Abstract
This paper examines a recently proposed per se rule to automatically treat as equity secured loans granted by shareholders to the corporation on the eve of insolvency. It shows that arguments based on the dual quality of the lendershareholder are insufficient by themselves to propose such a rigid rule, which would curb potentially socially beneficial loans. Further empirical research is needed to shed light on this issue.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
See David A. Skeel, Jr. and Georg Krause-Vilmar, ‘Recharacterization and the Nonhin-drance of Creditors’, 7 European Business Organization Law Review (2006) p. 259.
Ibid., at p. 265. In the words of Jo Ann J. Brighton, ‘recharacterization is an action where a party requests that a bankruptcy court disregard form over substance and “recharacterize” a transaction that was structured as debt into an equitable contribution which, by its nature, is behind the secured creditors in line for repayment.’ See Jo Ann J. Brighton, ‘Submicron Developments in Recharacterization: Certainty and Finality, or Further Confusion? Plus: Credit Bidding — Were the Unsecured Creditors Outwitted and Outplayed?’, 25 ABI J (2006) p. 28.
See Judge Easterbrook’s opinion in Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351 (7th Circuit, 1990).
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 265. On the same subject, see Georgette Chapman Poindexter, ‘Dequity: The Blurring of Debt and Equity in Securitized Real Estate Financing’, 2 Berkeley Bus. L.J. (2005) p. 233, and the recent decision In Re: Submicron Systems Corporation, 432 F.3d 448 (3rd Circuit, 2006).
See Robert C. Clark, ‘The Duties of the Corporate Debtor to its Creditors’, 90 Harvard L. Rev. (1977) p. 505.
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 262.
Ibid., at p. 273.
For another proposal in support of the subordination of shareholder loans, see Martin Gelter, ‘The Subordination of Shareholder Loans in Bankruptcy’, 26 International Review of Law and Economics (2006) p. 478, suggesting a two-prong test: first, only loans given when a firm would have been legally required to file for bankruptcy can be subordinated, and, second, subject such a loan to an ex ante efficiency test to specifically assess whether subordination is required.
As mentioned before, RNC does not discuss moral grounds to support their claim, and this paper therefore does not follow this line of argument.
On this issue, see, for example, Matthew Nozemack ‘Note: Making Sense out of Bankruptcy Courts’ Recharacterization of Claims: Why not Use § 510(c) Equitable Subordination’, 56 Wash & Lee L. Rev. (1999) p. 689 at p. 708.
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 268.
Ibid., at p. 270.
Ibid., at p. 268.
Ibid., at p. 268.
Most likely, RNC reasons that, without formal documents, no registration of the loan exists that would make it public, and consequently it will already be unsecured. Therefore, even though there may be a need for the recharacterisation of the loan as equity if the facts of the case support that ruling and the problem involves a shareholder lending to the firm, the proposed rule does not need to extend to this problem, as the gains to the shareholder are not big enough to induce rent extraction and hence support such a policy.
It is relevant to note that not every firm in distress will generate a loss by the mere passage of time. On this subject, see Jeremy Bulow and John Shoven, ‘The Bankruptcy Decision’, 9 The Bell Journal of Economics (1978) p. 437, distinguishing between economic and financial distress.
See Michael C. Jensen and William H. Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, 4 Journal of Financial Economics (1976) p. 305; George G. Triantis, ‘A Theory of the Regulation of Debtor-in-Possession Financing’, 46 Vand. L. Rev. (1993) p. 901.
For an early account of the separation of ownership and control, see Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property (New York, MacMillan 1933).
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 271.
Ibid., at p. 274.
It would be interesting to see how RNC’s analysis applies to other financial instruments that have both attributes of debt (secured or unsecured) and equity. For a discussion of this instrument in the real estate context, see Chapman Poindexter, loc. cit. n. 4.
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 272.
Ibid., at p. 272.
Ibid., at p. 273.
Ibid., at p. 273.
