Systemic Risk & Chapter 11
Volume 82, No. 2, Summer 2009
By Stephen J. Lubben [PDF]

The U.S. economy lost more than 650,000 jobs in February of 2009, and the unemployment rate hit eight percent, the highest rate since the early Reagan administration. It would have seemed inconceivable six months ago to consider General Electric (“GE”) a risky investment, but as of this writing, GE is trading in the credit default swap (“CDS”) market with “points upfront,” typically an indication of a high near-term probability of default. In early September of 2008, just before Lehman Brothers entered bankruptcy, there were about seventy-five companies trading “upfront.” By March of 2009, the number was 260.

In this context, chapter 11 is notable in its absence. Chapter 11 is the thing that wrecked Lehman Brothers and perhaps the credit markets. It is the thing that the Federal Reserve and Treasury worked so hard to keep AIG and Bear Stearns away from, and the thing that General Motors and Chrysler were working so hard to avoid. Chapter 11 is something to be feared, not part of the solution.

This apprehension of chapter 11 predates the recent financial crisis. Asset securitization, the premiere new financial vehicle of the last decade, represents a straightforward effort to exploit formalities to avoid chapter 11. In a typical securitization transaction, income-producing assets are sold to a newly created legal entity. This entity’s governing documents are designed with features that prevent a voluntary bankruptcy filing, and the entity is limited in purpose to avoid creation of creditors who might support an involuntary filing.

Similarly, credit derivatives originally developed as a kind of insurance against default, but speculative trading in these instruments grew from the belief by many investors that it was better to trade in “debt” that came unburdened by the other roles accompanying traditional debt ownership, including potential obligations to work with a debtor toward a restructuring. More broadly, in 2005 the derivatives industry obtained a broad exemption from the key provisions of chapter 11, primarily based on the dubious argument that chapter 11 represented a threat to the overall financial system.

In a rather ironic twist, both proponents of the alleged sources of the current financial crisis—credit derivatives and asset securitization—and those that would rescue us from the crisis share a common skepticism of chapter 11. In this puzzling context, it bears asking if the fear of chapter 11 is warranted.

In particular, what role does chapter 11 play in a time of widespread financial distress? Does it matter if the financial distress affects financial firms like Lehman and AIG, or traditional industrial firms like GM? And if chapter 11 has a role to play, what accounts for the suspicion of chapter 11 among nonlegal professionals?

I begin to examine these questions by probing the fear of chapter 11, which is often premised on the speculation that if one firm in an industry were to enter chapter 11, then proximate firms would follow in a domino effect—that is, chapter 11 will create systemic risk. The lack of any actual examples of an industry-wide cascade of failure in the century-long history of American corporate reorganization undermines the notion that chapter 11 could be the cause of such an occurrence. Particular industries have experienced waves of the financial distress—at present, the newspaper industry is experiencing one—but this seems to be most often caused by the similar assets owned or the common business cycles faced by these firms, rather than any particular aspect of chapter 11.

In short, I reject the foundational premise for much of the fear of utilizing chapter 11 in the present crisis. The start of the present financial crisis involved two problems: a lack of lending and a lack of investment. Now the crisis appears to have evolved, with declining home prices, retirement account balances, and low consumer confidence stalling the economy; the initial alarm being replaced with protracted investor insecurity about the basic competence of key financial institutions and their executives. Chapter 11 does not obviously exacerbate any of these problems, and indeed chapter 11 has a role to play in dissipating panics through the automatic stay.

Having cracked open the door for a potential role for chapter 11, I next directly examine the use of chapter 11 in times of systemic crisis. In particular, I examine the utility of chapter 11 with regard to the different types of debtors. There seems to be no reason why an industrial firm like GM should not use chapter 11—these kinds of debtors were exactly the firms that Congress had in mind when it adopted the chapter in 1978. As recent events have shown, the belief that bankruptcy would mean GM goes “bust” reflects either a serious misunderstanding of chapter 11 or an intentional effort to create fear and panic about chapter 11 to support the case for a bailout.

Financial firms represent a more difficult task. Because investment banks like Lehman Brothers are entirely dependent on their credit rating and reputation (to the extent those are different things), reorganization is unlikely to be an option. Nevertheless, chapter 11 provides an effective means of liquidating a larger corporation and thus can play a role here too. I thus argue that the Treasury Secretary’s recent plan to create a new system for the liquidation or reorganization of financial firms represents an unnecessary duplication of existing structures.

Beneath this analysis is an argument that Lehman’s chapter 11 filing did not cause the current credit crisis, but rather Lehman’s failure caused the crisis. That failure was likely to occur with or without chapter 11, unless the government prevented it or mitigated its consequences, as in the case of AIG. Chapter 11 has (or at least had) a role to play here, by providing a framework for government intervention that avoids the need for the kind of intervention we have recently been seeing on an ad hoc basis. The company in question enters chapter 11, which provides a kind of breathing space that prevents a “run on the bank,” at which point the government can step in to save counterparties from their exposure to the debtor if policymakers feel that such a step is warranted.

The key caveat to all of this is the unbridled fear of chapter 11. Companies avoid chapter 11 because key players argue that chapter 11 will make matters worse. Accepting this argument at face value, Congress has largely acquiesced by creating new exceptions from chapter 11. The “chancellor’s umbrella” that once protected firms from financial storms has become so perforated that it barely serves its function anymore. The brisk demise of Circuit City, rooted in large part in the landlord-friendly 2005 amendments to § 365(d)(4), is but the most obvious example of this phenomenon in action.

I conclude by arguing that the obsessive focus on bankruptcy avoidance in the last decade—a consequence of the fear of chapter 11—moved the financial industry’s focus away from credit analysis. Once achieved, the apparent goal of avoiding any interaction with chapter 11 took priority over a real analysis of the risks of the underlying loan transaction. But avoiding chapter 11 is clearly not the same thing as avoiding default. This is yet another reason why it may be time to reconsider the piecemeal erosion of chapter 11 and return to the more inclusive bankruptcy process that Congress enacted in 1978.

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