One Dollar, One Vote: Mark-to-Market Governance in Bankruptcy

• Author: Edward J. Janger & Adam J. Levitin
• Position: David M. Barse Professor of Law & Associate Dean for Faculty Research and Scholarship, Brooklyn Law School/Agnes N. Williams Research Professor and Professor of Law, Georgetown University Law Center
• Pages: 1857-1920

1857

One Dollar, One Vote:

Mark-to-Market Governance in

Bankruptcy

Edward J. Janger* & Adam J. Levitin**

ABSTRACT: In bankruptcy, creditors exercise governance rights over a debtor

firm—they vote to accept or reject a proposed plan of reorganization. These

governance rights are apportioned based on the amount of a creditor’s claim:

“one dollar, one vote.” This allocation assumes a claim reflects the creditor’s

true economic interest in the debtor, and the creditor is thus presumed to use

its governance rights in the bankruptcy to maximize the value of the debtor,

and hence its claim.

Yet a creditor’s financial interest is not always limited or even linked to the

face amount of its claim. For example, the interest of employee creditors extends

beyond recovering back pay to ensuring future employment, while a landlord’s

interest may be less in recovering back rent than in being able to terminate a

lease so it can relet the property at a higher rate. Historically, this has been a

discrete and manageable problem. Two recent developments in financial

markets, however, have made the mismatch between a creditor’s total economic

interests and its claim—and the concomitant governance rights—more

problematic.

First, a robust market has arisen in distressed debt, enabling investors to

purchase bankruptcy claims—and thus governance rights—at a discount.

Second, the emergence of derivatives markets now enables investors to go

“short” on the debtor and benefit from its misfortune. Combined, these

developments enable investors to cheaply acquire governance rights in

bankruptcy and then use that power to further the value of their extraneous

*

David M. Barse Professor of Law & Associate Dean for Faculty Research and

Scholarship, Brooklyn Law School.

**

Agnes N. Williams Research Professor and Professor of Law, Georgetown University Law

Center. This Article has benefitted from the comments of Miriam Baer, Corinne Ball, Anne

Fleming, Riz Mokal, Spencer Webber Waller, and from workshop participants at the Georgetown

University Law School Faculty Workshop, the University of Pennsylvania Wharton School Legal

Studies and Business Ethics Department’s Faculty Workshop, and the 2016 Financial Lawyers

Seminar (including from the participant who generously referred to this as our “creepy paper”),

as well as the Brooklyn Law School Summer Faculty Workshop and the Brooklyn Law School

Dean’s Research Fund. Mistakes are, of course, ours alone.

1858 IOWA LAW REVIEW [Vol. 104:1857

interests rather than maximizing the value of their bankruptcy claim. As a

result, the “one dollar, one vote” principle underlying bankruptcy governance

is now in question.

This Article illustrates problems that result from the divergence of economic

interests and governance rights in bankruptcy. It shows that existing

bankruptcy law tools, such as disclosure, vote designation, trading bars,

equitable subordination, and equitable disallowance, fail to provide adequate

remedies for the problems. Accordingly, we propose an administrable system of

“mark-to-market governance,” in which the governance rights, but not the

economic distribution rights, associated with a creditor’s bankruptcy claim

would be adjusted to reflect the creditor’s true net economic position. Under

mark-to-market governance, hedgers and shorts would be subject to

proportional dilution, claims purchasers would have their governance rights

discounted based on purchase price, and secured creditors would have their

credit bidding rights limited to the value of their collateral. Together these

adjustments will promote the core bankruptcy policies of maximizing the value

of the debtor firm and equitably distributing its value.

I. INTRODUCTION ........................................................................... 1859

II.EMPTY VOTING AND EMPTY CREDITORS IN BANKRUPTCY ............ 1867

A.EMPTY VOTING ..................................................................... 1867

B.EMPTY GOVERNANCE IN ASSET-BACKED SECURITIES ................ 1868

C.EMPTY CREDITORS ................................................................ 1869

D.EMPTY CREDITORS, ECONOMIC EXIT AND EQUALITY

OF DISTRIBUTION .................................................................. 1877

E.MECHANISMS FOR SEPARATING ECONOMIC INTEREST

FROM GOVERNANCE RIGHTS .................................................. 1878

1.Put Options .................................................................. 1879

2.Credit Default Swaps ................................................... 1880

3.Total Return Swaps ..................................................... 1881

4.Investment in Competitors ......................................... 1882

5.Investment Across the Capital Structure ................... 1882

6.Investment in Multiple Affiliates ................................ 1883

F.PROBLEMS CREATED BY SEPARATING ECONOMIC

INTEREST FROM GOVERNANCE RIGHTS ................................... 1883

1.Current Mechanisms ................................................... 1884

2.Fragmentation Concerns ............................................ 1885

3.Transparency Concerns .............................................. 1887

G.DISTRESSED DEBT TRADING AND GOVERNANCE ....................... 1888

1.The Event-Horizon—Insolvency ................................ 1889

2.Control Mechanisms in Insolvency and

Bankruptcy ................................................................... 1891

2019] ONE DOLLAR, ONE VOTE 1859

3.Insolvency, Claims Trading and the

Control Premium ........................................................ 1893

III.CLAIMS TRADING—EQUAL TREATMENT, REALIZATION,

AND GOVERNANCE RIGHTS ......................................................... 1894

A.EQUAL TREATMENT .............................................................. 1894

B.CONTROL, COLLATERAL AND EQUAL TREATMENT:

THE PROBLEM OF CREDIT BIDDING ........................................ 1895

C.CLAIMS, THE CONTROL PREMIUM, AND EQUAL

TREATMENT ......................................................................... 1897

D.THE PRICE OF THE CONTROL PREMIUM AND EQUAL

TREATMENT ......................................................................... 1898

IV.EXISTING REMEDIES AND THEIR LIMITATIONS ........................... 1899

A.DISCLOSURE .......................................................................... 1899

B.LIMITING THE FRANCHISE ..................................................... 1901

C.TRADING BARS ...................................................................... 1903

D.LIMITATION OF DISTRIBUTION ............................................... 1904

E.PROBLEMS WITH THE CURRENT REMEDIES ............................. 1904

V.MARK-TO-MARKET GOVERNANCE................................................ 1906

A.DISTRIBUTION V. GOVERNANCE—AN ILLUSTRATION ............... 1906

1.Proportional Dilution for Hedgers and Shorts ......... 1909

2.Basis-Allocated Governance Rights: Preserving

Equality of Distribution .............................................. 1910

B.THE PROPOSED SOLUTION ..................................................... 1911

C.SOME COMPLICATIONS .......................................................... 1913

D.PURCHASE OF SECURED POSITIONS ......................................... 1915

E.PRELIMINARY CONCLUSIONS .................................................. 1916

VI.IMPLEMENTATION ....................................................................... 1916

A.IMPLEMENTING MARK-TO-INTEREST AND MARK-TO-BASIS ....... 1917

B.IMPLEMENTING MARK-TO-VALUE ........................................... 1919

VII. CONCLUSION .............................................................................. 1919

I. INTRODUCTION

Bankruptcy is a system for maximizing, realizing, and fairly distributing

the value of a failed firm to its stakeholders. In Chapter 7 of the Bankruptcy

Code an independent and disinterested trustee liquidates the debtor firm.1

Secured creditors are paid from the proceeds of their collateral, and any

1. 11 U.S.C. § 704 (2012).