LS07CH08-White ARI 1 October 2011 17:47 Corporate and Personal Bankruptcy Law Michelle J. White1,2 1Department of Economics, University of California, San Diego, La Jolla, California 92093; email: [email protected] 2Cheung Kong Graduate School of Business, and Research Associate, National Bureau of Economic Research, Cambridge, Massachusetts 02138 Annu. Rev. Law Soc. Sci. 2011. 7:139–64 Keywords The Annual Review of Law and Social Science is reorganization, liquidation, priority, absolute priority rule, default, online at lawsocsci.annualreviews.org exemptions, filtering failure, workouts, fresh start, foreclosure This article’s doi: 10.1146/annurev-lawsocsci-102510-105401 Abstract Copyright c 2011 by Annual Reviews. Bankruptcy is the legal process by which the debts of firms, individ- All rights reserved uals, and occasionally governments in financial distress are resolved. 1550-3585/11/1201-0139$20.00 by University of California - San Diego on 09/05/12. For personal use only. Bankruptcy law always includes three components. First, it provides a collective framework for simultaneously resolving all debts of the Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org bankrupt entity, regardless of when they are due. Second, it provides rules for determining how the assets and earnings used to repay are divided among creditors. Third, bankruptcy law specifies punishments intended to discourage debtors from defaulting on their debts and fil- ing for bankruptcy. This review discusses and evaluates bankruptcy law by examining whether and when the law encourages debtors and cred- itors to behave in economically efficient ways. It also considers how bankruptcy law might be changed to improve economic efficiency. The review shows that there are multiple economic objectives of bankruptcy law because the law has very diverse effects. Some of these objectives differ for individuals versus corporations in bankruptcy. 139 LS07CH08-White ARI 1 October 2011 17:47 INTRODUCTION of time after filing.1 Another part of the pun- Bankruptcy is the legal process by which the ishment for bankruptcy is whether and when debts of firms, individuals, and occasionally filers’ liability to repay debts is discharged. In governments in financial distress are resolved. the United States, most bankruptcy filers re- Debtors file for bankruptcy because they can- ceive a quick discharge from debt, but in France not pay debts as they come due and/or because and Germany, discharges are issued only af- their liabilities exceed their assets. ter debtors use part of their earnings for 5 to Bankruptcy law always includes three com- 10 years to repay debts, and bankruptcy judges ponents. First, it provides a collective frame- can deny the discharge if they feel that debtors work for simultaneously resolving all debts of did not try hard enough to repay debts. In other the bankrupt entity, regardless of when the countries, debt discharge occurs only when the debts come due. Bankrupts may be required to debtor dies. For corporations in bankruptcy, use some or all of their assets to repay their debt is discharged quickly, but the corporation debts: Bankruptcy law includes rules determin- itself ceases to exist. ing which assets must be used to repay debts Bankruptcy procedures may involve ei- versus which assets bankrupts are allowed to ther liquidation or reorganization of the keep (if any). Bankrupts may also be required bankrupt entity. When corporations liquidate to use some of their future earnings to re- in bankruptcy, all of their assets are sold and pay debts, and bankruptcy law provides simi- the proceeds are used to repay creditors. Assets lar rules determining how much of their future may be sold piecemeal or as a going concern earnings must be used to repay debts. These if the corporation is still operating when it rules differ depending on whether bankrupts files for bankruptcy. The size of the pie in are corporations, individuals, or governments. bankruptcy liquidation is all of the corpora- Second, bankruptcy law provides rules for de- tion’s assets. When corporations reorganize termining how the assets and earnings used to in bankruptcy, they keep some or all of their repay debts are divided among creditors. This assets, continue to operate, and follow a plan to part of bankruptcy law also includes rules that use part of their future earnings to repay debt. limit creditors’ rights to grab assets and keep In this situation, the pie includes only part of those assets out of the collective debt resolu- the corporation’s assets, but it also includes tion procedure. Thus bankruptcy law deter- part of the corporation’s future earnings. For mines both the size of the pie in bankruptcy, individuals, bankruptcy never involves com- i.e., the total amount paid to creditors, and plete liquidation. Individual bankrupts may be the division of the pie among individual required to give up some of their assets; these creditors. by University of California - San Diego on 09/05/12. For personal use only. Third, bankruptcy law specifies how debtors 1There