Exogenous Risks Versus Endogenous Risks: The Only Relevant Distinction?

Dean Jackson and Professor Scott [referring to Chapter 10 in this volume. Eds.] provide us with a vivid image: the captain of an imperiled ship must decide whether to jettison cargo, to cut off the mast, or to jettison the ship's supplies. If losses fall where incurred and are not shared, the captain would be expected to foster his own interest instead of maximizing the savings of the group. Admiralty's rule of general average reduces the captain's perverse incentive to jettison another participant's cargo when it is cheaper in the aggregate to jettison the ship's own supplies.

Bankruptcy's priority system recreates the imperiled ship scenario. Deviations from the priority system for exogenous risks are analogous to admiralty's rule of general average. The parties could do nothing to avoid the calamity or to mitigate its effects. The costs of bargaining to the value-maximizing solution are high due to priority. Accordingly, the theoretical justification for respecting priority in a bankruptcy caused by exogenous factors evaporates.

Strategic creditor action, they argue, justifies bankruptcy's sharing rules. Another justification is available – debtor moral hazard: if the owner of a closely held firm fears that his equity interest will be reduced to zero, he has an incentive to abandon the enterprise or to take unwarranted risks to create some possibility of a payback. By giving the entrepreneurial debtor an interest in the ongoing enterprise, sharing rules mute his incentive to gamble with, or to abandon, the enterprise.