Bankruptcy Law Archives – Southern California Law Review

The Bankruptcy Court as Crypto Market Regulator

April 2024April 2024Yesha Yadav* & Robert J. Stark†

In the second half of 2022, several large and systemically important cryptocurrency firms, such as BlockFi, Celsius, FTX, and Voyager, collapsed into bankruptcy. Their sudden implosion can be attributed, at least in part, to a scant pre-existing framework for oversight, allowing firms to engage in runaway risk-taking, exuberant opportunism, and, in some cases, outright fraud. Bankruptcy courts adjudicating these cases found themselves in a strange role: serving as a sort of proxy overseer for a maturing cryptocurrency industry, and forced into doing some of the work historically entrusted to regulatory agencies like the SEC, CFTC, and Fed. This Article explores the implications of bankruptcy courts being drafted into this kind of quasi-regulatory service. We observe that bankruptcy’s intervention comes with numerous payoffs, given that Chapter 11’s end-goals often align with traditional regulatory objectives. Indeed, by case necessity, bankruptcy courts have overseen broad and detailed reporting from some of the industry’s darkest corners, rendered decisions that likely will have lasting impact on customer protection, directed regulatory attention to particular points of public vulnerability, and afforded opportunity for regulatory agencies to advance their policy initiatives. Nevertheless, we also observe that bankruptcy courts are inadequate proxies for administrative, technocratic oversight. Focused mainly on the debtor’s fate, the Bankruptcy Code is ill-equipped to address, in a prophylactic way, system-wide risks in crypto markets. Even disclosure––a foundational regulatory tool––works idiosyncratically when delivered in the bankruptcy context, intended to inform the debtor’s stakeholders in furtherance of bankruptcy-specific imperatives, rather than to facilitate knowledgeable investing by the general public. Bankruptcy courts are, moreover, statutorily constrained in ways that lack the mission, modalities, and mechanisms to protect an industry and its participants. As we show here, even as bankruptcy courts have stepped up to do their work, their role in overseeing crypto bankruptcies firmly establishes a paramount need for comprehensive regulation tailored for the digital asset space.

INTRODUCTION

The collapse of the FTX cryptocurrency exchange in November 2022 was a pivotal moment for the digital asset industry. The company’s sudden implosion triggered billions in economic damage across the sector, as well as immeasurable personal pain for millions of everyday customers.¹

Prior to its failure, FTX had been one of crypto’s brightest stars, serving as a leading trading hub for digital assets, offering a panoply of sophisticated financial products, and boasting a (supposedly) enviable balance sheet.² Just one year after its founding in 2019, the company was hosting $385 billion in annual trading volume.³ The following year, it reported five million customers worldwide, more than $1 billion in revenue, and almost $275 million in earnings.⁴ By January 2022, FTX was valued at $32 billion.⁵ The company had also been absorbed into popular culture, helping to demystify digital assets for everyday Americans: the FTX brand was emblazoned across the Miami Heat’s basketball stadium; it was endorsed by celebrities like Tom Brady and Larry David, including a memorable advertisement aired during the 2022 Superbowl; and, Sam Bankman-Fried, FTX’s once-wunderkind CEO, became known for contributing lavishly to political campaigns and marketing himself as the legitimizing, ethical face of crypto.⁶ In fewer than four years, FTX had become big, powerful, and ubiquitous––bridging Wall Street, Main Street, and the nation’s capital to a brand new crypto marketplace––which too had become far too big, powerful, and ubiquitous to ignore.⁷

But, in November 2022, FTX was outed as a possible fraud, suspected of grossly misrepresenting its enterprise value and misusing customer deposits.⁸ Within weeks, Bankman-Fried was in handcuffs,⁹ other FTX executives were cutting plea deals,¹⁰ and the company was in bankruptcy.¹¹ The resulting Chapter 11 case is sweeping, both in scale and complexity, spanning over 130 entities worldwide, with total value estimates ranging anywhere from $10 to $50 billion.¹² The administrative fee burn has been commensurately immense, with the debtor’s bankruptcy professionals seeking over $200 million in fees for the initial six months of work.¹³

Intriguingly, the FTX story is not unique.¹⁴ The company’s meteoric rise and sudden descent tracks that of other crypto behemoths. Firms like BlockFi, Celsius Network, Core Scientific, Genesis Global, Three Arrows Capital, and Voyager Digital each found themselves intermediating billions in crypto assets only a few years after launch and, like FTX, imploding in the wake of a sharp market downturn. Several major crypto bankruptcies have also generated substantial allegations of executive wrongdoing, and those allegations overlap, reflecting somewhat repeating patterns of alleged customer deception and sloppy safeguarding of customer assets.¹⁵

None of this should be terribly surprising. The crypto market has, through its evolution, lacked a systematic regulatory framework to constrain excessive risk-taking, interconnection, and propensities for predation against customers.¹⁶ This has meant, for example, a lack of vetted, mandatory public disclosure about the business dealings of some of its most significant enterprises, as well as their corporate governance and risk management practices.¹⁷ Nor has regulation imposed comprehensive standards for protecting customer assets.¹⁸ It has thus failed to speak on how the market should ensure the overall safety and soundness of crypto firms––and, importantly, what procedures crypto businesses need to follow in order to legally insulate the value of customer assets against instances of theft, hacks, and firm bankruptcy.¹⁹ This relatively threadbare regulatory environment has afforded considerable space for firms to take excessive financial risks or institutionalize problematic practices (e.g., opaque governance), with predictably costly consequences. This has left bankruptcy courts to become, oddly, the frontline responders–– tasked with cleaning up the fallout by imposing their jurisprudence onto an otherwise lightly governed crypto marketplace.

This Article shows that, by dint of historical happenstance, bankruptcy law has been required to partially fill an administrative void and to function in an almost quasi-regulatory capacity. Several bankruptcy courts in New York, Delaware, and New Jersey have come to simultaneously oversee what is, collectively, a sort of grand public inquest into crypto market infrastructure and operations, surveying a wide spectrum of industry-specific transactions, practices, and methods of corporate decision-making. These courts have also decided issues of first impression that will likely leave a lasting impact on the maturing crypto industry (e.g., modified terms of service).²⁰ The courts have been doing their work in advance of a mainstay framework for regulating cryptocurrency markets, driven by case imperatives to perform certain functions commonly entrusted to financial supervisors like the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Reserve.²¹

In forwarding this argument, this Article moves to examine the implications of bankruptcy law and its courts being drafted into quasi-regulatory service. It makes three points. First, we observe that bankruptcy has stepped into an arena where financial regulators have struggled to craft a system of rules and standards, applying its own principles and processes to the messy task of preserving and allocating economic value. In many respects, crypto represents an inherently complicated challenge for U.S. financial regulation, given the industry’s extraterritorial nature, fast-moving technology, and originating anti-government spirit.²² But, even as the likes of FTX are far from the first crypto players to fail,²³ the scale of alleged wrongdoing and magnitude of damage caused by 2022’s “crypto winter”²⁴ have laid bare the significance of sparse regulation and deepened the strains experienced by the New Deal administrative apparatus in policing the digital asset space.²⁵ This has left the bankruptcy system charged with, among other things, calculating the economic costs of regulatory failure and, where possible, developing mechanisms to safeguard and redistribute enterprise value within otherwise under-protected crypto markets.

Second, we show that bankruptcy law offers a number of advantages when its courts are, by default, performing traditional regulatory functions. By its very design, bankruptcy involves a system of rules that advance certain core regulatory objectives. For example, Chapter 11 is demanding when it comes to disclosure, a phenomenon highlighted by the production of startling revelations across various crypto Chapter 11 proceedings (e.g., FTX, Celsius, Voyager, and BlockFi).²⁶ Chapter 11’s adversary process typically divulges more as the case unfolds. And, in bankruptcies involving particularly troubling facts, the court may compel the appointment of an examiner to deliver a “tell-all” report, as it did in two crypto cases (Cred and Celsius)²⁷ and is poised to do in FTX.²⁸ This emphasis on disclosure can meaningfully promote management accountability and, in turn, help ward away bad C-Suite behavior. In the Celsius case, for instance, the 689-page examiner’s report presented a damning account of the company’s historical business practices.²⁹ The report presaged, and likely contributed to, the Celsius CEO’s eventual indictment and arrest, which occurred only a few months after the report’s publication.³⁰

Bankruptcy disputes also deliver poignant teaching moments for government overseers and the wider public. For instance, a value allocation contest in the Celsius bankruptcy––pitting depositors in interest-bearing accounts against depositors in “wallet” accounts––revealed just how fragile customer ownership rights can be when deposited crypto-value exists in digital and legally ambiguous form.³¹ Customers came to learn that, contrary to marketing promises,³² the cryptocurrency ceased being legally “theirs” upon deposit in interest-bearing accounts. That is, customers were deemed to be merely unsecured creditors in the bankruptcy case, left to fight for scraps near the bottom of the priority ladder.³³ The bankruptcy court, in so ruling, not only resolved a critical case issue, it also delivered a hard truth to crypto customers: entrusting savings to an unregulated crypto exchange or “bank” comes with serious risks, given that these companies are not well policed for fraud and that customer savings lack conventional protective mechanisms, like federal deposit insurance.³⁴ Such lessons can be unsparing, yet also clarifying about the economic and legal vulnerabilities faced by crypto customers––who, en masse, were tempted by tantalizing marketing promises but ultimately found themselves exposed to inherently complex, opaque legal and economic risks.³⁵ By highlighting the traps, bankruptcy courts direct agency attention to acute public vulnerabilities, hopefully motivating regulators to develop the kind of customer protections that have long existed in more traditional marketplaces (e.g., securities or commodities markets).³⁶

As a concluding observation on this point, we show how bankruptcy represents a forum where regulatory agencies can press specific policy objectives in advance of a new statutory framework and without facing the usual set of political/rulemaking constraints and ramifications. Regulators have some leeway to inject themselves into bankruptcy proceedings, promoting an agency’s policy priorities.³⁷ The SEC and the federal government, for example, intervened in Voyager’s Chapter 11 case to object to its proposed sale to Binance.US, the American affiliate of Binance––the world’s largest crypto exchange, by volume.³⁸ The government contended that the proposed Chapter 11 sale came with serious regulatory problems, suggesting that Binance.US may not be a fully law abiding corporate citizen and that distributions to Voyager creditors (via Binance.US) might violate securities laws.³⁹ The government’s arguments floundered in court,⁴⁰ but its highly public attack effectively terminated the transaction.⁴¹ This case study illustrates how agencies can, with efficiency, produce regulatory impact when the target of their action falls under the bankruptcy court’s stewardship.

Nevertheless, in our third contribution, we observe that reliance on bankruptcy courts to perform regulatory functions comes with serious shortcomings. Bankruptcy courts are tribunals of limited jurisdiction, and their powers are localized to the specific debtor and its stakeholders, not the public welfare more generally.⁴² They are, in turn, intended to work in tandem with functioning regulatory arms of government; they are not supposed to assume their oversight responsibilities.⁴³ These courts are particularly ill-equipped to address risks arising from an interconnected and multifaceted financial market, especially in a prophylactic way.⁴⁴ Stated differently, corporate bankruptcy is not structured to expressly entertain regulatory imperatives, like stopping financial calamity before it happens or ensuring that a firm’s distress does not trigger systemic contagion within the wider market.⁴⁵

Further, Chapter 11’s legal and normative rules––focused on maximizing each debtor’s distributable value, allocating that value among stakeholders, and where possible rehabilitating the broken business––are not friendly to outsiders, even government outsiders seeking to advance public policy aims.⁴⁶ Competition between economic and regulatory agendas can, in fact, lead to value-deteriorating outcomes, such as dooming Voyager’s sale to Binance.US, contrary to bankruptcy’s primary mission. Even concerning matters of disclosure, the objective is case-specific (e.g., maximizing and allocating estate value) and often strategic in nature (e.g., the debtor’s desire to remain in possession of estate assets), not to obviate risk in the industry generally.⁴⁷ In some cases, the court may not favor augmented public disclosure if doing so may be prohibitively costly or where greater public disclosure threatens an orderly Chapter 11 process.⁴⁸ This may explain why examiner reports were commissioned in the Cred and Celsius cases, but not in the FTX case (that is, until compelled by the Third Circuit Court of Appeals).⁴⁹ Stated simply, even as bankruptcy is (by case necessity) doing important regulatory work, it is far from its natural functionality and is an inherently inadequate substitute for administrative agencies whose mandates include establishing a set of robust, lasting, and standardized rules that protect marketplaces both in peacetime and in crisis.

This Article proceeds as follows. Part I describes the cryptocurrency ecosystem and the challenges of establishing regulatory perimeters for this emerging asset class. Even though regulators have struggled to develop rules-of-the-road for the digital asset industry, this Part highlights some key risks (e.g., systemic risk, information deficits, and user vulnerability) that are commonly cited to justify the application of traditional financial regulation. Part II explains how Chapter 11 has been drafted into quasi-regulatory service to help clean up the mess enabled by crypto’s sparse regulatory environment. This Part illustrates how bankruptcy court oversight has generated a slew of benefits, with the potential to promote insight, expertise, clarity, and good governance. Part III explores the fuller implications of bankruptcy serving quasi-regulatory functions. It shows that, despite all their good and hard work, bankruptcy judges are imperfect overseers for the crypto marketplace. Not only do they lack the statutory directive and powers to address market risks, their decision-making is further limited by the estate-specific focus of bankruptcy’s adversary process, the case-specific nature of bankruptcy disclosures, as well as general inexperience in addressing complex, esoteric, and systemic financial risks––especially risks arising outside prevailing regulatory frameworks. Relying on bankruptcy courts for quasi-regulatory assistance, instead of technocratic rulemaking, is thus profoundly problematic, as Part IV concludes.

I. CRYPTO’S MISSING REGULATORS

Despite acquiring popular appeal and developing a sophisticated array of financial services and products, the market for cryptocurrencies has come of age largely outside of a comprehensive system of regulation.⁵⁰

papers.cfm?abstract_id=4405036 [https://perma.cc/S8C4-TN4B] (discussing the legality of “regulation by enforcement” and exploring why agencies rely on this approach, alongside the trade-offs of doing so, especially in the context of using litigation to test novel/ambitious applications of law to innovation). There are many reasons to explain this historical gap in oversight. For one, the asset class is legally complex, with agencies, most notably the SEC and CFTC, publicly at odds over which of them has authority.⁵¹ In other words, jurisdictional wrangling is underway over whether some or all crypto-assets ought to be legally defined as securities (the purview of the SEC) or commodities (the purview of the CFTC)––this determination being critical to situating crypto within existing bodies of securities and commodities regulation. Additionally, digital assets are far from monolithic in their design, with different types of tokens implicating different kinds of risks and entitlements: more decentralized and volatile cryptocurrencies like Bitcoin, for example, operate distinctively from so-called stablecoins, digital assets typically attached to an identifiable issuer and designed to maintain a steady one-token-to-one-dollar correspondence.⁵² Even while navigating such definitional challenges, digital assets raise intriguing considerations for policymakers looking to calibrate their supervisory toolkit, such as: how should domestic national authorities oversee risks arising across decentralized, globally dispersed blockchains; and, do existing administrative processes suffice, or might regulators benefit from crafting tailored solutions to match novel attributes of the asset class (e.g., decentralization)?⁵³

This Part has two objectives. First, it summarizes key features of crypto markets to highlight some of its distinguishing features and risks. Second, it describes fundamental theories of financial regulation that generally explain and justify its application (e.g., to protect financial stability and enhance consumer welfare). This Part shows that crypto markets exhibit the kinds of risks that fall under usual rationales justifying the application of financial regulation. We observe, however, that the crypto market has evolved largely outside of a dedicated system of financial regulation, leaving it intrinsically vulnerable to costly externalities and failure.

A. Some Key Features of Crypto Market Structure

Broadly, the cryptocurrency market is made up of three major parts: (1) at its most fundamental, it originates within globally dispersed computer networks that work to produce a “distributed ledger” (or blockchain) recording the transactions submitted to and verified by each network; these automated networks often mint digital tokens/coins as a means of rewarding users that work to maintain the system’s integrity;⁵⁴

click&module=RelatedLinks&pgtype=Article [https://perma.cc/P7DL-YD3C]; Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, Bitcoin.org 2–4, https://bitcoin.org/bitcoin.pdf [https://perma.cc/HFX5-DAWH]. (2) various types of more centralized firms like cryptocurrency exchanges and quasi-banks that intermediate access to cryptocurrency assets (e.g., coins) and offer related financial services and products;⁵⁵ and (3) a slate of digital applications aiming to offer financial products in a more decentralized manner, harnessing the verification capacity of blockchain networks. These applications derive their utility by running automated programs (colloquially, “smart” contracts), rather than relying on centralized firms like exchanges or banks to provide an intermediary service.⁵⁶ A detailed discussion of each of these component parts is outside the scope of this Article. However, the summary below outlines some of their defining characteristics (and risks).

1. The Building Blocks: Chains, Coins, and Ledgers

The origin story of modern-day cryptocurrencies emerges from the Bitcoin white paper, written by Satoshi Nakamoto, that sets out a vision for an entirely digital payments network capable of operating globally on a person-to-person basis.⁵⁷ Its radicalism lies in envisioning the creation of a payments system that does not look to centralized intermediaries like banks to validate flows of money, nor does it presuppose the power of the state to enforce bargains or maintain the integrity of the system. Instead, it conceptualizes an infrastructure for making payments that depends on a network of computers, running a common protocol, to verify and record transactions. In place of a bank checking key details (e.g., whether the sender has enough money in his account) or regulators monitoring transactions, these tasks are approximated by the application of computerized code. By running the Bitcoin protocol, participating networks of computers (“nodes”) apply verification rules that examine incoming transactions to check whether they conform to the protocol’s standards of accuracy and integrity. Once nodes agree, by consensus, that a transaction is valid, it can be accepted, processed, and written into the protocol’s “ledger.” Transactions are batched into blocks and presented for validation, a practice that has given rise to the nomenclature of the “blockchain.” Unlike a bank payment, which remains confidential between the parties and the bank, the ledger is public and verifiable. This transparency is supposed to provide a mechanism whereby external scrutiny constitutes a means of interrogating whether the system is running in a safe and trusted way (e.g., that the same coins are not being sent twice or double spent).⁵⁸ Once accepted and validated, transactions are generally irreversible. This aspiration for immutability provides a proxy for certainty and reliability within the system, where it is not subject to idiosyncratic changes by one or another player.⁵⁹

2021), https://medium.com/coinmonks/finality-in-bitcoin-f82890bf39b7 [https://perma.cc/ZHD7-NJLB] (noting that finality on the Bitcoin blockchain is probabilistic).

The “coins” underlying the Bitcoin blockchain speak to digital rewards given to those that work to safeguard the network. Within Bitcoin, the dispersed network of nodes is vulnerable to the risk that a node (or a group) turns malicious––seeking to disrupt its function or to use it for its own benefit (e.g., by only proposing transactions that are sent to accounts connected to operators of a malicious node).⁶⁰ To secure the network’s integrity, the blockchain looks to a system of “protectors” tasked with looking into the pool of transactions entering the system and picking those for approval that should meet the protocol’s standards.⁶¹

The network creates incentives for participants to become “protectors” by awarding “coins” to those that succeed.⁶² In the Bitcoin network, “protectors” can also collect any discretionary fees that users might attach to a transaction.⁶³ Bitcoin looks to a “proof of work” validation mechanism, where network protectors––or “miners”–– competitively deploy extensive computing power to solve a mathematical challenge. A winning miner then builds a block of transactions for the network to approve and receives new Bitcoin (and fees) for their effort.⁶⁴ The “proof of stake” validation mechanism is also common across major blockchains (e.g., Ethereum). Broadly, in a proof-of-stake blockchain, those that already have a number of coins in the system can win the chance to build the block and collect more coins (and fees) as rewards.⁶⁵

While this description is highly simplified, it serves to highlight some legal puzzles confronting regulators. Major blockchain networks, like Bitcoin or Ethereum, are global and open to anyone, anywhere, willing to download and run the relevant protocol on their computer.⁶⁶ Additionally, users do not give their real-world names in order to join, as they would when using a bank. Instead, users are known and accounted for on a blockchain by their “public keys,” a form of pseudonymous public handle, that links to a private password known to the user.⁶⁷ If a user loses her password, she cannot access her account or make and receive payments, meaning that value on the network is lost.

This globally distributed system, designed to operate outside of traditional private and public intermediation, presents unusual regulatory conundrums. How should U.S. regulators construct a system of rules capable of applying to an automated cross-border network that aims to avoid centralized governance and control altogether? What tools can regulation deploy to overcome information gaps, address potential misconduct, or costly fragilities existing within a blockchain’s operation?⁶⁸ And, what legal classification ought to apply to coins minted on blockchains: do they constitute securities or commodities under conventional stipulations of federal law, extending existing regimes to crypto assets; or, do they fall under an entirely different, more tailored legal category?

As such, while market regulation is usually equipped to accommodate innovation, crypto assets have come to pose a significant challenge.⁶⁹ For example, the definition of innovative kinds of security––as covered by the concept of an “investment contract” in the Securities Act of 1933––was elaborated by the 1946 case of SEC vs. Howey. Per Howey, a security is a claim that represents: (1) an investment of money; (2) in a common enterprise; (3) for profit; and (4) through the effort of others, where those that promote an investment exercise managerial control over any scheme.⁷⁰ A discussion of the jurisprudence born out of Howey is outside the scope of this Article. But concepts like “common enterprise” or “through the efforts of others” signal the difficulties confronting policymakers when seeking to apply conventional precepts to cryptocurrencies and their blockchains. Emphasis on miners/stakers extracting higher returns relative to other network participants, for example, sits uneasily with long-rooted notions of a horizontal common enterprise. The task of identifying promoters with managerial powers strains in the context of public blockchains that seek to structure themselves in ways that look to be deliberately diffuse from a governance standpoint and where self-help constitutes a basic rule-of-thumb.⁷¹ With these thorny definitional questions key to establishing how regulators legally assert authority in the first place, it is not surprising that debates on the issue have become contentious as between regulators themselves, each seeking to jostle for their agency to have primary jurisdiction.⁷² This administrative squabbling has arguably played an important part in delaying the production of a comprehensive system of rulemaking for digital asset markets, leaving them to evolve largely outside of everyday administrative oversight.

2. Centralized Finance in Crypto Markets

As much as decentralization is popularly perceived as the distinguishing feature of cryptocurrencies, the everyday experience of digital asset markets for many is often intermediated through “centralized finance.” Engaging with sophisticated blockchains, setting up public keys, protecting their private passwords, or learning technical specifics of the computing involved can act as a barrier to entry for the average person looking to enter the crypto market. Finding a party through which to buy and sell crypto on a blockchain might similarly be impractical for those unfamiliar or uncomfortable with searching online for brokers.

So-called “centralized finance” firms have emerged as essential conduits for mitigating these difficulties and increasing crypto’s appeal for the mainstream. Exchanges, in particular, have established themselves as organizing architecture for the crypto markets, bringing together volumes of institutional and retail users, developing a variety of financial products, and helping to popularize the asset class for everyday people.⁷³ By connecting to users through smartphone apps, advertising on prime time television slots (e.g., the Superbowl), and using top-flight celebrity endorsements, crypto exchanges like Coinbase, Binance, Kraken, and infamously, FTX have established a prominent position both within crypto as well as financial markets more broadly.⁷⁴

Exchanges deploy established market structure tools to connect cryptocurrency buyers and sellers. By creating an organized marketplace, users no longer have to worry about seeking out a counterparty privately within an ecosystem of pseudonymous users who could be located anywhere in the world. The need for self-help is also reduced. Centralized firms provide a known point of contact, capable of correcting problems (e.g., hacked accounts), as well as offering users compensation and recourse if they suffer damage.⁷⁵ Unlike public blockchains that demand that their users be capable of looking after their own interests or dealing with the consequences (e.g., irreversible transactions), exchanges offer services to facilitate uptake of cryptocurrency trading (e.g., by offering loans for trading, custody services, or educational resources). By reducing the transaction costs and building avenues for accessible participation, exchanges have introduced everyday users to cryptocurrency markets. Tellingly, leading exchanges were drawing in eye-catching trading volumes during most of 2021––the cryptocurrency market’s boom year. Binance, for example, intermediated around $7.7 trillion in trading over 2021, reportedly generating $20 billion in revenue.⁷⁶ FTX, founded in 2019, saw its valuation grow over 1000% in the course of 2021 to around $1.1 billion, soaring to $32 billion by 2022––before collapsing into insolvency in November 2022 and liqudidation in January 2024.⁷⁷ Even as trading volumes fell sharply with the onset of “crypto winter” and FTX’s failure, crypto exchanges remained financially significant for the digital asset ecosystem. In its first quarter earnings report for 2023, Coinbase reported revenues of $773 million, up 23% from the final quarter of the previous year.⁷⁸ In April 2023, Binance saw sharply reduced activity, losing almost 50% in trading volume, while still recording approximately $287 billion in trading activity for the month.⁷⁹

In addition to exchanges, centralized finance includes firms performing a variety of financial services (e.g., lenders, hedge funds, broker-dealers, and specialist traders). Cryptocurrency deposit/lending and investment firms, in particular, have assumed considerable importance. Crypto quasi-banks, for instance, took in vast sums of customer capital/crypto––offering lucrative interest rates on these deposits––and for a shot time profited handsomely by relending those deposits. Predictably, as the crypto markets suffered a sharp downturn in 2022, these entities were hit especially hard with loan defaults and collapsing collateral prices, pushing several of the more prominent quasi-banks into bankruptcy.⁸⁰

Take Celsius. Founded in 2017, Celsius billed itself as a way for everyday people to “unbank” themselves––meaning, exiting the traditional banking system and putting money into a vehicle that promised depositors tantalizing returns. At its height, Celsius marketed investments that would pay as much as 18% interest on customers’ crypto deposits. Given such dazzling promises, the firm ended up controlling assets of around $20 billion, reaching 1 million or so customers.⁸¹ Its business model relied on putting customer assets into high-yield, high-risk investments. The value of these investments eventually plummeted with the onset of “crypto winter” in May 2022. Owing approximately $4.7 billion to its customers and unable to make good, Celsius filed for Chapter 11 protection.⁸²

Genesis Global, alongside two of its lending subsidiaries, also found itself in Chapter 11 in January 2023. Genesis, too, functioned like a quasi-bank; it took in customer deposits, offering high interest rates, and redeployed those deposits as loans extended to other industry players, like hedge funds.⁸³ With a loan book totaling around $12 billion in 2021, Genesis found itself in a vulnerable position with the onset of “crypto winter”: first, it lent $2.4 billion (partially collateralized) to the defunct crypto hedge fund, Three Arrows Capital, that collapsed in Spring 2022; and, second, it lent hundreds of millions of dollars to FTX’s affiliated hedge fund, Alameda Research, which imploded a few months later.⁸⁴ The mounting losses, alongside larger struggles in the crypto market, contributed to Genesis entering into Chapter 11.⁸⁵

Centralized firms have come to exercise enormous economic influence within the cryptocurrency marketplace.⁸⁶ As exemplified by the likes of FTX, Celsius, and Genesis, centralized firms routinely hold deep pools of crypto capital and convene a crowded and diverse range of stakeholders within their institution.⁸⁷ This capacity to build scale and complexity within a purportedly decentralized marketplace is hardly accidental. As noted above, centralized firms often offer a range of services and conveniences that bypass many of the novel and technically quirky facets of crypto market structure.⁸⁸

The far-reaching pull of centralized platforms within crypto has given rise to sources of vulnerability, creating risk for everyday users and market integrity. For example, platforms routinely require customers to transmit the password to their crypto “wallets” to the venue.⁸⁹ Practically speaking, by taking custody of user passwords (or “keys”), the venue is able to move the user’s crypto into accounts (i.e., the “wallets”) that it (the platform) controls, meaning that assets can be pooled and placed by the venue into various onward investments. With the platform holding the customer’s passwords, users confront the risk that they lose control of––and, indeed, potentially even legal title to––their own assets.⁹⁰ Because crypto’s foundational design assumes that those that hold the password to an account constitute its owners, a platform’s custodianship can leave customers suddenly bereft should the platform fail or end up losing the passwords for whatever reason (e.g., a theft or fraud).⁹¹

From a broader structural standpoint, the ability of centralized firms to pool and deploy capital has resulted in the creation of fragile interconnections between various types of market participants. Described above, exchanges and firms like Celsius and Genesis have emerged as prolific investors, putting customer capital into various crypto ventures. Such investments have taken the form of loans––where funds have made their way into crypto-lending arrangements promising (sometimes) double-digit interest rates (e.g., Celsius). BlockFi, for example, found itself in Chapter 11 after making bad loans to failed hedge funds, Three Arrows and Alameda.⁹² But, they can also comprise equity investments. That is, platforms put capital into the riskiest slice of the corporate balance sheet in a bid to secure potentially unlimited upside should the venture succeed. Exchanges, for example, have emerged as active investors in start-ups. FTX, notably, collapsed holding an eclectic balance sheet comprising crypto as well as more mainstream equity investments, reportedly worth around five billion dollars at the time of its failure.⁹³ Seen as a whole, centralized finance firms have shown themselves to be economic lynchpins of the crypto ecosystem, creating close financial linkages between themselves, their customers, as well as any number of stakeholders through often opaque, complex investments. Such relationships have resulted in regulators confronting a broad tangle of interconnected exposures, where risks from one entity can be transmitted to other firms, and ultimately to everyday customers, resulting in potentially heavy economic fallout whose permutations are not understood ex ante and cannot be easily remedied ex post.

B. Rationales for Regulation in Crypto and Finance

Though crypto markets have evolved mostly outside of the regulatory perimeter, they showcase a number of features that have traditionally proven persuasive in anchoring oversight for financial markets: (1) vulnerability to systemic risks; (2) information asymmetries; and (3) customer and investor protection. While a full discussion examining theoretical grounds justifying financial regulation is outside the scope of this Article, the observations below demonstrate that the relative absence of oversight in crypto markets represents a costly gap out-of-step with established paradigms in financial market design.

1. Mitigating Systemic Risks

Traditional financial regulation is often justified by reference to the importance of reducing “systemic” risk.⁹⁴ The task of defining systemic risk, in practice, has proven to be notoriously slippery.⁹⁵

153927406281.pdf [https://perma.cc/MH65-GS8B] (noting the role of interconnectedness in the definition of systemic risks); Morgan Ricks, The Money Problem: Rethinking Financial Regulation, 52–77 (2016) (highlighting short-term run-risks within the unregulated money market sector as a key indicator of systemic risks, justifying financial regulation). Particularly in the shadow of the 2008 financial crisis, the capacious intervention of the federal government to backstop the safety of financial markets pointed to a concept whose parameters might only become clear ex post, when failure illuminates sources of previously unknown but intolerably high risks within the marketplace. Even as banking regulators invoked an emergency “systemic risk” exception to fully protect deposits at two fairly large but relatively niche banks in March 2023 (Silicon Valley Bank and Signature Bank), the ensuing debate surrounding the need and propriety of such interventions has only served to underscore the tricky boundaries of conceptualizing systemic risk and what regulators ought to do about controlling it.⁹⁶

Notwithstanding these definitional difficulties, containing systemic fallout has long been a critical objective of financial regulation. Broadly seen, it references two core scenarios. The first scenario is one in which a firm’s behavior leads it to take risks that result in it creating dangers that can spread far beyond its own four walls. In other words, a risky, failing firm lacks the resources to pay for its own behavior, forcing others to bear the losses, risking collapse themselves. The second scenario is where a shock to the market (e.g., a pandemic) causes similarly situated firms to face potential distress, resulting in crisis impacting multiple firms simultaneously.⁹⁷ Simplifying things, certain kinds of firms have traditionally been viewed as being especially susceptible to failure, with the potential to trigger a larger crisis. Specifically, firms vulnerable to sudden runs––for example, they owe money short-term and may have invested it in longer-term ventures––can face catastrophe if creditors seek to take out their money all at once. This can force a firm to sell its longer-term investments at distressed prices, plunging its balance sheet into the red, as assets end up fetching less than the money it owes. Conventionally, banks represent the quintessential purveyors of such run-risk. Their depositors constitute short-term (on-demand) creditors, while their assets typically take the form of longer-term loans. But, exemplified by the wide-ranging rescue of institutions like money market mutual funds in 2008, other types of firms and markets can become vulnerable to sudden crises, setting-off the possible specter of systemic collapse.⁹⁸

Regulation normally wields a range of tools to prevent such crises from occurring, as well as to respond to them when they do. Ex ante levers can include, for example, mandatory requirements on vulnerable firms to maintain buffers of high-quality assets that make a firm safer and less likely to end up without money.⁹⁹ Firms might be subject to regular “stress tests,” designed to interrogate how well they might withstand a sudden shock.¹⁰⁰ Federal insurance might prevent customers from panicking and rushing for the exits, where the state stands behind the promises made by a financial firm. U.S. bank accounts, notably, are protected by insurance that promises to cover up to $250,000 worth of deposits.¹⁰¹ Expert monitoring by regulators can help spot and punish the kinds of risky behaviors that might lead to a crisis and loss of customer confidence.¹⁰² In turn, ex post tools can also mitigate harm as and when they arise. Regulators might step in with emergency loans. The Federal Reserve, for instance, offers banks a “lender of last resort” facility, providing bridge lending during difficult times.¹⁰³ In extreme cases, liquidity support can take the form of federal facilities set up with the specific purpose of prioritizing systemic stability, even if such rescues protect firms that otherwise deserve to fail.¹⁰⁴ Or, if there is no prospect of a rescue, a specialist insolvency regime can step in to wind down a failing institution before its collapse can contaminate the rest of the market. In the context of banking, the Federal Deposit Insurance Corporation¹⁰⁵ operates a resolution regime for failed banks, designed to ensure that their loans and deposits can be transferred to viable firms without lengthy bankruptcy regimes that might leave depositors in limbo.¹⁰⁶

Crypto markets have shown themselves capable of inhabiting an ecosystem where systemic risks can manifest in a number of ways. First, as highlighted above, it is home to a number of centralized firms that constitute singularly important points of failure. Crucially, these firms have tended to become interconnected to a web of stakeholders, creating transmission pathways for losses to flow from one institution to another. FTX offers perhaps the most compelling example of such entanglement, where its sudden failure caused firms like BlockFi and Genesis also to seek bankruptcy protection.¹⁰⁷ Several traders failed too, as they were unable to retrieve their deposits from the FTX the platform.¹⁰⁸

Second, major centralized firms have shown themselves exposed to the costs of sudden runs, where customers seek to retrieve their funds en masse resulting in the platform suffering a cash crunch. FTX is again case in point, experiencing a wave of redemption requests from fleeing customers, eventually causing the firm to pause withdrawals.¹⁰⁹ Celsius, too, is instructive. According to a study by the Federal Reserve Bank of Chicago, 35% of all withdrawals in June 2022 (just before Celsius filed for bankruptcy protection) came from relatively wealthier depositors–– customers each with crypto worth more than $1 million in their accounts.¹¹⁰ Those holding $500,000 ended up being the fastest to retrieve their money. Put differently, larger institutional customers, likely possessing financial sophistication and reasonably roomy balance sheets, were among the most liable to trigger a panic. And, by dint of their size and resources, their private instincts to run resulted in a cost on those that could not adjust their behavior as quickly (i.e., less wealthy customers).¹¹¹

Unlike traditional markets, however, exposure to run-risk has come without the usual ex ante and ex post levers that might mitigate panic and control the costs of fallout. Even as a swath of crypto market participants––retail as well as institutional actors––faced the prospect of devastating losses, they lacked recourse to protections taken for granted in traditional financial markets (e.g., federal deposit insurance).

2. Addressing Information Gaps

A second key objective of financial regulation lies in addressing information gaps and the costs that they pose.¹¹² This involves ensuring that regulatory supervisors as well as market participants can acquire insight about the riskiness of claims and assets alongside an understanding of the institutions that operate within the perimeters of financial and capital markets. In seeking to intermediate the informational environment, policy can also seek to create ways in which thorough due diligence becomes less important, for example, where the claims being issued are presumed to be so safe that detailed investigation would be a waste of time and money.¹¹³ Broadly seen, regulation can work to provide tools and create incentives for reducing information costs, improving the accuracy by which risk is priced. It can help firms and investors protect themselves by equipping them with insight as well as offer spaces for creating informationally-insensitive claims, contracts that do not need a great deal of due diligence owing to their perceived safety, connecting parties in situations that might otherwise showcase complexity, and unknowable risks.¹¹⁴

perma.cc/2ZHA-GLDT] (highlighting varying interpretations of the notion of information insensitivity). A full discussion of this interplay between information deficits in markets and regulation is outside the scope of this Article. A few examples, however, serve to underscore how foundational this relationship is for shaping key aspects of market design.

First, regulation can help ensure that the marketplace enjoys a baseline level of insight about key claims and assets. When a company issues equity or debt in public markets, the worth of the promised cash flows emerges through an understanding of the capacity of the firm to deliver on its promises. At a very general level, whether and how it can do so constitutes a function of many aspects of its enterprise, such as its organization, governance, business model, and industry. This multiplicity of factors helps shape the kinds of results that a firm can achieve and, ultimately, what kinds of future cash flows investors and other stakeholders might expect to receive.¹¹⁵

Regulation has stepped in to overcome some of the frictions that might cause actors to withhold information about their firm. As modeled by Sanford Grossman and Oliver Hart, disclosure can be excessively costly for a firm, creating a disincentive for revelation. It also might expose a firm to outside scrutiny, give away competitive secrets, or highlight managerial failures.¹¹⁶ At the same time, where the firm constitutes the most knowledgeable repository of its own activities, the chances that single investors (or even regulators) might be able to obtain information efficiently about and from it are slim, if not outright impossible. Everyday investors will not be able to muster the resources, or obtain the access needed, to acquire key details of the risks governing their claim. Even deep-pocketed institutional investors may be loath to share the fruits of their labor, forcing others to replicate the same research and analysis that might still be incomplete.¹¹⁷

Where firms have few incentives to distribute information freely, regulation can mandate full and honest disclosure. In seeking to punish those that fail to disclose or lie, regulation modifies the incentives against putting information into the marketplace. Such broad and freely available distribution of prized information affords all investors access to this knowledge, reducing the pressure on their own pocketbooks and minimizing the risks of duplicative investigation. Rather, investors might focus on honing the quality of their analysis, making money, or deriving some other gain by bringing new interpretations of the disclosures to the fore.¹¹⁸ In this way, investors can learn about the kinds of risks that they are carrying in a relatively systematic and thorough manner. They can protect themselves by charging more for their capital, taking other precautions (e.g., putting only so much at risk as they are willing to lose), and ensuring that their prior biases and expectations are better kept in check.¹¹⁹

In addition to ensuring information about claims, regulation provides ways to increase understanding about entities within the marketplace. Regulators benefit from knowing whether entities that are active within financial markets can do so safely and have the resources to fulfill their obligations to stakeholders (including customers). This also entails supervisors knowing that firms can look after themselves, with sufficient and accessible resources to pay creditors and to reduce the systemic risks they create for others.¹²⁰ In place of enabling a free-for-all, allowing anyone to set-up shop, regulation imposes stipulations designed to procure detailed information from a firm. For example, eligibility criteria demand that those seeking to do business satisfy entry conditions concerning internal corporate governance, balance sheet capacity, and customer protection.¹²¹ Supervisors can conduct examinations on a regular basis to assure themselves that the firm conforms to expected rules and standards. Enforcement actions offer regulators and others a mechanism to learn more about an entity generating suspicion (e.g., via discovery).

