Lipson on The BS That Didn't Bark: Why Didn't (Doesn't) Bear Stearns Go Into Bankruptcy Part II

This post concludes my colleague Jonathan Lipson's set of observations about Bear's bailout. You can find part I, in which Lipson demonstrates some of the advantages of a bankruptcy for Bear, here. Check out also Ribstein's response, here.

Why Didn't Bear Bark?

So, if the standard arguments against a BS bankruptcy don’t stack up, and in fact it might produce a better result than the hastily structured, poorly-executed deal on the table, why no bankruptcy?

The answer may be that while bankruptcy might benefit shareholders, JPM and other stakeholders, it would not benefit the folks who are in fact most likely responsible for the current state of affairs—BS’ officers and directors, and the managers of the hedge funds with whom they were intimately involved.

In any BS bankruptcy, insider transactions with the company of at least the last year—and probably quite a bit longer—would almost certainly be subjected to a searching inquiry. Most likely, a chapter 11 examiner would be appointed to determine what happened at BS, just as Neal Batson did at Enron.

Batson produced a huge report in Enron. Some would say it was not worth the price—allegedly about $100 million. But others would respond that Batson’s investigation did two very important things that created far greater value. First, his report was used in countless litigations that are said to have brought many times that amount back into the bankruptcy estate.

Second, his report revealed at least some of what really happened at Enron. My research on the use of examiners in chapter 11 cases suggests that this “public” value was, at least in the case of Enron, important because it gave lawyers and other professionals guidance on acceptable conduct well beyond that case.

In BS, scrutiny is likely the last thing that senior managers want. The media assumes that management is suffering along with everyone else because people like CEO Cayne had large share holdings, the value of which has been slashed. But this glosses over two important questions.

First, what did BS senior managers—and the management of the hedge funds they supported—get from BS over the last couple of years, whether in stock they sold for far more than $2 (or $10) per share, or cash bonuses, or compensation of some sort from hedge funds within or proximate to BS? These questions become relevant in bankruptcy because these transactions would certainly be scrutinized, and some may be avoided for the benefit of the bankruptcy estate.

BS’s senior managers doubtless understand this. It may be that for them, keeping last year’s goodie basket is worth far more than what they lose in the JPM deal. In a JPM deal—no matter how bad it gets for today’s shareholders—last years’ executive compensation is safe. Bankruptcy may put some or all of that at risk.

Second, and ultimately more important, there is the simple, cleansing effect of public scrutiny. Today, the question that no one asks—the elephant in the room—is where, exactly, all the money went? Of course, not all of it was real money. There was a lot of marking-to-model, which means that some valuations never really involved cash.

But lots of investors bought toxic securities from or through BS or affiliated hedge funds. And they paid cash. So, where did all that money go? Answering that question could go a long way toward understanding what went wrong in the mortgage crisis generally, and perhaps understanding how to prevent similar problems in the future. Today, thanks to JPM and the Federal Reserve, we won’t know.

In some ways, this is really about Sherlock Holmes famous dog that did not bark. There, after all other explanations were eliminated, only one—silence—made sense. Here, it may be that there are plenty of sound reasons to keep BS out of bankruptcy. But so far, it just looks like only one: the insiders want to keep the muzzle on.

Posted by Dave Hoffman at 10:56 AM | Comments (0) | TrackBack

Lipson on The BS That Didn't Bark: Why Didn't (Doesn't) Bear Stearns Go Into Bankruptcy

My colleague, Jonathan Lipson, is an incredibly astute observer of bankruptcy law and practice. I was talking with him the other day about Bear's bailout, and he offered some characteristically interesting thoughts. I invited him to share them in written form with our audience, and will be posting his comments in two parts today and tomorrow.

What’s so bad about bankruptcy?

Today’s New York Times reports that both shareholders and lock-up acquiror JP Morgan-Chase have threatened to put the financial firm into bankruptcy if the other doesn’t blink.

But, if bankruptcy is the only thing both sides agree on, why doesn’t the board authorize a chapter 11 filing?

Two classes of arguments have been made against a BS bankruptcy, one about market disruption, the other about value maximization. The cost, delay and uncertainty of bankruptcy could bring the whole system down, the theory goes. In any case, it would wipe out shareholders’ entire interest.

These are, of course, possible outcomes. But they’re not as likely as people think. In any case, the important question is not whether bankruptcy would do this, but whether ex ante we think bankruptcy would be worse than the current deal.

There is some reason to think bankruptcy might actually be better. If so, then something else may explain why BS, JPM and the Fed would rather spend the next couple of years in Delaware Chancery Court than the U.S. Bankruptcy Court for the Southern District of New York.

Market Disruption

Consider first the claim that a BS bankruptcy would irreparably disrupt fragile capital markets. A domino effect is possible, of course: First BS, then Lehman, then JPM, then Citigroup, until only Goldman remains to drool over the carcasses. Bear Stearns is, the thinking goes, simply “too big to fail.”

But this position loses force if we actually think about a how bankruptcy would likely play out.

First, bankruptcy would simply not touch at least some BS entities and many of their larger, system-sustaining transactions. Entities that are banks or insurance companies generally cannot be debtors under the Bankruptcy Code. While this would not keep the public parent company out of the tank, it would appear that at least some subsidiaries would be outside the reach of bankruptcy.

So, too for the major swap, derivative or repo transactions to which the company was party if it went into bankruptcy. These were the sorts of deals that were thought “too big to fail.” A BS bankruptcy would surely disrupt these trillion-dollar deals, the claim goes, thereby annihilating the economy and all of civilization.

