The Ex Ante Effects of Bankruptcy Reform on Investment Incentives

More socially efficient results obtain where the current liquidation value of the assets is low. In this situation, the parties will each retain shares of the reorganized firm based on the bargain that they reach. Assuming that both the creditor and the managers have the same discount rate, they will split the value of the firm equally. This being the case, the managers now have the incentive to invest in all positive net present value projects and to avoid most negative net present value projects. The managers will invest in all positive net present value projects because they will capture a large portion of the increase in firm value. They will, as a general matter, avoid negative net present value projects because such projects decrease their expected share of the reorganized company. This suggests that the selective stay may be most desirable in firms with low liquidation values and high human capital assets. None of the touted replacements thus represent a clear efficiency gain over Chapter 11 in terms of ex ante effects for all firms. The proposals for both automatic cancellation and mandatory auctions respect contractual priority, but it is unclear whether this respect creates better investment incentives than a regime that incorporates loss sharing. Automatic cancellation has the potential to reduce the time during which the firm experiences financial distress, but the threat of this quick change in the firm's capital structure creates new ex ante costs. Much of the ex ante effect of mandatory auctions cannot be assessed without knowledge of what event triggers the auction. The selective stay holds out great hope for reducing the incentives for inefficient investment in some small firms, but is clearly not an appropriate insolvency regime for all firms. Thus, while the various proposals for bankruptcy reform have differing ex ante effects, none can be said to be clearly superior to current law in all respects. IV. CHOOSING THE OPTIMAL SET OF INSOLVENCY RULES What are we to do with this mess? The ex ante effects generated by Chapter 11 and its proposed replacements do not lend themselves to easy characterization. There is no clear efficiency gain, at least from an ex ante perspective, of shifting from current law to any of the proposed major reforms. One cannot in the abstract come up with a rank ordering of the various competing regimes based on the way in which they will affect firm investment prior to the bankruptcy filing. Given that the various proposed reforms are not clearly superior to current law, the defenders of the status quo might assert that such law is entitled to a presumption of remaining in [VOL. 72:1159 http://openscholarship.wustl.edu/law_lawreview/vol72/iss3/28 EX ANTE EFFECTS OF BANKRUPTCY REFORM place, and that the proposed reforms have failed to overcome that presumption. This argument should be rejected. It fails to ask the crucial question of which institution should select the legal rules that govern the firm when it encounters financial distress. 3 Before deciding what to do with the information regarding the ex ante effects of various bankruptcy proposals, we have to decide which institution is best able to process this information in a useful fashion. The goal is to pick the institution which can best minimize the sum of the deadweight cost to society arising from the substantive rule itself and the transaction costs of implementing the rule. There are three possible candidates for the role of selecting the governing insolvency rules: the bankruptcy court, Congress, or the shareholders of the firm itself. 4 The bankruptcy court is the institution least suited to the role of selecting insolvency rules. One could imagine a world where, after a firm filed for bankruptcy, the bankruptcy court would decide which set of insolvency rules would apply. It is easy to see why no one has suggested such a bankruptcy regime. First, it deprives the parties of certainty-prior to bankruptcy they are unsure as to what will happen if the firm encounters financial distress. This uncertainty would discourage lending to firms that have a significant chance of encountering financial distress. Second, bankruptcy judges only see those cases which actually end up before them. They do not see firms that do not encounter financial distress or firms that do have financial problems but are able to conclude a workout outside of bankruptcy. Bankruptcy judges cannot assess the effect that their decisions have on firms that they never see.'35 This lack of certainty and inability to assess the results of their decisions disqualify bankruptcy courts from being the institution that should select insolvency rules. The unstated premise of those who assert that Chapter 11 should be 133. On the general question of institutional choice, see Neil Komesar, In Search of a General Approach to Legal Analysis: A Comparative Institutional Alternative, 79 MICH. L. REv. 1350 (1981). See also ROBERT C. ELLICKSON, ORDER WITHOUT LAW: How NEIGHBORS SEIrLE THEIR DISPUTES 242-43 (1991). 134. David Skeel has argued that state legislatures should select the governing insolvency rules for corporate bankruptcies. See Skeel, supra note 120, at 475. He asserts that states have better incentives to adopt efficient laws than does Congress. Id. at 517-20. To the extent that one accepts Skeel's argument, one would have state legislatures, as opposed to Congress, select the governing bankruptcy regime. The broader question, which is addressed in the text, is whether bankruptcy rules should be selected by a court, a legislature, or private parties. Which legislature would do the selecting does not affect the argument offered in the text. 135. See Rasmussen, supra note 5. 