The Janus Faces of Reorganization Law.

• Author: Buccola, Vincent S.J.

1. Introduction II. Two Takes on Reorganization Policy III. Bankruptcy's Two Faces The End: Looking to the Past The Beginning: Looking to the Future C. An Unstable Boundary IV. Reconciling Bankruptcy's Janus Faces A. Diminishing Signal Quality B. Diminishing Magnitude of Gains from Efficient Redistributions V. Conclusion I. INTRODUCTION

   The Supreme Court's most recent foray jnto the world of corporate reorganization, in Czyzewski v. Jevic Holding Corporation, (1) reveals as much about the conceptual underpinnings of modern bankruptcy law as any case has done in decades. (2) At stake in Jevic was the legality of a recent innovation in bankruptcy practice--the so-called "structured dismissal" (3)--when used to sidestep rules of distributional priority that govern liquidations and plans of reorganization. The Bankruptcy Code appears on its face to vest bankruptcy judges with the power to order these dismissals, but the court condemned them on the ground that priority norms, being central to bankruptcy, must not be subverted absent clear permission from Congress. (4) Neither the Court's judgment in the case nor its logic came as a surprise to seasoned observers. At the same time, however, the Court struck a different note with respect to techniques debtors routinely use to pay low-priority claims early in a case. (5) These techniques lack clear textual warrant and can undermine priorities as surely as a structured dismissal can, yet Jevic went out of its way to distinguish and seemingly bless them. (6) The contrast in attitude toward economically similar transactions is remarkable. At least as puzzling is just how unremarkable the contrast seemed to students of bankruptcy. What this state of affairs says about the structure of reorganization law, and what we ought to make of it, are the subjects of this essay.

   More specifically, this essay seeks to do two things--to characterize and elaborate on a doctrinal tension Jevic exposes and to advance a claim about this tension's significance for bankruptcy policy. The doctrinal observation is that reorganization law is two-faced. Jevic's holding and dictum were unsurprising because two rival interpretive paradigms have come to shape judicial understanding of the Bankruptcy Code. By this I do not mean simply that the Code is a result of uncomfortable compromises between legislative coalitions with distinctive viewpoints (although of course it is). Nor do I mean that different judges understand bankruptcy's animating aims differently (although perhaps they do). I mean rather that what appear to be two very different sets of assumptions and values, two conflicting frameworks, coexist with relative purity within the body of orthodox doctrine--and that their conflict is mediated by a kind of truce. One paradigm orients interpretation during the early stages of a reorganization case; the other orients interpretation at its conclusion. The two paradigms are defined by their radically opposed positions on the inevitable trade-off between the value of discretion, on one hand, and the sanctity of entitlements, on the other. Early in a bankruptcy case, ambiguity in the code is understood to vest the debtor, under judicial supervision, with authority to use the estate's property as it sees fit in a bid to preserve the going concern, irrespective of the implications for distributional priorities. I call this the discretion paradigm. At bankruptcy's close, on the contrary, ambiguity in the Code is understood to vindicate creditors' distributional priorities, irrespective of their effect on the estate's value as a whole. I call this the entitlement paradigm.

   Jevic did not create the order of divided rule. That has developed over a quarter century or more. Rather, Jevic at once reflects and deepens the prevailing order. As we shall see, the decision's rationale depends on fidelity to a particular distributional scheme--"absolute priority"--over and above what the Bankruptcy Code's plain text demands. (7) Indeed, a straightforward textual analysis would have yielded a judgment going the other way. The Court's opinion reads naturally only if one first posits the normative primacy of distributional entitlements. But Jevic confines its own logic to the end of a bankruptcy case, disclaiming any negative implications for the legality of critical vendor orders and other, similar staples of modern bankruptcy practice whose textual authority is dubious and whose effect on distribution can be profound. (8)

   The dual-paradigm regime raises an obvious practical question: How should a lawyer or judge know when one paradigm has given way to the other? The conceptual difficulty is clear. Time is continuous but doctrinal categories are not. A line must be drawn somewhere, even if arbitrarily, and a good lawyer would like to know where. For reasons to be made clear, however, no straightforward answer is likely forthcoming. The two paradigms can coexist only if a vague standard, as yet unannounced, defines the boundary between them. (9)

