The Inequities of Equitable Subordination

Sitting as courts of equity, bankruptcy judges have embraced an exceptionalist role whereby they exercise widespread discretion in deciding cases. The doctrine of equitable subordination epitomizes bankruptcy exceptionalism and its potential for market distortion.

The doctrine originated as a remedial measure to give innocent creditors of insolvent debtors priority over creditors that engage in malicious misconduct. The Supreme Court introduced equitable subordination in a bankruptcy case in which a parent company virtually preyed upon its subsidiary, effectively driving it into insolvency. The Court ruled that the subsidiary’s preferred shareholders should have priority over the parent’s intercompany debt claims against the … Read more

Bankruptcy Shopping: Domestic Venue Races and Global Forum Wars

The United States Bankruptcy Code gives debtors wide discretion to reorganize in the venue of their choice. These lenient venue selection rules long have allowed bankruptcy courts in the District of Delaware and the Southern District of New York to dominate the market for large Chapter 11 cases, though recently the Southern District of Texas has also begun to attract a large number of cases.

Critics of liberal venue rules charge that bankruptcy districts are engaged in a “race to the bottom” as judges compete for blockbuster cases. Others counter that competition for cases improves efficiency and predictability as judges … Read more

Can Excess CEO Confidence Increase Risk of Corporate Failure?

A recent report by KPMG [1] on the behavior of chief executive officers (CEOs) suggests that 67 percent of UK CEOs trust their intuition over data. The impact of intuition may become problematic if it is driven by biased perception. One of the most common biases among CEOs is overconfidence, a tendency to believe that they are better than they objectively are, particularly in their judgment, ability, and knowledge.

In a recent paper, we investigate whether CEO overconfidence can help explain the probability of corporate failure. Despite extensive research exploring the consequences of managerial overconfidence for corporate policies and outcomes, … Read more

Liquidity, Pledgeability, and the Nature of Lending

In a new paper, we explain that variation in prospective liquidity in an industry or economy prompts changes in corporate lending and banking, including changes in the level of corporate borrowing, the type of debt contracts issued, the covenants contained in them, and the role and leverage of banks.

We start with the basic principle that the nature of business lending in an economy changes over a financial cycle. This includes the amount of debt that a borrower can take on and the extent to which banks play an important role or become dominated by non-bank lenders issuing arm’s length … Read more

The Government Tools for Responding to Market Distress

In the spring of 2020, as the Covid-19 pandemic shut down economies around the world, pressure arose for governments to respond to the growing threat of pandemic-related market distress. In the United States, the initial proposals for government action varied in nature and focus. Some proposals targeted the financial system while a few targeted small businesses and individuals. Others were intended to bail out large businesses and specific industries. Still other proposals took a more institutional focus. In the context of bankruptcy law, many experts imagined building up the bankruptcy system as a primary bulwark against a seemingly imminent wave … Read more

How Principal Reduction Through Mortgage “Cramdown” Affects Household Distress

The U.S. experienced an unprecedented number of home foreclosures during the Great Recession of 2007-2009. To limit defaults and deadweight losses, the government implemented various policies that reduced monthly payments by homeowners (i.e., Home Affordable Modification Program) and facilitated mortgage refinancing (i.e., Home Affordable Refinancing Program). These initiatives had modest success. An alternative policy proposal that was not implemented during the Great Recession would have allowed mortgage “cramdown” by judges as part of the Chapter 13 bankruptcy process. The proposal passed the House of Representatives but failed in the Senate. In these restructurings, the underwater portion of the mortgage is … Read more

Bankruptcies and the Covid-19 Crisis

The COVID-19 pandemic has disrupted normal life and triggered massive economic slowdowns. In the United States, consumer spending has dropped dramatically and unemployment temporarily hit the highest levels since the Great Depression. As a result, many experts have projected a massive number of consumer and business bankruptcy filings in the coming months.

