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Abstract:
The collapse of Long Term Capital Management (LTCM) in Fall 1998 and the Federal Reserve Bank's subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the "automatic stay" and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor's assets. It is commonly believed that the exemption for derivatives contracts helps reduce "systemic risk" in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity. Indeed, Congress is now contemplating reforms that would extend the exemption to include a broader array of financial contracts, all in the name of reducing systemic risk. This is a mistake. The Bankruptcy Code can do little to reduce systemic risk and may in fact exacerbate it, as the experience of LTCM suggests. Risk of a systemic meltdown arose there and prompted intervention by the Fed precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring.

A better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay. The stay protects assets to the extent they are needed to preserve a firm's going-concern surplus (its value above and beyond the sale value of its assets). Assets are needed to preserve going-concern surplus only if they are firm-specific, that is, only if they are worth more inside the firm than outside it. This is often true for plant and equipment. It is never true for derivatives contracts. This observation helps rationalize the Code's treatment of derivatives contracts and other features of the automatic stay. There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts). These downsides are probably not significant, but they highlight the fragility of the Code's treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code's exemptions for derivatives contracts.

Bankruptcy, Derivatives, Systemic Risk, Automatic Stay, Long-Term Capital Management, Enron, Asset Specificity

Abstract:
Until the firm is sold or a plan of reorganization is confirmed, Chapter 11 entrusts a judge with the decision of whether to keep a firm as a going concern or to shut it down. The judge revisits this liquidation decision multiple times. The key is to make the correct decision at the optimal time. This paper models this decision as the exercise of a real option and shows that it depends critically on particular types of information about the firm and its industry. Liquidations take place too soon if we merely compare the liquidation value of the assets with the expected earnings of the firm. Moreover, existing law undermines effective decisionmaking. Even though the judge makes the liquidation decision, a number of rules prevent the judge from controlling the timing of the decision, and those who do control it lack the incentive to ensure it is made at the optimal time. The paper introduces a framework that can illuminate many areas of law, such as summary judgment motions, parole, and agency rule making.

Abstract:
We analyze a sample of large privately and publicly held businesses that filed Chapter 11 bankruptcy petitions during 2001. We find pervasive creditor control. In contrast to traditional views of Chapter 11, equity holders and managers exercise little or no leverage during the reorganization process. 70 percent of CEOs are replaced in the two years before a bankruptcy filing, and few reorganization plans (at most 12 percent) deviate from the absolute priority rule to distribute value to equity holders. Senior lenders exercise significant control through stringent covenants, such as line-item budgets, in loans extended to firms in bankruptcy. Unsecured creditors gain leverage through objections and other court motions. We also find that bargaining between secured and unsecured creditors can distort the reorganization process. A Chapter 11 case is significantly more likely to result in a sale if secured lenders are oversecured, consistent with a secured creditor-driven fire-sale bias. A sale is much less likely when these lenders are undersecured or when the firm has no secured debt at all. Our results suggest that the advent of creditor control has not eliminated the fundamental inefficiency of the bankruptcy process: resource allocation questions (whether to sell or reorganize a firm) are ultimately confounded with distributional questions (how much each creditor will receive) due to conflict among creditor classes.

creditor, control, conflict, chapter 11, bankruptcy, equity, lenders, Ayotte, Morrison

Abstract:
We analyze a sample of large privately and publicly held businesses that filed Chapter 11 bankruptcy petitions during 2001. We find pervasive creditor control. In contrast to traditional views of Chapter 11, equityholders and managers exercise little or no leverage during the reorganization process: Seventy percent of CEOs are replaced in the two years before a bankruptcy filing; very few reorganization plans (at most eight percent) deviate from the absolute priority rule in order to distribute value to equityholders. Senior lenders exercise significant control through stringent covenants contained in DIP loans, such as line-item budgets. Unsecured creditors gain leverage through objections and other court motions. We also find that bargaining between secured and unsecured creditors can distort the reorganization process. A Chapter 11 case is significantly more likely to result in a sale if secured lenders are oversecured, consistent with a secured creditor-driven fire-sale bias. It is much less likely when these lenders are undersecured or when the firm has no secured debt at all. Our results suggest that the advent of creditor control has not eliminated the fundamental inefficiency of the bankruptcy process: resource allocation questions (whether to sell or reorganize a firm) are ultimately confounded with distributional questions (how much each creditor will receive), due to conflict among creditor classes.

