Stuart Gilson, writing sometimes with Michael Vetsuypens, has produced an impressive body of empirically based scholarship documenting extensive creditor control over financially distressed firms.\u27 This work should end the practice of starting an analysis with the assumption that management in financially distressed firms remains loyal to equity interests

Whitford, William C.

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Washington University St. Louis: Open Scholarship

Washington University Law Review Volume 72 Issue 3 Interdisciplinary Conference on Bankruptcy and Insolvency Theory January 1994 Comment William C. Whitford Wisconsin Law School. Follow this and additional works at: https://openscholarship.wustl.edu/law_lawreview Recommended Citation William C. Whitford, Comment, 72 WASH. U. L. Q. 1027 (1994). Available at: https://openscholarship.wustl.edu/law_lawreview/vol72/iss3/19 This Conference Proceeding is brought to you for free and open access by the Law School at Washington University Open Scholarship. It has been accepted for inclusion in Washington University Law Review by an authorized administrator of Washington University Open Scholarship. For more information, please contact digital@wumail.wustl.edu. COMMENTWILLIAM C. WHITFORDStuart Gilson, writing sometimes with Michael Vetsuypens, has producedan impressive body of empirically based scholarship documenting extensivecreditor control over financially distressed firms.' This work should endthe practice of starting an analysis with the assumption that managementin financially distressed firms remains loyal to equity interests.'Gilson and Vetsuypens have little doubt that creditor control of insolventfirms is a good thing. They see creditor control as a way of puttingdecisionmaking in the hands of the residual claimants--"those whosewealth directly rises or falls with marginal changes in firm values."3Placing decisions in the hands of persons whose futures will be affected bythem is, in principle, a good thing. Nonetheless, I see the question of thedesirability of creditor control of the insolvent firm as more complex thanGilson and Vetsuypens do.First, many publicly traded firms will be only somewhat insolvent, notdeeply so, when entering bankruptcy or undergoing other financialreorganization. In such cases creditors are the residual claimants, and yetthey are not indifferent to outcomes with an equally likely prospect of gainor loss. Substantial gains will push the firm into solvency, and some of thegain will accrue to the benefit of equity interests. Yet creditors willcontinue to bear all future losses. Consequently, they have an incentiveto cause the firm to adopt conservative investment strategies-i.e., ones that* Young-Bascom Professor of Business Law, Wisconsin Law School.I. The previous articles are summarized, and then augmented, in Stuart C. Gilson & Michael R.Vetsuypens, Creditor Control in Financially Distressed Firms, 72 WASH. U. L.Q. 1005 (1994).2. E.g., Michael Bradley & Michael Rosenzweig, The Untenable Case for Chapter 11, 101 YALEL.J. 1043, 1052 (1992) ("The social costs of Chapter 11 proceedings are well known. Bankruptcy lawencourages corporate managers... to create a net equity position for stockholders .... [T]he ChapterII presumption in favor of reposing control ... in the hands of prebankruptcy management leavescreditors with too little influence over the reorganization process to protect themselves adequately.My frequent collaborator, Lynn LoPucki, and I have argued elsewhere that this assumption shouldnever have been made, even on an a priori basis. Lynn M. LoPucki & William C. Whitford, CorporateGovernance in the Bankruptcy Reorganization of Large, Publicly Held Firms, 141 U. PA. L. REV. 669,694-716 (1993). Like Gilson and Vetsuypens, we also have published work that disproves theassumption empirically. Id. at 720-52.3. Gilson & Vetsuypens, supra note I, at 1006.1027Washington University Open Scholarship1028 WASHINGTON UNIVERSITY LAW QUARTERLYavoid risks of additional losses even at the cost of forgoing more likelyprospects for gain.' These motivations are just the inverse, of course, ofthe distorted incentives of equityholders in such circumstances;equityholders have everything to gain and nothing to lose, and thus, arelikely to urge investment strategies that are too risky.5A second reason that the desirability of creditor control is a complexquestion is that creditors are rarely a monolithic group with identicalinterests. In large, publicly held firms there are likely to be priorityconflicts even within the unsecured creditor group. One of these creditorgroups will constitute the residual claimants, as that term