In our recent paper, “Bankruptcy and the COVID-19 Crisis,” we track bankruptcy filings in the U.S. using real-time data on the universe of filings. Historically, bankruptcy filings have closely tracked the business cycle and unemployment rates. However, we show that this relationship has reversed during the COVID-19 crisis … Read more

Puerto Rico; Act III

In 2017, Puerto Rico and certain of its affiliates filed “bankruptcy” petitions under Title III of the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”).  These cases are pending in the U.S. District Court for  Puerto Rico; however, under the law Judge Laura Taylor Swain in New York was appointed to preside over the cases.  My new paper – Puerto Rico; Act III – provides an overview of where things stand  and where they might be heading.

PROMESA is a bankruptcy law, with various bells and whistles attached. In addition to its restructuring provisions, the law creates the Financial … Read more

Arnold & Porter Discusses Covid-19 and Antitrust, Bankruptcy, and Distressed Sales

The COVID-19 pandemic has created significant financial distress for many businesses and there have been a number of bankruptcy filings recently,[1] with more likely on the horizon. As a result, there is likely to be an increase in acquisitions of companies or assets out of bankruptcy.[2] Companies considering bankruptcy sale-transactions need to consider the structure that best suits their needs—e.g., a “363 sale”  offering a separate sale process and potentially speed, or a sale as part of the plan of reorganization or liquidation plan, which allows for the sale to be incorporated into the plan process. It also … Read more

Estimating the Need for Additional Bankruptcy Judges in Light of the COVID-19 Pandemic

We recently estimated the U.S. bankruptcy system’s ability to absorb an anticipated surge of financial distress among American consumers, businesses, and municipalities as a result of COVID-19.

An increase in the unemployment rate has historically been a leading indicator of the volume of bankruptcy filings that occur months later.  If prior trends repeat this time, the May 2020 unemployment rate of 13.3 percent will lead to a substantial increase in all types of bankruptcy filings.  Mitigation, governmental assistance, the unique features of the COVID-19 pandemic, and judicial triage should reduce the potential volume of bankruptcies to some extent, or make … Read more

Covid-19 and Bankruptcy: A Case For “Light-Touch” Reorganizations

Different countries have adopted various strategies to prevent or delay initiation of insolvency proceedings and protect businesses in the wake of the Covid-19 crisis. Global response has broadly been along the lines of providing direct financial aid (by way of loans or grants) or taking steps by way of emergency legislation to delay insolvency proceedings. Whether it is the United States or Europe, the overall aim of these strategies is to keep businesses afloat and provide them with protection, albeit temporary, from creditor action. The protection is based on the premise that, in a post-lockdown period, businesses will be able … Read more

The Case for Creditor Cooperation Duties in Corporate Workouts

The COVID-19 pandemic is causing financial distress to economically viable firms on an unprecedented scale.  In this post, we introduce the novel idea of creditor cooperation duties to stabilize corporate workouts.

The prospect of widespread defaults by viable firms triggered by the COVID-19 pandemic has prompted emergency legislation around the globe. To a significant degree, these measures aim to keep distressed firms out of formal bankruptcy proceedings.  For example, duties to initiate such proceedings have been suspended in Germany, Italy, and Spain; rules that govern the liability of directors of near-insolvent or insolvent companies have been relaxed in Australia, Singapore, … Read more

Large Corporations Did Not Need A Bailout

The CARES Act passed in response to the COVID-19 crisis provides billions of dollars in industry-specific loans that will go to large corporations like Boeing and the major airlines. These provisions are part of a larger compromise that also puts important funds into the hands of individuals and small businesses. But one should not be fooled into thinking the provisions benefiting large corporations and their shareholders were a necessary part of a coronavirus bailout. Instead they go against the core principles that should guide policymakers in responding to a crisis of this sort.

