THE HISTORY OF AMERICAN THE HISTORY OF AMERICAN BANKRUPTCY LAWBANKRUPTCY LAW

David SkeelDavid Skeel

25 November 200825 November 2008

Roadmap for the Two LecturesRoadmap for the Two Lectures

Today: brief history of American Today: brief history of American bankruptcy regulationbankruptcy regulation• start with corporate reorganizationstart with corporate reorganization• then consumer bankruptcythen consumer bankruptcy

Tomorrow: simple theory of Tomorrow: simple theory of relationship between corporate law relationship between corporate law and corporate bankruptcyand corporate bankruptcy

1) The Creation of Corp Reorganization1) The Creation of Corp Reorganization

The Context: Failures of the railroads, The Context: Failures of the railroads, America’s first large scale corp’s (Jay America’s first large scale corp’s (Jay Gould, Daniel Drew and robber Gould, Daniel Drew and robber barons)barons)

The Problem: No authority to devise The Problem: No authority to devise solution (Constitutional lim’s on solution (Constitutional lim’s on Congress and individual states)Congress and individual states)

The Original Innovation: 19The Original Innovation: 19thth Century “Equity Century “Equity Receiverships”Receiverships”

Devised by courts (and Wall Street Devised by courts (and Wall Street investment banks and lawyers)investment banks and lawyers)

Theoretically, a foreclosure saleTheoretically, a foreclosure sale Actually, debtor and committees Actually, debtor and committees

renegotiated capital structurerenegotiated capital structure U.S. Chapter 11 = still based on the U.S. Chapter 11 = still based on the

same principlessame principles Not codified until 1933 and 1934Not codified until 1933 and 1934

The New Deal Revolution in 1938The New Deal Revolution in 1938

This = the one time scandals This = the one time scandals contributed to major bankruptcy contributed to major bankruptcy reformreform

Reforms based on SEC study Reforms based on SEC study overseen by William Douglasoverseen by William Douglas

Chapter X = aimed at Wall StreetChapter X = aimed at Wall Street

Key Features of Chapter XKey Features of Chapter X

Managers replaced by court Managers replaced by court appointed trusteeappointed trustee

Disinterestedness requirement: Disinterestedness requirement: current banks and lawyers excludedcurrent banks and lawyers excluded

SEC has major role, evaluates reorg SEC has major role, evaluates reorg plansplans

Result: Wall Street disappearsResult: Wall Street disappears

1978 Code and the Return of Wall 1978 Code and the Return of Wall StreetStreet

Corporate debtors spent next forty Corporate debtors spent next forty years evading Chapter Xyears evading Chapter X

Bankruptcy laws re-written in 1978: Bankruptcy laws re-written in 1978: managers continue running debtor; managers continue running debtor; no trustee; SEC role reducedno trustee; SEC role reduced

Result: Corp reorg is Wall Street Result: Corp reorg is Wall Street practice once againpractice once again

One difference: commercial banks One difference: commercial banks and hedge funds as key playersand hedge funds as key players

Why the shift to commercial bank Why the shift to commercial bank control?control?

Chapter 11 has extraordinarily generous Chapter 11 has extraordinarily generous financing provisionsfinancing provisions

Commercial banks and other lenders used Commercial banks and other lenders used to tighten control over debtors in 1990sto tighten control over debtors in 1990s• The WorldCom example (choose any CRO you The WorldCom example (choose any CRO you

want …)want …)• Restrictive covenants force sales etcRestrictive covenants force sales etc• Baird & Rasmussen; SkeelBaird & Rasmussen; Skeel

Implication: Chapter 11 is much less Implication: Chapter 11 is much less debtor friendly than beforedebtor friendly than before

2) Personal Bankruptcy in the 2) Personal Bankruptcy in the United StatesUnited States

Key historical point: personal Key historical point: personal bankruptcy was entirely separate bankruptcy was entirely separate from large scale corporate from large scale corporate bankruptcybankruptcy

The pattern: occasional laws (1800, The pattern: occasional laws (1800, 1841, 1867) then quick repeal1841, 1867) then quick repeal

No federal bankruptcy law for most No federal bankruptcy law for most of nineteenth centuryof nineteenth century

Why this pattern?Why this pattern?

Creditors wanted bankruptcy Creditors wanted bankruptcy regulation (to clarify/simplify regulation (to clarify/simplify collection)collection)

Debtors feared regulation (worried Debtors feared regulation (worried about losing farms)about losing farms)

Bankruptcy laws passed only when:Bankruptcy laws passed only when:• Economic crisisEconomic crisis• Republicans (conservatives) controlled Republicans (conservatives) controlled

presidency and Congresspresidency and Congress

Why did the 1898 Act endure?Why did the 1898 Act endure?

Key is compromise between debtor and Key is compromise between debtor and creditor viewscreditor views• Creditors got a bankruptcy law outlawing Creditors got a bankruptcy law outlawing

preferential transfers etcpreferential transfers etc• Debtors got: state exemptions; tough limits on Debtors got: state exemptions; tough limits on

involuntary bankruptcyinvoluntary bankruptcy Weak administrative structure created Weak administrative structure created

need for lawyersneed for lawyers Bankruptcy bar created a stable Bankruptcy bar created a stable

constituency for retaining the lawconstituency for retaining the law

Key innovation in 1930sKey innovation in 1930s

““Wage earner” plans (Chapter XIII) Wage earner” plans (Chapter XIII) added in 1938added in 1938

Distinction between immediate Distinction between immediate discharge (Ch. VII, now Ch. 7) and discharge (Ch. VII, now Ch. 7) and repayment plan (Ch. XIII, now Ch. 13)repayment plan (Ch. XIII, now Ch. 13)

Significance of the 1978 CodeSignificance of the 1978 Code

Terminology shift: now “debtors,” not Terminology shift: now “debtors,” not “bankrupts”“bankrupts”

Incentives to file for Chapter 13 (more Incentives to file for Chapter 13 (more expansive discharge, co-debtor stay)expansive discharge, co-debtor stay)

New Federal exemptionsNew Federal exemptions Who uses Chapter 13?Who uses Chapter 13?

• Those with house to save, need dischargeThose with house to save, need discharge• But most important: local legal cultureBut most important: local legal culture

The 2005 ChangesThe 2005 Changes

Force some debtors to use Chapter Force some debtors to use Chapter 13 (above median income, able to 13 (above median income, able to repay)repay)

Require credit counselingRequire credit counseling Does this change the overall shape Does this change the overall shape

of American bankruptcyof American bankruptcy• Hansen: yes, due to credit cardsHansen: yes, due to credit cards• Skeel: noSkeel: no

What to Watch For in 2009What to Watch For in 2009

Mortgage write-down provisionMortgage write-down provision• Obama supportedObama supported

Revisit 2005 reforms?Revisit 2005 reforms? More limits on exec compensation in More limits on exec compensation in

corporate bankruptcy?corporate bankruptcy? General Motors bankruptcy?General Motors bankruptcy?