учебный год 2023 / (Encyclopedia of Law and Economics 5) Boudewijn Bouckaert-Property Law and Economics -Edward Elgar Publishing (2010)

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having identified the appropriate holders of the residual interest in the firm from the exercise of the Bebchuck-type options, hereafter permit them to vote on new capital structure proposals offered by competing management groups. Baird (1986) proposed that instead of elaborate and expensive recontracting, that the firm simply be auctioned off in Chapter 11, with the auction proceeds being distributed in accordance with priorities fixed in the claimants’ pre-bankruptcy investment contracts. Whatever going concern values the firm had would presumably be saved by being included in the price the winning bidder was willing to pay, buying the firm as an intact unit. Since the auction proceeds could be distributed in accordance with all the claimants’ prebankruptcy priority contracts, the auction argument also showed that the solution to the collective action problem did not necessitate ex post modification of those contracts. Auctions are, nevertheless, known to entail their own transaction costs and imperfections (Baird, 1993; Cramton and Schwartz, 1991; French and McCormick, 1984; Bhattacharyya and Singh, 1999).

Adler (1993b) and Bradley and Rosenzweig (1992) both proposed that firms might issue new types of securities which automatically erase the lowest priority claims upon a default of an obligation to the next higher priority class and simultaneously place that next-higher class in control of the firm. Adler’s proposal also eliminated the individual collection rights of holders of any of the contingent securities, thus eliminating any right and therefore any incentive for individual creditors to take action to dismember the debtor, and powerfully eliminating any justification for Chapter 11 if it was designed to ameliorate the collective action problem which arises when creditors have rights to act individually. Adler and Ayres (2001) resorted to the mechanism design literature to develop a procedure which might induce the parties in a reorganization to forego strategic manipulation of uncertain asset valuation in a reorganization process.

All of these proposals to reform Chapter 11, on the other hand, seem implicitly to accept that permitting individual creditors to enforce their credit contracts under nonbankruptcy law creates such significant collective action problems that a mandatory collective type proceeding is required as a solution. Some proposals offer the possibility that hybrid collective/individual type processes might improve on Chapter 11. Baird and Picker (1991) proposed that a collective stay be imposed on smaller creditors while permitting a single major financing creditor to individually decide whether to liquidate or continue the firm. Perhaps the most comprehensive proposals were those of Rasmussen (1993) and Schwartz (1993) under which individual firms would be obliged to specify the details of the collective program claimants against them would be required to follow. All of these proposals share the strategic presupposition that firms

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themselves can, in the design of their credit contracts or securities, also include contract terms which will ameliorate the collective action problems which might arise thereafter, by specifying a collective procedure in which the claims would be processed (Adler, 1994b). The fact that firms never seem to have attempted to use these devices then gives rise to some interesting empirical inferences. Perhaps the theoretically alarming collective action problem is not, in practice, as dreadful as armchair theorists and congressmen have feared. Adler (1993a) argues that automatically recapitalizing securities, at least, may not have been adopted for a variety of unrelated tax, tort and corporate law reasons. Gilson (1996) showed the most astonishing difference between failing firms which recapitalized using Chapter 11 and those recontracting outside of a regulated bankruptcy proceeding was that the net-operating-loss carry forwards (NOLS) of the Chapter 11 firms were nearly five times larger than those which recapitalized privately. This suggests that Chapter 11 may provide a technique for obtaining favorable corporate income tax treatment, a justification far afield from those currently speculated about. It is not easy to see, however, why a distressed firm should be required to undergo the details of a Chapter 11 reorganization before being entitled to these particular tax benefits. Such an understanding would have to proceed first by elaborating on the desirability of the creation of NOLS in the first place.

7.Bankruptcy and investment incentives

As the previous discussion showed, the collective action problem faced by a firm’s creditors can be addressed without altering the investors’ prebankruptcy priority plans ex post (Schwartz, 1994b) and Rasmussen (1994b) proposed that refusing ex post to honor investors’ prebankruptcy priority contracts might be explained by their affects on the firm’s near-insolvency investment incentives. They both concluded that none of the proposed contractual means of addressing the potential collective action problems could be judged better on this a priori basis, however. The inconclusiveness of these affects they deemed as a strong argument for giving individual firms their own ability to choose among a ‘menu’ of different possibilities for the proposal which best suited the concerns of that particular firm. Even if a one-size-fits-all bankruptcy regime could be improved upon by allowing each firm to tailor-make its own procedure, however, in the absence of a comprehensive understanding of how to create an optimal capital structure it is not easy to know how investors could value the differing choices on the resulting menus. The theoretical difficulties of knowing why capital structures might even matter raised by the Miller/Modigliani irrelevance theorem (1958) have begun to be overcome, largely as an offshoot of the theory of agency costs (Jensen and Meckling, 1976). It is now