Finally, regulation can control information gathering and dissemination to account for some of the costs and effects of disclosure. In particular, regulation can determine who gets data, how fully, at what speeds, and at what time intervals. Even where transparency constitutes a valuable policy goal, full openness to the inner workings of complex institutions can, in some situations, constitute a risk in itself. For example, regulators are typically careful about how much information is publicly disclosed about banks (e.g., through stress tests or supervisions).¹²² Revelations about a bank’s balance sheet might foster panic where information ends up interpreted by the public as presaging a collapse, triggering a needless run on the firm.¹²³ Relatedly, developing disclosure regimes can also look to policies in which the goal lies in ensuring that relationships do not have to require detailed disclosure between parties. For example, where money is lent on a very short-term basis and fully collateralized, lenders have less need to invest in uncovering information on a borrower. Instead, this debt becomes more informationally-insensitive, allowing for credit to flow more quickly, with fewer formalities, and still providing for risk mitigation by the terms of the debt agreement.¹²⁴

Limited comprehensive regulation for cryptocurrency markets has thus resulted in a relative paucity of tools for addressing the need to create information about the quality of claims being traded and market participants.¹²⁵ Interestingly, crypto represents a unique mix between the transparent and opaque. On the one hand, it is defined by its reliance on blockchains, which intend to provide the ultimate in transparency––by ensuring that each transaction is readily inspectable¹²⁶––as described above.

On the other hand, crypto’s larger ecosystem is opaque, with critical aspects of its workings taking place without adequate standardization and verifiability. For a start, digital assets themselves can exhibit unknown risks for which even the traditional regulatory system can be a poor match. Crypto inhabits an informationally complex environment from the point of view of its technology. As Chris Brummer, Trevor Kiviat, and Jai Massari observe, crypto combines legacy informational deficits (e.g., about a token issuer’s internal governance) with novel considerations about technological riskiness that conventional regulatory paradigms are ill-suited to match.¹²⁷ Without an applicable and properly tailored regulatory framework, token holders must take on the costs of diligence privately. Even where they can get some help (e.g., through “white papers” that typically launch new crypto ventures), a lack of regulatory vetting for these disclosures can result in limited accountability for those producing them.¹²⁸ Exchanges too might demand information from token issuers seeking to list the asset on their exchange. But, even here, the approach is ad hoc and varies by venue, creating a hodge-podge of regimes for customers to try to follow.¹²⁹

Crypto market regulation also lacks tools to acquire information about key market participants. As noted earlier, exchanges are key pillars within the crypto ecosystem. Notwithstanding this significance, considerable uncertainty exists about their inner governance, the quality of their balance sheets, or their readiness to respond in a crisis. According to a May 2023 Financial Times survey of 21 of the most prominent crypto firms, many refused to supply critical information about their governance, measures for customer protection, and balance sheets––underscoring concerns raised in the wake of “crypto winter” failures about opaque and complex governance structures that pose a risk for stakeholders.¹³⁰ In the absence of express disclosure regimes to stipulate eligibility criteria or supervisory regimes to ensure compliance, certain crypto firms appear to lean heavily on opacity as a part of their business model.¹³¹

3. Protecting Customers and Stakeholders

Perhaps the most straightforward rationale for financial regulation lies in protecting customers and stakeholders.¹³² Investors and financial consumers routinely fall prey to scams, display biases and impulsivity, and open themselves up to losses that can result in enormous personal suffering.¹³³

perma.cc/A9GZ-CNJV] (noting the especial prevalence of investment fraud); Sec. & Exch. Comm’n, Social Media and Investment Fraud––Investor Alert (Aug. 29, 2022), https://www.sec.gov/oiea/investor-alerts-and-bulletins/social-media-and-investment-fraud-investor-alert [https://perma.cc/PK5W-ZKDG] (noting the ways in which social media might lure investors in scams). Beyond safeguarding customers against predation, regulation can also step in to secure financial assets and their integrity. Predictably, where vast pools of customer money are entrusted to an agent (e.g., a fund or bank), there is the risk of misuse, misappropriation, and mismanagement. To counter such “agency costs,” regulation provides a slew of measures to safeguard customer interests and counter the negative incentives of those holding money for others.¹³⁴

Arguably the most consequential for a customer’s everyday peace-of-mind are rules designed to ensure that their assets are safely custodied and accounted for, and, where custody arrangements work, to prevent such assets from being mingled with those of the agent (e.g., a broker) in the event of an agent’s insolvency. Customer protection rules in securities and commodities regulation, for example, set out detailed procedures for ensuring that customer assets are diligently protected.¹³⁵ A variety of measures enable such assurance to be offered through regulation. For example, rules governing brokers of traditional securities and commodities provide that customer assets must be fully segregated, so that there can be no mixing between a broker’s funds and those of the customer.¹³⁶ Additionally, the broker must rigorously track how customer assets are being handled and can only entrust them to reputable custodians. To ensure compliance, firms face examination by regulators and must maintain an appropriate paper-trail.¹³⁷ Firms that fall short risk economic penalties and may suffer reputational damage.¹³⁸ Those risks can extend to supervisors, incentivizing more rigorous policing. When the failed brokerage firm, MF Global, was found to have breached applicable rules for protecting and safekeeping customer assets, its frontline regulator (the Chicago Mercantile Exchange) came under heavy scrutiny¹³⁹ and ultimately paid $130 million to the broker’s customers.¹⁴⁰

Crypto customers are subject to similar risks (e.g., being scammed and seeing their funds stolen or misappropriated) but they do not today enjoy specific protections as part of a regulatory scheme. This leaves crypto customers exposed to a slew of dangers that they have little power to mitigate, while being afforded few practical levers under law to safeguard their interests privately. The costs of this regulatory gap have come into sharp focus, as millions of everyday crypto customers fell victim to a series of high-profile firm failures during 2022’s “crypto winter,” leaving them caught in uncertain and costly bankruptcy proceedings, rather than protecting them from these processes in the first place.

II. BANKRUPTCY IN CRYPTO WINTER

Part I charted the limited federal regulatory landscape for the cryptocurrency industry. Post-pandemic, the crypto-market experienced sharp growth and, as a result, there was a period of time during which the digital asset marketplace was flush with customer money and able to operate freely in the relative shadows outside of a dedicated system of oversight. This created, predictably, room for mischievous C-Suite behavior, where billions in customer deposits could be lured with promises of outsized returns (typically adorned with marketing puffery about corporate integrity, transparency, and investment safety) but without providing customers any real capacity (e.g., through mandated disclosures) to know what was truly happening. A series of catalytic events would bring down large segments of the industry in mid-2022, starting the so-called “crypto winter.” Major Chapter 11 filings followed. But, while bankruptcy is used to cleaning up individual corporate messes, it is not the arm of government usually charged with taming unruly facets of a financial system. But, by necessity, that has become an inadvertent aspect of the work performed by bankruptcy courts in seminal crypto cases, as described in this Part below.

A. A Brief History of Crypto Winter

In May 2022, the Terra/Luna stablecoin ecosystem suffered a surprise crash, wiping out approximately $60 billion in value from digital asset markets.¹⁴¹ The hedge fund Three Arrows Capital held significant investments in Luna and, consequently, was immediately forced into liquidation in the British Virgin Islands.¹⁴² This resulted in the default of around $657 million in unsecured debt Three Arrows owed to Voyager, the crypto quasi-bank and brokerage firm.¹⁴³ As word spread, Voyager became inundated with customer withdrawal requests, prompting it to suspend trading and redemptions¹⁴⁴ A week later, Voyager filed for Chapter 11 protection.¹⁴⁵ Contagion also hit Celsius, another crypto quasi-bank. Celsius too was required to pause customer redemptions and withdrawals, ending up in bankruptcy come mid-July.¹⁴⁶ BlockFi, yet a third large quasi-bank, avoided bankruptcy by tethering itself to FTX, securing emergency financing from the then-powerful exchange.¹⁴⁷

On November 2, 2022, a leading news service dedicated to cryptocurrency, CoinDesk, reported (based on a leaked internal document) that the wealth of FTX’s hedge fund affiliate, Alameda Research, was largely comprised of FTX’s native token, called FTT.¹⁴⁸ This crypto asset was issued by the exchange itself and offered to customers, promising holders a variety of rewards like reduced trading fees, loyalty benefits, and miscellaneous customer services.¹⁴⁹ As the exchange’s popularity had grown, so too had the market value of FTT, even though the token’s intrinsic worth was controlled in key ways by FTX management (e.g., by calibrating the available float).¹⁵⁰ Thus, for purposes of determining FTX’s enterprise value, FTT may be better likened to FTX treasury stock than value independent of the corporate entity itself. ¹⁵¹

Prior to this publication, the public did not know the skewed composition of Alameda’s balance sheet. Once disclosed, the market reacted with fury. Binance, for example, promptly announced it would sell all of its FTT holdings.¹⁵² Watching its enterprise value plummet, FTX immediately offered to sell itself to Binance––which alone seemed financially positioned to catch the company in free-fall.¹⁵³ After some cursory due diligence, Binance passed on the offer,¹⁵⁴ thickening the cloud of suspicion hovering over FTX. Nine days after CoinDesk’s publication, FTX collapsed into bankruptcy.¹⁵⁵ Restructuring specialist John J. Ray III was appointed to succeed Bankman-Fried as CEO, and Ray promptly declared that, in his “40 years of legal and restructuring experience,” he had never seen “such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”¹⁵⁶ Bankman-Fried was soon arrested.¹⁵⁷

FTX’s sensational collapse deepened 2022’s “crypto winter.” The token native to Crypto.com, another large exchange, lost $1 billion in market value virtually overnight.¹⁵⁸ BlockFi, facing another round of withdrawal demands, liquidated all of its domestic crypto portfolio and filed for Chapter 11 protection.¹⁵⁹ Core Scientific, one the largest crypto mining firms, also filed for bankruptcy.¹⁶⁰ Genesis, the brokerage firm, lasted outside of bankruptcy only until mid-January 2023,¹⁶¹ as discussed above. Smaller and ancillary crypto companies succumbed as well.¹⁶²

On January 31, 2023, the court-appointed examiner in the Celsius Chapter 11 case filed her final report.¹⁶³ Purportedly, Celsius too operated in a deceitful manner: “In every key respect—from how Celsius described its contract with its customers to the risks it took with their crypto assets—how Celsius ran it [sic] business differed significantly from what Celsius told its customers.”¹⁶⁴ On July 13, 2023, the company’s founder and CEO, Alex Mashinsky, was arrested and charged with seven criminal counts, including securities and wire fraud.¹⁶⁵

The rash of bankruptcies and revelations of customer deception––following patterns that overlap across companies––began infusing popular culture. Late night television hosts turned crypto headlines into crypto punchlines.¹⁶⁶ The FTX logo was removed from the Miami Heat’s stadium.¹⁶⁷ Consumer fraud claims were filed against not only crypto executives but also celebrities that had provided paid endorsements.¹⁶⁸ Charlie Munger, Berkshire Hathaway’s venerable chairman, declared the cryptocurrency market to be “stupid and evil” and that digital assets are only useful to “kidnappers.”¹⁶⁹ Both chambers of Congress began a series of hearings focused on, among other things, what the government should do to rein in the perceived lawlessness.¹⁷⁰ But, neither Congress nor traditional regulatory arms of government (e.g., SEC and CFTC) seized the moment, essentially deferring to bankruptcy courts to assume immediate responsibility.

Chapter 11 thus became the default legal framework, overseeing not only the affairs of each individual debtor but also, seemingly, the trajectory of the industry more generally. Millions of individual customers had entrusted tens of billions to debtors that, collectively, controlled a substantial share of the ecosystem. How could all of this have happened? What kinds of value-maximizing strategies would be available to resolve these cases and deliver real value to customers as quickly and efficiently as possible? And how could bankruptcy’s recuperative powers help an industry in tumult, with government agencies still competing for jurisdiction, and a regulatory void still in existence? This simultaneously became the charge of several bankruptcy courts, primarily in New York, Delaware, and New Jersey. But, to better understand their particular case work, it first must be contextualized through the lens of Chapter 11’s general missions and mechanisms.

B. A Primer on Chapter 11’s Missions and Mechanisms

Chapter 11’s baseline theory is that business reorganization is preferable to liquidation.¹⁷¹ Rehabilitating productive, albeit insolvent, firms can generate more distributable value.¹⁷² It insulates contagion by preserving and continuing customer/vendor relations, jobs, retiree benefits, and future tax payments.¹⁷³ Reorganization also helps solve the so-called “common pool” problem––that is, the tendency of competing creditors to destroy value by racing to take before all others––by channeling stakeholders toward a durable system that prioritizes distributable value (e.g., equity in a reorganized entity) over distributable cash.¹⁷⁴ And, it provides legal rules that are not only flexible but also sophisticated about emerging economic and market theories,¹⁷⁵ as exemplified by developments in distressed debt financing and investment techniques.¹⁷⁶

The Bankruptcy Code, for all its size and complexity, boils down to five essentials: (1) the creation of the bankruptcy estate;¹⁷⁷ (2) the statutory pause and protective blanket of the automatic stay;¹⁷⁸ (3) interim steps a debtor may take to maintain and hopefully augment enterprise value, such as entering into a new financing arrangement (“debtor-in-possession” or “DIP” financing)¹⁷⁹ and the rejection of burdensome contracts and leases;¹⁸⁰ (4) rules governing value distribution to stakeholders, typically via a confirmed plan of reorganization;¹⁸¹ and (5) the debtor’s entitlement to lead the bankruptcy,¹⁸² subject to an effective adversary process.¹⁸³ The outcome is, in theory, supposed to distribute reorganization value largely consistent with stakeholder expectations established pre-petition under contract and other non-bankruptcy law.¹⁸⁴

The Bankruptcy Code does not look much further than the interests of the debtor and its stakeholders.¹⁸⁵ It provides a list of options available for the debtor to try to solve its financial woes; and, it offers rights and empowerments enabling stakeholders to counter or even undermine the debtor’s intended reorganization strategy.¹⁸⁶ The debtor is required to continue post-petition as a law-abiding corporate citizen¹⁸⁷ and the government’s police powers are excepted from the automatic stay.¹⁸⁸ But, the “general public interest” finds little quarter in the statutory regime.¹⁸⁹ The adversary process, rather, pits the debtor on one side of the bargaining table (and courtroom) against its stakeholders––typically, bank lenders and the official committee of unsecured creditors––on the other side.

Bankruptcy court jurisdiction hews close to this scheme. Bankruptcy courts are not Article III tribunals with full judicial power over life, liberty, and property; bankruptcy courts are, rather, Article I tribunals of limited authority.¹⁹⁰ Bankruptcy judges may only decide issues that are “core” to the bankruptcy, meaning those “arising in” or “arising under” the Bankruptcy Code.¹⁹¹ That includes matters such as DIP financing, asset sales, contract assumption or rejection, and plan confirmation¹⁹² Bankruptcy courts also may adjudicate matters “related to” the bankruptcy, but only if the litigants consent;¹⁹³ otherwise, the court may only issue proposed findings of fact and conclusions of law for the overseeing district court to consider.¹⁹⁴ Bankruptcy courts cannot conduct jury trials without litigant consent;¹⁹⁵ they cannot send anyone to prison for criminal contempt;¹⁹⁶ and, they cannot render judgments on personal injury claims.¹⁹⁷ Matters beyond what directly concerns the debtor and its stakeholders are for other courts to decide.¹⁹⁸

Separately, bankruptcy’s adjudicatory process is peculiar. In most commercial litigation, the plaintiff seeks redress for a past event. An alleged wrong happens, and the trial can be scheduled any time after the complaint is filed and pre-trial procedure has run its course. Chapter 11, by contrast, litigates to a future event, again most often confirmation of a plan of reorganization. The debtor’s business rehabilitation is, in other words, a sort of “becoming” in which much of the nucleus of operative fact develops post-petition, as the reorganization takes shape.¹⁹⁹ The process is, nevertheless, often pressured and time constrained. The debtor’s exclusivity periods to file and then solicit acceptances for a plan are not limitless.²⁰⁰ And, in cases where DIP financing is required (that is, most business cases), it is customary for such loans to include “milestone” covenants or a near-term maturity––essentially a ticking timebomb for the case.²⁰¹ The debtor must move the case along quickly, all the while meeting performance and other covenants, or the DIP lender may cut off liquidity.²⁰² The adjudicatory process thus invariably melds legal principle with pragmatism and business necessity.²⁰³ The Bankruptcy Code allows for this by establishing rules that, among other things, lean heavily on judicial discretion.²⁰⁴ But, in practice, that means bankruptcy courts are often required to make interim case decisions on relatively thin evidentiary records, always trying to preserve and advance the process to some form of successful outcome. ²⁰⁵

Further, getting to a confirmable plan can be brutal work.²⁰⁶ Section 1129 of the Bankruptcy Code imposes extensive structural, voting, and evidentiary requirements for plan confirmation, especially for so-called “cram down” on non-consenting classes.²⁰⁷ Stakeholders use those rules for their benefit, threatening and jockeying for larger helpings.²⁰⁸ They may accumulate “blocking” positions in critical debt classes.²⁰⁹ They may contest ambiguities and assumptions undergirding the debtor’s business plan and proposed reorganization value.²¹⁰ They may strategize to exclude others from plan treatments²¹¹ or exploit the debtor’s desperation for DIP or exit financing.²¹² Stakeholders exploit ingenious structures to fleece others in the capital structure, sometimes even above or within the same class.²¹³

These cases can, in sum, burn hot in their own self-contained crucible until extinguished by winnowing fuel or other paramount need for resolution. The announcement of a plan, any plan, can bring about hope and a sense of relief. The costs can be astounding, both in terms of administrative expense and consumption of judicial resources.²¹⁴ This is especially true in complex, multilayered cases.

To avoid this, bankruptcy tends to nudge stakeholders toward settlement. It does this in two primary ways. First, the Bankruptcy Code compels disclosure of substantial private information. Mandatory public disclosures include the debtor’s schedules of assets and liabilities,²¹⁵ statement of financial affairs,²¹⁶ monthly operating reports,²¹⁷ and a disclosure statement to inform voting on any plan of reorganization.²¹⁸ A debtor will invariably supplement the record with additional disclosures as it seeks interim relief from the bankruptcy court over the course of its Chapter 11 case.²¹⁹ Stakeholders may demand discovery in connection with any case dispute.²²⁰ They also may seek extraordinary discovery from the debtor and third-parties under Bankruptcy Rule 2004, so long as such discovery may serve a useful bankruptcy purpose.²²¹ In cases involving disconcerting facts, the bankruptcy court may order the appointment of an examiner to conduct an investigation and publish a “tell-all” report of their findings.²²² In these ways, bankruptcy embraces the unremarkable proposition that knowledgeable negotiations are ultimately more efficient and efficacious. Bankruptcy courts enforce this expectation.

Second, bankruptcy courts render decisions over the course of the Chapter 11 process that narrow points of disagreement. “Contested matters,” i.e., general bankruptcy motion practice, are resolved with procedural expediency;²²³ “adversary proceedings,” i.e., mini-lawsuits within the bankruptcy, follow more traditional federal civil procedure.²²⁴ But, either way, the bankruptcy court will often bring the matter to a quick evidentiary presentation, followed by a clear ruling that guides the case towards larger resolution. A bankruptcy court might, for example, determine, well in advance of a plan, whether a creditor does or does not have a perceived value entitlement; by resolving the dispute (one way or the other), the court clears a path to more effective plan negotiations.²²⁵ Same is true for corporate decision-making: if the case generates substantial allegations of corporate wrongdoing and such allegations start to inhibit negotiations, the court may prompt management changes.²²⁶

Respecting financial firms (e.g., a bank holding company or brokerage firm), bankruptcy relies on and works in tandem with regulatory authorities.²²⁷ By the time of filing, a financial debtor typically has been policed by government regulators (e.g., the SEC, CFTC, or the Fed) for quite some time. The company’s books, records, public disclosures, and manner of business have long been based on rules and expectations established by those administrative supervisors.²²⁸ The regulatory interplay is supposed to continue post-petition, with bankruptcy focusing primarily on a reworked balance sheet and regulatory authorities keeping an eye on operational developments.²²⁹ This affords regulatory agencies some leeway to intervene in the bankruptcy, asserting non-economic imperatives. As Jared Ellias, George Triantis, and Robert Rasmussen have observed, the interplay between bankruptcy and regulatory regimes can generate considerable case frictions.²³⁰ But, if all goes well, the company leaves bankruptcy in a stronger financial position, without objections voiced by regulatory supervisors.²³¹

This is the context in which bankruptcy courts have been engaged to oversee the factual development and consider the legal implications of 2022’s “crypto winter.” The crypto bankruptcies have, to date, shed disinfecting light on some of the industry’s darkest corners, revealing what may have occurred there and who may bear responsibility for the staggering losses. Bankruptcy courts have also rendered rulings that not only propel their cases forward, but also instruct the crypto community––and market regulators––more generally. Bankruptcy has, furthermore, provided a unique forum for regulatory involvement and, it seems, an occasional clash of economic and agency agendas. Below, we set out two case studies that exemplify the ways in which the bankruptcy court has emerged as a sort of default regulatory forum for crypto markets.

C. Crypto in Chapter 11: The Celsius and Voyager Cases

1. Celsius

Celsius, founded in 2017 and led by Alex Mashinsky, grew over a few years to be one the largest crypto finance platforms in the world. It presented itself as a sort of virtual bank. Individual customers could electronically, via computer or cellphone, deposit their crypto assets in a Celsius “Earn” account (akin to a traditional savings account) and accrue a relatively high rate of interest, payable in kind or in the Celsius native token, called the “CEL.”²³² Customers could borrow fiat money from Celsius (e.g., to pay household expenses with fewer tax consequences)²³³ collateralized by their deposited crypto in the Earn account.²³⁴ Celsius would, in turn, lend deposited crypto to third-parties, pocketing what it made in interest/fee income over what it owed to the account holders.²³⁵

Earn accounts, though functioning economically like general savings accounts, were not insured by the FDIC.²³⁶ Not to worry, said Celsius. The company’s management emphasized “safety,” touting that “our top priority is keeping your assets secure.”²³⁷ Celsius would not lend capital to third-parties without first conducting extensive diligence, and would use deposited capital only in “a very conservative” way, “such as only allowing very small or overcollateralized positions.”²³⁸ Even though Celsius was not a public reporting company, customers were promised even better disclosure: Celsius committed to “publish to a blockchain all our transactions which will provide users transparency as to how many coins we have and what they are used for.”²³⁹ Any Earn account holder that did not like how the business was operating had the ability to pull his money out at a moment’s notice.²⁴⁰

The company’s marketing strategy also sought to play into crypto’s anti-establishment ethos. As discussed above, Celsius was a home for those wanting to “unbank” themselves and thereby enjoy a newfound “financial freedom.”²⁴¹ Here, an everyday customer could “dream big” and help pursue “economic opportunity and income equality to everyone in the world,”²⁴² just as the people were freed from quarantine and the so-called “Great Resignation” became a mass phenomenon.²⁴³ Mashinsky presented himself as the leader of this “financial freedom” movement.²⁴⁴

The marketing strategy worked. By December 2020, Celsius had more than $3.3 billion under management²⁴⁵ and, by January 2021, that figure had grown to $4.5 billion.²⁴⁶ In October 2021, the business was valued at $3 billion.²⁴⁷ Management expedited plans to grow internationally, including the acquisition of an Israeli cybersecurity firm in October 2021.²⁴⁸ Come May 2022, Celsius had almost $12 billion under management and more than $8 billion in loans outstanding to third- parties.²⁴⁹ It boasted 1.7 million registered users by July 2022.²⁵⁰ Then it all came to an abrupt end: Luna’s collapse segued into a run-on-the-bank scenario for Celsius, leading to a brief suspension of withdrawals, and the company’s emergency Chapter 11 filing on July 13, 2022.²⁵¹

The bankruptcy was, from its inception, surrounded by controversy. In his “first day” declaration, Mashinsky asserted that Celsius was a sound, well-run company victimized by extraneous forces and rumor mongering.²⁵² He attributed the company’s financial troubles to the “macroeconomic” crypto environment and world economy, with only passing reference to certain “poor asset deployment decisions.”²⁵³ Purportedly, the bank-run was due to “unsupported and misleading” news reports.²⁵⁴

For many, the narrative did not add up. How could Celsius find itself in this position if it deployed capital in only “very conservative” ways? Indeed, Mashinsky’s own declaration admitted a “shortfall” in its balance sheet of at least $1.2 billion and about one-third of its loan book was comprised of “bad” debt.²⁵⁵ Moreover, news outlets started reporting that, while Celsius was touting CEL, Mashinsky was liquidating tens of millions of the native token from his personal account.²⁵⁶ Former employees began leaking stories of excessive risk-taking, disorganization, and perhaps even market manipulation.²⁵⁷

On September 14, 2022, the bankruptcy court entered an order directing the appointment of an examiner to conduct a broad-ranging investigation into the facts undergirding the case.²⁵⁸ Two weeks later, Mashinsky resigned as CEO.²⁵⁹ On September 29, 2022, the bankruptcy court approved the appointment of former federal prosecutor, Shoba Pillay, as examiner.²⁶⁰

On January 30, 2023, Pillay published her “tell-all” final report, a scathing 689-page description of the company and its historical practices. The report explained: (1) how the cryptocurrency ecosystem operates;²⁶¹ (2) Celsius’ important role in that ecosystem as a sort of virtual thrift bank for millions of individual customers;²⁶² (3) how the business operated day-to-day, including granular investment choices;²⁶³ and (4) how those operations and business decisions differed materially from what was represented to customers.²⁶⁴ Despite customer promises of disclosure and transparency, Celsius “frequently” made statements “that were inaccurate and misleading.”²⁶⁵ According to the report, Celsius ultimately could not generate earnings over what it owed customers, driving it into ever riskier investments that ultimately caused its undoing.²⁶⁶ The report includes an internal email describing certain corporate strategies as “very ponzi like.”²⁶⁷ It also revealed that, despite mounting corporate losses, Mashinsky pocketed nearly $70 million by selling his personal holdings in CEL, while the company was hawking CEL’s (supposed) intrinsic value to the market.²⁶⁸ The final report is a detailed account that, again, likely contributed to Mashinsky’s indictment and arrest seven months later.

Disclosure aside, Celsius came to bankruptcy with billions in assets, including fiat cash, crypto assets, a loan book, mining interests, and other hard and inchoate assets,²⁶⁹ which needed allocation among and distribution to the company’s creditors (predominantly customers). Prior to bankruptcy, management repeatedly communicated to the customer-base that crypto deposits remain “your” crypto,²⁷⁰ giving the customers the clear impression that Earn accounts liken better to safe deposit boxes than traditional savings accounts. With Celsius in bankruptcy, 600,000 Earn account holders, who had collectively deposited $4.2 billion, wanted “their” crypto traced, excepted from the automatic stay, and immediately released to their rightful owners.²⁷¹ This was, after all, what Mashinsky had promised all along.²⁷²

Celsius’ advertising puffery did not, however, match up with what was written in the customer agreements. Earn customers may not have realized, when they signed their Celsius contracts, that deep within the legalese was a transfer of ownership of all digital assets deposited into an Earn account.²⁷³ Earn depositors could redeem such assets at will, requiring Celsius to go into the market to cover any demanded crypto it did not then have in treasury. But, after deposit and prior to redemption, the crypto belonged to Celsius and could be exploited as management saw fit for the company’s own profit-making purposes.²⁷⁴ The contract relationship was, contrary to Mashinsky’s “unbank” representations, very much like that of traditional depository institutions.²⁷⁵

This entitlement issue was, as described by the bankruptcy court, “a gating issue at the center of many disputes in this case.”²⁷⁶ On January 4, 2023, following an evidentiary hearing, the bankruptcy court issued its opinion resolving the matter. The court concluded that, despite the marketing representations and client expectations, the language of the customer agreements control.²⁷⁷ Earn customers were merely unsecured creditors in the Celsius Chapter 11 cases, entitled to recover the remainderman’s interest after payment of ever-ballooning administrative expenses.²⁷⁸ Deposits were not, in sum, “your” crypto after all²⁷⁹ and, making matters worse, the deposits were not FDIC insured. The ruling delivered a painful lesson not only to the 600,000 Celsius Earn customers, but also hundreds of thousands of BlockFi customers who deposited their crypto in comparable accounts and came to learn that the Celsius ruling would be followed in BlockFi’s bankruptcy as well.²⁸⁰

2. Voyager

Voyager was founded a year after Celsius (in 2018) and, like Celsius, also focused its marketing strategy on individual crypto enthusiasts. But, Voyager was a hybrid brokerage and quasi-banking firm. Customers could trade, after depositing digital assets, using an interface accessible via the Voyager app.²⁸¹ They just needed to sign a customer agreement, download the app, and then select which of over one hundred asset types they wanted to buy or sell.²⁸² Voyager made money by pocketing the spread between the buy and sell prices of traded crypto assets and by relending customer deposits, akin to Celsius and BlockFi.²⁸³

Like Celsius, Voyager too experienced explosive growth.²⁸⁴ In 2020, Voyager counted only 120,000 users on its platform.²⁸⁵ A year later, Voyager’s app was among the top 10 in the world.²⁸⁶ At year-end 2021, Voyager had nearly $5.9 billion in assets under management.²⁸⁷ By springtime 2022, it counted over 3.5 million users.²⁸⁸ Then came the Luna collapse and Three Arrows defaulting on its $657 million Voyager loan. Mass customer redemptions followed.²⁸⁹ Voyager filed for bankruptcy protection on July 5, 2022.²⁹⁰

Given Voyager’s abrupt failure, the board of directors created a special committee to investigate underlying facts.²⁹¹ The special committee retained independent counsel to conduct this investigation.²⁹² The investigative report was made public (in redacted form) on February 14, 2023.²⁹³ The report focused on the decision-making process driving the Three Arrows loan, which was put in place only a few months before Luna’s collapse.²⁹⁴ As detailed, management conducted negligible diligence before agreeing to lend Three Arrows up to $1 billion. Prior to committing capital, Voyager: (i) received merely a single-line statement in lieu of detailed financials, to wit, “We confirm the following for Three Arrows Capital Ltd as at 1-January-2022 in millions of USD. NAV 3,729”;²⁹⁵ and (ii) conducted a single due diligence call with two executives from Three Arrows, where no mention was made of the fund’s Luna exposure.²⁹⁶ None of the loans were collateralized.²⁹⁷ At the time of Voyager’s bankruptcy filing, the Three Arrows debt represented nearly 58% of its loan book.²⁹⁸

Blame aside, Voyager’s bankruptcy––like all bankruptcies–– required an exit strategy. At case inception, Voyager proposed a plan of reorganization.²⁹⁹ This was, however, merely an aspirational statement, given the tumultuous state of the industry in July 2022.³⁰⁰ The plan, nevertheless, functioned as a kind of “stalking-horse” for alternative exit strategies, particularly a sale transaction.³⁰¹ On August 5, 2022, the bankruptcy court approved bid procedures, initiating an M&A process designed to find a buyer for Voyager.³⁰² That process concluded in September, with FTX advancing a $1.422 billion offer to buy the company.³⁰³ That transaction had not yet closed when, in November, CoinDesk published its article outing FTX as a possible fraud, and the company imploded.³⁰⁴

This was devastating news for Voyager and its stakeholders.³⁰⁵ By then, Voyager had incurred millions in professional fees chasing the FTX deal.³⁰⁶ Fortunately, Voyager found another potential suiter: Binance.US,³⁰⁷ the American affiliate of Binance, the behemoth cryptocurrency exchange.³⁰⁸ In December, Binance.US agreed to acquire Voyager for approximately $1.022 billion, and the transaction would be consummated as part of Voyager’s pre-existing plan of reorganization.³⁰⁹ Under the plan, Voyager customers would transition to the Binance.US platform, subject to various vetting procedures.³¹⁰ Ineligible customers would have their crypto liquidated and receive the cash proceeds.³¹¹ Same for customers located in jurisdictions where Binance.US was not licensed to provide digital currency services.³¹²

But, there was a problem. The federal government, as well as the SEC, United States Trustee, and several state regulatory agencies expressed concerns over Binance.US as purchaser.³¹³ Binance.US, it seems, was an entity of concern for federal and state regulators, evoking government suspicion that it was not a suitable buyer for Voyager’s expansive role in the U.S. market.³¹⁴ The SEC, in particular, contended that the Binance.US transaction and its distribution of digital assets to creditors might end up violating federal securities law,³¹⁵ with the federal government furthering that, as a matter of principle, the plan should not have any preclusive effect on regulatory authorities (federal or state) if the transaction or such distributions are subsequently found to be wrongful.³¹⁶ That meant, among other things, that Voyager and Binance.US executives, as well as bankruptcy professionals advising the debtors and the official committee of unsecured creditors, could face post-consummation regulatory scrutiny––perhaps even liability––for supporting and helping consummate the plan.³¹⁷

The bankruptcy court was unmoved by these arguments. The court accepted Voyager’s contention that the proposed transaction was the most value-maximizing path forward, with approximately $100 million in value over liquidation.³¹⁸ The court disagreed, as a matter of fundamental bankruptcy principle, that parties should remain liable under securities laws for helping the plan close and, in turn, fulfilling their statutory mandates under the Bankruptcy Code, especially as the government equivocated on whether the Binance.US transaction would or would not actually violate securities laws.³¹⁹ The court further chastised the government objectors for interposing objections rooted in speculation, not evidence.³²⁰ The court ultimately overruled the objections, and the plan was confirmed.³²¹ Voyager was thus authorized to move forward with the sale to Binance.US.³²²

The government appealed, focusing its argument on the plan’s exculpation provision, contending that it infringed on its regulatory authority to prosecute enforcement actions against, among others, those working to close the deal.³²³ A motion for stay pending appeal followed shortly thereafter.³²⁴ The appeal did not go far, however. In the face of these developments, Binance.US exercised its right to terminate the transaction, decrying the “hostile and uncertain regulatory climate in the United States.”³²⁵ On April 25, 2023, Voyager announced that it had pivoted to liquidation.³²⁶

The Voyager case story is, from the perspective of bankruptcy law, rather strange: the most value-accretive case solution was scuttled based on unproven contentions. But, considering the government’s larger regulatory ambitions, it is instructive. Management remained in possession throughout the case. The case background factswere not buried. The public ultimately received exacting, candid, and stark disclosures of how the C-Suite took excessive risks with customer deposits (i.e., the Three Arrows loan). These disclosures, when married with comparable revelations from the BlockFi, Celsius, Cred, and FTX cases, reflect patterns of governance failures that can be targeted by administrative agencies as well as the consuming public. Moreover, with respect to the failed Binance.US transaction, the case illustrates––in about as clear and impactful way as possible––how bankruptcy can provide an oddly effective forum for public regulators to advance their administrative agendas, prior to comprehensive regulatory reform, with relative ease and crisp effectiveness. That is so, even if the bankruptcy court is left almost entirely in the dark about what is motivating aggressive agency response.

These observations point to a number of gains for overseers arising out of the bankruptcy court’s role as accidental quasi-regulator. Just as traditional financial regulation seeks out ways to protect the marketplace, produce information on its risks, and safeguard user interests, the court’s unique legal toolkit can achieve outcomes aligned with these regulatory objectives. Indeed, there is an argument that the court’s intervention comes with specific advantages. The capacity of bankruptcy judges to exercise wide discretion in applying statutory measures, combined with powers to compel delivery of detailed disclosures, can allow for a flexible, solutions-orientated approach that may be especially well-suited to address the novel, evolving nature of the crypto industry. An objective examiner’s report (e.g., Cred and Celsius),³²⁷ for example, can reveal insights about a firm and its industry that may not be easily discernible through regular, standardized disclosures, where a company might present its affairs in an overly curated, sanitized light. Approaches to address thorny problems like valuation of crypto assets (e.g., Voyager) can reflect efforts on the part of any number of experts enlisted by the court, including regulatory agencies. This can better equip judges to develop resolution strategies that stand the best chance of success in addressing risks and distress within a novel, understudied asset class like crypto. Further, the public nature of the bankruptcy process means that the court’s efforts are afforded general scrutiny (including on social media). There is signaling of regulatory priorities (e.g., customer protection). And, the court’s judgments and analysis create opportunities for wider learning about the legal complexities (e.g., custody) and industry characteristics of crypto markets.

Yet, even as bankruptcy courts have risen to meet the legal and economic challenges posed by “crypto winter,” the consequences of their engagement reveal the high costs of relying on these courts to function as proxy financial regulators. As we discuss in Part III, bankruptcy courts are highly specialized actors that are poorly suited to act as general overseers and rule-makers for any financial industry.

III. THE BANKRUPTCY COURT AS (IMPERFECT) CRYPTO MARKET REGULATOR

Part II showed how bankruptcy is, functionally, administering the clean-up of large segments of the crypto ecosystem. It observes that some of bankruptcy’s work is serving non-bankruptcy regulatory objectives, including broad and exacting public disclosures, management accountability, loss allocation in ways that are instructive to regulators and crypto investors, even opportunity for traditional government supervisors to advance policy objectives before enactment of corrective regulation. This contention might, however, be troubling, perhaps even to the bankruptcy judges overseeing the crypto cases. As explained in Section II.B, bankruptcy’s purpose and intentions look no further than the estate and its stakeholders. Any larger-scale administrative objectives served by bankruptcy are, therefore, more or less incidental to––rather than and by virtue of––the Bankruptcy Code’s underlying design.

