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Article Excerpt
ARTICLE CONTENTS
INTRODUCTION I. THE ECONOMICS OF SYMMETRY AND ASYMMETRY IN ASSET PARTITIONING A. A Simple Model of Asset Partitioning B. Asset Partitioning and Appraisal Costs C. Asset Partitioning and Creditor Monitoring 1. Monitoring as a Response to Debtor Misconduct 2. Monitoring Under the Pro Rata Rule 3. Monitoring Under Symmetry 4. Monitoring Under Asymmetry: Asset 1 5. Monitoring Under Asymmetry: Asset 2 6. A Separate Note on Debt Dilution D. Asset Partitioning and Speedier Bankruptcy Proceedings E. Asymmetry as a Means for Debtor Opportunism F. Asset Shifting and "Imbalanced" Debtors II. SYMMETRY APPLIED: REFORMING THE SECURED LOAN A. The Secured Loan Under Current Law B. The Secured Loan and Appraisal Costs C. The Secured Loan and Creditor Monitoring D. The Secured Loan and Bankruptcy Speed E. The Secured Loan's Asymmetry as a Source of Opportunism F. Oversecurity and Blanket Liens 1. Oversecurity Under Symmetry 2. A (Brief) Economic Analysis of the Blanket Lien G. A Proposal for Symmetrical Secured Loans H. Symmetry Versus Previous Reform Proposals CONCLUSION
INTRODUCTION
The foundation of modern bankruptcy systems is the pro rata rule, which pays all creditors an equal percentage on their claims. But debtors can, and often do, override the pro rata rule through asset partitioning, which is the nonconsensual subordination of creditor claims to particular debtor assets. (1) Legal arrangements that partition assets are both varied and ubiquitous, ranging from the corporation and partnership to the secured loan.
Because partitioning arrangements forcefully subordinate creditor claims, they transfer wealth away from claimants such as tort victims who do not adjust when their claims are impaired. (2) Despite the social costs of these wealth transfers, previous scholarship has argued that partitioning arrangements can create value by providing various economic efficiencies. (3) In weighing costs and benefits, however, this literature has taken little account of key differences in the ways that partitioning arrangements prioritize creditor claims. (4)
This Article provides an original framework for comparing the efficiency of different partitioning arrangements. I identify a universal distinction between two basic types of asset partitioning, which I term symmetry and asymmetry. Despite their variety, all partitioning arrangements can be categorized as either symmetrical or asymmetrical. Symmetrical arrangements divide creditors into groups and give each group a prior claim to a distinct asset pool in the debtor's estate. (5) In contrast, asymmetrical arrangements give prior claims to some creditors but not others, advantaging select creditors by according them both a prior claim to one asset pool and a pro rata claim to remaining debtor assets. (6)
The distinction between symmetry and asymmetry is powerful because, as Part I of this Article demonstrates, symmetry is superior to asymmetry with respect to each of the major economic benefits of asset partitioning that scholars have identified. In particular, symmetry does more than asymmetry to tie each creditor's fortunes to a discrete asset pool, thereby permitting creditors to economize on the costs they incur when appraising risk. Symmetry also encourages efficient monitoring of debtors by allowing creditors who rescue assets from debtor misconduct to keep more of those assets for themselves. Asymmetry, by contrast, undermines monitoring incentives, because it insulates some creditors from the losses they could most cheaply prevent. Finally, symmetry does more than asymmetry to expedite the distribution of assets to creditors in a bankruptcy proceeding.
If asymmetrical arrangements are categorically inefficient, why are they so common? The answer, I argue, is opportunism. It is easier to use asymmetry than symmetry to transfer wealth away from nonadjusting creditors. And the use of asymmetry to transfer wealth is a drag on the economy: not only does it forgo the social benefits of symmetry, but by distorting interest rates it encourages wasteful investment decisions.
These findings reveal that lawmakers could create social wealth by reforming asymmetrical arrangements to be symmetrical. Part II considers in depth the opportunity for reform of the secured loan, which is asymmetrical under current law. Because of its central role in modern commerce, (7) the secured loan has been the subject of numerous reform proposals. I show that all of these proposals seek to reduce opportunism costs in a manner that would undermine the economic benefits that secured loans now provide. Symmetry, by contrast, would curtail opportunism while simultaneously enhancing rather than undermining the secured loan's economic benefits. In short, symmetry is the only reform proposal for the secured loan with no apparent economic downside.
