Bankruptcy's Endowment Effect

• Publication year: 2016

Bankruptcy's Endowment Effect

Anthony J. Casey

BANKRUPTCY'S ENDOWMENT EFFECT

Anthony J. Casey^*

Abstract

In this Essay, I respond to Professor Markell's analysis of the recent controversy over the cramdown interest rate applied in corporate bankruptcies. I argue that the main source of controversy is a misperception that pervades much of bankruptcy law and scholarship. Namely, courts and scholars commonly assign undue importance to preserving creditors' nonbankruptcy endowments, which is inconsistent with foundational bankruptcy policy.

I make the case here that the guiding principle for optimal bankruptcy design should not be the preservation of nonbankruptcy rights but rather should be the minimization of opportunistic behavior that reduces the net value of a firm. Applying this principle to the question of the cramdown interest rate, I show that an optimal rule—properly focused on the minimization of opportunistic behavior—supports a cramdown interest rate based on the prevailing market rates for similar loans. Along the way I also show that this approach is consistent with the Bankruptcy Code and the theoretical principles (although not the ultimate conclusion) that Professor Markell has advocated.

Introduction

The endowment effect runs strong in corporate bankruptcy scholarship. Scholars commonly make the mistake of assuming that because a creditor is endowed with a right outside bankruptcy, that creditor must therefore be entitled to maintain the same right inside bankruptcy.¹ These scholars often

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assert that this result is required by the foundational theory of bankruptcy—it is not—and then defend policy proposals as scrupulously protecting creditors' entitlements.²

Despite its popularity in academic scholarship, this idea of sacred endowments is an untenable position that misunderstands the fundamental principles of bankruptcy. Corporate bankruptcy is, at its core, a system that alters nonbankruptcy endowments according to a hypothetical bargain— hypothetical because it is not the one the parties actually entered into—that we assume all creditors of a firm would have entered into if bargaining were costless.³ The entire point of that hypothetical bargain is to suspend and alter some nonbankruptcy endowments to protect other endowments that maximize the value of the bankruptcy estate⁴ and the firm as a whole.⁵ Indeed, if every party retained every nonbankruptcy endowment, the Bankruptcy Code (the "Code") would have no provisions at all.

Of course, altering nonbankruptcy endowments can impose costs. Foremost among those costs is the risk of opportunistic behavior.⁶ We do not want to create incentives for parties to pursue (or avoid) a bankruptcy filing for the sole purpose of transferring (or avoiding the transfer of) value between stakeholders. Such opportunistic maneuvering is costly for the estate as a whole. Thus, optimal bankruptcy policy will be designed to achieve its estate-maximizing purpose in part by minimizing opportunistic bankruptcy behavior that destroys firm value. Protecting nonbankruptcy endowments can, in many cases, be a means to that end. But protecting those endowments is not, as many scholars appear to believe, an end in and of itself.⁷

The unwarranted focus on nonbankruptcy endowments is a mistake that bankruptcy law scholars commonly make, including scholars arguing for

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absolute priority⁸ as well as scholars arguing against it.⁹ Courts and lawyers are no different. The recent and ongoing dispute over cramdown in In re MPM Silicones, LLC ("Momentive") provides a salient example.¹⁰ The dispute in Momentive was about what interest rate the senior creditors would get in a chapter 11 cramdown.¹¹ The bankruptcy court ultimately decided the case by importing a creditor-endowment framework from consumer bankruptcy law.¹² That framework—the "Till formula" or "Till interest rate"—comes from the plurality opinion in Till v. SCS Credit Corp.¹³ Eight of the nine Supreme Court Justices framed Till as an endowment case.¹⁴ Indeed, the plurality and dissenting opinions in Till focused almost exclusively on ex ante endowments. The same was true of the bankruptcy court's opinion in Momentive. In each case, considerations about a properly designed bankruptcy system were conspicuously absent from the discussion.¹⁵

The result of all of this focus on endowments is that corporate bankruptcy scholarship and precedent are often bogged down in a back-and-forth about who is entitled to what, when the relevant question is what rule makes the most sense. The first part of Professor Markell's article on Till and Momentive

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provides a refreshing alternative. Instead of focusing on senior creditors' nonbankruptcy entitlements, Professor Markell marshals history and precedent to suggest three basic doctrinal principles that courts should follow in applying priority rules in chapter 11 cases: (1) "don't pay too little"; (2) "don't pay too much"; and (3) "don't expect precision." In doing so, he exposes the fallacies in commonly held notions (partially embraced by the Till dissent) that a creditor is somehow entitled to get exactly what it had before bankruptcy or to be made "subjectively indifferent between present foreclosure and future payment."¹⁶ Professor Markell shows that there are no statutory or historical grounds for such arguments.