Bankruptcy, corporate reorganization, Chapter 11, creditor control, DIP lending, creditor conflict

Abstract:
Over half of all small businesses reorganizing under Chapter 11 of the U.S. Bankruptcy Code are ultimately liquidated. Little is known about this shutdown decision and about the factors that increase or reduce the amount of time a firm spends in bankruptcy. It is widely suspected, however, that the Chapter 11 process exhibits a "continuation bias," allowing non-viable firms to linger under the protection of the court. This paper tests for the presence of continuation bias in the docket of a typical bankruptcy court over the course of a calendar year. A variety of tests are employed, including the extent to which entrenched managers dominate the bankruptcy process, the accuracy and speed with which viable and nonviable firms are distinguished, and the extent to which the hazard of shutdown is consistent with the implications of a simple, formal model of the optimal Chapter 11 process. Contrary to conventional wisdom, the paper finds that continuation bias is either absent or empirically unimportant.

Bankruptcy, Corporate Reorganization, Optimal Timing, Judicial Decisionmaking

Abstract:
The reforms of 2005 yield important but subtle changes in the Bankruptcy Code's treatment of financial contracts. They might appear only to eliminate longstanding uncertainty surrounding the protections available to financial contract counterparties, especially counterparties to repurchase transactions and other derivative contracts. But the ambit of the reforms is much broader. The expanded definitions - especially the definition of "swap agreement" - are now so broad that nearly every derivative contract is subject to the Code's protection. Instead of protecting particular counterparties to particular transactions, the Code now protects any counterparty to any derivative contract. Entire markets have been insulated from the costs of a bankruptcy filing by a financial contract counterparty. Equally important, the amendments limit judicial discretion to assess the economic substance of financial transactions, even those that resemble ordinary loans or that retire a debtor's outstanding debt or equity. The reforms of 2005 direct judges to apply a formalistic inquiry based on industry custom: a financial transaction is a "swap," "repurchase transaction," or other protected transaction if it is treated as such in the relevant financial market. The transaction's loan-like features or its effect on outstanding obligations of the debtor are irrelevant, unless they affect the transaction's characterization in financial markets. Absent fraud, form trumps substance - a desirable outcome, we argue, in light of the impossibility of drawing coherent lines between combinations of ordinary financial contracts and loans, dividends, or debt repurchases.

Bankruptcy, Financial Markets, Derivatives and Other Financial Contracts

Abstract:
This empirical study suggests that, far from ensuring assets are put to their best use, Chapter 11 encourages small-business entrepreneurs to remain too long with failed businesses before trying to start (or work for) new ones. Small entrepreneurs open and close a number of businesses over the course of their careers as they search for the business (or employer) that offers the best match with their skills. Chapter 11 delays this matching process and, over this dimension, differs little from rent control and other government policies that encourage socially wasteful lock-in of scarce resources. These costs may not be large, as bankruptcy judges are aware of and guard against them. At the same time, however, few benefits offset these costs. The typical Chapter 11 is a small business that has few, if any, specialized assets. It is organized around the owner-operator's human capital and can be (and usually is) reassembled by the owner at low cost. Other than delay, the outcome of a Chapter 11 case - reorganization or liquidation - has little bearing on a small entrepreneur's career.

Small Business Bankruptcy, Chapter 11, Entrepreneurship, Asset Specificity, Job Search

Abstract:
In the United States, few failing businesses invoke the Bankruptcy Code to reorganize or liquidate. Most use non-bankruptcy procedures to accomplish the same purposes. These procedures include voluntary agreements between the debtor and its creditors (workouts) and formal devices such as friendly foreclosures, bulk sales, and assignments for the benefit of creditors. This paper documents the importance of non-bankruptcy procedures using firm-level data from Cook County, Illinois. I find that these procedures are used by eighty percent of distressed small businesses. The paper also identifies the conditions under which a business chooses federal bankruptcy law over non-bankruptcy procedures. I model this choice - theoretically and empirically - as the outcome of a bargaining game between the debtor's owner and its senior lenders. The parties are more likely to consent to non-bankruptcy procedures when bargaining costs are low and when the debtor has maintained a close relationship with senior lenders, who trust the information provided by the owner. When the number of senior lenders is relatively large (raising bargaining costs) or when the debtor has defaulted on senior debt (thereby harming its relationship with lenders), senior lenders are more likely to push for a federal bankruptcy filing. Owners may also prefer a federal filing when in-bankruptcy rules give greater priority to particular creditors whom the owner would like to favor. These findings suggest that federal bankruptcy reforms, such as the Bankruptcy Abuse and Protection Act of 2005, will have two effects on distressed small businesses: They will impact outcomes in federal courts (intensive margin) as well as the debtor's choice between bankruptcy and non-bankruptcy procedures (extensive margin). Variation along the extensive margin can neutralize reforms in federal law, as when a reform designed to protect unsecured creditors raises the cost of federal law and induces businesses to use cheaper non-bankruptcy procedures instead.

