58 Pages Posted: 27 Feb 2013 Last revised: 17 Nov 2016
Date Written: October 2013
Bankruptcy reallocates value in a faltering firm. The bankruptcy apparatus eliminates some claims and alters others, leaving a reduced set of claims to match the firm’s diminished capacity to pay. This restructuring is done according to statutory and agreed-to contractual priorities, so that lower-ranking claims are eliminated first and higher ranking ones are preserved to the extent possible. Bankruptcy scholarship has long conceptualized this reallocation as a hypothetical bargain among creditors: creditors agree in advance that if the firm falters, value will be reallocated according to a fixed set of predetermined rules and contracts. In any given reorganization case, creditors may contest how the priority rules are applied — arguing over which creditor is prior and by how much. But once creditors’ relative status under the fixed priority rules is determined or compromised, the lowest-ranking financiers are eliminated. If there is not enough value left to go around for a group of equal-ranking creditors, creditors in that lowest-ranked group share proportionately.
In this paper, we argue that over the long haul, the normal science of Chapter 11 reorganization differs from this creditors’ bargain. The bargain is never fixed because creditors regularly attempt to alter the priority rules and often succeed. Priority is in fact up for grabs. Bankruptcy should be reconceptualized as an ongoing rent-seeking contest in which creditors continually seek to break priority — to obtain categorical changes in priority rules in order to jump themselves ahead of competing creditors. Creditors seek to break priority by inventing innovative transactional structures, by persuading courts to validate their priority jumps with new doctrine, or by inducing Congress to enact new rules. Because these breaks are often successful, creditors must continually adjust to other creditors’ successful jumps. They can adjust to a priority break either by accepting it and modifying their terms for future transactions, or by attempting to suppress it with countermeasures. In recent years, major priority jumps have come from transactional innovation — such as special purpose vehicles — and from judicial sanction — via roll-up financing and critical vendor payment doctrines. And they have come from lobbying Congress. Financial industry participants obtained jumps from Congress for derivatives and repurchase agreements in the 1980s and 1990s, concessions that facilitated the financing that exacerbated the 2007-2009 financial crisis. Priority jumping, and the subsequent acquiescence, reaction, and reversal, are also part of bankruptcy history, from the equity receivership to the chapter X reforms of the 1930s to the 1978 Bankruptcy Code.
We explain how priority jumping interacts with finance theory and how it should lead us to reconceptualize bankruptcy not as a simple, or even a complex, creditors’ bargain, but as a dynamic process with priority contests fought in a three-ring arena of transactional innovation, doctrinal change, and legislative trumps. The process of breaking bankruptcy priority, of reestablishing it, or of adapting to it is where bankruptcy lawyers and judges spend a large portion of their time and energy. While a given jump’s end-state (when a new priority is firmly established) may sometimes be efficient, bankruptcy rent-seeking overall has significant pathologies and inefficiencies.
Keywords: bankruptcy, restructuring, priority, rent-seeking, creditors’ bargain, reorganization, derivatives, financial crisis, repo, special purpose vehicle
JEL Classification: G18, G30, C34, G38, J52, K11, K12, K22, L21, L62
Suggested Citation: Suggested Citation
Roe, Mark J. and Tung, Frederick, Breaking Bankruptcy Priority: How Rent-Seeking Upends the Creditors’ Bargain (October 2013). Virginia Law Review, Vol. 99, No. 6, 2013 ; Harvard Public Law Working Paper No. 13-15; Boston Univ. School of Law, Law and Economics Research Paper No. 13-4; Boston Univ. School of Law, Public Law Research Paper No. 13-4. Available at SSRN: https://ssrn.com/abstract=2224035 or http://dx.doi.org/10.2139/ssrn.2224035