Outside the U.S. District Bankruptcy Court for the Southern District of New York in Manhattan. (Brendan McDermid/Reuters)How to think about the coming Chapter 11 epidemic.
NRPLUS MEMBER ARTICLE I n 19th-century English novels, bankruptcy is a tragedy that just happens to people, often with no real explanation, as though it were a natural disaster or an unexpected infection, a cartoon anvil out of the sky over the head of some poor Wile E. Coyote in Regency garb. Bankruptcy was on the mind of everyone from Charles Dickens to William Makepeace Thackeray to George Eliot to Anthony Trollope, and it is a major plot point in Dombey and Son, Vanity Fair, and The Mill on the Floss, among many other novels. The threat of bankruptcy produces suicides in The Way We Live Now and in Little Dorrit — such was its terror.
In our time, the economic effects of the coronavirus epidemic will be severe, and for many individuals and businesses they threaten to be, or already are, catastrophic. On the other hand (it’s an ill wind, etc.) bankruptcy lawyers are going to have one of their best years ever. And here is a sentence one does not often have occasion to write: There may not be enough lawyers to go around. As the Wall Street Journal reports, the bankruptcy world’s “ranks have been thinned by a decade of economic growth” following the 2009 high-water mark for Chapter 11 filings amid the financial crisis. Promising law students and young lawyers have avoided specializing in bankruptcy, and the courts may not be ready for the influx of cases. Notwithstanding the bleak prospect of being sent to live in Delaware, it is a fantastic time to be a bankruptcy lawyer.
Because bankruptcy is associated with something that we are deeply uncomfortable talking about — business failure and personal financial distress — our bankruptcy procedures remain among the great unsung achievements of American life. We have retained the Victorian terror of bankruptcy, both the thought and the word itself — recall Donald Trump’s avoidance of the word “bankruptcy” when talking about being forced to take one of his struggling businesses and “throw it into a chapter,” his favorite evasive euphemism for bankruptcy. But bankruptcy in our time is not a disaster on par with dying in a cholera epidemic. Though it may be embarrassing and painful, our bankruptcy process performs the invaluable service of codifying the terms of failure. And failure is essential to the success of a free and dynamic economy — a world without it is a world without innovation and growth.
Failure is one of the main ways we adapt our economic arrangements to new conditions. Sometimes, those new conditions emerge slowly, as with the death by inches of many American newspaper publishers; sometimes, those conditions change almost overnight, as with the coronavirus.
It is famously the case that most new businesses fail. And that is especially true of small businesses, though it is good to keep in mind that many of today’s corporate behemoths (Microsoft, Facebook, Apple) were once small businesses, too. Among new small businesses, one in five fail in their first year, and half fail by their fifth year. One wonders why entrepreneurs bother with the risks and demands of starting something new when many of them, being capable and energetic, might find comfortable salaried employment at a well-established firm. The answer has to do with risk and reward. Successful entrepreneurship is generally much more lucrative than is a successful career managing someone else’s business: There are not very many billionaires who made their money on salary, but even at the less rarefied levels of business life, an entrepreneur who starts a successful dry cleaner or a prospering coffee shop will generally earn much more than someone who manages a dry cleaner or a coffee shop started by someone else. The upside is great — and, equally important, the downside is not as grim as it could be.
It is amazing what can be accomplished by creative and driven people in an environment characterized by stable and agreed-upon rules. The financial institutions that do most of the business lending are not run by naïfs. When big, sophisticated financial firms such as Goldman Sachs or JP Morgan lend money to a business, they know what they are getting into. (Give or take a subprime mortgage derivative or two — every company is capable of making bad investments.) They know where they sit in the pecking order of creditors and what assets are in play. They have a pretty good idea of what their exposure to loss is and how much they stand to lose or recover if things go wrong — and they know this because the rules generally are clear and well-understood, with generations of precedent and established processes. Some investors even specialize in the debt and assets of companies that are in bankruptcy or on the verge of it, and these distressed-asset investors are another unappreciated part of the vast financial ecosystem that keeps business in business.
We do not have debtors’ prisons (not for business debts, anyway), and we do not maintain arrangements in which entrepreneurs are forever ruined by a business failure. Instead, we have a process that encourages risk-taking and entrepreneurship, and that allows financial institutions, lenders, and investors to make decisions in a stable policy environment under which the rights and obligations of all parties are clearly defined.
Doing violence to those arrangements would impose a great social loss on our people and our economy, even if relatively few of us understood or appreciated it. And we have developed a dangerous new habit of risking just that. We see it in political shenanigans ranging from the thuggish arm-twisting of the Obama administration during negotiation of the GM and Chrysler bailouts (in which the usual rules of creditor priority were upended in the interest of Barack Obama’s political allies) to Mitch McConnell’s recent suggestion, uncharacteristically boneheaded, that bankruptcy procedures be extended to the states, which have put themselves into impossible financial positions by habitually underfunding their pension systems and taking on other unfunded liabilities.
About the latter case: There is no such thing as state bankruptcy law in the United States for excellent constitutional and practical reasons; states deal with their creditors under a different set of rules, also longstanding, and creditors and debtors both have the right to negotiate settlements under the rules that governed the agreement when it was made rather than under a new set of rules put into place for political reasons by Senator McConnell and his colleagues. Pulling the rug out from underneath creditors, changing the rules in the middle of the game, is precisely the wrong policy. We have far too much ad-hocracy as it is.
Political actors often seek to intervene on behalf of politically important debtors — and sometimes, though less often, on behalf of creditors — in the belief that they can offer financial relief to an important constituency at no cost to anybody they care about, only “greedy” bankers and the like. What they refuse to acknowledge is that investors and lenders will remember getting screwed and will be forced to alter their calculations to reflect the fact that the rules are not always the rules — they may not be able to do anything about the transaction immediately at hand, but they can certainly take the new reality into account the next time somebody asks them for a loan or an investment. More risk to lenders means less lending or more expensive lending, which means less entrepreneurship, which means a less fruitful and dynamic economy, fewer jobs, lower wages, and diminished tax collections — lost opportunity and lost prosperity.
Bankruptcy is one of Chesterton’s fences. Of course there is room for reform. But you should understand what you have, what purpose it serves, and how it works before you knock it down.