The Empty Idea of “Equality of Creditors”

For 200 years, the equality of creditors norm—the idea that similarly situated creditors should be treated similarly—has been widely viewed as the most important principle in American bankruptcy law, rivaled only by our commitment to a fresh start for honest but unfortunate debtors.   Back in her law professor days, Senator Elizabeth Warren once said that she knew her students could recite the equality of creditors principle in their sleep, because she’d heard them do it in her 8:30 a.m. classes.

Yet if we look at current bankruptcy practice, creditor equality seems to be rapidly disappearing.  The departures from equality in the Chrysler and Detroit cases are well known, but bankruptcy courts often bless starkly different treatment for different groups of general creditors even in ordinary cases.  Debtors frequently use restructuring support agreements to secure the approval of creditors to a potential reorganization plan, for instance, sometimes offering side payments to creditors if they sign the agreement, but not to creditors that decline to sign.

How difficult – and beneficial – would it be to resuscitate equality of creditors?  The good news is that reinvigorating equality would be surprisingly easy.  Although several of the most common departures from equality would require legislative reform to correct, others would not.  And in each case, the adjustments would be quite straightforward.

The problem is that the equality norm itself contributes nothing to the analysis.  As we begin to assess whether equal treatment would be beneficial in each of the contexts where its influence is waning, it quickly becomes clear that the key considerations lie elsewhere—with concerns such as curbing self-dealing or secret liens, and maximizing the value of the debtor’s estate.  Although equality originally served as a rough proxy for some of these issues, this is no longer the case.  In some contexts, the equality language is unnecessary but harmless.  But in others, its historical pedigree and rhetorical resonance have been pernicious.

In a recent article, I begin my inquiry into the equality norm by attempting to discover where the norm came from.  Hints of the equality principle can be found in the early English cases, and creditor equality was given a ringing endorsement in America in an influential 1807 case.  That case, like many of the cases that followed, involved preferences – payments or transfers made to a favored creditor shortly before bankruptcy – which were condemned as a violation of the equality of creditors principle.  Under the Bankruptcy Acts of 1841, 1867, and 1898, preferences could be retrieved from creditors who received them, and a debtor that had made a preferential payment could be denied access to bankruptcy.

Throughout the 19th century, the domain of the equality of creditors was limited to individual and small-business bankruptcy cases.  The principle played little role in reorganization cases involving substantial corporations, for reasons I explore in the article.  After Congress finally codified large scale corporate reorganization in 1933 and 1934, however, the norm quickly spread to these cases as well.  As with many central bankruptcy issues in the 1930s and 1940s, Justice William Douglas played a key role in the diffusion of the norm throughout all of American bankruptcy law.

After tracing the historical origins of creditor equality, I ask in the article how debtors and favored creditors so often manage to circumvent the equality norm.  It turns out that current bankruptcy law provides numerous devices for privileging one creditor or group of creditors over others.  They range from transferring value to the creditor prior to bankruptcy, to assuming the creditor’s contract in bankruptcy or proposing to pay the creditor more than another class of unsecured creditors in connection with a reorganization plan.

If courts and lawmakers were committed to promoting equality, they could clamp down on each of these strategies for evasion.  Briefly revisiting each, I consider how equality might be enhanced.  In each context, courts or lawmakers could reinvigorate equality by making simple adjustments to existing doctrine.  Lawmakers could remove the safe harbors that protect many preferences from avoidance, for instance, and courts could prohibit the special treatment of “critical vendors” and tighten the rules for classification of claims.

The question is whether reinvigorating the equality of creditors norm would improve bankruptcy law.  I conclude that it would not.  Equality does not appear to be the central concern with any of the doctrines I consider.  In each context, the real issues, as noted above, are policing self-dealing, reducing the risk of “secret liens,” or maximizing the value of the debtor’s assets.  The case for retaining a vestige of the equality norm is slightly stronger in consumer cases and Chapter 7 liquidations, since these cases more closely resemble the context in which equality of creditors first emerged.  But creditor equality does not play a meaningful role in practice in either of these contexts, or even in the last redoubt of the equality principle—the ostensibly equal treatment of claims within a particular class of creditors.

In the final part of my article, I ask whether there are any other reasons for retaining the equality of creditors norm, despite its apparent obsolescence.  As I address this question, I consider the most compelling responses to the famous article referenced in my title, as applied to the very different bankruptcy context.[1]  None provides a plausible basis for a renewed commitment to equality in bankruptcy.  The equality principle should be abandoned.

ENDNOTE

[1]   Peter Westen, The Empty Idea of Equality, 95 HARV. L. REV. 537 (1982).

This post comes to us from Professor David Skeel at the University of Pennsylvania Law School. It is based on his recent article, “The Empty Idea of ‘Equality of Creditors’,” which is available here and scheduled for publication early next year in the University of Pennsylvania Law Review.

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