But the reality is that’s not how it would work. In 2005, large financial institutions succeeded in having complex “netting” provisions added to the Bankruptcy Code (or expanding ones that already existed) precisely so that the bankruptcy of a major financial institution—e.g., Bear Stearns—would not otherwise disrupt the larger capital markets. These provisions do this by permitting non-debtor parties to close (“net”) out their positions without risk of the cost or delay of a bankruptcy. It would be as though bankruptcy never happened so far as those deals, and those counterparties, were concerned.

In any case, while the too-big-to-fail mantra may have resonance when applied to major commercial banks, it didn’t (at least in the past) send the Fed to rescue non-bank financial firms. Drexel Burnham was too big to fail, too, remember? But we seem to have gotten through their bankruptcy.

Second, to the extent that BS subsidiaries were statutory broker-dealers, bankruptcy would have to be a comparatively quick liquidation under special provisions of chapter 7, not the longer, more drawn out “reorganizations” we typically think of when we think of business bankruptcy.

True, a BS bankruptcy would probably halt future deal flow. But didn’t events leading up to (and including) the announcement of the JPM deal kill that activity? Bankruptcy can’t kill a dead dog twice.

Value Maximization
If bankruptcy law exempts truly system-critical transactions, and those were much of what BS did, what would a BS bankruptcy add? The answer is value maximization—or at least competitive valuation of some sort for those portions of the business that would go through bankruptcy, including the parent company.

This goes to the second argument usually advanced against a BS bankruptcy--it would kill shareholder value. Often, that’s true. But given the appallingly low price offered—even $10/share is a small fraction of its recent close—it is not surprising that many shareholders would prefer a gamble in bankruptcy.

Why? Because in bankruptcy, any major deal to sell or reorganize the company would likely result in some sort of competitive process that would drive the price closer to market. Committees of creditors (and probably) equity holders would vet any deal and object to a process that seemed to dampen value. For example, they might challenge the so-called “Bear Put”, which appears to permit JPM to keep the deal in play until shareholders finally give up. It might also put BS’s valuable real estate on the auction block, rather than give it to JPM no matter what, even as a breakup fee.

Because bankruptcy is increasingly a venue for the sale of assets—rather than traditional reorganizations—a court may well approve a controlled liquidation of the company. But it would almost certainly require a meaningful market test, to assure that the assets received the highest and best price. Today, even with JPM sweetening its offer, we have no idea what the real market value of the company is. The JPM process appears designed to make sure we never find out.

A related argument is that bankruptcy is a costly and time-consuming process. But here, too, there is less than meets the eye.

Those who would make this claim cite Enron, which took several years and hundreds of millions of dollars in professional fees. But the important question is not whether bankruptcy is costly—it is. Rather, the important question is whether, ex ante, it appears to cost more than the current deal.

Given the litigation that the JPM deal is likely to spawn, it is not clear why a well-managed (a big caveat, that) bankruptcy would be any worse. Is one or more roundtrips through Delaware Supreme Court likely to be quicker and cheaper than time on Bowling Green? Perhaps. But more than a half-dozen years of Disney litigation does not bode well.

A final (somewhat incongruous) argument is that bankruptcy would scare off JPM and/or the Fed, who have thrown a lifeline to BS. That may be, but given the deal's reception, it looks more like an anchor than a float was at the receiving end of the line.

More important, there is simply no reason JPM and the Fed could not have walked into bankruptcy court, arm in arm with BS, proposing the exact same deal that was inked March 16. The only difference would be that it would be subject to court approval. The fact that JPM head Dimon now “threatens” bankruptcy suggests he may understand this.

Indeed, the fact that this didn’t happen is especially baffling when you think about how much bankruptcy might actually benefit JPM. If they really were offering the best deal around—one that a competitive auction in bankruptcy would confirm—then they would also get the benefit of a discharge of most pre-bankruptcy BS liabilities. This means they would not have to worry about unanticipated liabilities—like lawsuits--haunting them after the fact. True, JPM agreed to guarantee a variety of BS obligations in connection with the acquisition. But that could all have been part of the deal run through—and approved by—the bankruptcy court. If it was the best deal going.

Posted by Dave Hoffman at 05:17 PM | Comments (5) | TrackBack

A Trillion Here, a Trillion There. . .

and, as a latter-day Everett Dirksen might say, soon you're talking real money. As Bilmes and Stiglitz have estimated, the Iraq War will likely ultimately cost three trillion dollars. Today's Krugman column in the NYT suggests that the cost of bailing out ailing US financial institutions may approach these figures:

The U.S. savings and loan crisis of the 1980s ended up costing taxpayers 3.2 percent of G.D.P., the equivalent of $450 billion today. Some estimates put the fiscal cost of Japan’s post-bubble cleanup at more than 20 percent of G.D.P. — the equivalent of $3 trillion for the United States. If these numbers shock you, they should. But the big bailout is coming.

Krugman pins the blame squarely on a market fundamentalism that blinded regulators to extraordinary risks accumulating over the past five years:

Between 2002 and 2007, false beliefs in the private sector — the belief that home prices only go up, that financial innovation had made risk go away, that a triple-A rating really meant that an investment was safe — led to an epidemic of bad lending. Meanwhile, false beliefs in the political arena — the belief of Alan Greenspan and his friends in the Bush administration that the market is always right and regulation always a bad thing — led Washington to ignore the warning signs.

The deep irony here is that the same ideological movement that promised deep tax cuts for all may be delivering a staggering national debt that will assure everyone higher tax bills--paid out in large part to foreign owners of our national debt.

As I've mentioned earlier on this blog, Bob Kuttner has harkened back to the 1933 Pecora Hearings as an analogue for the type of fundamental re-evaluation of the financial order that we may need to do today. After having a decade of policy mirroring 1920s era laissez-faire, I hope we aren't in for a replay of the 1930s.

