BANKRUPTCY'S NEW AND OLD FRONTIERS.

• Author: Bratton, William W.
• Position: A - Symposium on the Fortieth Anniversary of the 1978 Bankruptcy Code

1. THE BIRTH OF CORPORATE REORGANIZATION 1573 II. REIMAGINING BANKRUPTCY IN THE NEW DEAL 1576 III. CORPORATE REORGANIZATION UNDER THE 1978 CODE 1579 IV. MAKING SENSE OF THE NEW FRONTIERS 1584 A. The New Bond Workouts 1584 B. The Bankruptcy Partition 1585 C. Corporate Bankruptcy Hybridity 1587 D. Taking Control Rights Seriously 1588 E. Bankruptcy's Uneasy Shift to a Contract Paradigm 1589 F. Valuation Disputes in Corporate Bankruptcy 1589 G. The Creditors' Bargain Revisited 1590 V. THE WAY FORWARD? 1592 This Symposium marks the fortieth anniversary of the enactment of the 1978 Bankruptcy Code (the "1978 Code" or the "Code") with an extended look at seismic changes that currently are reshaping Chapter 11 reorganization. Today's typical Chapter 11 case looks radically different than did the typical case in the Code's early years. In those days, Chapter 11 afforded debtors a cozy haven. Most everything that mattered occurred within the context of the formal proceeding, where the debtor enjoyed agenda control, a leisurely timetable, and judicial solicitude. The safe haven steadily disappeared over time, displaced by a range of countervailing forces and a cooperative bankruptcy bench. Lenders, especially debtor-in-possession (DIP) financers, (1) gradually began to shape the trajectory of many proceedings. They today determine the course of most of the cases. More recently, additional players such as hedge funds and equity funds have also entered the scene, altering the bargaining dynamic. New financial instruments complicate debtors' capital structures and creditor incentives. Even the sites and modes of decisionmaking have shifted, as today's key decisions are negotiated and embedded in contracts concluded even before the debtor files for bankruptcy. The changes, which continue to accumulate, are fundamental.

   Congress has given a gentle assist to a few of these changes. (2) Sometimes this has followed from direct intervention, as when Congress amended the Code to diminish the debtor's agenda control of judicial reorganization proceedings. (3) At other times the effect is indirect, as when Congress encouraged the use of derivatives and other new financial instruments by largely exempting them from key bankruptcy provisions such as the automatic stay that requires other creditors to halt any collection efforts. (4) Whether direct or indirect, most of the legislative interventions have been of minor importance and the statutory framework is largely identical to that enacted in 1978. The changes have been driven by innovations in reorganization practice and judicial interpretation. It is a dynamic situation. Some of the most important and controversial of these new developments, such as the use of restructuring support agreements to lock up votes for a potential reorganization, will likely have seen further evolution by the time this Foreword appears in print.

   This Foreword provides context for the Symposium's academic contributions by recounting the historical developments that have brought us where we are. After chronicling the origins, New Deal redirection, and recent evolution of corporate reorganization, we describe some of the remarkable and often counterintuitive insights the articles in this Symposium offer for the current moment. We conclude by venturing a few thoughts about the future. As we shall see, the Nietzschean vision of history as eternal recurrence has surprising explanatory power in the bankruptcy context. (5)

1. THE BIRTH OF CORPORATE REORGANIZATION

   American corporate reorganization first emerged in the late nineteenth century, facilitated by a dramatic common law innovation, the federal equity receivership. The new procedure was first applied to what were then the country's only publicly held corporations, the railroads, and was later extended to other corporations. (6)

   The railroads filled a vital need, providing timely and affordable transportation for food, manufactured goods, and people. But the growth and expansion of the private railway companies was haphazard. Entrepreneurs competing to control essential routes, such as New York to Chicago, raced to build track and acquire smaller railroads, waging epic battles over key links such as the Erie Railway. (7) During flush periods, the railroads attracted huge amounts of capital and investment, most of it debt capital. When the economy crashed, as it did with some regularity during the nineteenth century, numerous railroads defaulted.

