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Thursday, November 6, 2014

The Takings Clause in Bankruptcy: Making Sense of the Different Outcomes for Secured and Unsecured Claims

In  a recent edition of the invaluable Daily Bankruptcy News, a link appeared to an article by one Professor Charles Jordan Tabb entitled "The Bankruptcy Clause, the Fifth Amendment and the Limited Rights of Secured Creditors in Bankruptcy" which dealt with subjects I find interesting and have written about, so I read it.  It turns out to be essentially the same as a paper he gave at an ABI panel earlier this year, and as that paper is more accessible, I link to it rather than the cumbersome SSRN site that DBN linked to.

The article is a good example of two things:  One, the traditional law-professor-approach of taking some appellate opinions, identifying alleged inconsistencies in them, and then concluding that they really don't mean what people think they mean, they mean what the professor wants them to mean.   The second thing the article exemplifies is the current vogue of making conclusory claims about deficiencies in corporate reorganization due to purported domination of those cases by secured creditors in some "unfair" way, leading to a cry to "reform" the process to restore a Edenic "balance" that actually never existed at all.

I think the article is wrong on both counts.  First, as I assume the reader has not read it, I must explain what it says in some detail.  But to save the busier readers among you some time, here is the punch line of my argument:  All claims, secured and unsecured, are entitled to be protected against government expropriation under the Takings clause; the reason the topic only comes up in the context of secured claims is that that is the only context, when dealing with an insolvent debtor, where there is value to litigate about.  The discharge of unsecured debt in bankruptcy is indeed a taking, but often the just compensation for the taking amounts to zero when the asset taken (the discharged claim) is worthless, and, to the extent there is value available for distribution on account of unsecured claims, the bankruptcy process does a fairly reasonable job of getting that value to the holders of those claims, mitigating any Takings claim. 

Tabb;s article focuses mainly on a close reading of the major 20th century Supreme Court opinions on the limits of the Bankruptcy Clause, which, he says, rest on a "property/contract" distinction, that is,  a secured creditor's property interest in collateral is protected by the Takings Clause to the extent of its value, while unsecured (for which he uses the word "contract: as a proxy) claims are not protected at all.  (I will not address what he says about older case law, which is largely irrelevant because that era did not purport to affect secured debts via bankruptcy; in many ways, including no concept of a going concern reorganization, and debtors' prisons, the legal norms of the age were so different than our own that the subject was not even dreamed of).   Tabb says the "property/contract" distinction is "false" and "with only the slightest of pushes ... collapses".

He says the distinction is "false" because contract claims in other, non-bankruptcy contexts, have been held at the Supreme Court level to be protected by the Takings Clause.  This is correct and I won't belabor it further. 

He then goes on to devote the bulk of his attention to the (rhetorical) question, how, then can this distinction between protecting secured creditors under the Fifth Amendment and not protecting unsecured creditors be sustained?  Obviously he concludes it can't, and therefore, he syllogizes, we can treat secured claims with the same back of the hand with which we treat unsecured claims, all "for the national good" [he actually says that]. 

This argument is wrong for two very obvious reasons: (1) unsecured claims against an insolvent are often worthless, while secured claims are often not.  So, yes, unsecured claims are "taken" when a discharge occurs, but the just compensation required by the Takings Clause winds up being zero, because those claims are worthless as a practical matter, and no one bothers to spend the money needed to pursue the point as a matter of principle.  (2) When unsecured claims do have value, the bankruptcy process does a fairly reasonable job of getting that value out to the holders of those claims, so, again, the discharge may be a "Taking" in principle, but the amount of the loss -- the difference between the claim amount and the value received on account of it in the case -- which determines the amount of "just compensation" amounts to very little in real-world dollars, and again, no one seems to want to spend the kind of money required to establish the principle in our legal system just as an academic matter.