Posted by Frank Pasquale at 08:45 AM | Comments (5) | TrackBack

The New Hall Monitors

The front page of today's Washington Post reports on a recent explosion in the number of corporate "monitorships," noting a sevenfold increase since 2001. In these cases, the article reports, federal prosecutors direct contracts to private parties, who are given responsibility to oversee sometimes radical reconstructions of companies charged with fraud or other wrongdoing. The often hefty bill, of course, goes to the relevant company.

Much of the analysis in the article speaks to potential corruption/favoritism in the appointment of individuals to fill these lucrative positions. The article notes the appointment of "various former prosecutors and SEC officials with ties to President Bush, his father and other Republican luminaries," before focusing on a particular case out of New Jersey. (Which choice I saw, as a perhaps overly defensive temporary resident, to play on pernicious stereotypes of this fair state...)

I was more interested, however, to think about the nature of the institution of "monitors" more generally. What, I wondered, were potential analogies in our schemes of law and governance? Court-appointed special masters immediately came to mind. Naturally, there's some whiff of our sorely missed independent counsels. Perhaps given my international interests, I somehow thought of the U.N. trusteeship system as well, which in turn brought to mind the various uses of private trustees in the U.S. bankruptcy system.

Wtih full appreciation of the significant variation captured by this litany, what might we say generally about the use of monitorships and similar institutions as mechanisms of regulation? All, of course, involve a certain delegation of monitoring, counseling, and even disciplining functions. But what motivates that delegation? What institutional gains do we understand to follow from such delegation? I assume it's not simply a matter of cost-savings or some general notion of relatively greater efficiency of the private sector. The latter isn't out of the question, of course: Taking the case of monitors by way of example, it's clear, at a minimum, that corporate payments for the privilege of being monitored are more easily made to private monitors than they would be to a public servant or even the agency for whom she acts. And perhaps private monitors are somewhat more likely to be fastidious in their monitoring, given their profit motive (though it's not entirely clear how that motive would play itself out in the particular institutional context of corporate monitorships).

But I wonder whether the operative notions of regulatory "efficacy" behind the use of monitors (and analogous institutions) don't also involve some substantive evaluation of the comparative advantages of public versus private institutions, in varied regulatory settings. The Post thus cites "a shift from lodging criminal indictments against businesses for fear they will collapse and cost employees their jobs. Instead, the government has taken a different path: forcing companies to submit to outside oversight at their own expense as a condition of settling fraud and corruption cases."

Perhaps, this might be understood to suggest, there's some notion of comparative institutional efficacy at work. While public regulators may be quite effective at penalizing behavior, perhaps they are less effective at changing it? To similar effect, perhaps public institutions are good at defining relevant boundaries, but less effective at more nuanced, day-to-day classifications of relevant behavior? Assuming public institutions enjoy a comparative advantage at least at some things, though, greater attention to questions of relative regulatory efficacy would seem to be in order.

Beyond the fascinating question of what institutions such as monitors imply for our understandings of regulatory design, a distinct (and no less fascinating) issue concerns the contracts by which the relevant relationships are established. Assuming a single contract, who are the parties in privity and who is the third-party beneficiary of the contract? At what level of detail are the contracts drafted? And what, perhaps more oddly, what might be the remedies for breach?

Posted by Robert Ahdieh at 10:58 AM | Comments (0) | TrackBack

Predatory Lending: Meet Jonathan Swift

At the new website of the Predatory Lending Association, aspiring lenders can find concentrations of "working poor" customers in their neighborhood, calculate effectively usurious loans, not blacklist crusaders against payday lending, including Liz Warren, and learn all the arguments that goo-goos will make against high-interest borrowing. One Q&A in particular should be familiar to contracts professors (or maybe just those, like me, who use Randy Barnett's Perspectives book):

Myth: Payday lending is comparable to selling yourself into slavery.

Reality: Although there is a market need for slavery, people do not choose to sell themselves into slavery. Free choice is the difference between payday lending and slavery.

(There is even a neat chart to make the connection more clear.) On the discussion boards, you can share your thoughts with other predatory lenders. Sure, it all seems a little too cute, but it's worth checking out anyway.

Posted by Dave Hoffman at 04:32 PM | Comments (2) | TrackBack

The Fear Economy

Many commentators worried that the 2005 bankruptcy law would discourage entrepreneurs from taking risks. Now it appears to be accelerating the housing downturn:

A new bankruptcy law, approved by Congress in 2005 after years of debate, makes it much harder for households to get out from under their consumer debt. The result: More people being forced to walk away from their homes, leaving lenders holding the bag. Perversely, a law intended to help the financial industry may be damaging the housing sector, creditors and borrowers alike.

Another recent BusinessWeek article shows just how weak bankruptcy protections may be becoming in the wake of a voracious debt-collection business and slow-footed credit bureaus.

In the 1990s, businesses adept at tracking and trading consumer debt expanded their reach to dabble in accounts enmeshed in bankruptcy. That dabbling has grown into a robust market. Some of the trade in so-called bankruptcy paper involves debts that remain collectible. What's troubling is that the market now also includes billions in discharged debts, which ought to have no dollar value. Owners of canceled liabilities can revive their value in two main ways: by directly pressuring consumers to cough up cash or by gaming the credit system. . . .

After Chapter 7 cases, "debtors expect their credit is going to become pristine," [one commentator] notes. "But now you have people who buy the debts, even bankruptcy debts, and all of a sudden, new people are supplying information to the credit bureaus." She adds: "The way the system is working now, it doesn't give [debtors] that fresh start."

The new collectors are adept at resurrecting debt:

Pfister, 63, a retired AT&T technical supervisor in Denton, Tex., received a Chapter 7 discharge in 2001. Then, last January, while applying for a mortgage, he learned that two discharged credit-card debts, a Discover Card balance of $6,306 and a former Chase account for $2,683, were showing up on his credit reports. Lenders turned him away because of what appeared to be unpaid obligations, he says.

