The Three Faces of Bankruptcy Law A Dissertation Presented to the Faculty of the Law School Of Yale Univesity In Candidacy for the Degree of Doctor of the Science of Law By G. Eric Brunstad, Jr. Dissertation Committee Supervisor: William N. Eskridge, Jr. Readers: William N. Eskridge, Jr. Ian Ayres George L. Priest February, 2014 © 2014 by G. Eric Brunstad, Jr. All rights reserved Table of Contents Chapter 1: Introduction...................................................................................................................1 The Creditors’ Bargain...............................................................................................................24 Bankruptcy Contracting, Super-Foreclosure, and the Cost-of-Capital Metric ...............................................................................................................54 Bankruptcy Contracting..........................................................................................................57 Super-Foreclosure...................................................................................................................84 The Cost-of-Capital Metric ....................................................................................................95 Bankruptcy Law as an Assortment of Loss-Spreading Norms .......................................................................................................................................101 Chapter 2: The Problems of Insolvency......................................................................................112 Defining the Relevant Problem Set..........................................................................................118 Problems of Claims Mediation and Payment Discrimination..................................................119 Claims Mediation .................................................................................................................121 Payment Discrimination .......................................................................................................129 Problems of Overinvestment, Underinvestment, and Other Moral Hazard............................................................................................................................137 Incentives for Delay and Excessive Risk Taking.................................................................138 Dueling Stakeholders, the Debt-Collection “Free-for-All,” and Stagnating and Overburdened Assets ............................................................................156 Dueling Stakeholders.......................................................................................................156 The Debt-Collection Free-for-All....................................................................................162 Stagnating and Overburdened Assets ..............................................................................169 Gratuitous Transfers .............................................................................................................174 Deadweight Collection and Monitoring Costs .........................................................................180 Chapter 3: Remediating the Problems of Insolvency and the Contours of the Bankruptcy Market ............................................................................................190 Categorizing the Problems of Insolvency and Their Potential Solutions...................................................................................................................................205 Epistemic Complexities........................................................................................................213 Resolving the Problems of Debt Collection.............................................................................228 Equity ...................................................................................................................................231 ii Efficiency .............................................................................................................................242 Entitlement ...........................................................................................................................249 Resolving the Problems of Debt Forgiveness ..........................................................................254 The (Typically) Accidental Need for Bankruptcy Relief.....................................................259 Equity and Discharge Relief.................................................................................................273 The Efficiency of Discharge Relief......................................................................................286 Discharge and Entitlement ...................................................................................................293 Resolving the Problems of Debt Adjustment...........................................................................300 Equity and Relative Payment Priorities................................................................................303 Efficiency and Payment Prioritization..................................................................................321 Entitlement and the Priority of Payment Rights...................................................................327 Prioritizing the Functions of Bankruptcy Law.........................................................................335 The Bankruptcy Market ...........................................................................................................346 Access...................................................................................................................................348 Accuracy Versus Speed........................................................................................................350 Traditional or Problem-Solving Courts................................................................................352 Liquidation or Reorganization..............................................................................................353 Distributing Value............................................................................................................363 Conclusion................................................................................................................................368 Bibliography.............................................................................................................................370 Acknowledgments I am deeply grateful to the members of my dissertation committee at the Yale Law School: Professors William N. Eskridge, Jr., Ian Ayres, and George L. Priest. Many thanks for their generous support. INTRODUCTION The Three Faces of Bankruptcy Law Bankruptcy law is an ancient, peculiar feature of our legal landscape. Historically, it has existed from time to time as a collection of extraordinary remedies assembled to address three basic questions: (1) what is to be done with the person of an insolvent debtor, (2) what is to be done with the insolvent debtor’s property, and (3) what is to be done with the insolvent debtor’s liabilities?1 It is peculiar for several reasons. First, the need for a special collection of bankruptcy procedures is not so obvious. Non-bankruptcy law already provides vast mechanisms for collecting debts, distributing 1 As used throughout, the term “debtor” refers to a person who owes unpaid debt obligations. A debtor may be either an individual or a firm. The term “insolvent” refers to a debtor’s general inability (or in some cases unwillingness) to satisfy existing obligations, either as they mature (“equity insolvency”) or because they exceed the value of the debtor’s assets (“balance-sheet insolvency”). In contrast, the term “bankrupt” refers to the status of an insolvent debtor who has become caught up in a legal bankruptcy proceeding of some kind. It is worth noting that not all insolvent debtors will or should seek formal bankruptcy relief. See Alan Schwartz, Bankruptcy Workouts and Debt Contracts, 36 J.L. & ECON. 595, 595 (1993) [hereinafter Schwartz, Bankruptcy Workouts] (observing that many firms that experience financial distress restructure their affairs without resort to bankruptcy); see also Joseph E. Stiglitz, Some Aspects of the Pure Theory of Corporate Finance: Bankruptcies and Take-overs, 3 BELL. J. ECON. MGMT. SCI. 458, 480 (1972) (noting that firms approaching insolvency may consider takeovers and mergers rather than bankruptcy). For example, some debtors experience insolvency as purely a temporary phenomenon—including most college students immediately upon graduation and many start-up firms. For these debtors, resort to bankruptcy is not typically warranted. Similarly, not all debtors experiencing financial distress are or will become insolvent, either in the equity-insolvency sense or the balance- sheet-insolvency sense. The concept of financial distress is thus not synonymous with insolvency. 2 property, and sorting the rights of competing claimants against a common obligor. One might well ask: why have yet another mechanism for doing so simply because one of the parties in interest—the debtor—has become insolvent? For much of United States history, the nation had no formal bankruptcy law,2 and thus one potential answer to this question (albeit an incorrect one) is that there is no particular need for a distinct bankruptcy regime. Second, few areas of the law have been the subject of such rancorous experimentation. In both England and the United States,