International bankruptcy: in defence of universalism.

• Author: Guzman, Andrew T.

1. INTRODUCTION

   The globalization of business activity is rightfully celebrated as one of the triumphs of the second half of the twentieth century. The benefits stemming from the globalization of commerce are substantial, but international transactions also bring with them important challenges for the world's legal systems. Traditionally, national governments could focus on their domestic economies without undue attention to international issues. Today, however, a country's policymakers must respond to the growth in international business activity with appropriate legal changes. Failure to do so will cause their legal regimes to fall further and further out of step with the needs of the global marketplace. The exact content of the changes to be made, however, remains uncertain. This Article attempts to address one of the many international business issues that is forcing us to change the way we think about regulating cross-border activity -- the treatment of transnational bankruptcy.

   It is a fact of economic life that businesses fail. The growth of international business, therefore, has brought with it a growth in the number of international business failures.(1) In recent years, the increased number of international insolvencies has brought attention to the question of how to deal with transnational bankruptcies.(2) That said, it must be noted that cross-border business failures are new to neither the business world nor academia. Nor has there been a great shift in the perspective of legal academics over the years. In an article published in the Harvard Law Review in 1888, John Lowell wrote: "It is obvious that ... it would be better in nine cases out of ten that all settlements of insolvent debtors with their creditors should be made in a single proceeding, and generally at a single place."(3) One hundred years later, the call for "universalism" continues: "[A]ll questions of importance to the distribution of the debtor's assets should be governed by the law of the debtor's principal place of business."(4) Legislators(5) and judges, however, have resisted these academic proposals out of concern for the welfare of domestic creditors.(6) This Article seeks to address that concern directly.

   In simplified terms, two polar approaches to the adjudication of international insolvencies exist: universalism and territorialism. In its purest form, universalism would have all bankruptcy claims adjudicated within the debtor's "home country" and would apply the substantive laws of that country. Based on the law of that jurisdiction, the assets of the firm would be distributed to creditors around the world.(7) The alternative to universalism is territorialism or, more pejoratively, the "grab rule."(8) Under this rule, "the courts in each national jurisdiction seize the property physically within their control and distribute it according to local rules."(9) Critiques of the territorialist position are numerous and will not be repeated in detail here.(10) For present purposes, it is enough to note that proponents of universalism argue that it would yield a variety of benefits, including a more efficient ex ante allocation of capital,(11) reduced administrative costs due to a reduction in the number of proceedings,(12) avoidance of forum shopping and the race to file,(13) facilitated reorganizations,(14) increased liquidation value,(15) and the provision of clarity and certainty to all parties.(16) The most eloquent and effective proponent of universalism in the last decade has been Jay Westbrook, who has also contributed to this symposium.(17) Although Professor Westbrook and I approach the subject of international bankruptcies from somewhat different perspectives, we hold very similar views of the preferred policy prescription. With this in mind, and in the interest of space, I will not address his arguments directly in this Article. If I did, it would be primarily to express my support for his views.

   Territorialist objections to universalism center on the treatment of small, local creditors. United States courts often express reluctance to turn assets over to foreign jurisdictions when doing so would put local creditors at a disadvantage, ex post, relative to foreign creditors. The academic criticism of universalism is similarly focused on the treatment of local creditors, although the argument is somewhat more subtle. The argument against universalism rests on the belief that "universalism would be unpredictable to all but the largest creditors of multinational companies."(18) It is claimed that only they would have enough at stake to warrant adjustment.(19) This Article attempts to make progress toward resolving the debate between universalists and territorialists through an analysis of this most central element of the criticism of universalism. Is there a class of creditors that is better off under territorialism? If so, how many such creditors are there and how much do they stand to lose? What conclusions can we reach about overall social welfare in the face of these concerns?

   To understand why the debate needs to focus on what are termed "nonadjusting creditors," one needs to recognize that in a competitive market -- the most reasonable assumption for capital markets -- "adjusting creditors" (those who adjust the terms of their lending to reflect the risks they face) will earn a market rate of return regardless of the choice of bankruptcy rule.(20) If all creditors are adjusting, the debtor will bear all costs imposed by the choice of law rule because competitive pressures will prevent the creditors from earning more or less than the risk-adjusted market rate. In a particular case, of course, local creditors may be at a disadvantage, from an ex post perspective, relative to foreign creditors.(21) As long as the creditors understand the bankruptcy rules ex ante, however, they will be able to adjust the out-of-bankruptcy rate of return that they demand.(22)

   From the perspective of the debtor, however, the choice of regime is important even if all creditors adjust, because a reduction in the costs imposed by the bankruptcy system will reduce the overall cost of lending -- leading to a reduction in the cost of capital for debtors. From the debtor's point of view, therefore, bankruptcy policy should be guided by the overall efficiency of the system. For these purposes, universalism offers the most appealing regime because it provides greater certainty with respect to the applicable rules, lower litigation costs, and a better system for reorganizations than does territorialism.(23)

   The current debate, therefore, focuses on three groups -- adjusting creditors, who are indifferent to the choice of regime; debtors, who prefer universalism because it imposes lower costs; and nonadjusting creditors, whose role is examined in this Article. Unless nonadjusting creditors suffer losses under universalism that outweigh the efficiency benefits of that regime, territorialism must be rejected. To date, there has been no clear analysis of the impact of universalism on nonadjusting creditors, making it difficult to evaluate the claims in favor of territorialism. This Article provides the analysis required to evaluate those claims and, in the end, finds them wanting.

   Part II of this Article defines what are termed "nonadjusting creditors," and explains why understanding the role of these actors is critical to understanding the debate on transnational bankruptcy. Part III presents a theoretical analysis and the impact of territorialism and universalism on nonadjusting creditors. Part IV examines the costs of each regime, and demonstrates that the costs of territorialism outweigh the costs of universalism.

2. NONADJUSTING CREDITORS

   1. Nonadjusting Creditors Defined

      The category of "nonadjusting creditors" includes any creditors that cannot, or will not, adjust the terms of their loans on a case-by-case basis in order to take into account the risks associated with the loan, including the risk of nonpayment. Tort creditors, for example, enter into a creditor relationship with tortfeasors involuntarily and obviously do not adjust the terms of that relationship to reflect the risk that the debtor may not pay. The nonadjusting creditor category includes both involuntary creditors, such as taxation authorities and tort creditors, as well as voluntary creditors, such as trade creditors.(24)

      The general category of nonadjusting creditors can be further divided into two subcategories, which I term "weakly nonadjusting" and "strongly nonadjusting." Both subcategories are nonadjusting in the sense that they are unable or unwilling to alter the terms of their loan based on the identity of the borrower. The creditors differ, however, in the extent to which they adjust credit terms over their entire portfolio of lending.

      Nonadjusting creditors are termed weakly nonadjusting when they account for the risks they face by adjusting the terms of their loans on an expected value basis calculated over their entire portfolio of loans. For example, credit card companies are weakly nonadjusting creditors. A credit card company will charge a single interest rate to all of its cardholders, without differentiating one cardholder from another based on the risk of nonpayment.(25) The company, however, will set its overall interest rate such that it earns, in expectation, a competitive rate of return. The weakly nonadjusting category might also include retail customers, trade creditors, employees, landlords, educational lenders, and health care providers.(26) Each of these groups provides credit voluntarily, but typically does not adjust the terms of the credit on a debtor-by-debtor basis.

      Most weakly nonadjusting creditors could, in principle, adjust each individual loan to take into account the risks presented by a particular debtor. Nevertheless, a creditor may rationally choose to remain nonadjusting because, for example, it is too costly to conduct a...