More broadly, this Article's framework reveals opportunities for reform of other widely used asymmetrical arrangements. As I show next, the benefits of reform can be understood through a simple model that demonstrates the efficiency of symmetry in the allocation of creditors' rights.
I. THE ECONOMICS OF SYMMETRY AND ASYMMETRY IN ASSET PARTITIONING
This Part begins by presenting a simple model of a lending arrangement that illustrates the difference between symmetry and asymmetry. I then use the model to evaluate symmetry and asymmetry in terms of each of the important social benefits and costs of asset partitioning.
A. A Simple Model of Asset Partitioning
The simple model has three parties: Debtor, and two creditors--Creditor 1 and Creditor 2--who have claims against Debtor. (8) Debtor owns two asset pools-Asset 1 and Asset 2. (9) Three versions of the model can be imagined, reflecting in turn the pro rata rule, symmetry, and asymmetry. (10)
The pro rata rule, which is the modern bankruptcy default rule in the absence of asset partitioning," pays all creditors an equal percentage on their claims. Thus, in the pro rata version of the simple model, if Debtor owes Creditor 1 and Creditor 2 $100 each, and defaults when Asset 1 is worth $50 and Asset 2 is worth $90, then each creditor recovers $70, or 50% of Debtor's overall estate.
Symmetry departs from the pro rata rule by dividing creditors into groups and giving each group a prior claim to a distinct debtor asset pool. Thus, in the symmetrical version of the model, Creditor 1 has a prior claim to Asset 1, and Creditor 2 has a prior claim to Asset 2. If once again each creditor is owed $100 and Debtor defaults when Asset 1 is worth $50 and Asset 2 is worth $90, then under symmetry Creditor 1 recovers $50 and Creditor 2 recovers $90. As this example illustrates, it is possible under symmetry for either creditor to recover a higher percentage on his or her claim than the other does, depending on the relative values of the asset pools in bankruptcy.
An additional feature of symmetrical arrangements is that they give at least some creditors a "deficiency claim," which is a right to levy on the debtor's remaining assets to the extent of any shortfall in the creditor's designated asset pool. Deficiency claims in symmetrical arrangements are always subordinated. This means that, in the symmetrical version of the simple model, Creditor 2 can levy on Asset I if there is a shortfall in Asset 2, but only if Creditor i is first paid in full. Conversely, Creditor 1 can collect from Asset 2 if there is a shortfall in Asset 1, but only if Creditor 2 is first paid in full. Another possibility under symmetry is that the debtor enjoys limited liability, and therefore that some creditors lack a deficiency claim altogether. In the model, this would mean that Creditor 2 has a deficiency claim but Creditor 1 does not. When I discuss the symmetrical version of the simple model in this Article, I generally assume that both creditors have deficiency claims, but I comment on the implications of the limited liability alternative where relevant.
Finally, asymmetry also divides creditors into groups, but unlike symmetry it gives only one group a prior claim to a distinct asset pool. Thus, in the asymmetrical version of the model, Creditor 1 has a prior claim to Asset 1, and he also has a deficiency claim to Asset 2 that is paid pro rata with Creditor 2's claim. This structure ensures Creditor 1 that he will always recover a higher percentage on his claim than Creditor 2 does if Debtor falls bankrupt (unless Asset 1 drops in value to nothing, in which case the two creditors recover pro rata). As an illustration, assume once more that each creditor is owed $100 and Debtor defaults when Asset 1 is worth $50 and Asset 2 is worth $90. Under asymmetry, Creditor 1 recovers the full $50 in Asset 1, and he then asserts a $50 deficiency claim against Asset 2. Because Creditor 1's deficiency claim is half the size of Creditor 2's $100 claim, his share of Asset 2 is half as big as hers: Creditor 1 gets $30, bringing his total recovery to $80, and Creditor 2 gets the remaining $60. (12) I also will assume in the asymmetrical version of the model that Creditor 2 has a deficiency claim to Asset 1, but it is subordinated to Creditor l's claim. (13)
Despite their variety, all asset partitioning arrangements can be characterized as either symmetrical or asymmetrical. The symmetrical version of the model illustrates creditor priorities in the common law's "jingle-rule" partnership, as well as in limited liability entities such as the corporation, limited liability company (LLC), limited liability partnership (LLP), and Delaware business trust. In each of these commercial arrangements, the firm's creditors have a prior claim to the firm's assets, and the personal creditors of each owner have either a prior (under the jingle rule) or exclusive (under limited liability) claim to that owner's personal assets. (14) The asymmetrical version of the model, in turn, represents the general partnership as modified by statute in the United States, where partnership creditors enjoy both a prior claim to partnership assets and, to the extent of any deficiency in those assets, a claim to personal assets paid pro rata with the claims of personal creditors, (15) And it represents the secured loan, which gives the secured creditor a prior claim to the secured assets plus a deficiency claim to the unsecured assets that is paid pro rata with the claims of the unsecured creditors. (16)