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understood that debt in a firm’s capital structure contributes to the firm’s value by imposing discipline on managers whose personal incentives do not coincide with the desires of their principals, the equity investors. Fixed obligations impose a measurable task on management either to operate the firm profitably enough to raise the cash needed to meet the fixed obligation, or else to subject themselves to the discipline of the financial market in order to obtain the funds they need to operate the business (Easterbrook, 1984; Grossman and Hart, 1982; Jensen, 1986; Triantis, 1994). Since only firms with debt can incur financial distress, the overall expected gains from reduction of management misbehavior must be greater than the prospective losses which the existence of debt may create.

(a)Entrenchment Aside from the ex post collective action problems supposedly met by Chapter 11, it is also known that the existence of debt in the firm’s capital structure has some downsides. First, just as debt is thought to reduce agency costs by controlling management’s powers over the firm’s free cash flow, it is also recognized that the existence of debt gives rise to the positive probability of a financial default. Managers may fear that if the firm is to be liquidated upon default, they will lose their valuable positions, including some firm-specific investment in human capital. This reasoning gives rise to the perverse incentive known as management entrenchment. When the firm has issued debt, managers will tend to warp the firm’s investment decisions in favor of those projects in which managers can make themselves indispensable, even though these projects are not necessarily those with the highest net present values to investors (Morck, Shleifer and Vishny, 1989; Bebchuck and Picker, 1993).

(b)Overinvestment Second, it is now well understood that especially as the firm nears insolvency, low priority claimants have a perverse incentive to gamble with the firm’s assets, since they can pay off the higher priorities with the winnings and keep the profits for themselves, but all the losses will be imposed on the higher priority claimants. This set of perverse incentives is known as the Jensen and Meckling (1976) ‘overinvestment’ problem. The current bankruptcy regime is sometimes thought to ameliorate this incentive by refusing to enforce the investors’ ex ante contracts which require that equity be totally subordinated to debt claimants. If, as is known to be the case, Chapter 11 distributions deviate from the absolute priority rule, then the managers and equity may be gambling with some of their own money when they undertake risky projects and will be less inclined to do so. Insofar as these risky investments were likely to be in negative net present value projects, then the deviation from absolute priority might even be applauded as a means of avoiding socially detrimental wasteful

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investment decisions. On the other hand, it has also been shown that priority redistributions in bankruptcy create a classic case of moral hazard for solvent firms. By insuring management and equity against losses if insolvency eventuates, it is likely to aggravate the tendency of equity-holders and their managers to undertake undue risk during the periods when the firm is solvent (Adler, 1992; Bebchuk, 2002).

(c) Underinvestment The third perverse incentive known to haunt capital structures which contain debt is the so-called debt-overhang, or Myers’s (1977) ‘underinvestment’ risk. If the firm is nearly insolvent and is presented with a promising investment opportunity, equity (and management, their agents) may decide to forgo investing in it because the payoffs are likely to be captured entirely by the higher priority creditors. In that way, the existence of debt may cause the firm to forgo the opportunity to invest in positive net present value projects. For firms with investible internal funds, then, eliminating the claims of the higher priority creditors ex post in order to make distributions to the lowest priority claimants (equity) is a way of permitting equity to share in the returns from those valuable projects (Rasmussen, 1994b). Once in bankruptcy proceedings, the bankruptcy judge may approve subordinating senior claims to those of new financiers in order to overcome this underinvestment incentive (Triantis, 1993a).

Nevertheless, Schwartz (1994b) has shown that if the firm must resort to the capital markets in order to obtain the financing for positive net present value projects, then the failure to enforce pre-bankruptcy priority contracts creates an underinvestment incentive even for solvent firms and exacerbates those incentives for nearly insolvent firms. Generally, he argues, outside financiers, aware that their nonbankruptcy priority will not be honored in a Chapter 11, will insist not only on market returns for their investments, but also will insist on extra returns for being forced to bear the costs of the bankruptcy redistribution. The extra returns they will insist upon will render otherwise positive net value projects not worthwhile to undertake at the margins. It is thus an empirical issue whether the extra underinvestment risks which bankruptcy reorganization imposes on solvent firms and on those who must resort to the capital markets to finance their projects and are near insolvency, are outweighed by the mitigation of those risks to nearly insolvent firms with internal investible capital.

