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Editor's Note:In this chapter, Douglas G. Baird argues that boilerplate — like mass-produced product components — should not be considered problematic for the reason it usually is, namely, the absence of meaningful bargaining. By looking at three classic contracts case, Baird suggests that boilerplate terms can hide different types of abuses, such as anticompetitive terms, misrepresentation, and provisions that circumvent mandatory protections. It is not the symptom — the standard-form provision — that is troublesome but rather the substance that it sometimes hides.
The warranty that comes with your laptop computer is one of its many product attributes. The laptop has a screen of a particular size. Its microprocessors work at a particular speed, and the battery lasts a given amount of time between rechargings. The hard drive has a certain capacity and mean time to failure. There is an instruction manual, online technical support (or lack thereof), and software. Then there are the warranties that the seller makes (or does not make) that are also part of the bundle. Just as I know the size of the screen but nothing about the speed of the microprocessor, I know about some of the warranty terms that come with the computer and remain wholly ignorant of others.
With respect to some product attributes, the seller will give buyers a choice of options. For a higher price, I can buy a computer with a bigger screen. But with respect to others, there is no choice.
Fraudulent transfer law in the United States provides a safety net for corporate creditors. It prohibits insolvent debtors from making transfers or incurring obligations for less than reasonably equivalent value. Moreover, it reaches any transaction that lacks economic substance and that is designed merely to make it hard for creditors to monitor the debtor. The distinctive shape of fraudulent transfer law in the United States is not replicated in the other common law or in civil law jurisdictions. Nevertheless, the functions it performs are likely to be part of any legal regime that protects the rights of creditors and other investors.
A bankruptcy proceeding is a day of reckoning for all parties with ownership interests in an insolvent firm. Ownership interests are valued, the assets are sold, and the proceeds are divided among the owners. Bankruptcy proceedings take one of two forms, depending on whether ownership rights to the assets are sold on the open market to one or more third parties or whether ownership rights to the assets are transferred to the old owners in return for the cancellation of their prebankruptcy entitlements. The first kind of bankruptcy proceeding, a liquidation, is governed by chapter 7 of the Bankruptcy Code; the second kind, a reorganization, is governed by chapter 11. A bankruptcy proceeding always involves a sale of assets followed by a division of the proceeds among the existing owners. In a chapter 7 proceeding the sale is real; in a chapter 11 proceeding the sale is hypothetical.
An analysis of the law of corporate reorganizations should properly begin with a discussion of whether all those with rights to the assets of a firm (be they bondholders, stockholders, or workers) would bargain for one if they had the opportunity to negotiate at the time of their initial investment. Properly understood, a bankruptcy proceeding itself can be seen as the back end of the “creditors' bargain.” If they had the opportunity, investors in a firm might bargain to accept a bankruptcy proceeding in advance in order to avoid a destructive race to a firm's assets that could arise when several investors exercise their right to withdraw their contribution to the firm.
The absolute priority rule provides that in a reorganization senior owners are paid in full before junior owners are paid anything. When a firm owes more than its assets are worth, the shareholders receive nothing unless the creditors consent. Under the 1978 Bankruptcy Code, consent can be given through a classwide vote of creditors. A single uncompromising creditor's objection is not sufficient to prevent the participation of shareholders. Nevertheless, the absolute priority rule and its rhetoric stand in distinct contrast to the distrust of market mechanisms and ex ante bargains that pervades both the practice of bankruptcy and discussions of bankruptcy policy. Walter Blum's classic essay, “The Law and Language of Corporate Reorganizations,” takes as its theme this tension between the need for respecting the prebankruptcy bargain and the harshness of vindicating that bargain after the fact. Recognition of that tension permeates much of what he has written since. The insights contained in his work establish the common ground upon which all modern bankruptcy scholars stand.
The dispute in Case v. Los Angeles Lumber Products and the other opinions that gave rise to much of Walter Blum's work, however, developed only after the absolute priority rule was well into middle age. These cases all involved battles between a creditor or group of creditors on the one hand and shareholders on the other. In its infancy, the absolute priority rule involved not two parties but three. In this chapter, we make an effort to extend Walter Blum's work.
At the Constitutional Convention in 1787, the only objection to giving Congress the power to pass uniform laws on the subject of bankruptcies was that bankrupts were occasionally put to death in England and that no similar fate should await debtors in this country. The answer to this objection at the Convention – and one fully borne out over the last two centuries – was that there was little danger of such abuse.
The first English bankruptcy statutes gave the creditors of a merchant, as a group, rights they did not have individually. These rights arose when a debtor committed certain specified acts. These “acts of bankruptcy,” as they were called, focused not on the financial difficulties of the debtor per se, but rather on actions, such as fleeing to “parts unknown,” that were thought to thwart the conventional efforts creditors used to obtain repayment. If a merchant committed a specified act of bankruptcy, creditors could petition the Lord Chancellor to appoint a commission that had the power to gather the debtor's assets together and sell them. The commission would then distribute the proceeds “to every of the said creditors a portion, rate and rate alike, according to the quantity of his or their debts.” If creditors were not paid off in full, “then the said creditor or creditors, and every of them, shall and may have their remedy for the recovery and levying of the residue of their said debts or duties … in like manner and form as they should and might have had before the making of this act.”
The traditional view of bankruptcy law begins with the idea that diverse general creditors of a firm face a collective action problem when their corporate debtor becomes insolvent. These general creditors now are the firm's residual owners. Under the traditional view, bankruptcy law is designed in the first instance to allow them to act collectively. This characterization of bankruptcy, however, fails to capture what is often at stake when a closely held firm needs to rearrange its capital structure. The debt owed a single senior creditor may well exceed the value of the firm. Because of its security interest in all the firm's assets, this creditor is entitled to priority over the general creditors. Frequently, bankruptcy serves principally to frame the negotiations between this senior creditor and the firm's manager-shareholder.
A bankruptcy proceeding is needed largely because these negotiations cannot be entirely the province of private contracting. If the firm is worth less than what the most senior creditor is owed, the general creditors should receive nothing, but some mechanism, perhaps a judicial one, is needed to decide whether this condition holds, as the manager-shareholder and the senior creditor cannot be relied on to protect the rights of third parties. Before a court can extinguish the claims of the junior creditors, it must be satisfied that these creditors, in fact, are entitled to nothing. In the case of a closely held firm, bankruptcy does not solve a collective action problem that the general creditors of a firm face when they are its residual owners.
Elizabeth Warren has presented a view of bankruptcy that, while rarely as well articulated, is widely shared. The virtues of Warren's paper, like those of the rest of her work, are easy to identify. Her style is sharp and penetrating. She writes with insight and wit, and she demands that all analysis be held against the light of empirical data – the brighter the better. Warren has put forward a critique of the work I have done with Thomas Jackson that merits a response both because of its own strengths and because it captures misgivings other traditional bankruptcy scholars have shared about our work.
There is much in Warren's view of bankruptcy policy that I admire and agree with. Indeed, to understand our disagreement, it is necessary first to recognize the extent of our common ground. Warren and I agree that, in the main, existing bankruptcy law is consistent with sound bankruptcy policy. The trustee should have the powers of a hypothetical lien creditor; the trustee should be able to set aside voidable preferences and reject executory contracts; creditors (including secured creditors) should be stayed from asserting their substantive claims after the filing of a bankruptcy petition. Warren and I also agree that victims of nonmanifested torts should have their rights against the firm recognized in bankruptcy.
On what in my view is a different front, Warren and I also think existing laws do not adequately protect many, such as workers, who are affected when a firm fails.