Is the Bankruptcy Code an Adequate Mechanism for Resolving the Distress of Systemically Important Institutions?

The President and members of Congress are considering proposals that would give the government broad authority to rescue financial institutions whose failure might threaten market stability. These systemically important institutions include bank and insurance holding companies, investment banks, and other large, highly leveraged, and interconnected entities that are not currently subject to federal resolution authority. Interest in these proposals stems from the credit crisis, particularly the bankruptcy of Lehman Brothers. That bankruptcy, according to some observers, caused massive destabilization in credit markets for two reasons. First, market participants were surprised that the government would permit a massive market player to undergo a costly Chapter 11 proceeding. A very different policy had been applied to other systemically important institutions such as Bear Steams, Fannie Mae, and Freddie Mac. Second, the bankruptcy filing triggered fire sales of Lehman assets. Fire sales were harmful to other non-distressed institutions that held similar assets, which suddenly plummeted in value. They were also harmful to any institution holding Lehman\u27s commercial paper, which functioned as a store of value for entities such as the Primary Reserve Fund. Fire sales destroyed Lehman\u27s ability to honor these claims. Lehman\u27s experience and the various bailouts (of AIG, Bear Steams, and other distressed institutions) have produced two kinds of policy proposals. One calls for wholesale reform, including creation of a systemic risk regulator with authority to seize and stabilize systemically important institutions. Another is more modest and calls for targeted amendments to the Bankruptcy Code and greater government monitoring of market risks. This approach would retain bankruptcy as the principal mechanism for resolving distress at non-bank institutions, systemically important or not. Put differently, current debates hinge on one question: is the Bankruptcy Code an adequate mechanism for resolving the distress of systemically important institutions? One view says no, and advances wholesale reform. Another view says yes, with some adjustments. This Essay evaluates these competing views: Section II discusses the current structure of the Bankruptcy Code and its limited ability to protect markets from failing systemically important institutions. Section III outlines policy responses. In Section IV, I conclude that the Code is indeed inadequate for dealing with failures of systemically important institutions. A systemic risk regulator is needed because a judicially administered process cannot move with sufficient speed and expertise in response to rapidly changing economic conditions

No Exit? Withdrawal Rights and the Law of Corporate Reorganizations

Bankruptcy scholarship is largely a debate about the comparative merits of a mandatory regime on one hand and bankruptcy by free design on the other. By the standard account, the current law of corporate reorganization is mandatory. Various rules that cannot be avoided ensure that investors’ actions are limited and they do not exercise their rights against specialized assets in a way that destroys the value of a business as a whole. These rules solve collective action problems and reduce the risk of bargaining failure. But there are costs to a mandatory regime. In particular, investors cannot design their rights to achieve optimal monitoring as they could in a system of bankruptcy by free design. This Article suggests that the academic debate has missed a fundamental feature of the law. Bankruptcy operates on legal entities, not on firms in the economic sense. For this reason, sophisticated investors do not face a mandatory regime at all. The ability of investors to place assets in separate entities gives them the ability to create specific withdrawal rights in the event the firm encounters financial distress. There is nothing mandatory about rules like the automatic stay when assets can be partitioned off into legal entities that are beyond the reach of the bankruptcy judge. Thus, by partitioning assets of one economic enterprise into different legal entities, investors can create a tailored bankruptcy regime. In this way, legal entities serve as building blocks that can be combined to create specific and varied but transparent investor withdrawal rights. This regime of tailored bankruptcy has been unrecognized and underappreciated and may be preferable to both mandatory and free design regimes. By allowing a limited number of investors to opt out of bankruptcy in a particular, discrete, and visible way, investors as a group may be able to both limit the risk of bargaining failure and at the same time enjoy the disciplining effect that a withdrawal right brings with it