are other punishments for debtors who default but Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org are punished for filing for bankruptcy. In do not file for bankruptcy, including credit collectors call- the United States, the main punishments for ing them, suing them, and garnishing their wages (see below bankruptcy are making filers’ names public and for further discussion). Past punishments for default were allowing the bankruptcy filing to remain on far more severe and included the death penalty, exile, selling debtors into slavery, and putting them in debtors’ prisons. their credit records for 10 years. These pun- Early bankruptcy laws also specified severe punishments for ishments stigmatize bankruptcy filers and harm filing, including debtor’s prison and the death penalty for them financially because they face greater diffi- filers who concealed assets. Debts were discharged only if creditors consented. See Efrat (2006) for multicountry infor- culty postbankruptcy in obtaining loans, rent- mation on punishments for default and bankruptcy. Sandage ing apartments, and sometimes obtaining jobs. (2005), Balleisen (2001), and Mann (2002) discuss attitudes In the United Kingdom, punishments include toward debt and default in the United States and the adoption of U.S. bankruptcy laws—there were several—in the nine- barring bankruptcy filers from managing firms teenth century. Skeel (2001) gives a history of U.S. personal or holding certain public offices for a period and corporate bankruptcy law during the twentieth century. 140 White LS07CH08-White ARI 1 October 2011 17:47 are liquidated and the proceeds are used to on personal and small business bankruptcy.2 repay creditors. But individuals’ most valuable Corporate bankruptcy refers to the bankruptcy asset is usually their human capital—their of large- and medium-sized firms, which I as- education and training—and the only way to sume are organized as corporations. Personal liquidate human capital is to sell individuals bankruptcy refers to the bankruptcies of both into slavery. Because slavery is no longer individual debtors and small businesses. Small allowed, bankrupt individuals always keep their business bankruptcy is treated as part of per- human capital and the right to decide whether sonal bankruptcy because small businesses are and how to use it. Thus bankrupt individuals owned by individuals or partners who are legally always keep some of their assets. However, like responsible for their business debts. When corporations that reorganize, bankrupt individ- businesses fail, owners often file for personal uals may be obliged to use some of the future bankruptcy in order to have their business debts earnings that their human capital produces to discharged. Even when small businesses are in- repay creditors, usually for a fixed number of corporated, owners often guarantee the debts years. This means that bankruptcy procedures of their businesses, so personal bankruptcy law for individuals are always reorganizations, and applies. the size of the pie used to repay creditors is less than the value of bankrupt individuals’ I. CORPORATE BANKRUPTCY assets. This review discusses and evaluates Bankruptcy law affects the economic efficiency bankruptcy law by examining whether and of corporate behavior, both when corporations when the law encourages debtors and creditors are in financial distress and when they are fi- to behave in economically efficient ways. It nancially healthy. also considers how bankruptcy law might be changed to improve economic efficiency. The Effects of Priority Rules in Bankruptcy discussion abstracts from the details of U.S. and on Corporate Behavior other countries’ bankruptcy laws in order to Priority rules are rules for dividing repayment focus on common features of bankruptcy law, in bankruptcy among creditors and sharehold- and it also attempts to avoid use of legal terms. ers of a corporation. An important priority rule This review shows that bankruptcy law has a is the absolute priority rule (APR), which re- variety of economic objectives, some of which quires that unsecured creditors be repaid in full differ for individuals versus corporations. The before shareholders receive anything. When variety of economic objectives results from the there are multiple creditors, priority among fact that bankruptcy law has widespread effects: them is determined by whether creditors have by University of California - San Diego on 09/05/12. For personal use only. causing responses that change the supply and a secured interest in a particular asset owned demand for many types of credit; which finan- Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org by the corporation or by whether creditors cially distressed firms shut down versus which have made agreements with the corporation continue to operate; corporate managers’ in- that specify a priority ordering. Suppose a centives to work hard, invest, and take risks; and corporation has creditors A and B and A’s individual debtors’ incentives to work hard, be- loan was made before B’s.