is used by Gilsonand Vetsuypens. However, the value of the firm may be close enough tothe line at which this group is no longer the residual claimants that thegroup is not indifferent between risk of loss and prospect of gain. Indeed,the existence of groups with different priorities among unsecured creditorsincreases the likelihood that in any particular case the residual claimantgroup will unduly prefer either avoidance of risk or prospect for gain.Creditors differ in ways other than their formal priority entitlements.Trade and employee creditors often have an incentive to favor reorganiza-tion of the firm under current management, because of the prospect offuture profits from continued relationships with the surviving firm. Theprospect of future profits may induce these creditors to approve unfavorabletreatment of past obligations. Institutional creditors may also hope forfuture business with a surviving firm, but in most instances they canwithdraw from the business relationship more cheaply than the trade andemployee creditors can.'Institutional creditors are also more likely than trade or employeecreditors to be important players in other insolvency proceedings. Asrepeat players, they need to be concerned about how their stance in onecase may affect their returns in other cases. This concern may cause them4. Gilson and Vetsuypens may be anticipating this problem when they limit their endorsementof creditor control to circumstances "[w]hen a firm is clearly insolvent, and the face value ofoutstanding debtfar exceeds the present discounted value of the assets." Gilson & Vetsuypens, supranote 1, at 1006 (emphasis added). I suggest that the difficulty described in the text arises withconsiderable frequency, particularly when one considers the possibility of intercreditor conflictsdescribed below.5. See Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior,Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305, 334-37 (1976).6. In the language sometimes used to describe this situation, institutional creditors are likely tohave made fewer idiosyncratic investments in the relationship with the debtor-investments that willbe lost if the debtor fails to reorganize.[VOL. 72:1027https://openscholarship.wustl.edu/law_lawreview/vol72/iss3/19COMMENTto take a tough stand in a particular bankruptcy in the hope that this actionmay result in a favorable precedent, or create a reputation for obstinatebargaining, that will yield positive returns in other cases. Such action canbe sensible even if the resources invested in pursuing a negotiating orlitigating position in one case exceed the potential return in that case. Suchaction would rarely be maximizing for trade or employee creditors.7Although there is now a considerable body of empirical evidence aboutthe reorganization of insolvent firms, no studies have concentrated on theintercreditor conflicts mentioned in this Comment. It is hoped that the nextgeneration of studies will make such conflicts an important focus. We needto know more, for example, about how intercreditor conflicts are resolvedwithin creditor committees. I would not be surprised if the interests ofinstitutional creditors are identified as the general creditor interest, evenwhen other creditors have quite different interests.The presence of intercreditor conflicts raises questions about thedesirability of creditor control of insolvent firms. Unless some mechanismcan be devised to insure that the interests of all types are represented, itmay be better to leave management in control and give them appropriateincentives to maximize the interests of the firm, rather than the interests ofany one group of claimants of the firm. Lynn LoPucki and I have writtenextensively about this problem.8 I will not repeat our proposals here.7. The interests of occasional creditors, such as tort claimants, are different still. Because theyare likely to be creditors only in one case, they have less incentive to adopt a litigious stance in aparticular case, since they can justify that stance only if it will yield a positive return in the particularcase. On the other hand, the occasional creditor cannot look to profits from future transactions fromthe debtor, and hence, does not have the same incentives as trade and employee creditors to avoidliquidating solutions to insolvency.S. Lynn M. LoPucki & William C. Whitford, Compensating Unsecured Creditors for&-traordinary Bankruptcy Reorganization Risks, 72 WASH. U. L.Q. 1133 (1994); LoPucki & Whitford,supra note 2, at 787-96.1994] 1029Washington University Open Scholarshiphttps://openscholarship.wustl.edu/law_lawreview/vol72/iss3/19

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