   The default of a substantial railroad posed a serious dilemma. Since the railroads were crucial to America's future, there was an enormous public interest in rescuing and sustaining them. A defaulting line's creditors were likely to see things the same way, favoring reorganization over liquidation. Despite this pervasive support, the most obvious strategies for facilitating a reorganization faced serious constitutional obstacles. (8) Today, there are no doubts about Congress's ability to pass a reorganization law. In the nineteenth century, by contrast, the Commerce Clause was much more narrowly construed, and might not have provided constitutional authority for a reorganization law. Congress's other source of authority, the Bankruptcy Clause, was similarly shaky, because there were serious questions regarding whether a reorganization law would impermissibly encroach on the chartering state's role as the principal regulator of corporations. In theory, a railroad's state of incorporation could pass a railroad reorganization law. Unfortunately, such a state-level enactment would have amounted to an idle gesture, for states could not alter existing contracts and had no power to regulate beyond their borders--a potentially crippling limitation given a multi-state railroad.

   It was against this backdrop that the equity receivership emerged. When a railroad defaulted, its creditors would commence two related actions, often in coordination with the line's managers: first, bondholders who held mortgages on some of the assets would ask the court to commence a foreclosure proceeding; second, other creditors would ask the court to turn control over all of the company's assets to a receiver. The bondholder plaintiffs in the first action, rather than asking for a prompt foreclosure sale, would ask the court to put the sale on hold. During the intervening weeks, the investment banks that had sold the railroad's stock and bonds would form committees to represent each different type of security. The debtor and the committees would negotiate the terms of a restructuring. Once terms had been agreed upon, the parties would combine the committees into one large reorganization committee. The bondholder plaintiffs would then ask the court to schedule the foreclosure sale. The only bidder at the sale would be the reorganization committee, which would submit a bid consisting of the bonds and stock held by the investors who had agreed to be represented by a committee, together with enough cash to pay dissenting investors. (9)

   The process the parties concocted was the world's first large scale corporate reorganization framework, an invention borne of necessity. But the equity receivership did not emerge fully formed like Athena from Zeus's head. The parties confronted a variety of obstacles, which they solved through contract, court approval, or both. Because most railroads were fully encumbered with mortgages when the receivership commenced, it might be impossible for them to borrow the funds they needed to continue operating during the receivership, since the new money would be subordinate to the existing mortgage liens. The reorganizers solved this problem by creating "receiver's certificates." If the court approved a receiver's certificate, it was given the first share of the debtor's revenues, before they ever got to the mortgage bondholders. Receiver's certificates were the forerunner to what we now call DIP financing. (10)

   Another problem was the cost of paying dissenting bondholders and stockholders--the investors who refused to "deposit" their securities with the committees. Paying these investors in full would have invited holdouts and undermined the composition process, since investors who declined to deposit their securities would get paid much more than those who participated in the restructuring. To solve this problem, the reorganizers persuaded courts to set an "upset price." This price was ostensibly the fair value of the defaulted security. Rather than paying dissenters in full, the reorganization committee, as winning bidder, was only required to pay them the upset price. This significantly diminished the incentive to hold out, especially when the reorganizers persuaded the court to set a low upset price. (11)

   There was also a question regarding the priority status of unsecured creditors vis-a-vis shareholders, a question that famously came to the fore in an early twentieth century case, Northern Pacific Railroad v. Boyd. (12) There, a creditor who had been wiped out in a reorganization that gave a continued stake to the railroad's old shareholders, despite the shareholders' lower priority, challenged the receivership as fraudulent. (13) The Supreme Court vindicated the creditor, holding that the exclusion from participation was impermissible. (14) This was a serious complication, because shareholder support was thought to be essential to the receivership process, in part because shareholders often contributed new funds to the reorganization. Reorganizers once again created a clever workaround: they started inviting general creditors to participate in the receivership, but only if they too agreed to pay a cash subscription toward the effort. (15)

   The question of the parties' respective priority rights also prompted the most important scholarly exchange of the equity receivership era. In a 1927 article, the leading corporate reorganization lawyer of the time argued that mortgage holders' priorities should not...