1994] 1207 Washington University Open Scholarship 1208 WASHINGTON UNIVERSITY LAW QUARTERLY retained or only modestly amended is that Congress is best positioned to select insolvency rules. Legislative determinations of insolvency rules probably do minimize the transaction costs associated with the selection procedure. Once Congress identifies the governing rules, the parties affected by these rules do not have to spend any resources drafting their own rules to govern financial distress and disseminating these rules to all those who do business with the firm. Mandatory rules have the virtue of removing the subject at issue from the bargaining table, and thus, reducing the amount of societal resources devoted to bargaining. What congressionally mandated insolvency rules gain in reduction of transaction costs, however, they lose in terms of the efficiency of the rules themselves. Congress, by its nature, acts without regard to any specific firm. Under current law, Congress has adopted a single bankruptcy regime for all firms that wish to reorganize. Given the diversity in the nature of firms, it is highly unlikely that one bankruptcy regime will meet the needs of all firms.'36 Certainly, Congress could enact a number of different bankruptcy regimes, each one designed for a different type of firm. Indeed, the 1898 Bankruptcy Act, which the current Bankruptcy Code replaced, had two separate procedures for dealing with reorganizations.'37 Similarly, Congress recently considered, but did not enact, a proposal to add a new chapter designed to handle the reorganization of small businesses.' The problem with these proposals is that Congress still must decide which firms should be relegated to which type of insolvency proceeding. Even assuming that Congress attempted to promote efficiency in making such selections,139 it is unlikely, given the diversity of firms, that it could craft a set of rules which correctly assign each firm to the most efficient set of bankruptcy procedures for that firm. The analysis in the prior two Parts of this Article shows that there are important ex ante effects of both current bankruptcy law and the various reform proposals. Yet, it would be impossible to craft a set of rules to sort all firms so that each firm resided in the most efficient bankruptcy system. 136. Id. at 63. 137. See Bankruptcy Act of 1898, 30 Stat. 544 (1898), amended by Ch. X, 52 Stat. 840 (1938) (repealed 1978). 138. For a description and analysis of the proposed "Chapter 10," see Dan J. Schulman, Business Reorganizations Under Proposed Senate Bill 540, 3 J. BANKR. L. & PRAC. 265 (1994). This proposal was not included in the final bankruptcy bill enacted by Congress this year. H.R. 5112, 103d Cong., 2d Sess. (1994). 139. As to the forces that suggest that Congress does not act efficiently in the bankruptcy area, see Adler, supra note 2, at 341-46; Rasmussen, supra note 3, at 88-89; Skeel, supra note 1, at 494-509. [VOL. 72:1159 http://openscholarship.wustl.edu/law_lawreview/vol72/iss3/28 EX ANTE EFFECTS OF BANKRUPTCY REFORM This leaves the third institution which could craft insolvency rules-the market, represented in this case by the shareholders of the firm. Allowing private parties to select the appropriate set of bankruptcy rules provides a higher probability that each firm is governed by the set of rules that best fits the needs of that firm. The firm's shareholders bear the cost of inefficient insolvency rules. 14 Thus, they have the incentive to select the insolvency rules that best fit the needs of their firm. Moreover, shareholders have better information about their firm and their taste for risk than any other party. Consequently, they are more likely to select the appropriate rules for their firm than is either a legislature or a bankruptcy court. Unfortunately, having the best incentives does not imply that mistakes will not be made; they will. But it does ensure that there will be fewer mistakes than there would be if another institution were to make the decision. Indeed, contract scholars long ago recognized this very point. The debate over whether courts, through the unconscionability doctrine, or the federal and state governments, through their regulatory powers, should intervene to protect one party to a contract was in large part a debate over institutional competence. While most recognize that private parties sometimes make mistakes, the consensus is that a well-functioning market protects parties more effectively than either legislatures or courts. There is little reason to expect that the lessons learned from that debate would not extend to the bankruptcy context. 4 ' Private contracting, however, is no panacea. While it holds out the best possibility for choosing bankruptcy rules that best suit the needs of individual firms, it also creates greater transaction costs than would exist under a system of legislatively determined bankruptcy rules. If bankruptcy law were relegated purely to private contracting, private parties would face two sources of transaction costs. The first would be the cost of designing the set of insolvency rules that would govern the firm's financial distress. The second would be the cost of communicating the rules that are drafted to the relevant parties. If the parties view the costs of financial distress, discounted to present value, as relatively low (not an implausible assump140. See Rasmussen, supra note 3, at 57-65. 141. If anything, the case for allowing shareholders to select their own set of insolvency rules is stronger than the case for allowing consumers to make their own choices. Shareholders are more likely to receive legal advice when incorporating the firm than are consumers entering into a simple contract. Moreover, there is little reason to fear that a lender will have monopoly power over potential borrowers. Thus, the concerns that gave rise to the consumer protection movement do not appear to be present when a firm seeks financing. 1994] 1209 Washington University Open Scholarship 1210 WASHINGTON UNIVERSITY LAW QUARTERLY tion given that not all firms fail, and those that will fail may not do so for many years), then it may be that the shareholders of any single firm would not have the incentives to craft an optimal set of bankruptcy rules. In such a situation, the shareholders may be content to live with whatever default rule the law provides. It is possible, however, to combine the legislature's ability to economize on transaction costs with the private parties' ability to determine which set of rules best serves their needs. Congress could craft a number of varied bankruptcy regimes but allow the shareholders to select which regime would govern their firm. 42 While the shareholders would be free to decline the options offered by Congress and craft their own set of insolvency rules, many firms would prefer not to invest the resources in drafting and publicizing their own set of insolvency rules. They would instead prefer to rely on what are, in essence, standard form contracts. Firms would thus garner the benefits of choosing the rule that best suits their needs while taking advantage of the legislature's ability to economize on transaction costs.