There lies the trouble with relying on bankruptcy courts to serve as default quasi-regulators. This Part surveys the implications. We observe that there are difficult tensions between core bankruptcy policies and those of more traditional financial regulation. Particularly on matters of systemic risk or customer protection, bankruptcy’s usual focus––looking to safeguard, augment, and ultimately distribute estate value––can result in destabilizing and costly externalities for actors like customers or creditors. Though knock-on hardships are commonplace and expected in insolvencies, bankruptcy courts cannot deploy the kind of tools available to financial regulators (e.g., to backstop customer money claims or provide emergency bridge financing for struggling counterparties) to shore up a hurting market or ensure its go-forward integrity.

Even disclosure, a foundational regulatory device, furthers a different imperative in bankruptcy. The timing, extent, and even reliability of bankruptcy disclosure encapsulates the point-counterpoint nature of bankruptcy’s adversary process. It is sharply focused on its intended audience––Chapter 11 stakeholders––not the markets more generally. Such disclosures can only instruct and, hopefully, positively affect crypto market development by presenting cautionary tales. Bankruptcy courts can do little more for the wider audience.

Finally, the frictions exemplified by BlockFi, Celsius, FTX, Genesis, Three Arrows, and Voyager illustrate the costs to financial market design where policy looks to the bankruptcy court as a frontline regulator––rather than as but one critical part of an otherwise larger, dedicated architecture for oversight and resolution. Requiring bankruptcy courts to step into a leadership role, rather than to adjudicate within an existing framework for oversight (where oversight is largely entrusted to other facets of government), imposes on these courts a responsibility far outside of their usual functions and capabilities, creating enormous inefficiency and, in the end, grave concerns over effectiveness.

A. Systemic Risk and The Bankruptcy Code

The interventions of bankruptcy courts in the context of crypto have exemplified the tensions between the Bankruptcy Code and financial regulatory approaches designed to address systemic risks. As noted in Part I, crypto markets showcase the potential for externalities––where institutions like exchanges (e.g., FTX, Genesis, and Voyager), quasi-banks (e.g., BlockFi and Celsius), and hedge funds (Alameda and Three Arrows) pose dangers to others, resulting in the creation of pathways for risk to move from one firm to others rapidly and unpredictably.

But, despite these risks, fundamental aspects of the Bankruptcy Code stand in tension with regulation’s emphasis on preserving market stability and assuring the safety and soundness of large, deeply networked financial firms. For one, the typical mission of bankruptcy courts looks to address the debtor’s insolvency, protecting and enhancing the value of the estate, and overseeing the development of a plan to distribute value to creditors. How bankruptcy courts achieve this has long elicited debate and prompted recourse to competing judicial philosophies to guide how the pie is best divided among stakeholders. Scholars have tussled, for example, over the workability of divergent economic approaches when deciding how much leeway to afford managers struggling to return a distressed business to profitability: whether only creditors’ rights ought to be recognized; or, if community interests should also be afforded some voice in a bankruptcy process; or even whether certain creditors (e.g., DIP lenders) ought to be permitted especially close control over the firm’s workings and managerial discretion.³²⁸ While not underplaying their importance, nor diminishing the attention bankruptcy courts often pay to non-economic stakeholders (like local communities and public policy imperatives), these variations generally operate with an overarching focus on the debtor and the financial distress that it is experiencing.³²⁹ Indeed, bankruptcy law expects third-parties to absorb loss, uncertainty, and distress of their own in order to afford the debtor an opportunity to reorganize.³³⁰ In other words, the focus of the Bankruptcy Code is almost exclusively on the debtor––rather than preventing the spread of distress to third-parties and the industry sector more generally.

Perhaps the most visible tension between the Bankruptcy Code and its effect on systemic risks can be seen in the broad application of the automatic stay. Designed to freeze attempts to collect debts against the debtor’s estate, it precludes any number of creditors from accessing and retrieving their funds.³³¹ In the context of crypto insolvencies, such as Celsius and BlockFi, this has meant precluding the firms’ customers from accessing assets and withdrawing them from the debtor platform, leaving billions of dollars trapped without clarity as to when they might be returned––if they might be returned at all.³³² Importantly, limited financial regulation has meant that the automatic stay is applied bluntly to crypto assets, without any calibration to reflect the common sense (but not, in the end, legal) notion that these assets constitute customer property.³³³ By contrast, in regulated securities and commodities markets, rulemaking mandates that assets be protected to clearly recognize investor ownership rights, with custody arrangements eliminating the risk of these assets becoming scooped up in a custodian’s bankruptcy.³³⁴

This tension has played out repeatedly across the major crypto insolvencies. Bankruptcy courts do not have discretion and must strictly enforce the automatic stay, without regard for potentially systemic consequences within the crypto-ecosystem and the economic damage inflicted on otherwise blameless retail creditors. For one, platform clients not been able to withdraw their assets, causing damaging knock-on effects, if they lack the cash to pay out on their own obligations.³³⁵ In the case of FTX, for instance, this included institutional creditors, such as BlockFi, that ended up pushed into their own insolvency.³³⁶ It also compromised millions of vulnerable retail interests, everyday savers with limited or negligible economic slack to absorb the shock.³³⁷ Indeed, in seeking to navigate the damage, retail creditors have been forced to reckon with sophisticated parties in crowded and confusing legal proceedings. This has required administrative investment in filing claims as well as in carefully following the trajectory of their legal entitlements.³³⁸ With these cases (and the automatic stay) stretching on for many months, the complex nature of crypto bankruptcies invariably threaten all customers, retail and institutional, with lengthy and legally burdensome separation from whatever value is ultimately left for them – no matter the resulting knock-on shocks.³³⁹

As an added source of risk, crypto holders confront reckoning with the shifting valuation of a highly volatile asset. As Anthony Casey, Brook Gotberg, and Joshua Macey write, the changing valuation of crypto assets can create incentives for a debtor to use these assets to fund itself at low cost.³⁴⁰ With crypto assets likely to have a depressed valuation on the filing date of a large bankruptcy, an exchange can gain by holding onto a base of assets with appreciating price, and to eventually reap winnings from the difference between a low-dollar customer claim and a higher valuation further into the insolvency process.³⁴¹

These risks are not new for insolvencies where the debtor’s failure might result in costly externalities for financial markets. Crucially, however, regulated markets have developed sophisticated conventions to recognize and privilege systemic risk considerations over the interests of the debtor. As noted above, custody arrangements in securities and commodities markets look to keep customer assets outside of the bankruptcy.³⁴² But, other provisions, too, are worth highlighting. For example, under the Bankruptcy Code, certain kinds of risky and short-term financial contracts are expressly exempted from the stay.³⁴³ For certain kinds of derivatives and short-term credit arrangements, a debtor’s counterparty is permitted to close-out the contract and set-off liabilities to secure what is owed to them.³⁴⁴ This process is designed to happen automatically, preventing these specific financial creditors from becoming locked in lengthy proceedings and facing the prospect of cash-shortages themselves.³⁴⁵ Of further note is the fact that certain kinds of financially systemic firms are saved from becoming subject to long and uncertain corporate bankruptcies. This is most clearly exemplified by the regime for addressing bank failures, where the process is managed by a particular government agency––the FDIC––rather than the courts. This design is supposed to offer a highly technocratic, fast, and minimally disruptive process, where customer deposits and outstanding bank loans are transferred (ideally) seamlessly to another bank, preventing worries about the larger solvency of the banking system and helping to prevent a run by frightened depositors.³⁴⁶

In other words, regulatory policy recognizes the tension between the Bankruptcy Code and the costs of system-wide fragility. Whereas rulemaking in securities markets, commodities, and banking regulation has looked to navigate this tension through well-established, Congressionally-approved, crafted tools, crypto markets have been left exposed to the vulnerability of systemic risks but with only the discretion and generalized case oversight of bankruptcy court for recourse. With courts equipped only with traditional tools (e.g., the automatic stay), bankruptcy law is ill-equipped to protect short-term creditors and vulnerable customers in crypto markets.

B. Bankruptcy Disclosure vs. Market Disclosure

The close nexus between financial regulation and disclosure finds its originating, and perhaps best, articulation in Justice Brandeis’ famous statement: “Sunshine is said to be the best of disinfectants; electric light the most efficient policeman.”³⁴⁷ And, so, while scholars have long debated the efficacy of disclosure as a regulatory tool, and contested even further how best it should be implemented to achieve its intended purpose, compelling businesses to periodically divulge core performance and governance data remains a vital component in the administration of financial systems.³⁴⁸ The general idea is that, if the law mandates regular and sufficient disclosure, the consuming public and markets more generally will do much of the policing on their own.³⁴⁹ The SEC and other regulatory agencies have, in turn, issued extensive guidelines and disclosure standards have evolved to aspire for clarity, consistency, and comparability in public communications.³⁵⁰

voxeu/columns/bank-transparency-regulation-and-stress-tests-what-works-and-what-does-not [https://
perma.cc/54KC-NXH8]. Broadly viewed, capital markets, as well as the general consuming public, have come to expect high-quality, reliable disclosures (as compelled by law and enforced by federal and state administrative agencies), assuring greater confidence in the efficient and safe workings of regulated markets.³⁵¹

That is not the nature of bankruptcy disclosure, however. Debtors do not have to broadly divulge information in their bankruptcy cases to accommodate a regulatory scheme intended to properly inform a market.³⁵² Come Chapter 11, the typical debtor’s securities are already delisted, ³⁵³ and disclosure imperatives arising under non-bankruptcy law shift to what is expected in bankruptcy. Thereafter, and as a normative attribute of Chapter 11, debtors tend to publicly disclose only what is necessary and only when they desire particular relief from the bankruptcy court.³⁵⁴ As explained in Section II.B, a debtor’s reorganization is a sort of “becoming” that often takes shape after the bankruptcy has started.³⁵⁵ Bankruptcy law does not compel the debtor to issue much in the nature of progress reports along the way. And, at least during the formative stages of the bankruptcy, a shroud of secrecy is generally acceptable, allowing key constituents, such as the official creditors committee, to do their work.³⁵⁶ Unlike the public more generally, key constituents receive sensitive information early on because they are the counter-balance in bankruptcy’s adversary process and they are the ones the debtor needs to eventually negotiate a plan.³⁵⁷ It is true, as mentioned above, that the Bankruptcy Code and Bankruptcy Rules compel granular public disclosures about the assets comprising and the debts burdening the estate, as well as public release of monthly operating reports.³⁵⁸ But, these disclosures are far from fulsome, they are not completely standardized, and they are neither designed nor intended to offer everyday market participants confidence, clarity, and comparability about firms and their workings.³⁵⁹ For example, monthly operating reports, untethered to a disclosed bankruptcy strategy or turnaround business plan, do little to elucidate where the case is going at any particular moment.³⁶⁰ It is not until the publication of a detailed disclosure statement that the “case story” comes together for the public more generally. But, by then, the story may be almost over.

Debtors do make interim disclosures in the bankruptcy––including, especially, the debtor’s so-called “first day” declaration (an explanatory, often lengthy, statement filed with the Chapter 11 petition)––and those disclosures often present a detailed case narrative: why and how the debtor finds itself in need in bankruptcy relief; what it hopes to achieve while in bankruptcy; how and when it expects to exit bankruptcy.³⁶¹ But, unlike disclosure requirements under non-bankruptcy law,³⁶² there are few repercussions for a debtor whose interim disclosures are ultimately found to be insufficient, incomplete, or even inaccurate.³⁶³ Bankruptcy anticipates that the debtor’s case narrative, including the “first day” declaration, may be inculcated with advocacy; it relies on the debtor’s case adversaries (e.g., the official creditors committee) to exploit discovery and other tools of bankruptcy to ferret out and eventually present the counter-narrative.³⁶⁴ Celsius, for example, initially presented its case narrative in the “first day” declaration of its CEO, Alex Mashinsky. This narrative was largely debunked in the examiner’s final report,³⁶⁵ and Mashinsky was arrested a short time later. But, tellingly, that did not lead to the appointment of a Chapter 11 trustee, conversion to a Chapter 7 liquidation, dismissal of the case, or even curtailment of the debtor’s exclusivity to file its own bankruptcy plan.³⁶⁶ Bankruptcy wants the parties to negotiate and, so, bankruptcy courts are loath to impose interim process changes over factual disputes, even where the debtor’s factual narrative is so blatantly wrong.³⁶⁷ Stated differently, bankruptcy rarely prioritizes factual accuracy in interim (prior to dissemination of a disclosure statement) public disclosure over an orderly Chapter 11 process.³⁶⁸

It is perhaps for this reason that examiner appointments have been rare occurrences in Chapter 11, historically reserved for only the most extreme cases.³⁶⁹ Examiners seize part of the adversary role occupied by creditor representatives, who are otherwise entrusted not only to learn the case facts but also to exploit them at bargaining table.³⁷⁰ Examiner appointments can, in other words, enervate the official creditors committee (among others) and that may not help the parties reach consensus on a plan.³⁷¹ Examiner reports also can be costly, eating into eventual recoveries, and they take time to prepare, resulting in case delay.³⁷² Moreover, examiners are required to make their investigative findings public––even the findings that may be best reserved for quiet negotiation––and this can further chill dealmaking.³⁷³ These dynamics may help explain why even in a case as extreme as FTX the bankruptcy the bankruptcy court was reluctant to order the appointment.³⁷⁴

Finally, and most specific to crypto, bankruptcy disclosure does not have permanence. Data delivered in cases such as BlockFi, FTX, and Voyager explain the root causes of failure, and thus can offer cautionary tales for regulatory authorities and the industry more generally to observe and consider.³⁷⁵ But, it can do little more. A “bad” Chapter 11 debtor will change its ways through the reorganization process; a liquidating debtor has no future; and, other industry participants have no obligation to study or heed any cautionary tale. Bankruptcy disclosure, therefore, offers little protection unless the lessons learned are formalized into some kind of mandatory rulemaking.³⁷⁶

C. An Imperfect Policymaker

Facing information deficits and without a mandate to address systemic risks and market stability, bankruptcy courts are a sort of “make-do” but ultimately highly imperfect proxy-regulator for the crypto-market. Yet, their decision-making is likely to have lasting effects that shape future rulemaking and constrain the room to maneuver available to policymakers looking to craft a framework for crypto oversight.

Perhaps the clearest illustration of the courts’ impact as imperfect policymaker is reflected in the ownership determinations respecting customer crypto assets deposited with bankrupt custodians. As detailed in Part I, cryptocurrencies reflect a relatively novel kind of asset class, where ownership rests with those holding the private keys (the passwords) to a crypto accounts. This design speaks to the fundamental self-help orientation of underlying blockchains that have emerged from a philosophical rejection of third parties like banks, brokers, or state regulators.³⁷⁷ However, as centralized actors have come to assume a critical role, attracting waves of customers, they have also become vast repositories of user assets, holding onto passwords and able to access accounts, the value of which they carry.³⁷⁸ As Adam Levitin notes, this leaves customer assets vulnerable, caught up in a legal gray zone where the fact of a custodian having de facto control and the capacity to access assets at will can leave customers holding a simple contractual––rather than a property-based––claim.³⁷⁹ It has also left the courts facing a complex policy conundrum, whether to (1) recognize customer property rights in crypto assets and, in turn, to permit those assets to remain outside of the custodian’s estate or (2) deem the assets property of the estate, repositioning customers as general unsecured creditors.³⁸⁰ Arguably, financial regulatory policy would favor recognizing and protecting customer’s property rights–and by extension their savings. As evidenced by the safeguards afforded to customer assets in securities and commodities markets, the emphasis placed by traditional financial regulation on investor protection is well-established and uncontroversial. Even where comingling of assets or failure to secure them has meant that customers have not been able to fully enforce their property rights, regulation has stepped in (e.g., MF Global) to ensure compensation and redress for those whose entitlements were abridged.³⁸¹

By contrast, the absence of a focused regulatory policy and a relative lack of prior rulemaking in crypto markets, has led the bankruptcy courts––the Celsius court in particular––to assert bankruptcy norms, thus reducing customer claims to a contractual (rather than proprietary) nature. As such, around $4.2 billion in customer assets deposited with Celsius were found to belong to the bankruptcy estate, and a broad swath of depositors entitled only to the remainderman’s interest after a long and torturous bankruptcy case.³⁸²

As detailed above, while this ruling might reflect bankruptcy’s interpretative norms, it nevertheless raises broader policy concerns surrounding fairness and market integrity. For one, the impact of this ruling can result in some customers faring better than others during a crisis. Specifically, the effect of the ruling means that those that leave assets with an intermediary face the risk that these assets can end up subsumed within a custodian’s estate. It follows that those able to hold their assets off-platform, hosted on their own private wallets face far better odds in maintaining their property rights. While straightforward, this scenario creates the risk of a two-tier market, where those possessing the technical savvy to protect themselves out-maneuver the risk, but those that are perhaps less knowledgeable or otherwise unable to take such steps lose their entitlements. Such a state of affairs appears especially problematic given that those most likely to see their assets tapped on a platform are likely to include the most vulnerable, with less knowledge and sophistication about using crypto technologies. In other words, rather than protect all customers equally, the decision leaves crypto investors to fend for themselves. Those that cannot––in other words, customers that are in the most precarious situation––end up unprotected and liable to be harmed.

The Celsius court’s ruling ended up being especially powerful in the absence of wider regulatory action to protect customers and support market integrity. This has meant that decisions of the bankruptcy court – formed within a particular system of constraints – have given rise to structural effects on the marketplace (e.g., interpretations of terms of service, review of custodianship norms). Unlike administrative rulemaking, however, this impact has taken effect without the benefit of precision market understanding, cost-benefit analysis, stakeholder consultation, or deliberation. While bankruptcy courts have done what they can within their mandate, bringing some order to the prevailing chaos, their intervention can hardly be considered as optimally engineered to provide a lasting and reliable set of guardrails for the crypto-marketplace, designed to operate both in peacetime and in crisis.

CONCLUSION

This Article has sought to offer a new account of cryptocurrency regulation to highlight bankruptcy’s role, by default, as a force in financial markets oversight. With the industry lacking a real framework to govern its integrity, customer protection, and relationship with regulators, bankruptcy courts have been required to step in, addressing gray areas and thorny problems surrounding cryptocurrency’s legal and economic underpinnings. In applying its expertise and authority, these courts have shown themselves to be deft and creative, bringing clarity to important questions impacting customer entitlements and the risk management practices adopted by crypto firms (e.g., in relation to crypto custody). But the courts’ role remains an imperfect and incomplete one. The focus of bankruptcy remains on the debtor. Bankruptcy courts cannot perform policy to address larger concerns––such as the immediate welfare of customers or the overall health of the market. Even as bankruptcy’s influence in this space has grown, its deficits have also become apparent, underscoring the larger costs of regulatory inertia and inaction for establishing standards of governance and safety within innovating industries. Ultimately, the bankruptcy court’s emergence as an accidental financial regulator raises deeper questions about how best to push administrative mobilization to rise to the challenge of complex innovation. As financial regulators endeavor to create new standards for crypto oversight, they face an even more complex task ahead, forced to maneuver in the shadow of the bankruptcy’s authority as a first mover in this arena.

96 S. Cal. L. Rev. 1479

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Yesha Yadav*

* Yesha Yadav is the Milton R. Underwood Chair, Associate Dean, and Professor of Law at Vanderbilt Law School.

Robert J. Stark†

† Robert J. Stark is Chair of the Bankruptcy and Restructuring Practice Group at Brown Rudnick LLP. We are deeply grateful to Kenneth Aulet, Jordan Barry, Preston Byrne, Cathrine Castaldi, Jill Fisch, Pamela Foohey, Andrew Hayashi, Elizabeth Pollman, Danny Sokol, Robert Rasmussen, Andrew Rizkalla, and Samuel Weinstein, as well as participants at the USC Digital Transformation in Business and Law Symposium, the Cardozo Law School Corporate Governance Symposium, and the BYU Winter Deals Conference for all of their valuable insights, comments, and perspectives. We also thank Matthew Fisher, Samuel Khan, and Roshni Parikh for excellent research assistance. In the interest of full disclosure, Robert J. Stark and/or his firm were involved in several of the cases discussed in this Article: he served as the examiner in the Cred Chapter 11 case; he represented the official creditors committees in the BlockFi and Prime Trust Chapter 11 cases, as well as the winning bidder (Fahrenheit LLC) in the Celsius Chapter 11 case; his firm represented an ad hoc claimants committee in the Genesis Global Chapter 11 case, the Bahamas Government in connection with the FTX collapse, and parties in other restructurings in the digital asset and mining spaces. This Article represents the views of the authors only. Errors are our own.

The Rise of Bankruptcy Directors

February 2023April 2024Jared A. Ellias, * Ehud Kamar† & Kobi Kastiel‡

In this Article, we use hand-collected data to shed light on a troubling development in bankruptcy practice: distressed companies, especially those controlled by private equity sponsors, often now prepare for a Chapter 11 filing by appointing bankruptcy experts to their boards of directors and giving them the board’s power to make key bankruptcy decisions. These directors often seek to wrest control of self-dealing claims against shareholders from creditors. We call these directors “bankruptcy directors” and conduct the first empirical study of their rise as key players in corporate bankruptcies. While these directors claim to be neutral experts that act to maximize value for the benefit of creditors, we argue that they suffer from a structural bias because they often receive their appointment from a small community of repeat private equity sponsors and law firms. Securing future directorships may require pleasing this clientele at the expense of creditors. Indeed, we find that unsecured creditors recover on average 20% less when the company appoints a bankruptcy director. While other explanations are possible, this finding shifts the burden of proof to those claiming that bankruptcy directors improve the governance of distressed companies. Our policy recommendation, however, does not require a resolution of this controversy. Rather, we propose that courts regard bankruptcy directors as independent only if an overwhelming majority of creditors whose claims are at risk supports their appointment, making them accountable to all sides of the bankruptcy dispute.

Introduction

In August 2017, the board of directors of shoe retailer Nine West confronted a problem. The firm would soon file for Chapter 11 protection, and its hopes to emerge quickly from the proceeding were in danger due to the high probability of creditor litigation alleging that the firm’s controlling shareholder, private equity fund Sycamore Partners Management, had looted more than $1 billion from the firm’s creditors.[1] The board could not investigate or settle this litigation because it had a conflict of interest.[2]

To take control of the litigation, the board appointed two bankruptcy experts as new directors who claimed that, because they had no prior ties to Sycamore or Nine West, they were independent and could handle those claims.[3] Once the firm filed for bankruptcy, its creditors objected. They argued that the new directors still favored Sycamore because it stood behind their appointment, so the directors would “hamstring any serious inquiry into [its] misconduct.”[4] Nevertheless, the gambit was successful. The bankruptcy court allowed the new directors to take control of the litigation.[5] The new directors blocked creditor attempts to file lawsuits on their own[6] and ultimately settled the claims for about $100 million.[7]

The Nine West story illustrates the emergence of important new players in corporate bankruptcies: bankruptcy experts who join boards of directors shortly before or after the filing of the bankruptcy petition and claim to be independent[8] The new directors—typically former bankruptcy lawyers, investment bankers, or distressed debt traders—often receive the board’s power to make important Chapter 11 decisions or become loud voices in the boardroom shaping the company’s bankruptcy strategy.[9] We call them “bankruptcy directors.”

The rising prominence of bankruptcy directors has made them controversial. Proponents tout their experience and ability to expedite the reorganization and thus protect the firm’s viability and its employees’ jobs.[10] Opponents argue that they suffer from conflicts of interest that harm creditors.[11]

This Article is the first empirical study of these directors. While a voluminous literature has considered the governance of Chapter 11 firms, this Article breaks new ground in shining a light on an important change in the way these firms make decisions in bankruptcy and resolve conflicts with creditors.[12] It does so by analyzing a hand-collected sample of all large firms that filed for Chapter 11 between 2004 and 2019 that disclosed the identity of their directors to the bankruptcy court.[13] To our knowledge, it is the largest sample of boards of directors of Chapter 11 firms yet studied.[14]

We find that the percentage of firms in Chapter 11 proceedings claiming to have an independent director increased from 3.7% in 2004 to 48.3% in 2019.[15] Over 60% of the firms that appointed bankruptcy directors had a controlling shareholder and about half were under the control of private equity funds.

After controlling for firm and bankruptcy characteristics, we find that the recovery rate for unsecured creditors, whose claims are typically most at risk in bankruptcy, is on average 20% lower in the presence of bankruptcy directors. We cannot rule out the possibility that the firms appointing bankruptcy directors are more insolvent and that this explains their negative association with creditor recoveries. Still, this finding at least shifts the burden of proof to those claiming that bankruptcy directors improve the governance of distressed companies to present evidence supporting their view in this emerging debate.

We also examine a mechanism through which bankruptcy directors may reduce creditor recoveries. In about half of the cases, these directors investigate claims against insiders,[16] negotiate a quick settlement, and argue that the court should approve it to save the company and the jobs of its employees.[17] We supplement these statistics with two in-depth studies of cases in which bankruptcy directors defused creditor claims against controlling shareholders: Neiman Marcus and Payless Holdings.

Finally, we consider possible sources of pro-shareholder bias among bankruptcy directors. Shareholders usually appoint bankruptcy directors without consulting creditors. These directors may therefore prefer to facilitate a graceful exit for the shareholders. Moreover, bankruptcy directorships are short-term positions, and the world of corporate bankruptcy is small, with private equity sponsors and a handful of law firms generating most of the demand. Bankruptcy directors depend on this clientele for future engagements and may exhibit what we call “auditioning bias.”

In our data, we observe several individuals appointed to these directorships repeatedly. These “super-repeaters” had a median of 13 directorships and about 44% of them were in companies that went into bankruptcy when they served on the board or up to a year before their appointment.[18] Our data also show that super-repeaters have strong ties to two leading bankruptcy law firms.[19] Putting these pieces together, our data reveal an ecosystem of a small number of individuals who specialize in sitting on the boards of companies that are going into or emerging from bankruptcy, often with private equity controllers and the same law firms.

These findings support the claim that bankruptcy directors are a new weapon in the private equity playbook. In effect, bankruptcy directors assist with shielding self-dealing transactions from judicial intervention. Private equity sponsors know that if the portfolio firm fails, they could appoint bankruptcy directors to handle creditor claims, file for bankruptcy, and force the creditors to accept a cheap settlement.[20] Importantly, the ease of handling self-dealing claims in the bankruptcy court may fuel more aggressive self-dealing in the future.[21]

Our findings have important policy implications. Bankruptcy law strives to protect businesses while also protecting creditors. These goals can clash when creditors bring suits that threaten to delay the emergence from bankruptcy. While bankruptcy directors may aim for speedy resolution of these suits, their independence may be questionable because the defendants in these suits are often the ones who appoint them. Moreover, bankruptcy directors often bypass the checks and balances that Congress built into Chapter 11 when they seek to replace the role of the official committee of unsecured creditors (“UCC”) as the primary check on management’s use of the powers of a Chapter 11 debtor.

We argue that the contribution of bankruptcy directors to streamlining bankruptcies should not come at the expense of creditors. We therefore propose a new procedure that bankruptcy judges can implement without new legislation: the bankruptcy court should treat as independent only bankruptcy directors who, in an early court hearing, earn overwhelming support of the creditors whose claims are at risk, such as unsecured creditors or secured creditors whom the debtor may not be able to pay in full. Bankruptcy directors without such support should not be treated as independent and therefore should not prevent creditors from investigating and pursuing claims.

The creditors will likely need information on the bankruptcy directors to form their opinion, and bankruptcy judges can rule on what information requests are reasonable. This will create standardization and predictability. However, disclosure is no substitute for creditor support. Requiring disclosure without heeding creditors on the selection of bankruptcy directors will not cure bankruptcy directors’ structural biases.

Some might argue that our solution is impractical or otherwise lacking. We answer these claims. More importantly, our solution is the only way to ensure that bankruptcy directors are truly independent. If it cannot be made to work, bankruptcy law should revert to the way it was before the invention of bankruptcy directors, where federal bankruptcy judges were the only impartial actors in most large Chapter 11 cases. In such a scenario, debtors will be free to hire whomever they want to help them navigate financial distress, but the court will regard these bankruptcy directors as ordinary professionals retained by the debtor. The court should weigh the bankruptcy directors’ position against the creditors’, allow the creditors to conduct their own investigation and sue over the bankruptcy directors’ objections, and not approve settlements merely because the bankruptcy directors endorse them.

Our study also lends support to the bill recently introduced by Senator Elizabeth Warren to prevent debtors from prosecuting and settling claims against insiders.[22] Like our proposal, this bill would restore the traditional checks and balances of the bankruptcy process while allowing distressed firms to appoint directors of their choice. Still, our proposal has several advantages. It does not require new legislation, it preserves greater flexibility for the bankruptcy court and, by requiring that bankruptcy directors be acceptable to creditors, it ensures that all board decisions in bankruptcy, not just decisions regarding claims against insiders, advance creditor interests.

Our analysis also has implications for corporate law. Much of the literature on director independence in corporate law has focused on director ties to the corporation, to management, or to the controlling shareholder.[23] We explore another powerful source of dependence: dependence on future engagements by other corporations and the lawyers advising them.

This Article proceeds as follows. Part I lays out the theoretical background to our discussion, showing how the use of independent directors has migrated from corporate law into bankruptcy law. Part II presents examples of bankruptcy director engagements from the high-profile bankruptcies of Neiman Marcus and Payless Holdings. Part III demonstrates empirically how large firms use bankruptcy directors in Chapter 11. Part IV discusses concerns that bankruptcy directors create for the integrity of the bankruptcy system and puts forward policy recommendations.

[1]. See Notice of Motion of the 2034 Notes Trustee for Entry of an Order Granting Leave, Standing, and Authority to Commence and Prosecute a Certain Claim on Behalf of the NWHI Estate at 15, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. Jan. 31, 2019) [hereinafter Notice of Motion of the 2034 Notes Trustee]; Kenneth Ayotte & Christina Scully, J. Crew, Nine West, and the Complexities of Financial Distress, 131 Yale L.J.F. 363, 373 (2021) (describing some of the transfers in detail). For example, the private equity sponsor had allegedly purchased the assets of Kurt Geiger for $136 million in April 2014 and sold them in December 2015 for $371 million. See Notice of Motion of the 2034 Notes Trustee, supra, at 34.

[2]. See Motion of the Official Committee of Unsecured Creditors for Entry of an Order Granting Leave, Standing, and Authority to Commence and Prosecute Certain Claims on Behalf of the NWHI Estate and Exclusive Settlement Authority in Respect of Such Claims at 17, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. Oct. 22, 2018) [hereinafter Nine West Standing Motion].

[3]. See Transcript of Hearing at 43, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. May 7, 2018).

[4]. See Nine West Standing Motion, supra note 2, at 34 (“[The lawyers for the independent directors] attended . . . depositions . . . but asked just a handful of questions of a single witness . . . . [And they] chose not to demand and review the Debtors’ privileged documents relating to the LBO . . . .”).

[5]. See Nine West Standing Motion, supra note 2, at 13 (“The Debtors have barred the Committee from participating in its settlement negotiations with Sycamore . . . .”).

[6]. Shortly after the unsecured creditors proposed to put the claims against the private equity sponsor into a trust for prosecution after bankruptcy, the independent directors unveiled their own settlement plan. See Notice of Filing of the Debtors’ Disclosure Statement for the Debtors’ First Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the Bankruptcy Code at 1–3, In re Nine West Holdings, Inc., No. 18-10947 (Bankr. S.D.N.Y. Oct. 17, 2018) [hereinafter Nine West Disclosure Statement Announcing Settlement].

[7]. See Nine West Standing Motion, supra note 2, at 11 (seeking permission to prosecute claims for “well over $1 billion”); Soma Biswas, Nine West Settles Potential Lawsuits Against Sycamore Partners, Wall St. J. (Oct. 18, 2018, 2:12 PM), https://www.wsj.com/articles/nine-west-settles-
potential-lawsuits-against-sycamore-partners-1539886331 [https://perma.cc/RLH4-M9EU] (“Nine West Holdings Inc. unveiled Wednesday an amended restructuring plan that settles potential lawsuits against private-equity owner Sycamore Partners LP for $105 million in cash, far less than the amount the unsecured creditors committee is seeking.”).

[8]. See, e.g., Notice of Appearance—Lisa Donahue, AlixPartners, Petition (Feb. 19, 2020), https://www.petition11.com/news/2020/2/19/notice-of-appearance-lisa-donahue-alixpartners [https://
perma.cc/NA6H-69AT] (noting that “[independent directors in bankruptcy have] . . . become the latest cottage industry in the restructuring space”).

[9]. See Regina Stango Kelbon, Michael DeBaecke & Jonathan K. Cooper, Appointment of Independent Directors on the Eve of Bankruptcy: Why The Growing Trend? 17 (2014) (“Employing an outside director to exercise independent judgment as to corporate transactions in bankruptcy may not only provide additional guidance to a suffering business, but can make the decision-making process seem right in the eyes of stakeholders and ultimately, the court.”).

[10]. See Robert Gayda & Catherine LoTempio, Independent Director Investigations Can Benefit Creditors, Law360 (July 24, 2019, 3:55 PM), https://www.law360.com/articles/1174248/independent-director-investigations-can-benefit-creditors [https://web.archive.org/web/20220401015757/https://
http://www.law360.com/articles/1174248/independent-director-investigations-can-benefit-creditors%5D (noting that independent directors are helpful in bankruptcy where “speed to exit is paramount”).

[11]. See, e.g., “Independent” Directors Under Attack, Petition (May 16, 2018), https://petition.substack.com/p/independent-directors-under-attack [https://perma.cc/G9RY-U9D4]; Lisa Abramowicz, Private Equity Examines Its Distressed Navel, Bloomberg (May 26, 2017), https://www.bloomberg.com/opinion/articles/2017-05-26/payless-shoesource-private-equity-examines-its-distressed-navel [https://perma.cc/NC4H-DK9M]; Mark Vandevelde & Sujeet Indap, Neiman Marcus Director Lambasted by Bankruptcy Judge, Fin. Times (June 1, 2020), https://www.ft.com/content/
0166cb87-ea50-40ce-9ea3-b829de95f676 [https://perma.cc/5VY4-VQA8]; American Bankruptcy Institute, RDW 12 21 2018, Youtube (Dec. 20, 2018), https://www.youtube.com/watch?v=
Ah8RkXYdraI&ab_channel=AmericanBankruptcyInstitute [https://perma.cc/KG37-TJUC]; The “Weil Bankruptcy Blog Index,” Petition (Jan. 10, 2021), https://petition.substack.com/p/weilbankruptcy
blogindex [https://perma.cc/L356-TFPY] (calling the Nine West case a “standard episode of ‘independent director’ nonsense”).

[12]. See, e.g., Douglas G. Baird & Robert K. Rasmussen, Antibankruptcy, 119 Yale L.J. 648, 651 (2010) (considering creditor conflict); Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751, 784 (2002); David A. Skeel Jr., Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U. Pa. L. Rev. 917, 919 (2003) (considering the role of secured creditors); Michelle M. Harner & Jamie Marincic, Committee Capture? An Empirical Analysis of the Role of Creditors’ Committees in Business Reorganizations, 64 Vand L. Rev. 749, 754–56 (2011) (considering the role of unsecured creditors). For other articles that, like this Article, criticize recent changes in Chapter 11 practice, see generally Adam J. Levitin, Purdue’s Poison Pill: The Breakdown of Chapter 11’s Checks and Balances, 100 Tex. L. Rev. 1079 (2022); Lynn M. LoPucki, Chapter 11’s Descent into Lawlessness, 96 Am. Bankr. L.J. 247 (2022).

[13]. Our full dataset consists of the boards of directors of 528 firms and the 2,895 individuals who collectively hold 3,038 directorships at these firms. While all Chapter 11 firms are required to provide information on their board to the bankruptcy court, not all comply with the law. For more on our sample, see infra Part III.

[14]. See infra note 152 and accompanying text.

[15]. We identified bankruptcy directors using information from each firm’s disclosure statement. We then searched those disclosure statements and identified 78 cases in which the debtor represented that its board was “independent” or “disinterested.” See infra Section III.C.1. Independent directors are not new to bankruptcy. WorldCom, for example, used independent directors as part of its strategy to get through the bankruptcy process in its 2003 Chapter 11 filing. See Kelbon, supra note 9, at 20. The change is that a practice that was once relatively uncommon has become ubiquitous and a central and standard part of the process of preparing for a Chapter 11 bankruptcy filing, leading to the growth of an industry of professional bankruptcy directors who fill this new demand for bankruptcy experts on the board of distressed firms. See infra Section III.C.1

[16]. See infra Table 2.

[17]. In many cases, a debtor-in-possession contract that requires the firm to leave bankruptcy quickly heightens the debtor’s urgency. See, e.g., Frederick Tung, Financing Failure: Bankruptcy Lending, Credit Market Conditions, and the Financial Crisis, 37 Yale J. on Regul. 651, 672 (2020).

[18]. See infra Section III.C.4.

[19]. See infra Section III.C.5.

[20]. See Telephonic/Video Disclosure Statement and KEIP Motion Hearing at 34, In re Neiman Marcus Grp. Ltd. LLC, No. 20-32519 (Bankr. S.D. Tex. July 30, 2020) [hereinafter Neiman Marcus Settlement Transcript] (arguing that independent directors are changing incentives for private equity sponsors, who will be “encouraged to asset strip”).

[21]. As Sujeet Indap and Max Frumes write, a leading bankruptcy law firm that advises debtors “developed a reputation for keeping a stable of ‘independent’ board of director candidates who could parachute in to bless controversial deal making.” Sujeet Indap & Max Frumes, The Caesars Palace Coup: How a Billionaire Brawl Over the Famous Casino Exposed the Power and Greed of Wall Street 419 (2021).

[22]. See Alexander Saeedy, Elizabeth Warren Floats Expanded Powers for Bankruptcy Creditors Against Private Equity, Wall St. J. (Oct. 20, 2021, 1:17 PM), https://www.wsj.com/articles/elizabeth-warren-floats-expanded-powers-for-bankruptcy-creditors-against-private-equity-11634750237 [https://
perma.cc/P3XE-U24Y].

[23]. See generally Lucian A. Bebchuk & Assaf Hamdani, Independent Directors and Controlling Shareholders, 165 U. Pa. L. Rev. 1271 (2017); Da Lin, Beyond Beholden, 44 J. Corp. L. 515 (2019).

* Professor of Law, Harvard Law School.

† Professor of Law, Tel Aviv University, Faculty of Law.

