The political economy of the Bankruptcy Reform Act of 1978.

• Author: Posner, Eric A.

INTRODUCTION

Why do we have a bankruptcy law? The conventional story is that bankruptcy law reflects two requirements of a modern commercial economy: a method for the orderly payment of debts owed to multiple creditors and a means to ensure that individual debtors retain sufficient assets and rights to maintain a dignified or at least nonpenurious existence. No doubt this story contains elements of the truth, but it also has many limitations. The story does not explain many significant attributes of the Bankruptcy Code, including the administrative structure it establishes, its reliance on a mixture of federal- and state-determined rights, and its balancing of interests between creditors and debtors.

When commentators try to explain these aspects of the Bankruptcy Code, they generally describe them as the result of conflicts between debtor interests, on the one hand, and creditor interests, on the other. The outcome is explained as just a compromise reflecting the relative political power of each group. On reflection, however, this explanation is not satisfactory. It does not take account of the following factors: (1) different kinds of creditors have different, and often conflicting, interests; (2) other actors have a strong interest in the Bankruptcy Code, including lawyers, judges, agency officials, managers and shareholders of corporations, and politicians; and, perhaps most significantly, (3) debtors, considered as the class of people who are potential beneficiaries of bankruptcy law, do not compose an organized and politically influential group. A satisfactory explanation of the Bankruptcy Code must take into account the interests of all relevant parties and the extent of their political power.

An understanding of the political influences on the origin of the Bankruptcy Code is of considerable importance at the present time. In 1994 Congress created a National Bankruptcy Review Commission for the purpose of evaluating the bankruptcy system and proposing amendments.(1) The Commission has held hearings, has voted on a variety of proposals, and is expected to issue a report in October, 1997.(2) One question that has not received much attention concerns the extent to which political realities constrain the Commission's behavior and the extent to which they will affect Congress's reception of its report. One way to approach this question is to look back at the political background of the Bankruptcy Reform Act of 1978, develop a political theory of its origin, and use this theory to shed light on the political determinants of the bankruptcy amendment process.

These are the goals of this article. In particular, this article analyzes the legislative history of the Bankruptcy Reform Act of 1978(3) and related materials, in the hope of describing the influence of interest groups on the final statute. It has, of course, long been assumed that certain narrow provisions of the 1978 Act reflect the influence of interest groups -- for example, the section that gives special protection to security and lease interests in aircraft.(4) This article goes farther and argues that fundamental elements of the 1978 Act reflect political compromises among competing interest groups. In particular, I claim (1) that -the allocation of powers to bankruptcy judges and trustees resulted from efforts by Congress to increase its patronage opportunities, (2) that the provisions on exemptions resulted from a conflict between federal and state officials over the power to make transfers to local interest groups, and (3) that the provisions on business reorganization resulted from efforts by managers' lawyers and large creditors to maximize their influence on the reorganization of distressed firms, at the expense of other interests, such as equity and small debt. I make similar claims about the provisions on reaffirmation, student loans, and the fraud exception to the right to discharge.

These conclusions grow from the application of ideas from public choice theory to the legislative history of the Bankruptcy Code. The use of this methodology represents a departure from most bankruptcy scholarship, which is normative, doctrinal, or empirical. This article, in contrast, analyzes the political determinants of bankruptcy law: its contribution is its description of the ways in which the political process resulted in a particular kind of bankruptcy system.(5)

Because of the length of the article, a brief overview will be helpful to the reader. The argument begins in Part I with a general discussion of the features that are generally believed to characterize a socially desirable bankruptcy law. This discussion provides a baseline for identifying distortions caused by the influence of interest groups. To clarify the nature of these political interests, Part II contains a stylized cast of characters, categorized into debtors, creditors, elected and unelected federal authorities, state authorities, and lawyers, and analyzes their interests in bankruptcy reform. After some methodological notes in Part III, Part IV describes the legal and political background of the Code. It describes the 1898 Act, as amended, that prevailed prior to the enactment of the Bankruptcy Reform Act in 1978; it discusses the sources of dissatisfaction with the 1898 Act; and it summarizes the legislative history of the 1978 Act.

