Institutional Capture: Why We’re Overdue for a New Bankruptcy Act

Injustice does not exist only in matters of civil rights, human dignity, and economic development. Rather, the grains of inequity can be found in all of our institutions, and each must be critically examined to determine the cause of systemic injustice and how it may be rectified for the betterment of the whole. The same is true for the US bankruptcy system and the Bankruptcy Code (‘the Code’). Looking from the outside, the bankruptcy system appears designed to protect crucial stakeholders in the economy, particularly because the Code is the most ‘debtor-friendly’ in the world. However, upon closer view, the deep institutional capture of the system becomes clear. Through a series of exemptions, promises of regulation, and broad drafting, the bankruptcy system has been reduced to nearly a puppet show, orchestrated by powerful corporations and financial institutions. The inequity has become vast, leaving unprotected stakeholder-creditors with little refuge.

The Code, as it stands now, was drafted in 1978 (though there have been amendments since). It comes as no surprise, given the academic discourse during the 1970s, that the Code is corporate-friendly as opposed to debtor-friendly. The previous version of the Code was drafted 40 years prior, demonstrating that, if the pattern holds, we may have reached a point on the timeline for a new analysis. The American Bankruptcy Institute shares this view, creating a commission in 2012 to study Chapter 11 reform. The commission then presented a 400-page report to Congress in 2014, outlining changes thought to ‘better balance the goals of rehabilitating companies, preserve jobs, and provide value to creditors.’ Even so, we have yet to see significant change in the Code. Though not an easy undertaking, a new Bankruptcy Act would serve to better protect stakeholders and vulnerable debtors than does the current Code.

As evidenced by several features of the Code, including the automatic stay, third-party releases, and safe harbors, it is clear that the purported goal of the bankruptcy system has been warped to protect its strongest players rather than its weakest. Each of these topics could constitute a paper of their own, but each also serves a crucial role in the systemic analysis of the fallacies of the bankruptcy system, which serves as the starting point of my paper. The paper then turns to the increased role (and success) of government intervention in bankruptcy, primarily analyzing the politics of the Chrysler reorganization in the 2000s. Lastly, my paper suggests three major changes to the Code intended to protect the equity and promise of the bankruptcy system.

The Automatic Stay

Once a corporation files Chapter 11, the stay kicks in. To be sure, the automatic stay has a valid legislative purpose: protecting debtors and small creditors from a ‘race to the courthouse,’ in which all creditors would sue to collect and be repaid. In theory, the automatic stay prevents this from happening, as creditors are stayed from litigation, and thus creditors are encouraged to cooperate with each other and the debtor to create a plan that is beneficial to the most amount of people.

The execution of the automatic stay reflects the deeply rooted bias within the Code as written—the system has fallen victim to puppetry from big business (institutional creditors and large corporate debtors), who are afforded a higher status in both general distribution and relief from the automatic stay. Even the government only has limited ability to act without being encumbered by the stay, as it must be acting within its police power and not for a ‘money judgment.’ Secured creditors, though not in any way immune from the stay, are provided with a path around its barriers. Additionally, some debtors may use the stay to their advantage as well—specifically aiming to prevent unsecured creditors from collecting the full value of what they are owed.

Third-Party Releases

Perhaps the strongest example of corporations warping the Code beyond its original purpose can be found in third-party releases. Third-party releases have split the circuits, receiving various degrees of support, disapproval, and something in the middle. Unlike other examples of distortion, though, there is no explicit foundation for third-party releases within the Code. Rather, courts have found authority in 11 U.S.C. § 105(a):

‘The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.’

Courts have interpreted this provision broadly, with many believing it to permit a third-party release. The theoretical argument is simple: third-party releases extend to parties against which collection of assets would be detrimental to the debtor. Namely, if a third party holds an asset the debtor could draw upon during reorganization, that asset should be protected—allowing the upside of bankruptcy without the burden of the filings. The Code, though, takes the controversy further, as it states:

‘discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.’

§ 524(e) seems in tension with the administration of third-party releases, as extending the release to additional parties directly affects their liability. Thus, when presented with differing sections of the Code, courts reach different conclusions on the permissibility of third-party releases. The issue of third-party releases is currently in the spotlight, with the Sackler family possibly receiving one in the course of the Purdue Pharma restructuring—a bankruptcy that has worked its way all the way to the Supreme Court.

The Safe Harbors

Another method employed by institutional influences to alter the risk and rewards of bankruptcy are safe harbors placed throughout the Code. These safe harbors remove various liabilities from institutional actors—mainly financial institutions—who are gaming the markets for profit. Of importance is fraudulent conveyance liability, which allows the trustee of a bankrupt estate to void a transfer of money. Essentially, a fraudulent conveyance would be if you knew that you had lost all your money in Vegas and owed some money to your bookie. You have no money to your name, but you do have the signed football from what was thought to be Tom Brady’s last touchdown (which sold for $518,628). To ensure nobody takes your ball (even though it is surely not the last touchdown ball anymore), you give it to your cousin. That transfer is a fraudulent conveyance: moving assets away from the debtor to another party to prevent creditors’ collection. Doing so shifts the value out of a debtor, and thus hinders the creditors at the bottom of the priority list the most, as they are the last to be paid. In many ways, financial institutions find themselves exempt from this liability.

The New Bankruptcy Act

Taking lessons from prior versions of the bankruptcy system, as well as other governmental and business entities, we are able to structure a bankruptcy system that protects going concern but prevents abuse.

Briefly, the structure is as follows:

1. Reflecting an understanding of incentives and Federal Circuit trends, the Code will include a good faith filing requirement, rather than only requiring good faith at the plan proposal stage.
2. Taking note from the Chandler Act, businesses will return to being split by market capitalization. This is crucial, as mom-and-pop businesses will not have the same concerns as large corporate entities.
3. The control of the large corporation who enters bankruptcy will be passed over to the federal government. The government, then, will handle the bankruptcy proceedings while the corporation remains in bankruptcy.

These three key steps—requiring good faith, separating businesses back out by market capitalization, and then passing the reigns to an unbiased government actor—will ensure that the abuses we have seen will no longer be prevalent.

The authors’ complete article is available here.

Jessica R. Graham has a JD from Harvard Law School.