When should bankruptcy be an option (for people, places, or things)?

Author:Skeel, David A., Jr.

TABLE OF CONTENTS INTRODUCTION I. WHAT IS BANKRUPTCY? II. A FEW BANKRUPTCY PUZZLES III. WHEN DOES BANKRUPTCY WORK?: A FRAMEWORK FOR ANALYSIS A. Unsustainable Debt B. Reshaping Decision-Making Incentives C. Preventing Premature Liquidation D. The Dignity of the Debtor E. Spillover Effects IV. THE FRAMEWORK IN ACTION: THREE APPLICATIONS A. City Versus State Bankruptcy B. Corporations C. The Crisis in Europe CONCLUSION INTRODUCTION

Since the turn of the twenty-first century, bankruptcy has been proposed as a potential solution for the financial distress of an ever expanding group of entities. Three years ago, at a time when California was projecting annual deficits of more than $10 billion each year and Illinois's pensions were radically underfunded, a handful of U.S. politicians flirted with the idea of proposing a bankruptcy framework for U.S. states. (1) A decade earlier, after Argentina's most recent default, the International Monetary Fund (IMF) proposed, and briefly defended, a statutory framework it dubbed the "Sovereign Debt Restructuring Mechanism." (2) In each case, the proposals were quickly shot down, although neither seems to be entirely dead. As Greece's finances deteriorated in 2009 and 2010, for instance, the architect of the earlier IMF proposal rolled out a new version adapted to the European Union. (3)

At least for those of us in the United States, the fate of these proposals fits perfectly with widespread intuitions about where bankruptcy does and does not make sense. Whether they are bankruptcy experts or lay people, when most people think about bankruptcy, they have a simple left-to-right spectrum of possibilities in mind. The spectrum starts with personal bankruptcy, moves next to corporations and other businesses, and then to municipalities, states, and finally countries. We assume that bankruptcy makes the most sense for individuals; that it makes a great deal of sense for corporations; that it is plausible but a little more suspect for cities; that it would be quite odd for states; and that bankruptcy is unimaginable for a country.

The left-to-right spectrum also roughly parallels the history of federal bankruptcy law in the United States. The first federal bankruptcy law, enacted in 1800 and repealed several years later, was designed for merchants and traders--that is, individuals in business. (4) Subsequent nineteenth-century bankruptcy laws focused primarily on individuals and small businesses. Congress first added large-scale corporate reorganization to the bankruptcy laws in 1933 and 1934, (5) and it enacted the first municipal bankruptcy law in 1934. (6)

If we are working with this left-to-right spectrum in the back of our mind, the quick demise of proposals for a state or country bankruptcy framework is just what we would expect. The reaction to Detroit's recent bankruptcy filing has also been consistent with the usual intuitions. (7) Municipal bankruptcy is right in the middle of the spectrum, the point at which many observers may get a little queasy about the desirability of bankruptcy. In the past, nearly every municipal bankruptcy filing involved special-purpose entities like a sewage or water district or a small town, not a sizeable city. (8) Bankruptcy seemed harmless enough for these entities. But Detroit is different. It is a major city, and many wonder whether bankruptcy is an acceptable destination for a city. (9)

I hope to show in this Article that the standard shorthand for determining when bankruptcy should be an option is simply wrong. Although the intuitions are widespread and perfectly understandable, the left-to-right spectrum turns out to be incoherent. To develop this argument, I will begin by identifying a series of puzzles for the conventional wisdom. Using the left-to-right spectrum as our guide, we would expect, for instance, personal bankruptcy statutes to be ubiquitous, but they are not. Although state bankruptcy's near neighbor on the spectrum is corporate bankruptcy, it has far more in common with personal bankruptcy. State bankruptcy may make more sense, not less, than bankruptcy for municipalities. And bankruptcy is hard to justify for some corporations. At some point, as the anomalies multiply, it is time for another paradigm, or so I will argue.