The Chase loan has been sold twice and is now owned by a debt buyer called Pinnacle Credit Services, according to Pfister's reports from credit bureaus TransUnion and Experian. Pinnacle reported to those credit bureaus as recently as May—six years after the bankruptcy discharge—that the debt is still subject to collection. In addition, Pinnacle has given the former Chase debt a new account number. Pfister's lawyer, James J. Manchee, says that creating a new account number is a strategy some debt buyers use to make it more difficult to tie accounts back to discharged debts, and therefore make the debts appear collectible. Pinnacle declined to comment. In June, Quicken Loans became the 12th mortgage lender to reject Pfister.

Since FICO score-setting mechanisms are a trade secret, I predict more and more consumers like Pfister are going to end up hounded for unenforceable debt and effectively unable to enjoy the protections bankruptcy is supposed to afford. I fear we are heading toward an economy of fear--where one bad break leads to a cycle of mutually reinforcing stigmas that law is incapable of addressing. As we reconsider our policies on debt and credit bureaus, we should keep in mind how new "reputation economies" can render old bankruptcy protections obsolete. As we make the key players in these economies more accountable, we should also consider the sound advice of sociologists Katherine Newman and Victor Tan Chen in their new book, The Missing Class:

Many banks shun poorer neighborhoods, depriving families of opportunities for savings, alternatives to check-cashing companies and their exorbitant fees, and loans at reasonable interest rates for buying a car or paying for a college education. The policies we've suggested are not handouts but investments in the potential of our country's people. They will put in place the kinds of incentives that inspire individuals at the bottom to rise to the top. They will pay off for the whole country by making workers more productive and less at risk of sinking into poverty and illness — personal crises that nonetheless create burdens for the rest of society.

If the new "fear economy" advances unchecked, you might end up being a "music serf" for life for downloading a few dozen songs. Or you might end up with a credit report tarnished for years by a health emergency that happened while you were uninsured. And forget about ever fully understanding how the all-important FICO score (that translates these debts into a number indicating creditworthiness) is tabulated--trade secret protections make it a black box.

Posted by Frank Pasquale at 01:30 PM | Comments (3) | TrackBack

"Cops" for Commercial Law Profs

Today in my Article 9 class, we reached one of my favorite parts of the course: the law of the repo man. I have blogged before about the philosophical significance of the repo man, but today we focused on the more mundane issue of what constitutes a breach of the peace under UCC 9-609. Fortunately, YouTube came to my rescue. It turns out that there is a whole YouTube genre of repo-men (and a few women) filming and posting their work. Its like "Cops" for commercial law profs. (Warning: profanity)

My class was pretty unanimous in their belief that this constituted a breach of the peace, but -- I am happy to say -- could not agree on when the breach actually happened. Now if I could find some YouTube videos on the Statute of Frauds.

Posted by Nate Oman at 01:04 PM | Comments (0) | TrackBack

The Care/Profit Tradeoff in Nursing Homes

We're often told that inequality helps keep the US economy efficient. Cut regulation and give high rewards to those at the top, and they'll work hard to cut costs and compete on quality, providing better and cheaper goods and services for all. Private equity firms like Carlyle Group might be considered the apotheosis of such a market-based approach, taking over companies and forcing them to meet market imperatives.

Here's a fascinating NYT study of their influence on the nursing home industry, which "compared investor-owned homes against national averages in multiple categories, including complaints received by regulators, health and safety violations cited by regulators, fines levied, [and] the performance of homes as reported in a national database known as the Minimum Data Set Repository." The findings describe an extraordinary combination of business efficiency and deflection of legal responsibility:

The Times analysis shows that . . . managers at many . . . nursing homes acquired by large private investors have cut expenses and staff, sometimes below minimum legal requirements. Regulators say residents at these homes have suffered. At facilities owned by private investment firms, residents on average have fared more poorly than occupants of other homes in common problems like depression, loss of mobility and loss of ability to dress and bathe themselves, according to data collected by the Centers for Medicare and Medicaid Services. The typical nursing home acquired by a large investment company before 2006 scored worse than national rates in 12 of 14 indicators that regulators use to track ailments of long-term residents.

The law plays an important role in preventing accountability here; "private investment companies have made it very difficult for plaintiffs to succeed in court and for regulators to levy chainwide fines by creating complex corporate structures that obscure who controls their nursing homes." So perhaps the key "innovation" here was the decision to aggressively reduce care and skillfully deploy legal strategies to prevent any liability for injuries that reduced care caused. It certainly worked well for investors; "A prominent nursing home industry analyst, Steve Monroe, estimates that [one investment group's] gains from [its sale of a nursing home chain] were more than $500 million in just four years."

I have to confess that I've always wondered what business practices could "create the value" that's resulted in such extraordinary gains at the top of the income scale. The Times has done us a great service by putting a human face on some of them. . . and on the legal strategies that make them possible.

Posted by Frank Pasquale at 11:28 AM | Comments (6) | TrackBack

Religion and Bankruptcy

What impact does religion have on personal bankruptcy filings? That is the question asked by Zeke Johnson and James Wright in a recent Suffolk University Law Review article.*

Their article reports on survey research that they conducted among Utah bankruptcy filers. The survey results were then matched with case files to provide additional data, and the results were then compared with the 2001 Consumer Bankruptcy Project. They conclude:

Households in the state of Utah filed for bankruptcy at a rate of 24 per 1000 in 2004, which is approximately twice the national rate. The most easily accessible, and most often cited reasons for this revolve around demographic or behavioral aspects linked to the state’s predominant religion: Mormonism. The data gathered in the Utah Bankruptcy Project strongly suggests that any attribution of the high bankruptcy rate in Utah to Mormon traits is misplaced and lacks explanatory power. Mormons appear slightly underrepresented among those filing for bankruptcy. In addition, demographic characteristics linked to Mormons, such as the high number of children, the young age of homeowners, and the payment of tithing do not appear to account for the state’s bankruptcy problem. While Mormons appear to fare slightly better in Utah than their peers, and likely do not cause the bankruptcy problem, they are also suffering financially more than their national peers. (pg. 628-629)

I have some questions about the methodology used in this study, as well as the way in which the authors analyzed their data. I am also somewhat skeptical of their ultimate explanation, which is economic hardship. The problem with this is that it doesn’t explain Utah’s high filing rate, unless one can somehow demonstrate unique economic hardship in Utah. For example, Utah’s filing rate may be determined the unique structure of Utah’s non-bankruptcy law. What are homestead exemptions or collections law like in Utah? Still, the study does seem to have the virtue of being the first study of Utah bankruptcy that actually collected information about religious affiliation and practice.

