To Protect Their Interests: The Invention and Exploitation of Corporate Bankruptcy

How did large scale corporate restructuring (or bankruptcy) develop the way it did? In the United States, the standard answer is that reorganization developed in the 1890s, as JP Morgan sought to protect the foreign bond investors he had previously convinced to lend to American railroads. That story fit well with the dominant law and economics trend of late twentieth century legal scholarship, inasmuch as it showed Morgan acting with the correct incentives, with little governmental encouragement.

But was it historically accurate?  In my new book — To Protect Their Interests: The Invention and Exploitation of Corporate Bankruptcy, just published with Columbia University Press — I argue the answer is ‘no’. I place the start of large-scale corporate reorganization about a decade earlier, and I am far less sanguine about the incentives of the founders.

That is, rather than start with the ‘Morganizations’ of the 1890s, I look to the work of Jay Gould in the 1880s. Particularly, as explained in early Chapters, I view the Texas and Pacific’s 1885 receivership as a moment when several already extant techniques came together to be used in the successful reorganization of a large railroad. This is less a genesis moment than simply a clear point of unity, in a context with economic significance. Jay Gould did not invent any new reorganization tools in 1885, he simply used existing tools in a coherent way in the case of a large railroad (the 1,500+ mile Texas and Pacific) for the first time.   

I identify this case as the first truly big reorganization, and note that the primary goal was to protect Jay Gould’s control of the railroad. I see a direct line between Gould and today’s private equity sponsors.

The book also addresses the first big reorganization overseen by JP Morgan, in the 1890s, and the first statutory reorganization, the epic section 77 case of the Missouri Pacific, which ran from 1933 to 1956. The case studies conclude with the last big case under the Chandler Act: the failed 1975 reorganization of WT Grant. The remaining chapters cover the enactment of the 1978 Code, and more recent events like RSAs and third-party releases.

I also use this book to push against another Reagan Age chestnut, the confidence that regulatory systems work better when they solely rely on markets, rather than government, to address concerns. The current American Bankruptcy Code, enacted in 1978, is steeped in this mentality. And certainly, the New Deal corporate bankruptcy system that it replaced sometimes did not work very well.  But did the Bankruptcy Code, and its chapter 11, go too far in the deregulatory direction? That is, did the rush to trash the New Dealer’s inelegant solutions reopen the door to the real problems that they had identified? I suggest the answer is ‘yes’.

Chapter 11 has undoubtedly become extremely economically important. The chapter 11 cases of Lehman Brothers, Washington Mutual, J Crew, Sears, Enron, Owens Corning, Pan Am, General Motors, Chrysler, United Airlines, Texaco, Neiman Marcus, and Pacific Gas & Electric (twice), all attest to the central role of corporate bankruptcy in modern America.

The predominant explanation for corporate bankruptcy is that chapter 11 exists to promote the efficiency of the American economy. By providing an agreeable structure for addressing overindebted companies, chapter 11 reduces the finance costs of all companies. At its best, the common wisdom is to view chapter 11 as a government provided framework for negotiation that protects the American economy from the failure of big firms. Chapter 11 is often painted as a kind of ‘win-win’, in which everyone benefits from improved capital markets.

This understanding of business bankruptcy is also rooted in the prevailing popular history which (as noted) designates JP Morgan as the craftsman of the modern system, rehearsing that in the 1890s the financier established the deal-based format that we still use today. The consensus view adopts Morgan’s own framing of his firm’s role as leading a noble effort to protect bondholders from the depredations of corporate insiders. The acceptance of this account has the practical effect of dismissing the reform efforts of New Dealers, who moved to replace the nineteenth century restructuring process with a new statute, while also legitimizing the current chapter 11 system (modeled on the nineteenth century form), which features judicial deference to insider-negotiated deals. 

In the book, I instead argue that corporate restructuring has always been about buying consent from those who could stop you, and imposing your will on those who could not. That is, corporate bankruptcy is mostly about control. And while the New Dealers might have been misguided in their remedies, they correctly identified key problems with the roots of modern corporate restructuring that persist to this day. Only by understanding the history of corporate restructuring — stripped of the mythology of the magnanimous JP Morgan, putting down his cigar to rescue pitiful, oppressed English bondholders — can we understand the reasons for the defects of today’s chapter 11, which recent commentators have deemed ‘lawless’.

Corporate restructuring indeed evolved from a lawless origin. It was designed by Jay Gould not as the efficient bondholder protection device of myth, but instead as a way for those in power to manipulate the legal system to retain power. Morgan embraced Gould’s system and popularized it with good ‘spin’. We see the same basic form at work in today’s private equity-backed chapter 11 cases. Continuing to attribute the goals of chapter 11 to Morgan and his supposed good intentions represents little more than a blind acceptance of his skillful public relations.

I thus offer a critical look at the DNA of a system of vital economic importance. This widely accepted story of corporate bankruptcy allows a sheen of ‘for the good of the people’ to be applied to reorganization. In fact, the actual origin story exposes that it was developed as a way for power to maintain power. Only by acknowledging the true roots of the system can we understand its problems and how it might be fixed.

Too often blind faith, an outgrowth of the Morgan myth, is weaponized to dispel criticism aimed at the corporate bankruptcy system we have. When critical judgment raised against the current system is scorned as ‘populist’, scholars and practitioners adopt a dangerous myopic stance. By understanding that today’s embrace of ‘deals’ has its roots in Jay Gould’s quest to retain control, we can see the need for more judicial skepticism about the deals that are presented to them — even those with marvelous ostensible support — and more understanding of what is really going on.

Indeed, one large policy question looming over the entire field is whether it makes sense to provide public support (through courts and the power of law) to maintain what amounts to a dueling ground. We may be largely indifferent to the question of ‘who wins’ as between Hedge Fund A and Private Equity Fund B, but why should taxpayers pay for the arena for such clashes? And who precisely gets hurt in these clashes? The historical approach I adopt in this book helps make these questions — and their answers — plain.

The author’s book is available here.

Stephen J. Lubben is the Harvey Washington Wiley Chair in Corporate Governance, Seton Hall University School of Law, Newark, New Jersey.