Financial distress as a noncooperative game: a proposal for overcoming obstacles to private workouts.

• Author: Finkelstein, Claire

1. INTRODUCTION

   In the past several years, academics have increasingly expressed dissatisfaction with Chapter 11.(1) Among other complaints, critics point out that reorganizations of major public companies are expensive and usually take a number of years to complete.(2) In addition, from the scant empirical information available, failure rates appear high. One study shows that 38.3% of reorganized companies liquidate within four years.(3) Accordingly, academic writers have cast about for alternatives to court-supervised reorganizations. Suggestions include proposals for an all-equity capital structure,(4) market solutions like mandatory auctions,(5) and measures designed to encourage private workout agreements which avoid the need for judicial supervision altogether.(6)

   From a theoretical perspective, private solutions are preferable to public ones. First, because of the great expense of formal judicial proceedings, private negotiations should produce substantial savings over litigation.(7) Second, consensual resolution of disputes is more likely to maximize preferences than a solution forced on parties in the course of litigation.(8) Third, public procedures, such as litigation and auctions, exploit public funds for the sake of private dispute resolution. Any benefits to the general public from these expenditures would be indirect, and presumably direct and more substantial benefits would result from alternative expenditures. For these reasons, scholars should to look for ways of removing the obstacles to private settlements before searching for alternative public procedures.

   This Note presents a contractual scheme to increase the likelihood of settling conflicts incident to financial distress out of court: the incorporation into debt contracts of a clause suspending creditors' state-law collection rights for a fixed period of time. Part II diagnoses the impediments to private workout agreements under current contractual provisions. It argues that the low settlement rate is caused by a collective action problem which prohibits negotiation in a multi-creditor situation. It then considers the effect of uncertainty on the above analysis. In particular, this Part rebuts the possible objection that the uncertainty of Chapter 11 litigation provides a better explanation for the low settlement rates. Part III shows why the parties must implement any consensual solution to the collective action problem in the original debt contracts. In theory, a direct, intercreditor contract drafted ex ante--prior to the onset of financial distress--could avoid collective action problems. Part III, however, explains why transaction costs bar such an agreement, and thus why creditors must make use of their common relation with the debtor to control the behavior of other creditors. Part IV presents the proposed suspension clause solution. It considers, among other things, the problem of preferential treatment of certain creditors prior to the public declaration of financial distress. This Note argues that appending a unanimous consent condition to the suspension clause would effectively solve the preference problem. Part V explains that the inclusion of unanimous consent clauses in debt contracts would eliminate another potential impediment to private workouts, the "holdout" problem.(9) It also argues that scholars often exaggerate the importance of the holdout problem as an adequate explanation for the low success rates of private workouts. This emphasis on holdouts leads them to overlook the correct explanation, the collective action problem.

2. THE COLLECTIVE ACTION PROBLEM

   Until relatively recently, the prevailing academic wisdom on corporate reorganization justified Chapter 11 on efficiency grounds: Chapter 11 prevents the dismantling under state collection laws of firms whose going-concern value exceeds their liquidation value.(10) Without Chapter 11, creditors would pursue immediate satisfaction of their claims against a financially distressed debtor. This would forfeit the excess of the going-concern value over the liquidation value, and the creditors as a group would receive less than they would were they willing to wait.(11) Federal intervention is justified, the argument runs, because it solves a collective action problem.(12)

   Thomas Jackson and Douglas Baird, the original proponents of this view of federal reorganization, present what they call the "creditors' bargain model" of federal bankruptcy law." Chapter 11, they claim, implements the agreement the creditors of a common debtor would reach if collective action problems did not preclude negotiations. Mandating collective proceedings, Jackson and Baird argue, thus helps to maximize the preferences of creditors, since the payoff structure otherwise precludes creditors from realizing the outcome they would regard as most advantageous.

