THE CREDITORS' BARGAIN REVISITED.

AuthorAdler, Barry E.
PositionSymposium on the Fortieth Anniversary of the 1978 Bankruptcy Code
  1. THE CREDITORS' IMPLICIT BARGAIN 1854 II. A CREDITORS' EXPRESS BARGAIN 1856 III. THE REAL WORLD 1859 IV. THE END OF BANKRUPTCY 1862 V CONCLUSION AND THOUGHTS ON ASSET LAUNDERING 1864 Thirty-six years ago, Tom Jackson suggested that corporate bankruptcy law can best be explained and defended as the terms of an implicit bargain among creditors. (1) This assertion is founded on a belief that creditors, as a group, prefer bankruptcy's collective process to a grab race among themselves, particularly when such a race may cause the demise of a viable going concern.

    Since Jackson's article, scholars have discussed and debated whether creditors need to rely on bankruptcy's bargain for collective action. Some have contended that creditors could in fact contractually arrange for a collective process and that the law should permit them to do so. Others have argued that the impediments to such a contractual arrangement would be too daunting. With rare exception, though, participants in this dialogue assumed that creditors desire some form of collective process, whether provided by statute or contract. That is, while implementation was debated, the collectivization premise went mostly unchallenged.

    The recent transformation of the bankruptcy process from a forum of reorganization to, largely, an auction block further supports the collectivization premise. A collective process may not seem attractive when it features the contests inherent in reorganization, described colorfully by Sol Stein as a feast for lawyers. (2) But the bankruptcy process may appear in a more favorable light when it is used simply to conduct an orderly sale of the debtor's assets, including a sale as a going concern if that configuration of assets garners the highest bid.

    All may seem well, then, in the world of bankruptcy, where the apparent confluence of theory and practice led Douglas Baird and Robert Rasmussen to declare the end of bankruptcy, (3) by which they meant that bankruptcy has evolved to its ideal. But there is a fly in the ointment.

    At a series of recent conferences attended by academics and practitioners, the latter have suggested, sometimes expressly, that if freed from legal constraint, creditors they know would not only contract out of bankruptcy but out of any collective proceeding. That is, at least some practicing lawyers--presumably not immersed in Jacksonian orthodoxy--seem to believe that their clients would like to engage in a grab race after all, consequences be damned.

    Do these lawyers, who represent sophisticated lenders, simply mean that their clients favor a competition in which they would occupy a privileged position? Perhaps. But this seems unlikely because in a functioning capital market, creditors are mere stakeholders who are forced by the market to pay for any privilege in the form of lower interest rates. Sophisticated lenders, along with their lawyers, well understand this.

    But perhaps a better explanation for why lenders might forgo collectivization exists: debtors would insist on interest rates possible only if the debtor obtained funds within a capital structure designed to throw the firm to the creditor wolves in the event of an uncured default. This conjecture is not new. I first raised the idea years ago in dissent to the collectivist hegemony. What is new, and the focus of this Article, is the extent to which the conjecture is supported by recent developments in bankruptcy practice and creditor activism.

  2. THE CREDITORS' IMPLICIT BARGAIN

    On the desirability of collective action, almost all were Jacksonians once, myself included. In an article I wrote some years ago, (4) I invoked Thomas Jackson to explain that, at its core, bankruptcy serves creditors as a group when it supplants individual creditor debt collection remedies with a "collective debt-collection device." (5) In theory, as I said then, bankruptcy's collectivized proceeding is superior to individual creditor actions because individual creditors have perverse incentives to act in their own interests, even if those interests disserve the creditors' collective interest. Thus, I joined the consensus that bankruptcy is beneficial to the extent it protects creditors from their own worst instincts.

    To elaborate slightly, assume a debtor firm operates a business worth more as a going concern than if its assets were sold piecemeal. That is, the assets are worth more as parts of the debtor's business than they are distributed separately to become parts of other businesses. Assume further that the debtor is subject to obligations even greater than the value of the firm as a going concern and that the debtor is in default on those obligations. The debtor has insufficient assets to pay all creditors in full, so each creditor may have an incentive to collect on its debt before the debtor's assets are depleted by other creditors' collections. In the absence of bankruptcy law, a creditors' race to the assets could divide those assets piecemeal, with each race winner taking a piece of the debtor large enough to satisfy its own claim. As a result, the creditors could take from the debtor assets worth in the aggregate only the piecemeal liquidation value.

    Foundational to the Jacksonian creditors' bargain paradigm is that, without bankruptcy law, a potentially destructive creditor grab race would be inevitable. The premise is that such a race--rather than an actual bargain among creditors--would occur because each creditor would know that it could be left without recourse to any assets if it delayed its own action on the mere hope that the creditors would both find one another and agree to act collectively. This presumed dilemma of coordination presents a collective action problem.

    Bankruptcy solves a creditors' collective action problem by disallowing individual creditor action. A bankruptcy court supervises the use and disposition of the debtor's assets and can hold the assets together to maximize their value. The court then divides the value of the assets among creditors in an orderly fashion, either through the sale of the assets to a third party and the distribution of sale proceeds or through the distribution of interests in a debtor freed from prebankruptcy obligations. In no instance does an individual creditor have an opportunity to withdraw vital assets unilaterally.

    In the illustration above, for example, the bankruptcy court would prohibit individual creditor action and could sell the debtor's business as a going concern or distribute securities in the firm with an aggregate worth equal to the value of the firm as a going concern. This sale or distribution would thus preserve the debtor's going-concern surplus. Such bankruptcy intervention is thought to reflect a hypothetical creditors' bargain or the solution the creditors would reach could they solve their coordination problems. Accordingly, bankruptcy's solution to the collective action problem is the chief justification for its elimination of individual creditor remedies.

    Douglas Baird has summarized this analysis as follows: "[W]e may not desire a world without bankruptcy because the self-interest of creditors leads to a collective action problem, and a legal mechanism is needed to ensure that the self-interest of individuals does not run counter to the interests of the group." (6)

  3. A CREDITORS' EXPRESS BARGAIN

    Against this background, a number of scholars considered the possibility that creditors desirous of collective action need not rely on an implicit bargain. Rather, they might enter an actual bargain that deprived individual creditors of unilateral collection rights. Robert Rasmussen, for example, suggested that bankruptcy law could be adopted, or forgone, by a corporate debtor based on a selection from options in a federal register that he proposed. (7) David Skeel suggested...

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