Contract bankruptcy: a reply to Alan Schwartz.

• Author: LoPucki, Lynn M.

Since the publication of Professor Robert Rasmussen's landmark article in 1992,(1) the central focus of bankruptcy scholarship has been to discover a practical method of contracting for bankruptcy procedure.(2) The task is difficult because a debtor may have hundreds or even thousands of creditors whose interests will be interdependent at the time of insolvency. The contract by which they select a bankruptcy procedure optimal for the particular firm would have to be a contract among all of them, and it would have to be capable of changing over the years as the firm evolved.(3)

The theory of business bankruptcy that dominated the scholarship until recently--Professors Douglas Baird and Thomas Jackson's "creditor's bargain" theory--was based on the assumption that actually making such a contract was impossible. Instead, Baird and Jackson sought to discover and impose on all parties to bankruptcy cases the contract they would have chosen had contracting been possible.(4)

In the early 1990s, several bankruptcy scholars challenged the assumption that such contracting was impossible.(5) One, Rasmussen, also proposed a method for adjusting the contract over time. The state would offer a "menu" of alternative bankruptcy regimes, and business debtors would select among them by inserting provisions in their corporate charters.(6) Changes in the election would be made by charter amendment.(7) Prospective lenders could discover the debtor's chosen bankruptcy regime from the public record and refuse to extend credit if they did not approve.(8) Rasmussen's proposal was of doubtful practicality,(9) in part because all parties had to update their information and recontract with changing conditions. But the proposal demonstrated that regimes of actual contracting were possible, and it inspired other scholars to attempt to improve upon it.(10)

The most ambitious of those attempts to date is the one by Professor Alan Schwartz that was published in The Yale Law Journal in 1998. Schwartz proposed an elegant scheme in which the debtor would need to negotiate changes only with the most recent creditor and in which that creditor could rely upon information voluntarily disclosed by the debtor.(11)

Had it worked, Schwartz's method would have been in some respects more efficient than Rasmussen's.(12) But what was most intriguing was Schwartz's claim to have proven, with the precision of an elaborate economic model, that permitting parties to contract for the bankruptcy systems they preferred would be superior to the current system of "state-supplied bankruptcy."(13) That is, Schwartz asserted that his model proved the superiority of contract bankruptcy over the current system in a manner applicable to the real world,(14) and he advocated a change in current law based upon it.(15)

Though scholars have questioned some of the assumptions underlying Schwartz's model as unrealistic,(16) to date his proof has been accepted as correct on its assumptions.(17) Rasmussen himself hailed it as "a major contribution to the bankruptcy literature" that "provides the first formal confirmation of the intuition that firms, acting prior to the onset of financial distress, are better able to select the appropriate bankruptcy procedure than is a mandatory rule...."(18)

Schwartz's proof is defective. The model employs materially inconsistent assumptions and the proof reaches its goal only through miscalculations from those assumptions. To understand the nature and significance of these errors, the reader must first understand the operation of the model. To accomplish that, this Essay proceeds by restating the purpose and essential assumptions of Schwartz's model and tracing his proof in nontechnical language. To facilitate comparison with the technical language of Schwartz's essay, it includes extensive footnotes to the essay, uses verbal expressions that correspond to the symbolic expressions of Schwartz's model, and indicates the symbolic expression in brackets when such a verbal expression is used.

The three-part task Schwartz sets for himself is to demonstrate that a set of bankruptcy contracts exists that would induce optimal bankruptcy choices even though "[al firm may have numerous creditors; these creditors may lend at different times; and they may have different preferences about bankruptcy systems."(19) He constructs his model in three stages that correspond to these three parts. At its first stage, the model proves that "a set of contracts that will induce optimal bankruptcy choices exists" when a debtor has numerous creditors.(20) Expanded to the second stage, the model purports to prove that "[a] set of contracts exists that will achieve the results described above even though creditors lend at different times."(21) Further expanded to its third stage, the model purports to prove that inconsistent preferences among creditors would not prevent the parties from reaching agreement.

