Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution
Seton Hall Law School; Harvard Law School - John M. Olin Center for Law and Economics
Davis Polk & Wardwell LLP - New York Office
August 29, 2010
Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011
Seton Hall Public Law Research Paper No. 1632084
The United States is at the start of a surge in fraudulent transfer litigation. During the credit boom that started in 2003 and peaked in 2007, a remarkable volume of bank loans and bonds were issued, and a remarkable volume of highly leveraged transactions were financed. As these debts become due and financially strapped businesses struggle to refinance, the outcome will almost certainly be a wave of defaults, bankruptcies, and intercreditor disputes including fraudulent transfer litigation.
The decisions that bankruptcy courts make in adjudicating these disputes will cause tens if not hundreds of billions of dollars to change hands over the next few years. If bankruptcy courts make prudent decisions, courts could help shape credit policy at U.S. banks for a generation. Unfortunately, the methods that bankruptcy courts have traditionally used to adjudicate fraudulent transfer claims have at times led to inconsistent, unpredictable, and inadvertently biased outcomes. The problem is two-fold: First, courts’ reliance on experts introduces tremendous subjectivity and complexity into the process. Second, well-established features of human psychology - which cannot be overcome through bankruptcy judges’ good intention - taint the decision making process with legally impermissible hindsight bias.
This article discusses recent legal and financial innovations that may aid bankruptcy courts in assessing fraudulent transfer claims in large business bankruptcies. These innovations have the potential to diminish the importance of experts, increase consistency and predictability of the law, de-bias and simplify judicial decision-making, and ultimately help stabilize the economy by deterring imprudent business decisions. Part I of this article discusses the dramatic increase in financial leverage throughout the economy during the last decade of prosperity, the recession that began in 2008, and why fraudulent transfer law may determine who will bear billions in losses. Part II of this article describes the historic and intellectual development of fraudulent transfer law, the expert-centered paradigm that prevailed during the last twenty years, experimental and real-world evidence of the problem of hindsight bias, and two recent decisions that suggest the emergence of a new market-centered paradigm. Part III of this article explains how this new market-centered paradigm - coupled with recent innovations in the financial markets and finance theory - can enable fraudulent transfer law to more effectively achieve its historic policy objectives. Part IV of this article includes original empirical analysis of the relationship between equity and credit default swap prices as debtors approach bankruptcy. Part V explains how judicial adoption of the methods we suggest would improve credit decisions at banks and prevent destabilizing transactions.
Number of Pages in PDF File: 104
Keywords: LBO, Leveraged Buyout, Bankruptcy, Banking, Psychology, Predicting Default, Credit Default Swap, Bond Spread, Credit Spread, Structural Model, KMV, Merton, Market-Implied Probability, Risk, Hindsight, Hindsight Bias, Judicial Decision Making, Equity, Debt, Derivatives, Fixed Income, Spread
JEL Classification: G33, K20, K4, K41, K42, A1, A11, B23, B41, C53, C78, D4, D8, D81, D84, D83, E37, E4, E43, E44, E47
Date posted: July 17, 2010 ; Last revised: April 25, 2011
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