‡ Associate Professor, Tel Aviv University, Faculty of Law; Lecturer on Law, Harvard Law School. We thank Kenneth Ayotte, Lucian Bebchuk, Vincent Buccola, Anthony Casey, Alma Cohen, Elisabeth de Fontenay, Jesse Fried, Lynn LoPucki, Tobias Keller, Michael Klausner, Michael Ohlrogge, Adam Levitin, Robert Rasmussen, Adriana Robertson, Mark Roe, Daniel Sokol, Robert Stark, Roberto Tallarita, Robert Tennenbaum, and seminar and conference audiences at the Annual Meeting of the American Law and Economics Association, Bay Area Corporate Law Scholars Workshop, the Bar Ilan University Law Faculty Seminar, the Corporate Law Academic Webinar Series (CLAWS), the Duke Faculty Workshop, Florida–Michigan–Virginia Virtual Law and Economics Seminar, the Harvard Law School Empirical Law and Economics Seminar, the Harvard Law School Faculty Workshop, Harvard Law School Law and Economics Workshop, Tel Aviv University Faculty of Law Workshop, the Turnaround Management Association, the University of Toronto Seminar in Law and Economics, and the University of California, Berkeley Law, Economics, and Accounting Workshop for helpful comments. We also thank Noy Abramov, Jacob Barrera, Jade Henry Kang, Spencer Kau, Victor Mungary, Julia Staudinger, Or Sternberg, Jonathan Tzuriel, and Sara Zoakei for excellent research assistance. This research was supported by The Israel Science Foundation (Grant No. 2138/19).

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The Rise of Bankruptcy Directors

Jared A. Ellias, * Ehud Kamar† & Kobi Kastiel‡

In this Article, we use hand-collected data to shed light on a troubling development in bankruptcy practice: distressed companies, especially

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Without Exception? The Ninth Circuit’s Evolving Stance on Nondebtor Releases in Chapter 11 Reorganizations

December 2022December 2022Caleb Downs*

INTRODUCTION

Chapter 11 of the Bankruptcy Code (or the “Code”) allows a troubled business debtor the opportunity to restructure its financial affairs so that it may successfully operate in the future.[1] To facilitate this process, a Chapter 11 debtor is given the exclusive right to propose a reorganization plan that, among other things, “provides for distribution on, and discharge of, all of the debtor’s prebankruptcy debts.”[2] Under some circumstances, a Chapter 11 debtor may choose to include a nondebtor release provision in its reorganization plan with creditors. Nondebtor releases (or “third-party releases”) vary in scope and form but generally are designed to shield nondebtors from liability on pre- and/or post-petition claims and are accompanied by injunctions barring actions against the released party.[3] Nondebtor releases are often provided in exchange for contributions to the reorganization.[4] For example, guarantors of the debtor may distribute funds to the reorganization effort in exchange for a release from their obligation under the guaranty. If a bankruptcy judge were to approve the nondebtor release and issue an accompanying injunction, any claims a creditor might have had against the guarantor are effectively extinguished.

So long as the enjoined party consents to the release, courts typically have no difficulty in finding the nondebtor release valid.[5] But when bankruptcy courts are asked to approve the release over the objection of an enjoined party, courts are confronted with fundamental questions about the objectives of the Bankruptcy Code and the rights of the enjoined party. How courts decide these issues can have significant consequences for the parties to the bankruptcy case and society more generally.

Does a bankruptcy court have the authority to extinguish otherwise valid claims against a nondebtor to protect the debtor’s reorganization effort? And if so, under what conditions? These questions have divided circuit courts for more than three decades.[6] Practically every jurisdiction weighing in on the merits of nondebtor releases has established its own rules regarding their approval or prohibition. A majority of circuit courts hold that nondebtor releases are an appropriate use of the bankruptcy court’s equitable powers.[7] They differ, however, on what circumstances justify the inclusion of a nondebtor release in a reorganization plan. Some majority opinions focus on how necessary the release is to ensure the success of the reorganization and thereby avoid liquidation of the debtor’s assets.[8] Other courts in the majority balance considerations of necessity with concerns about fairness to enjoined creditors.[9] A minority of jurisdictions prohibit the use of nondebtor releases in reorganization plans under any circumstances.[10] According to these courts, nondebtor releases “improperly insulate” nondebtors and function as de facto discharges outside of bankruptcy.[11]

Until 2020, the Ninth Circuit had “repeatedly held, without exception,” that nondebtor releases were precluded by the provisions of the Code.[12] Its decisions denying nondebtor releases used broad language that seemed to foreclose the possibility of the Ninth Circuit approving any nondebtor release, regardless of form or scope.[13] The Ninth Circuit was one of the first appellate courts to disapprove of a nondebtor release under the Bankruptcy Code of 1978,[14] and its opinions laid out a blueprint for other courts in their disapproval of nondebtor releases.[15] To say the Ninth Circuit was firmly established in the minority of jurisdictions prohibiting nondebtor releases is a bit of an understatement. In many ways, it was the leading authority on the invalidity of nondebtor releases.[16]

The Ninth Circuit’s decision in Blixseth v. Credit Suisse revised its stance on nondebtor releases. Blixseth involved a type of nondebtor release known as an exculpation clause.[17] Exculpation clauses are designed to release any named party, including nondebtors, from liability for any negligent acts or omissions related to the formulation, negotiation, or confirmation of the Chapter 11 case itself.[18] Seemingly upending decades of precedent, Blixseth held the language of the Bankruptcy Code did not prohibit such a “narrow” nondebtor release.[19] Contrasting the “sweeping nondebtor releases” denied in previous Ninth Circuit decisions, the court opined that the exculpation clause in Blixseth did “nothing more than allow the settling parties . . . to engage in the give-and-take of the bankruptcy proceeding without fear of subsequent litigation over any potentially negligent actions in those proceedings.”[20] After decades of disapproving of nondebtor releases, Blixseth’s reasoning and statutory interpretation indicate an important, yet incremental, shift towards the majority view on nondebtor releases.

This Note will conduct a critical analysis of Blixseth to illuminate how the decision differs from the court’s previous decisions on nondebtor releases and what it means for the future of nondebtor releases in the Ninth Circuit. The Note will then draw from that analysis to critique Blixseth’s reasoning and point to an alternative position on nondebtor releases that better aligns with the provisions and goals of the Bankruptcy Code. Part I will discuss the policy goals of Chapter 11 of the Bankruptcy Code and their relationship to nondebtor releases, analyze the statutory provisions relevant to the debate on nondebtor releases, and review the most common forms of nondebtor releases. Part II contains an analysis of the court’s reasoning in Blixseth and its predecessors and attempts to forecast how the court will rule on nondebtor releases in the future. Finally, Part III will argue that the Ninth Circuit should have embraced a more liberal position on nondebtor releases because the Code does not prohibit nondebtor releases and it sufficiently mitigates the “potential for abuse”[21] posed by nondebtor releases.

[1]. United States v. Whiting Pools, Inc., 462 U.S. 198, 203 (1983).

[2]. Ralph Brubaker, Bankruptcy Injunctions and Complex Litigation: A Critical Reappraisal of Non-Debtor Releases in Chapter 11 Reorganizations, 1997 U. Ill. L. Rev. 959, 961 (1997).

[3]. 4 Collier on Bankruptcy ¶ 524.05 (Richard Levin & Henry J. Sommer eds., 16th ed. 2021), LexisNexis; Brubaker, supra note 2, at 961; Richard L. Epling, Third-Party Releases in Bankruptcy Cases: Should There Be Statutory Reform?, 75 Bus. Law. 1747, 1749 (2020).

[4]. See, e.g., In re AOV Indus., Inc., 792 F.2d 1140, 1152 (D.C. Cir. 1986) (describing a nondebtor release given in exchange for the nondebtor’s commitment of “millions of dollars to a reorganization plan”).

[5]. Joshua M. Silverstein, Hiding in Plain View: A Neglected Supreme Court Decision Resolves the Debate over Non-Debtor Releases in Chapter 11 Reorganizations, 23 Emory Bankr. Devs. J. 13, 25–26 (2006).

[6]. The Ninth Circuit denied a nondebtor release as early as 1985 in Underhill v. Royal, 769 F.2d 1426, 1432 (9th Cir. 1985). One year later, the D.C. Circuit approved a nondebtor release in In re AOV Indus., Inc., 792 F.2d at 1154.

[7]. SE Prop. Holdings, LLC v. Seaside Eng’g & Surveying, Inc. (In re Seaside Eng’g & Surveying, Inc.), 780 F.3d 1070, 1077–78 (11th Cir. 2015) (describing the circuit split); see infra Table 1 (describing competing interpretations among different circuits).

[8]. See, e.g., In re Drexel Burnham Lambert Grp., Inc., 960 F.2d 285, 293 (2d Cir. 1992) (holding “a court may enjoin a creditor from suing a third party, provided the injunction plays an important part in the debtor’s reorganization plan”).

[9]. See, e.g., Gillman v. Cont’l Airlines (In re Cont’l Airlines), 203 F.3d 203, 211–14 (3d Cir. 2000); see also infra Table 1.

[10]. In re Seaside Eng’g & Surveying, Inc., 780 F.3d at 1077–78; see infra Table 1.

[11]. See, e.g., In re W. Real Est. Fund, Inc., 922 F.2d 592, 602, 600 (10th Cir. 1990) (“Obviously, it is the debtor, who has invoked and submitted to the bankruptcy process, that is entitled to its protections; Congress did not intend to extend such benefits to third-party bystanders.”).

[12]. Resorts Int’l, Inc. v. Lowenschuss (In re Lowenschuss), 67 F.3d 1394, 1401 (9th Cir. 1995).

[13]. See id. at 1401–02; see also Am. Hardwoods, Inc. v. Deutsche Credit Corp. (In re Am. Hardwoods, Inc.), 885 F.2d 621, 626 (9th Cir. 1989) (concluding § 524(e) “limits the court’s equitable power under section 105 to order the discharge of the liabilities of nondebtors”).

[14]. See supra note 6.

[15]. See In re W. Real Est. Fund, Inc., 922 F.2d at 601–02 (“[W]e follow the Ninth Circuit’s lead . . . and hold that . . . the stay may not be extended post-confirmation in the form of a permanent injunction that effectively relieves the nondebtor from its own liability to the creditor.”).

[16]. Silverstein, supra note 5, at 44 (noting “[t]he Ninth Circuit is the leading proponent of the view that third-party releases are invalid under § 524(e)”).

[17]. Blixseth v. Credit Suisse, 961 F.3d 1074, 1078–79 (9th Cir. 2020), cert. denied, 141 S. Ct. 1394 (2021).

[18]. Joshua M. Silverstein, Overlooking Tort Claimants’ Best Interests: Non-Debtor Releases in Asbestos Bankruptcies, 78 UMKC L. Rev. 1, 30 (2009).

[19]. Blixseth, 961 F.3d at 1082.

[20]. Id. at 1083–84.

[21]. Deutsche Bank AG, London Branch v. Metromedia Fiber Network, Inc. (In re Metromedia Fiber Network, Inc.), 416 F.3d 136, 142 (2d Cir. 2005) (“The potential for abuse is heightened when [nondebtor] releases afford blanket immunity.”).

* Executive Senior Editor, Southern California Law Review, Volume 95; J.D. Candidate 2022, University of Southern California Gould School of Law. I dedicate this Note to my wife, Elizabeth, who has selflessly supported me throughout my legal education. I also would like to thank Lecturer in Law George Webster for his generosity, patience, and insight throughout the development of this Note.

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Regulating Bankruptcy Bonuses – Article by Jared A. Ellias

March 2019July 2019Southern California Law Review Admin

From Volume 92, Number 3 (March 2019)
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Regulating Bankruptcy Bonuses

Jared A. Ellias [*]

In 2005, the perception that wealthy executives were being rewarded for failure led Congress to ban Chapter 11 firms from paying retention bonuses to senior managers. Under the new law, debtors could still pay bonuses to executives—but only “incentive” bonuses triggered by accomplishing challenging performance goals that go beyond merely remaining employed. This Article uses newly collected data to examine how this reform changed bankruptcy practice. While relatively fewer firms use court-approved bonus plans after the reform, the overall level of executive compensation appears to be similar, perhaps because the new regime left large gaps that make it easy for firms to bypass the 2005 law and pay managers without the judge’s permission. This Article argues that the new law was undermined by institutional weaknesses in Chapter 11, as bankruptcy judges are poorly situated to analyze bonus plans and creditors have limited incentives to police executive compensation themselves.

TABLE OF CONTENTS

Introduction

I. The Rise of Bankruptcy Bonuses and the 2005 Bankruptcy Reforms

A. The Rise of Bonuses as a Prominent Feature of
Chapter 11 Bankruptcy

B. As the Economy Fell into Recession in the Early 2000s,
the Public Salience and Controversy over Chapter 11 Bonuses Increased

C. Congress Empowers the Oversight of Managers and Restricts Retention Bonuses with the 2005 Reform

II. Theoretical Problems with the 2005 Reform

III. Evidence of Design Problems in the 2005 Reform

A. Sample and Data Gathering

B. Assessing Evidence of Design Flaws in the 2005 Reform

1. Assessing the Effect of the Reform: Evidence of
Higher Costs and Regulatory Evasion.

2. Assessing the Limitations of the Bankruptcy Judge

3. Assessing the Role of Creditors and the U.S. Trustee

IV. The Case for RETHINKING the 2005 Reform

Conclusion

Appendix: Methodology FOR Analyzing
Bankruptcy Costs

Introduction

When large firms struggle financially, they usually restructure by firing employees, cutting the pay of those who remain, and cancelling promised pensions. While these measures are often necessary, they can seem unfair when highly paid senior managers do not appear to share in the pain.[1] This unfairness became a major public issue in the early 2000s, as formerly–high-flying titans of corporate America like K-Mart, Enron, and WorldCom filed for headline-grabbing Chapter 11 bankruptcies and subsequently paid millions of dollars in bonuses to senior managers.[2] The ensuing public outrage contributed to a growing sense that the economy had become rigged in favor of high-level executives who prospered no matter how poorly their companies fared.[3]

In 2005, Congress responded to this public outcry by banning Chapter 11 debtors from paying retention bonuses to high-level executives.[4] This legal reform eliminated part of then-existing bankruptcy practice, as the largest firms typically paid retention bonuses shortly after filing for bankruptcy on the theory that bonuses were needed to keep employees working hard to turn the firm around.[5] However, the reform did not ban Chapter 11 debtors from paying any type of bonus to senior managers—only bonuses triggered by a manager’s mere continued employment. Under the new regime, Chapter 11 debtors can pay bonuses if they convince a bankruptcy judge that the bonuses are “incentive” bonuses, or bonuses managers would only receive if they accomplish specific, challenging performance goals.[6]

This Article offers the first comprehensive analysis and empirical study of how the 2005 law changed corporate bankruptcy practice. As further explained below, the data suggest that the reform appears to have had little substantive effect on executive compensation.[7] The evidence suggests that this is primarily due to two flaws that undermine the reform. First, the new law only regulates payments characterized as bonuses during the period when firms are in Chapter 11 bankruptcy. Firms can easily sidestep the new law by paying managers before or after the bankruptcy case, and many appear to have done so.[8] Second, bankruptcy law institutions have struggled to administer the law. A rule that bans retention bonuses while allowing incentive bonuses requires bankruptcy judges to make fact-intensive determinations about the “challengingness” of a proposed bonus plan. Unfortunately, bankruptcy judges often lack the information and expertise necessary to perform this inquiry.[9] Although creditors would appear to be well-situated to assist the judge and scrutinize executive compensation themselves, they have little economic incentive to quibble over relatively small bonuses, because doing so might anger the managers with whom they need to negotiate more important Chapter 11 issues.

This Article proceeds as follows. Part I describes how bankruptcy bonuses became a frequent subject of public outrage and how Congress changed the law in 2005 to alter the process through which Chapter 11 debtors pay executive bonuses. Part II explains potential flaws in the design of the reform and develops hypotheses about how those design flaws arguably doomed its implementation. Part III summarizes the sampling and data gathering methodologies and then presents evidence that illustrates the design flaws predicted in Part II. One question that this Article does not answer is whether there actually was a problem that needed fixing prior to the 2005 reform. Most Chapter 11 attorneys appear to believe so, but this is an empirical question that is impossible to answer with available data. However, because the evidence presented in this Article does not support the view that Chapter 11 executive compensation was improved by the reform, Part IV argues that Congress should rethink the 2005 reform.

I. The Rise of Bankruptcy Bonuses and the 2005 Bankruptcy Reforms

Part I first summarizes how the phrase “bankruptcy bonus” entered the public lexicon and why these bonuses became so controversial. Next, I explore the legislative history of the 2005 reform, before discussing the ways in which the new law altered the ability of Chapter 11 debtors to pay bonuses to their executives.

A. The Rise of Bonuses as a Prominent Feature of Chapter 11 Bankruptcy

For the first two decades of the Bankruptcy Act of 1978, bonus plans approved by bankruptcy judges were not an important part of bankruptcy practice.[10] The new Bankruptcy Code contained few provisions dealing with executive compensation, and bankruptcy courts routinely granted uncontroversial motions to pay employees their promised salaries.[11] This quiet period ended in the early twenty-first century, as Chapter 11 debtors and the law firms advising them developed a practice of paying retention bonuses outside the ordinary course of business after filing for bankruptcy.[12] Generally, firms that wanted to pay retention bonuses would file a motion asking the judge to approve “Key Employee Retention Plans,” or “KERPs,” which created schedules of payments of retention bonuses.[13]

Chapter 11 debtors offered two main justifications for why they needed to pay retention bonuses. First, they usually pointed to the value that the debtor’s current employees contribute to the restructuring effort.[14] Incumbent employees often have firm-specific knowledge that would be costly to lose and hard to replicate in new employees.[15] Even if the knowledge could be replicated, Chapter 11 debtors may fear that they will have trouble attracting new employees because new hires might hesitate before accepting a job with a bankrupt company.[16]

Second, many debtors claimed that they needed to update their compensation practices to avoid underpaying employees.[17] This underpayment problem arose because of the growing complexity of executive pay packages.[18] At a high level, executive compensation consists of two components: (1) a “base” payment, (2) and a “bonus” payment. The base payment is what we usually think of as salary; the amount of money that a manager expects to be paid for showing up to work every day.[19] The bonus payment is a catchall term that consists of all performance-related pay, such as rewards for achieving a sales goal or remaining an employee of the firm for a certain period of time.[20] Increasingly, in the early 1990s, large firms began to rely on bonus compensation, creating new pressure to update performance–compensation policies to reflect changes in the firm’s business and the disruption created by bankruptcy.[21] Accordingly, Chapter 11 debtors argued that they needed to pay retention bonuses to avoid paying valuable employees significantly less money than they were accustomed to making, undermining morale and retention.[22]

B. As the Economy Fell into Recession in the Early 2000s, the Public Salience and Controversy over Chapter 11 Bonuses Increased

These retention bonus plans became the subject of controversy in the early 2000’s for three main reasons. First, the public spectacle of a failed firm paying millions of dollars in bonuses to senior managers while firing workers naturally led to populist outrage.[23] The controversy over bankruptcy-related pay echoed the still-raging public controversy over the high levels of executive pay, which seemed unfair to many observers and was especially salient after the dot-com bust sent the nation into recession.[24]

Second, the bonuses attracted criticism from some commentators who worried that the public nature of the payments and the large amount of media attention that they attracted were undermining public confidence in the bankruptcy process.[25]

Third––and most importantly from the perspective of bankruptcy policy––some observers believed that management was exploiting the basic structure of Chapter 11 to extract undeserved pay.[26] When a firm files for bankruptcy, existing management remains in control of the business, giving managers great influence over the firm and its stakeholders.[27] Management’s control over the bankruptcy process can lead the board of directors and even creditors to seek to pay managers for desired outcomes, such as enticing management to agree to sell the firm.[28] The dislocations created by bankruptcy can also provide management with bargaining power.[29] The board of directors may fear that the departure of a key executive would seriously reduce the prospect of a successful reorganization, creating an opportunity for opportunistic managers to demand more pay than they deserve.[30] This agency problem threatens the basic structure of Chapter 11 bankruptcy, a process in which a firm’s asset value is supposed to be maximized for the benefit of pre-bankruptcy creditors, not the personal wealth of incumbent managers.

Of course, the Bankruptcy Code recognizes the power that management has over a corporation in bankruptcy and thus creates a strong system of checks and balances to counterbalance managerial power.[31] The first line of defense is the federal bankruptcy judge, who must approve any payment of bonuses.[32] Next, bankruptcy law appoints an “[o]fficial [c]ommittee of [u]nsecured [c]reditors” to act as a “watchdog” that scrutinizes management’s business decisions.[33] This committee is generally composed of some of the firm’s major creditors, who stand to receive lower payouts at the end of the bankruptcy case if the firm overpays management.[34] The committee will usually have a high-powered law firm and investment bank assisting them, and they will analyze any proposed bonus plan to determine whether it overpays managers.[35] To the extent that creditors believe management is extracting undeserved pay, they can file written objections informing the judge of the bonus plan’s problems and negotiate in the shadow of those objections and the right to object.[36]

Further, the Department of Justice’s United States Trustee Program provides a second level of governmental oversight that helps the bankruptcy judge assess the motions in front of her.[37] Congress created the United States Trustee Program as a part of the Bankruptcy Act of 1978 to oversee the then-new system of bankruptcy courts.[38] Each district has its own Office of the United States Trustee, which generally consists of several attorneys and other legal professionals.[39] These lawyers supervise all bankruptcy cases, looking for evidence that bankruptcy law is being abused.[40] The United States Trustee has the right to file an objection of its own if it determines that management is using its control of the corporation to extract excessive compensation.[41]

Prior to the 2005 reform, this system of checks and balances lay dormant because bankruptcy law instructed the judge to defer to management in determining if bonuses were needed.[42] Chapter 11 debtors only needed to convince the judge that a proposed retention bonus plan was the product of reasonable business judgment.[43] This was an easy standard to satisfy, and firms would do so by arguing that the employees were important to the successful reorganization of the business [44] and that the board of directors engaged in some sort of deliberative process to develop the plan.[45]

C. Congress Empowers the Oversight of Managers and Restricts Retention Bonuses with the 2005 Reform

This equilibrium changed when Congress banned retention bonuses as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “BAPCPA”).[46] Congress sought to “eradicate the notion that executives were entitled to bonuses simply for staying with the Company through the bankruptcy process.”[47] After the reform, bankruptcy judges were only allowed to authorize Chapter 11 debtors to pay “incentive” bonuses, typically through a formal “Key Employee Incentive Plan” (“KEIP”).[48] In theory, KEIPs tie any bonus payments to the achievement of challenging performance goals, such as improving the firm’s financial performance or attaining a milestone in the bankruptcy process like confirming a plan of reorganization.[49] As a result, bankruptcy judges found themselves with the challenging new task of evaluating proposed bonus plans to determine if they were permissible incentive plans or “disguised retention plans” that did not actually challenge management.[50]

Consider a hypothetical bonus plan that pays an executive if the firm’s revenue increases by 10 percent. Is this an incentive plan or a retention plan? The answer turns on how likely it is for that anticipated revenue increase to occur.[51] An executive who commits to such a plan may very well have private information regarding an imminent sale to a major customer that will yield the 10 percent increase, making the incentive plan a “disguised retention plan” that rewards the manager for remaining employed without requiring extra effort and accomplishment to earn the bonus.[52] On the other hand, in some cases a 10 percent increase in revenue could be highly unlikely and something management can only achieve with extra effort.[53] How can one proposed bonus plan be distinguished from another? In the seminal case interpreting the 2005 reform, Judge Burton I. Lifland of the Southern District of New York declared “if it walks like a duck (KERP) and quacks like a duck (KERP), it’s a duck (KERP).”[54]

Judge Lifland also identified several factors that bankruptcy courts should analyze to determine if a proposed bonus plan creates challenging incentive bonuses or disguised retention bonuses:

Is there a reasonable relationship between the plan proposed and the results to be obtained, i.e., will the key employee stay for as long as it takes for the debtor to reorganize or market its assets, or, in the case of a performance incentive, is the plan calculated to achieve the desired performance?

Is the cost of the plan reasonable in the context of the debtor’s assets, liabilities and earning potential?

Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?

Is the plan or proposal consistent with industry standards?

What were the due diligence efforts of the debtor in investigating the need for a plan; analyzing which key employees need to be incentivized; what is available; what is generally applicable in a particular industry?

Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?[55]

To summarize, the 2005 reform is best understood as creating new responsibilities for Chapter 11 debtors, the bankruptcy judges, and the Department of Justice’s United States Trustee Program, while providing new bargaining power for creditors. Prior to the reform, a Chapter 11 debtor could easily obtain a judge’s permission to pay bonuses by demonstrating a plausible business justification.[56] After the reform, Chapter 11 debtors can only pay bonuses if they convince a judge that a proposed bonus plan requires management to demonstrate extra effort and skill. The standard developed in the Dana Corp., and re-articulated above, requires the debtor to present evidence of industry and firm practices to demonstrate the reasonableness of the overall level of compensation, as well as the structure that would trigger the payment of bonuses. In making this case, Chapter 11 debtors typically present the testimony of an independent compensation consultant that helped to develop the incentive plan. The judge then must weigh significantly more evidence and make more findings of fact than was the case prior to the 2005 reform. This new bargaining dynamic empowers creditors, who can investigate a proposed bonus plan, file an objection, and negotiate to change the plan in the shadow of the objection.[57]

II. Theoretical Problems with the 2005 Reform

This Part describes theoretical flaws that undermine the bankruptcy system’s then-newfound mandate to police executive compensation in bankruptcy. These flaws lead to three testable hypotheses about the reform, which are respectively analyzed using empirical evidence in Section III.B.

As a general rule, laws that leave gaps create incentives for regulatory evasion.[58] The 2005 reform only affects bonuses paid through court-approved bonus plans in Chapter 11. This narrow scope allows firms to simply sidestep the regulation by paying managers prior to filing for bankruptcy or waiting until a Chapter 11 case ends to adjust management’s compensation retroactively. Indeed, the reform likely created financial incentives for firms to engage in evasion, as the additional work that law firms need to do to meet the new standard is costly.

Accordingly, hypothesis one is that firms will respond to the increased costs of proposing a bankruptcy bonus plan by evading the new regulation and paying managers through channels unaffected by the 2005 reform.[59]

Further, the reform places bankruptcy judges in the challenging position of distinguishing permissible incentive plans from forbidden retention plans. To do so, judges must assess ex ante the likelihood that a triggering event will occur. If a performance goal is likely to occur without additional managerial effort, the judge should reject it as a disguised retention plan that rewards management for remaining employed. This is a difficult analysis. The boards of directors and managers that develop bonus plans presumably know their businesses better than the judge, placing the judge at a disadvantage in evaluating a bonus plan. Further, judges are bankruptcy lawyers and lack subject-matter expertise in executive compensation, let alone specific knowledge of the firm’s industry. Moreover, even in a world with perfect information, the judge would still struggle to perform this analysis because the line between retention and incentive plans is very thin. All incentive plans have some retentive element, as employees often remain in jobs to earn promised bonuses.[60]

Therefore, hypothesis two is that bankruptcy judges are unlikely to be able to screen out all but the most obviously disguised retention plans, and the bonus plans that are approved are unlikely to be significantly different in substance than the bonus plans prior to the reform.[61]

The challenges that bankruptcy judges face are exacerbated by the incentives that creditors have to use their bargaining power to police executive compensation.[62] One of the main reasons that executive compensation theorists have long sought to empower investors with a greater voice in determining executive pay is because of the belief that the excess compensation paid to managers reduces the returns to investors.[63] Superficially, this is the case in Chapter 11 as well, as creditors are generally the firm’s residual claimant and thus the losers if the firm overpays management. However, executive bonuses affect such a small amount of value in large Chapter 11 cases—single-digit millions when the firm’s assets can potentially be worth billions—that we would expect creditors might decline to spend the time and money required to actively police executive compensation.

Further, the bankruptcy judge is unlikely to get much help from the Department of Justice’s U.S. Trustee Program. In theory, the Department of Justice only has incentives to enforce bankruptcy law, and the 2005 reform created a new Congressional policy of policing abuses in executive compensation. In practice, the U.S. Trustee suffers from the same informational asymmetries and expertise deficits that limit a judge’s effectiveness in evaluating a proposed bonus plan. The 2005 reform did not provide extra money to hire compensation experts to help the lawyers in the U.S. Trustee’s office analyze proposed bonus plans.

Accordingly, hypothesis three is that the bankruptcy judges are unlikely to receive much help from creditors and the U.S. Trustee. Creditors have weak incentives, on average, to invest the time and resources required to police executive compensation aggressively. The U.S. Trustee lacks the necessary expertise to perform the role assigned to it by Congress.[64]

III. Evidence of Design Problems in the 2005 Reform

Part III presents an account of the flaws that undermine the 2005 reform. Section III.A first describe the data gathering methodology and the sample of bankruptcy cases. In Section III.B, evidence from the empirical study tests the hypotheses developed in Part II.

A. Sample and Data Gathering

To study the reform, I gathered two samples of data: (1) a large sample that represents the population of large companies that filed for Chapter 11 between 2001 and 2012 with traded debt or equity and (2) a smaller case study sample of cases from before and after the statutory change to examine bonus plans (and bankruptcy litigation) in a more comprehensive and detailed way. Both samples are drawn from Next Generation Research’s list of large company bankruptcies from 2001 to 2012.[65] I describe the construction of the large sample and the case study sample in turn.

The large sample consists of all large companies from Next Generation Research’s list of large company bankruptcies from 2001 to 2012 that traded debt or equity. I focus on firms with publicly traded debt or equity because those firms have obligations to file disclosures with the Securities and Exchange Commission (“SEC”), so information on firm compensation practices are available. Nearly all of the largest firms to file for bankruptcy have traded debt or equity, and this larger sample is very close to the population of large companies that restructured their debt in Chapter 11 court proceedings between January 1, 2001 and December 31, 2012.

I identified the firms included in the larger sample through the following procedure.[66] For each of the 1,998 large firms that filed for Chapter 11 bankruptcy between 2001 and 2012, I looked for matches in the list of debt or equity issued by large firms that traded in the databases kept by TRACE, MarkIt, and Bloomberg.[67] For example, if I found that a firm filed for bankruptcy on January 3, 2003, I looked for trades in that firm’s debt or equity entered on or after that date. This larger sample consists of 408 cases. For each of the firms in the sample, I collected extensive information about the firm and the bankruptcy case from the court docket and important pleadings. Most importantly, I recorded whether the firm sought judicial approval of a bankruptcy bonus plan and identified which, if any, bonus plans were approved by the bankruptcy judge. For all of these firms, I also examined their securities filings to obtain additional information on how the firm historically compensated its executives.[68]

I collected the case study sample using a similar method. I again began with the list of all firms listed in Next Generation Research’s database of corporate bankruptcies, including those without traded debt or equity.[69] The case study sample comes from two time periods. First, I collected a “before” sample of every large bankruptcy case from Next Generation Research’s list of large corporate bankruptcies that filed between January 1, 2004 and April 20, 2005, the date that BAPCPA was signed into law by President George W. Bush. I begin with January 1, 2004, because older dockets are generally no longer available on the Public Access to Court Electronic Records database (“PACER”). The initial sample consisted of 140 potential Chapter 11 debtors, of which forty-one (approximately 30%) sought judicial approval for a key employee retention or incentive plan. These forty-one Chapter 11 debtors constitute the pre-BAPCPA sample, which I term the “pre-reform” or “pre-2005 reform” sample.

The second case study sample period consists of all firms that filed for Chapter 11 bankruptcy between January 1, 2009 and December 31, 2010 that implemented bankruptcy bonus plans. I choose a period four years after the reform because it took several court decisions to settle on a legal standard for adjudicating proposed post-reform incentive plans and lawyers needed time to develop customs to meet that standard.[70] I began with the list of 375 large bankruptcy cases and examined each court docket to look for a proposed bonus plan. The final sample consists of fifty-seven bonus plans filed by debtors that filed for bankruptcy in 2009 and 2010.[71]

I studied each case in the case study sample very closely. In addition to examining the docket and acquiring basic information from court filings, I examined all objections filed by creditors and the United States Trustee to managements’ motions seeking approval of bonus plans. I also compared the bonus plans approved by the court to the original bonus plans to track changes made over the course of the bargaining process. Next, I examined the goals created by the plans and used the date of bankruptcy events, the disclosure statement and subsequent securities disclosures, news stories, and press releases to determine whether management achieved the incentive payout.

Finally, I examined all of the legal bills filed by the debtor’s counsel for the period between the petition date and the bonus plan being approved by the court. When large firms are in Chapter 11 bankruptcy, they ask for (and receive) a court order allowing them to retain a law firm to help them with their bankruptcy.[72] The Chapter 11 debtor then submits its law firm’s legal bills to the court and asks for permission to pay them.[73] The Federal Rules of Bankruptcy Procedure require a detailed statement of the time the attorneys spent on the firm’s legal problems, which in practice translates to the full record of all time charged to the client. I oversaw a team of research assistants that worked together to identify the amount and value of time that law firms spent on bonus plans for both time periods in the case study sample. I provide an illustrative example of this analysis in the Appendix. To my knowledge, this is a new method in the bankruptcy practice literature, and a very labor-intensive one, but it holds significant promise in terms of aiding our understanding of bankruptcy costs.

B. Assessing Evidence of Design Flaws in the 2005 Reform

The 2005 reform aimed to reduce public outrage over bankruptcy bonuses, force managers to earn their pay, and reduce the overall level of executive compensation. Section III.B uses evidence from the sample to test the hypotheses developed in Part II. In general, I begin with the high-level portrait painted by the larger sample, test for obvious confounding explanations of the findings using regression analysis, and then look closely at the case study sample to reveal a more detailed picture.

1. Assessing the Effect of the Reform: Evidence of Higher Costs and Regulatory Evasion.

Hypothesis one predicts that the reform will increase the costs associated with bankruptcy bonus plans and lead to regulatory evasion. I begin by assessing the impact of the reform on bankruptcy costs before moving on to the observed frequency of bonus plans and evidence that points to rampant regulatory evasion.

a. The Effect of the Reform on Bankruptcy Costs

As a threshold matter, by requiring the debtor’s counsel to do extra work to approve a bonus plan, the 2005 reform and Dana Corp. may have increased the costs of bankruptcy.[74] To estimate the size of the increase, I reviewed all of the debtor’s counsel’s bills and identified the time entries corresponding to work on a bankruptcy bonus plan. Pre-reform, the median debtor’s counsel billed $30,484 (mean of $65,198) for work on a bankruptcy bonus plan in constant 2010 U.S. dollars.[75] Post-reform, the median debtor’s counsel billed $86,411 (mean of $140,218) for their work on their debtor’s bonus plans, an increase of 64%. For comparison’s sake, the debtor’s counsel’s bill for the entire bankruptcy case was $5,191,576 in the post-reform sample, as compared to $3,449,969 pre-reform—an increase of 33%. The costs associated with a bankruptcy bonus plan grew twice as fast as the debtor’s counsel’s fees as a whole, suggesting that the new standard significantly increased the amount of legal work the debtor’s attorneys needed to do to comply.[76]

b. The Effect of the Reform on Bonus Plan Utilization

The observed increase in costs associated with bonus plans is likely to deter other Chapter 11 debtors from implementing them. Sure enough, as Figure 1 shows, relying on the larger sample of the population of Chapter 11 debtors between 2001 and 2012, the percentage of firms filing for bankruptcy that seek a bonus plan falls precipitously after the 2005 reform, going from nearly 60% in 2004 to less than 40% in 2007.

It is difficult to conclude too much by examining the raw proportion of Chapter 11 firms with bonus plans, as the observed change could be a composition effect. For example, 2004 may have featured more firms in industries where bonuses are a larger part of executive compensation than did 2007.[77] I cannot eliminate the possibility that a composition effect drives the shift observed in Figure 1, although it seems unlikely that this would be the whole explanation. I can, however, control for some observable firm characteristics in a regression analysis to test the robustness of the observed post-reform decline in the utilization of bankruptcy bonus plans, specifically by controlling for firm size, industry, and the debtor’s law firm. Table 1 displays those regression results. In Models 1, 2, and 3, I regress a dummy variable for post-2005 reform filing on the likelihood of a bonus plan being proposed, with the second Model adding control variables. In Models 4, 5, and 6, I instead study the likelihood that a bonus plan is approved. In the cases of both proposal and approval, the results are the same: controlling for firm characteristics, firms become less likely to implement bankruptcy bonus plans after the 2005 reform.

c. The Effect of the Reform on the Overall Level of Executive Compensation

Given that proportionately fewer firms used court-approved bonus plans, it is possible that the overall level of executive compensation was reduced by the reform. To the extent the pre-reform equilibrium was characterized by managerial rent extraction, the reform might have eliminated some opportunistic retention bonus plans that effectively overcompensated managers.

While I am not able to measure overcompensation, I can look for evidence of a change in the level of compensation that managers receive before and after the 2005 reform. I take two approaches to doing so. First, for a subset of the large sample with available data, I calculate the percentage change in CEO compensation in the year prior to bankruptcy and the year the firm filed for bankruptcy.[78] This facilitates comparison of bankruptcy-period compensation to pre-bankruptcy–period compensation, controlling for the firm’s historic level of compensation.

Second, to make sure that industry changes do not bias the analysis, I adjust each firm’s observed CEO compensation to control for the firm’s industry. For each firm in the sample, I identify the firm’s industry using its three digit SIC code. I then use the ExecuComp dataset to identify S&P 1,500 firms in the same industry as each sample firm to understand how the sample firm’s compensation compared to its industry peers. I then calculated a percentile ranking that reflects how the Chapter 11 debtor compared to its peers in each observed calendar year. So, for example, a firm in the 90th percentile in terms of compensation is a firm that paid their CEO more than 90% of all other firms in the same industry.