In most cases, a partitioning arrangement's symmetry or asymmetry is the product of a default rule. Thus, parties often use contract law to switch an arrangement from one configuration to the other. For example, owners of closely held corporations often issue personal guaranties on the firm's debt, (17) and managers of corporate groups frequently cause one company in the group to guaranty the debt of another. (18) In both cases, the guaranty makes an otherwise symmetrical arrangement (the corporation) asymmetrical: the corporate creditor who receives the guaranty enjoys both a prior claim to the corporate assets and a deficiency claim against the guarantor that, if the guarantor is bankrupt, is paid pro rata with the claims of the guarantor's other creditors. (19) In this way, the guaranty contract can be characterized as another asymmetrical arrangement. (20) Conversely, parties sometimes create "nonrecourse" secured loans in which the secured creditor waives his deficiency claim, thereby converting an otherwise asymmetrical arrangement into a symmetrical one. (21)
Given that symmetrical and asymmetrical arrangements are both so common, one might expect that symmetry and asymmetry generate different economic efficiencies, and that parties choose between them based on whichever efficiencies will predominate in a particular setting. But direct analysis using the simple model indicates that this is untrue. As the discussion that follows demonstrates, symmetry outperforms asymmetry in terms of each of the major social benefits of asset partitioning that scholars have identified. (22) The implication is that, when parties opt for asymmetry, they do so for reasons other than wealth creation.
B. Asset Partitioning and Appraisal Costs
The economic efficiency that scholars have most frequently attributed to various partitioning arrangements is the reduction of what I will call appraisal costs, which are the costs that creditors incur when evaluating a prospective debtor to decide whether to extend credit and on what terms. Creditors will be particularly interested in the value of the debtor's assets, as asset values will determine the creditors' recoveries if the debtor falls bankrupt. (23)
The first scholar to discuss appraisal costs was Richard Posner, who argued that the doctrine of piercing the corporate veil, which abrogates limited shareholder liability, makes it more expensive for creditors to evaluate lending risk. (24) Although Posner's argument was (in effect) a defense of the corporation's symmetry, (25) scholars subsequently have cited appraisal efficiencies as a benefit of various asymmetrical arrangements, including the secured loan, (26) guaranty contract, (27) and American general partnership. (28)
Analysis using the simple model suggests that these extensions of Posner's original argument should have come with an important caveat. Yes, asymmetrical arrangements may generate some appraisal benefits relative to the pro rata rule. But the benefits are smaller than they are under symmetry. In particular, asymmetry does not tie lending risk to particular asset pools to the same extent that symmetry does, nor does it enable all creditor groups to specialize by lending against only a portion of a debtor's estate. Therefore, appraisal efficiencies alone cannot explain why parties would choose asymmetry when a symmetrical alternative is available. Nor can they justify a decision by lawmakers to make an arrangement asymmetrical as a default rule.
To understand the relationship between asset partitioning and appraisal costs, it is useful to observe that a debtor's insolvency can take different forms, as the simple model will serve to illustrate. Thus, assume that both of Debtor's asset pools are initially "above water"-meaning that Asset 1 is worth more than Creditor l's claim, and Asset 2 is worth more than Creditor 2's claim. Assume further that there is some risk that the pools will drop in value, which in turn may cause Debtor to fall insolvent and default before it repays its debts. It follows that Debtor's insolvency could take three different forms. First, Asset 1 might devaluate far enough to render Debtor insolvent even though Asset 2 remains above water. Second, Asset 2 might devaluate far enough to render Debtor insolvent even though Asset 1 remains above water. And third, both asset pools might drop underwater. The riskiness of each creditor's lending position is therefore a product of the probabilities of these three insolvency outcomes and the amount the creditor recovers in each.
Under the pro rata rule, both creditors recover from both asset pools in all three insolvency outcomes. Therefore, to get an accurate risk assessment under the pro rata rule, the creditors must spread their appraisal efforts evenly across Debtor's estate. The question is whether asset partitioning can permit the creditors to economize on their appraisal costs by rationally narrowing their focus.