As Eric Posner and I explained in … Read more

Bankruptcy’s Role in the COVID-19 Crisis

Current policy discussions tend to minimize the role of bankruptcy law in mitigating the financial fallout from COVID-19. Scholars too are unsure about the merits of bankruptcy, especially Chapter 11, in resolving business distress. In this paper, we argue that bankruptcy should be a central part of policies targeting large corporations, but should be used only as a backup to other policies for consumers and small businesses.

With respect to large corporations, we begin with the observation that, although the current crisis has destabilized all businesses, many were likely to suffer distress regardless of a pandemic. The past decade saw … Read more

The Future of Financial Institution Resolution

One of the principal lessons learned from the 2007-2009 financial crisis was the need for new legal regimes to facilitate the rapid and orderly resolution of systemically important financial institutions without a government bailout.  In the final part of a six-part article that has just been published, I trace the development of these new legal regimes.[1]  The United States was itself a first mover in this regard with the enactment in 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).[2]

The Dodd-Frank Act contains two provisions of singular importance to the resolution of … Read more

Household Debt Overhang and Unemployment

Personal bankruptcy is pervasive in the U.S.—about one in 10 Americans will declare bankruptcy in his lifetime.1 Under the U.S. bankruptcy code, households are protected by limited liability. That is, they can discharge their debt and still keep a substantial amount of their assets. Such limited-liability protection distorts the incentives of indebted households, just as it distorts the incentives of indebted firms in corporate finance. In our forthcoming paper,  we investigate how this distortion can affect the labor market. In particular, we ask the following questions. How does limited-liability debt distort household labor supply, and how does this affect aggregate … Read more

Bankruptcy Hardball

By many accounts, we have entered an era of unprecedented contentiousness in debtor-creditor relations.  For an example of the new status quo, consider the recent actions of PetSmart, a perfectly normal American corporation struggling with debt from a leveraged buy-out gone sour.  The textbook account of corporate governance would suggest that PetSmart’s board of directors would respond to this financial distress by seeking to improve the underlying business or, perhaps, by filing for Chapter 11 bankruptcy to maximize the value of the firm for the benefit of creditors.  Instead, PetSmart’s board authorized a transaction that seems shocking for a firm … Read more

How Bankruptcy Law Affects Digital Assets

In the last few years, an increasing number of digital platforms have launched initial coin offerings (ICOs). ICOs are primarily studied from the perspective of securities laws. In a new paper, however, I examine how bankruptcy law applies to entities that have tokens in their investment portfolios. What happens, for example, if a debtor that owns tokens becomes insolvent and is subject to insolvency proceedings? How can tokens be made available to the debtor’s creditors? How can the bankruptcy stay be preserved? And how can rules against fraudulent conveyances be enforced?

In general, when insolvency proceedings are opened against a … Read more

Valuation Disputes in Corporate Bankruptcy

In bankruptcy, as in corporate law, valuation drives disputes. Prior bankruptcy scholarship points to disagreements about valuation and judicial valuation error as key drivers of Chapter 11 outcomes, including the decision whether to reorganize the distressed firm or sell it off pursuant to a Section 363 sale. Avoiding valuation disputes and valuation errors is also the underlying driver of most proposed reforms to Chapter 11, from Douglas Baird’s mandatory auctions to Lucian Bebchuk’s options approach.

In a new paper, we undertake a detailed examination of bankruptcy court opinions involving valuation disputes. We study all reported cases filed between 1990 and … Read more

Toys ‘R’ Us and Bankruptcy: Death by Disruption, Not Debt

As Toys ‘R’ Us heads for liquidation, a common refrain has it that the toy retailer failed to successfully reorganize in Chapter 11 because it took on too much debt.  The 2005 leveraged buyout (LBO) of Toys ‘R’ Us by a group of investors led by KKR Group, Bain Capital, and Vornado Realty Trust is a particular target for blame.  But this ignores the larger issue, of which the LBO and the subsequent bankruptcy are merely symptoms.  In short, Toys ‘R’ Us collapsed, like many companies have, because of a failure to innovate.

Unmanageable debt and capital structures – though … Read more