By Kenneth Ayotte (University of California Berkeley), Jason Donaldson (University of Southern California), and Giorgia Piacentino (University of Southern California)
What is the purpose of corporate bankruptcy law? What problems is the law set up to solve? In our paper, we propose an economic framework that is simple but more comprehensive than existing frameworks. We argue that there are three major problems that bankruptcy law addresses: commons, anticommons, and agency. The commons problem is sometimes called the ‘creditor run,’ or the ‘grab race’: creditors acting individually to seize a debtor’s assets can destroy value for the creditors collectively. The anticommons problem is the problem of holdout: creditors exercising rights to block a collective action can lead to costly delay. And the agency problem occurs when some creditors have neither the rights to seize, nor to block. This absence of creditor rights empowers controllers to benefit themselves at the weakened creditors’ expense.
These three problems constitute what we call bankruptcy’s trilemma: three undesirable alternatives that a firm in financial distress cannot eliminate simultaneously. Bankruptcy’s key changes to non-bankruptcy rights come in three basic forms: a stay (to address commons problems), transaction limits on controllers (to address agency problems), and forced exchanges of rights (to address anticommons problems). When the law tries to address one problem, it inevitably creates one of the other two. Bankruptcy’s automatic stay, for example, stops the creditor run, but it leaves assets under the control of management who may dissipate them. Reorganization plan rules that disable holdouts, such as majority voting provisions in classes and cramdown plans, can also enable collusive deals between controllers and majority groups of creditors.
By simplifying the law in this way, our framework can serve as a helpful teaching tool—one equipped to analyze the law from a case’s beginning to middle to end. The predominant theory of bankruptcy, the Creditors’ Bargain Theory, focuses exclusively on the commons problem. But much of bankruptcy law in practice involves the other problems in the trilemma. U.K. debt restructuring law, for example, operates mostly without a stay. Legal interventions, such as schemes of arrangement, target anticommons problems.
In the modern U.S. bankruptcy, the tension between the anticommons and agency problems is the most salient. One example of an agency-anticommons tradeoff is the “sub rosa DIP loan.” These loans strategically bundle reorganization plan terms and case process controls into DIP financing requests at the outset of cases. Controllers argue that anticommons costs of blocking the loan are extreme, since a lost financing opportunity will destroy the going concern. But plan-like DIP loan terms can lock in
collusive deals that undermine priorities while providing protections for agents, such as releases of liability. The normative debate about “Texas Two-Step” divisional mergers similarly reflects an agency-anticommons tradeoff. Proponents of the strategy argue that keeping operating assets outside of bankruptcy entirely limits undue court interference and delay, while its opponents argue that it enables corporate controllers like Johnson & Johnson to escape tort liability.
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