Federal Intervention to Enhance Shareholder Choice

Abstract

The modern approach to corporate reorganizations begins in a curious place. Everywhere else in corporate law, we focus on those who control the firm and on when others should be able to go to court and reverse their decisions. With respect to corporate reorganizations, however, we ignore these questions and instead focus on priority rights. Our lodestar is the real estate foreclosure. A real estate foreclosure is an actual sale of a physical asset, and the proceeds of the sale are distributed to old creditors and shareholders according to nonbankruptcy priorities. A reorganization is also a sale, albeit a hypothetical one, and the proceeds of the sale (usually in the form of new claims against the reorganized firm) are again distributed to the old creditors and shareholders. Hence, nonbankruptcy priorities should be respected here as well. According to this conventional wisdom, the primary challenge in the law of corporate reorganizations lies in devising a process that allows us to respect priority rights when there is not an actual foreclosure with competing bids.

In this paper, we show that this conventional understanding of corporate reorganizations is wrong. It might seem that the primary question when all cannot be paid in full is who gets what, but this question is in the first instance merely distributional. It concerns only the size of the slices, not the size of the pie. Rational investors are indifferent to the priority they enjoy in bad states as long they enjoy a competitive risk-adjusted return on their investment. Hence, the central focus of corporate reorganizations should not be upon priority rights. Instead, as in corporate law generally, it should remain upon how the firm's assets are used and who controls them. Investors care intensely about ensuring that control of a firm's assets resides in able hands in good times; they care even more in bad times. When a firm is in financial distress, a large part of its value can be lost in a short period of time.

The starting place for corporate reorganization scholarship since the 1930s -- the real estate foreclosure -- ignores the question of control. Real estate foreclosure turns tangible assets into cash. With such a sale, there is no need to decide whether to liquidate the firm or to replace the current managers. These decisions can be entrusted to the new buyer. The only question is the distribution of cash among old creditors and shareholders. By contrast, in a reorganization that might last months or years, we must ask whether to continue the firm, how to identify those who will run it, and how to monitor them. About these questions, the real estate foreclosure analogy has nothing to say.

Moreover, the foreclosure analogy leads to a method of allocating rights among old investors in the new entity that is affirmatively suspect. This distributional scheme-the absolute priority rule- demands that shareholders of insolvent firms be wiped out in the event of a reorganization. This rule exists uncomfortably with a persistent and pervasive feature of the capital structures of all but the largest, publicly held firms. In smaller firms, there is a near identity between shareholder and manager.

The value of such firms as going concerns depends upon the firm-specific human capital of its manager. To be sure, if the firm lacks any value as a going concern, it should be liquidated. In such a case, there is an actual sale and nonbankruptcy priorities should be respected. But a significant number of firms have value as going concerns, and this value can be preserved only if the current manager remains in place and continues to hold the equity of the firm. When such a firm is kept as a going concern, a deal must be struck with the current manager one way or another. The dynamics of these renegotiations are such that the absolute priority rule likely has no effect on the share of the firm the manager enjoys after the reorganization, nor does it change her incentives beforehand. In short, modern scholars of corporate reorganizations have asked the wrong question and then offered an answer that is very likely irrelevant.

In this Essay, we reexamine the foundations of corporate reorganizations. More in harmony with the modern understanding of corporate law, our approach does not begin with the real estate foreclosure and does not assume the centrality of the absolute priority rule. With respect to small firms or firms in less developed capital markets, we show that the question of whether to shut down the firm is of central importance. The challenge of the law of corporate reorganizations should be one of ensuring that this decision is in the hands of someone well equipped to make it.

The thesis put forward in this Essay is straightforward. When the managers and shareholders cannot be easily separated, control rights should lie in the hands of someone whose loyalties are aligned with the creditors, but the reorganization itself should not affect the value of the managers' equity interest. These principles are not new, but rather forgotten. Although they barely made a toehold in the academic literature of the time, 10 the early law of corporate reorganizations in this country adopted these principles in an environment in which it seems likely that they vindicated the creditors' bargain. Hence, it is this body of law to which we turn first.

JEL Classification: G30, H70, K22