With the emergence of modern reorganization law in the 1930s, the absolute priority rule came into being. In contrast to what proceeded it, this priority regime cashed out the value of everyone’s stake in the firm at the time of the reorganization. The fifth chapter shows that this idea emerged in large reorganizations not because of any belief in the intrinsic merit of recognizing absolute priority but only because New Deal reformers thought that such a priority rule best protected passive and unsophisticated investors from insiders. Giving each individual creditor the right to insist on being paid in full before anyone junior received anything, however, proved to be incompatible with achieving the mutually beneficial bargains that justified reorganization law in the first instance.

The Statute of 13 Elizabeth originally appeared merely to prohibit a debtor from fraudulently conveying assets in order to defeat creditors, but it served as the fountainhead of many important principles in American commercial law. Chapter 1 shows how this law came to be applied to negotiations among creditors and their common debtor. This chapter explores how it operated in the wake of the financial failure of Robert Morris at the end of the eighteenth century. Robert Morris had been one of the richest and most prominent men in the country, but he failed spectacularly and pulled many other once successful merchants down with him. This financial catastrophe drew parties to the courthouse, where the judges began with first principles.

This chapter focuses upon retail merchants and their suppliers at the start of the twentieth century. When small retailers at the start of the twentieth century encountered trouble, it fell to the credit professionals who worked for their faraway and unpaid suppliers to sort things out. These credit men, as they called themselves, did not tolerate debtors whom they deemed unworthy, but they believed that it was appropriate to give some debtors a second chance. Their solicitude for these “worthy debtors” combined notions of honor and decency with self-interest. They pressed for legal reforms to provide a check against the forces that interfered with their efforts to reach a “friendly adjustment” of debt. In the process, they changed what behavior between debtor and creditor was acceptable and what was not.

This chapter connects fraudulent conveyance principles to the practices that judges adopted during the reorganization of the Atchison, Topeka and Santa Fe and the other great railroads that failed in the second half of the nineteenth century. The benchmarks judges put in place during this era established the ground rules for bargaining among investors for the next several decades. Judges did not try to shape the outcome of the negotiations. Instead they ensured that deals were only struck honestly and in good faith. There had to be a process that gave everyone a fair opportunity to participate.

This chapter shows how reorganization law changed dramatically during the 1970s. A group of skilled lawyers and academics returned to first principles and boldly reworked reorganization law once again. In their hands, the unwritten law that governs today took its modern form. These reformers focused squarely on creating an environment that was conducive to bargaining. Judges were to provide oversight, but they were no longer to do the heavy-handed policing upon which New Deal reformers had insisted. At the same time, however, judges had to embrace the basic norms of the credit men and do more than simply ensure that everyone had a seat at the table. Bargaining had to be forthright, and parties could not conceal conflicts of interest or advance private agendas.

During the 1980s, Thomas Jackson and I showed how reorganization law took nonbankruptcy rights as it found them. It limited itself to sorting out the collective action problem that existed when a corporate debtor lacked the assets to meet all its obligations in full. The challenge was one of sorting out nonbankruptcy entitlements, ensuring that assets were being put to their highest valued use, and at the same time requiring the debtor to play by the same rules as everyone else. Although this view of reorganization law does not seem especially controversial today, it led to much sturm and drang, most notably perhaps in the spirited, but consistently civil debates that I had with Elizabeth Warren during this period.

In the 1930s, a group of New Deal reformers joined the investment bankers and the credit men to refashion the bargaining environment once again. The consensus that emerged during this decade is the focus of the book’s fourth chapter. The New Deal reformers brought their own distinctive understanding of how judges were to oversee negotiations among creditors and their common debtor. They believed that judges had to take steps to ensure that, at every turn, the bargaining process did not slight the rights of passive investors who had neither the information nor the sophistication to bargain on equal terms with Wall Street insiders.

The sixth chapter looks at reorganization practice after the Second World War. The heavy regulatory oversight that New Deal reforms imposed on large firms was unsuccessful. Government regulators showed themselves to be insufficiently nimble. And the law depended too much on judicial valuations that proved too malleable and too uncertain. Moreover, although the norms of the credit men and the emphasis on accommodating worthy debtors worked tolerably well for small businesses, these norms offered judges no easy way to find their bearings elsewhere. Nowhere was this more evident than in real estate insolvencies.

The final chapter examines the challenges that have appeared over the last decade. New players and new capital structures make negotiations harder to manage. Applying old norms to novel practices is never easy. That said, today’s bankruptcy judge continues to call upon the same core ideas that have been with us from the start. Side deals that corrupt or even cloud the process are forbidden. The judge is not a dispenser of Solomonic wisdom, but a referee who ensures a level playing field. She insists that the parties follow the rules, but she does not enforce rules for their own sake nor does she allow her oversight to interfere with the flow of play. In the end, she leaves it to the parties to find a path forward. If they cannot find a future for the firm, she will not do it for them.

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.

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.

Introduction

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.”