Next come the arguments about the influence of interest groups on the final statute. Part V analyzes the administrative structure created by the 1978 Act. Part VI analyzes the exemption rules. Part VII analyzes the provisions relating to corporate reorganization. Part VIII analyzes three less significant issues that nonetheless generated a great deal of controversy: the dischargeability of educational loans, the reaffirmation of debts, and the fraud exception to discharge. The conclusion, Part IX, draws out the implications of the arguments for bankruptcy reform and discusses some of the proposals currently before the National Bankruptcy Review Commission.

1. NORMATIVE THEORIES OF BANKRUPTCY LAW

   In public choice studies it is standard to describe the optimal version of the law in question and use interest group theory to explain the observed deviations. This approach raises difficulties because the optimal version of a particular law may be controversial. Bankruptcy law is no exception. Nevertheless, a few comments on the academic debate concerning optimal bankruptcy law may provide a useful, if rough, baseline for the political analysis.

   1. Procedures for the Satisfaction of Multiple Claims

      The optimal bankruptcy law solves a collective action problem that arises when a debtor defaults on loans from several creditors. Default frequently occurs when a debtor borrows from multiple creditors and has too few assets to pay back all of them. In the absence of a bankruptcy system, the creditors would have an incentive to race to the courthouse and obtain a judgment before the other creditors realized that the debtor is insolvent. The reason is that under state law the first creditor to obtain a judgment against a debtor has a better chance to seize the debtor's assets than later creditors do. The race to the courthouse creates several costs, including the cost of monitoring the debtor closely in order to be the first to detect an impending default and the loss of the going-concern or relationship-specific value of assets that occurs when solvent debtors with temporary cash-flow problems are driven into insolvency because creditors prefer seizing assets immediately to maximizing the value of all the debtor's assets. Bankruptcy law reduces these costs by providing for an orderly collection procedure, including (1) an automatic stay that prevents creditors from pressing a claim unless it would be destroyed by the delay, and (2) a distribution system that for the most part respects prebankruptcy entitlements.(6)

      In theory, the collective action problem could be mitigated through bargaining. Ex ante, creditors can protect themselves with security interests, debt covenants, and other contractual provisions; in the absence of the Bankruptcy Code's restrictions on waivers they could contractually provide for a post-insolvency division of assets.(7) Because the rules designed to ensure an orderly collection procedure also affect such bargaining, and the influence of rules on bargaining can be analyzed only with great difficulty, the optimal design of the collection procedure in bankruptcy remains poorly understood.

   2. Discharge

      The bankruptcy policy of discharge for consumer debtors does not have as clear an explanation. The puzzle is that debtors, like creditors, want to minimize the cost of credit. The right to discharge, however, increases the cost of credit, because it prevents creditors from collecting some of their debts, and they must pass on their costs to debtors in the form of higher interest rates. Although debtors who face unanticipated costs ex post should be delighted with the chance of discharging their debts, the policy injures the interests of debtors as a class. Another way of putting this is that people who already have a lot of debt may support discharge; but the vast majority of people, who, whether or not they already have debt, expect to continue taking on debt into the future, should object to the (nonwaivable) right to discharge.(8)

      There are two possible solutions to this puzzle.(9) The first assumes that most people see poverty as an evil and are willing to pay, through taxes, to see it reduced. The nonwaivable right to discharge supplements the welfare system in two useful ways. First, it discourages debtors from contracting out of the welfare system by using as collateral assets that are necessary to minimal well-being. Welfare laws prohibit the use of welfare payments as collateral; discharge law (along with exemption law) renders valueless "necessary" assets, however defined, and future income as collateral by barring...