If we throw out the standard spectrum, what are we left with? My second objective in this Article is to try to develop a more useful framework for considering whether and when bankruptcy makes sense. Drawing liberally from the existing literature, I will offer a five-factor typology for determining whether a bankruptcy framework is appropriate in any given context. The typology does not remove all questions about whether bankruptcy should be an option for any type of individual or entity, but it focuses attention on the key factors and relevant tradeoffs. The typology also helps to explain an odd disconnect in contemporary bankruptcy theory: the sharp differences between the normative justifications for corporate bankruptcy, on the one hand, and for consumer bankruptcy, on the other. (10)

Some may question whether a framework like this is necessary or useful. Why not simply ask, for instance, whether a bankruptcy option would be efficient and would minimize the cost of credit? To this objection, I give two answers. First, the five factors operationalize the efficiency concern by focusing attention on the particular factors that will determine whether bankruptcy is likely to be efficient in any given context. They give content to the efficiency analysis. Second, sometimes we do not want to minimize the cost of credit, as for example in contexts where potential spillover effects come into play. The five-factor framework allows us to account both for non-efficiency concerns and for the full range of efficiency issues.

Before I introduce the puzzles that seem to confound the left-to-right spectrum on bankruptcy, I should first explain what I mean by bankruptcy. I offer a very simple definition in Part I. I turn to the puzzles in Part II, outline the typology in Part III, and offer a series of applications in Part IV. I should note that I will focus entirely on the question of whether some kind of bankruptcy option is desirable, not the particular details of any given bankruptcy framework. I will not be concerned, except incidentally, with key issues such as the optimal priority rules or who should be permitted to initiate bankruptcy. (11)


    For my purposes, bankruptcy has four basic attributes. (12) First, bankruptcy enables a debtor to restructure its obligations. Thus, if the debtor owes $100 to a creditor, bankruptcy provides a way to reduce this obligation, so that it is decreased, say, to $70 or perhaps wiped out altogether. The extent to which the obligation is restructured will generally depend on the debtor's assets, current income, or both. But the important thing is that the obligation is reduced as a matter of law--the debtor now owes $70 or $0, not $100. The technical term is that part or all of the original obligation is "discharged." (13)

    Second, bankruptcy is imposed or facilitated by government or another third party. If a debtor owes $100 to a creditor and cannot pay it all, the debtor and creditor can, of course, agree on their own that the debtor will only pay $70, rather than $100. This is a private restructuring or workout, but it is not bankruptcy. (14) Bankruptcy is not purely private; there is a public role. (15)

    Third, it is collective in nature. A bankruptcy framework adjusts the debtor's relationship with most or all of its creditors, not just one. (16) A law that enables a debtor to discharge a particular obligation--say, a law that provided a partial or full tax amnesty to debtors who disclosed previously hidden income--would restructure an important debt, but it would not by itself be a bankruptcy law. Bankruptcy provides a collective forum for resolving financial distress.

    Finally, bankruptcy is specific to a particular individual, enterprise, or entity. (17) We could in theory restructure every business in an industry at the same time, (18) but that is not the way bankruptcy ordinarily works. Bankruptcy is specific to a particular debtor.

    Those who are familiar with insolvency law may immediately think of examples that do not fit neatly within the description I have just provided. For instance, most states have assignment for the benefit of creditors statutes that function very much like our federal bankruptcy laws. (19) Under an assignment law, a trustee takes control of the firm's assets, ordinarily sells them, and distributes the proceeds to creditors. (20) In recent years, many troubled businesses or their creditors have used state assignment laws as an alternative to bankruptcy, often due to the increased costs of a traditional bankruptcy after Congress's 2005 amendments to the bankruptcy laws. (21) State assignment laws have essentially the same effect as bankruptcy. They differ only in that they usually do not formally discharge all of the debtor's obligations. But the absence of a discharge has little significance if the business that is subject to an assignment for the benefit of creditors is a corporation, because limited liability already removes shareholders' personal responsibility for the obligations of the business. (22) Indeed, based on this reasoning, corporations that are liquidated under the bankruptcy laws are not given a discharge. (23) Assignment laws can thus be seen as bankruptcy laws, at least for debtors that have limited liability.

    Bank resolution laws, such as the new resolution powers given to bank regulators under the Dodd-Frank Act, are other borderline cases. Many commentators, including this one, distinguish between Dodd-Frank resolution and bankruptcy, usually characterizing Dodd-Frank or other bank insolvency rules as "administrative resolution," in contrast with bankruptcy under the bankruptcy laws. (24) The key difference lies in...

To continue reading