Bankruptcy Law As a Liquidity Provider Kenneth Ayottet & David A

The University of Chicago Law Review Volume 80 Fall 2013 Number 4 O 2013 by The University of Chicago ARTICLES Bankruptcy Law as a Liquidity Provider Kenneth Ayottet & David A. Skeel Jrtt Since the outset of the recent financial crisis, liquidity problems have been cited as the cause behind the bankruptcies and near bankruptcies of numerous firms, ranging from Bear Stearns and Lehman Brothers in 2008 to Kodak more recently. This Article expands the prevailing normative theory of corporate bankruptcy-the Creditors'Bargain theory-to include a role for bankruptcy as a provider of liquidity. The Creditors' Bargain theory argues that bankruptcy law should be limited to solving problems caused by multiple, uncoordinated creditors, but focuses almost exclusively on the problem of creditor runs. We argue that two well-known problems that cause illiquidity-debt overhang and adverse selection-are also caused by multiple-creditor-coordinationproblems. As such, bankruptcy law is justified in solving these problems in addition to creditor-runprob- lems. t Professor of Law, Northwestern University School of Law, [email protected]. ft S. Samuel Arsht Professor of Corporate Law, University of Pennsylvania Law School, [email protected]. We thank Barry Adler, Douglas Baird, Michal Barzuza, Margaret Blair, Patrick Bol- ton, Anthony Casey, Jens Dammann, Rich Hynes, Thomas Jackson, Jason Johnston, Randall Klein, Edward Morrison, Dotan Oliar, Richard Squire, Amir Sufi, Fred Tung, and participants at the Conference on Creditors and Corporate Governance at the Uni- versity of Chicago Law School, the Law and Economics Workshop at the University of Virginia School of Law, the Corporate and Securities Law conference at Vanderbilt Uni- versity School of Law, and the faculty workshops at Northwestern and UC Berkeley for helpful comments and discussions; Lauren-Kelly Devine and Jin Gu for excellent re- search assistance; and the University of Pennsylvania Law School for summer funding (Skeel). 1557 1558 The University of Chicago Law Review [80:1557 With this insight in hand, we argue that many of bankruptcy's existing rules, including debtor-in-possessionfinancing, sales free and clear of liens, and coerced loans, can be seen as liquidity-providing rules that target either debt-overhang problems, adverse-selectionproblems, or both. Using bankruptcy to solve liquidity problems can create costs, however, such as the risk of continuation bias. We sug- gest rules of thumb for judges to use in balancing the benefits and costs of these rules. We also connect our theory to the use of bankruptcy for financial institutions, where liquidity concerns loom large. INTRODUCTION ................................................. ...... 1559 I. THE CREDITORS' BARGAIN THEORY .............................. 1563 II. LIQUIDITY ................................................. ...... 1567 A. Benchmark Case: Full Liquidity in an Ideal World ...... ..... 1567 B. Illiquidity Caused by Debt Overhang .............. ....... 1570 C. Solutions to the Debt-Overhang Problem ............. ..... 1572 1. Existing creditors make the new loan ...................... 1573 2. Renegotiation ...................................... 1576 3. Full seniority for the new lender ..................... 1576 4. Limited seniority for the new lender .......................1577 5. Sell assets free of existing debts .............................. 1578 6. Conclusion: solutions to debt overhang and nonbankruptcy rights ......................... ................ 1579 D. Illiquidity Caused by Adverse Selection .........................1579 E. Strategic Illiquidity Creation and Senior-Creditor Control............ 1585 F. Solutions to the Adverse-Selection Problem ................ 1587 1. Disseminate information to uninformed parties...................... 1588 2. Disadvantage informed parties... ............................ 1588 3. Issue information-insensitive claims ................... 1588 III. BANKRUPTCY LAw's LIQUIDITY-PROVIDING RULES ..................... 1589 A. Seniority Rules..................................... 1590 1. Administrative-expense priority. ...........................1590 2. Security interests. ....................... ......... 1590 B. Sales Free and Clear of Liens and Obligations ..................... 1592 1. Alleviating debt overhang. ............... .............. 1593 2. Alleviating adverse selection.............. .......... 1594 C. Rules That Provide Coerced Loans ............. .......... 1594 1. Defining substantive rights in coerced loans............................ 1599 2. Caveats. ................................. ...... 1601 IV. NORMATIVE ANALYSIS OF BANKRUPTCY'S LIQUIDITY-PROVIDING RULES.... 