The Fraudulent Conveyance Origins of Chapter 11: an Essay on the Unwritten Law of Corporate Reorganizations
| Publication year | 2020 |
The Fraudulent Conveyance Origins of Chapter 11: An Essay on the Unwritten Law of Corporate Reorganizations
Douglas G. Baird
It might be possible to have a law of corporate reorganizations in which a judge or bureaucrat imposed a new capital structure by fiat, but our law of corporate reorganizations relies on creditors (and the professionals who work for them) to sit down at a conference table and forge a new capital structure themselves. The law's ambition is to make these negotiations possible. In large part for this reason, the way the Bankruptcy Code (Code) operates cannot be easily reconciled with conventional understandings of how statutes are supposed to work.
Negotiations are the lifeblood of bankruptcy practice, but the Code says little about how they are to be conducted. Instead, the bankruptcy judge enforces a set of largely unwritten rules.1 Some logrolling and give-and-take are permissible, while other sorts of side deals are out of bounds. These are well-known to insiders, but largely invisible to those on the outside. This essay explores how reorganization's unwritten rules have evolved and tries to make sense of them.
Rather than a dispenser of Solomonic wisdom, the bankruptcy judge is like a referee. A good referee ensures that the rules of the game are followed. Some rules are set out with mechanical precision, but many others are not. Negotiations must be kept on track, and doing this requires enforcing principles that lie within the interstices of the Code. These unwritten rules have developed over time, and they grow out of a small handful of ideas that emerged in the early days of the republic.
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The key question in the law of corporate reorganizations is one of construing the inherent power of the court to oversee the process. This equitable power derives from a general principle that was already deeply embedded in the law by the end of the eighteenth century: debtors cannot make transfers with the intent to "hinder, delay, or defraud" creditors.2
"Hinder, delay, or defraud" first appeared in a statute Parliament passed in 1571, the thirteenth reginal year of Queen Elizabeth.3 This statute came to be cited in American courts as shorthand for the court's equitable power to review a distressed debtor's transfer of property. Eventually, these principles would be extended to crafting plans of reorganization in an equity receivership.4 At the outset, however, the statute reached only the most obvious abuses.
In the first instance, the Statute of 13 Eliz. c. 5 was aimed at sham transactions.5 A debtor attempts to thwart creditors by pretending to transfer assets to friends or relatives before absconding. The debtor plans to return and enjoy the assets once again once creditors lose interest. The statute was always understood to give the court the power to void such transfers, empowering creditors to seize the assets from the friend or relative just as if they were still in the hands of the debtor.6
The statute's reach, however, soon expanded beyond merely prohibiting out-and-out fraudulent transfers. The first inflection point came in Twyne's Case in 1602.7 Twyne's Case held that, in addition to transactions involving actual fraud, the Statute of 13 Eliz. empowered the court to strike down any transactions that had "badges of fraud."8 Badges of fraud came to be understood as indicia that a transaction was not an arm's-length deal in the marketplace.9 A transaction was done secretly. There was no reasonably equivalent value. There was no physical transfer of assets. A transaction did not serve an economic purpose. Such
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transactions and many others possessed badges of fraud.10 A transaction could "hinder, delay, or defraud" creditors even when there was no proof of the deceit that is essential to bringing an action for common law fraud.11
Over time, courts acquired the ability to review any transaction and decide whether it violated the rights of creditors.12 It was already plain by the end of the eighteenth century that a transaction was not insulated from scrutiny merely because a third party acted with the debtor entirely in good faith. In the 1770s, Lord Mansfield, the greatest commercial law judge of his (or perhaps any) era, confronted a case that raised the question of whether creditors could challenge a transaction in which the only property that left the debtor's hands went to a third party who acted entirely honorably.13
The case involved a person who loaned a friend a large amount of money in order to help him sort out his business affairs.14 Just a few days after he received the loan, however, the friend realized that he could no longer save his business.15 The friend returned the money and then fled to France.16 The creditors started a bankruptcy proceeding and sought to recover the repayment.17 The loan had been made in good faith, and the lender's behavior was impeccable.18 But Lord Mansfield held that this payment was void nevertheless.19
In the case before him, Lord Mansfield willingly conceded, the creditor was "very meritorious."20 But this was of no moment. Allowing debtors to pick and choose among creditors when bankruptcy is imminent undermines the bankruptcy process, as bankruptcy is a regime in which assets are distributed pro rata. A transfer a debtor makes just before absconding therefore bears a badge of fraud. There is no actual fraud, but such a preferential payment nevertheless "hinders, delays, and defrauds" other creditors within the meaning of the Statute of 13 Eliz.
