Bankruptcy’s Endowment Effect

The notion of endowments and entitlements has a powerful effect on corporate bankruptcy policy. Scholars and lawyers generally assume a creditor endowed with a right outside of the bankruptcy system must receive the equivalent of that right when its debtor is within the bankruptcy system. The proponents of this idea often assert that the result is required by the foundational theory of bankruptcy.

In a forthcoming essay, ‘Bankruptcy’s Endowment Effect’, I demonstrate that this is false. The idea of sacred creditor endowments is an untenable position that misunderstands the fundamental principles of bankruptcy. Corporate bankruptcy is, at its core, a system that alters nonbankruptcy endowments according to a hypothetical bargain that all creditors of a firm would have entered into if bargaining were costless. The entire point of that hypothetical bargain is to suspend and alter some nonbankruptcy endowments with the goal of maximizing the value of the bankruptcy estate and the firm as a whole. Indeed, if every stakeholder retained all of its nonbankruptcy endowments, the Bankruptcy Code would have no provisions at all.

Of course, altering nonbankruptcy endowments can impose costs. Foremost among those costs is the risk of opportunistic behavior that is costly for the estate as a whole. Bankruptcy policy will, therefore, be designed to achieve its estate-maximizing purpose while minimizing opportunistic bankruptcy behavior that destroys firm value. This is all to say that the guiding principle for optimal bankruptcy design should not be the preservation of nonbankruptcy rights but rather should be the minimization of opportunistic behavior that reduces the net value of a firm.

With that principle in hand, we can resolve many difficult questions of bankruptcy policy. In the essay, I focus applying the principle to the debate over what interest rate a senior creditor should get in a chapter 11 cramdown. In particular, I analyze the dispute in In re MPM Silicones, LLC (‘Momentive’) where the bankruptcy court mistakenly reached its final decision by importing a creditor-endowment framework from consumer bankruptcy law (where the framework might make more sense).

I show that an optimal rule for corporate bankruptcy—properly focused on the minimization of opportunistic behavior—supports a cramdown interest rate based on the prevailing market rates for similar loans. A coherent cramdown system will both prevent creditors from destroying value by opportunistically opposing a plan and prevent debtors from destroying value by opportunistically proposing cramdown. If a creditor can insist on foreclosing on an asset that has going concern value, it will make threats to extract rents. Those threats can lead to bargaining failures that destroy estate value. Similarly, if debtors get consistently better rates of interest in cramdown, they will flood courts with chapter 11 cases that never should have been filed. Moreover, debtors who otherwise would have filed will be artificially drawn toward proposing inefficient cramdown plans. They will even, as the debtors in Momentive did, make threats of or propose inefficient plans for the sole purpose of extracting rents from creditors.

Neither of these outcomes serves any valid purpose for corporate reorganization. And both can be avoided by a system that allows cramdown but tests its rate against the market alternatives that face a debtor at that time in the real world. I show that a focus on real-world market rates—and not intrinsic values—is necessary to properly align the incentives of those making the decision to pursue the cramdown option rather than the other options available in the market.

Anthony J. Casey is a Professor of Law and Mark Claster Mamolen Teaching Scholar at the University of Chicago.