Bankruptcy's Uncontested Axioms

Baird, Douglas G., The Yale Law Journal

Debates about the law of corporate reorganizations often seem to be debates about facts.(1) From this it might seem that good empirical research can resolve the large differences that exist between competing camps of bankruptcy scholarship. First-rate empirical work has, of course, been done.(2) It has also changed the way some have thought about bankruptcy law.(3) Nevertheless, it would be a mistake to think that empirical studies will do much to end the current debates. To be sure, new information requires scholars and policymakers to update their prior beliefs, but rarely will so much information be available that differences can be resolved among those who begin at separate starting places. Strongly held prior beliefs will converge only if new information is plentiful. Among modern bankruptcy scholars, the starting places are far apart and the chance that new information will do much to bring them closer together is remote.

If it is unlikely that new information can bring scholars closer together, it might seem that nothing can. Prior beliefs can be compared to postulates in geometry. Euclidean geometry is based on the notion that only one line can run parallel to another through any given point. This idea is neither true nor false. One can build a coherent geometry either with this postulate, or with the postulate that multiple lines can run parallel to another line through a given point, or with the postulate that none can. Neither is more or less true than the other. All axioms in mathematics have this character.

It is a mistake, however, to assume that axioms are incontestable, even in mathematics. Axioms can be more or less interesting. Axioms can be more or less consistent with each other. They can be more or less complete.(4) Even in the world of pure mathematics, axioms can be assessed according to how useful they are.(5) In the messy universe of the law, it is not only even easier to cast a critical eye, it is also more important. In this Essay, I set out the two different sets of axioms now current among bankruptcy scholars, examine each, and suggest why people are drawn to one set or the other. I do not try to bridge the gap between the two camps, but rather to assess its implications, both for the future of scholarship and the dynamics of bankruptcy legislation.

In this Essay, I attempt to look at this problem as a neutral observer who comes to these questions without preconceptions. Nevertheless, these questions hold an interest for me precisely because I have been involved in these debates for a long time and have been strongly identified with the ranks of those whom I call proceduralists.(6) Hence, I must remind both myself and the reader of the difficulties I face in trying to assume the vantage point of a disinterested observer.(7)

My aim is twofold. First, I set out the ways in which these two sets of axioms have created the world in which bankruptcy scholars now find themselves--one in which there are two discrete groups, yet few in either group pay much attention to the other. Second, I explore the foundations of each set of axioms, quite apart from testing their empirical assumptions. The different axioms, I suggest, stem not from different political beliefs but rather from radically different views of the underlying normative bases of the role of bankruptcy law and the aims of legal scholarship.

Part I of the Essay identifies the two competing groups and outlines in general terms their different axioms. The next three Parts examine each competing axiom in turn. Part V connects the tensions between these competing axioms with the purposes the law serves and the politics of bankruptcy reform. Part VI concludes with observations about why these two groups start in such different places.

I. COMPETING AXIOMS

Sorting legal scholars into distinct camps is a dangerous business. Successful academics have views that are too complex and too modulated to be rigidly categorized. Moreover, each axiom identifies positions that themselves may be more or less strongly held. Notwithstanding these qualifications, however, there are two distinct camps. In the first are traditional bankruptcy lawyers and scholars whose views are largely reflected in the recent report of the National Bankruptcy Review Commission.(8) They focus on the rich store of bankruptcy cases that has developed over time. The traditionalists' basic approach stems from a conviction that bankruptcy law plays a special role in our legal system and advances substantive goals that are both important and distinctive.(9) This group contains not only scholars firmly ensconced in the academy but also practitioners and judges who write and are active in legal reform.(10) The second group consists almost entirely of academics, including an unusually large number of scholars whose primary work as academics lies elsewhere,(11) The group's distinctive characteristic is its focus on procedure(12) and its belief that a coherent bankruptcy law must recognize how it fits into both the rest of the legal system and a vibrant market economy.(13)

The traditionalists and proceduralists have different beliefs that emerge from the divergent ways in which they answer three sets of questions. As the rest of this Essay shows, much of the work of traditionalists and proceduralists can be derived from different starting places, and these two starting places can in turn be described by setting out for each group three simple propositions. In their simplicity and the way they organize so many of the issues in corporate reorganization, they resemble the axioms of mathematics. Nevertheless, these propositions are more normative than positive, and alternative formulations (with more or fewer propositions) might do as well.(14)

First, what role should bankruptcy law play in keeping a firm intact as a going concern? Should that role be anything more than determining whether keeping the firm intact makes economic sense (that is, to ask the same question, whether a sole owner would keep the firm intact if she had the choice)?(15) The traditionalists believe that bankruptcy law serves an important purpose in rehabilitating firms that, but for bankruptcy protection, would fail. Jobs would be lost and communities damaged, economically and otherwise, if the protections that bankruptcy law provides were unavailable.(16) By contrast, the proceduralists deny that bankruptcy can work any special magic.(17) Firms must live or die in the market. All bankruptcy can do is ensure that fights among creditors and other investors of capital do not accelerate a firm's liquidation. For them, one does more harm than good by doing anything more to protect a firm from the forces of the market.(18)

