Authored by: Tithi Neogi
India’s Insolvency and Bankruptcy Code, 2016 is a novel attempt at consolidating the laws and smoothening the existing framework relating to corporate reorganization and insolvency resolution, with the prerogative to achieve wealth maximisation, availability of credit and fulfilment of stakeholders’ interests in a time-bound manner. It puts the creditors in control in case of reorganization, puts a cap on default by debtors, and strives not to destroy more value than is created. In the heart of this Code lies Section 53 (see here), which provides for pro-rata distribution of proceeds from the sale of liquidation assets to a variety of stakeholders. This Section, and in fact, the entire Insolvency and Bankruptcy Code, like several other bankruptcy laws across various jurisdictions, are based on the Creditors’ Bargain Theory. In this article, I argue why the Creditors’ Bargain Theory might not be a very strong base for a bankruptcy law to be built upon it.
CREDITORS’ BARGAIN THEORY AND ITS ROLE IN BANKRUPTCY LAW
Thomas Jackson’s creditors’ bargain theory gives a normative view of what bankruptcy law should be- according to the theory, bankruptcy laws should be restricted to solving coordination issues solved by conflicts between multiple creditors. Corporate reorganization should be strategized so as to recreate the agreement which the creditors can be expected to form amidst themselves, if they had to do so from an ex-ante position. This basically indicates that ideally reorganization must focus on achieving value maximisation of assets in bankruptcy.
The primary function of bankruptcy law, is to reinstate an efficient model that governs the relationship between an investor and a distressed firm. A bankruptcy law seeks to protect the economic interests of the investor, but swaps the investor’s right to property with the official value of his right. This means that in exchange for the investor’s right to withdraw his investment upon debtor’s default, the bankruptcy law offers a judicially mediated procedure to recover the value of the right over assets. An example would be a secured creditor’s power to sell collateral being stayed, and in place of it the creditor being given a right only to adequately protect his interest in the collateral.
The Insolvency and Bankruptcy Code relies heavily on the absolute priority rule, which is derived from the creditors’ bargain theory. This rule says that senior creditors should be paid the full value of their investment, before junior creditors are paid anything. This follows the contractual right to priority that exists for creditors outside of bankruptcy.
PROBLEMS WITH CREDITORS’ BARGAIN THEORY
A study titled ‘Bankruptcy law as a liquidity provider[i]’ concluded in its findings that debt overhang and adverse selection are the two primary problems that lead to illiquidity, and that these problems increase in magnitude when there are several uncoordinated creditors.
This situation of illiquidity among uncoordinated creditors is the result of a conflict related to allocation of resources. The creditors’ bargain theory fails to address this problem properly. Normally, a quick going concern sale is the chosen means of corporate reorganization. When a debt is issued by a firm, its repayment depends on the future value of the firm. A secured creditor is paid all the future value up to the face value of its debt. The remaining future value after the payment of the face value to the senior creditor, goes into the pockets of junior creditors. This implies that the junior creditor’s interest in the assets is comparable to a call option with a strike price equivalent to the face value of the senior debt. But the junior creditor in a real case scenario, does not get what he rightfully deserves because the absolute priority rule diminishes the value of that call option. Since all futuristic scenarios are calculated using present-day values, the absolute priority rule destroys all interest in future value and thus wipes out the contractual rights of the junior creditor.
Thus, we see that senior creditors are able to enjoy rights of such a magnitude that was not meant to be enjoyed by them as per market forces, and this is enabled by the absolute priority rule that is championed by the creditors’ bargain model.
From this real world situation, we see that there is a conflict of incentives between senior creditors and junior creditors. For senior creditors, it is more profitable to sell-off the company’s assets without losing out on time, even when a longer process of reorganization can yield a higher expected return for the firm. On the other hand, junior creditors are best protected by stopping a quick going concern sale, and supporting instead a protracted reorganization even when a quick sale can yield higher expected return for the firm.
These conflicts result in a failed attempt at maximising the value of the distressed firm’s assets. When senior creditors are in control, they will in all probability sell off the assets at a price less than their highest value, in a bid to dispose them off quickly. Junior creditors promote spending unnecessary resources on a drawn-out reorganization.
There is another theoretical error in the creditors’ bargain model. The creditor’s bargain theory promotes the insolvency argument, i.e. the creditors should retain control over the common pool of assets of the distressed firm, since they have the incentive to maximise asset value if they are forced to act cooperatively. However, this argument stands incorrect if we take into consideration that market value may actually not be the correct measure of insolvency (see here). Insolvency is not the point of shift of maximisation motive from debtor to creditor. Ordinarily, a debtor values his assets for their infra marginal rents, i.e. consumer or producer surpluses, and marginal quasi rents. Thus, a market insolvent debtor will always have the incentive to maximise the wealth in his portfolio so as to retain maximum possible rents. A debtor also stands to gain by choosing which creditors to pay.
Thus, we see that the creditors’ bargain theory on which the Insolvency and Bankruptcy Code, 2016 is based, might be flawed. Scholars have suggested alternatives to this theory. Anthony Casey recommends following the Option Preservation Priority[ii], which suggests that along with wealth maximisation, bankruptcy law must also respect non-bankruptcy rights for which the creditors have bargained. This is because a bargained-for capital structure is a market mechanism of alleviating transaction costs. If both wealth maximisation and non-bankruptcy rights are taken care of, then creditors will have no bias between an asset distribution rule that favours secured creditors and one that favours unsecured creditors.
[i] Kenneth Ayyote and David Skeel, University of Chicago Law Review, Vol. 80, Fall 2013.
[ii] Anthony Casey, “The Creditors’ Bargain and Option-Preservation Priority in Chapter 11,” 78 University of Chicago Law Review 759 (2011).
The author is an undergraduate student at KIIT School of Law, Bhubaneswar, Odisha.