As Table 2 shows, I fail to find any statistically significant effect suggesting that the overall level of executive compensation in bankruptcy was altered by the reform. To be sure, my failure to find this relationship does not mean there is not one. This analysis is conducted on a subset of the sample firms highly constrained by data availability, and it is possible that if the analysis included the missing firms the result would be different.[79] There may also be an omitted variable that would uncover an otherwise hidden relationship. However, at the very least, the results suggest that the lower rate of bonus plans might not have changed the overall level of compensation of Chapter 11 executives, relative to pre-bankruptcy compensation and industry trends.

d. Anecdotal Evidence of Regulatory Evasion

A potential explanation for this result is that firms may simply sidestep court-approved bonus plans to engage in regulatory evasion. I cannot offer comprehensive statistics on how frequently Chapter 11 debtors utilize these strategies, as firms do not necessarily go out of their way to disclose these strategies and are not necessarily required to do so. I also cannot rule out the possibility that the observed change in bonus plan utilization reflects improved governance of executive compensation. However, I find extensive anecdotal evidence suggesting that many firms are simply paying managers in ways that evade the judicial scrutiny demanded by the reform. There are three main strategies to get around the 2005 reform: (1) adjusting compensation pre-bankruptcy; (2) paying bonuses as part of other bankruptcy court orders that the 2005 reform does not regulate; and (3) waiting until after the firm emerges from bankruptcy to pay bankruptcy related-bonuses. I explain each strategy in turn.

First, the reform does not affect compensation adjustments that firms made before filing for Chapter 11 bankruptcy, and some firms appear to have taken advantage of this.[80] A Chapter 11 debtor cannot simply pay management a large bonus on the eve of bankruptcy, as doing so might create an avoidable transfer that creditors could recover.[81] However, at least some firms implemented bankruptcy-related bonus plans prior to filing for Chapter 11 that were overt and open attempts to evade the 2005 reform. For example, OTC Holdings, a manufacturer of party supplies and children’s toys, set up a Key Employee Performance Incentive Plan (“KEPIP”) to “align the interests of OTC’s key employees with the interests of OTC and its creditors” prior to the firm’s bankruptcy petition.[82] This plan was designed to pay bonuses only after the firm emerged from bankruptcy, which, the firm argued, meant that the Bankruptcy Code’s restrictions on executive bonuses would not apply to the incentive plan.[83] Similarly, the board of directors of Regent Communications implemented a “Special Bonus Plan . . . [which] was triggered upon commencement of the Chapter 11 Cases,” suggesting that OTC is, at the very least, not the only firm that engaged in this sort of bankruptcy planning.[84]

Second, some firms simply “bundled” bankruptcy bonus plans with other, more important motions to evade close court monitoring of bankruptcy-related compensation.[85] When large firms file for bankruptcy, they usually also file a variety of intermediate motions while they try to reorganize their business—a motion for a bonus plan is an example of such an intermediate motion—before filing a proposed plan of reorganization for the approval of the bankruptcy judge. The plan of reorganization is a lengthy document that contains hundreds of provisions that describe how the firm will leave bankruptcy, how it will pay its creditors, and what the post-bankruptcy life of the company will be. Bankruptcy law instructs the judge to evaluate this document under section 1129 of the Bankruptcy Code.[86] The approval of this document will normally end the bankruptcy case and allow the firm to emerge as a restructured company. Adding a retroactive bankruptcy bonus plan into this document is as simple as adding a single line of text.

By “bundling” the executive bonus plan with the larger plan of reorganization, a Chapter 11 debtor can evade the scrutiny that comes when the bonus plan is squarely before the court. This strategy also puts the judge in a difficult position, as it creates a choice between approving the plan of reorganization (with the bundled executive bonus plan) or rejecting the plan, when rejecting the plan might mean forcing the company to remain in bankruptcy with unknown costs for the business and its employees.

As such, it should not be surprising that “bundling” was the most commonly observed regulatory evasion strategy. For example, in the bankruptcy of Journal Register, management abandoned an attempt to obtain judicial approval of a bankruptcy bonus plan after the pension fund objected. But management did not abandon the goal of paying itself for bankruptcy-related performance. Instead, the company bundled a “bankruptcy emergence bonus” into the plan of reorganization, which, it reasoned, was governed by a different part of the Bankruptcy Code than section 503(c).[87] In evaluating this attempt at bundling, the court first noted that the debtors “filed a motion during the cases for approval of the Incentive Plan, but thereafter withdrew that motion and incorporated the Incentive Plan in the Reorganization Plan.”[88] However, the court also pointed out that the plan process involved creditor voting and the creditors—whose money was going to the executives—supported the plan.[89] Accordingly, the judge approved the payment of the bonuses.[90]

Finally, a third strategy to evade court monitoring of bankruptcy-related executive compensation is deferring bonuses for bankruptcy-related conduct for the post-bankruptcy board of directors.[91] Once a firm leaves bankruptcy, it is no longer under judicial supervision and can pay its employees however much it wants. As such, boards of directors can sidestep the 2005 reform by promising management a bonus that is never formally contracted for or paid until the firm emerges from bankruptcy.

While post-bankruptcy executive compensation is, by definition, hard to survey in detail, I did observe strange behavior in the bankruptcy of Citadel Broadcastings, a radio station conglomerate that filed for bankruptcy in late 2009.[92] Citadel proposed a plan of reorganization that, like most cases in the sample, included setting aside a percentage of the firm’s post-reorganization equity for managers.[93] This plan of reorganization was hotly contested by hedge fund creditors, who charged that management was undervaluing the firm and going to profit in the form of underpriced post-bankruptcy stock grants.[94] In response to the criticism, the CEO testified in court, “I have tried to get stock and each time I was told I am getting options at market value . . . [that] will vest one-third each year on the anniversary from the time I got those options. So they will be actually vest[ed] three years from now.”[95]

The company thus dealt with the charge of self-dealing in an elegant way. Instead of an outright stock grant, management received out-of-the-money or market value stock options, which meant that management could not use those stock grants to extract value that should have gone to creditors. After hearing this testimony, the judge confirmed the plan of reorganization.[96]

This testimony appears to have been forgotten shortly after the firm exited bankruptcy. Less than a month after leaving Chapter 11, reorganized Citadel distributed the stock in the form of restricted stock grants that vested on a two–year schedule.[97] The CEO alone received $55 million, making him the highest paid manager in the history of the radio industry.[98] These stock grants were only publicly disclosed due to Citadel’s obligations as an issuer of public debt. The disclosures caught the ire of the activist investors who had lost in court at the confirmation hearing.[99] They filed a motion seeking to “prevent one of the most egregious frauds by a company emerging from bankruptcy under Chapter 11.”[100] They noted that this conduct was “fraudulent because Citadel representatives, including [the CEO] himself, repeatedly told this Court, under oath, that they were not getting under the Plan the very securities that they gave themselves only weeks later immediately upon emergence [from bankruptcy.]”[101]

The Citadel Broadcasting Corp. case is an outlier, however. I have not come across any other cases with similar facts. However, the 408 firms in the large sample set aside more than $400 million in post-bankruptcy equity for post-bankruptcy management incentive plans. To be sure, most large companies have some sort of equity incentive plan, and it is entirely in the ordinary course for companies to compensate managers with stock. But other research has noted that creditors sometimes persuade managers to support their incentive plan with lucrative post-bankruptcy employment contracts.[102] Thus, it remains an open question how often managers are rewarded after the firm emerges from bankruptcy for conduct that took place during bankruptcy.

2. Assessing the Limitations of the Bankruptcy Judge

As hypothesis two discussed above,[103] bankruptcy judges suffer from an informational asymmetry and lack of expertise that make it difficult for them to make the determination that the 2005 reform wants them to—that a bonus plan is an “incentive plan” with challenging goals and not a “disguised retention plan.” To assess this hypothesis, I first examine how the structure of bonus plans changed after the reform and then determine whether the post-2005 bonus plans are substantively different than the retention plans that Congress banned.

a. Changes in Bonus Plan Structure

Table 3 summarizes differences in the structure of bonus plans from the case study sample before and after the reform. As Table 3 shows, the reform clearly changed the structure of bankruptcy bonus plans.[104] While bonus plans did not appear to change much in terms of the amount of money set aside for bonuses, the bonus plans after the reform are much more likely to include some sort of operational or financial target that rewards management for meeting specific performance objectives.[105] Bankruptcy-related objectives remain very popular, such as paying management a bonus when the court confirms a plan of reorganization. But in the post-reform era, approximately 20% of the plans with bankruptcy “milestone” bonuses were tied to the specific milestone occurring by a specific date, which makes them more challenging to accomplish.

b. Do the Post-Reform Bonus Plans Appear to Be Challenging Incentive Plans?

Of course, these changes could very well be superficial. Unfortunately, much like a bankruptcy judge, I cannot directly measure the extent to which these plans created “truly incentivizing goals,” because that would require perfect knowledge of the facts and circumstances at the time the bonus plan was adopted. Whether a revenue goal is challenging, for example, would depend on observing the probability distribution of hitting the revenue goal, which I obviously cannot do.

I can, however, examine theoretical predictions that indirectly capture an aspect of how challenging the bonus plans would have been considered. First, we would expect the post-reform plans to pay managers at a lower rate than the pre-bankruptcy bonus plans, because challenging performance goals are likely to be missed more often than the pre-bankruptcy retention plans that rewarded managers for staying at their desks. Second, theory would predict that, as the risk associated with a bonus increases, so too should the size of the bonus, to compensate management for the increased risk of not hitting the challenging goal. For example, a $100 bonus might be an effective motivating tool if management knows there is a 100% chance of receiving the payment. But if there is only a 10% chance of receiving the payment, management would need a much larger bonus to provide the same motivation to perform.[106] I assess each of these predictions in turn.

First, I analyzed every stated goal from every court-approved bankruptcy bonus plan in the case study sample. I then used information from the court docket and subsequent public information (such as securities filings) to determine whether the bonus plan paid out.[107] As Table 4 shows, the rate of payout appears to be similar across both time periods.[108] This finding at least casts doubt on the view that the post-reform bonus plans are different as a matter of substance, in addition to being procedurally different from the pre-reform plans.[109]

Second, I examine the schedule of payments under the bonus plan to look for evidence that the payouts were increased to compensate management for the increased risk of an incentive plan. After adjusting the proposed maximum payouts for inflation, I find that CEOs received nearly identical bonuses after the reform as they did under the pre-bankruptcy retention bonus plans. Post-2005, firms implementing court-approved bonus plans planned to pay a 30% year-over-year increase in CEO compensation for the first year of bankruptcy, as compared to 29.3% for the firms implementing bonus plans in the sample years before the reform. A caveat to this analysis is that firms may have wanted to implement bonus plans but felt restricted by the bankruptcy judge, so the observed maximum bonus plans might be censored. However, this finding casts doubt on the argument that these “incentive” bonuses are much riskier than the pre-bankruptcy retention plans.

3. Assessing the Role of Creditors and the U.S. Trustee

Bankruptcy law, of course, understands that the bankruptcy judge cannot ever know as much about a debtor as its management team and relies on creditors and the Department of Justice’s U.S. Trustee Program to police abuses. As hypothesis three predicts, there are two theoretical problems that might constrain the willingness and ability of the creditors and U.S. Trustee to monitor executive compensation. The first is that the creditors lack strong incentives to invest time and money into monitoring relatively small bonus plans, as bonus plans represent only a small percentage of the overall value on the table in a bankruptcy plan. The second is that the U.S. Trustee suffers from a similar expertise deficit as the judge, making it just as hard for the U.S. Trustee to distinguish challenging incentive plans from disguised retention plans. I analyze evidence of the role played by creditors and the U.S. Trustee Program in turn.

a. The Observed Role of Creditors

In theory, creditors have limited incentives to police executive compensation. While it is true that creditors are generally the residual claimants of the firm, and thus the party that loses if management extracts unearned compensation,[110] their economic incentives are to focus more on the hundreds of millions or billions of dollars that are at stake in large bankruptcy cases, not the relatively small amount of money involved in bonus plans.

To see how creditors actually used their bargaining power, I reviewed all of the objections the official committee of unsecured creditors filed in response to the firm’s motion seeking bonus plan approval; those objections are summarized in Table 5.[111] There are limits to reviewing the objections of the official committee, as doing so does not reveal how creditors may have negotiated in the shadow of their right to object, nor does it capture how creditors might have influenced bonus plans before they were even proposed by the court. Accordingly, caution is needed in interpreting this Section, as it relies on an incomplete record of creditor influence on negotiations. In the Appendix, I present a summary Table, which shows how bonus plans changed between being proposed on the docket and being approved by the court. The Appendix Table suggests, at least on paper, that Chapter 11 debtors are forced to make performance goals more challenging in response to creditor demands.[112]

As Table 5 shows, official committees became much more litigious after the 2005 reform. They filed written objections to 33% of the proposed bonus plans, a 79% increase from the pre-reform sample. Categorizing the objections, the most common legal argument—expressed in every case in which the official committee objected—was that the bonus plan was a disguised retention plan, violating the 2005 reform. This observed litigation is obviously only a small part of their influence, as they almost certainly negotiated in the shadow of their right to object and may have influenced many bonus plans in unobserved ways.

However, creditor objections seldom presented particularized criticisms of the proposed bonus plan. Creditors did file objections to the proposed bonus plans alleging that the compensation level exceeded industry standards in 26% of cases (as compared to 9% before the reform), but that was only 40% of the cases for which an objection was filed. More importantly, creditors only offered evidence from an opposing expert in 8% of cases (as compared to 11% prior to the reform). For the five cases where the official committee complained about the bonus plan exceeding industry standards, one offered evidence from other Chapter 11 cases,[113] one simply pointed to the dire climate of the industry,[114] two complained that the numbers were high without supporting evidence of “competitive compensation in the [company’s] industry,”[115] and one asked for management to provide more information.[116] In no objection in the case study sample was the judge provided with concrete numbers that could be used to compare the bonus plan to an industry standard.

The Foamex Int’l, Inc. bankruptcy litigation provides a representative example of a typical official committee objection to a proposed bonus plan. Foamex’s management originally sought approval of a bonus plan that would pay out in the event that the company successfully sold its assets.[117] The committee first complained that the bonus plan motion was filed “within the first few weeks of the case” and while the debtors were attempting to sell the firm on a faster schedule than the committee wanted.[118] The committee then complained that management was likely not only to get the bankruptcy bonuses but also “generous employment agreements” if the planned sale went through.[119] The committee further deemed the bonus plan targets “effortless” and instead demanded that the company link incentive compensation to “the payment of a dividend to general unsecured creditors.”[120] Nowhere in the objection is there any analysis of the underlying compensation plan itself. There are only bald complaints about how the committee disagreed with the idea of rewarding management for a sale and preferred management receive a bonus in the event a plan of reorganization was approved, preferably one paying unsecured creditors a significant recovery.[121]

Other official committee objections in the sample served as a similar opportunity for the official committee to negotiate the plan of reorganization through litigation. The lack of substance in some of these objections suggests that the objection itself is better understood as a chance to express a partisan view about how the Chapter 11 case should proceed. For example, in the bankruptcy case of Trico Marine Servs., Inc., the official committee informed the court that it objected because the committee was at loggerheads with management over how the case would proceed.[122] In the bankruptcy of NEFF Corp., the official committee complained that the Management Incentive Plan incentivized management to approve a plan favored by senior lenders and not “explore alternative plan strategies.”[123] Similarly, in the Hayes Lemmerz bankruptcy, the creditor’s committee complained that bonuses should not be paid “for merely confirming a plan quickly for the benefit of the Debtors’ secured lenders who . . . were involved in the design and approval of the [bonus plan.]”[124]

b. The Observed Role of the Department of Justice’s U.S. Trustee Program

Unlike creditors, the Department of Justice’s U.S. Trustee Program only has incentives to enforce bankruptcy policy. The trouble with the U.S. Trustee’s frequent interventions, as described further below, is that the body largely lacks the expertise needed to effectively police executive compensation.

Sure enough, as Table 5 shows, the U.S. Trustee became far more litigious after the reform, objecting to almost half of filed bonus plans, a 300% increase from the pre-reform sample.[125] The U.S. Trustee objection in the Lear Corporation bankruptcy is fairly representative of U.S. Trustee objections in the sample.[126] The Trustee first asserted that the proposed incentive plan is actually a disguised retention plan on the grounds that the milestones are too easy to achieve.[127] To support this claim, the U.S. Trustee pointed out that the major bankruptcy-related milestones have to do with filing a plan of reorganization, which, the U.S. Trustee noted, has already been mostly negotiated by the time the firm filed for bankruptcy.[128] Accordingly, this is not the type of “challenging result ” that “warrant[s] a bonus.”[129] The U.S. Trustee also noted that the responsibility of preparing a plan of reorganization mostly falls on the debtors’ lawyers—not the managers—meaning managers do not deserve a bonus for work done by their lawyers.[130] The Trustee then noted that the financial targets for part of the bonus payment were not disclosed, and therefore, may be too easy. Therefore, the Trustee demanded that management produce more evidence to satisfy its burden of proof.[131]

This sort of conclusory analysis characterizes many other U.S. Trustee objections in the sample. In one case, the U.S. Trustee condemned a bonus plan linked to asset sales by declaring that the plan simply “require[s] the employees to do their jobs” and was not “tied to any specified sales activity or task.”[132] In another case, the U.S. Trustee objected that a bonus plan linked to an asset sale paid managers “based on the first dollar of proceeds” and was thus insufficiently incentivizing.[133] In another example, the U.S. Trustee pointed out that a different sale incentive plan would create rewards “determined in large part by complicated macroeconomic, market and industry-specific forces” and that management’s contribution to the effort would be minimal, calling the incentivizing nature of the plan into question.[134]

Another noteworthy change in the U.S. Trustee’s litigation activity after the 2005 reform is that the written objections became visibly more alike, with similar allegations and complaints about the bonus plans. I can quantify this using a cosine–similarity analysis. At a high level, a cosine–similarity analysis measures the textual similarity between two documents—it can be used to detect whether, for example, documents are based on a single template.[135] To quantify the similarity between the written objections before and after the 2005 reform, I calculated the cosine similarity score of every filed objection with every other written objection and took a mean for each case. I then took the mean for the U.S. Trustee for all objections filed in each period of the case study sample. Prior to the 2005 amendment, the mean cosine similarity score for each objection in the dataset filed by the U.S. Trustee was 0.68. After the change, the mean cosine similarity score was 0.87, a roughly 28% increase. If nothing else, this analysis suggests that the written objections became much more generic and much less individualized after the change, which also required the various U.S. Trustee’s offices to file many more objections than they had in the past.

One possibility is that the U.S. Trustee’s vigorous, yet-generic, litigation after the reform reflects a policy of objecting to bonus plans under political pressure from Congress, and there is some public evidence of that pressure. On February 7, 2012, Senator Charles Grassley, the ranking member of the United States Senate Judiciary Committee, wrote the U.S. Trustee to ask for information on how that office’s role in policing bankruptcy bonus plans was going after the 2005 reforms.[136] The Trustee responded that

[t]he United States Trustee Program (USTP) of the Justice Department vigorously seeks to enforce the [2005 amendments restricting bankruptcy bonus plans.] . . . Although all parties in interest in a chapter 11 case have standing to object to [bankruptcy bonus plans], the USTP often is the only party in a case to do so. . . . [A]necdotal evidence suggests that the USTP’s section 503(c) litigation success rate before the bankruptcy courts is lower than its success rate for any other litigation on which the USTP maintains data.[137]

IV. The Case for RETHINKING the 2005 Reform

This Article’s account of the 2005 reform suggests that various institutional limitations and incentive problems have undermined the ability of the bankruptcy system to achieve the policy goals that prompted the reform. The main challenge in designing a further legal change that solves the issues previously identified is that many of the problems are structural. Bankruptcy judges are not suddenly going to become experts in executive compensation, and the incentives of creditors will continue to lead them to focus on larger bankruptcy issues, rather than the relatively small amounts of money at stake in discussing executive compensation. The Department of Justice’s U.S. Trustee Program will continue to litigate aggressively, but the underlying problems of informational asymmetry and an expertise deficit will limit their ability to help the bankruptcy judge’s deliberation.

Moreover, this Article suggests that the reform may very well have had significant negative consequences for bankruptcy practice. By driving at least some executive compensation underground, the reform may have decreased, on average, the public’s view into the black box of executive compensation of Chapter 11 debtors. The reform may have increased bankruptcy costs and redistributed value from creditors to lawyers. The reform has put very real pressure on the bankruptcy judge and Department of Justice to conduct inquiries that they are poorly situated to perform, a difficult situation exacerbated by the continuing public interest in executive compensation of Chapter 11 debtors.

Of course, in a cost-benefit analysis, these flaws must be analyzed in light of the potential benefits of the 2005 reform, and the analysis above identified two potential benefits. First, it is possible that some firms that might have implemented opportunistic and unnecessary bonus plans are choosing not to do so in light of the more challenging legal path to obtaining approval of such plans. Second, it is possible that the reform may have improved public confidence in our bankruptcy system. After all, court consideration of executive bonus plans continues to invite public and press scrutiny.[138] To the extent the reform pushed boards of directors to engage in regulatory evasion to avoid the public spectacle of a hearing on executive compensation, the reform may have helped the bankruptcy courts avoid adverse headlines. While it is possible that the reform provided some benefit by forcing the development of compensation contracts that lead managers to perform better, the evidence supporting this view is difficult to assess and nothing in this study suggests that this is the case on average. However, this Article cannot dismiss the possibility that the structure of executive compensation was indeed improved by the 2005 reform.

In light of the evidence presented in this Article, Congress and bankruptcy judges should re-think the 2005 reform. Two changes seem particularly worthwhile. First, Congress should consider providing the Department of Justice (“DOJ”) with funding to hire their own executive compensation experts who can assist with policing executive compensation. Bonuses for senior managers are an important part of modern corporate governance, and reflexive objections without detailed analysis to all proposed bonus plans are unlikely to improve the administration of bankruptcy law. The current situation would be improved if the DOJ had access to greater expertise, whether through new employees or money to hire consultants.

Second, Congress (or bankruptcy judges) should consider creating new post-bankruptcy reporting requirements to force post-bankruptcy Chapter 11 debtors to report their overall level of senior management compensation for a period of two years after bankruptcy. This will not solve all of the problems described above, but it would curtail the ability of managers to extract promises from creditors in bankruptcy that lead to excess compensation once the firm leaves bankruptcy court. Very few Chapter 11 debtors emerge from bankruptcy as public companies these days, which creates a regulatory blind spot that might be aided through additional disclosure that discourages the worst abuses, such as the example of Citadel Broadcasting.

Conclusion

This Article’s account of the 2005 reform is one of the most detailed analyses of an executive compensation regulation in the scholarly literature to date. As the results above show, the reform clearly appears to have reduced the usage of bankruptcy bonus plans and forced firms to style their bonus plans as “incentive plans.” However, the incentive plans that are approved create similarly sized bonuses to the retention plans approved before the reform, which suggests that the risk associated with the probability of bonus payment might not have been materially increased. This may be why incentive bonus plans after the reform appear to result in pay-outs just as often as the pre-reform retention plans did. I also do not find evidence that the reform altered the overall level of compensation of the CEOs of Chapter 11 debtors. At the same time, the evidence suggests that the reform may have made the process of formulating a bonus plan more expensive than it had been prior to the enactment of a more demanding legal standard.

While the new statutory scheme does appear to have succeeded in giving new bargaining power to creditors, they do not, at the least, appear to use this bargaining power to inform the judge of substantive problems with the underlying bonus plan. They appear, instead, to use their right to object mostly to pursue their partisan bankruptcy interests of influencing the overall plan of reorganization. This conclusion is qualified because I do not observe the work they might do outside of court negotiating the terms of the bonus plan––work which is clearly ongoing. But it is hard to say based on the evidence that creditors are using their new governance power to make executives more accountable, implement true pay-for-performance, or reduce the overall level of compensation, as Congress intended. Indeed, more than ten years after its implementation, the putative benefits of the reform are hard to identify.

Appendix: Methodology FOR Analyzing Bankruptcy Costs

A team of research assistants, acting under my supervision, reviewed all of the legal bills filed by the debtor’s attorneys for every Chapter 11 bankruptcy in the case study sample. For each case, the research assistants began with the first fee request and reviewed all of the bills until the time period including the day that the first bankruptcy bonus plan (in the pre-reform period, usually key employee retention plans, and in the post-reform era, key employee incentive plans (“KEIP”)) was approved by the court. The review team stopped reviewing time entries after the day the KEIP was approved.

A representative example from the post-reform 2009 bankruptcy case of Foamex International, filed by the debtor’s counsel Akin Gump, includes the following entries:

03/26/09 SLN 0018 Review asset purchase agreement for Tax issues. 0.6
03/01/09 AQ 0019 Emails re KEIP. 0.2
03/01/09 PMA 0019 Review and respond to email re KEIP motion (.1). 0.1
03/02/09 ISD 0019 O/C AQ re: KEIP. 0.7
03/03/09 RJR 0019 Telephone conference w/1. Rosenblatt re Asset Purchase Agreement and relevant labor issues. 0.3 [139]

Time entries #1 and #5 have nothing to do with the key employee incentive plan (or at least were not written down by the attorney to reflect that they do), so those time entries were discarded by the research assistant. Time entries #3, #4, and #5 reflect work on the incentive plan. The research assistant recorded all of the time each attorney spent on the KEIP, multiplied those numbers by the court approved attorney’s billing rate, and tabulated the amount the debtor’s attorneys charged for work on the bankruptcy bonus plan. The research assistant also obtained the debtor’s final fee applications to record the total amount billed for the bankruptcy case to understand what percentage of the overall bankruptcy costs (at least the portion owed to the debtor’s main attorney) was devoted to bankruptcy bonus plan matters, before and after the reform.

The total review constituted more than 103,781 pages of attorney time entries and cover notes from 792 fee applications.

Appendix Table 1 displays ordinary least squared regression with robust standard errors in parenthesis. Industry Fixed Effects are Fama-French 12. “Debtor Counsel Bonus Plan Fees” are the logged total fees in constant 2010 dollars associated with negotiating, writing, and obtaining the approval of a bonus plan. “Debtor Counsel Bonus Plan Hours” are the logged total hours in constant 2010 dollars associated with negotiating, writing, and obtaining the approval of a bonus plan. “Debtor Counsel Bonus Plan Fees as a Percentage of Total Case Fees” are the percentage of the debtor’s overall bill that are associated with the bonus plan. Appendix Table 2 summarizes the observed changes in bonus plans from the version first filed with the court to the version approved by the judge. For example, financial targets are raised in 22% of the post-2005 reform bonus plans between the original filing on the court docket and the judge’s approval order. Bankruptcy milestones are event dates in the bankruptcy process, such as the day a plan of reorganization is approved. In 10.5% of cases, the deadlines tied to those goals were lengthened, such as giving management 180 days to obtain approval of an order selling substantially all of the firm’s assets instead of 120 days.

[*] *.. Visiting Associate Professor of Law, Boston University School of Law; Associate Professor of Law, University of California, Hastings College of the Law. I appreciate helpful comments from Afra Afsharipour, Jordan Barry, Abe Cable, John Crawford, Ben Depoorter, Scott Dodson, Michael Klausner, Emily Murphy, Shu-Yei Oei, Elizabeth Pollman, Diane Ring, Natalya Schnitser, Fred Tung, David Walker, and faculty workshops at the University of California, Davis, Boston College, and Boston University.

[1]. See Gretchen Morgenson, MARKET WATCH; A Year’s Debacles, From Comic to Epic, N.Y. Times (Dec. 30, 2003), https://www.nytimes.com/2003/12/28/business/market-watch-a-year-s-debacles
-from-comic-to-epic.html (condemning American Airlines for negotiating wage concessions from its unionized workers while rewarding top executives with retention bonuses and setting aside $40 million to protect the pensions of executives); see also David Olive, Many CEOs Richly Rewarded for Failure; They Didn’t Suffer as Stocks Tanked in New Economy, Toronto Star, Aug. 25, 2002, at A10.

[2]. These bonus plans were very controversial because the payment of bonuses in bankruptcy is a public event, leading to press coverage. See Bloomberg News, Bankruptcy Court Approves FAO Executive Pay Plan, N.Y. Times (Feb. 15, 2003), https://www.nytimes.com/2003/02/15/business
/company-news-bankruptcy-court-approves-fao-executive-pay-plan.html (noting an approved FAO Inc. executive-retention plan paying $1.1 million in bonuses); see also Seth Schiesel, Revised Contract for WorldCom’s New Chief Executive Wins Approval from 2 Judges, N.Y. Times (Dec. 17, 2002), https://www.nytimes.com/2002/12/17/business/revised-contract-for-worldcom-s-new-chief-executive-wins-approval-from-2-judges.html (detailing the executive compensation plan for the CEO of WorldCom, which was approved during the company’s bankruptcy); Rhonda L. Rundle, FPA’s CEO Received Salary Increase Five Days Before Chapter 11 Filing, Wall St. J. (Aug. 3, 1998), https://www.wsj.com/articles/SB902097584655373000. Senator Charles Grassley, Republican of Iowa, summarized the populist argument against bankruptcy bonuses in a 2012 letter demanding that the Department of Justice police them more vigorously: “Corporate directors, executives and managers who were at the helm of a company as it spiraled into bankruptcy should not receive bonuses of any kind, let alone excessive bonuses, during a reorganization or liquidation.” Mike Spector & Tom McGinty, U.S. Is Asked to Review Bankruptcy Bonuses, Wall St. J. (Feb. 13, 2012), https://www.wsj.com
/articles/SB10001424052970204642604577218033661586936.

[3]. See, e.g., Kristine Henry, Beth Bonus Called Good Way to Keep Salaried Steel Talent, Balt. Sun (Jan. 6, 2002), https://www.baltimoresun.com/news/bs-xpm-2002-01-06-0201050169-story.html (detailing executive retention plans paid out in high-profile Chapter 11 bankruptcy cases); Nelson D. Schwartz, Greed-Mart Attention, Kmart Investors. The Company May Be Bankrupt, but Its Top Brass Have Been Raking It In, Fortune (Oct. 14, 2002), http://archive.fortune.com/magazines
/fortune/fortune_archive/2002/10/14/330017/index.htm. Many bankruptcy lawyers at the time were also upset by this behavior, fearing that managers were abusing Chapter 11 to extract excessive compensation at the expense of public confidence in the bankruptcy system. See generally Robert J. Keach, The Case Against KERPS, 041003 Am. Bankr. Inst. 9 (2003) (discussing issues with key employee retention plans (“KERPS”) at the American Bankruptcy Institute’s 2003 Annual Spring Meeting).

[4]. See In re U.S. Airways, Inc., 329 B.R. 793, 797 (Bankr. E.D. Va. 2005) (“Congressional concern over KERP excesses is clearly reflected in changes to the Bankruptcy Code that will become effective for cases filed after October 17, 2005.”); see also Dorothy Hubbard Cornwell, To Catch a KERP: Devising a More Effective Regulation than §503(c), 25 Emory Bankr. Dev. J. 485, 486–87 (2009) (discussing the amendments to the Bankruptcy Code); Rebecca Revich, The KERP Revolution, 81 Am. Bankr. L.J. 87, 88–92 (2007) (explaining how Congress restricted the ability of Chapter 11 debtors to “retain management employees under programs generally referred to as Key Employee Retention Plans (KERPs)”). In support of the ban, Senator Edward Kennedy delivered a memorable floor statement condemning “glaring abuses of the bankruptcy system by the executives of giant companies.” In re Dana Corp., 358 B.R. 567, 575 (Bankr. S.D.N.Y. 2006) (noting statement of Senator Kennedy in support of the amendments and discussing the legislative history of the amendments to section 503 of the Bankruptcy Code). It is worth noting that beyond the arguments over the propriety of paying bankruptcy bonuses, some observers questioned their efficacy, noting, for example, that after Kmart implemented a KERP plan, nineteen of the twenty-five covered executives left within six months and that Enron’s KERP failed to staunch the outflow of talented employees. Keach, supra note 3.

[5]. The executive compensation restrictions were a very minor piece of a much larger reform, as part of a bill called the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), Pub. L. No. 109-8, 119 Stat. 23 (2005) (codified as amended in scattered titles of the U.S. Code). While this paper is the first to study the executive compensation restrictions in this degree of detail, many other papers study other aspects of this reform. See generally, e.g., Kenneth Ayotte, Leases and Executory Contracts in Chapter 11, 12 J. Empirical Legal Stud. 637 (2015); Pamela Foohey et al., Life in the Sweatbox, 94 Notre Dame L. Rev. 219 (2018); Robert M. Lawless et al., Did Bankruptcy Reform Fail? An Empirical Study of Consumer Debtors, 82 Am. Bankr. L.J. 349 (2008); Michael Simkovic, The Effect of BAPCPA on Credit Card Industry Profits and Prices, 83 Am. Bankr. L.J. 1 (2009).

[6]. For example, a Chapter 11 bonus plan might require management to increase earnings or move through Chapter 11 quickly. See infra notes 46 and 57 and accompanying text.

[7]. Bankruptcy lawyers largely share this skeptical view of the efficacy of the reform. See, e.g., Eric Morath, Bankruptcy Beat: ABI Poll Casts Doubt on Bonus Reforms, Wall St. J. (Oct. 21, 2009), https://blogs.wsj.com/bankruptcy/2009/10/21/abi-poll-casts-doubt-on-bonus-reforms (reporting survey results that a majority of respondents agree that the reform was not effective in limiting executive compensation). These poll results are consistent with other anecdotal evidence in the popular media. See, e.g., Nathan Koppel & Paul Davies, Bankruptcy-Law Overhaul Has Wiggle Room; Limits Set on Key Executives’ Pay, but Door Is Wide Open on Bonuses Linked to Achieving Certain Goals, Wall St. J., https://www.wsj.com/articles/SB114342447370208718 (last updated Mar. 27, 2006) (“[B]ankruptcy lawyers say companies have managed to sidestep some of the law’s provisions.”). Lee R. Bogdanoff, a founding partner of the law firm Klee, Tuchin, Bogdanoff & Stern LLP in Los Angeles, was quoted by Bloomberg News as saying that “[t]he amendment to the code changed the means, but not the value of these plans . . . It’s just changed the way you get there, not necessarily how much management gets at the end.” Steven Church, Buffets Rewards Managers Who Put Chain in Bankruptcy, Bloomberg News (Apr. 5, 2012), http://www.bloomberg.com/news/articles/2012-04-05/buffets-rewards-managers-who-put-chain-in-bankruptcy. A former Department of Justice official charged with supervising the bankruptcy system argues, “Congress took a stab at righting the problem and companies quickly found a way to circumvent their intent.” Mike Spector & Tom McGinty, The CEO Bankruptcy Bonus, Wall St. J. (Jan. 27, 2012), https://www.wsj.com/articles
/SB10001424053111903703604576584480750545602. A contemporaneous working paper provides suggestive evidence that at least some firms contracted around the reform. See Vedran Capkun & Evren Ors, When the Congress Says “PIP Your KERP”: Performance Incentive Plans, Key Employee Retention Plans, and Chapter 11 Bankruptcy Resolution (Feb. 15, 2009) (unpublished manuscript), https://people.hec.edu/ors/wp-content/uploads/sites/24/2018/02/PIP_your_KERP_20140104.pdf (“By trying to suppress KERPs, which were deemed to be ‘self-dealing’ plans proposed by unscrupulous managers, BAPCPA appears to have led to ‘structural arbitrage.’”).

[8]. See infra Section III.B.1.c.

[9]. See infra Section III.B.2.b. The fact that bonuses created by the post-2005 incentive bonus plans are similarly sized to the pre-reform retention plans casts doubt on the notion that these bonuses came with the additional risk that would come from truly challenging performance goals. Michael C. Jensen & Kevin J. Murphy, CEO Incentives—It’s Not How Much You Pay, but How, Harv. Bus. Rev., May–June 1990, at 138 (outlining the difficulty of adequately linking executive pay to compensation while simultaneously not appearing to overpay executives).

[10]. See Sreedhar T. Bharath et al., The Changing Nature of Chapter 11 at 12–14 (Fisher Coll. of Bus., Paper No. 2008-03-003, 2010), http://ssrn.com/abstract=1102366.

[11]. See, e.g., Motion of Debtor and Debtor in Possession Pursuant to 11 U.S.C. §§ 105, 507(a)(3), 507(a)(4) and the “Doctrine of Necessity” for an Order Authorizing It to Pay: (A) Prepetition Emp. Wages, Salaries and Related Items; (B) Prepetition Emp. Bus. Expenses; (C) Prepetition Contributions to and Benefits Under Emp. Benefit Plans; (D) Prepetition Emp. Payroll Deductions and Withholdings; and (E) All Costs and Expenses Incident to the Foregoing Payments and Contributions Filed by Debtor-in-Possession Bush Indus., Inc. at 13, In re Bush Indus., 315 B.R. 292 (Bankr. W.D.N.Y. 2004) (No. 04-12295).

[12]. In re Allied Holdings, Inc., 337 B.R. 716, 721 (Bankr. N.D. Ga. 2005) (“KERP programs such as the one the Debtors seek approval to implement have become customary uses of estate funds in large business reorganizations.”); see also David A. Skeel, Jr., Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U. Pa. L. Rev. 917, 926–28 (2003) (discussing innovations in executive compensation and the evolution of bankruptcy bonuses); Mechele A. Dickerson, Approving Employee Retention and Severance Programs: Judicial Discretion Run Amuck, 11 Am. Bankr. Inst. L. Rev. 93, 96–97 (2003) (discussing the prevalence of retention bonuses offered in Chapter 11 cases); James H. M. Sprayregen et al., First Things First—A Primer on How to Obtain Appropriate “First Day” Relief in Chapter 11 Cases, 11 J. Bankr. L. & Prac. 275, 299 (2002) (suggesting Chapter 11 debtors consider bonus plans as part of bankruptcy planning). A contemporaneous press account suggests that bonuses became a common feature because many of the formerly high-flying tech firms had high bankruptcy costs associated with a prolonged stay in Chapter 11 that would leave little value for creditors in the event creditors were forced to hire new managers. In effect, the inability of Chapter 11 to preserve the going concern value of telecom firms provided managers with the power to extract holdout value in exchange for remaining at their desks. One investment banker was quoted as saying that sophisticated activist bondholders budgeted for bankruptcy bonuses when they made their investments in the firm’s debt. Ann Davis, Want Some Extra Cash? File for Chapter 11, Wall St. J., Oct. 31, 2001, at C1 (discussing the rise in popularity of Chapter 11 bonuses and the changing views among creditors). By keeping them at their desks with retention payments, creditors retain value in the firm that would otherwise be lost if they were to quit. Yair Listkoin criticizes retention payments for not being more closely related to positive bankruptcy outcomes. Yair Listokin, Paying for Performance in Bankruptcy: Why CEOs Should Be Compensated with Debt, 155 U. Pa. L. Rev. 777, 790 (2007) (summarizing arguments against “pay to stay” compensation). Robert Rasmussen makes an argument that Congress erred by eliminating retention bonuses because they usefully provided creditors—the new owners—with a real option regarding the debtor’s workers. That is to say, by retaining employees long enough to evaluate them, retention bonuses serve the useful purpose of allowing creditors or new managers to decide who to keep. See Robert K. Rasmussen, On the Scope of Managerial Discretion in Chapter 11, 156 U. Pa. L. Rev. PENNumbra 77, 80–85 (2007).

