Bankruptcies, Bailouts, and the Politics of Corporate Reorganization

Bankruptcy law has evolved over the centuries as an orderly way to deal with dying firms. However, during the recent recession, many policy experts, officials, and legislators advocated sidestepping the bankruptcy process and resorting to so-called bailouts.

Bailouts have been praised for reducing systemic risk and transforming failed firms into going concerns. Alan Krueger and Austan Goolsbee expressed that view in their paper, “A Retrospective Look at Rescuing and Restructuring General Motors and Chrysler.” However, in our recent paper, “Bankruptcies, Bailouts, and Some Political Economy of Corporate Reorganization,” we argue that defending bailouts on the grounds that they transform dead firms into living ones is a misleading measure of success. Bailouts are designed to resuscitate failed firms, but, in a sense, so is the bankruptcy process, which distributes capital losses and moves assets to new uses. Those assets might no longer be part of the now-bankrupt firm, but they continue to exist and are used in the market.

Thus, at the “point of reorganization,” there is little distinction between bailouts and bankruptcy. Under both forms of corporate reorganization, a fixed amount of capital losses must be distributed among “creditors.” Bailouts create the impression of a free lunch, because they make taxpayers unwilling creditors who bear part of the capital losses.

However, important differences arise when we consider the systemic changes set in motion by the different approaches to corporate reorganization. Bankruptcy is a public process that requires all the stakeholders of a firm to reach an agreement. Debtor and creditor meet on an equal footing and haggle over the best possible deal.  Likewise, if the owners of the firm decide to sell some or all of its assets, then, under private ordering, the sale will be open and competitive. The emphasis on voluntary agreement ensures that resources will be allocated to socially valuable uses.

In contrast to the public character of bankruptcies, bailouts tend to involve negotiations behind closed doors. Regulators can exercise unilateral control over the restructuring decisions. To the extent we can say that the regulators bargain with the firm, its creditors, and potential acquirers, they do so from a privileged position. Although regulators are not directly concerned with the profitability of the restructured enterprise, because they aren’t residual claimants, they will for political reasons want the restructured firm to be successful. If the restructured firm fails after the bailout, it will tarnish the administration they serve. Legislators who oversee the regulators might also suffer if the firm fails or if the firm, as part of the restructuring, leaves the legislator’s district. Thus, there is an incentive to keep the firm afloat and restructure it in a way to preserve some semblance of the status quo.

But keeping the firm alive and redeploying assets in a socially useful manner are two distinct endeavors. The market is particularly good at revealing unseen opportunities and configurations for mutually beneficial exchange. This process is propelled by entrepreneurs competing with one another and trying to correct the errors of their predecessors. In doing so they discover new ways to serve consumers (Kirzner 1973). However, this process is short circuited when a government task force handles the restructuring, because competition for the firm’s assets occurs through a closed-door process designed to serve political rather than consumer interests.

In our paper, we detail the political transactions that made the recent wave of bailouts possible. In the case of financial services, bailed-out firms were required to accept executive pay limits and other conditions involving the structure of their organizations. Though politically popular, it is unclear whether those conditions were ultimately beneficial for consumers.

Further, though executive agencies aren’t residual claimants, they may nonetheless profit by increasing their influence and responsibility. One example is the Treasury Department’s extra-legal use of TARP funds to purchase senior securities in American Insurance Group (AIG), which was not initially a candidate for TARP funding.

Finally, firms negotiate with executive agencies as supplicants.  Unlike in bankruptcy proceedings, where an insolvent firm has some room to haggle with its creditors, it must yield to the executive agency’s wishes or face punishment. The ability of bailouts to quickly resolve the failure of a large firm is often touted as a benefit, because a speedy resolution can presumably lower systemic risk. Although unilateral decision-making might make the restructuring process more expedient, it relies on the wisdom of a few regulators to make prudent decisions rather than taking advantage of the input of all parties involved.

The bailouts of automakers GM and Chrysler were similar in many ways, but especially noteworthy were the government’s sale of the two companies. As David Skeel points out, the auto task force managed the sale so that “a favored arrangement” could be insulated “from market interference.” This led to a significant “chilling effect” as potential bidders recognized that they had to adhere to the Obama administration’s objectives, like protecting costly labor union contracts, rather than potentially more consumer-friendly goals.

When administrative agencies handle reorganizations, decisions may be made based less on economic calculations than on political objectives like redistribution of wealth to favored activities or groups. This opens the door to a further problem: When the government handles corporate restructuring, other firms in the economy might find that they can acquire assets from failed firms by fostering connections with the government. Fiat, for instance, was well-positioned to take advantage of the Chrysler bailout, because it could further the administration’s objectives with respect to producing fuel-efficient vehicles. A system of corporate reorganization which rewards assets based on political connections will tend to strengthen established enterprises at the expense of fledgling firms, because regulators, given their time constraints, are more likely to help the companies they know (Wagner 2016).

The real danger is that the significance of political connections will lead to an ossified economy. A bailout, at its very core, is a decision to fund the known at the expense of the unknown. First, the funds used to bail out the dying firm must come from somewhere else in the economy. Second, the bailout subsidizes the known pattern of enterprises in the economy: Investors who might have bought the bailed-out firm, suppliers that could have redirected their resources toward new companies, and new entrepreneurs who might have entered the market are all deterred. A game of political maneuvering and status-seeking displaces the process of entrepreneurial discovery.

References

DelliSanti and Wagner. (2017) Bankruptcies, Bailouts, and Some Political Economy of Corporate Reorganization. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2956439

Kirzner, I. (1973) Competition and Entrepreneurship. Chicago: The University of Chicago Press.

Krueger, A., & Goolsebee, A. (2015) A Retrospective Look at Rescuing and Restructuring General Motors and Chrysler. The Journal of Economic Perspectives, 29, 3-23.

Skeel, D. (2015) From Chrysler and General Motors to Detroit. Penn Law: Legal Scholarship Repository, Paper 1420, 121-148.

Wagner, R. (2016) Politics as a Peculiar Business. Cheltenham: Edward Elgar.

This post comes to us from Dylan DelliSanti, a PhD candidate at George Mason University, and Richard Wagner, a professor at the university. It is based on their recent paper, “Bankruptcies, Bailouts, and Some Political Economy of Corporate Reorganization,” available here.