The Law of the Jungle and the New Era of Governance of Distressed Firms
On the eve of the financial crisis, a series of Delaware court decisions added up to a radical change in law: Creditors would no longer have the kind of common law protections from opportunism that helped protect their bargain for the better part of two centuries. In this Article, we argue that Delaware's shift materially altered the way large firms approach financial distress, which is now characterized by a level of chaos and opportunism that goes far beyond the historical norm. It is now routine for distressed firms to engage in tactics that harm some creditors for the benefit of other stakeholders, often in violation of contractual promises and basic principles of corporate finance. The fundamental problem is that Delaware's change in law was predicated on the faulty assumption that creditors are fully capable of protecting their bargain during periods of distress with contracts and bankruptcy law. We show through a series of case studies how the creditor's bargain is, contrary to that undergirding assumption, often an easy target for opportunistic repudiation and, in turn, dashed expectations once distress sets in. We further argue that the Delaware courts paved the way for scorched earth distressed governance, but also that judges can help fix the problem.
Regulating Bankruptcy Bonuses, forthcoming 92 Southern California Law Review ____(2019)
In 2005, the perception that wealthy executives were being rewarded for failure led Congress to ban Chapter 11 firms from paying retention bonuses to senior managers. Under the new law, debtors could still pay bonuses to executives – but only “incentive” bonuses triggered by accomplishing challenging performance goals that go beyond merely remaining employed. In this Article, I use newly collected data to examine how the reform changed bankruptcy practice. While relatively fewer firms use court-approved bonus plans after the reform, the overall level of executive compensation appears to be similar, perhaps because the new regime left large gaps that make it easy for firms to by-pass the 2005 law and pay managers without the judge’s permission. I argue the new law was undermined by institutional weaknesses in Chapter 11, as bankruptcy judges are poorly situated to analyze bonus plans and creditors have limited incentives to police executive compensation themselves.
Bankruptcy Claims Trading, forthcoming, 15 Journal of Empirical Legal Studies ___ (2018)
A robust secondary market has emerged over the past twenty years in the debt of Chapter 11 firms. Critics worry that the trading associated with this market has undermined bankruptcy governance, by forcing managers to negotiate with shifting groups of activist investors in the Chapter 11 bargaining process. This paper investigates whether this is a common problem and concludes that it is not. Although trading of bond debt is pervasive, the activist groups that tend to participate in negotiations usually enter cases early and rarely change significantly. Trading in general, therefore, does not appear to have the impact on governance that many claims trading critics fear, at least insofar as the average case is concerned.
What Drives Bankruptcy Forum Shopping? Evidence from Market Data, 47 Journal of Legal Studies 119-149 (2018)
Over the past thirty years, the majority of large firms that filed for bankruptcy did so in the Federal Bankruptcy Courts of the Southern District of New York and Delaware. Some believe these experienced courts attract firms because their expertise make bankruptcy more predictable. Critics dispute this explanation, arguing instead that “predictability” is a cloak for the true, self-interested motivation of the managers, lawyers and senior creditors that influence the debtor’s venue decision. In this paper, I look for evidence supporting the views of the proponents and detractors of bankruptcy forum shopping in a large sample of market data. My results suggest that the market is better at predicting the outcomes of bankruptcy cases in the two destination venues, consistent with the hypothesis that the law there is more predictable. I do not find evidence supporting the view that those courts are biased in favor of managers or senior creditors.
Summary: Oxford Business Law Blog
Do Activist Investors Constrain Managerial Moral Hazard in Chapter 11? Evidence from Junior Activist Investing, 8 Journal of Legal Analysis 493 (2016)
This paper examines the hedge fund investment strategy of buying junior claims of Chapter 11 debtors and playing an activist role in the bankruptcy process. These hedge funds are often accused of rent-seeking by managers. I use a new methodology to conduct the first empirical study of this investment strategy. I find little evidence that junior activists abuse the bankruptcy process to extract hold-up value. Instead, the results suggest that they constrain managerial self-dealing and promote the bankruptcy policy goals of maximizing creditor recoveries and distributing the firm’s value in accordance with the absolute priority rule.
The Shadowy Contours of Bankruptcy Resistant Investments, 114 Columbia Law Review Sidebar 123 (2015)
Baird and Casey recently argued in favor of contractual innovations that allow lenders to contract around bankruptcy law. These innovations, which they call withdrawal rights, are said to increase the efficiency of financing in many cases, and Baird and Casey urge judges to enforce them. This brief Essay uses a case study of a Chapter 11 bankruptcy where withdrawal rights were enforced by operation of foreign law to challenge Baird and Casey’s assumptions. The case study suggests that managers may lack a full understanding of how their actions ex ante affect bankruptcy outcomes. Substantial changes for managerial behavior and corporate regulation may be needed to allow managers and investors to utilize withdrawal rights when doing so would enhance the efficiency of financing.