*See Ezekiel Johnson & James Wright, Are Mormons Bankrupting Utah? Evidence from the Bankruptcy Courts,40 Suffolk U. L. Rev. 607 (2007) (westlaw access required)

Posted by Nate Oman at 10:46 AM | Comments (4) | TrackBack

Shylock and Article 9 of the U.C.C. (with some thoughts on bankruptcy)

Shakespeare’s A Merchant of Venice (1598) is often misidentified as an anti-Semitic play about a contract. This is not technically correct, as the transaction at the heart of the drama seems to be a secured loan. (Albeit an anti-Semitic one.) Furthermore, contrary to Shakespeare's conclusion, I believe that the security agreement is most likely enforceable, at least under Article 9 of the Uniform Commercial Code, a point that I hope to make to my secured transactions class. Here is Shylock's description of the loan agreement between himself and Antonio, a Venetian merchant:

SHYLOCK: This kindness will I show; go with me to a notary; seal me there your single bond, and – in merry sport – if you repay me not on such a day, in such a place, such sum or sums as are expressed in the condition, let the forfeit be nominated for an equal pound Of your fair flesh, to be cut off and taken In what part of your body pleaseth me. (I.3.141-149)

It seems fairly clear from the passage that there is a debt. Antonio promises to pay "such sum or sums as are expressed in the condition." However, without a valid security interest Shylock has only a personal right of action against Antonio. Indeed, even if Antonio promises the pound of flesh, all that Shylock gets in the event of a failure to deliver the bloody bond is a right to money damages. Section 9-109, however, teaches us that Article 9 governs "a transaction, regardless of form, that creates a security interest in personal property . . . by contract." Such seems to be the case here. Indeed, Shylock casts the transaction in the form of a bond, ie a promise to deliver the pound of flesh, with a condition, ie payment of the debt, that defeats the bond, a classic pre-Code security arrangement, and the "pound of . . . fair flesh" falls under 9-102(a)(44)'s definition of "goods" ("all things that are moveable when a security interest attaches"), bringing it within the personal property requirement of 9-109.

The initial question is whether or not Shylock's security interest has attached to Antonio's flesh. Section 9-203 contains three conditions for attachment. First, Shylock must have given Antonio value, in this case the loan. 9-203(b)(1) Second, Antonio must have rights in the collateral. 9-203(b)(2) Note, that Article 9 leaves the definition of "rights in the collateral" undefined, but the case law indicates that less than full ownership is sufficient. Hence, even if others can claim some property right in Antonio's flesh -- e.g. a master or spouse -- Antonio can still hypothecate what residual rights he retains. The third condition under 9-203(b) is a bit more complicated. In Shylock's case it could be met in two ways. First, he could take possession of Antonio's flesh pursuant to 9-313. This is likely impossible without cutting out the "pound of . . . fair flesh" at the time of the loan, as Antionio cannot retain possession of the flesh as Shylock's agent. See 9-313 cmt. 3. Second, Shylock can satisfy 9-203(b)'s third requirement by having Antonio authenticate a record of the security agreement. This condition seems to satisfied by Shylock's insistence to Antonio that he "seal me there your single bond."

Once the security interest is attached, there are no other steps that Shylock must take in order for it to be enforceable against Antonio. See 9-203(a). The question is whether other provisions of law would make the security interest unenforceable. First, let us dispose of the argument made by Portia in the climatic scene of the play. Portia declares that Shylock's cannot enforce the interest in Antonio's flesh unless he can do so without the effusion of any blood, as the written contract between Shylock and Antonio contained no explicit provision allowing for the spilling of blood. This argument is clearly spurious. Section 1-205 of the code requires that "the express terms of an agreement and an applicable course of dealing or usage of the trade shall be construed wherever reasonable as consistent with each other." Hence, provided that Shylock generally cuts out Antonio's flesh with the effusion of blood in prior transactions or if the effusion of blood is standard in human-flesh security agreements in the trade, then Portia's argument fails. Furthermore, given that Article 9 itself provides elaborate rules governing foreclosure, the absence of explicit contractual provisions specifying all rights in foreclosure cannot standing alone defeat a creditor's right to repossess the collateral. Indeed, such a requirement would run flatly counter to section 1-102(a)'s statement that the underlying policy of the UCC is "to simplify, clarify, and modernize the law governing commercial transactions." In short, the stale formalism upon which Portia's argument rests has no place in the post-realist code of Llewellyn and Gilmore.