Second, to what extent can one consider bankruptcy a closed or an open system? To what extent should bankruptcy rules be crafted with an eye to the way they affect the incentives of those who are involved with firms that are not in bankruptcy and have no immediate prospect of getting there? To what extent does bankruptcy law affect the way investors and entrepreneurs behave when a firm is in good financial health? Or, to put the matter differently, to what extent can courts shape bankruptcy law by focusing almost entirely on the parties before them and making sure that all the relevant interests are dealt with sensibly? To what extent should the legal system focus on making the best of a bad situation that no one anticipated and in which the rights of all the players must be balanced along with those of the community as a whole?(19)

For the traditionalists, the breathing space that bankruptcy law gives distressed firms and the other costs it imposes on the participants have only a modest effect on how creditors and others behave ex ante.(20) Creditors' interests must be taken into account, of course, along with those of others, but very little of bankruptcy law and procedure affects the decisions of creditors or anyone else to do business with a firm in the first place.(21) The bankruptcy process is self-contained.

The proceduralists, on the other hand, worry intensely about how rules in bankruptcy affect behavior elsewhere. Substantive rules implemented exclusively in bankruptcy are suspect because of the effects they may have on investment beforehand.(22) Conversely, if a social policy is worth implementing in bankruptcy, it should be implemented everywhere. Inconsistency may do more harm than good, even for the particular group one is trying to protect.(23)

Third, once a society settles on a particular substantive policy, how does it implement that policy? These competing axioms begin with different visions of the role the judge should play in the process. The traditionalist believes that each individual case, with its rich and textured facts, is not reducible to a common metric or capable of fitting the same Procrustean bed.(24) Implementing the goals of bankruptcy requires investing the judge with broad discretion to ensure that bankruptcy's goals are vindicated. The bankruptcy judge is a shepherd, whose job it is to push the flock in the desired direction.(25) Under the constraints of the law, the judge works with all the players to move them towards bankruptcy's substantive goals.

The proceduralists, by contrast, see the judge as a disinterested arbiter. In a corporate reorganization, none of the players alone has the combination of knowledge, expertise, and neutrality necessary to put a firm back on its course. The creditors tend to favor immediate liquidation because they have little to gain if things improve. The managers have the knowledge of the firm that may be required to make the firm profitable, but they are hardly neutral.(26) They want to keep their jobs and may also be substantial shareholders. These competing forces have to be understood, but ultimately these parties have to make their own decisions; the judge is not to make choices for them. Rather than being committed to any particular outcome, the judge should control the process to ensure that the biases of the parties are taken into account and all relevant information is gathered and disclosed.

In short, the traditional bankruptcy experts believe that: (1) the preservation of firms (and therefore jobs) is an important and independent goal of bankruptcy; (2) contemplation of the rights and needs of the parties before the court matters more than the effects on incentives before the fact; and (3) bankruptcy judges should enjoy broad discretion to implement bankruptcy's substantive policies. The proceduralists, on the other hand, believe that: (1) the preservation of firms is not an independent good in itself; (2) ex ante effects are important; and (3) the judge, after controlling for the biases and weaknesses of the parties and resolving the legal disputes, must allow the parties to make their own decisions and thereby choose their own destinies.

In the next three Parts, I examine each of these ideas in turn--the value of preserving firms, whether the bankruptcy system should be closed or open, and whether the judge should be a positive force in the process or a disinterested arbiter. I do not follow the obvious path and assert either that decisionmakers should chart a middle course or that answers must await additional empirical work. Rather, I explore the source of these differences, show that it is not likely to change, and suggest their implications for bankruptcy scholarship and bankruptcy reform.

II. REHABILITATION

A. Two Views of the Distressed Firm

Chapter 11 of the Bankruptcy Code helps ensure that firms in distress survive. Stated at this level of abstraction, its goal is uncontroversial. The views of traditionalists and proceduralists, however, soon diverge.

The proceduralist begins with the cold realities of a market economy: Success is rewarded and failure is brutally punished. Most firms fail. Keeping firms intact that cannot effectively compete results in more harm than good over the long run. The paradigmatic firm is a restaurant in a large city. When the restaurant closes, workers lose their jobs, but they can find work elsewhere. A new restaurant or another firm can move into the space, and life goes on. If a bad restaurant is replaced by a much better one, employment levels in the city may even increase. Keeping a bad restaurant in business postpones the inevitable and delays a desirable shift of labor and capital to somewhere the inputs can be put to better use. Hence, bankruptcy law is useful only when the restaurant is good and would be able to survive in the market but for fights among creditors and other investors.

For the proceduralist, the concept of a "troubled firm" is insufficiently specified. A firm may be troubled because it cannot succeed in the marketplace, since competitors produce a better product at a lower cost. On the other hand, a firm may be distressed because it cannot generate sufficient revenue to pay its debts. This first kind of adversity is called "economic" distress. It exists regardless of a firm's capital structure. The sole owner of a business that attracts no customers will shut it down, even if there are no banks or other creditors in the picture.

The second kind of trouble is "financial" distress, meaning the firm's income is not enough to pay …

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Publication information: Article title: Bankruptcy's Uncontested Axioms. Contributors: Baird, Douglas G. - Author. Journal title: The Yale Law Journal. Volume: 108. Issue: 3 Publication date: December 1998. Page number: 573. © 2009 Yale University, School of Law. COPYRIGHT 1998 Gale Group.

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