Bankruptcy: Cui Bono?

If you're interested in bankruptcy, you can't do better than David Skeel's book Debt's Dominion, which traces the emergence of American bankruptcy law.  America's free-and-easy bankruptcy regime was--indeed, is--pioneering, and I'd argue that it had a lot to do with the dynamism of our economy.  Yet his book illustrates just how messy, and contingent, that process was.  If anything, this gives me hope about the administration's shenanigans; there is no perfect historical era from which we are fallen, or falling.

But some eras are better than others.  Interestingly, Skeel has a new piece up at The American arguing that, at least on this front, the New Dealers improved bankruptcy--and that the administration's recent actions represent a throwback to a less happy era:

In the early 20th century, large troubled corporations did not file for Chapter 11 like they do today. They used a process known as "equity receivership," which involved an artificial "sale" of the company to a new entity set up by the debtor and the investment banks who represented its bondholders and stockholders. The new entity was the only bidder at the sale, and creditors who were unhappy with the terms of the reorganization had very little opportunity to interfere.

New Dealers hated the process, which they saw as opaque and designed to foist a deal crafted by the insiders on everyone else. Jerome Frank, a lawyer who later headed an important New Deal agency and became a federal judge, complained in 1933 that the judicial sale in these cases "was a mockery and a sham." He said, "A sale at which there can be only one bidder, is a sale in name only." In 1938, thanks to the handiwork of another prominent New Dealer, future Supreme Court Justice and then-SEC Chairman William Douglas, Congress dramatically altered the bankruptcy laws, eliminating the former practice.

The Obama administration blueprint for Chrysler's bankruptcy looks startlingly like the artificial sales that the New Dealers so abhorred. Unlike a traditional reorganization, in which the parties negotiate the terms of a restructuring that is then voted on by each class of creditors and shareholders, the administration plans to quickly sell Chrysler's most important assets to a new entity--"New Chrysler"--whose stock will be owned by Chrysler's employees and Fiat. The senior lenders who objected to the government's offer (which amounted to little more than 30 percent of their claims) will not have any vote on the sale. Their only option is the one they have pursued: objecting to the sale, and praying that bankruptcy judge Arthur Gonzalez takes a hard look at its terms even while the government is breathing down his neck and saying in a sense, he better approve or else.

As the administration has pointed out in defense of its plan to commandeer the bankruptcy process, asset sales (known as 363 sales, based on the relevant provision) have become a common feature of Chapter 11 cases in the last 20 years. What makes the Chrysler plan unique, and makes it similar to the receiverships of the New Dealers' era, is that it is not really a sale at all. It is a pretend sale and its main purpose is to eliminate the pesky creditors who might otherwise interfere with the government's plans. It also seems to flout bankruptcy's priority rules by giving Chrysler's employees (who are general creditors) a big stake in New Chrysler while forcing senior lenders to take a major haircut. The usual rule is that senior creditors must be paid in full before lower priority creditors are entitled to anything.

I've interviewed Skeel for several articles, and he can't plausibly be termed a right-wing lunatic axe to grind; he has flexible and nuanced views of the bankruptcy process with a healthy respect for the benefits of a debtor-generous system, as you'll discover if you read his book.  If he thinks this is rather dangerous precedent, it probably is.

Bankruptcy is often portrayed as a question of creditors v. debtors, and of course that's not a ridiculous frame.  But just as important is the tension between insiders and outsiders.  This conflict has existed for as long as we've had insolvency, and it doesn't match up to the creditor/debtor divide.  In fact, you might think of it as another axis, with four quadrants.

I suspect Obama views his administration's actions as moving along the X axis towards a more debtor-friendly system.  But in fact, Chrysler, not the UAW, is the debtor, and it's not likely the company would have ended up in liquidation.  The administration's actions weren't debtor-friendly, they were insider friendly.  This was classic collusion among creditors, and it's why the parts of the bankruptcy law that deal with Section 363 sales spend so much time talking about the importance of avoiding sham transactions.  Cutting back on that sort of abuse was at least as important an achievement as giving debtors a fresh start.