A more promising argument is to suggest that the security agreement cannot be enforced under section 1-203, which states that "Every contract or duty within this Act imposes an obligation of good faith in its performance or enforcement." Hacking out Antonio's flesh might violate such a duty. I suspect that it would depend on the jurisdiction in which one tried the case. As Judge Easterbrook, for example, has repeatedly stated the duty of good faith fills in gaps in the contract but should not be used to nullify its explicit terms. In this case, Antonio explicitly promised to deliver up his flesh, suggesting that in the 7th Circuit at least the appeal to 1-203 would be of little help. Of course, Antonio can always point to 1-103, which preserves "the principles of law and equity" so long as they are not displaced by the UCC to make some sort of an unconscionability argument or the like. As we have seen in class, however, 1-103 arguments tend to be the last hail-Mary attempts of regretful debtors to escape their just obligations and are seldom successful in the courts. It is also worth noting that Antonio, a merchant, as a very sophisticated party and he may be governed under 1-103 by "the law merchant," which is preserved in addition to principles of "law and equity."

Antonio might try to defeat Shylock by arguing that the flesh cannot be taken from him without a breach of the peace under 9-609(b)(2). The argument is problematic on a couple of fronts. Certainly, if Shylock tried to cut the flesh from a resisting Antonio it would likely be a breach of the peace. However, the Code defers to other state law in defining what constitutes a breach of the peace. For example, some particularly pro-creditor states might allow Shylock to take the flesh from a sleeping or anesthetized Antonio. Certainly, the policy rational behind 9-609(b)(2) is to prevent self-help repossession from degenerating into dangerous violence. Its purpose is not to allow the Debtor to retain possession of collateral to which a Creditor has a lawful right. Furthermore, even if there is no way of getting the flesh without a breach of the peace under 9-609(b)(2), this would only prevent Shylock from self-help repossession. He could always proceed against the collateral "pursuant to judicial process." 9-609(b)(1). Note, however, that in the absence of a Antonio's consent, Shylock cannot retain possession of the pound of flesh (see 9-620(b)), but must sell it at a sale that comports with 9-610's requirement of commercial reasonableness. However, Shylock may obtain such consent from Antonio through Antonio's silence, so long as Shylock sends to Antonio a record authenticated after default offering acceptance of the collateral in satisfaction of the debt to which Antonio does not respond within 20 days. See 9-620(c)(2). Shylock, of course, must return to Antonio any surplus from the sale of the flesh, and Antonio remains liable for any deficiency.

Of course, unless Shylock perfects the security interest, Antonio may be able to save himself from maiming by filing for bankruptcy. Under section 544(a) of the Bankruptcy Code (the so-called "Strong Arm Clause"), Antonio could avoid Shylock's unperfect security interest. Note, however, that in this case Shylock seems to contemplate perfection, as they are to "go . . . to a notary," presumably the public official who can accept financing statements under 9-501. Provided that Shylock filed a financing statement covering the flesh, then he should be protected from the strong arm clause by 9-317, which grants perfected security interests priority over the interest of a lien creditor. (Defined in 9-102(52)(C) to include a trustee in bankruptcy.) If there is some gap between the time when Shylock gave Antonio the money for the loan and the filing of the financing statement with the "notary," then Antonio can also attack the security interest as a voidable preference under section 547 of the Bankruptcy Code on the theory that it promoted Shylock from an unsecured to a secured claim holder on account of a pre-existing debt. Shylock, however, can probably defeat any such argument under 547(c)(1)'s exception for a "substantially contemporaneous exchange."

Despite the validity of Shylock's security interest in Antonio's flesh, however, he probably is not entitled to slice Antonio up. The reason for this is that in Act IV, Scene 1 of the play Antonio's friend Bassanio offers to pay off the debt in full, an offer that Shylock refuses. However, 9-623 the Antonio can redeem the collateral at any time prior to its final disposition under 9-610 provided that he "shall tender fufillment of all obligations secured by the collateral; and the reasonable expenses and attorney's fees of [Shylock]." 9-623(b)(1)-(2). Of course, 9-623 applies only to "[a] debtor, any secondary obligor, or any other secured party or lienholder," a class that does not include Bassanio. On the other hand, there is nothing to stop Bassanio from giving the money to Antonio, who can then pay Shylock. Shylock, unfortunately for him, has no right to refuse Antonio's offer of redemption.

Posted by Nate Oman at 12:53 PM | Comments (9) | TrackBack

The Unconstitutionality of State-Created Bankruptcy-Specific Exemptions

Judge Jeffrey R. Hughes, writing for the U.S. Bankruptcy Court for the Western District of Michigan, has held a Michigan exemption law that applies only in federal bankruptcy proceedings to be unconstitutional. In re Wallace, 2006 WL 2347807 (Bankr. W.D. Mich. Aug. 9, 2006) (to be published). The Bankruptcy Code authorizes states to opt out of the Code’s exemption scheme. As a general matter, then, debtors from opt-out states may only exempt property from their bankruptcy estates pursuant to state-provided exemptions and nonbankruptcy federal exemptions. 11 U.S.C. § 522(b)(2), (3)(A). In this regard, the Bankruptcy Code recognizes and defers to nonbankruptcy entitlements. A state exemption law that applies only in federal bankruptcy proceedings (a “bankruptcy-specific exemption”) raises the issue of whether the recognition of and deference to nonbankruptcy entitlements translates into a congressionally-delegated authority for states to create bankruptcy entitlements. Within the exemption context, the Wallace court has answered “no.” States do not have such authority, thus rendering a state-created bankruptcy-specific exemption unconstitutional.

The court in Wallace referenced a 2000 decision issued by the U.S. Bankruptcy Court for the Northern District of Indiana, In re Cross, 255 B.R. 25 (Bankr. N.D. Ind. 2000), which found that an Indiana bankruptcy-specific exemption regarding entireties property was unconstitutional. Aside from these two decisions, I know of no others that address this issue. This is curious as Delaware, Georgia, Iowa, Kentucky, New York, Ohio, and West Virginia have all enacted bankruptcy-specific exemptions in one form or another—some allowing debtors in bankruptcy to claim more exempt property than they otherwise could outside of bankruptcy and others providing the opposite. I wonder whether courts and/or legislatures in these jurisdictions will take notice of the Wallace decision. Perhaps there are more constitutional challenges or even statutory amendments on the horizon. Stay tuned.