Ibid., at p. 270.
If their conceptualisation of general rent extraction problems is correct, one wonders why the shareholder loan is recharacterised as unsecured and not as equity, because it is plausible to imagine a rent extraction scenario that would work for the shareholder even if he is treated as unsecured.
The corporate governance literature on efficient assignment of control rights is extensive. See, for example, Phillippe Aghion and Patrick Bolton, ‘An Incomplete Contracts Approach to Financial Contracting’, 59 Review of Economic Studies (1992) p. 473; and Mathias Dewatripont and Jean Tirole, ‘Biased Principals as a Discipline Device’, 8 Japan and the World Economy (1996) p. 195.
See Uniform Fraudulent Transfers Act (UFTA) § 5(a), stating that ‘A transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation.’
See Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 266. See also Nozemack, loc. cit. n. 10, at p. 708.
An anonymous referee has pointed out to me that courts sometimes subordinate the loans using as leading information the fact that they are given at a below market interest rate. If this is the case, the shareholder/lender has even less possibilities of extracting value from creditors, as he is in fact subsidising the firm.
See Allen N. Berger and Gregory F. Udell, ‘The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle’, 22 Journal of Banking & Finance (1998) p. 613; Christopher James, ‘When Do Banks Take Equity in Debt Restructurings?’, 8 The Review of Financial Studies (1995) p. 1209.
See David A. Skeel, Jr., ‘Creditors’ Ball: The “New” New Corporate Governance in Chapter 11’, 152 U. Pa. L. Rev. (2002) p. 917, arguing that the new financial structure of businesses shows that they get into bankruptcy with fewer unencumbered assets, which results in less cash to finance the reorganisation.
The assumption that there is a 100 per cent chance of recovery of the shareholder loan does not seem realistic. The lesser the chances that the loan will be repaid the lesser the benefit of the shareholder to grant the loan ex ante. This important assumption lacks solid argumentation in RNC.
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 270.
See, for example, Karen Hopper Wruck, ‘Financial Distress, Reorganization, and Organizational Efficiency’, 27 Journal of Financial Economics (1990) p. 419.
See Douglas Baird and Edward Morrison, ‘Bankruptcy Decision Making’, 17 J. L. Econ. & Org. (2001) p. 356, arguing that the decision whether or not to liquidate at the beginning of the bankruptcy process depends on the growth of the profit rate and the variance of the profits over time, as the liquidation value gives you a minimum that remains constant.
On this issue, see Michael C. Jensen, ‘Agency Costs of Free Cash Flow, Corporate Finance, and Takeover’, 76 American Economic Review (1986) p. 323, arguing that the control function of debt is more important for firms with higher cash flow and lower growth opportunities.
For subordination purposes, Germany and Austria operate a minimum shareholding requirement unless the lender is also the manager. See Martin Gelter, loc. cit. n. 8, at p. 480.
See, for example, Clifford G. Holderness, ‘A Survey of Blockholders and Corporate Control’, 9 Economic Policy Review (2003) p. 51 at p. 55.
A very interesting example of private benefits can be found in David Yermack, ‘Flights of Fancy: Corporate Jets, CEO Perquisites, and Inferior Shareholder Returns’, 80 Journal of Financial Economics (2006) p. 211.
This is a fact-driven analysis, and discovering any ‘feeding the lien’ strategy would certainly help the court determine shareholder control.
See Pepper v. Litton, 308 US 295 (1939), noting that ‘A director is a fiduciary (Twin-Lick Oil Co. v. Marbury, 91 US 587). So is a dominant or controlling stockholder or group of stockholders (Southern Pacific Co. v. Bogert, 250 US 483).’ See also Geyer v. Ingersoll Publications Co., 621 A.2d 784 (Del. Ch. 1992), noting that directors of an insolvent firm operating outside bankruptcy owe fiduciary duties to creditors.