Part I of this Essay describes the first stage of Schwartz's model and his proof that contracting would occur on the assumptions at that stage. Part II describes the extension of the model to its second stage and demonstrates that Schwartz has ignored in this stage assumptions that were crucial to the first stage. Part III describes the further extension of the model to its third stage. It demonstrates that Schwartz's contracting solution to the conflict between junior and senior creditors fails because it misapprehends the source of conflict between them, and that his contracting solution to the conflict between trade and other creditors--majority rule--fails because it is inconsistent with his second stage solution--the last contract governs. Part IV examines the sparse empirical evidence to conclude that actual bankruptcy contracting is proceeding in directions less benign than those predicted by Schwartz and other theorists. Part V summarizes the arguments presented and conclusions reached in the preceding parts.

1. STAGE ONE: CONTRACTING WHEN ALL CREDITORS LEND AT THE SAME TIME

   Schwartz's model assumes only a single subject for bankruptcy contracting: whether the case should be a reorganization or liquidation.(22) For each firm, reorganization or liquidation might be best, depending on the state of facts existing at the time of bankruptcy.(23) The obvious solution to the contracting problem presented--a contract providing that the firm will choose liquidation when liquidation is best [[[Theta].sub.L]] and reorganization when reorganization is best [[[Theta].sub.R]]--is blocked by an assumption that the contract would be too expensive to write.(24)

   The model assumes that the firm makes the choice between reorganization and liquidation at the time of bankruptcy,(25) knows at that time which is best,(26) knows the amount of the loss it will inflict on the creditors if it chooses reorganization when liquidation is best,(27) but cannot be trusted to choose the best because its incentives are biased in favor of reorganization.(28) The bias results from the firm's(29) assumed ability to obtain "private benefits"(30) in reorganization in excess of those that would be available in liquidation [[b.sub.R] - [b.sub.L]]. Though the firm knows the amount of these private benefits,(31) the model assumes that "lending agreements ... cannot ban or regulate private benefits by contract" because they are "unverifiable."(32) By that, Schwartz means that "the parties cannot establish in court the monetary value of these benefits, nor can they show that the firm is consuming excessively."(33)

   Schwartz's solution to the contracting problem thus presented is a contract in which the parties agree ex ante that whether the firm chooses reorganization or liquidation, the creditors will permit the firm to keep, as a "bribe," a percentage [s] of the firm's insolvency monetary return [y].(34) He proves the optimal percentage [s*] to be the ratio that the private benefit to the firm of choosing an ill-advised reorganization [[b.sub.L,R] - [b.sub.L,L]] bears to the increased monetary return the firm would enjoy from correctly choosing liquidation when it was efficient [[Y.sub.L,L] - [Y.sub.L,R]].(35) Although he assumes that percentage is unverifiable, he also assumes that the firm has all the information necessary to calculate it at the time the firm borrows.(36) Finally, he assumes that the creditors may not have the knowledge necessary to calculate the optimal bribe percentage [s*].(37)

   On these assumptions, Schwartz concludes that the parties can agree on the optimal bribe percentage [s*] because the creditors can count on the firm to disclose that percentage accurately at the time of contracting.(38) Schwartz assumes this accurate disclosure,(39) but does not explain why it occurs. The reason is that in Schwartz's model, the firm captures the entire value of the firm and so wants a contract that will maximize that value.(40) Firm-value maximization will occur only if the firm has the incentive at the time of bankruptcy to file the optimal type of bankruptcy.

   Schwartz's formula fixes the bribe so that it will be equal to the marginal private benefit from choosing ill-advised reorganization [[b.sub.L,R] - [b.sub.L,L]] under all conditions. The effect is to align the interests of the firm with those of the creditors. To state it another way, the amount of the bribe creates a good incentive to file liquidations that precisely equals and therefore offsets the bad incentive the private benefits create to file reorganizations. The effect is that the firm maximizes its share in the event of bankruptcy--the bribe--by maximizing the base upon which it is calculated--the monetary return [y]. The firm will do that by choosing the optimal form of bankruptcy.(41)

2. STAGE TWO: CONTRACTING WHEN CREDITORS LEND AT DIFFERENT TIMES

   Recognizing that a model that assumed all creditors contracted with the firm at the same time would be of "only theoretical interest,"(42) Schwartz extends his model to...