In summary, the current American corporate reorganization scheme has not yet been satisfactorily explained. In the first place, the collective action problems it seems designed to address may not be so serious after all, and in the second place, even if they are serious, they are capable of being addressed more cheaply by altering the contractual terms of credit

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contracts and securities. Finally, corporate reorganization’s failure to honor prebankruptcy contractual priorities does not seem to address management entrenchment, the first set of perverse incentives which inhere in corporate capital structures. The impact of denying enforcement to prebankruptcy contractual priority is, at best, ambiguous with respect to both the overinvestment and underinvestment perverse incentives.

8.Structures with preplanned liquidations

Adler (1997) has suggested that the failure of law and economics scholarship to develop a satisfactory explanation for corporate reorganization bankruptcy may to be due to a flawed initial premise generated by a faulty ex post point of view. He suggests that asking why and how investors would like to be able to salvage going concern values, as looked at from the point in time when the debt obligations of the firm go into default themselves, ignores a significant feature of any business’s necessarily prior decision to select its capital structure. The ex ante point of view, from the time the structure is designed, he suggests might offer a more fruitful perspective. Investors at the time the firm is structured may purposely design it so that it experiences financial distress whenever it is also likely to become economically unviable. Bowers (1991) had, in a similar vein, proposed that firms might employ security interests in a manner which would build self-executing optimal liquidating plans into their capital structures. See also Cornelli and Felli (1997).

Firms whose projects have no economic value ought not to be reorganized. Instead their assets ought to be redeployed to higher and better uses. It is a commonplace that, ex post, managers (Rose-Ackerman, 1991) and lower priority claimants (Bebchuck and Chang, 1992) have an incentive to fuzz the distinctions between economic and financial viabilities simply to milk the higher priority creditors for the last available dime before the firm must cease business, and that they apparently succeed in doing so (White, 1994a, 1994b). Describing the optimal moment at which management’s control over the assets should be eliminated is a formidable task (Buckley, 1992). Even if the initial capital structure design does not perfectly separate the economically from the merely financially unviable firms ex post, however, the gains from rehabilitating a few firms may not be worth the losses from attempting to save a multitude of unsalvageable ones. Chapter 11’s record for rehabilitating firms is not a stellar one since many Chapter 11 firms must refile shortly after being recognised (Hotchkiss, 1995). Kahl (2002) argues, on the other hand, that serial refilings may simply be part of the process of finely sorting economically inviable firms from those who are merely financially distressed. The potential for an out-of-court workout also provides a failsafe mechanism if the capital structure turns

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out, ex post, to have been an especially bad predictor (Fitts, et al., 1991; Gilson, John and Lange, 1990; Haugen and Senbet, 1988).

9.Nonbankruptcy law’s responses to perverse investment incentives

This insight might in fact explain the nonbankruptcy creditors’ remedy system in which, if creditors are unpaid, they can trigger a liquidation which will send the firm’s assets back into the market to be reallocated to better uses. The nonbankruptcy system also can address some of the perverse incentives built into typical capital structures having a debt component. The overinvestment incentive is addressed by permitting creditors to seize the assets of the firm. Once the assets are seized, equity and its management can no longer gamble them on risky ventures. Furthermore, even management entrenchment can be resisted under the nonbankruptcy system. Creditors who can effectively precommit to a version of the ‘grim’ strategy, to seize and sell whatever assets the managers invest in, can eliminate the incentives of managers to invest in them even if such investments owe a lot of their value to information which is private to the managers. It is only the prospect of a job in the reorganized project which permits the entrenchment incentive to operate. An absolute commitment to liquidate rather than reorganize thus makes entrenchment prospectively unprofitable. In that sense, then, one of the most serious of the perverse incentives is created by the law of bankruptcy reorganization.

The final perverse incentive that arises under capital structures which include debt, so-called underinvestment, may also not be of the sort which can easily be resolved by altering the terms of credit contracts. The potential positive net present value project which might not be exploited in the future is difficult for the initial investors to describe in their present contracts. The underinvestment incentive is not addressed by corporate reorganization bankruptcy doctrine either. The problem, thus, may be practically intractable.

In that case, the investors may conclude that if the firm suffers distress, its assets ought not to be deployed in any new projects in a firm still laden with the old capital structure. The best alternative may be to liquidate the old firm and to structure a new one in order to pursue the new investment opportunities. It seems unlikely that a satisfactory explanation and justification for any sort of corporate reorganization law will be possible until such time as a generally acceptable model of optimal initial organization is developed. While the shape of such a model might be inferable from the actual behaviors of investors and executives, the empirical literature to date has not succeeded in distinguishing the essentials from the noise. Nor has the theory of corporate financial structure yet advanced to the point of offering a satisfying understanding.

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