How Physics Informs Law

In a new article, I observe that an accurate understanding of intersecting bodies of law can sometimes turn on the scale of observation. In particular, I examine how the intersection of commercial and insolvency law can create uncertainty whether a transfer of money may be avoided (that is, rescinded) as preferential.

Insolvency law often avoids transfers of an insolvent debtor’s property that prefers certain creditors over others (in the United States, for example, bankruptcy law can avoid transfers of an insolvent debtor’s property, made within 90 days prior to its bankruptcy, that prefers certain creditors over others). Most such transfers are monetary repayments of debt claims.

Courts often assume that such monetary repayments involve the debtor’s property and thus can be avoided. That mistaken assumption has serious real-world consequences, potentially causing billions of dollars of payments annually to be mistakenly avoided. The mistake reflects a “macro” view of the world as courts and practitioners ordinarily see insolvency law. They tend to overlook that at the more “micro” level of commercial law, most monetary payments—at least those made by businesses—are transfers of a bank’s, not a debtor’s, property. These different observational perspectives parallel physics, in which classical physics accurately describes interactions in the physical world from a macro perspective whereas quantum mechanics accurately describes more micro interactions.

In the United States, for example, even the Supreme Court has missed this distinction. The leading case of Barnhill v. Johnson, 503 U.S. 393 (1992), involved a dispute over when payment of a check under the Uniform Commercial Code (UCC) should be preferential, and thus avoidable, under the Bankruptcy Code. A check is a type of draft: a request from one party, X (the drawer), to X’s bank (the drawee bank) to pay a third party, Y (the payee). Once the drawee bank accepts that request, it becomes independently obligated to make that payment. After making that payment, the drawee bank has a reimbursement claim against the drawer.

In the Barnhill case, the drawer of the check was insolvent. More than 90 days before its bankruptcy, the drawer delivered the check to one of its creditors. Within that 90-day period, the drawee bank paid the check. The drawer’s trustee in bankruptcy argued that the creditor would have to return the payment because it constituted a preferential transfer of the drawer’s property under the Bankruptcy Code. The Supreme Court heard the appeal in order to determine when the transfer of property occurred: on the date the check was delivered to the creditor (outside the 90-day preference period), or on the date the bank paid it (within that 90-day period).

The Court held that the transfer occurred on the date the bank paid the check, and therefore was preferential. That decision implicitly viewed the transfer from a macro level, that payment of a check transfers money from a drawer to its creditor. The Court overlooked the micro view: when a check is paid, whose property is being transferred? Remarkably, none of the litigation counsel raised that question.

Viewed from a micro level, payment of a check constitutes a transfer of the drawee bank’s funds, not of the drawer’s funds. This reflects that a checking account is a type of deposit account, and deposit accounts evidence loans from a depositor—in this case, the drawer—to its bank. Money collected from depositors does not sit in a segregated bank account in trust for the depositors; rather, it belongs to, and is used (for example, to make business loans) by, the bank. Because the bank does not hold the depositor’s money, it necessarily pays a check from its own money. After paying the check, the bank has a reimbursement claim against the depositor. Because the bank’s money, not the drawer-depositor’s money, is used to pay the check, that payment cannot be preferential vis-a-vis the drawer. Ironically, the Court in Barnhill acknowledged that it was the bank’s money that was used to pay the check without interpreting that fact’s significance to bankruptcy law.

My article observes that this mistake is not limited to payments by check. Under the commercial or banking law of many nations, including the United States, payments made under letters of credit, demand guarantees, and electronic funds transfers may also come from property of a bank, not from property of the debtor. As the article details, however, a legislative body having jurisdiction over insolvency law could choose to amend the nation’s law to remedy the mistake.

The authors’ full article can be found here.

Professor Steven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law. A slightly modified version of this post was first published by the Columbia Law School Blue Sky Blog and can be accessed here.