When a corporation’s assets appear to be worth less than its liabilities–for whatever reason–the economists’ normal solution (as discussed last week) is for the bankruptcy judge to legally convert the bank’s rigid debt claims into flexible equity claims. That’s corporate bankruptcy in one sentence.
In a financial crisis, when megabanks are supposedly too big and too complicated and interconnected to wait for a formal, years-long bankruptcy process, I recommend doing the debt-to-equity conversion of the course of a weekend: I call this speed bankruptcy. I wrote a short piece on this in Fall 2008 here
, a later academic version here
One of the major complaints about speed bankruptcy is that it’s not fair: It rips off bondholders who were promised a fixed payment, it doesn’t follow a formal legal proceeding where bondholders can argue that the firm really could repay its debts, and it could even run afoul of the Takings Clause of the U.S. Constitution by transferring wealth without just compensation.
I won’t discuss the Takings issue, too far afield. And I’ll only discuss the rip-off claim by noting that bankruptcy is all about
people getting less than they were promised–the pie is probably too small for us to all get our contractually agreed slices. [Cue sad horn –ed.
But I will note that in real-world corporate bankruptcy a major legal doctrine is the “value maximization norm,” which says that if you want to make an omelette you have to break some eggs. Less cavalierly, a major goal of bankruptcy should be to maximize the firm’s value going forward. That usually means violating justice: so even if legal precedent and contract say “group X gets paid before group Y,” group Y will get paid first if that helps the firm become more productive in the future. That’s called violating the priority of claims.
The maximization norm gives weight to efficiency and opposes the dead hand of history–and justice. In spirit, it reminds me of parts of Coase’s “Problem of Social Cost
In a classic paper
, Lawrence Weiss showed that most real-world corporate bankruptcies violate the priority of claims. And the priority violation at least prima facie
is driven by the quest to maximize firm value. So tossing contracts out the window to help the firm is typical.
Of course, if you want to convert bank bonds to bank shares in a weekend, you’re going to violate a lot of prior claims. For instance, the guy who waters the plants might have a line in his contract saying he gets paid only after bondholders do. But notice: If the megabanks are right–if they can’t survive a normal bankruptcy process, if they really are too big to fail–then that strengthens the legal argument for weekend debt to equity conversion.
How? Because if the megabank can’t survive normal bankruptcy, then wealth maximization demands that we rip off the bandage quickly–even if it rips off some skin. The fragility of the megabanks strengthens the case for crude triage.
Absent bailouts–or some well-run, widely-trusted bankruptcy system that doesn’t yet exist for megabanks–the best way to maximize the megabank’s future value is probably for a bankruptcy judge to grab all the tradable bank debt she can find and legally declare it to be shares. With bank liabilities now smaller than bank assets, the new shareholders have a strong incentive to grow the future firm; the new shareholders will treat their firms the way a householder treats his home when he has home equity. They’ll take better care of the place, because they’ve got skin in the game.
Those who oppose speed bankruptcy–also known as bondholder bail-ins or shared sacrifice–are hollowing out the middle range, leaving only the stark alternatives of a theoretically pure, years-long bankruptcy process or massive bank bailouts. I know which option real politicians will choose.
Take a look through the comments section
of last week’s post, where practitioners offered real insight into corporate bankruptcy.