Bankruptcy’s Trilemma: A Unifying Framework

Abstract

We propose a unified framework to explain the key problems underlying corporate bankruptcy law. Creditor rights take two primary forms: the right to take assets from the debtor and the right to block asset transfers from the debtor to third parties. Taking and blocking rights control agency problems, such as value-diverting transfers by management. But in financial distress, one creditor’s rights can impose costs on the others. Multiple taking rights create the well-known commons problem: creditors can race to the debtor to collect, causing a valuable firm to be liquidated. Bankruptcy law can stay the creditor race, but a stay creates one of two alternative problems. Replacing taking rights with blocking rights creates an anticommons problem of holdout and costly delay. Holdout problems can be mitigated by removing blocking rights for some creditors. But creditors who can neither take nor block are vulnerable to the very agency problems their contracts try to prevent. We call these three problems—commons, anticommons, and agency—bankruptcy’s trilemma: the law cannot solve all three at once. We show how most of bankruptcy law’s features target at least one of the three problems. U.S. law’s back-and-forth evolution over time reveals the inevitable tension between them.

Practicalities

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