Consider symmetry first. Regardless of the form of Debtor's insolvency, Creditor 1 recovers from Asset 1, just as he does under the pro rata rule. But under symmetry he recovers from Asset 2 only in the insolvency outcome where Asset 1 alone is underwater, as that is the only outcome where there is both a deficiency in Asset i and a surplus in Asset 2. Moreover, in that outcome he recovers less from Asset 2 under symmetry than he does under the pro rata rule, because under symmetry his claim to Asset 2 is subordinated. (And in the limited liability alternative he recovers nothing from Asset 2, because then his deficiency claim is eliminated altogether.) Therefore, if Creditor i were to conserve on his appraisal efforts by focusing solely on Asset 1, he would know more about his overall risk exposure under symmetry than he would under the pro rata rule.
Because of the nature of symmetry, the same analysis applies in mirror-image form to Creditor 2. She now recovers from Asset 1 only in the insolvency outcome where Asset 2 alone is underwater, and she recovers less from it under symmetry than she does under the pro rata rule. If she were to focus her appraisal efforts solely on Asset 2, she too would know more about her overall risk exposure under symmetry than she would under the pro rata rule.
Symmetry will be especially beneficial to both creditors if Debtor's assets are used for different purposes, thereby permitting the creditors to specialize in lending against the type of asset they can appraise more cheaply. Consider an example of a sole proprietor who owns both a grocery store and some personal assets. Assume that the proprietor has one trade creditor and one personal creditor. Because of his industry experience, the trade creditor will naturally find the grocery assets cheaper to valuate. If the proprietor were to form a corporation and assign to it both the grocery assets and the trade creditor's claim, the corporation's symmetry would tie the trade creditor's fortunes to the grocery assets, thereby reducing the trade creditor's appraisal costs. In a competitive lending market, this benefit would be captured by the proprietor in the form of a lower interest rate on the trade debt. Incorporation of the grocery business also would automatically tie the personal creditor's risk exposure to the personal assets, which the personal creditor also would probably be able to appraise more cheaply. Similar benefits from specialization would arise if, to use a different example, joint owners of two distinct businesses incorporated them separately, thereby forming a corporate group. (29) The potential for an asymmetrical arrangement to generate appraisal efficiencies is much more limited. In the asymmetrical version of the simple model, Creditor 1 recovers from Asset 1 in all three insolvency outcomes, just as he does under symmetry. And because his deficiency claim to Asset 2 is not subordinated, he recovers from that asset pool not only in the outcome when Asset 1 alone is underwater, but also when both asset pools are underwater. Finally, when Asset 1 alone is underwater, he takes a larger portion of Asset 2 under asymmetry than he does under symmetry. Therefore, if Creditor 1 were to conserve on his appraisal efforts by focusing solely on Asset 1, he would know less about his overall risk exposure under asymmetry than he would under symmetry. He would, however, know more than he would under the pro rata rule, where as noted he recovers from Asset 2 in all three outcomes.
A potential objection at this point is that nothing forces Creditor 1 to valuate his deficiency claim; even under asymmetry, he could choose to appraise only Asset 1 and disregard Asset 2. But it must be remembered that Creditor 2 will demand a higher interest rate from Debtor under asymmetry to compensate her for the risk that Creditor 1's deficiency claim will cut into her own recovery. Debtor therefore will insist that Creditor 1 either subordinate his deficiency claim or pay for it through an interest rate concession. And Creditor 1 cannot know how large a concession to make without some sense of the value of Asset 2.
Asymmetry is even less beneficial to Creditor 2. Once again, she recovers directly from Asset 2 in all three insolvency outcomes. And under asymmetry the value of Asset 1 also affects her recovery in all three outcomes, just as is true under the pro rata rule. Thus, when Asset 2 alone is underwater, her (subordinated) deficiency claim causes her to recover from Asset 1 directly. And in the two insolvency outcomes where Asset 1 is underwater, the value of Asset 1 determines the size of Creditor 1's deficiency claim, which under asymmetry determines her recovery from Asset 2. (30) The only difference with the pro rata case is that the impact on her of Asset 1's value is somewhat smaller because under asymmetry Creditor 1 is paid out of that pool first. The implication is that, if Creditor 2 were to conserve on her appraisal efforts by focusing solely on Asset 2, she would know little more about her overall risk exposure under asymmetry than she would under the pro rata rule.