1602 A. Timing Rules for Valuing Secured Claims......................... 1602 B. Section 364(d) Priming Liens ................... ........ 1604 C. Section 552(b) Liens on Proceeds .................. ...... 1606 D. Prebankruptcy Commitments to Make Loans....... ......... 1608 2013] Bankruptcy Law as a Liquidity Provider 1559 E. Sales Free and Clear: Defining the Value of a Lien........................ 1610 V. THE COSTS OF LIQUIDITY-PROVIDING RULES .......................... 1610 A. Identifying the Principal Costs ........................... ...... 1611 B. General Principles for Controlling the Costs .................... 1613 VI. LIQUIDITY IN FINANCIAL INSTITUTION BANKRUPTCIES .. ................ 1617 A. Derivatives and Third-Party Effects.............. ............. 1618 B. The Need for Immediate Liquidity................ ............. 1622 CONCLUSION ................................................. ........ 1623 INTRODUCTION The financial crisis generated increased attention on the importance of liquidity, and the dramatic consequences that can follow from illiquidity. At the beginning of the week of March 10, 2008, Bear Stearns held over $17 billion in cash and a stock market capitalization of over $7 billion. By the end of the week, Bear required a massive capital infusion from the Federal Re- serve to fund its merger with JPMorgan Chase. The assets against which Bear borrowed to fund its operations had sudden- ly become illiquid. Bear simply could not find a lender willing to lend against them, even on a fully secured basis.1 Since the financial crisis, liquidity problems have been cited as the cause behind both the decisions to file for bankruptcy and the outcomes of many Chapter 11 cases. 2 Kodak, the iconic film and imaging company, is a prominent recent example. After fail- ing to capitalize on the trend away from traditional film and to- ward digital imaging, Kodak shifted focus to monetizing its portfolio of imaging patents through litigation, licensing, and patent sales. As Kodak's financial condition deteriorated, it found that companies like BlackBerry, Apple, and HTC employed delay tac- tics to starve the company of cash and gain advantage in litigation. Kodak responded by filing for Chapter 11 bankruptcy in January 2012. The Chapter 11 filing was made to buy time and free up cash, allowing Kodak to maximize the sale and litigation value of its patent portfolio and to reorganize around its core printing business. As Kodak's lead bankruptcy lawyer explained 1 Kate Kelly, News in Depth: Bear Stearns Neared Collapse Twice in Its Frenzied FinalDays; Treasury Secretary Pushed for a Low-Ball Bid, Relented; Testy Time for J.P. Morgan CEO, Wall St J Europe 18 (May 30, 2008). The most extensive discussion of the Bear Stearns collapse is William D. Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street (Doubleday 2009). 2 See, for example, Maria Aprile Sawczuk, Are the Days of Knights Over? Lack of Liquidity Stymies Chapter 11 Cases, J Corp Renewal (Turnaround Management Associa- tion Feb 19, 2009), online at http://www.turnaround.org/Publications/Articles .aspx?objectID=10642 (visited Nov 18, 2013). 1560 The University of Chicago Law Review [80:1557 to the court on the first day of the case: "We're here for liquidity."23 The goal of this paper is to bring to light the crucial role that bankruptcy law plays in creating liquidity for firms in financial distress, and to incorporate this liquidity-creating func- tion into bankruptcy theory. We define a firm as liquid when it can borrow against its full value, or sell its assets for full value, on short notice.4 Firms that suffer from illiquidity may be forced into premature liquidation or going-concern sales at prices below their fundamental values. The predominant theoretical foundation for corporate bankruptcy is known as the Creditors' Bargain theory.5 This normative theory argues that the scope of bankruptcy law should be limited to solving the particular problems caused by multiple, uncoordinated creditors when firms face financial distress.6 Although liquidity may at first seem far removed from these concerns, liquidity and creditor-coordination issues are tightly linked in contemporary finance. Using insights from the theory of financial economics, we examine two well-known causes of illiquidity, the debt-overhang problem7 and the adverse-selection 3 See Mike Spector and Dana Mattioli, Can Bankruptcy Filing Save Kodak? Doubts Persist on Printer,Patent Strategy as Icon Seeks Chapter 11 Protection,Wall St J B1 (Jan 20, 2012). 4 By full values, we mean the values at which the asset would trade or serve as collateral in an ideal environment: one that is free of the debt-overhang and asymmetric- information problems we discuss below. 5 See, for example, Thomas H. Jackson, The Logic

Load more