Equity Auctions and a New Concept of Priority: Two Bankruptcy Reform Proposals
17 Pages Posted: 23 Mar 2001
Date Written: March 1, 2001
In this paper I present two reform proposals for a simplification of bankruptcy, especially for threshold and transition economies with mostly low standards of accounting, scarce institutional resources, and insufficient specific training for judges and lawyers. Goals are increased reliance on market valuations in business rescues, and more efficient and more intense involvement of creditors in decisions on the course and outcome of insolvency proceedings.
One proposal is to allow auctions of the equity of debtor corporations, in addition to traditional auctions of the assets of the debtor entity. Admitting an auction of the debtor's equity and maintaining the debtor entity in existence in a proceeding of the liquidation type will either enlarge our rescue toolbox, or permit a significant simplification of business rescues for threshold or transition economies because cumbersome reorganization proceedings may either become entirely unnecessary, or be needed only for very large enterprises, utilities, municipalities, or firms of significant regional and societal impact where a change of ownership may be impractical or undesirable. The traditional focus of bankruptcy on realizing the property of the debtor, i.e., essentially its garnishable and transferable assets, is ill suited to the fact that, in modern circumstances, credit is given generally not so much with a view to existing (static) property but with a view to the debtor's (dynamic) earning capacity which may often be inextricably inherent in the debtor organization. There are numerous cases where a survival of the debtor entity will serve creditors better than a rescue via one of the traditional asset deals, and where negotiation and confirmation of a plan in the traditional fashion will be too complex and too time-consuming.
The most critical issue in all liquidation types of enterprise rescue is the treatment of insider bids. There is a wide concern with fraudulent bankruptcies in some legislatures like the Russian. The specter of managers or shareholders who drive a company into bankruptcy willfully for the sole purpose of acquiring its business debt free at a depressed price is not altogether a fantasy. I propose to address the risk of insider dealing not by a ban on rescues of the liquidation type but by appropriate auction terms. In this context, the definition of "insider" must take account of the potential presence of asymmetric knowledge. For the treatment of insider bids a system of sequential auctioning, and civil and criminal sanctions on undisclosed insider bids are proposed.
Another proposal deals with priorities for pre-bankruptcy claims. Priorities create a number of inefficiencies and regrettable complexities. Priorities are accountable for the wide-spread disinterest and absenteeism of general creditors in creditor bodies. They also conflict in various ways with the principles of market conformity of the bankruptcy process. Claimants should be allotted influence rights on the course and outcome of proceedings according to the real value of their entitlements, i.e., the hypothetical dividend they may receive in a best-case liquidation, and not according to the nominal amount of their claims. Only those whose monetary interest is at stake should have a say. The aggregation of rights with different priorities in one voting pool or class conflicts with this principle.
I propose to replace traditional priorities, or the lexical (serial) ordering of priority classes, whereby a junior class may only receive value when all senior classes are paid in full, by a system of weighted multipliers that makes all creditor classes receive at least some payment and allows to aggregate all creditors in one voting pool and to simplify creditor voting. Obviously this system is not suited for secured credit and for administrative claims.
JEL Classification: K22
Suggested Citation: Suggested Citation