Financial Restructuring to Sustain Recovery

Bankruptcy and Economic Recovery

 Bankruptcy and Economic Recovery 3 To measure economic growth or recovery, one traditionally looks to metrics such as the unemployment rate and the growth in gross domestic product (GDP). To devise institutional policies that will stimulate economic growth, the focus most often is on policies that encourage investment and entrepreneurial enterprises and reward risk taking with appropriate returns. As bankruptcy academics , we tend to add our own area of expertise to this stable—with the firm belief that thinking critically about bankruptcy policy is an important element of any set of institutions designed to speed economic recovery. In this paper, we outline the crucial role that bankruptcy plays in advancing a robust economy, while also identifying several areas in which bankruptcy law—and practice—could be improved so as to enhance bankruptcy’s role in economic growth, including its recovery from periods of recession. Along the way, we suggest that a standard (and appropriate) baseline metric for successful economic policies—namely, employment —if carried outside its macro focus so as to become an independent bankruptcy policy (as it often is), carries with it, often inadvertently, the potential to undermine bankruptcy’s key role in facilitating economic growth. Bankruptcy and Economic Growth We start by outlining our underlying proposition: an effective free-market, entrepreneurial economy depends on the existence of an effective bankruptcy thomas jackson david skeel 03 2524-4 ch3.indd 97 10/21/13 8:53 PM  thomas jackson and david skeel process. This is so because, while entrepreneurial innovation is usually conceived in terms of its successes—encouraging the flow of funds to new businesses and ideas driven by the prospect of riches—the reality is that the prospect of large returns for risk taking also means the necessary potential for failure and loss. The correlation between risk and return has a downside as well as an upside; thus in anything resembling a free-market, entrepreneurial economy, rewarding successful risk taking requires consequences to unsuccessful risk taking. Only in Lake Wobegon—or a society where government bailouts are the norm—can all ventures succeed. The natural opposition to bailout by those who have faith in the reward and punishment nature of markets, whether of financial firms or industrial firms—or, indeed, categories of creditors—is born from the realization that bailouts distort incentives and interfere with important market mechanisms for monitoring and disciplining firms. Modern bankruptcy law primarily exists1 to reduce the frictions that otherwise would impede assets from moving to their highest-and-best use. Even those who think this is too narrow a description of the purposes of bankruptcy law would almost certainly agree that it is a, if not the, primary purpose. When a firm is insolvent—when its liabilities exceed its assets at fair valuation—and the creditors realize that not all of them will be paid in full, the creditors have incentives to demand payment or to use available judicial procedures to seize assets sooner rather than later. “First-come, first-served” is a sensible policy for solvent firms, but it creates externalities—a common pool problem—for insolvent firms.2 This use of individual creditor remedies will result in the assets of a firm being pulled apart and the firm being dismantled. But not all insolvent firms should be liquidated ; there is a recognized distinction between economic failure (a firm should be shuttered) and financial failure (liabilities exceed assets). Sometimes, the assets are being used for their highest-and-best use, and it would be inefficient to have creditors, lacking a coordination mechanism, pull the firm apart, “saving” some creditors but imposing costs on the creditors as a group—and on society. A simple example of the distinction between insolvency and financial failure is perhaps helpful. When Johns Manville filed for bankruptcy in the early 1980s, the firm appeared to be solidly solvent but, in fact, was hopelessly insolvent . The insolvency was due, in significant part, to crushing liability in tort for its manufacture of asbestos, generally twenty to forty years earlier—the time 1. Here we speak of its role for firms and other commercial ventures. We set aside the separate policy, applicable to human beings, of a “fresh start.” 2. This was first explored in a systematic fashion in Jackson (1982). While the author may regret the phrase “creditors’ bargain,” which has taken on a life of its own (often as used by critics), the central point of bankruptcy as a response to externalities remains core. 03 2524-4 ch3...