The Shadow Bankruptcy System
Jonathan C. Lipson
Temple University - James E. Beasley School of Law
April 24, 2009
Boston University Law Review, Vol. 89, 2009
Temple University Legal Studies Research Paper No. 2009-21
This article exposes and explores a puzzle at the heart of the current economic crisis: The surprising under-use, and increasing misuse, of Chapter 11 of the United States Bankruptcy Code, the principal legal system for salvaging troubled businesses.
The answer offered here: The rise of the shadow bankruptcy system. "Shadow bankruptcy" describes the severely under-regulated non-bank financial institutions (e.g., hedge funds, private equity funds and investment banks) that increasingly dominate and manipulate Chapter 11 reorganizations.
Like the "shadow banking" system for which it is named, shadow bankruptcy thrives on and promotes opacity and undisclosed, possibly perverse, incentives. Shadow bankruptcy players exploit regulatory gaps to conceal their identities and motives, and so increase the uncertainty, complexity - and thus the cost - of negotiations to restructure distressed firms; they burden judicial resources through internecine fights of little benefit to reorganizing debtors; they have complex, multi-faceted hedging strategies that may effectively short-sell the debtor's reorganization effort, resulting in depressed asset values and the premature liquidation of otherwise viable firms.
Shadow bankruptcy threatens Congress' basic aspiration in creating Chapter 11: preserving going concerns and jobs through negotiated reorganizations. Shadow bankruptcy thus promises to do for corporate reorganization what shadow banking did for the global financial system: privatize gains and socialize losses.
This article explores the contours and costs of the shadow bankruptcy system. It also suggests some cures.
Number of Pages in PDF File: 78
Keywords: bankruptcy, reorganization, chapter 11, shadow banking, credit crisis, financial regulation, securities regulation, hedge funds, investment banks, private equity funds
JEL Classification: K12, K22
Date posted: April 25, 2009 ; Last revised: May 12, 2010