[13]. Sandra E. Mayerson & Chirstalette Hoey, Employee Issues from Pre-Petition Severance to Post-Petition Defaulted Pension Plans; and Standards for Permitting Senior Management Bonuses, 092002 Am. Bankr. Inst. 409 (2002).

[14]. See, e.g., In re Aerovox, Inc., 269 B.R. 74, 76 (Bankr. D. Mass. 2001).

The Debtor summarized the incentives it designed as follows: 1) to keep the eligible employees, including the Key Employees, in the Debtors employ; 2) to compensate the eligible employees, including the Key Employees, for assuming “additional administrative and operational burdens imposed on the Debtor by its Chapter 11 case;” and 3) to allow the eligible employees, including the Key Employees, to use “their best efforts to ensure the maximization of estate assets for the benefits of creditors.”

Id. (internal citations omitted).

[15]. Id. at 79.

Moreover, in the Board’s view, replacing the Key Employees would cause the Debtor to incur significant costs. Mr. Horsley testified that the process of replacing any one of the Key Employees could cost up to one years’ salary in order to cover the cost of a headhunter and other recruitment expenses. He added that, even if the Debtor were to find qualified replacements, it would not be able to quickly get these new employees “up to speed.” This cost-benefit analysis weighed heavily into the Board’s ultimate decision.

Id.

[16]. See id.

[17]. In the face of intense criticism, firms began to change their compensation practices to try to align pay with performance. See, e.g., Jensen & Murphy, supra note 9.

[18]. See Brian J. Hall & Jeffrey B. Liebman, Are CEOs Really Paid Like Bureaucrats?, 113 Q.J. Econ. 653, 661–63 (1998) (finding that most of the pay increase for chief executive officers between 1980 and 1994 was in the form of stock options, which increased the percentage of a firm’s total compensation package weighted towards performance compensation).

[19]. See Kevin J. Murphy, Executive Compensation, in 3B Handbook of Labor Economics 2485, 2491 (Orley Ashenfeller & David Card eds., 1999) (“[M]ost executive pay packages contain four basic components: a base salary, an annual bonus tied to accounting performance, stock options, and longterm incentive plans (including restricted stock plans and multi-year accounting-based performance plans).”). Stock compensation includes both outright grants of stock as well as restricted stock and stock options.

[20]. The compensation consulting firm Equilar reported that in 2013, 63.8% of S&P 1500 companies used some form of performance-based equity compensation, 82.8% used short-term cash incentives, 15% had a discretionary cash bonus, and 8.3% had a long-term incentive plan tied to multiyear performance goals. Equilar, CEO Pay Strategies Report 4–5 (2014), https://www2.deloitte.com/content/dam/Deloitte/us/Documents/regulatory/us-aers-ceo-pay-strategies-report-2014-equilar-july-2014-020915.pdf. While Equilar does not aggregate these numbers, it is fair to assume that virtually all large firms use bonus compensation. The pre-bankruptcy use of stock compensation can be in and of itself sufficient to require a new compensation policy, as Chapter 11 usually ends with pre-bankruptcy shareholders receiving no recovery. See generally Notice of Filing of Amended Disclosure Statement for Debtors’ Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the Bankr. Code, In re Hawker Beechcraft, Inc., 486 B.R. 264 (Bankr. S.D.N.Y. 2013) (No. 12-11873) [hereinafter Hawker Beechcraft Disclosure].

[21]. See Hall & Liebman, supra note 18. Firms have two alternatives to adjusting compensation policy in bankruptcy, but they are unattractive, for different reasons. One option is to adjust management’s compensation pre-bankruptcy by giving them large base salaries, which effectively reweights their compensation away from bonus and towards base. Doing so creates important risks for a firm, as news of bonus payments can disrupt negotiations with creditors and create liability for the executive who might find the payment clawed back as a fraudulent conveyance. Alternatively, the firm can avoid adjusting compensation until after bankruptcy, which creates the risk that managers might leave the firm rather than wait for an uncertain payment. See James Sprayregen et al., Recent Lessons on Management Compensation at Various Stages of the Chapter 11 Process, Financier Worldwide (Mar. 2013), https://www.financierworldwide.com/recent-lessons-on-management-compensation-at-various-stages-of-the-chapter-11-process/#.XEZb6S3Myu4.

[22]. See, e.g., Mitchell A. Seider et al., Two Recent Decisions Highlight Pitfalls in Creating and Implementing Key Employee Incentive Plans for Executives in Bankruptcy Cases, Latham & Watkins: Client Alert (Sept. 24, 2012), https://www.lw.com/thoughtLeadership/employee-incentive
-plans-executives-bankruptcy (“[I]t may be difficult to replicate . . . employees’ pre-petition compensation during the Chapter 11 case because a significant part of their compensation may have been in the form of stock options (which are likely worthless in light of the bankruptcy proceedings) and performance bonuses based on metrics that are no longer achievable. Furthermore, these employees may seriously consider other employment opportunities that do not involve the risks inherent in working for a company in Chapter 11.”); Notice of (1) Filing of the Solicitation Version of the Amended Disclosure Statement for the Debtors’ Solicitation Version of the Amended Joint Plan of Reorganization Pursuant to Chapter 11 of the Bankruptcy Code and (2) Deadline for Parties to Object Thereto, In re Hawker Beechcraft, Inc., 486 B.R. 264 (Bankr. S.D.N.Y. 2013) (No. 12-11873) (“[C]urrent compensation levels for each of the KERP Participants are below market levels largely because no MIP or Equity Investment Plan bonuses have been paid in recent years and also due to a decrease in earned commissions. The Debtors believe the KERP will aid the Debtors’ retention of the KERP Participants and will incentivize them to expend the additional efforts and time necessary to maximize the value of the Debtors’ assets.”).

[23]. See, e.g., Nancy Rivera Brooks, Enron Execs Were Paid to Remain, L.A. Times (Dec. 7, 2001), http://articles.latimes.com/2001/dec/07/business/fi-12293.

[24]. See, e.g., Henry, supra note 3 (detailing executive retention plans paid out in high-profile Chapter 11 bankruptcy cases).

[25]. At the 2003 Annual Spring Conference of the American Bankruptcy Institute, a lawyer arguing against allowing KERPs worried very much that the failure to curb bankruptcy bonus abuse (in the form of the Key Employee Retention Plans that had become a routine part of bankruptcy practice) would result in congressional intervention. See Critical Vendor Motions, Retention Bonuses Headed for Endangered List, 39 Bankr. Ct. Decisions: Wkly. News & Comment 1 (Aug. 13, 2002); see also Keach, supra note 3.

[26]. See M. Todd Henderson, Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs Are Low, 101 Nw. U. L. Rev. 1543, 1543–44, 1570 (2007) (“According to [academic accounts of bankruptcy], the Bankruptcy Code’s preference for management operation of the debtor allows managers to extract rents in the form of higher salaries, big option grants, and lavish retention and emergence bonuses.”); Lynn M. LoPucki & William C. Whitford, Corporate Governance in the Bankruptcy Reorganization of Large, Publicly Held Companies, 141 U. Pa. L. Rev. 669, 740 (1993) (“In the course of our study, we became suspicious that some CEOs were using leverage generated from the power vested in the debtor-in-possession by the Bankruptcy Code to negotiate increases in their personal compensation.”); Lucien Ayre Bebchuk & Howard F. Chang, Bargaining and the Division of Value in Corporate Reorganization, 8 J.L. Econ. & Org. 253, 267 n.14 (1992) (“In reality, the incumbent management controls the agenda during this initial period [of Chapter 11 Bankruptcy].”).

[27]. Alan Schwartz, A Contract Theory Approach to Business Bankruptcy, 107 Yale L.J. 1807, 1836 (1998) (noting Chapter 11 is preferable to Chapter 7 for current management, in terms of ability to manipulate the process for personal gain); see also Henderson, supra note 26, at 1574 (noting a potential factor favoring management in Chapter 11 is “the possibility that creditors will tolerate inefficient or unfair compensation to curry favor with CEOs, since the debtor has the exclusive right to propose a reorganization plan”); LoPucki & Whitford, supra note 26, at 692 (“[M]anagement of the debtor corporation routinely remains in office after [the bankruptcy] filing and has considerable power over both the business plan and the reorganization plan.”).

[28]. One student researcher interviewed legendary bankruptcy attorney Harvey Miller in 2005 and reported:

Eventually, according to Miller, the negotiations come to point where the controlling distressed investors tell the CEO, “if you want to be CEO of the company, don’t fight

us—because if you fight and we win, you’re dead.” According to Miller, some management teams will eventually give in, often after the distressed investors have agreed to provide them with post-emergence employment contracts.

Paul M. Goldschmid, Note, More Phoenix Than Vulture: The Case for Distressed Investor Presence in the Bankruptcy Reorganization Process, 2005 Colum. Bus. L. Rev. 191, 266–67 (2005).

[29]. See Henderson, supra note 26, at 1575–76 (2007) (“Thus, given the firm’s poor performance, whether or not it can be deemed to be the CEO’s fault, the firm should be able to pay the CEO less, but the costs of the next best alternative are so much higher that the CEO is actually in a stronger negotiating position.”).

[30]. See LoPucki & Whitford, supra note 26, at 742 (“[I]n some reorganization cases management derives considerable power from their incumbency.”).

[31]. See id. at 694–720 (describing the checks on management).

[32]. In re Salant Corp., 176 B.R. 131, 132 (S.D.N.Y. 1994) (“The Bankruptcy Court approved the bonus to [the CEO] at the confirmation hearing . . . .”); see also In re Velo Holdings Inc., 472 B.R. 201, 204 (Bankr. S.D.N.Y. 2012) (approving KERP during bankruptcy case).

[33]. See, e.g., In re W. Pac. Airlines, Inc., 219 B.R. 575, 578 (D. Colo. 1998) (“[A] creditors committee serves something of a ‘watchdog’ function in bankruptcy and enjoys unique rights and responsibilities under the Code.”).

[34]. Wei Jiang et al., Hedge Funds and Chapter 11, 67 J. Fin. 513, 527 n.10 (2012).

[35]. See generally Jared A. Ellias, Do Activist Investors Constrain Managerial Moral Hazard in Chapter 11?: Evidence from Junior Activist Investing, 8 J. Legal Analysis 493 (2016) (finding activist investors actually reduce self-dealing and promote the goals of bankruptcy); Michelle M. Harner & Jamie Marincic, Committee Capture? An Empirical Analysis of the Role of Creditors’ Committees in Business Reorganizations, 64 Vand. L. Rev. 749 (2011) (providing data on the impact of creditors on bankruptcy proceedings).

[36]. See Ellias, supra note 35, at 495 (“In Chapter 11, managers must obtain judicial approval for all major business decisions . . . [creditors] may inform the judge that management is abusing Chapter 11 and file motions seeking judicial relief.”).

[37]. See Charles Jordan Tabb, The History of the Bankruptcy Laws in the United States, 3 Am. Bankr. Inst. L. Rev. 5, 35 (1995). (“In 1986 the United States Trustee system was established nationwide . . . . An attempt was made to relieve bankruptcy judges of administrative duties, thereby permitting them to focus more exclusively on their judicial role.”).

[38]. See id.

[39]. About the Program: The United States Trustee Program, U.S. Dep’t Just., https://www.justice.gov/ust/about-program (last updated Mar. 6, 2019).

[40]. Id.

[41]. See Objection of the U.S. Trustee to Debtors’ Motion Pursuant to Section 363(b) of the Bankr. Code for Authorization to Implement a Key Emp. Incentive Plan at 9, In re BearingPoint, Inc., 453 B.R. 486 (Bankr. S.D.N.Y. 2011) (No. 09-10691) [hereinafter BearingPoint Objection].

The Motion is not supported by any indication that the costs of the KEIP are reasonable under the circumstances. To the contrary, the currently-prevailing view here appears to be that such proceeds will be insufficient to generate a recovery for unsecured creditors. Also, there is no basis on which to conclude that the $7.0 million cost of the Debtors’ revised bonus plan is reasonable . . . .

Id.

[42]. That’s not to say that judges did not sometimes reject bonus plans. Levitz Judge Rejects Bankruptcy Bonus, Limits Severance Package, 2 Andrews Bankr. Litig. Rep. 7 (2005) (discussing Judge Burton Lifland’s rejection of a proposed retention bonus in the Levitz Homes bankruptcy when the company had mostly outsourced operation of its business to consultants).

[43]. See In re Montgomery Ward Holding Corp., 242 B.R. 147, 155 (D. Del. 1999) (noting the discretion the bankruptcy court has to defer to management’s business judgment in approving bankruptcy bonus plans). Bankruptcy courts approved executive bonuses upon a showing by the debtor that: (i) the debtor used proper business judgment in creating the plan, and (ii) the plan is “fair and reasonable.” Emily Watson Harring, Walking and Talking like a KERP: Implications of BAPCPA Section 503(c) for Effective Leadership at Troubled Companies, 2008 U. Ill. L. Rev. 1285, 1293 (2008); see also George W. Kuney, Hijacking Chapter 11, 21 Emory Bankr. Dev. J. 19, 78–80 (2004) (summarizing the standard in pre-BAPCA cases). Kuney notes that this standard was either considered overly permissive or unnecessarily restrictive, depending on the particular biases of the critic. Id. at 80; accord Cornwell, supra note 4, at 493–94 (summarizing the pre-BAPCA standard).

[44]. In re Brooklyn Hosp. Ctr., 341 B.R. 405, 409 (Bankr. E.D.N.Y. 2006); see also In re Aerovox, Inc., 269 B.R. 74, 79 (Bankr. D. Mass. 2001) (discussing the importance of the employees to the turnaround effort).

[45]. See Brooklyn Hosp. Ctr., 341 B.R. at 412 (discussing the deliberations of the Board); see also In re Georgetown Steel Co., 306 B.R. 549, 554 (Bankr. D.S.C. 2004) (“The CEO described the deliberations of the Board of Directors with respect to the Retention Motion as well as the processes utilized to arrive at the final amount of the Retention Plan.”); Aerovox, 269 B.R. at 81–82 (“[T]he Board utilized sound business judgment in evaluating the need for and financial implications of the KERP. . . . [T]he Board met five times before approving the original KERP.”); Dickerson, supra note 12, at 97–103.

[46]. See Paul R. Hage, Key Employee Retention Plans under BAPCPA? Is There Anything Left?, 17 J. Bankr. L. & Prac. 1, 15 (2008) (“[S]ection 503(c) prohibits payments to an insider ‘for the purpose of inducing such person to remain with the debtor’s business.’”). The BAPCPA mostly affected consumer bankruptcy, and the reform studied in this Article was one of the handful of provisions that altered business bankruptcy in a significant way.

[47]. In re Global Home Prods., L.L.C., 369 B.R. 778, 783–84 (Bankr. D. Del. 2007) (quoting Karen Lee Turner & Ronald S. Gellert, Dana Hits a Roadblock: Why Post-BAPCPA Laws May Impose Stricter KERP Standards, 3 Bankr. Litig. Rep. 2, 2 (2006)); see also Edward E. Neiger, Bankruptcy Courts Continue to Approve Performance-Based Bonuses for Executives of Companies in Chapter 11, 3 Pratt’s J. Bankr. L. 356, 357 (2007).

[48]. See 11 U.S.C. § 503 (2018); In re Dana Corp., 358 B.R. 567, 575–78 (summarizing the changes to the Bankruptcy Code); Skeel, supra note 12, at 928 (describing KEIPs). In sample cases, it is very clear that––in at least some instances––the KEIP was designed more with a view to what the court would approve than what actually needed to provide incentive compensation to senior executives. For example, in the bankruptcy of Nortel, the debtor’s compensation consultant examined other recent KEIPs and provided its senior managers with a maximum number of how much money could be distributed in bonuses and how many people could be paid, and this was used to generate an incentive plan. See Declaration of John Dempsey in Support Debtors’ Motion for an Order Seeking Approval of Key Emp. Retention Plan and Key Exec. Incentive Plan, and Certain Other Related Relief at 5, In re Nortel Networks Inc., 426 B.R. 84 (Bankr. D. Del. Feb. 27, 2009) (No. 09-10138) [hereinafter Dempsey Declaration].

In determining the appropriate number of employees eligible, maximum program cost, and the size of awards to be granted, I reviewed Key Employee Incentive Plans that had been approved by bankruptcy courts in a number of recent chapter 11 cases. The companies for which these plans were approved reflect entities both inside and outside the technology sector as well as companies facing multi-jurisdictional issues, including SemGroup LLP, Quebecor World, Delphi Corporation, Dura Automotive, and Calpine Corporation.

Id. In Dempsey’s defense, Nortel was a large firm and the compared firms, albeit engaged in entirely different lines of business and headquartered in different cities, were also large firms. Nonetheless, the selection of compared firms is curious. In terms of the number of managers, he testified, “I advised Nortel management to select participants that would result in a population of employees totaling approximately 5% of the aggregate Nortel population, as this amount was well within the range of competitive market practice.” Id.

[49]. See Skeel, supra note 12, at 928 (“[C]reditors have insisted in recent cases that the managers’ compensation be tied to the company’s progress under Chapter 11. The most straightforward strategy for rewarding managers who handle the case expeditiously is to base their compensation, at least in part, on the speed of the reorganization.”).

[50]. See Hage, supra note 46, at 22–27 (discussing the early decisions); see also Revich, supra note 4, at 94.

[51]. See In re Velo Holdings Inc., 472 B.R. 201, 211 (Bankr. S.D.N.Y. 2012) (analyzing a proposed KEIP plan to insure the targets are “difficult to achieve”).

[52]. See LoPucki & Whitford, supra note 26, at 694 (“Management also gains considerable power by being better informed than other interested parties.”).

[53]. Of course, in some cases a 10% revenue increase can result from changed market conditions or political developments that improve the firm’s prospects with no increased effort from managers.

[54]. In re Dana Corp., 351 B.R. 96, 102 n.3 (Bankr. S.D.N.Y. 2006).

[55]. In re Dana Corp, 358 B.R. 567, 576–77 (Bankr. S.D.N.Y. 2006) (emphasis in original) (internal citations omitted).

[56]. See Revich, supra note 4, at 116.

[57]. See Bharath et al., supra note 10, at 24 (suggesting the use of KERPs contribute to more equitable Chapter 11 outcomes, as measured by the frequency of Absolute Priority Deviations).

[58]. See, e.g., Victor Fleischer, Regulatory Arbitrage, 89 Tex. L. Rev. 227, 278–80 (2010).

[59]. For evidence supporting this hypothesis surveyed, see generally infra Section III.B.1.

[60]. See Margaret Howard, The Law of Unintended Consequences, 31 S. Ill. U. L.J. 451, 456 (2007); Allison K. Verderber Herriott, Toward an Understanding of the Dialectical Tensions Inherent in CEO and Key Employee Retention Plans During Bankruptcy, 98 Nw. U. L. Rev. 579, 615 (2004); Revich, supra note 4, at 112 (considering Judge Lifland’s decision in In re Dana Corp., which noted permissible incentive plans may have retentive effects).

[61]. For evidence supporting this hypothesis surveyed, see infra Section III.B.2.

[62]. Economic theory has long held that people respond to incentives. E.g., Gary S. Becker, Irrational Behavior and Economic Theory, 70 J. Pol. Econ. 1, 9 (1962).

[63]. Karen Dillon, The Coming Battle over Executive Pay, Harv. Bus. Rev. (2009), https://hbr.org/2009/09/the-coming-battle-over-executive-pay.

[64]. For evidence supporting this hypothesis surveyed, see infra Section III.B.3.

[65]. See generally Data & Research, Bankr. Data, http://bankruptcydata.com/p/data-research (last visited Apr. 8, 2019). Next Generation Research’s Bankruptcy Data service is a commonly used data source for empirical bankruptcy studies. Accord, e.g., Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis 511, 517 (2009).

[66]. A portion of this larger sample was used previously in Jared A. Ellias, What Drives Bankruptcy Forum Shopping? Evidence from Market Data, 47 J. Legal Stud. 119, 124–26 (2018). I provide greater detail regarding construction of the larger sample. While this Article shares basic information on bankruptcy cases with that larger dataset, the data on executive compensation presented here were collected specifically for this project and are unique and new.

[67]. “TRACE” is a complete record of all buying and selling of corporate bonds, with transaction-level data on all trades during the sample period. It is the standard source for bond data in empirical finance literature. “MarkIt” is a data provider that compiles trading in corporate loans. Bloomberg maintains records in trading of both listed and over-the-counter equity. I do not report results using TRACE, MarkIt, or Bloomberg data in this Article.

[68]. Firms generally disclose executive compensation as part of their annual report or proxy statements for their annual meeting. See Fast Answers: Executive Compensation, U.S. Sec. & Exchange Comm’n, https://www.sec.gov/fast-answers/answers-execomphtm.html (last visited Apr. 8, 2019) (“The easiest place to look up information on executive pay is probably the annual proxy statement. Annual reports on Form 10-K and registration statements might simply refer you to the information in the annual proxy statement, rather than presenting the information directly.”).

[69]. This means that the case study sample is drawn from a slightly broader universe than the larger sample, which is restricted to public firms with traded claims. I do not believe this introduces bias into the analysis, and it avoids any bias that could result from looking only at public firms. The results presented below are the same if I restrict the case study sample to the universe of firms with traded claims.

[70]. In re Dana Corp, 358 B.R. 567, 576–77 (Bankr. S.D.N.Y. 2006) (emphasis in original). (internal citations omitted); see also supra note 55 and accompanying text.

[71]. One possible complaint about my methodology is that the 2009 and 2010 “post-reform” sample includes the bankruptcy cases that resulted from the financial crisis. The broad conclusions from the study come from the larger sample. The case study sample is used mostly to illustrate problems with the reform, provide institutional detail, and estimate the increase in costs, which should not be affected by the financial crisis and its aftermath.

[72]. 11 U.S.C. § 327 (2018).

[73]. See First Verified Monthly Application of Alston & Bird LLP as Counsel for the Debtors and Debtors-in-Possession for Allowance of Compensation and Reimbursement of Expenses Incurred for the Interim Period June 22, 2009 through July 31, 2009 at 2, In re Sea Launch Company, No. 09-12153 (Bankr. D. Del. Aug. 25, 2009); see also Fed. R. Bankr. P. 2016(a) (providing for the compensation of services provided to the debtor by professionals).

[74]. Others have speculated that the new, post-reform statutory regime requires more attorney time and expense. See Jonathan C. Lipson, Where’s the Beef? A Few Words About Paying for Performance in Bankruptcy, 156 U. Pa. L. Rev. 64, 68 (2007).

[75]. All of the nominal dollar amounts in the bills were adjusted to 2010 dollars using the Consumer Price Index.

[76]. In Appendix Table 1, I use regression analysis to try to verify that the observed fee increase is not due to a difference in observable firm characteristics between the population of pre-reform Chapter 11 debtors and post-reform Chapter 11 debtors. The results suggest that, controlling for firm financial characteristics and industry, the 2005 bankruptcy reform is associated with a 118% increase in the debtor’s fees for time spent on bonus plans, a 102% increase in attorney’s hours devoted to the bonus plan, and a 110% increase in the percentage of the total bill for the case devoted to matters related to the bankruptcy bonus plan.

[77]. Some firms may be more likely to enact bonus plans if, for example, a large part of their pre-bankruptcy compensation was in the form of stock that is unlikely to be worth anything after bankruptcy. Thus, it is possible that a composition effect drives the effect in Figure 1, if the cohort of Chapter 11 debtors pre-reform were firms that used more stock compensation than the cohort that came afterwards. I addressed the question of pre-bankruptcy compensation practices further in supra Part I.

[78]. For example, if a firm’s CEO was paid $100 in the year before bankruptcy and $120 in the year the firm filed for bankruptcy, the test statistic is ($120-$100)/$100, or 12%.

[79]. The firms in Table 2 all had historic and bankruptcy-year compensation data publicly available, either in securities filings or in the bankruptcy court documents that I reviewed to assemble the sample. It is possible that the missing firms are non-randomly selected, so the results in this Section should be interpreted cautiously. In general, firms tend to avoid disclosing executive compensation numbers if they can, viewing it as a trade secret, so the firms in Table 2 tend to skew towards the largest firms.

[80]. From the large sample, both OTC Holdings and Regent Communications engaged in this type of planning. I studied both cases closely for my article, Do Activist Investors Constrain Managerial Moral Hazard In Chapter 11?: Evidence from Junior Activist Investing, supra note 35. Stumbling upon them—and their thoughtful and successful attempts to use bankruptcy planning to evade court review—inspired this project.

[81]. One law firm that represents many large debtors in bankruptcy expressly warned its clients against this strategy, saying that it risked upsetting negotiations with creditors and created fraudulent conveyance risk. Sprayregen et al., supra note 21. Anecdotal evidence suggests that this practice is both common and continuing to this day. See Andrew Scurria, Takata Insiders Took in Millions Before Bankruptcy, Wall St. J. Pro: Bankr. (Aug. 10, 2017), https://www.wsj.com/articles/takata-insiders-took-in-millions-before-bankruptcy-1502405497.

[82]. Disclosure Statement Under 11 U.S.C. § 1125 in Support of the Debtors’ Third Amended Joint Plan of Reorganization at 26–27, In re OTC Holdings Corp., No. 10-12636 (Bankr. D. Del. Nov. 2, 2010), ECF No. 263.

[83]. See id.

[84]. First Amended Disclosure Statement for the First Amended Joint Plan of Reorganization for Regent Commc’ns Corp., et al. at 24, In re Regent Commc’ns, Inc., No. 10-10632 (Bankr. D. Del. Mar. 22, 2010), ECF No. 128. A third non-case study sample, the 2009–2010 Chapter 11 of CCS Medical, involved similar bankruptcy planning and similarly allowed management to be paid bankruptcy-related bonuses without a judge finding that the plan satisfied the revised statute. See Transcript of Hearing re Debtors’ Motion for Order (a) Approving Bidding Procedures in Connection with Mktg. and Proposed Sale of Substantially All of the Debtors’ Assets, and (b) Granting Related Relief at 37–38, In re CCS Medical, Inc., No. 09-12390 (Bankr. D. Del. Nov. 23, 2009), ECF No. 673.

[85]. Importantly, I only count bankruptcy bonuses that are bundled with the plan of reorganization and pay cash consideration as part of the analysis in this paragraph.

[86]. See 11 U.S.C. § 1129 (2018).

[87]. See In re Journal Register Co., 407 B.R. 520, 527, 537 (Bankr. S.D.N.Y. 2009) (noting the court agreed that the confirmation of a plan is governed by section 1129, not section 503(c), of the Bankruptcy Code).

[88]. Id. at 535.

[89]. Id. at 528, 537.

[90]. Id. at 538. In collecting data for Ellias, supra note 35, I observed other firms engage in similar behavior without first seeking court approval of a bonus plan. For example, Caraustar Industries paid management 50% of its 2009 incentive compensation on the effective date of the plan of reorganization. See Disclosure Statement for Debtors’ Joint Plan of Reorganization at 40, In re Caraustar Indus., Inc., No. 09-73830 (Bankr. N.D. Ga. May 31, 2009), ECF No. 21. Orleans Homebuilders paid $2.3 million in bonuses to forty senior managers as part of its plan of reorganization. See Debtor’s Second Amended Joint Plan of Reorganization at 44, In re Orleans Homebuilders, Inc., 561 B.R. 46 (Bankr. D. Del. 2010) (No. 10-10684). Other firms paying large bonuses as part of the plan—presumably for performance during the bankruptcy case—that filed for bankruptcy in 2009 and 2010 include: Lyondell Chemical Company ($27.75 million); Reader’s Digest Association ($12.9 million); Visteon Corporation ($8.1 million for twelve managers); Mesa Air Group; Inc. ($5.5 million); Six Flags, Inc. ($5.025 million for seven managers); Innkeepers USA Trust ($4.5 million); Almatis B.V. ($4.3 million); Tronox Incorporated ($3 million for four managers); Cooper-Standard Holdings, Inc. ($2.49 million for thirteen managers); Orleans Homebuilders, Inc. ($2.38 million for forty managers); NTK Holdings, Inc. (Nortek, Inc.) ($2 million); FairPoint Communications, Inc. ($1.8 million); Journal Register Company ($1.7 million); Affiliated Media, Inc. ($1.6 million for fifty employees); Centaur, L.L.C. ($1.5 million for three managers); Great Atlantic & Pacific Tea Company, Inc. ($1.48 million for 146 managers); Panolam Industries International, Inc. ($1 million); EnviroSolutions Holdings, Inc. ($1 million); Pliant Corporation ($0.87 million for one manager), International Aluminum Corporation ($0.65 million); Newark Group, Inc. ($0.5 million); Oriental Trading Company, Inc. ($0.45 million for fourteen managers); Neff Corp. ($0.35 million for two managers); and Regent Communications, Inc. ($0.31 million).

[91]. Congress has long recognized the need for public disclosure of post-bankruptcy compensation and retention of bankruptcy insiders. See, e.g., 11 U.S.C. § 1129(a)(5)(B) (2018) (requiring disclosure of the identity of insiders who will be employed or retained by the debtor as well as their compensation).

[92]. See Voluntary Petition (Chapter 11), In re Citadel Broadcasting Corp., No. 09-17442 (Bankr. S.D.N.Y. Dec. 20, 2009).

[93]. Objection of Virtus Capital LLC and Kenneth S. Grossman Pension Plan to the Disclosure Statement for the Joint Plan of Reorganization of Citadel Broadcasting Corp. and Its Debtor Affiliates Pursuant to Chapter 11 of the Bankr. Code at 4–5, In re Citadel Broadcasting Corp., No. 09-17442 (Bankr. S.D.N.Y. Mar. 5, 2010), ECF No. 172. Post-bankruptcy equity incentive plans are largely outside the scope of this study because of data constraints. While I often observe firms setting aside post-reorganization equity for a management incentive plan as part of the plan of reorganization, I do not systematically observe the post-bankruptcy payouts. Citadel is an outlier case because it involved management misrepresenting the post-bankruptcy incentive plan to the court, with creditors learning about it and seeking some sort of remedy. The vast majority of Chapter 11 debtors do not become publicly traded immediately after bankruptcy; accordingly, there is little disclosure of post-bankruptcy equity compensation. The value of post-bankruptcy equity compensation is substantial and dwarfs all observed bankruptcy bonus plans (for the 2009 and 2010 sample, the aggregate amount of value in all of the bonus plans in the case study sample is $70 million; those same firms set aside approximately $387 million in aggregate management post-bankruptcy equity incentive plans). However, without information on post-bankruptcy distributions and understanding how equity was allocated across the employee base, it is impossible to determine how much of this equity actually flowed to management and how much may have flowed to management as a form of compensation for performance while the firm was in Chapter 11.

[94]. See id.

[95]. Reply of R2 Investments, LDC in Support of Motion Pursuant to 11 U.S.C. §§ 1142 and 105(a) to Direct Reorganized Debtors to Comply with Plan ¶ 5, In re Citadel Broadcasting Corp., No. 09-17442 (Bankr. S.D.N.Y. Oct. 29, 2010), ECF No. 507. scienter
1

[96]. Motion Pursuant to 11 USC §§ 1142 and 105(a) to Direct Reorganized Debtors to Comply with Plan at 2, In re Citadel Broadcasting Corp, No. 09-17442 (Bankr. S.D.N.Y. Oct. 6, 2010), ECF No. 498.

[97]. Id. at 3.

[98]. Id. at 2.

[99]. See id. 1–5.

[100]. Id. at 1.

[101]. Id. at 2.

[102]. Goldschmid, supra note 28, at 266–67.

[103]. See supra Part II.

[104]. An important limitation of the data is that in many cases, bonus plans were either incomplete when filed with the court or filed under seal. Accordingly, Table 3 reports the information that was publicly available both from bankruptcy court filings and from contemporaneous or post-bankruptcy SEC filings that filled in gaps from the court filings.

[105]. This is consistent with anecdotal reports of practitioners. For example, a prominent creditor’s attorney told Bloomberg that “the amendment to the code changed the means, but not the value of these plans . . . [i]t’s just changed the way you get there, not necessarily how much management gets at the end.” Church, supra note 7.

[106]. In expectation, the expected value of $100 in the future that will be received with 100% certainty is $100 ($100*100%). If management only has a 10% chance of receiving the bonus, in expectation that bonus is worth $10 ($100*10%). Thus, the board would need to propose a bonus plan that paid $1000 as part of a challenging incentive plan with a 10% ex ante probability of payout (because $1000*10% = $100) to provide the same level of motivation as a guaranteed retention bonus of $100.

[107]. For example, if a bonus plan was tied to confirming a plan of reorganization by a certain date, we examined whether the bonus plan was approved by that date or if there was a subsequent extension.

[108]. The exception is a higher observed rate of payout for firms with whole firm sale targets and payouts for emerging from bankruptcy. This likely reflects changes in bankruptcy practice, as it became more common for firms to go into Chapter 11 and conduct going-concern sales. See, e.g., Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751, 751, 786–88 (2002) (discussing the rise in the use of Chapter 11 as a platform for the sale of a firm’s assets, often as a whole firm going-concern sale).

[109]. This finding deserves two qualifications. As Table 4 shows, there is enough missing data to potentially bias the result. Additionally, bonus plans often have “tiers” of goals (as where, for example, a 10% revenue increase might yield $100 and a 15% revenue increase might yield $200), and I do not systematically examine enough information to determine which payout tier was reached in enough cases to report results.

[110]. For example, if management would have worked for $100, but extracts extra rents of $50 for total compensation of $150, the extra $50 is money that could have otherwise been paid (in some form or another) to unsecured creditors in the event they are not being paid in full.

[111]. In some cases, creditors file their own objections, either because they are secured creditors who are not represented by any official committee or because they want to act on their own, apart from the committee, for strategic reasons. I also summarize the litigation of these creditors as part of Table 4. The qualitative trends I discuss in this Section, while focusing on the official committee, are the same as the trends observed by unsecured creditors acting on their own.

[112]. It is difficult to evaluate this because managers may simply propose an unreasonable bonus plan before moving the plan to what they know creditors will accept after negotiations and litigation. It is hard to know if management actually “moved” or simply went to where they always planned to be.

[113]. Objection of the Official Comm. of Unsecured Creditors to the Motion of the Debtors and Debtors in Possession for Entry of an Order Approving a Key Employ. Incentive Plan at 8, In re Midway Games, Inc., No. 09-10465 (Bankr. D. Del. Mar. 27, 2009), ECF No. 203.

[114]. Objection of the Official Comm. Of Unsecured Creditors to Debtor’s Motion for Order Approving the Implementation of Key Emp. Incentive Plan and Short Term Incentive Plan at 2, In re Hayes Lemmerz Int’l, Inc., No. 09-11655 (Bankr. D. Del. Aug. 14, 2009), ECF No. 460 [hereinafter Hayes Lemmerz Objection].

[115]. Objection of the Official Comm. Of Unsecured Creditors to Debtor’s Motion for Order Authorizing Use of Cash Collateral for Payments Regarding HVM LLC Incentive Program at 28, In re Extended Stay Inc., No. 09-13764 (Bankr. S.D.N.Y. Oct. 26, 2009), ECF No. 530; Objection of Official Comm. Of Unsecured Creditors to Motion of the Debtors for an Order Authorizing the Debtors to Continue Their Short-Term Incentive Plan at 12–13, In re Merisant Worldwide, Inc., No. 09-10059 (Bankr. D. Del. Mar. 20, 2009), ECF No. 211.

[116]. Objection of the Official Comm. Of Unsecured Creditors to: (A) Debtors’ Motion for an Order Authorizing the Debtors to Implement Severance and Non-Insider Retention Programs; and (B) Debtors’ Motion for an Order Authorizing the Implementation of the Visteon Incentive Program at

8–10, In re Visteon Corp., No. 09-11786 (Bankr. D. Del. Jul. 13, 2009), ECF No. 528.

[117]. Objection of the Official Comm. of Unsecured Creditors to Debtors’ Motion for Order Authorizing Debtors to Adopt and Implement an Incentive Plan for Certain Key Employ. Pursuant to Sections 363(b)(1), 503(c)(3), and 105(a) of the Bankr. Code at 13, In re Foamex Int’l, Inc., 368 B.R. 383 (Bankr. D. Del. 2007) (No. 09-10560).

[118]. Id. at 1–2.

[119]. Id. at 2.

[120]. Id. at 2–4.

[121]. See id. at 2–5.

[122]. Official Comm. Of Unsecured Creditors’ Objection to Debtors’ Motions to Shorten Notice Relating to Their (I) Motion for Approval of Exec. Comp. and Emp. Incentive Plan for Non-Debtor OpCo Subsidiaries and (II) Motion to File Related Exhibits Under Seal at 2–3, In re Trico Marine Servs., Inc., 450 B.R. 474 (Bankr. D. Del. 2011) (No. 10-12653).

[123]. Debtors’ Reply to the Objection of the Official Comm. of Unsecured Creditors to Motion of the Debtors for Entry of an Order Approving the Debtors’ Key Employee Incentive Plan at 2, In re NEFF Co., No. 10-12610 (Bankr. S.D.N.Y. Jun. 28, 2010), ECF No. 199. In response, the debtors moved the “emergence incentive award” to the plan of reorganization. Id. at 3; see also supra note 90 and accompanying text.

[124]. Hayes Lemmerz Objection, supra note 114, at 3.

[125]. In one case, the Debtor complained that the U.S. Trustee’s objection “appears to be based on a form and ignores the evidence [the debtor] submitted.” Tronox’s Response to the Objection of the U.S. Tr. to Tronox’s Motion for Entry of an Order Approving Tronox’s Key Emp. Incentive Plan at 2, In re Tronox, Inc., 503 B.R. 239 (Bankr. S.D.N.Y. 2009) (No. 09-10156).

[126]. See generally Objection of the U.S. Tr. to Debtor’s Motion for Order Approving Debtors’ Key Mgmt. Incentive Plan, In re Lear Corp., No. 09-14326 (Bankr. S.D.N.Y. Jul. 20, 2009), ECF No. 161.

[127]. Id. at 1–2, 6.

[128]. See id. at 7.

[129]. Id.

[130]. Id.