Bankruptcy, small business, corporate reorganization, debt collection, state law, assignment for the benefit of creditors, empirical

Abstract:
The Supreme Court's decision in Timbers of Inwood Forest occupies an unhappy position in bankruptcy case law. It is often remembered as a troubled interpretation of the Code, denying undersecured creditors compensation for an important source of depreciation - depreciation in the real value of a creditor's claim during a lengthy reorganization process. But Timbers was not a simple case in which a bank was denied adequate protection for lost investment opportunities. It was instead a case in which the bank tried to opt out of the bankruptcy process itself. The debtor was an apartment complex. After it entered bankruptcy, it assigned the apartment rents to the bank. These rents, economic theory tells us, closely approximated compensation for physical depreciation as well as lost investment opportunities. Yet the bank wanted more: it requested a second helping of compensation for lost investment opportunities, citing the Code's provision for adequate protection. Surprisingly, the bankruptcy court agreed; so did the Court of Appeals. But by the time the case reached the Supreme Court, it had morphed into something altogether different. Instead of an illustration of bank over-reaching, the case had become a vehicle for testing an abstract question - whether the phrase adequate protection encompasses compensation for lost investment opportunities. The Court may have decided that question incorrectly, but the end result - preventing bank over-reaching - was probably the right one. Indeed, Timbers' long-run impact may not go far beyond the parties to the case itself. The past fifteen years have seen legislative reforms, speedier cases, relatively low interest rates, and creditor control over the bankruptcy process, all of which have effectively neutralized Timbers' impact on most secured creditors.

Bankruptcy, Chapter 11, real estate, secured debt, adequate protection, time value of money

Abstract:
Recent scholarship emphasizes the increasing rarity of trials (adversary proceedings) in bankruptcy cases. We assess the importance of this pattern using data from the Northern District of Illinois. Adversaries are indeed rare - they are absent from the vast majority of bankruptcy cases - but their rarity tells us little that is meaningful about the bankruptcy process. They tend to be clustered in a tiny number of cases (one percent of bankruptcy cases account for over fifty percent of adversaries). They also focus on a narrow range of issues (objections to discharge in consumer cases; recovery of preferential transfers in business cases). Little has changed since the early 1990s. Although we see a decline in the rate with which adversaries are filed (from six percent of bankruptcy cases in 1993 to about three percent in the late 1990s), the baseline rate was already very low. The decline only tells us that a rare event has become rarer. One temporal change, however, is noteworthy: the average duration of adversaries fell from ten months to 7.5 between 1993 and 2002. This is consistent with recent evidence on the speediness of today's Chapter 11 process. These patterns tell us two things about the bankruptcy process. First, in consumer cases, the persistent rarity of adversaries, even when consumer filings surged during the late 1990s, casts doubt on claims that bankruptcy abuse was prevalent during the late 1990s and early 2000s. If abuse were becoming more prevalent, we should have seen more frequent use of adversaries to contest a debtor's discharge. Second, in corporate cases, adversary proceedings generally address issues, such as preferential transfers, that are orthogonal to the primary concern of Chapter 11 - rehabilitation of the debtor's business. Moreover, when adversaries are brought to attack preferential transfers, the proceedings are often commenced after the court has confirmed a plan of reorganization.

Bankruptcy, trials, adversary proceedings, empirical

Abstract:
When a firm encounters financial distress, there is a significant possibility that, at some point, the firm itself should be shut down and its assets put to a better use. But Chapter 11 and indeed all market-mimicking reorganization regimes other than a speedy auction entrust the shutdown decision to a bankruptcy judge who lacks information and expertise, as well as the ability to control the timing of her decisions. Understanding the costs of entrusting the shutdown decision to a bankruptcy judge is central to assessing any law of corporate reorganizations. This paper models the shutdown decision as the exercise of a real option. The model suggests that the shutdown decision may loom so large in the early parts of the bankruptcy case that it erases any significant difference between Chapter 11 and many alternative market-mimicking regimes. All these regimes take more time than mandatory auctions and thus increase the cost of taking the shutdown decision away from a market actor. Moreover, the real option itself gives parties an incentive to withhold information. Only a system of mandatory auctions both limits the amount of time the shutdown option resides with an inexpert decisionmaker and forces insiders to give that decisionmaker sufficient information to value the option while it is in her hands.

Abstract:
Most nations have enacted statutes governing business liquidation and reorganization. These statutes are the primary focus when policymakers and scholars discuss ways to improve laws governing business failure. This focus is misplaced, at least for distressed small businesses in the United States.

Evidence from a major credit bureau shows that over eighty percent of these businesses liquidate or reorganize without invoking the formal Bankruptcy Code.

The businesses instead invoke procedures derived from the laws of contracts, secured lending, and trusts. These procedures can be cheaper and speedier than a formal bankruptcy filing, but they typically require unanimous consent of senior, secured lenders. This essay identifies the conditions under which a business owner is able to obtain lender consent. The empirical findings point to an important balance between a nation's formal insolvency statutes an alternative modes of liquidation an reorganization. This balance, the essay argues, should play a central role in any discussion of insolvency-law reform.