Document Type

Article

Publication Date

1989

Center/Program

Center for Contract and Economic Organization

Center/Program

Program in the Law and Economics of Capital Markets

Abstract

Finance theorists have long recognized that bankruptcy is a key component in any general theory of the capital structure of business entities. Legal theorists have been similarly sensitive to the substantial allocational and distributional effects of the bankruptcy law. Nevertheless, until recently, underlying justifications for the bankruptcy process have not been widely studied. Bankruptcy scholars have been content to recite, without critical analysis, the two normative objectives of bankruptcy: rehabilitation of overburdened debtors and equality of treatment for creditors and other claimants.

The developing academic interest in legal theory has spurred a corresponding interest in expanding the theoretical foundations of bankruptcy law as well. One of us has developed over the past several years a conceptual paradigm, based on a hypothetical bargain among creditors, as a normative criterion for evaluating the bankruptcy system.' The cornerstone of the creditors' bargain is the normative claim that prebankruptcy entitlements should be impaired in bankruptcy only when necessary to maximize net asset distributions to the creditors as a group and never to accomplish purely distributional goals.2

The strength of the creditors' bargain conceptualization is also its limitation. The hypothetical bargain metaphor focuses on the key bankruptcy objective of maximizing the welfare of the group through collectivization. This single-minded focus on maximizing group welfare helps to identify the underlying patterns in what appear to be unrelated aspects of the bankruptcy process. It also implies that other normative goals should be seen as competing costs of the collectivization process. Yet this claim uncovers a further puzzle. Despite the centrality of the maximization norm, persistent and systematic redistributional impulses are apparent in bankruptcy. Is redistribution in bankruptcy simply attributable to random errors or misperceptions by courts and legislators? Or are other forces present in the bankruptcy process as well?

In this Article we undertake to examine the "other forces" that may be at work in bankruptcy.' Many bankruptcy rules require sharing of assets with other creditors, shareholders, and third parties. Too often these distributional effects are grouped together under general references to equity, wealth redistribution, or appeals to communitarian values. These labels are unhelpful. They disguise the fact, for instance, that the justification and impact of consensual risk sharing among creditors is entirely different in character from the rationale for using bankruptcy to redistribute wealth to nonconsensual third parties. Understanding these diverse effects requires, therefore, a method of discriminating among the different motivations that impel redistributions in bankruptcy.

Comments

Copyright is owned by the Virginia Law Review Association. The article is used with the permission of the Virginia Law Review Association.

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