1 6: The Nature and Purposes of Bankruptcy Relief © Charles Tabb 2010

2 What does bankruptcy ADD? Enable CRS to get paid?

3 Cr payment mechanism? Radin – NO Already have writs of execution etc. What would be the point of having a 2 nd, parallel system that does the same thing?

4 Fraud Prevention? Levinthal suggested one function of a bankruptcy law is to protect CRs from Dr’s bad acts – E.g., fraudulent transfers Bernie Madoff puts title to multimillion $ condo in wife’s name

5 Already have fraudulent transfer laws Radin again rejects  already HAVE fraudulent transfer laws Allow Crs to unwind transfers Dr made to hinder, delay, or defraud them Date from 1571 Statute of Elizabeth

6 So then what? If a “bankruptcy” law is not needed either to – Facilitate CR collection of debts Or – Prevent DR fraud What distinct function does it serve??

7 COLLECTIVE “A single creditor could have got along without a bankruptcy procedure.” “… bankruptcy posits a plurality of creditors” “Unless we intend to bring the creditors into one large group, and adjust their common claims to a fund consisting of a single debtor’s property, there is no need to have recourse to bankruptcy."

8 What is different about multiple CRS? Story, Levinthal, Radin and Tabb all agree that bankruptcy needs a multiplicity of CRs to be justified But WHY? – What is it about having > 1 CR that is different from protecting the interests of a single CR?

9 Only matters if not enough to go around Even if have lots of CRs, still no worry if DR has enough assets to pay all the CRs in full In short, if Dr is solvent, every CR is fully protected by state law execution etc. and by fraudulent transfer laws

10 Ok if Bill Gates has > 1 CR

11 Not Ok if this guy has > 1 CR

12 Why bad if > 1 CR, insolvent DR? “… if there were many creditors, any one stood in great danger of being left in the lurch by the greater good fortune, insistence, harshness or skill in intrigue of some of his fellow- creditors.” Radin

13 > 1 Cr, insolvent Dr “All bankruptcy law … aims, first, to secure an equitable division of the insolvent debtor’s property among all his creditors … In other words, bankruptcy law seeks to protect the creditors … from one another.” Levinthal

14 Where have we seen this? Grupo Mexicano – Dr insolvent – Many Crs – Dr planned to pay some Crs, exclude others

15 What happens?

16 Why is scramble for Dr’s assets bad? If Crs find out that the DR has multiple Crs, and is insolvent – not enough to pay everybody, have a wild scramble for Dr’s insufficient assets – Like a run on the bank Why is that bad?

17 Unfair As matter of distribution between similarly situated CRs – Some get paid – Others do not Strikes us as unfair as a matter of distributive justice

18 Inefficient Economically inefficient Destroys value May kill off a debtor who otherwise could be saved See Problem 1.18  Dr worth more alive than dead  But IRS seizure would kill off DR

19 Crs waste $ Every CR has to spend $ trying to collect, or certain to get nothing More efficient if Crs could agree to cooperate Example: – $1000 in assets, 4 Crs, $2000 in claims ($500 each), $100 per creditor collection cost

20 CR race example Without a collective proceeding: – Each creditor spends $100 (so $400 total) – Net to group = $600 ($1k assets - $400 costs) Average per CR = $150 – Unequal (2 Crs paid in full, 2 Crs left out)

21 It’s a Mad, Mad, Mad, Mad World

22 Oklahoma Land Rush

23 Cr Race example With a collective proceeding: – Cr group only spends $100 – one agent to collect – Net to group = $900 Average per CR = $225 – Equal – each CR paid $225

24 Maximize Value Furthermore, CRs IF they can act collectively, as a single unit, can maximize value May be better to reorganize, for example Example – problem 1.18 (Whiting Pools)

25 Why not just AGREE to cooperate? Well … if it is more EFFICIENT, and FAIRER, for the CRs all to cooperate … – Why don’t they just AGREE to cooperate?

26 Defector

27 Prisoner’s dilemma The problem is akin to that raised in the classic prisoners’ dilemma game – Each prisoner is better off if doesn’t talk AND the other prisoner also doesn’t talk – but is worse off if does not talk and the other does – And is better off if does talk and the other does not Result – has to talk or sure to get hosed by other If could AGREE would both better off

28 Common pool problem Also a classic “common pool” problem Scarce asset, many who can draw on the common pool Incentive is to grab whatever you can as fast as you can, or will get left out

29 Crs hate to have to do this

30 How solve collective action problem? BINDING AGREEMENT I.e., need COMPULSION

31 CRs can’t defect With a compulsory collective action, key point is that none of the CRs is able to defect Thus the group of Crs can act as a single unit – maximize value – save costs – fairer distribution

32 Bankruptcy as compulsory collective action In essence, that is what bankruptcy is – a compulsory collective action Trustee (or, in chapter 11, DIP) acts as agent for CR group Automatic stay (§ 362) prevents CRs or Dr from “opting out” Bound to distribution, whether agree or not, either by statute (§ 726) or in plan (eg, §1141)

33 Problem 1.18 Facts: – DR, an operating business, owes IRS $92K – IRS seizes DR’s assets – would put DR out of business – Liquidation value of assets = $35K – Going concern value = $162K What is best approach here??

34 Bankruptcy Reorganization 1 st – interests of all of DR’s other Crs are being harmed by IRS solo action – Classic collective action problem 2nd – chapter 11 reorganization more efficient than chapter 7 liquidation – Debtor’s business worth more alive than dead

35 How protect IRS? Note that IRS does have a lien on Dr’s assets So NOT = to unsecured CRS – entitled to prior payment out of collateral (the seized assets) Is there any way to protect the IRS secured claim AND also the interests of DR’s unsecured CRs?

36 Solution? Make IRS return assets to DR so DR can keep business alive and realize going concern value AND Give IRS full protection up to amount of debt (here, $92k) – Easy to do since assets worth $162K as going concern

37 What about debtors?? So far have only focused on bankruptcy’s function as a solution to a creditor collective action problem But what about the debtor?

38 Only worry about human beings Often hear talk about bankruptcy offering companies a “fresh start” That’s just stupid A corporation is an inanimate legal entity, can just be dissolved

39 What’s the concern with human Drs? “ relieve unfortunate and honest debtors from perpetual bondage to their CRS” – Story What would happen if CRs had “an absolute right to appropriate and monopolize all their future earnings”?

40 Consequence of inescapable debt “destroys all encouragement to industry and enterprise on the part of the unfortunate debtor” Societal loss – disincentivize a potentially productive person from working Lose the benefit of their human capital

41 Local Loan “This purpose of the act has been again and again emphasized by the courts as being of public as well as private interest, in that it gives to the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preëxisting debt.”

42 Called the “fresh start” “ Fresh start” actually has 2 parts: – Discharge of prior debt So human debtor can enjoy her future earnings Incentive to work – Exemptions Allow human debtor to keep some essential current property

43 Any limits on fresh start? Problem 1.19 DR has good education, could work as teacher Choosing to work for very little $ as a potter As a potter, could never, ever repay his debts  Should this DR get a “fresh start” and be able to wipe away his student loan debts?

44 Earn more?? Should Dr have to maximize earnings as quid pro quo for fresh start? Should Dr have to go through a chapter 13 repayment plan to get a fresh start?