The Costs of Liquidity Enhancement: Transparency, Risk Alteration and Coordination Problems
Edward J. Janger
Brooklyn Law School
January 25, 2010
Brooklyn Journal of Corporate, Financial, and Commercial Law, Vol. 34, p. 38, 2010
Brooklyn Law School, Legal Studies Paper No. 180
Much of modern commercial law is devoted to the cause of enhancing the liquidity of debt. From the “holder in due course” doctrine for commercial paper to the laws designed to facilitate asset backed securitization, the advent of credit derivatives and the emergence of bankruptcy claims trading the focus has been on protecting liquidity.
Little attention has been paid to the fact that liquidity enhancement has costs. This Article takes a skeptical look at liquidity enhancement, seeking to catalogue the direct (transactional) and indirect (social) costs of enhancing liquidity, and then questioning certain assumptions about the justification for facilitating the post-petition trading of claims in bankruptcy. Part I describes the traditional doctrines used to enhance the liquidity of otherwise illiquid assets, and detail the modern transactional devices that are used to similar effect on new categories of assets, regardless of whether the traditional prerequisites for liquidity enhancement are met. Part II catalogues the various transparency, and other costs, associated with liquidity enhancement generally, and the novel liquidity enhancement devices in particular. Part III describes a number of contexts in bankruptcy where courts have been faced with a tension between liquidity enhancement and bankruptcy policies. In most of these cases, liquidity policies have won out over bankruptcy policies. The article concludes by arguing that the debate about post-bankruptcy claims trading operates from the wrong baseline. Regulation of claims trading is generally treated as liquidity harming, but actually, allowing any claims trading post-bankruptcy should be viewed as a liquidity enhancement doctrine, and its desirability as policy should be weighed against its effects on reorganization policy. In my view, bankruptcy policy and the market will be better served by close attention to the traditional limits on liquidity enhancement than by a mindless solicitude for debt markets.
Number of Pages in PDF File: 20
Keywords: bankruptcy, commercial law, contracts, securities, law and economics
Date posted: January 27, 2010