   The scant available empirical evidence supports Jackson and Baird's diagnosis of the problem. Settlement rates in bankruptcy are disproportionately low as compared with other areas of the law.(14) Studies indicate that workout offers from insolvent firms succeed in fewer than half the cases,(15) whereas settlement rates in other kinds of private suits exceed 90%.(16) Private suits in other domains, however, do not appear to differ in relevant ways from litigation in Chapter 11. Reorganizations of large, public companies may be exceedingly complex, but settlement rates in contexts other than financial distress are high even for complex disputes involving major corporate players.(17) Moreover, once the relevant parties actually enter negotiations, the prospects of reaching agreement are high. Bankruptcy litigation under Chapter 11 almost always results in the confirmation of a plan of reorganization.(18) In addition, the vast bulk of successful reorganizations occurs consensually. "Cramdowns"(19) are quite rare.(20)

   Taken in combination, the above data suggest that there are no significant impediments to agreement. Therefore, settlement rates in the financial distress context could equal those in other types of disputes. A plausible explanation for the low settlement rates is that a collective action problem impedes otherwise feasible agreements. Proponents of the creditors' bargain model thus correctly assert that Chapter 11 allows the parties to achieve a solution comparable to one they would reach through negotiations were it possible to eliminate collective action problems.

   The collective action problem is a species of n-person prisoner's dilemma ("P-D"). The problem is that each creditor's pursuit of a rational strategy maximizing her welfare in the short run produces an outcome which is suboptimal for all. Another possible outcome, the cooperative solution, improves the collective welfare, even from an individual maximizing perspective. By following individual maximizing strategies, however, the parties foreclose this solution.

   To take a simple, two-party example, suppose a debtor has only two creditors, both unsecured. Each creditor has a claim against the debtor for $100. Suppose also that the debtor has only one asset, a machine worth exactly $100 if sold. The liquidation value of the debtor's business is thus $100. But adding the debtor's expertise makes the business worth $150 as a going concern. Each creditor faces a choice: either seek immediate satisfaction of her claim, or wait and hope to capture the going-concern value. Suppose [Creditor.sub.1] decides to demand immediate repayment. If [Creditor.sub.2] decides to wait, [Creditor.sub.1] will recover her claim in full. But [Creditor.sub.2] May also decide to seek immediate recovery. Since, ex ante, each creditor has a 50% chance of getting to the debtor first, the value of the claim diminishes in accordance with the probability of its satisfaction in full. The claims ex ante are thus worth $50 to each creditor if both pursue collection immediately.(21) Alternatively, [Creditor.sub.1] could decide to wait. If, however, [Creditor.sub.2] decides to seek payment, [Creditor.sub.1] will lose completely. If both decide to wait, each will eventually recover $75.(22) Each party's dominant strategy is to seek payment, but exercising these strategies simultaneously is inefficient. Unfortunately, however, only this solution is a Nash(23) equilibrium.

   This case, however, differs from the usual P-D situation in one important respect. In the usual P-D, the parties cannot make binding agreements. Therefore, even if they agree in advance to cooperate, they cannot trust one another not to defect. In the present situation, the problem is not that an agreement would not be binding. On the contrary, an intercreditor agreement would be enforceable as is any other legally binding contract.24 The problem lies instead in the fact that the parties cannot negotiate with one another at any point before or during the game.

   The imposition of the automatic stay(25) in reorganization proceedings facilitates cooperation by eliminating the payoffs from noncooperative behavior. Proponents of the creditors' bargain model are right thus far. But this result does not constitute an adequate justification for Chapter 11.(26) For the following reasons, Chapter 11 is a suboptimal solution to the collective action problem. First, the return to the parties if they litigate is lower than it would be if they could cooperate without court supervision. Private settlement creates a cost savings which the parties could divide pro rata. Second, to the extent that Chapter 11 is the only way to prevent a run on assets, debtors are forced to take refuge in Chapter 11 even when they have no other reason for using a court-supervised procedure. The collective action problem and the lack of available alternatives to a Chapter 11 filing thus encourage use of federal bankruptcy law that would otherwise be unnecessary. A solution to the collective action problem that severed collective action from distributional questions...