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 both simple and comprehensive. We argue that there are three major problems that the 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.
To see the trilemma in action, consider bankruptcy’s automatic stay. The stay is a well-known solution to the commons problem of creditor runs. It creates time and breathing space for the debtor to restructure. And it creates liquidity by suspending payment obligations, conserving scarce cash for the debtor to operate. But more time and more liquidity are not always good for the creditor body because they can exacerbate agency problems, giving management time and money to further their own interests. One possible solution is to give creditors the power to block management’s decisions. But if each creditor had a veto over all decisions, there would be too much risk of costly delay. Bankrupt firms are often analogized in the case law to melting ice cubes or critical patients on an operating table. Time-sensitive opportunities might be lost in the pursuit of creditor consent.
None of these problems is new individually. The bankruptcy literature emphasizes each. But it analyzes them one or two at a time. In particular, the Creditors Bargain Theory, the predominant theory of bankruptcy, focuses on only the commons problem. The existence of a creditor run provides a rationale for beginning-of-case interventions like the automatic stay. But it has less to say about middle-of-case rules, like those governing the debtor’s power to sell assets, borrow money, or otherwise transact during the bankruptcy case. Nor does it explain the content of end-of-case rules, like those governing approval of reorganization plans that restructure debts.
Our contribution is to uncover the connections among the three problems and to show that they alone lead to a nearly comprehensive explanation of the law. 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). By simplifying the law in this way, our framework can serve as a teaching tool—one equipped to analyze the law from a case’s beginning to middle to end. It can also provide straightforward guidance to policymakers: when targeting one problem, they must anticipate the risks associated with the other two.
US bankruptcy law’s evolution over time is easily explained within the framework. Take, for example, the absolute priority rule (APR), one of bankruptcy’s bedrock principles. It gives unsecured creditors the right to insist on being paid in full before shareholders can retain value in the reorganized firm. This rule evolved in the reorganization cases of the late 19th and early 20th centuries, where the agency problems of collusive, priority-distorting deals between management and secured creditors predominated. The APR, finalized in the Case vs Los Angeles Lumber Products opinion in 1939, gave unsecured creditors an individual right to block these reorganizations. But it also exacerbated holdout problems, contributing to the slow and ineffective reorganization process in the Chandler Act era that followed. The 1978 Bankruptcy Code addressed these holdout risks by making the APR a class-based right, shifting power back toward agents.
The framework also provides a convenient way to compare bankruptcy systems around the world. Much of UK debt restructuring takes place without the benefit of a stay. This is largely due to the different capital structures of distressed firms in the two countries. In the US, the prevalence of dispersed secured and unsecured bondholders in capital structures generated the need for both commons (a stay) and anticommons (forced exchange) interventions. In the UK, by contrast, concentrated and secured credit-heavy capital structures were the historical norm, and restructuring patterns involved a lighter-touch, more contractarian approach to restructuring. Over time, as UK capital structures have become more dispersed and uncoordinated, the need for anticommons interventions have increased. The 2020 Corporate Insolvency and Governance Act (CIGA) introduced restructuring plans with cross-class cramdown mechanisms to deal with holdout classes. This provides debtors with more forced-exchange power than under schemes of arrangement, where holdouts can be bound only within approving classes.
The controversial flash points in the modern US reorganization concern the agency versus anticommons tradeoff. One example is the ‘sub rosa DIP loan.’ These loans strategically bundle reorganization plan terms and case process controls into financing requests at the beginnings of cases. This amplifies the perceived anticommons cost of delay to a court, since a lost financing opportunity can destroy a firm’s going-concern value. With it, these loans bundle in protections for agents, such as liability releases for controllers’ pre-bankruptcy conduct.
Mass tort case strategies such as the ‘Texas Two Step’ also reflect this trade-off. They remove operating assets from the estate before the bankruptcy and replace them with a funding promise from a non-bankrupt entity. Proponents argue that the anticommons problem justifies the strategy: the costly interference with operations in a Chapter 11 case justifies removing these assets from court oversight. We argue instead that the agency costs of these maneuvers likely outweigh any anticommons benefits, as they entail an end-run around Bankruptcy Code provisions like Section 363 that already balance these competing concerns.
The authors’ article can be found here.
Kenneth Ayotte is a Professor of Law at the University of California, Berkeley - School of Law.
Jason Donaldson is an Associate Professor of Finance and Business Economics at USC Marshall School of Business.
Giorgia Piacentino is an Associate Professor of Finance and Business Economics at USC Marshall School of Business.
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