The Markell principles (as I will call them) not only have the support of history and caselaw, but they also make for good bankruptcy policy. But when Professor Markell attempts to operationalize his principles, bankruptcy's endowment effect sneaks back in. "Too much" and "too little" are defined for Professor Markell—just as they were for eight Justices on the Till Court—by reference to what the creditors are entitled to outside of bankruptcy. Here I must part ways with his analysis. Neither the history that Professor Markell presents¹⁷ nor the statute that controls cramdown¹⁸ requires this definition. Rather, Professor Markell convincingly shows us that the history leaves doubt about (and creates wiggle room for) how one should define entitlements. And the statute—as well as recent precedent interpreting it—suggests an altogether different inquiry, which has little to do with nonbankruptcy entitlements and much to do with implementing a coherent foundational theory of corporate reorganization. As such, I suggest a fourth and preeminent guiding principle that is supported by the statute and history: "do what makes sense." And on that front, the court in Momentive got things exactly wrong.

I proceed in four parts. In Part I, I briefly review the applicable statutory provisions, Professor Markell's historical insights on those statutes, and the import of recent Supreme Court cases interpreting them. I suggest, similarly to Professor Markell, that these foundations provide only general and uncertain guidance. But that guidance does foreclose certain forms of cramdown, including that which was used in Till (and imported to Momentive). I show, therefore, that, on the one hand, the application of the Till formula in

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Momentive is inconsistent with the Markell principles. On the other hand, the foundational guidance does not foreclose a cramdown system that is consistent with and advances general policies of a properly functioning corporate bankruptcy system. The inferences one can, and should, draw support embracing a method and framework of cramdown that best advance the foundational theory of corporate bankruptcy and reorganization.

In Part II, I review and examine that foundational theory and explain how it relates to the cramdown process. The real question that emerges from the analysis is not who is entitled to what, but rather, how should one design a bankruptcy system that produces a coherent set of incentives and outcomes. I suggest that while properly designed bankruptcy law should not, and does not, require any special attention to senior creditor entitlements or to making a senior creditor subjectively indifferent between foreclosure and cramdown, the law does require a system that minimizes opportunistic behavior that would destroy firm value. That is, the bankruptcy system should minimize the extent to which it creates value-destroying opportunities for stakeholders to exploit the bankruptcy process to capture value from other stakeholders.

In Part III, I derive the optimal cramdown rule. A coherent cramdown system will not only prevent creditors from destroying value by opportunistically opposing a plan, but it will also prevent debtors from destroying value by opportunistically proposing cramdown. If a creditor can insist on foreclosing on an asset that has going concern value, it will make threats to extract rents. Those threats can lead to bargaining failures that destroy estate value. Similarly, if debtors get consistently better rates of interest in cramdown, they will flood courts with chapter 11 cases that never should have been filed. Moreover, debtors who otherwise would have filed will be artificially drawn toward proposing inefficient cramdown plans. They will even, as the debtors in Momentive did, make threats of or propose inefficient plans for the sole purpose of extracting rents from creditors.¹⁹

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Neither of these outcomes serves any valid purpose for corporate reorganization. Both can be avoided by a system that allows cramdown but tests its rate against the market alternatives that face a debtor at that time in the real world. I show that a focus on real-world market rates—and not intrinsic values—is necessary to properly align the incentives of those making the decision to pursue the cramdown option rather than the other options available in the market. In Part IV, I present examples and apply this framework to the specific facts of Momentive, showing how the focus on real-world market rates better aligns incentives and is more consistent with bankruptcy's fundamental purpose.

I. History,...