The fact that the values of both asset pools affect Creditor 2's recovery under asymmetry regardless of the form of Debtor's insolvency also hampers specialization. Consider again the example of the sole proprietor who owns a grocery store. To create asymmetry, the proprietor could give the trade creditor a secured claim to the grocery assets. Although this would (partially) tie the trade creditor's risk exposure to the grocery business, it would not capitalize on the personal creditor's corresponding advantage in appraising the personal assets, because her exposure to the risks associated with the grocery business would be almost as great as it would be under the pro rata rule.
In sum, asymmetry also generates appraisal benefits relative to the pro rata rule. But the benefits are smaller than under symmetry, because asymmetry does not create tight links between particular creditors and particular assets, nor does it permit specialization by all creditors.
C. Asset Partitioning and Creditor Monitoring
Another purported benefit of partitioning arrangements is that they make it easier for creditors to monitor debtors and thus to prevent wealth-destroying debtor misconduct. Scholars have claimed monitoring efficiencies as a benefit of symmetrical arrangements: for example, Larry Ribstein has advocated the jingle rule for partnership bankruptcies on grounds that it reduces creditor monitoring costs by allowing "separate groups of creditors to focus on separate piles of assets." (31) As with appraisal efficiencies, however, monitoring efficiencies are more often touted as an advantage of asymmetrical arrangements. (32) Thus, several scholars have argued that the secured loan promotes efficient creditor monitoring-although, as Part II discusses, they disagree about which creditors it encourages to monitor. (33) Similarly, Avery Katz
has argued that the guaranty contract is superior to alternative arrangements when the lender whose claim is guarantied can monitor the borrower more cheaply than the guarantor's other creditors can. (34)
Taken as a whole, this scholarly commentary suggests that the difference between symmetry and asymmetry has little impact on creditor monitoring incentives. But analysis using the simple model shows that this is inaccurate, and in fact that only symmetry makes efficient monitoring more likely. Symmetry has what I will call a focusing effect, meaning that it increases the degree to which a creditor's recovery is determined by the value of a particular asset pool. This focusing effect promotes the benefits of specialization, an observation consistent with Ribstein's defense of the jingle rule. And symmetry's focusing effect also permits creditors to capture more of the benefits of their own monitoring efforts, thereby ameliorating a collective action problem caused by the pro rata rule. Asymmetry, in contrast, provides neither of these benefits. This is because asymmetry has what I will call an insulating effect, meaning that it shields creditors from devaluation of the assets to which the creditors enjoy prior claims. As a result, asymmetry discourages monitoring by those creditors who could most cheaply prevent a loss. In addition, asymmetry does little to overcome the collective action problem, and makes it harder for creditors to determine whether monitoring will be cost-justified. Asymmetry therefore does not improve monitoring incentives relative to the pro rata rule-and indeed in many situations may make efficient creditor monitoring less likely.
Before analyzing creditor monitoring incentives under each version of the simple model, it will be useful to consider in general terms why creditors monitor a debtor after they extend credit.
I. Monitoring as a Response to Debtor Misconduct
A debtor and its creditors normally share an interest in preserving the value of the debtor's estate. But when a debtor's liabilities exceed its assets, further deterioration in the debtor's estate harms only its creditors, opening a gap between debtor and creditor interests that the debtor might try to exploit. The resulting debtor conduct-which from the perspective of creditors is surely "misconduct"-can be divided into two types. The first, which I will call asset depletion, is action by a debtor that reduces the value of its assets to its creditors. An example is when an insolvent debtor consumes its assets or gives them away to family members or charity. Another example is when a debtor engages in "asset substitution," meaning that the debtor converts its assets to a riskier form. (35)Riskier assets are less valuable to creditors because creditors are owed fixed amounts, and they therefore suffer the deeper downswings more than they profit from the higher upswings when their collateral becomes more volatile. The second type of debtor misconduct, which I will call debt dilution, occurs when a debtor takes on new liabilities that are not offset by a contribution of recoverable assets to the debtor's estate. An example is when a debtor incurs liability to a tort victim or to a governmental claimant such as a tax authority. (36)
One way to conceptualize the difference between asset depletion and debt dilution is to observe that creditors recover based on the ratio between a debtor's assets and liabilities. Asset depletion harms creditors by reducing the numerator of this ratio, and debt dilution harms them by increasing the denominator.
Besides potentially changing the distribution of wealth, debtor misconduct generates various social costs that destroy wealth. First, asset depletion can cause assets to be assigned to socially inferior uses, because insolvency gives a debtor reason to consume or shunt away assets even if the debtor gets less benefit from doing so than its creditors would get from seizing the assets. Second, asset substitution in particular can produce "overinvestment," which occurs when a debtor's ability to shift downside risk onto...
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