Posted by Rafael Pardo at 04:17 PM | Comments (1) | TrackBack

Educated Yet Broke

Can you be too poor to file for bankruptcy, yet have the ability to repay your student loans?

When Congress amended the Bankruptcy Code in 2005, it also amended the Judicial Code to provide for the waiver of the mandatory filing fee for bankruptcy. That’s right. Prior to this statutory amendment, if you were so financially strapped that you couldn’t pay the filing fee (then, $150 for Chapters 7 and 13; now, $220 for Chapter 7 and $150 for Chapter 13), you were out of luck: Per the Supreme Court’s 1973 decision in United States v. Kras, 409 U.S. 434, in forma pauperis relief was unavailable in bankruptcy. Lest we prematurely praise Congress for changing this state of affairs, debtors today will get a waiver of the filing fee only under very narrow circumstances. A debtor must have (1) household income less than 150% of the poverty line and (2) and an inability to pay the filing fee in installments (see 28 U.S.C. § 1930(f)(1)).

Now that we have a sense of what Congress deems to be a financially dire situation, at least for purposes of filing for bankruptcy, it strikes me that we might use this measure to gauge a debtor’s inability to repay other types of debts—say, for example, student loans. In an empirical study of the discharge of student loans in bankruptcy, Michelle Lacey (mathematics, Tulane) and I documented that the financial characteristics of the great majority of debtors in our sample evidenced an inability to repay their student loans. One measure we used was the amount of the debtor’s household income in relation to the poverty line established by the U.S. Department of Health and Human Services. We had sufficient information to calculate this figure for 262 discharge determinations. For this group of debtors, half of them had household income less than 200% of the poverty line. It didn’t occur to us to run the numbers using the 150% figure applicable to the fee waiver. In light of the new statutory provision, I’ve set out to look at our data from this perspective. The numbers are sobering, to say the least.

Approximately 35% of the 262 debtors had (1) household income less than 150% of the poverty line and (2) less than $201.93 (in 2003 dollars) in monthly disposable household income—that is, the equivalent of the $220 Chapter 7 filing fee in 2006. Based on these figures, slightly more than a third of the student loan debtors would have been on their way to qualifying for a waiver of the bankruptcy filing fee had they filed for Chapter 7 today. Within this subgroup, however, approximately 42% of the debtors were denied a discharge of their student loans—which, on average, would have taken 2 years and 9 months to repay if the debtor lived expense-free and devoted all household income to this endeavor. It seems horribly unrealistic to expect that such a debtor would have the ability to repay his or her student loan. While the Bankruptcy Code fails to define “undue hardship,” the standard for discharging student loans in bankruptcy, perhaps courts should begin to look at the new fee-waiver provision to inform their application of the standard and to avoid troubling results such as these.

Posted by Rafael Pardo at 02:29 PM | Comments (9) | TrackBack

Now Playing in a Bankruptcy Court Near You

Imagine that, for the past several years, you’ve worked diligently and dutifully as a bankruptcy judge. Unlike your Article III colleagues on the federal bench, you don’t have lifetime tenure or salary protection. But that doesn’t really bother you all that much because you care about what you do and you feel you make a difference. What’s more, you love the substance of your work—applying the Bankruptcy Code day in and day out. Sure, it has its share of inconsistencies and ambiguities that present some interpretive difficulties, as any statute would, but, at the end of the day, it’s elegant and workable. And then, BAM! Your life as a judge as you know it comes to a screeching halt.

On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) into law, thus becoming Congress’s willing accomplice in committing statutory massacre. And when I say statutory massacre, I’m not even thinking about how BAPCPA substantively changes the Bankruptcy Code. Rather, I’m focusing on BAPCPA’s inartful drafting. As recently blogged by Bob Lawless over at Credit Slips: “Regardless of one’s views about the substance of the amendments, most everyone seems to agree that the legislative drafting left something to be desired.” And that's putting it quite mildly. A quick glimpse at some of the statements from members of the bankruptcy bench during the past year gives the impression that some of the judges are not too happy with Congress.

Take, for example, Judge Lundin’s commentary on the eve of BAPCPA’s effective date, which appeared in the September 2005 issue of the American Bankruptcy Institute Journal:

Whether by design or default, bankruptcy practitioners and judges will spend decades unraveling cross-references that lead nowhere and interpreting new terms of art that fail to communicate. If the drafters intended to make bankruptcy more complicated and expensive by making the bankruptcy law less coherent and more difficult of application, they succeeded. There will be generations of “technical amendments.” Am. Bankr. Inst. J., Sept. 2005, at 1, 70.

Speaking of technical amendments to BAPCPA, consider Judge Haines’s opinion in In re McNabb:

It has been reported that a “technical amendments” bill is in the works to fix various glitches in BAPCPA, notwithstanding Congressional testimony that it was so perfect that not a word need be changed. Perhaps this is one of those glitches. If so, Congress can easily fix it. Frankly, this Court believes it should . . . . 326 B.R. 785, 791 (Bankr. D. Ariz. 2005).

Okay, okay, so maybe these two comments aren’t so bad. Perhaps a mix of tongue-in-check with a slight dose of admonition—the sort of checks-and-balances stuff the Founding Fathers had in mind with three equal branches of government, right? Well, from Judge Brook’s perspective, it seems there’s no need to sugarcoat or to be subtle. Better to come out and say what’s on your mind:

This is a case where the language of BAPCPA passed by Congress tends to defy logic and clash with common sense. This is an example of a specific revision to the Bankruptcy Code, if followed by the Court and applied as Congress seems to intend—i.e., by way of strict construction—would result in an absurd decision and totally unworkable legal precedent. These drafting problems have the potential of bringing the bankruptcy system to a halt while debtors, creditors, and the courts try to figure out just exactly what Congress intended. In re TCR of Denver, LLC, 338 B.R. 494, 495-96 (Bankr. D. Colo. 2006).