   For many observers, reorganization law's two paradigms will call to mind two visions of bankruptcy that defined scholarly debate during the 1980s and 1990s. Douglas Baird once described that debate as pitting "traditionalists" against "proceduralists." (10) The traditionalist perspective is forward-looking. Its fundamental question is how, all things considered, losses ought to be shared now that a debtor has proved unable to pay its creditors in full. Pre-bankruptcy arrangements factor into the calculus, but the prospective effects on all parties of one or another resolution are important. In striking the appropriate balance, the bankruptcy judge plays an important discretionary role. The proceduralist perspective, by contrast, is backward-looking. Its fundamental question is how a debtor's pre-bankruptcy investors would divvy up control rights were they able to do so cheaply. Ordinary principles of contract and property law establish investors' relative status. Clear priority rules are preferred to judicial discretion, because rules establish expectations against which investors can contract before bankruptcy.

   On the surface, then, my account of bankruptcy doctrine seems to suggest policy incoherence in addition to practical difficulty. Reorganization law centers on discretion, except when it does not; and distributional entitlements orient bankruptcy, except when they do not. But incoherence is not the only possibility. Janus has two faces, according to Ovid, so that he can at once look forward in time and back. (11) The god himself occupies the moment of transition. In placing him there, at the juncture between past and future, the Roman iconography gestures toward a deep unity in what appear on the surface to be contradictory postures. Likewise, I hope to show, bankruptcy's evident doctrinal tension may in fact reflect a singular attitude toward the aims of reorganization law.

   From this perspective, the right question to ask is not whether dueling paradigms can yield uncertainty or confusion in the marginal case, but whether a more general principle can harness their conflict to produce systemic coherence at a policy level. Here I argue that, given prevailing patterns of corporate finance, the discretion and entitlement paradigms indeed may work together roughly in service of a wealth-maximization norm. (12)

   The argument rests on a basic observation about priority deviations (or redistributions) and two complementary mechanisms at work in modern bankruptcies. The observation is that some but not all redistributions tend to maximize investor wealth. In general, there are two reasons a debtor's managers might seek to make a redistribution: to increase the total value of the estate (efficient redistributions), or to benefit favored creditors--and perhaps the managers themselves--at the expense of the estate (rent-seeking redistributions). If bankruptcy judges were capable of distinguishing between these motivations with perfect accuracy, the law would maximize investor wealth by simply directing the judge to permit efficient but not rent-seeking redistributions. Judges are not omniscient, however, and it follows that a pure discretionary regime is not obviously wealth-maximizing. To the contrary, the optimal model might withdraw judicial discretion over the course of a case, which is precisely what the dual-paradigm model accomplishes.

   Why might this be so? First, the accuracy with which bankruptcy judges distinguish between efficient and rent-seeking redistributions is likely to decline over the course of a case. This is because a senior creditor's acquiescence in a proposed redistribution produces a signal, of diminishing quality over time, about its desirability. Early in a bankruptcy, senior creditors are biased toward reducing risk even where doing so jeopardizes the expected value of the debtor's business. (13) To an oversecured creditor, time is the enemy. Given the prevailing incentives, senior creditor acquiescence in a proposed priority deviation, aimed as it typically will be at continuing debtor operations (and hence increasing volatility), is strong evidence of the deviation's capacity to increase the debtor's total value. But by the end of a bankruptcy things are changed. The senior creditor typically is looking at a known, fixed return. The risk it once faced has been liquidated, and, consequently, the creditor no longer has reason to police the debtor's proposed redistributions.

   Second, there is reason to believe the kinds of redistributions that occur early in a case have the greatest capacity to generate wealth. Deviating from priorities early in a case can make the difference between a reorganization or orderly sale of the business as a going concern and a liquidation producing meager recoveries. If operations are halted too soon, going-concern value can be difficult to restore. Humpty Dumpty is not easily put back together again. on...