Workshop on Bankruptcy

May 17–19, 2001
St. Louis, Missouri

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Christopher W. Frost
Frost Brown Todd Professor of Law
University of Kentucky
College of Law

The role of social welfare theory in the bankruptcy process depends on what we mean by "social welfare theory." I take the term to encompass a range of theories that operate to explain and justify bankruptcy law as a device intended to distribute the losses resulting from financial distress on some basis other than that obtained by the application of contract, tort and corporate law. My discussion will not focus on one particular brand of theory, however. Nor will I critique various theories of bankruptcy from a moral standpoint. Instead, I plan to examine the bankruptcy process to determine whether it is capable of achieving the kinds of results that these theories dictate.

If one sees bankruptcy as a loss sharing device which revises original contractual entitlements in light of current facts, some social welfare theory is needed to provide a basis for redefining those entitlements. Certainly, much of the fresh start policy relies heavily on social welfare theory for its justification. Policies regarding the individual discharge and property exemptions are best explained by theories that are redistributive in character. Debate over the extension of the fresh start policy revolves around the relative need of various participants in bankruptcy process for the type of relief provided on the one hand, and the economic effects of granting a particular scope of relief, on the other.

We are accustomed to discussing the fresh start policy in these terms. Debates about individual bankruptcy are really debates about the cost of the social policies underlying the process. Defining the scope of the fresh start requires an evaluation of the nation’s commitment to financial equality and its willingness to forgive past improvidence. The debates have been strident, but everyone agrees that the fresh start policy has its roots in social welfare theory.

Social welfare theory has also emerged in the debate over the appropriate role and definition of the corporate bankruptcy process. Applying the same fresh start policies that undergird individual bankruptcies, several commentators have viewed business bankruptcy through the same redistributional lens. Professor Elizabeth Warren is perhaps the most well-known advocate of this approach. She writes, "I see bankruptcy as an attempt to reckon with the debtor’s multiple defaults and to distribute the consequences among a number of different actors. Bankruptcy encompasses a number of competing - and sometimes conflicting - values in this distribution."¹ Professor Donald Korobkin has advanced a view of the bankruptcy process that treats bankruptcy as "a response to the problems that financial distress poses to the corporation in all of its aspects."² Included within those aspects are effects of financial distress on a broad array of interested parties including the general public and community.³ More recently, Professor Karen Gross has advocated a role for communities in the bankruptcy process. Gross explicitly treats bankruptcy as "a vehicle for social change."⁴ Of course, the specifics of each of these commentators’ analyses of the purpose of bankruptcy and the appropriate balance of interests differ. There is, however, a common theme--the willingness to depart from non-bankruptcy entitlements in an effort to achieve a particular redistributional result.

Much of the commentary advancing social welfare theory in the corporate bankruptcy context has been in direct response to the work of Douglas Baird and Thomas Jackson. Their creditor’s bargain theory views bankruptcy as a straightforward response to collective action problems that plague the non-bankruptcy debt collection process.⁵ On this view, bankruptcy should respect non-bankruptcy entitlements except to the extent necessary to reduce the collective action problems the system was designed to resolve.⁶ Redistributive policies that vary non-bankruptcy entitlements introduce costly forum shopping problems as debtors and claimants each vie to use the system that is most favorable to them.⁷

Like so many debates, the debate over the appropriate role of social welfare theory in corporate bankruptcies suffers from a lack of communication. The participants in the debate seem to talk past one another. Baird and Jackson’s focus on allocative efficiency is unlikely to be persuasive to critics who are willing to sacrifice efficiency for a broader conception of justice. Social welfare theorists, on the other hand, sometimes fail to recognize that there may be limits to the ability of the bankruptcy process to bring about the kinds of results that they desire.

I am agnostic about the desirability of sacrificing efficiency norms for social welfare norms. Instead, I have written, and will speak about, the pragmatic limits of the process. Rather than simply argue that corporate bankruptcy should be about efficiency, I will assume that loss redistribution based on social welfare theories is a desirable goal. My question is whether the corporate bankruptcy system is suited to the task.

To make this more concrete, consider the bankruptcy of a rust-belt industrial company. Any number of decisions that the bankruptcy judge overseeing the case may be called upon to make will implicate the interests of stakeholders without explicit non-bankruptcy entitlements. For example, the judge may be called upon to confirm a plan of reorganization that calls for the closure and liquidation of a plant in a local community that will be devastated by the loss of an employer and taxpayer. The creditors, however, may view the closure as an important element of the overall plan because they doubt the ability of the plant ever to achieve a positive cash flow. Assume the question of the plant’s economic viability is a close one.

Using a purely economic analysis of the situation, the bankruptcy judge is likely to choose the result favored by the creditors who actually stand to gain or lose from the decision. If creditors with money at risk choose to close the plant, the bankruptcy judge might reasonably question her ability to make a better decision. Under an analysis that considers the broader interests of the community, however, the bankruptcy judge might see herself in a more expansive role. If the function of the bankruptcy process is to redistribute losses, there is a substantial justification for allowing the plant to continue in operation in an effort to return it to economic viability. Even if the judge guesses wrong, she can take comfort from the fact that many of the creditors can spread the losses resulting from the decision across a number of loans. In addition, allowing the plant a chance to operate may give the community some time to soften the eventual blow of the plant closure. In this example, the losses in allocative efficiency resulting from the continuing operation of the plant may seem easy to justify. By the time the loss is spread across a number of loans, the net effect is minuscule. The benefits to the community may, however, be great. Social welfare theory seems to work well here.

The problem, of course, is that such episodes never occur in a vacuum and it is extremely difficulty to predict the way in which creditors will choose to distribute the loss. It is possible that creditors may choose to distribute the losses over a broad base of loans. It is also possible that the creditors may understand that the risk of redistribution in bankruptcy is highest in those industries and communities that are the most vulnerable. Loss distribution under this latter assumption may result simply in the redistribution of bankruptcy losses among the vulnerable communities - a result at odds with that desired by social welfare theorists.

Even if the incidence of the cost theoretically could be controlled in such a way to assure that the costs do not fall on groups who are unable to bear it, it is unlikely that the bankruptcy decision-making process is capable of such an undertaking. It is the nature of the judicial process that individual decisions have a collective effect. Bankruptcy judges act in an uncoordinated way, however. The decision of one judge in one case may make sense, but the collective result of all of the decisions may be loss redistributions that no single judge could anticipate or desire. Thus, the bankruptcy process seems uniquely unsuited to carrying out the sorts of overall loss redistributions that social welfare theorists desire.