[131]. See id.

[132]. U.S. Tr.’s Objection to Debtors’ Motion for Entry of an Order Authorizing Incentive Payments to Debtors Employees at 3, In re Noble Int’l Ltd., No. 09-51720 (Bankr. E.D. Mich. Apr. 22, 2009), ECF No. 60.

[133]. U.S. Tr.’s Objection to the Debtors Motion for Entry of an Order Approving the Debtor’s Incentive Plan and Authorizing Payments Thereunder Pursuant to §§ 363(b) and 503(b) at 2, In re Vermillion, Inc., No. 09 -11091 (Bankr. D. Del. May 6, 2009), ECF No. 42.

[134]. BearingPoint Objection, supra note 41, at 7.

[135]. See Kan Nishida, Demystifying Text Analytics Part 3 — Finding Similar Documents with Cosine Similarity Algorithim, Medium: Learn Data Science (June 23, 2016), https://blog.exploratory
.io/demystifying-text-analytics-finding-similar-documents-with-cosine-similarity-e7b9e5b8e515.

[136]. See Letter from Assistant Attorney Gen. Ronald Weich, to U.S. Senator Charles E. Grassley 1 (Mar. 5, 2012), http://online.wsj.com/public/resources/documents/Letter031312.pdf.

[137]. Id. at 2.

[138]. See Jonathan Randles, Westmoreland Paid Millions in Executive Bonuses in Year Before Bankruptcy, Wall St. J. (Nov. 9, 2018), https://www.wsj.com/articles/westmoreland-paid-millions-in-executive-bonuses-in-year-before-bankruptcy-1541804141.

[139]. See Second Monthly Application of Akin Gump Strauss Hauer & Feld LLP, Co-Counsel for Debtors and Debtors in Possession, for Interim Allowance of Compensation and for the Reimbursement of Expenses for Services Rendered During the Period from March 1, 2009 through March 31, 2009, Ex. B at 14, In re Foamex International Inc., No. 09-10560 (Bankr. D. Del. May 11, 2009), ECF No. 390.

Puerto Rico and the Netherworld of Sovereign Debt Restructuring – Article by Mitu Gulati & Robert K. Rasmussen

November 2017March 2018Southern California Law Review Admin

From Volume 91, Number 1 (November 2017)
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Puerto Rico and the Netherworld of Sovereign Debt restructuring

Mitu Gulati [*] & Robert K. Rasmussen [†]

TABLE OF CONTENTS

INTRODUCTION

I. THE PUERTO RICAN FISCAL CRISIS AND THE COMMONWEALTH’S ATTEMPT AT SELF-HELP

II. THE POWER OF STATES TO ENACT RESTRUCTURING REGIMES

III. PUERTO RICO

CONCLUSION

INTRODUCTION

Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”) in an attempt to pull Puerto Rico back from the abyss.[1] The reason for this drastic action—a special insolvency regime available only for Puerto Rico—was plain: the Commonwealth had accumulated debts well beyond its ability to repay. Its economy was in such a dreadful state that even if one were to declare an indefinite moratorium on all of its debt payments, it would still be the case that the island could not make ends meet without a drastic overhaul of both its operations and its finances.[2] Yet prior to congressional action there was no moratorium. The island’s creditors were demanding money, and the government’s cash reserves were nearing depletion. Disaster seemed imminent.[3]

Congress provided a glimmer of hope to the American citizens of Puerto Rico. PROMESA, at least temporarily, put a halt to the creditors’ collection efforts. It also created a proceeding that in essence replicates Chapter 9 of the Bankruptcy Code for the Commonwealth, as well as an alternative path relying on consensual restructuring coupled with the power to bind holdout creditors.[4] Puerto Rico gained two options that it lacked prior to the legislation’s passage. But the price for these protections was steep. A control board was put in place that effectively took over control of the territory’s finances and the conduct of any insolvency proceedings.[5] The members of this board were appointed by elected officials in Washington.[6] The elected government of Puerto Rico had no right to appoint or veto any members. Given potential constitutional infirmities with the control board, it remains to be seen whether this last–minute action is sufficient to save the island from total financial collapse.[7]

We here are interested in a different type of abyss than the one that spurred Congress to act. Prior to the passage and signing of PROMESA, Puerto Rico inhabited a netherworld of debt adjustment. In Puerto Rico v. Franklin California Tax-Free Trust, the U.S. Supreme Court held that the Bankruptcy Code provided no relief for Puerto Rico or its municipalities and at the same time precluded Puerto Rico from enacting an insolvency regime of its own.[8] The Commonwealth could neither repair to federal law to restructure some of the debts plaguing it nor could it enact legislation to address the fiscal crisis. In essence, Puerto Rico was faced with crushing debt and no mechanism to take action, other than attempts to have bondholders voluntarily agree to haircuts (something that bondholders are loath to do). Puerto Rico gamely undertook such efforts for some of its debt, but while these attempts may have shown glimmers of optimism to some, each of them eventually fell apart.[9] Not a single group of creditors was willing to restructure its debt to a sustainable level. Puerto Rico was in fiscal purgatory.

While the issue was not before the Supreme Court in Franklin, we want to explore whether the Constitution allows Congress to put Puerto Rico into such a bind. Can it take away a government’s power to enact a restructuring regime and put nothing in its place? Put in contractual terms, do the implicit terms of the deal struck between Puerto Rico and the U.S. federal government when Puerto Rico transitioned from the status of a colony to a “freely associated state” in 1952 [10] allow Congress to eliminate in full Puerto Rico’s ability to restructure the debt of its municipalities? This question encompasses both the situation that existed in Puerto Rico prior to the enactment of PROMESA and the potential lacuna that could arise should a state enact a restructuring law for its own debts and Congress seek to void such action.[11] We submit that the answer is no.

Our analysis proceeds in three parts. In the first, we describe the financial situation facing Puerto Rico, its attempts to address that situation, and the Supreme Court’s recent decision in Franklin. This articulation of the problem highlights the ills that can occur when a sovereign entity has the power to issue debt but lacks a means for resolving financial distress. We then ask the question of whether, when it comes to states, the allocation of authority between them and the federal government would allow Congress to put them in such an untenable situation. States under our federal system retain core functions. The power to issue and restructure debts, we submit, resides in this core. Indeed, prior Supreme Court precedent holds that the power to issue debt necessarily includes the power to create a mechanism for restructuring that debt. We argue that while Congress can adjust this power by replacing a state’s scheme with one of its own, it cannot, consistent with federalism, prohibit state action while putting nothing in its place.

We then turn our attention to Puerto Rico. The much–vilified Insular Cases seem to imply that Congress has substantial leeway in all matters regarding Puerto Rico.[12] We show, however, that the colonial conception of the relationship between Puerto Rico and the U.S. federal government, on which those cases rest, cannot form the basis for determining what the allocation of authority between Congress and Puerto Rico is today. Congress transferred sovereignty to Puerto Rico. It established and implemented a process by which the island became a commonwealth. As part of that transfer of sovereignty—something that was done in the post-Second World War era, when colonial outposts were to be phased out as a matter of the new international order—Congress authorized and then approved Puerto Rico’s constitution, which expressly gave the Puerto Rican government the power to issue debt and impose taxes.[13] This action, we submit, necessarily also gave Puerto Rico the power to enact a restructuring regime. Congress could negate Puerto Rico’s right to put in place a restructuring regime, but only if it were to put in place some substitute mechanism. Prohibiting the enactment of any means of restructuring its obligations cannot pass constitutional muster.

I. The Puerto Rican Fiscal Crisis and the Commonwealth’s Attempt at Self-Help

That Puerto Rico is facing a deep fiscal crisis is beyond doubt. Its problem consists both of the amount of debt that it owes and the varying and vague priorities among its various debt instruments. Unlike recently distressed sovereigns such as Greece and Argentina, which largely issued only one type of debt—unsecured sovereign bonds—Puerto Rico and its various instrumentalities issued many types of debt.[14] Some of the debt came from various government agencies, such as the power company, the highway agency, and the water company. Some of this debt was guaranteed by the main government; some was not. The main government itself issued multiple flavors of obligations, with the relative priority of the various issues a current matter of dispute among the debt holders.[15] When the bonds issued by the general government are added to the debt incurred by the various agencies, the total exceeds $70 billion.[16] This sum does not include Puerto Rico’s unfunded pension obligations that it has promised to its employees. Throwing these promises to pay into the mix brings the total indebtedness to well over $100 billion.[17]

The amount of Puerto Rico’s debt is only half of the analysis. A government’s debt load can only be viewed as unsustainable when it is compared to its ability to raise funds through taxation. Sovereigns with larger economies can support larger debt loads. When we compare Puerto Rico’s debt load with its prospects for generating future revenues, the results are bleak. Puerto Rico’s economy has little hope of servicing its extant debt stock. The island’s population is only around 3.4 million people.[18] Its gross domestic product for 2013 was $103 billion, which is roughly the same as, and indeed could well be less than, its debt obligations (with unfunded pension liabilities included).[19] Yet it is even worse than this snapshot indicates. The Commonwealth’s debt load and its GDP are moving in opposite directions.[20] The island’s debt has been ballooning for years. Its economy, on the other hand, has been in decline for over a decade.[21] Many of the island’s citizens have decamped for the mainland. Indeed, Puerto Rico is losing population at an alarming rate.[22] The gap between what Puerto Rico owes and what it can pay grows with each passing year.

The recent devastation wrought by Hurricane Maria has made things worse. The hurricane devastated the local economy and caused tens of thousands of Puerto Rico’s citizens to flee to the continental United States.[23] The lawyers representing the PROMESA board have estimated that the government will not be able to make any payments on its debt for at least five years.[24]

The Commonwealth’s looming inability to meet its obligations has not gone unnoticed. Puerto Rico has spent the last few years looking for a mechanism by which it can address its financial distress. Chapter 9 of the Bankruptcy Code, which allows a state to authorize its municipal units to file for restructuring, was not an option.[25] To be sure, even had Puerto Rico been able to use Chapter 9 for its municipal entities, this would have not provided a comprehensive solution to the island’s debt as it would not have offered a vehicle to restructure the debt issued by the Commonwealth itself. Chapter 9 is currently not available to the states, only to a state’s municipalities.[26] Still, access to Chapter 9 would have allowed Puerto Rico to ameliorate the debt problem. Yet even such partial relief was not available.

When the predecessor to Chapter 9 was enacted, Puerto Rico was treated the same as a state and thus had the ability to authorize its municipalities to seek shelter in its provisions.[27] When Congress passed the Bankruptcy Code in 1978, Puerto Rico maintained its ability to use Chapter 9’s provisions to restructure the debts of its municipalities.[28] Had that provision remained in place, Puerto Rico could have attempted to restructure the debt of its various agencies. In 1984, however, without comment or explanation, Congress, led by Senator Strom Thurmond of South Carolina, removed Puerto Rico’s access to Chapter 9.[29]

Attempting to deal with its financial predicament, Puerto Rico enacted the Puerto Rico Public Corporation Debt Enforcement and Recovery Act in 2014.[30] This Act contained a debt restructuring mechanism that drew its inspiration from Chapter 9. Chapter 9 allows for the instrumentalities of states, but not states themselves, to restructure their debts. Prior to its exclusion from Chapter 9, the same arrangement was available for Puerto Rico—it could place its instrumentalities into bankruptcy, but it could not use the provision for debts that it had issued. The law that Puerto Rico enacted followed this course; it would only be available to instrumentalities of the territory and not the territory itself. Puerto Rico in essence tried to restore what Congress had taken away.

Not so fast, claimed the holders of debt issued by Puerto Rico’s public corporations. Chapter 9, they argued, contains a provision that preempts state restructuring regimes (and “states” in this case, according to the way the term had been defined, included Puerto Rico).[31] The most relevant case in interpreting the predecessor of Chapter 9 was a famous wartime decision of the U.S. Supreme Court, Faitoute Iron & Steel Co. v. City of Asbury Park.[32] At issue was a law passed by New Jersey to enable its municipalities to restructure their debts with the approval of 85% of their creditors (and judicial supervision and approval).[33] A subset of creditors, who were unwilling to allow the municipality to restructure its debts, sued, arguing that New Jersey was not entitled to take such an action.[34] The Court in Asbury Park upheld the New Jersey statute, ruling that the states’ police power includes the ability to enact debt restructuring regimes for their municipalities.[35] To be sure, the Court said, the regimes could not run afoul of the Contracts Clause—in other words, the states could not put in place regimes that were aimed at simply expropriating value from investors and transferring that to the state.[36] However, so long as the regime that a state enacted respected this limit, the Court said, it could put a debt arrangement procedure in place.[37]

Asbury Park thus left municipalities with two options: they could restructure either under federal bankruptcy law or under an appropriately enacted state law. Congress did not approve of having to share the field with the states. To the extent states wanted to allow their municipalities to have the option of restructuring their debts, Congress wanted to specify a uniform mechanism across the country. Reacting to Asbury Park, Congress decided that Chapter IX [38] was to be the only game in town. It placed in Chapter IX a new provision, expressly preempting state restructuring laws.[39] The price for having access to Chapter IX was that states could not set up alternative restructuring arrangements. The states could choose to not have a bankruptcy system for their municipalities, but if they chose to have one, it would be the uniform mechanism that Congress had designed. That tradeoff continues to this day. No one disputes that Illinois, or any other state for that matter, cannot enact its own debt restructuring regime for its municipalities. The holders of Puerto Rican debt argued that this provision preempts the Puerto Rican effort on this score as well.[40]

Puerto Rico’s response to the argument from the creditors was that, when Congress took away Puerto Rico’s access to Chapter 9, it also took Puerto Rico out of the ambit of Chapter 9’s preemption provision.[41] In other words, preempting a state’s bankruptcy law for purposes of ensuring a uniform municipal bankruptcy system around the country was fine, but only if the federal government was going to put something in its place (which is what Congress did for the states). Absent any federal mechanism to substitute for a state mechanism, the state (or state–type entity) was allowed to substitute its own mechanism—that seemed to be the clear teaching of Asbury Park.

A divided Supreme Court disagreed with this reading of the Bankruptcy Code and, in an opinion by Justice Thomas, struck down Puerto Rico’s efforts to put in place its own municipal bankruptcy system.[42] The Court sided with the lenders and held that Chapter 9 preempted Puerto Rico’s restructuring law.[43] The effect of this ruling was to leave Puerto Rico with no federal law to help it restructure its debts and the inability to pass such a law on its own. It found itself in a position where it could take no action to address the existential financial challenge that it faced. Any future attempts to repair Puerto Rico’s unsustainable debt stock could only come through congressional action.

II. The Power of States to Enact Restructuring Regimes

Before examining the situation that Congress created when it left Puerto Rico in the netherworld of debt restructuring, we begin our analysis with the question of whether Congress could do the same thing to a state. As a starting point, one might think, if Congress could constitutionally enact such a law for the fifty states, it surely could do so for Puerto Rico. Puerto Rico may have fewer protections against incursions from Congress than the states do, but, at least as an initial matter, one would think that it does not have more.[44]

To begin, consider the following hypothetical. Congress, in order to promote efficiency and lessen the burden on interstate commerce caused by fires, creates a national fire department, and, in order to prevent needless duplication of effort, forbids the states and their instrumentalities from creating their own fire units. Assume that at least one state is fond of its own fire departments and seeks to have the new law struck down as transgressing the limits on federal interference with state authority. To determine whether the new law would comport with constitutional limitations on congressional inroads on state regulation of the state’s internal affairs, it is necessary to delve into the Supreme Court’s federalism cases.

At one time, the Court used to strike down with some regularity regulations that interfered with a state’s “traditional” functions. Our hypothetical law would have likely been found to be unconstitutional under this analysis, as establishing a fire department has been a function of states and their municipalities for decades. The Court, however, in Garcia v. San Antonio Metropolitan Transit Authority, abandoned the project of demarcating which government functions were “traditional” and hence subject to constitutional protection.[45]

The Court later made clear, in New York v. United States, that Garcia addressed federal laws that applied to states and private actors alike.[46] When the federal government regulates the states as states, a different analysis now takes hold. The federal government is allowed, within limits, to encourage states to take actions—for example, setting speed limits below seventy miles per hour on interstate highways within a state—through financial incentives.[47] Alternatively, the federal government can regulate the activity itself and forbid the state from regulating through preemption. What it cannot do, however, is require that the states regulate in a prescribed manner.

Based on this framework, it seems that Congress’s creation of a national fire department would be upheld. To be sure, Congress could not take over the extant local fire departments and run them—that would be commandeering and would run afoul of New York.[48] Having established a national fire force, however, Congress could then preempt all local efforts in this space. The federal government can bar duplication of effort.

But what if Congress passed a law that did not create a national fire department, but rather, seeking to spur the development of privately owned fire departments, Congress simply forbade states and municipalities from creating their own? Congress, in our hypothetical, has determined that the private market is the best way to provide for efficient fire protection. The Supreme Court has not addressed such a situation. Here, Congress is regulating the state as a state and is ousting the state from a traditional state power. It is not, however, putting a federal scheme in its place.

Such a law, we submit, would be unconstitutional. The Court is clearly worried more about the relationship between the federal and state governments when Congress attempts to regulate the states qua states. The Court in New York distinguished Garcia and its predecessors on precisely this ground.[49] The Court got back into the Tenth Amendment game in New York because the federal government was attempting to regulate the states as states. Thus, while Garcia abandons the project of articulating traditional state functions as to regulations that apply to a range of private and public parties, it would be over-reading that case to suggest that the Court would not act to protect core government functions when Congress seeks to divest them from the state yet put nothing in their place.

To be sure, Congress can exercise its power under the Commerce Clause to regulate this space for itself, but it would violate basic federalism principles were it to remove this area from the states and leave nothing in its place.[50] Put differently, the implicit deal among the states to delegate certain powers to a central government and maintain others for themselves is violated when the central government takes away the power of the state to protect its citizens in certain ways without stepping in to do the job itself. The rationale for allowing Congress to step in here is that there are going to be some instances where the assumption that regulation is best designed and applied at the local level does not hold. In economic terms, these are the contexts where domestic regulation of an activity by the individual states will either under– or over–produce the levels of that activity in a way that causes harm to the system: negative externalities, in economic parlance. Here it serves the interests of everyone to have the regulation centralized.[51] Congress would be within its zone of power if it were to conclude that local control of firefighting efforts has produced too little protection for the nation’s citizens, and thus central regulation is preferable. It cannot, however, prevent the state from fulfilling a core function and fail to provide an alternative.

The same analysis applies in the area of debt restructuring regimes. We begin with the Supreme Court’s jurisprudence in the area of municipal bankruptcies. Originally, the Court struck down Congress’s first attempt to enact a bankruptcy regime for municipalities, stating a concern that the provision at issue intruded too much on a state’s sovereignty.[52] In United States v. Bekins, though, the Court upheld a new federal effort,[53] pointing to the fact that under the revised Chapter IX only a “voluntary” petition could be filed.[54] In other words, the state’s municipalities could not be hauled into court over their objections. That the state had consented to have its municipalities subject to the federal regime was sufficient for the Court to quiet earlier concerns that the law intruded too much on state prerogatives. So long as the states themselves could choose to authorize their municipalities to file for bankruptcy under Chapter IX, the new regime did not run afoul of the Constitution.[55]

For our purposes, the most important case is the next in the lineage, Asbury Park. In that case, as described earlier, New Jersey had enacted a restructuring regime for its municipalities. The city of Asbury Park, hopelessly insolvent, sought to take advantage of this state-provided provision that allowed for a restructuring of its debt with the approval of 85% of the holders in principal amount. A subset of unhappy debtholders invoked the Court’s preemption jurisprudence. They argued that when Congress enacted the regime that was validated in Bekins, it occupied the field and left no room for a state to enact its own restructuring regime.

The Supreme Court, in an opinion by Justice Frankfurter, turned back the challenge. The Court held that the power to enact a restructuring regime is part and parcel of the power to tax and to issue debt in the first instance. The insight here is that issuing debt necessarily creates the risk that the municipality will issue more debt than it can service. It is not that the municipality is necessarily feckless when it defaults; rather, unforeseen events can well create a situation where the municipality simply does not have the financial wherewithal to service its debts. Regardless of why the government finds itself in financial distress, the financial distress can make it impossible for the government to fulfill its core mission. If the municipality were powerless to restructure its debt, it would be unable to provide the basic infrastructure for its citizens. Justice Frankfurter wrote:

But if taxes can only be protected by the authority of the State and the State can withdraw that authority, the authority to levy a tax is imported into an obligation to pay an unsecured municipal claim, and there is also imported the power of the State to modify the means for exercising the taxing power effectively in order to discharge such obligation, in view of conditions not contemplated when the claims arose. . . . The necessity compelled by unexpected financial conditions to modify an original arrangement for discharging a city’s debt is implied in every such obligation for the very reason that thereby the obligation is discharged, not impaired.[56]

The import of the passage seems to be that those who buy a municipality’s bonds are relying primarily on the municipality’s power to tax in order to have the bond serviced. The power to tax, after all, is almost always going to be a municipality’s primary source of income. The bondholders know this going into the transaction. The state has the ability to constrain a municipality’s taxing power, and it can deem how the taxes that a municipality receives are spent. To the extent that the government cannot both meet its basic needs and service the debt on the terms that it was issued, the state can create a procedure for the adjustment of the debt. As the Court said:

The intervention of the State in the fiscal affairs of its cities is plainly an exercise of its essential reserve power to protect the vital interests of its people by sustaining the public credit and maintaining local government. The payment of the creditors was the end to be obtained, but it could be maintained only by saving the resources of the municipality—the goose which lays its golden eggs, namely, the taxes which alone can meet the outstanding claims.[57]

Put differently, the bondholders’ primary expectation is to get paid back via taxes, and the state can ensure, via a restructuring regime, that a city maintains sufficient funds to run its operations and service the debt. Allowing the city to restructure its debt creates the possibility that the bondholders, while not receiving as much as they were promised, will receive more than if the city were to not maintain its operations.

The notion that a restructuring of extant debt can enhance the overall welfare of the bondholders was also crucial in rejecting the dissenting bondholders’ argument that the restructuring regime at issue violated the Contracts Clause. In rejecting the notion that the bondholders had their contracts impaired, the Court pointed out that the restructuring made the creditors as a group better off.[58] The bonds held by the holdouts were worth more after the restructuring than before.[59]

This observation implies that there are limits on the extent to which a state can restructure municipal debt. In the extreme, a state could not enact a law that took away the value of the bondholders’ instruments. In terms of whether a bondholder was better off, the Court seems to be willing to say that if 85% (which, as noted, was the requirement in New Jersey law)[60] were in favor of the new terms, that was good enough. Of course, no such limitation exists on Congress’s power to restructure municipal debts.[61]

The argument is that the power to tax is essential to the running of a state. It would be fanciful to propose that a modern state could finance itself without resorting to this power. The power to restructure debt is linked to the taxing power. Once the state allows a municipality to issue debt, the primary (if not the only) way that the debt will be serviced is through the exercise of the taxing power. There are, as the Court noted, practical limits on how much revenue taxes can raise. Moreover, the municipality has to be able to meet the basic needs for which it exists in the first instance. When feasible revenues cannot cover both the basic needs and the debt obligations, the state needs to have the power to orchestrate an adjustment in the debt burden.

Indeed, a moment’s reflection reveals that a debt restructuring regime is part and parcel of issuing debt, at least where a sovereign is concerned. Despite the best efforts of those charged with running the municipality, it is inevitably the case that a debtor will, on occasion, find itself in a position where it cannot satisfy all its obligations. Even putting aside the public choice dynamics that induce governments to worry more about the near term than the long term,[62] foresight is not perfect. Anticipated growth in revenues does not always materialize. Investments in new infrastructure may not yield the expected return. There may be an economic downturn that causes tax revenue to decline well below previous projections. A city can see its tax base erode with the loss of a major employer. A government utility can be whipsawed by rising commodity prices. There are countless ways in which things may go awry, and the municipality may be left with a debt stock that it cannot service. If, in such a situation, there is no restructuring mechanism to which the municipality can turn, then what one ends up with is chaos. At some point the municipality stops paying, and then the creditors begin fighting amongst themselves and with the debtor to grab assets—at least to the extent that the municipality does not enjoy sovereign immunity. Such a system has little to commend it. It thus is not surprising that the Supreme Court held that a government’s power to issue debt includes the power to restructure that debt when necessary.

Now, with private firms, we could imagine a world without a debt restructuring mechanism. If the parties cannot reach an agreement to restructure the debt, and the business can no longer service it, the firm can be liquidated. Indeed, liquidation is the most common outcome when a business cannot make ends meet. Alternatively, the firm can have a capital structure that itself is designed to deal with future financial distress. One can imagine a system where the default on a debt payment leads to the wiping out of old equity and conversion of the junior-most debt into new equity.[63]

Such options do not exist with a municipality. Liquidation is by and large out of the question. To be sure, states have at times terminated municipalities in order for the state to take over regulation of the affected citizenry.[64] Yet there has never been a case where the body that issued the debt was liquidated for the benefit of the creditors. Taking over an operation is one thing; shutting down and selling off its assets and leaving the affected citizens without services is quite another. At a fundamental level, the municipal corporation needs to continue in existence so as to fulfill its public purpose. In this respect, a government is better analogized to an individual than to a corporation.[65]

Revamping the capital structure of the distressed municipality so as to transfer control rights over its operations is also not an available option. Proposals in the private sector that call for the elimination of the interests of equity holders and a conversion of junior debt into new equity when financial distress hits in effect cede control of the company to the creditors. Such is not feasible in the case of a government. We have no objections when one group of financial investors—equity holders—is replaced by another group—debt holders. One cannot imagine, however, voters losing their ability to run the government and having the operations taken over by bondholders.[66] Hedge funds can run companies; our democratic system does not countenance them running cities.

That a state has the inherent power to put a restructuring regime for municipal debt in place does not imply that it has an obligation to do so. In theory, one could articulate a cogent reason as to why a state, when it establishes a municipal entity, may bar that entity from restructuring its debts. One could posit that those creating a new entity could decide that they want to ensure that the new public entity keeps its borrowing extremely low and funds almost all of its expenditures out of current income (taxes). For example, a state may be concerned about maintaining the creditworthiness of the state as a whole, and therefore want to constrain any individual entity from over-borrowing and therefore putting the credit of the other constituent units at risk. The state, in other words, may be concerned about moral hazard. This decision though, the Supreme Court has made clear, is a matter for the states—it is a matter of state sovereignty. To be sure, the federal government has preempted states’ power to create a restructuring regime, but it has put an adequate substitute in its place. The federal government provides a mechanism, Chapter 9, and the states get to decide whether they want to use it for their municipalities and, if so, whether there are conditions they wish to attach to its use.

Consistent with the foregoing, Asbury Park established that it is the states that have the inherent power to enact a restructuring regime. Congress, however, reacted to the decision by amending the federal municipal bankruptcy law so that it preempted state restructuring regimes such as the one at issue in the case. But Congress did so by saying that it was giving states the basic mechanism to use, should they wish to use it. The option—whether or not to have a restructuring mechanism at all—still rested squarely with the state.

To the extent that the power to establish a restructuring regime is an integral part of the power to tax, the question becomes whether Congress can take away this power and put nothing in its place. For the reasons that articulated above, the answer is no.

III. Puerto Rico

The above section argued that the power to enact a debt adjustment scheme is an integral part of a state’s sovereign power, and that Congress cannot take that power away and put nothing in its place.[67] But Puerto Rico is not a state; rather, it has a unique and convoluted relationship with the United States. The question necessarily arises whether Congress has greater latitude with respect to the Commonwealth than it does with the states.

If one considers Puerto Rico a territory, as that term is used in the United States Constitution, it follows that Congress has plenary power over the island. The much-discussed Insular Cases made the point clear.[68] There is much to criticize in these cases—particularly the thinly veiled undercurrents of racism and colonialism.[69] However, they stand for the proposition that Congress has plenary power with respect to territories, including (at that time) Puerto Rico. Territories, in short, do not enjoy the structural protections that federalism grants the states. If the relationship between the United States and Puerto Rico remained as it was in 1922, there would be no plausible argument that Congress transgressed the Constitution when it forbade Puerto Rico from enacting an insolvency regime while at the same time offering no alternative. Of course, if that relationship had not been altered, it is unclear that there would even be an issue—territories by and large do not have the power to issue debt.

But the relationship between the United States and Puerto Rico has undergone significant changes since the time of the Insular Cases—to quote the title of Chimène Keitner’s article, it has moved “From Conquest to Consent.”[70] Most importantly, Congress in 1950 enacted Public Law 600.[71] This law provided “[t]hat, fully recognizing the principle of government by consent, this Act is now adopted in the nature of a compact so that the people of Puerto Rico may organize a government pursuant to a constitution of their own adoption.”[72] Puerto Rico, however, did not have carte blanche. First, the law required that any constitution approved by the Puerto Rican people had to create a “republican form of government” and had to contain a bill of rights.[73] Moreover, Congress retained a veto over any constitution that Puerto Rico might put forth.[74] The constitution would become effective only with congressional approval. Congress had the power to reject the proposed constitution in full or to approve it subject to whatever amendments it deemed necessary.[75]

Following the passage of Public Law 600 in 1950, Puerto Rican officials drafted a constitution. It was approved by the citizens of Puerto Rico on March 3, 1952, with 82% voting in favor.[76] President Truman then, on April 22, 1952, submitted the draft constitution to Congress for its approval,[77] which occurred by joint resolution (subject to minor changes) on July 3 of the same year.[78]

The precise meaning of the creation of Puerto Rico’s constitution in terms of the relationship between Congress and Puerto Rico has been contested ever since, and we still do not have a definitive determination. Shortly after Congress blessed Puerto Rico’s constitution, many government officials represented to the United Nations and elsewhere that any future changes to Puerto Rico’s constitution could only take place with the consent of the citizens of Puerto Rico.[79] And this makes sense, because after the Second World War the United States was a key player in the creation of a new world order that explicitly disavowed colonialism. For example, U.N. General Assembly Resolution 1514 (XV) on the Granting of Independence to Colonial Countries and Peoples, and associated resolutions, set forth the right of self-determination of “[a]ll peoples;” a right by which those peoples were to be able to “freely determine their political status and freely pursue their economic, social and cultural development.”[80] In 1945, Puerto Rico was on the United Nations’ list of non-self-governing territories under the control of the United States (that is, the list of imperial colonies). In 1952, based on U.S. representations to the United Nations about the change in Puerto Rico’s status vis-à-vis the United States, it was taken off that list.[81] In other words, Puerto Rico was part of the United States, and its status could no longer be that of a vassal state (to remind ourselves, 1950 was when Public Law 600, which established the “compact” between the United States and Puerto Rico, was passed [82]).

The following pronouncements from key congressional committees are illustrative of the rationale behind Public Law 600. The House Committee on Public Lands explained that Public Law 600 would “fulfill in a most exemplary fashion our obligations with respect to Puerto Rico under chapter XI of the charter of the United Nations, relating to the administration of non-self-governing territories.”[83]

The Senate Committee on Interior and Insular Affairs, for its part, in its report on Public Law 600 explained that:

[Public Law 600] is designed to complete the full measure of local self-government in the island by enabling the 2¼ million American citizens there to express their will and to create their own territorial government. . . . [thereby] giv[ing] further concrete expression to our fundamental principles of government of, by, and for the people.[84]

The report cited the obligation to develop self-government contained in Article 73 of the U.N. Charter and expressed the view that the United States’ Charter obligations towards Puerto Rico “already have been fulfilled to an extent that is almost without parallel.”[85]

The foregoing is bolstered by the statement made by Frances Bolton, a U.S. congressional representative to the U.N. General Assembly’s eighth regular session, who said that “[t]he previous status of Puerto Rico was that of a territory subject to the full authority of the Congress of the United States . . . . [but that a new status has been created by] a compact of a bilateral nature whose terms may be changed only by common consent.”[86]

In addition, as Judge Juan Torruella of the First Circuit has emphasized, there exist international human rights treaties to which the United States is party that would be flatly inconsistent with a colony-type relationship between Congress and Puerto Rico.[87]

Putting the foregoing actions and statements together leads to the conclusion that Congress vested Puerto Rico with sovereignty somewhat on par with that of the states. Congress could override the Puerto Rican constitution by passing an inconsistent law, just as it could override a state’s duly enacted law. But it lacks the power to unilaterally amend the Puerto Rican constitution. The Puerto Rican constitution provided a mechanism for amendment—a mechanism that involved actions only by Puerto Rico itself.

If anything, though not essential to our argument here, Puerto Rico should have greater protection from congressional inroads than do the states. When the Supreme Court got out of the “core function” game in Garcia, part of its articulated reason was the that the states, through their representation in Congress, had structural measures by which they could protect themselves.[88] Each state has at least one representative. While the power of a lone representative is not great (though Puerto Rico, were it a state, would be entitled to four representatives), each state also receives two senators. As with every small state, even the senators and representatives working together cannot ensure that a state gets its way. Rather, it is the case that these congressional officials offer some guarantee that the interests of the state will be considered in the legislative process. They can join with others and form coalitions that ensure that they have a voice in the process.[89] They are not guaranteed to succeed, but they are guaranteed a seat at the table. Not so for Puerto Rico. It has no representatives that can look out for its affairs in the political rough–and–tumble in the halls of Congress. It has to rely on grace, not allies.[90] This lack of structural protection should, if anything, nudge the Court towards intervening to protect the sovereignty of the Commonwealth when a federal law seeks to remove power from the island.

The treatment of Puerto Rico’s access to Chapter 9 proves the point. Congress removed Puerto Rico and the District of Columbia from the ambit of Chapter 9 in 1984.[91] It is difficult to imagine such action being taken if Puerto Rico had voting representation in Congress. Its representatives could have lobbied their fellow representatives and could well have put together a coalition to block the measure. There does not seem to have been a great groundswell of enthusiasm for removing the availability of Chapter 9 for Puerto Rico’s municipalities; a small bit of organized resistance might well have stopped the effort.

One can find other statements around the creation of the Puerto Rican constitution, however, suggesting that at least some thought that Congress retained plenary power over Puerto Rico, undiminished in any way.[92] These statements, if credited, suggest that the act of creating the constitution was simply a way to put a process in place by which Puerto Rico could govern itself, though it would always be subject to overrule by the federal government.[93] One reason why this debate remains unresolved is that Congress has not made any attempt to unilaterally alter the Puerto Rican constitution since giving its consent in 1952.

Moreover, as Gary Lawson and Robert Sloane have pointed out, if Puerto Rico remains a territory, many features of the current arrangement would likely be unconstitutional.[94] Most prominently, the official in charge of Puerto Rico would seem to be an officer of the United States.[95] As such, he would have to be appointed by the President and confirmed by the Senate.[96] In fact, the governor of Puerto Rico, like the governor of every state in the Union, is elected by the citizenry.[97]

In 2016, a few weeks before its decision in Franklin, the Supreme Court reaffirmed that Puerto Rico is not the same for all constitutional purposes as a state. In Puerto Rico v. Sánchez Valle, Puerto Rico had filed a criminal action against Luiz Sánchez Valle for illegally selling firearms in violation of the Puerto Rico Arms Act of 2000.[98] The federal government then brought federal charges against him based on the same conduct. The defendant reached a plea agreement with the federal authorities while the case brought by Puerto Rican officials was still pending.[99] Sánchez Valle then moved to dismiss the case brought by the Puerto Rican authorities, arguing that convicting him would expose him to double jeopardy, in violation of the Fifth Amendment.[100]

Puerto Rico attempted to continue its prosecution by invoking the dual sovereign doctrine.[101] Under the dual sovereign doctrine, the federal government and the appropriate state government can prosecute an individual for the same activity and not run afoul of the Double Jeopardy Clause.[102] The theory is that while the act is the same, the crimes are distinct —one is against the federal sovereign, and one is against the state sovereign. Puerto Rico argued here that one crime was against the federal sovereign, and one was against Puerto Rico. The Court rejected this argument and held that the Commonwealth could not maintain a separate prosecution.[103]

The Court recognized that, in the dual sovereign context, “‘sovereignty’ . . . does not bear its ordinary meaning.”[104] Rather, the Court’s jurisprudence on the dual sovereign issue requires it to look to the source of the power to criminalize. To the extent that the power to criminalize comes from distinct sources, the two prosecutions can go forward.[105] With states and Indian tribes, they have that power apart from the federal government.[106] Their sovereignty preexists that of the federal government. In Puerto Rico’s case, however, the power to enact criminal laws was given to it by the federal government. Congress authorized Puerto Rico to adopt its constitution, and the prosecution at issue derives its legitimacy from that constitution. Since the ultimate source of the power was the federal government, such power could not originate from Puerto Rico.[107]

The Court’s analysis supports our argument. The Court went out of its way to emphasize that the Commonwealth enjoyed many if not all attributes of sovereignty.[108] What was critical to the double jeopardy analysis was the historical source of that sovereignty: from where did Puerto Rico get the power to enact its criminal laws? After the Insular Cases, it was clear that all power lay with Congress. Whatever power Congress transferred to Puerto Rico, even if this power was a one-way transfer of sovereignty, it remained the case that this power originated with the federal government. That being the case, the dual sovereign doctrine did not apply, and Puerto Rico could not maintain its action against Sánchez Valle. This analysis is consistent with an understanding of Puerto Rico’s current sovereignty as—once transferred by Congress—including the attributes of state sovereignty involving the power to issue and restructure debt.

The real question, left untouched by Sánchez Valle, is whether, having transferred sovereignty to Puerto Rico by authorizing its constitution, Congress may subsequently diminish or retract specific aspects of the conferred sovereignty in ways that it cannot for the states. One can infer that the Supreme Court is aware of this issue from its repeated efforts at ducking it. For example, in Examining Board of Engineers, Architects and Surveyors v. Flores de Otero, the issue was whether a Puerto Rico law violated the Constitution’s guarantee of Equal Protection (it did).[109] But there are two routes by which the Equal Protection Clause can apply. Under the Fourteenth Amendment, the Equal Protection Clause by its terms applies to states.[110] To the extent that one views the Commonwealth as a new type of entity, somewhere between a territory and a state, it may well be akin to a state for Fourteenth Amendment purposes. On the other hand, for territories like the District of Columbia, the Equal Protection constraint on government action applies via the Fifth Amendment’s Due Process Clause. The Court expressly declined to identify which clause was at issue, noting that the law in question would run afoul of either.[111]

Similarly, the Court has never addressed whether the Contracts Clause, which applies only to states, applies to Puerto Rico as well.[112] In Sánchez Valle, the Court noted that since both parties agreed that the Double Jeopardy Clause applied to Puerto Rico, it was not going to consider the question.[113] Indeed, if Puerto Rico were to be treated as a state for part of the Constitution other than the idiosyncratic dual sovereign doctrine, it would appear that treating Puerto Rico differently than states would be unconstitutional. The Bankruptcy Clause of the Constitution provides that “[t]he Congress shall have Power To . . . establish . . . uniform Laws on the subject of Bankruptcies throughout the United States.”[114] Congress cannot pass one set of bankruptcy laws for municipalities in Illinois and a different set for those in California. By the same token, to the extent that Puerto Rico is part of the United States, the exclusion of Puerto Rico from the protections of Chapter 9 runs afoul of the uniformity requirement.

