65 Pages Posted: 17 Sep 2018 Last revised: 26 Jun 2019

Date Written: September 10, 2018

Abstract

In bankruptcy, creditors exercise governance rights over a debtor firm—they vote to accept or reject a proposed plan of reorganization. These governance rights are apportioned based on the amount of a creditor’s claim: “one dollar, one vote.” This allocation assumes a claim reflects the creditor’s true economic interest in the debtor, and the creditor is thus presumed to use its governance rights in the bankruptcy to maximize the value of the debtor, and hence its claim.



Yet a creditor’s financial interest is not always limited or even linked to the face amount of its claim. For example, the interest of employee creditors extends beyond recovering back pay to ensuring future employment, while a landlord’s interest may be less in recovering back rent than in being able to terminate a lease so it can relet the property at a higher rate. Historically, this has been a discrete and manageable problem. Two recent developments in financial markets, however, have made the mismatch between a creditor’s total economic interests and its claim—and the concomitant governance rights—more problematic.



First, a robust market has arisen in bankruptcy claims, enabling investors to purchase bankruptcy claims—and thus governance rights—at a discount. Second, the emergence of derivatives markets now enables investors to go “short” on the debtor and benefit from its misfortune. Combined, these developments enable investors to cheaply acquire governance rights in bankruptcy and then use that power to further the value of their extraneous interests rather than maximizing the value of their bankruptcy claim. As a result, the “one dollar, one vote” principle underlying bankruptcy governance is now in question.



This Article illustrates problems that result from the divergence of economic interests and governance rights in bankruptcy. It shows that existing bankruptcy law tools, such as disclosure, vote designation, trading bars, equitable subordination, and equitable disallowance, fail to provide adequate remedies for the problems. Accordingly, we propose an administrable system of “mark-to-market governance,” in which the governance rights, but not the economic distribution rights, associated with a creditor’s bankruptcy claim would be adjusted to reflect the creditor’s true net economic position. Under mark-to-market governance, hedgers and shorts would be subject to proportional dilution, claims purchasers would have their governance rights discounted based on purchase price, and secured creditors would have their credit bidding rights limited to the value of their collateral. Together these adjustments will promote the core bankruptcy policies of maximizing the value of the debtor firm and equitably distributing its value.