There are, of course, changes that both benefit outsiders and debtors.  Britain's recent move away from letting senior secured creditors increased total recovery from the enterprise (though, to be fair, it also increased administrative costs.)  On the other hand, France's new debtor-friendly bankruptcy law has apparently made it nearly impossible for creditors to get insolvent companies to the table--nice for the companies, but bad for the creditors, and probably bad for anyone who would like to borrow money in the future.  American bankruptcy works so well precisely because it provides an orderly process that everyone has to participate in, where no one group's interests are paramount.

If you're interested in bankruptcy, you can't do better than David Skeel's book Debt's Dominion, which traces the emergence of American bankruptcy law.  America's free-and-easy bankruptcy regime was--indeed, is--pioneering, and I'd argue that it had a lot to do with the dynamism of our economy.  Yet his book illustrates just how messy, and contingent, that process was.  If anything, this gives me hope about the administration's shenanigans; there is no perfect historical era from which we are fallen, or falling.

But some eras are better than others.  Interestingly, Skeel has a new piece up at The American arguing that, at least on this front, the New Dealers improved bankruptcy--and that the administration's recent actions represent a throwback to a less happy era:

In the early 20th century, large troubled corporations did not file for Chapter 11 like they do today. They used a process known as "equity receivership," which involved an artificial "sale" of the company to a new entity set up by the debtor and the investment banks who represented its bondholders and stockholders. The new entity was the only bidder at the sale, and creditors who were unhappy with the terms of the reorganization had very little opportunity to interfere.

New Dealers hated the process, which they saw as opaque and designed to foist a deal crafted by the insiders on everyone else. Jerome Frank, a lawyer who later headed an important New Deal agency and became a federal judge, complained in 1933 that the judicial sale in these cases "was a mockery and a sham." He said, "A sale at which there can be only one bidder, is a sale in name only." In 1938, thanks to the handiwork of another prominent New Dealer, future Supreme Court Justice and then-SEC Chairman William Douglas, Congress dramatically altered the bankruptcy laws, eliminating the former practice.

The Obama administration blueprint for Chrysler's bankruptcy looks startlingly like the artificial sales that the New Dealers so abhorred. Unlike a traditional reorganization, in which the parties negotiate the terms of a restructuring that is then voted on by each class of creditors and shareholders, the administration plans to quickly sell Chrysler's most important assets to a new entity--"New Chrysler"--whose stock will be owned by Chrysler's employees and Fiat. The senior lenders who objected to the government's offer (which amounted to little more than 30 percent of their claims) will not have any vote on the sale. Their only option is the one they have pursued: objecting to the sale, and praying that bankruptcy judge Arthur Gonzalez takes a hard look at its terms even while the government is breathing down his neck and saying in a sense, he better approve or else.

As the administration has pointed out in defense of its plan to commandeer the bankruptcy process, asset sales (known as 363 sales, based on the relevant provision) have become a common feature of Chapter 11 cases in the last 20 years. What makes the Chrysler plan unique, and makes it similar to the receiverships of the New Dealers' era, is that it is not really a sale at all. It is a pretend sale and its main purpose is to eliminate the pesky creditors who might otherwise interfere with the government's plans. It also seems to flout bankruptcy's priority rules by giving Chrysler's employees (who are general creditors) a big stake in New Chrysler while forcing senior lenders to take a major haircut. The usual rule is that senior creditors must be paid in full before lower priority creditors are entitled to anything.

I've interviewed Skeel for several articles, and he can't plausibly be termed a right-wing lunatic axe to grind; he has flexible and nuanced views of the bankruptcy process with a healthy respect for the benefits of a debtor-generous system, as you'll discover if you read his book.  If he thinks this is rather dangerous precedent, it probably is.

Bankruptcy is often portrayed as a question of creditors v. debtors, and of course that's not a ridiculous frame.  But just as important is the tension between insiders and outsiders.  This conflict has existed for as long as we've had insolvency, and it doesn't match up to the creditor/debtor divide.  In fact, you might think of it as another axis, with four quadrants.

I suspect Obama views his administration's actions as moving along the X axis towards a more debtor-friendly system.  But in fact, Chrysler, not the UAW, is the debtor, and it's not likely the company would have ended up in liquidation.  The administration's actions weren't debtor-friendly, they were insider friendly.  This was classic collusion among creditors, and it's why the parts of the bankruptcy law that deal with Section 363 sales spend so much time talking about the importance of avoiding sham transactions.