We want to emphasize that our analysis does not rest solely on the fact that Puerto Rico’s citizens voted for a constitution. In the nineteenth century, many United States territories enacted constitutions.[115] While these constitutions may have held sway over the local citizens, no one thought that they altered the territory’s relationship with the federal government. Indeed, it would be odd to argue that any political entity could act unilaterally and in so doing claim for itself power that otherwise rests in Congress.

Rather, our argument focuses on the role of Congress in the creation. Puerto Rico was invited by Congress to draft a constitution. Indeed, Congress required that the Puerto Rican constitution guarantee a republican form of government. The U.S. Constitution, of course, requires the United States (interpreted by the Court to mean Congress)[116] to guarantee that all states have such a form of government. There is no such requirement that Congress ensure republican government in the territories.[117] Congress’s insistence on that requirement in the constitution that it was authorizing Puerto Rico to adopt is consistent with an investiture of sovereignty similar to statehood. We view the act “in the nature of a compact,” by which Congress brought the Puerto Rican constitution into being, as the transfer of sovereignty over the island from Congress to Puerto Rico.[118]

International law supports this interpretation. As noted earlier, among the United States’ commitments to the United Nations was that it was going to divest itself of its colonies. Indeed, as the House and Senate reports cited earlier suggest, the United States committed to setting an example for other colonial powers in terms of willingness to grant self-governance rights to former colonies such as Puerto Rico.[119] (Beginning in 1946, the United Nations had viewed the U.S.–Puerto Rico relationship as one in which the latter was a colony.[120]) The United States government, however, represented to the United Nations that the creation of the Puerto Rican constitution decolonized Puerto Rico.[121] These statements would be inconsistent with the assertion that the United States retained plenary power over the island.[122]

To be sure, some have argued that Congress could not give away any of its power. For these scholars, the Constitution, when it comes to relationships with the federal government, contemplates only a limited number of possibilities.[123] It is similar to the numerus clausus principle in property law.[124] For these scholars, the Constitution identifies and limits the type of relationships other political units can have vis-à-vis the federal government. A political unit can be a state, it can be a territory, it can be an Indian tribe, or it can be a foreign nation. That is all that the Constitution mentions, and that is all that there is. All agree that Puerto Rico is not a state, an Indian tribe, or a foreign nation; ergo, it must be a territory. To the extent that one finds this argument persuasive—and we do not—it ends the inquiry. Congress would have plenary power over Puerto Rico, and it could not object to Congress both barring it from enacting an insolvency regime and at the same time putting nothing in its place.

Yet another reading of the United States Constitution, however, is possible—and we think more plausible in the modern era. Congress began with plenary power over the territory. The act of working with the citizens of Puerto Rico to create a constitution was akin to an Ackermanian constitutional moment.[125] It was a fundamental alteration in the relationship between the United States and Puerto Rico. By putting in place a mechanism, in the nature of a compact, that led to the establishment of the Constitution, Congress ceded part of its former plenary power to the citizens of Puerto Rico. Consistent with the commitment of the United States to a world that had put the legacy of colonialism behind it, there were to be no more colonies with second-class status. The original states began with total sovereignty and ceded some of that to create the federal government. Here, the process is the converse. Congress started with total sovereignty and then transferred some to Puerto Rico.

The Constitution directs that Congress may add new states into the Union,[126], and when those new states arise from former territories, then Congress is in effect transferring sovereignty that it once held to the new states. Those new states then gain new status under the Constitution, including the protection of their sovereignty from incursion by Congress under the Tenth Amendment. What happened to Puerto Rico in 1952 represents a portion of that process having occurred. While not ending in full statehood, it involved a constitutional change in status and a profound alteration of relationship between the federal government and Puerto Rico. Sovereignty once yielded, particularly though an agreement to share governance, cannot be clawed back through unilateral action.

Since 1952, Congress has maintained a relationship with Puerto Rico similar to what it has with the states. Federal laws applicable to the nation can override local laws, as with all states. But Congress has not used its powers to legislate for Puerto Rico specifically. That power was ceded to the Puerto Rican government.

To the extent that Congress did irrevocably transfer sovereignty to Puerto Rico, it is beyond peradventure that part of what was transferred was the ability to tax its own citizens. Article six of the Puerto Rican constitution, which, again, was approved by Congress, expressly provides that the legislature can levy taxes. As per Asbury Park, the power to tax contains the power to create a debt restructuring scheme. If Congress cannot prevent a state from enacting a restructuring regime without offering an alternative, the same is true in the case of Puerto Rico.[127]

Conclusion

Puerto Rico has operated since 1952 in an uncomfortable place in our federal system. It is not a state, yet to call it a territory would be to ignore the combined efforts of Puerto Rico and the United States to remove its colonial status. Puerto Rico, it seems to us, may not have the structural protections of the fifty states, but it does have a degree of sovereignty unlike that of a colony or a territory. To quote President Truman’s message to Congress on the new relationship between Puerto Rico and the United States, issued while submitting the Puerto Rican draft constitution for congressional approval:

The Commonwealth of Puerto Rico will be a government which is truly by the consent of the governed. No government can be invested with a higher dignity and greater worth than one based upon the principle of consent. The people of the United States and the people of Puerto Rico are entering into a new relationship that will serve as an inspiration to all who love freedom and hate tyranny.[128]

That modicum of inherent power that was granted to Puerto Rico includes the power to tax and, with that, the power to enact its own restructuring scheme for its municipalities. Congress can take that power away so long as it provides an alternative. It cannot, however, consign Puerto Rico to the netherworld.

Indeed, to the extent that states can enact their own restructuring regimes, Puerto Rico is free to do so as well.

[*] Professor of Law, Duke University School of Law.

[†] †. J. Thomas McCarthy Trustee Chair in Law and Political Science, USC Gould School of Law. The authors thank Douglas Baird, Joseph Blocher, Rebecca Brown, Sam Erman, and David Skeel for their helpful comments on an earlier draft of this article, and Tobias Rushing for his excellent research assistance.

[1]. See Stephen A. Nuño, Congress Passes PROMESA Act for Puerto Rico Debt Crisis, NBC News (June 29, 2016, 8:33 P.M.), http://www.nbcnews.com/news/latino/congress-passes-promesa-act-puerto-rico-debt-crisis-n601291. See also Puerto Rico Oversight, Management, and Economic Stability Act, Pub. L. No. 114-187, 130 Stat. 549 (2016) (codified in scattered sections of 15, 29, and 48 U.S.C.).

[2]. For analyses of Puerto Rico’s fiscal and operational problems, see generally Robert K. Rasmussen, Puerto Rico: Of Capital Structures, Control Rights and Liquidity, 11 Cap. Markets L.J. 228 (2016); Anne O. Krueger, Ranjit Teja & Andrew Wolfe, Puerto Rico—A Way Forward (2015), http://www.bgfpr.com/documents/PuertoRicoAWayForward.pdf.

[3]. For an account of the evolution of the crisis, leading up to and including the passage of PROMESA, see Mary Williams Walsh, How Puerto Rico Is Grappling with a Debt Crisis, N.Y. Times (May 16, 2017), https://nyti.ms/2ro6b37.

[4]. Title III of PROMESA contains a judicially supervised restructuring mechanism, similar in many ways to Chapter 9. See Puerto Rico Oversight, Management, and Economic Stability Act, §§ 301–317. Title VI, in contrast, in effect inserts collective action clauses into Puerto Rico’s sovereign bonds. See id. §§ 401–413. The granting of choice of which path to proceed under echoes the debates in the sovereign debt literature over whether sovereign distress is better handled through a sovereign debt restructuring mechanism or collective action clauses placed in the debt instruments. Compare Anne O. Krueger, Int’l Monetary Fund, A New Approach to Sovereign Debt Restructuring 4–10 (2002), with John B. Taylor, Under Sec’y of Treasury for Int’l Aff., Sovereign Debt Restructuring: A US Perspective, Speech at the Conference “Sovereign Debt Workouts: Hopes and Hazards,” Institute for International Economics (Apr. 2, 2002), http://www.iie.com/publications/ papers/Taylor0402.htm.

[5]. Jackie Calmes, Puerto Rico Relief Measure Clears Senate, Goes to Obama, N.Y. Times (June 29, 2016), https://nyti.ms/2oh1iaH.

[6]. Creditor groups, seeking to enhance their chances for recovery on the bonds that they purchased, have argued that this method of filling the board violates the Appointments Clause. See Joseph Blocher & Mitu Gulati, Puerto Rico’s Colonial Status Hinges on a New York Hedge Fund’s Greed, Hill (Nov. 25, 2017, 10:00 A.M.), http://thehill.com/opinion/finance/361775-puerto-ricos-colonial-status-hinges-on-a-new-york-hedge-funds-greed; Mary Williams Walsh, Hedge Fund Sues to Have Puerto Rico’s Bankruptcy Case Thrown Out, N.Y. Times: DealBook (Aug. 7, 2017), https://nyti.ms/2uAgQc4.

[7]. See Blocher & Gualti, supra note 6.

[8]. Puerto Rico v. Franklin Cal. Tax-Free Tr., 136 S. Ct. 1938, 1948–49 (2016).

[9]. See, e.g., Michael Corkery, Let Us Help You, Hedge Funds Tell Puerto Rico, N.Y. Times: DealBook (Sept. 12, 2014, 11:05 A.M.), https://nyti.ms/2m4CqBU; Mary Williams Walsh, Puerto Rico Postpones Debt Plan, N.Y. Times: DealBook (Aug. 30, 2015), https://nyti.ms/2hHzAGd.

[10]. See Chimène I. Keitner, From Conquest to Consent: Puerto Rico and the Prospect of Genuine Free Association, in Reconsidering the Insular Cases: The Past and Future of the American Empire 77, 87–89 (Gerald L. Neuman & Tomiko Brown-Nagin eds., 2015). Some skeptics view Puerto Rico as still being essentially in a colonial vassal state, where Congress rules by fiat. See Mary Williams Walsh, Puerto Rico Debt Relief Law Stirs Colonial Resentment, N.Y. Times DealBook (June 30, 2016), https://nyti.ms/2jNQLSk. But such a status would be fundamentally inconsistent with the modern state of international law, which no longer countenances empires and colonies. See Joseph Blocher & Mitu Gulati, Forced Secessions, 80 Law & Contemp. Probs. 215, 225–26 & n.60 (2017); Joseph Blocher & Mitu Gulati, Puerto Rico and the Right of Accession, Yale J. Int’l L. (forthcoming 2018) (manuscript at 7), https://papers.ssrn.com/sol3/papers.cfm?abstract_id= 2988102.

[11]. For an argument, which we endorse, that Congress can enact a restructuring regimes for states, see generally David A. Skeel, Jr., States of Bankruptcy, 79 U. Chi. L. Rev. 677 (2012).

[12]. The canonical Insular Cases comprise Huus v. N.Y. & P.R. S.S. Co., 182 U.S. 392 (1901); Downes v. Bidwell, 182 U.S. 244 (1901); Armstrong v. United States, 182 U.S. 243 (1901); Dooley v. United States, 182 U.S. 222 (1901); Goetze v. United States, 182 U.S. 221 (1901); and De Lima v. Bidwell, 182 U.S. 1 (1901). See Juan R. Torruella, One Hundred Years of Solitude: Puerto Rico’s American Solitude, in Foreign in a Domestic Sense: Puerto Rico, the American Expansion, and the Constitution 241, 248 n.14 (Christina Duffy Burnett & Burke Marshall eds., 2001).

[13]. For details, see Keitner, supra note 10, at 87–90. Some would argue further that to treat Puerto Rico’s relationship to the rest of the United States through the lens of the Insular Cases (where Puerto Rico was explicitly conceptualized as U.S. “property”) would also arguably violate the United States’ international law obligations. See, e.g., Juan R. Torruella, The Insular Cases: The Establishment of a Regime of Political Apartheid, 29 U. Pa. J. Int’l L. 283, 293, 332–34 (2007) (emphasizing, in particular, the International Covenant on Civil and Political Rights that the United States became a party to in 1992).

[14]. There were differences among the Greek and Argentine sovereign bonds too, in that a small subset of Greek bonds were guaranteed by the state, and both Argentina and Greece had bonds governed by the laws of different jurisdictions (e.g., local, England, New York, Japan). However, the variation paled in comparison to what Puerto Rico had on offer. For details on the Greek and Argentine debts and their restructurings, see generally Juan J. Cruces & Tim R. Samples, Settling Sovereign Debt’s “Trial of the Century,” 31 Emory Int’l L. Rev. 5 (2016); Jeromin Zettelmeyer et al., The Greek Debt Restructuring: An Autopsy, 28 Econ. Pol’y 513 (2013).

[15]. The holders of general obligation bonds assert that they have first priority to the revenues of the Commonwealth by virtue of Puerto Rico’s Constitution. See Complaint at 2–3, Jacana Holdings v. Commonwealth of Puerto Rico, No. 1:16-cv-04702 (S.D.N.Y. June 21, 2016). The holders of CONFINA bonds, however, also argue that they have first dibs on half of the sales tax collected by the government.

[16]. See, e.g., Megan McArdle, Debt Alone Won’t Crush Puerto Rico. Depopulation is the Curse., Bloomberg (Oct. 6, 2017, 7:00 A.M.), https://www.bloomberg.com/view/articles/2017-10-06/debt-alone-won-t-crush-puerto-rico-depopulation-is-the-curse.

[17]. See id.

[18]. Patti Domm, Puerto Rico’s New Worry Is a Population Flight to the US Mainland that Could Slow Its Recovery, CNBC (Sept. 28, 2017, 7:53 P.M.), https://www.cnbc.com/2017/09/ 28/puerto-ricos-population-flight-could-slow-its-recovery.html.

[19]. Puerto Rico, World Bank: Data, https://data.worldbank.org/country/puerto-rico (last visited Nov. 13, 2017).

[20]. See Krueger et al., supra note 2, at 24–25.

[21]. Id. at 3–4.

[22]. See Nick Timiraos, Puerto Rico’s Drastic Population Loss Deepens Its Economic Crisis, Wall St. J. (June 29, 2016, 7:35 P.M.), https://www.wsj.com/articles/puerto-ricos-drastic-population-loss-deepens-its-economic-crisis-1467219467.

[23]. See Ana Campoy, Blown Away: Puerto Rico Is Set to Become the World’s Worst Economy Next Year, Quartz (Nov. 23, 2017), https://qz.com/1137351 (noting that thousands of businesses have not reopened two months after the hurricane and that over 100,000 people have left the island). In theory, Congress could enact disaster relief sufficient to allow Puerto Rico to rebuild its economy. Given the structural relationship that we describe in this piece, we are skeptical that aid at such a level will be forthcoming.

[24]. Steven Church & Michelle Kaske, Puerto Rico May Need to Skip Bond Payments for Five Years, Bloomberg (Nov. 15, 2017, 7:43 A.M.), https://www.bloomberg.com/news/articles/2017-11-15/puerto-rico-considering-suspending-debt-payments-for-five-years.

[25]. See 11 U.S.C. § 109(c) (2012).

[26]. See id.

[27]. See 11 U.S.C. § 401 (1970) (omitted 1976).

[28]. See, e.g., Stephen J. Lubben, Puerto Rico and the Bankruptcy Clause, 88 Am. Bankr. L.J. 553, 572–73 (2014).

[29]. Id. at 573–74. See also Bankruptcy Amendments and Federal Judgeship Act of 1984, tit. III, sec. 421, § 101, Pub. L. No. 98-353, 98 Stat. 333, 369 (“‘State’ includes the District of Columbia and Puerto Rico, except for the purpose of defining who may be a debtor under chapter 9 of this title”); Michal Kranz, Here’s How Puerto Rico Got into So Much Debt, Bus. Insider (Oct. 9, 2017, 6:20 P.M.), http://www.businessinsider.com/puerto-rico-debt-2017-10.

[30]. 2014 P.R. Laws Act No. 71. For discussion, see Recent Legislation, Puerto Rico Public Corporation Debt Enforcement and Recovery Act, 2014 P.R. Laws Act No. 71, 128 Harv. L. Rev. 1320, 1320–27 (2015).

[31]. See 11 U.S.C. § 903(1) (2012).

[32]. Faitoute Iron & Steel Co. v. City of Asbury Park, 316 U.S. 502 (1942).

[33]. Id. at 502–03.

[34]. Id. at 507.

[35]. Id. at 513–16.

[36]. Id. at 512–13.

[37]. Id. at 513–16.

[38]. At the time, bankruptcy chapters were denominated with Roman numerals.

[39]. See 11 U.S.C. § 903(1) (2012).

[40]. See Franklin Cal. Tax-Free Tr. v. Puerto Rico, 805 F.3d 322, 326 (1st Cir. 2015), aff’d, 136 S. Ct. 1938 (2016).

[41]. Franklin, 136 S. Ct. at 1946.

[42]. Id. at 1949. Not surprisingly, Justice Thomas used textualism in reaching this result. See id. at 1946 (“The plain text of the Bankruptcy Code begins and ends our analysis.”).

[43]. Id. at 1949.

[44]. We argue infra in Part III that one can articulate a reason for greater protection for Puerto Rico from congressional intervention, though the position that we put forward in this article does not hinge on this argument.

[45]. Garcia v. San Antonio Metro. Transit Auth., 469 U.S. 528, 546–47 (1985) (“We therefore now reject, as unsound in principle and unworkable in practice, a rule of state immunity from federal regulation that turns on a judicial appraisal of whether a particular governmental function is ‘integral’ or ‘traditional.’”).

[46]. New York v. United States, 505 U.S. 144, 160 (1992).

[47]. South Dakota v. Dole, 483 U.S. 203, 210–12 (1987). But see Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 580–82 (2012) (holding that Congress went too far with its incentives when it went from encouragement to compulsion).

[48]. New York, 505 U.S. at 160, 175.

[49]. Id. at 160.

[50]. Of course, there are times when federal power restricts state power, even if there is nothing put in place. The clearest example is the Dormant Commerce Clause. There, states are prevented from enacting laws even though there is no conflict with federal action. In such a setting, however, there is no interference with a core state function. See Martin H. Redish & Shane V. Nugent, The Dormant Commerce Clause and the Constitutional Balance of Federalism, 1987 Duke L.J. 569, 570.

[51]. For the basic economic logic, see generally Robert P. Inman & Daniel L. Rubinfeld, Economics of Federalism, in 3 Oxford Handbook of Law and Economics: Public Law and Legal Institutions 84 (Francesco Parisi ed., 2016).

[52]. Ashton v. Cameron Cty. Water Improvement Dist., 298 U.S. 513, 530–32 (1936).

[53]. United States v. Bekins, 304 U.S. 27, 50–54 (1938). While the Court treated the new regime as different from the one it struck down, today most commentators view the two regimes as virtually identical. The reason for the difference in outcome is now attributed to the Court’s famous “switch in time.” See Clayton P. Gillette & David A. Skeel, Jr., Governance Reform and the Judicial Role in Municipal Bankruptcy, 125 Yale L.J. 1150, 1174, 1175 n.108 (2016).

[54]. Bekins, 304 U.S. at 38–39. This requirement existed in the prior law as well. Indeed, most commentators find few if any significant differences in the law that the Court struck down in Ashton and the one that it upheld in Bekins. See Gillette & Skeel, supra note 53, at 1175–76.

[55]. Some have said that similar concerns would render congressional efforts to enact a debt adjustment law for states unconstitutional. For an argument to the contrary, see Skeel, supra note 11, at 707–11.

[56]. Asbury Park, 316 U.S. at 511.

[57]. Id. at 512.

[58]. Id. at 513–14.

[59]. Id. at 513. Courts have articulated this logic in other restructuring cases as well. See, e.g., Katz v. Oak Industries, Inc., 508 A.2d 873, 876–77 (Del. Ch. 1986).

[60]. Asbury Park, 316 U.S. at 504.

[61]. The Contracts Clause applies only to states, not to the federal government. See U.S. Const. art. 1, § 10, cl. 1 (“No State shall . . . pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts . . . .”).

[62]. See Gillette & Skeel, supra note 53, at 1198–99.

[63]. See generally Barry E. Adler, Financial and Political Theories of American Corporate Bankruptcy, 45 Stan. L. Rev. 311 (1993).

[64]. See generally Michelle Wilde Anderson, Dissolving Cities, 121 Yale L.J. 1364 (2012).

[65]. See generally Robert K. Rasmussen, Integrating a Theory of the State into Sovereign Debt Restructuring, 53 Emory L.J. 1159 (2004).

[66]. Of course, we do see voters losing control when a financial control is put in place, as was done in Detroit, New York City, Washington, D.C. and now Puerto Rico. These boards were always put in place by governmental officials, with a mandate to steer the finances back on track. They were not charged with looking after the interests of the bondholders first and foremost. See, e.g., Hazel Bradford, Detroit, D.C. Offer Clues to the Future of Puerto Rico’s Public Pension Funds, Pensions & Inv. (July 8, 2016, 11:50 A.M.), http://www.pionline.com/article/20160708/ONLINE/160709915/detroit-dc-offer-clues-to-the-future-of-puerto-ricos-public-pension-funds; Janell Ross & Matt Sledge, Detroit Financial Advisory Board Finds Model in New York City, Washington D.C., Huffington Post (Apr. 9, 2012, 8:17 A.M.), https://www.huffingtonpost.com/2012/04/09/detroit-financial-rescue_n_1409112.html.

[67]. A somewhat related question is raised by the Court’s decision in Franklin. In order to be eligible for Chapter 9, a state has to authorize its municipalities to file for bankruptcy. Recall that the consent of the state was a key factor in Bekins. Can a state decline the offer of Chapter 9 and instead enact its own debt restructuring regime? We know from Franklin that § 903 would apply to such an attempt. The difference in this case and the one we are considering is that, as to the states, Congress has provided the option of using Chapter 9, something that it did not provide for Puerto Rico. In other words, Congress did not take away the states’ power to enact a restructuring regime and give it nothing; rather, it took away the states’ power and said that the only route was the federal one. We think that this would be within Congress’s power.

[68]. See generally Reconsidering the Insular Cases, supra note 10. See also supra note 12.

[69]. See, e.g., Juan R. Torruella, Ruling America’s Colonies: The Insular Cases, 32 Yale L. & Pol’y Rev. 57, 71 (2013).

[70]. Keitner, supra note 10.

[71]. Act to Provide for the Organization of a Constitutional Government by the People of Puerto Rico, Pub. L. No. 81-600, 64 Stat. 319 (1950) (codified as amended in scattered sections of 48 U.S.C.).

[72]. Id.

[73]. 48 U.S.C. § 731(c) (2012).

[74]. See id. § 731(d).

[75]. See id.

[76]. Dieter Nolen, Puerto Rico, in 1 Elections in the Americas: A Data Handbook 543, 556 tbl. 2.5b (Dieter Nolen ed., 2005).

[77]. See 98 Cong. Rec. 4228 (1952) (message from Pres. Truman).

[78]. See Joint Resolution Approving the Constitution of the Commonwealth of Puerto Rico, Pub. L. No. 82-447, 66 Stat. 327 (1952).

[79]. See, e.g., T. Alexander Aleinikoff, Puerto Rico and the Constitution: Conundrums and Prospects, 11 Const. Comment. 15, 19, 33 n.76, 41 n.105 (1994).

[80]. G.A. Res. 1514 (XV), at 66 (Dec. 14, 1960). See also G.A. Res. 2878 (XXVI), at 16 (Dec. 20, 1971); G.A. Res. 2621 (XXV), at 2 (Oct. 13, 1970).

[81]. See Keitner, supra note 10, at 90–91.

[82]. We have drawn on Keitner’s superb article, for the sources and substance described here. See generally id.

[83]. See H.R. Rep. No. 81-2275, at 2 (1950).

[84]. See S. Rep. No. 81-1779, at 2 (1950).

[85]. Id. at 3.

[86]. See November 3 Statement by Mrs. Bolton, 29 Dep’t St. Bull. 802, 804 (1953). See also October 30 Statement by Mrs. Bolton, 29 Dep’t St. Bull. 797, 798 (1953); Memorandum by the Government of the United States of America Concerning the Cessation of Transmission of Information Under Article 73(e) of the Charter with Regard to the Commonwealth of Puerto Rico, 28 Dep’t St. Bull. 585, 586–88 (1953) [hereinafter 1953 Memorandum].

[87]. See Igartua-De La Rosa v. United States, 417 F.3d 145, 173–75 (1st Cir. 2005) (Torruella, J., dissenting); Torruella, supra note 13, at 333–35. See generally Joseph Blocher & Mitu Gulati, Forced Secessions, 80 Law & Contemp. Probs. 215 (2017) (describing the anti-colonial move in international law); Cesar A. Lopez Morales, A Political Solution to Puerto Rico’s Disenfranchisement: Reconsidering Congress’s Role in Bringing Equality to America’s Long-Forgotten Citizens, 32 B.U. Int’l L.J. 185, 194–95 (2014).

[88]. See Garcia v. San Antonio Metro. Transit Auth., 469 U.S. 528, 546–47, 555 (1985).

[89]. Constitutional law scholars have long debated whether the ability of states to defend their interests in the political realm implies that there is no need for judicial review to protect the interest of states. See generally, e.g., Larry D. Kramer, Putting the Politics Back into the Political Safeguards of Federalism, 100 Colum. L. Rev. 215 (2000); John C. Yoo, The Judicial Safeguards of Federalism, 70 S. Cal. L. Rev. 1311 (1997); William W. Van Alstyne, Comment, The Second Death of Federalism, 83 Mich. L. Rev. 1709 (1985); Jesse H. Choper, The Scope of National Power Vis-à-Vis the States: The Dispensability of Judicial Review, 86 Yale L.J. 1552 (1977); Herbert Wechsler, The Political Safeguards of Federalism: The Role of the States in the Composition and Selection of the National Government, 54 Colum. L. Rev. 543 (1954). While the participants in this debate disagree over the extent to which state interests are protected in the legislative process, and whether this protection means that there is no need for judicial review, they all acknowledge that states have some protection in the process—something that Puerto Rico does not have at all.

[90]. We have argued elsewhere that this lack of political representation explains the lack of urgency from the federal government in assisting Puerto Rico after the devastation wrought by Hurricane Maria in 2017. See Mitu Gulati & Robert K. Rasmussen, Puerto Rico: Devastation Without Representation, Hill (Oct. 22, 2017, 8:00 A.M.), http://thehill.com/blogs/congress-blog/politics/ 356455-puerto-rico-devastation-without-representation.

[91]. See supra note 29 and accompanying text.

[92]. See, e.g., S. Rep. No. 81-1779, at 3 (1950) (“The measure [Pub. L. 600] would not change Puerto Rico’s fundamental political, social, and economic relationship to the United States.”); H.R. Rep. No. 81-2275, at 3.

[93]. See Keitner, supra note 10, at 85 (“Because Congress would always have the last word on Puerto Rico’s status, the legacy of conquest circumscribed the principle of consent both structurally and symbolically.”).

[94]. See generally Gary Lawson & Robert D. Sloane, The Constitutionality of Decolonization by Associated Statehood: Puerto Rico’s Legal Status Reconsidered, 50 B.C. L. Rev. 1123 (2009).

[95]. Id. at 1167–68.

[96]. Id. at 1172.

[97]. Id. at 1147.

[98]. Puerto Rico v. Sánchez Valle, 136 S. Ct. 1863, 1865 (2016).

[99]. Id.

[100]. Id. at 1869.

[101]. Id. at 1869.

[102]. Id. at 1871.

[103]. Id. at 1876–77.

[104]. Id. at 1870.

[105]. Id. at 1871.

[106]. Id. at 1872.

[107]. Id. at 1875.

[108]. Id. at 1874 (“Puerto Rico today has a distinctive, indeed exceptional, status as a self-governing Commonwealth.”); id. (“[The drafting and passage of Puerto Rico’s constitution] were of great significance – and, indeed, made Puerto Rico ‘sovereign’ in one commonly understood sense of that term. As this Court has recognized, Congress in 1952 ‘relinquished its control over [the Commonwealth’s] local affairs[,] granting Puerto Rico a measure of autonomy comparable to that possessed by the States.’”) (quoting Examining Bd. of Eng’rs, Architects & Surveyors v. Flores de Otero, 426 U.S. 572, 597 (1976)). See also Rodriguez v. Popular Democratic Party, 457 U.S. 1, 8 (1982) (“Puerto Rico, like a state, is an autonomous political entity, ‘sovereign over matters not ruled by the Constitution’ . . . .”) (quoting Calero-Toledo v. Pearson Yacht Leasing Co., 416 U.S. 663, 673 (1974)).

[109]. Flores de Otero, 426 U.S. at 600–01.

[110]. U.S. Const. amend. XIV, § 1.

[111]. Flores de Otero, 426 U.S. 572 at 600.

[112]. The First Circuit applied the Contracts Clause to Puerto Rico in United Automobile, Aerospace, Agricultural Implement Workers of America International Union v. Fortuno, 633 F.3d 37, 41 (2011), but a footnote states that the Puerto Rican government conceded that the Contracts Clause applied to it. Id. at n.3.

[113]. Puerto Rico v. Sánchez Valle, 136 S. Ct. at 1870 n.1.

[114]. U.S. Const. art. I, § 8.

[115]. See, e.g., Gary Lawson & Guy Seidman, The Constitution of Empire: Territorial Expansion and American Legal History 154 (2004).

[116]. See Luther v. Borden, 48 U.S. 1, 42 (1849).

[117]. Baker v. Carr, 369 U.S. 186, 226 (1962) (“[The Court] has pointed out that Congress is not required to establish republican government in the territories before they become States, and before they have attained a sufficient population to warrant a popularly elected legislature.”) (citing Downes v. Bidwell, 182 U.S. 244, 278–79 (1901) (dictum)).

[118]. Act to Provide for the Organization of a Constitutional Government by the People of Puerto Rico, Pub. L. No. 81-600, 64 Stat. 319 (1950) (codified as amended in scattered sections of 48 U.S.C.). The only other territory that has received an equivalent transfer of sovereignty is the Northern Mariana Islands. See H.R. Rep. 104-856, at 2–3 (1996).

[119]. See supra text accompanying notes 83–85.

[120]. See G.A. Res. 66 (I), at 124–25 (Dec. 14, 1946).

[121]. See, e.g., 1953 Memorandum, supra note 86, at 585 (stating that Puerto Rico has achieved “the full measure of self-government”); id. at 587 (“Congress has agreed that Puerto Rico shall have, under [its] Constitution, freedom from control or interference by the Congress in respect of internal government and administration.”).

[122]. These representations to the international community, others have argued, have legal implications. See Lawson & Sloane, supra note 94, at 1155 (“[I]t is well established that a State may, by repeated, public representations intended to induce reliance on the part of other States . . . bind itself unilaterally”).

[123]. See T. Alexander Aleinikoff, Semblances of Sovereignty: The Constitution, the State, and American Citizenship 89–90 (2002); Lawson & Sloane, supra note 94, at 1127.

[124]. Thomas W. Merrill & Henry E. Smith, Optimal Standardization in the Law of Property: The Numerus Clausus Principle, 110 Yale L.J. 1, 3–4 (2000).

[125]. See generally Bruce A. Ackerman, The Storrs Lectures: Discovering the Constitution, 93 Yale L.J. 1013 (1984). Of course, one does not have to ascribe to this particular vision of constitutional law to endorse the proposition that Congress is free to create types of entities in addition to those expressly mentioned in the Constitution. Any version of a living Constitution will suffice. Indeed, even an originalist could agree with our point, so long as she did not find in the Constitution an intent to limit congressional flexibility on this score.

[126]. U.S. Const. art. IV, § 3.

[127]. At a minimum, this implies that when Congress created the netherworld, it should have done so with greater clarity. It clearly was not inadvertent that Congress removed Puerto Rico from the definitional section. Given that there is no evidence whatsoever behind this action, it is impossible to know whether Congress thought that it was leaving Puerto Rico defenseless. At a minimum, given the quasi-state-like status that Puerto Rico has today, the Court should require Congress to speak clearly when it wants to treat Puerto Rico worse than a state. It should not be allowed to invade the traditional government functions without a clear indication that that was its intent.

[128]. See 98 Cong. Rec. 4228 (1952) (message from Pres. Truman).

“No Money Down” Bankruptcy – Article by Pamela Foohey, Robert M. Lawless, Katherine Porter & Deborah Thorne

July 2017February 2018Southern California Law Review Admin

From Volume 90, Number 5 (July 2017)
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This Article reports on a breakdown in access to justice in bankruptcy, a system from which one million Americans will seek help this year. A crucial decision for these consumers will be whether to file a chapter 7 or chapter 13 bankruptcy. Nearly every aspect of their bankruptcies—both the benefits and the burdens of debt relief—will be different in chapter 7 versus chapter 13. Almost all consumers will hire a bankruptcy attorney. Because they must pay their attorneys, many consumers will file chapter 13 to finance their access to the law, rather than because they prefer the law of chapter 13 over chapter 7.

Attorneys charge about $1,200 to file a chapter 7 bankruptcy; their debt-laden clients must pay this amount up front. Attorneys charge about $3,200 to file a chapter 13 bankruptcy, but clients can pay attorneys’ fees over time as part of their cases. Chapter 7 and 13 bankruptcies also differ in the relief achieved. Almost all chapter 7 cases end with the debtor receiving a discharge of debts. In contrast, only around one-third of chapter 13 cases end in discharge.

This Article exposes the increasingly prevalent phenomenon of debtors paying nothing in attorneys’ fees to file chapter 13. New data from the Consumer Bankruptcy Project, our original empirical national study, suggest that these “no money down” consumers are similar to those who use chapter 7. However, because they cannot afford to pay their attorneys up front, these “no money down” bankruptcy debtors suffer. They pay $2,000 more and have their cases dismissed at a rate eighteen times higher than if they had filed chapter 7.

The two most significant predictors of whether a consumer files a “no money down” bankruptcy are the consumer’s place of residence and race. We could not identify legitimate ways that these factors correlate with debtors’ needs for the substantive legal benefits of chapter 13. “No money down” bankruptcy can be a distortion in the delivery of legal help. We suggest reforms to how attorneys collect fees from consumer debtors that will reduce the potential conflict between clients’ interests and attorneys’ interests. The reforms will deliver access to justice and improve the functioning of the bankruptcy system.

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Bankruptcy-Remote Special Purpose Entities: An Opportunity For Investors To Maximize the Value of Their Returns While Undergoing More Careful and Realistic Risk Analysis – Note by Katherine J. Baudistel

September 2013February 2018Colleen Bazak

From Volume 86, Number 6 (September 2013)
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The world of business and finance has become increasingly complex. Within the recent past, we have experienced significant improvements to finance as novel structures and concepts are created to meet people’s varied needs. For example, new business structures have emerged, including limited partnerships, limited liability companies, and even series LLCs. Simple lending and borrowing has changed to make debt more desirable and to further the economic growth of businesses. Commercial mortgage-backed securities allow companies to raise capital at lower interest rates. Parent-subsidiary relationships enable businesses to isolate their liability. Debt can be structured with numerous mezzanine tiers, each comprised of perhaps an unidentifiable number of investors

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Is Financial Regulation Structurally Biased to Favor Deregulation? – Note by Carolyn Sissoko

January 2013February 2018Colleen Bazak

From Volume 86, Number 2 (January 2013)
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In the early months of the financial crisis that started in August 2007, Citigroup suddenly had to take onto its balance sheet $25 billion of assets–which, due to subprime mortgage exposure, were worth on the market only a third the amount that Citigroup was required to pay for them. The reason for the appearance of these troubled assets on the bank’s balance sheet was a liquidity guarantee provided by Citibank from the time it originally sold the assets to protect short-term lenders from the possibility that their debt could not be refinanced at maturity. The Financial Crisis Inquiry Commission would conclude that such guarantees helped “bring the huge financial conglomerate to the brink of failure.”

The assets in question were collateralized debt obligations (“CDOs”), which package together a large number of loans and other debt products and use the income from those loans to pay returns to the investors in the CDOs. It is clear, however, that not all of the “loans” underlying Citibank’s CDOs were actual loans. Some of them were financial contracts called derivatives that promised payments based on the performance of a specific set of actual loans. That is, some of the underlying assets were not loans, but simply represented the promise of one financial institution to make payments to another.

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INTRODUCTION

I. CRYPTO’S MISSING REGULATORS

A. Some Key Features of Crypto Market Structure

1. The Building Blocks: Chains, Coins, and Ledgers

2. Centralized Finance in Crypto Markets

B. Rationales for Regulation in Crypto and Finance

1. Mitigating Systemic Risks

2. Addressing Information Gaps

3. Protecting Customers and Stakeholders

II. BANKRUPTCY IN CRYPTO WINTER

A. A Brief History of Crypto Winter

B. A Primer on Chapter 11’s Missions and Mechanisms

C. Crypto in Chapter 11: The Celsius and Voyager Cases

1. Celsius

2. Voyager

III. THE BANKRUPTCY COURT AS (IMPERFECT) CRYPTO MARKET REGULATOR

A. Systemic Risk and The Bankruptcy Code

B. Bankruptcy Disclosure vs. Market Disclosure

C. An Imperfect Policymaker

CONCLUSION

96 S. Cal. L. Rev. 1479

From Volume 92, Number 3 (March 2019) DOWNLOAD PDF

From Volume 91, Number 1 (November 2017) DOWNLOAD PDF

From Volume 90, Number 5 (July 2017) DOWNLOAD PDF

From Volume 86, Number 6 (September 2013) DOWNLOAD PDF

From Volume 86, Number 2 (January 2013) DOWNLOAD PDF

From Volume 92, Number 3 (March 2019)
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From Volume 91, Number 1 (November 2017)
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From Volume 90, Number 5 (July 2017)
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From Volume 86, Number 6 (September 2013)
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From Volume 86, Number 2 (January 2013)
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