Or, better yet, why not repay the favor? If Congress wants to enact legislation that is utter nonsense from a drafting perspective, then why not issue completely nonsensical opinions commenting on that legislation? Judge Cristol did so by issuing a sua sponte order penned in the vein of Dr. Seuss’s Green Eggs and Ham:

I do not like dismissal automatic,
It seems to me to be traumatic.
I do not like it in this case,
I do not like it any place.

As a judge I am most keen
to understand, What does it mean?
How can any person know
What the docket does not show.

…

Before this problem gets too old
it would be good if we were told:
What does automatic dismissal mean?
And by what means can it be seen?

Are we only left to guess?
Oh please Congress, fix this mess!
Until it’s fixed what should I do?
How can I explain this mess to you?

In re Riddle, 334 B.R. 702, 703 (Bankr. S.D. Fla. 2006)

At this point, you might be thinking that this is just the sort of anecdotal evidence that leads to unjustified inferential leaps. The situation can’t be all that bad, can it? The judges surely are overreacting, feeling (1) slighted by Congress’s efforts to strip them of their discretion through provisions like means-testing through mathematical formulas and automatic dismissals and (2) insulted by lobbyists from the credit industry, including one who said that bankruptcy judges are “not real judges” and are “part of the . . . problem” with the bankruptcy system (see L.A. Times story here). Actually, the situation may be more dire than perceived.

A search of Westlaw’s FBKR-CS database, which consists of reported and unreported bankruptcy decisions and orders that are issued by all levels of federal courts, reveals that, to date, there are 538 documents that mention “BAPCPA” or “Bankruptcy Abuse Prevention and Consumer Protection Act.” Notwithstanding that this is a new law that has presented issues of first impression for courts, this strikes me as an excessive amount of opinion-writing, more than one would normally expect to see with a legislative enactment that has been in effect for less than a year. Worse yet, of those 538 documents, 40 mention the phrase “absurd result.” Even if only some of those opinions involve a BAPCPA issue where a plain language interpretation could lead to an absurd result—conceivably, a court might mention the phrase as it rejects a weak absurd-result argument—it can’t be a good sign that approximately 7.4% of the issued opinions within the year of BAPCPA’s enactment make an “absurd result” reference.

When bankruptcy judges issue commentary or opinions like the examples set forth above, Congress should pay close attention and look to clean up the terrible mess it has made. After all, these folks are among the nation’s top experts in bankruptcy. But, as persuasively argued by Melissa Jacoby, past experience has shown that it’s not likely that Congress will listen and that change will have to come from the actors within the bankruptcy system.

Posted by Rafael Pardo at 11:26 PM | Comments (4) | TrackBack

Bankruptcy in the Wake of Katrina

I’ve recently been thinking about the difficulty researchers will face in studying Hurricane Katrina’s effects on bankruptcy filing rates in New Orleans. A couple of weeks ago, over at Credit Slips, Bob Lawless (University of Illinois) discussed the importance of extending credit relief to natural-disaster victims. Lawless’s empirical work on bankruptcy filing rates after a major hurricane has found “that for every two new bankruptcies that occur in areas unaffected by the hurricane, there are three new bankruptcies in the judicial district where the hurricane made landfall.” The study focused on hurricanes from 1980 – 2004, so I’m curious to see whether in the case of Katrina this finding will hold to be true for the Eastern District of Louisiana (E.D. La.), within which New Orleans is located. My hunch is that it won’t. Since the New Orleans diaspora involved hundreds of thousands of individuals, many of whom would be likely candidates for bankruptcy but have not returned (and may never return) to the city, the increased volume of bankruptcy filings will not materialize in E.D. La. A preliminary look at recent bankruptcy-filing data from the district suggests as much.

As an initial matter, there has recently been a national downward trend in bankruptcy filings. According to statistics from the Administrative Office of the U.S. Courts, bankruptcy filings for the second quarter of Fiscal Year 2006 (1/1/06-3/31/06) were down approximately 71% nationwide compared to the second quarter of FY 2005. This dramatic downturn has been attributed to the deluge of bankruptcy filings prior to October 17, 2005—the effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which was intended to make it more difficult for certain consumer debtors to obtain bankruptcy relief. However, bankruptcy filings for E.D. La. had dropped approximately 86% for the same period of time—15% more than the nationwide figure. In terms of absolute numbers, there were only 340 total bankruptcy filings (60 business and 280 consumer) within the district.

It strikes me that these figures, in addition to being a product of strategic behavior by debtors in anticipation of BAPCA, also reflect the fact that the majority of individuals who have returned to New Orleans probably have had the financial means to stave off a bankruptcy filing. On the other hand, many of the New Orleans evacuees who remain away from the city have probably lost much (if not all) and either (1) have less of an incentive to return or (2) do not have the financial means to return. It’s these individuals whom researchers will have to track down—in places like Houston, Birmingham, Atlanta and Nashville—in order to understand fully the effects of Hurricane Katrina on financial distress. Moreover, any comprehensive study will have to analyze the impact of the diaspora on the communities where New Orleans residents relocated. The economies of these communities will simultaneously have experienced financial gain (e.g., influx of consumer dollars, workforce expansion) and financial strain (e.g., increased demands on public services such as health care and education). Considering the latter, it could very well be the case that financial distress leading to bankruptcy will be experienced by individuals in communities that were not directly in the path of Hurricane Katrina. If the numbers are large enough, the Katrina experience could force us to reconsider our prior understandings of a natural disaster’s impact on bankruptcy filing rates.

Posted by Rafael Pardo at 02:42 AM | Comments (3) | TrackBack