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Friday, January 3, 2014

A Final Thought on Till v. SCS Credit Corp in Chapter 11 – Is it Really All About Efficiency? What about the Fairness of "Fair and Equitable"?

One of the most basic points about "Pareto efficiency" is that it is completely independent, or agnostic, in relation to the ex ante distribution of what market participants enter the market with.  A situation in which everyone is happy with their share of resources is Pareto-efficient, but so too is a situation in which one person has all the resources, since that person must necessarily be made worse off to make anyone better off.   Thus, it is often noted that a state of Pareto efficiency has nothing to do with "fairness" and is not necessarily "good";  "efficiency" does not necessarily lead to "equity" or even an improvement in "equity" 

A famous mid-20th-century American economist, Arthur Okun, wrote a book "Equality and Efficiency: The Big Tradeoff" that explored this in some detail.  As its title suggests, the book posited a zero-sum tradeoff between the two values, not a positive-sum relationship in which an improvement in efficiency made everyone better off in an absolute sense, even though their relative gains varied.  Okun, a staunch "Great Society" Democrat, advocated a left/liberal/progressive agenda to "fixing the problem" caused when the efficiency of economic institutions "transgress[ed] on rights".  The work prompted many responses from a free-market/ libertarian perspective that (in addition to hotly disputing Okun's list of "rights") inefficiency imposes opportunity costs and other avoidable costs or losses for no good reason, which is not morally defensible; improvements in economic efficiency benefit all people by lowering prices, increasing access to a greater universe of goods and services, and increasing the quality of those goods; ultimately, efficiency strengthens and enriches the economy and polity, in ways that government coercion could never achieve, and would continue to do so, if only markets were really allowed to operate freely.
In the fair and equitable context, judges applying Till to keep a local real estate developer in control of an over-leveraged asset seem to be engaging in their own informal dispensation of equity at the expense of efficiency, shaving 200 or so bps off the lender's yield to allow the original owner to hold on to its equity investment.  Does recognition that the criterion of "Pareto-efficiency" has nothing to say about distribution of assets excuse judges from applying the judgment of an "efficient market" to displace the equity owner and instead make it "fair and equitable" to distribute the value of the debtor in a way that does not eliminate one of the investors completely?  Superficially, you might think so. But, that would be wrong.

The reason it is "fair and equitable" to defer to efficient credit markets in cram-up litigation is that, well before they entered the bankruptcy court, the parties to the cram-up controversy had already freely negotiated their relative distributional relationship, deciding what was a "fair" distribution of risks and rewards in various contingencies.  Prior to entering the bankruptcy, the creditor and the equity holder used off-the-rack principles of contract law, debtor-creditor  and corporate law to negotiate a set of rights and priorities in relation to the property of the company that they both invested in.  In exchange for priority of payment, the creditor capped its claim on that property at principal plus interest and ancillary costs, and subjected its claim to the limitation on liability of the equity holder that is inherent in a corporate or other limited liability vehicle.  Conversely, the equity holder, in exchange for subordinating its investment in the downside scenario, got a free and clear claim to all the profits of the company above the creditor's fixed claim and further ensured his or her own immunity from liability for any shortfall in the creditor's distribution.  So the distribution of property was already negotiated and, by conventional legal principles of contract and corporate law, a negotiated distribution of property between two businesspersons can be at least presumed to have been negotiated freely and thus enforced.  And it certainly is enforced on the upside -- we don't have any rules that allow creditors of a hugely profitable business to run to a court and have it force the shareholders to pay over some of their dividends to make the creditors richer on grounds of "fairness" or "equity".  So a bankruptcy judge does not need to worry, therefore, that s/he is leaving important distributional matters out of his or her work by going down the efficient markets road in a cramup hearing.  The parties had already negotiated their ex ante distribution in a legally respected fashion before they came before the judge.  To allow one of them to appropriate some of the other party's distribution without the latter's consent is not "fair and equitable".  It is totally unfair to the latter.  It is really just a government subsidy of excessive risk-taking, which is proclaimed to be unfair in other contexts, for example, when it takes the form of banks that are "Too Big to Fail".  Look at the Broadbents in Castleton Plaza.  They owned a bunch of shopping centers and had combined net worths over ten million dollars.  They might be lovely people, but why do they need to have their business borrowing costs subsidized by bankruptcy law?

After all, the equity holder got into the transaction seeking a profit, and seeks to hold on to its stake to gain a profit.  So it is really their profit-seeking that is being subsidized by government when the creditor's return is haircut by a court applying bankruptcy law.  And this is why the courts that exclude the lender's profit from Till interest rate calculations are wrong.  The lender's profit is not in any plausible sense economically or socially inferior to the equity's.  The effect of knocking profit out of the lender's return is to subordinate it to the equity's profit objective, exactly the opposite of what the absolute priority rule would lead you to expect.  The absolute priority relationship should continue: as long as the equity holder is seeking a profit, the lender's profit should be a senior claim on the enterprise.  Its profit goal should be maintained in a senior position to the equity's profit goal.  

Nor is it accurate to assert that the equity is "walking away with nothing" when it gets "wiped out" in a bankruptcy.  The equity in the bankruptcy of a limited liability entity, like a corporation, walks away without liability for the creditors' losses, which is a quite a nice perk, relative to the alternative.  As well, the duration of a chapter 11 in effect amounts to giving the equity holders a free option to purchase the debtor's assets from the creditors, and options always have some value.  So equity holders do get meaningful benefits even in a chapter 11 that ultimately extinguishes their equity investment.  Upholding the creditor's end of the bargain is essential to a fair outcome as much as an efficient one.