On controlling shareholders fiduciary duties, see James D. Cox and Thomas L. Hazen, Cox & Hazen on Corporations, Vol. 1, 2nd edn. (New York, Aspen Publishers 2003) pp. 601–608. On lender liability analysis, see Daniel R. Fischel, ‘The Economics of Lender Liability’, 99 Yale L. J. (1989) p. 131.
This is also very interesting, as Robert Clark actually fell short of supporting the automatic subordination rule because of a lack of empirical data showing the extent to which the shareholder/creditor abuses its controlling status and because such a rule imperfectly implements the normative ideals of fraudulent conveyance law. See Clark, loc. cit. n. 5, at p. 539.
To further evaluate the net social effects of secured lending by shareholders, the positive net present value projects allowed by it should be taken into account.
On the issue of irrational decision making, see, for example, Glen Whyte, ‘Escalating Commitment to a Cause of Action: A Reinterpretation’, 11 Academy of Management Review (1986) p. 311, discussing self-justification theory (if the agent needs to justify previous actions due to the responsibilities they entail) and prospective theory (.previous actions and outcomes make the decision-maker frame the problem in such a way as to consider his next decision from the original starting position and not from the present one).
For a discussion of liquidity in bankruptcy, see Andrei Shleifer and Robert Vishny, ‘Liquidation Values and Debt Capacity: A Market Equilibrium Approach’, 47 Journal of Finance (1992) p. 1343, pointing to the fact that liquidation value is dependent on the liquidity of the assets, and hence, if there is an industry or economy-wide recession, a mandatory auction will not necessarily assign the assets to the highest-value users.
For a review of the literature on financial constraints, see R. Glenn Hubbard, ‘Capital-Market Imperfections and Investment’, 36 Journal of Economic Literature (1998) p. 193.
Small firms usually do not find it cost-efficient to conduct independent audits of their financial statements, and the information quality that lenders have is therefore very poor. For a discussion of related party transactions, see Elizabeth A. Gordon, Elaine Henry and Darius Palia, Related Party Transactions: Associations with Corporate Governance and Firm Value, Working Paper, Rutgers University, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=558983 (last checked 8 January 2007).
I am aware of the possibility of larger overinvestment if the RNC rule is not applied. What RNC misses is the underinvestment that such a rigid rule may create. For general discussions on this topic, see Michelle White, ‘Corporate Bankruptcy as Filtering Device: Chapter 11 Reorganizations and Out-of-Court Debt Restructurings’, 10 J. L. Econ. & Org. (1994) p. 268; Stewart C. Myers, ‘Determinants of Corporate Borrowings’, 5 Journal of Financial Economics (1977) p. 147; and Triantis, loc. cit. n. 17.
The fact that the loan made by a third party lacks the option of gaining from the equity it possess, which RNC mentions, is only true if one assumes that the company either does not emerge from bankruptcy or that the creditor is going to be paid in cash rather than equity if the firm emerges.
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 274.
With regard to the appropriateness of allowing secured credit in general, see Lucian A. Bebchuk and Jesse M. Fried, ‘The Uneasy Case for the Priority of Secured Claims in Bankruptcy’, 105 Yale Law Journal (1996) p. 857; for a different perspective, see Raghuram Rajan and Andrew Winton, ‘Covenants and Collateral as Incentives to Monitor’, 50 Journal of Finance (1995) p. 1113; and Steven L. Schwarcz, ‘The Easy Case for the Priority of Secured Claims in Bankruptcy‘, 47 Duke Law Journal (1997) p. 425.
Skeel and Krause-Vilmar, loc. cit. n. 1, at p. 261.
This results are in line with Gelter, loc. cit. n. 8, at p. 491.
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Muro, S.A. Economic Reasons for the Nonhindrance of Creditors Per Se Rule? A Reply. Eur Bus Org Law Rev 8, 401–411 (2007). https://doi.org/10.1017/S1566752907004016
Published:
Issue Date:
DOI: https://doi.org/10.1017/S1566752907004016