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Lord Mansfield's case, Harman v. Fishar, was connected with an impending bankruptcy, and it provided the wellspring for the power the trustee enjoys today to recover payments made to creditors on the eve of bankruptcy.21 But the reasoning in the case was not limited to transfers made when bankruptcy is imminent. The case also established a more general principle. Financially distressed debtors had to cut square corners. A payment of a completely legitimate debt could violate the rights of creditors, even if no bankruptcy was in the offing.22
A case involving a financer whose fortunes collapsed in the 1790s shows the reach of this principle. Blair McClenachan transferred his land to several men to hold in trust for the benefit of his creditors.23 On the face of it, McClenachan, far from evading creditors, was putting in place a mechanism to pay them. Moreover, the Court found that the facts "acquit Mr. McClenachan of any intentional, or mental, fraud."24
Most significantly, in distinct contrast to the case before Lord Mansfield, McClenachan was not trying to distort bankruptcy's rule of pro rata distribution as there was no bankruptcy law in place in the United States at the time.25 In assessing McClenachan's behavior, the court recognized that, in the absence of a bankruptcy law, a preference, even when a debtor is distressed, was unobjectionable.26
Nevertheless, the Court found that the transfer of land was ineffective.27 Various things McClenachan failed to do—such as call a meeting of his creditors or create a schedule of his assets or make some of the creditors trustees or explain to them how he would go about distributing the assets—suggested that McClenachan set up the trust as a way to defeat those who were about to secure judgments against him.28 There were enough badges of fraud to require voiding the transaction. McClenachan could not purport to create a vehicle for paying off some creditors if he did it in order to undermine the rights of other creditors.29
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As one of the justices explained:
I cannot conceive [anything] more dangerous, than to sanction by a judicial determination, a deed of this description. It will be vesting the debtor with unlimited power at all times over his property, to baffle his creditors, under the specious pretext of paying them.30
This case is one of the earliest instantiations of the idea that assignments for the benefit of creditors are themselves subject to judicial scrutiny. The judge has a general mandate to assess the conduct of the parties engaged in such transactions and look for badges of fraud. The judge has the power to strike down transactions that are designed to undermine the rights of one or more of the creditors.
The Supreme Court applied this principle to an equity receivership—the most direct predecessor to modern chapter 11—in Chicago, Rock Island & Pacific Railroad Co. v. Howard in 1868.31 The Mississippi & Missouri Railroad was hopelessly insolvent.32 By all accounts, there was not enough value to pay its senior creditors in full.33 The senior creditors wanted to foreclose on the railroad's assets and sell them to a third party, but those in control of the railroad could put numerous obstacles in their way.34
The senior creditors wanted to clear a smooth path to a sale so they reached a deal with those who controlled the debtor.35 The senior creditors agreed to give some of the proceeds of the sale to those in control of the railroad in return for their promise of cooperation.36 The buyer of the railroad would pay most of the consideration to the senior creditors, but some would go to the shareholders of the old corporation.37 Meanwhile, the general creditors of the old corporation would be left with nothing.38
The Supreme Court had little difficulty finding that the general creditors of the Mississippi & Missouri were entitled to the proceeds that the buyer of the railroad was to give to the old shareholders.39 The money the buyer promised to the shareholders was in the first instance an asset of the corporation, and, as
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between the shareholders and the general creditors, the general creditors were entitled to the corporation's assets first.40 To be sure, the case would have been utterly different if...
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