Pandemic Proposals ....................................................... 44

Conclusion...................................................................................................49

[Page 3]

Introduction

In the initial months of the COVID-19 pandemic, there was widespread concern that the economic effects of the pandemic would cause a dramatic upsurge of corporate and individual bankruptcy cases in the united States and around the globe. Although there have been numerous notable bankruptcy filings in the U.S. since then, and a sizeable caseload more generally, various factors seem to have held a larger surge of filings at bay, at least for the time being.¹ In the meantime, policymakers in the U.S. adopted some modest and targeted reforms to the bankruptcy system to assist some debtors affected by the crisis.² over the course of 2020, numerous commentators proposed other, more significant measures to address a potential upsurge of filings.³ These measures

[Page 4]

include increasing bankruptcy court personnel and resources;⁴ requiring that some firms file for bankruptcy as a condition of financial support from the government;⁵ promoting stream-lined pre-packaged bankruptcy filings;⁶ and increasing the amount of resources available for debtor in possession ("DIP") financing from the U.S. Treasury or the Federal Reserve.⁷

These proposals may or may not be promising ways to improve the functioning of the bankruptcy system in the event of a systemic economic or financial crisis. But most of them have an important feature in common: they would significantly expand the direct or indirect involvement of government or regulatory actors in the operation of the bankruptcy system. Consider, for example, the proposals to encourage pre-pack filings or to leverage government lending to require firms to file for bankruptcy as a condition for financial support. Both entail regulators directly influencing or determining critical bankruptcy decisions: whether to initiate a proceeding and whether to attempt to pre-arrange fundamental aspects of a case with important creditors. The proposal to augment DIP financing through a Federal Reserve facility would provide support to banks that in turn extend crucial financing to debtors in bankruptcy. The involvement of those banks in the bankruptcies of their borrowers would be subject to ongoing supervision by the government, which would also have at least an indirect financial stake in the outcomes of those bankruptcy cases. The government would have the motivation and various tools for influencing the behavior of banks as DIP lenders in their borrowers' bankruptcies under such a program.

The debate and discussion of these proposals has largely ignored the question of how we should evaluate the government's role in the bankruptcy system that each would likely involve. In fact, this is a question that the literature on bankruptcy theory and policy provides few if any useful insights. Most writing on bankruptcy theory and policy focuses primarily or exclusively on how it impacts the immediate stakeholders in a debtor's case.⁸ Bankruptcy theorists

[Page 5]

who often disagree on critical features of the system have tended to assume that the system serves to resolve the microeconomic problems of debtors, their various creditors, and an array of other direct stakeholders, and that these private actors drive outcomes based on their self-perceived interests within a legal framework created by statutes and courts.⁹

The literature on bankruptcy law primarily addresses how it should balance the goal of facilitating a debtor's recovery with that of maximizing the overall value of the debtor's estate.¹⁰ It generally assumes that, with certain limitations, debtors make basic decisions about whether to seek relief, and under which chapter, in the shadow of a predictable set of rules and requirements. Similarly, it assumes that creditors and affected parties act within the system pursuant to their own financial and economic motivations subject to the substantive and procedural constraints of the bankruptcy system.

Largely absent from this common underlying view of bankruptcy is the fact that government and regulatory actors routinely impact the operation of the bankruptcy system, sometimes directly and dramatically and sometimes indirectly and unobserved. When the engagement of government actors in the bankruptcy system is discussed or observed at all, it is usually in response to a highly visible and controversial case, and the relationship is then generally criticized. At least some scholars have proposed that this type of government involvement is inconsistent with basic theories of bankruptcy law; impairs the efficient operation of a bankruptcy system; or undermines government transparency and accountability.¹¹

This Article argues that engagement by government and regulatory actors in a bankruptcy system is, in most cases, a natural feature of bankruptcy law and policy, not a distortion. In fact, interaction between bankruptcy and non-bankruptcy law and regulation is ubiquitous and part of an overarching institutional design. Bankruptcy is properly understood as an extension, component, or qualification of almost every...