So one can come up with a much more coherent explanation of the "property/contract" distinction Tabb finds untenable:  It isn't a distinction based on label, but based on value.  Both interests are protected by the Takings clause from government expropriation to the extent of their value, but, in the main, unsecured claims against an insolvent tend to have no value  outside of bankruptcy, whereas secured claims have value outside of bankruptcy to the extent of the collateral's value.  That is why secured creditors wind up receiving protection, not because they bear  a magic label "property" but because their legal rights have meaningful value under non-bankruptcy law , while unsecured claims usually don't when the debtor is bankrupt.
An unsecured creditor has to reduce its claim to judgment, which may be extremely difficult (for example, in the consumer debt context, the barring of hearsay testimony under the rules of evidence, as well as statutes of limitations, pose real hurdles for a holder of defaulted debt to obtain a judgment by any means other than default).  Even then, there are non-bankruptcy laws that restrict the amount that can be collected from an individual judgment debtor, and restrict the property that may be levied to satisfy the judgment.  There are practical obstacles to getting paid on any judgment, including finding the debtor, finding unencumbered property, and most fundamentally, the fact that the debtor may not make enough money to pay much of anything on the claim.  Finally, as in the business bankruptcy context, there are usually more than just one or two unsecured creditors and it would be difficult for any one claimant making a "Takings" argument to prove that it would have been the one to win the "race to the courthouse" as opposed to coming in too late to recover anything.

In the business bankruptcy context, similar hurdles exist to realizing value on unsecured claims outside of bankruptcy.  A tort claimant will need years to get to trial, at which s/he may lose; even a winner faces appellate risks.  As a practical matter, tort claimants need settlements to get paid in any reasonable time, in or outside of bankruptcy.  A pension deficiency claim is easy to guesstimate, but much harder to prove as a fact and, as a practical matter, the cooperation of the debtor is necessary to expedite resolution.  Trade claims are surprisingly easy to delay payment on, including by way of disputing quality or price, except for "critical vendors".  Even for those creditors who might get a judgment before the debtor's assets dissipated, enforcing that judgment against a business operating in multiple states is again a tedious and draining process requiring large legal expenses that may not be economically recoverable.  And the "race to the courthouse" is likely to be even more congested with a business debtor than a consumer. 

So this is the point Tabb just misses: there are a large number of non-bankruptcy reasons why unsecured claims have no value to be compensated when they are extinguished, even though they are technically the subject of a governmental "Taking" every time a discharge is granted.

And, when there is value available to distribute to holders of unsecured claims, the bankruptcy process does a fairly reasonable job of doing that.  In particular, it solves for all the unsecured creditors the collective action problem that each would face individually.  Thus, properly administered with a view toward protecting creditors' priorities, as opposed to indulging local business owners, it delivers a reasonable approximation of the value that a "Takings" and "Just Compensation" suit would wind up delivering years later.  In fact, just as every discharge can be understood as a taking, so too we can see that every bankruptcy case embeds a just compensation litigation, and the Bankruptcy Code is a template for specifying the manner in which just compensation is to be figured out and paid out. And once the parties accept their respective awards consensually, or litigate them to finality, they are bound by the results and precluded by both claim and issue preclusion doctrines from relitigating the taking in the Court of Claims. 

Although Tabb makes a list of arguments that might rationalize the "property/contract" distinction (and knocks them down one by one), this is one he just misses completely.  He approaches the issue briefly, but fails to think in terms of value and the lack thereof.  Instead, he contends that, if the unsecured creditor just gets its ratable share of distributable value from the debtor's estate, there is "no compensation at all" and a clear "Takings violation" -- but then, he notes, the Supreme Court has never been troubled by that, so it must not be a "Taking".  Again, if one ignores economic worthlessness of an unsecured claim against a no-asset estate, as he does, that is literally correct.  But when what is "Taken" as a matter of form has no value as a matter of economic substance, his insight becomes merely academic.   The lack of value to be compensated explains fully why no one debates the Constitutionality of the discharge of unsecured debt outside of the academy.

Obviously, it isn't his goal to conclude that the Fifth Amendment limits what the government can do to creditor claims that have value. He's quite upfront about that early on, before he even begins his argument.   Citing absolutely no empirical data, he contends that, in the new "millenium" there has been a dramatic expansion in the power of secured creditors." As I have shown in prior posts, that is not true - it was well understood at the time the Bankruptcy Reform Act of 1978 was passed that secured creditors would generally have to consent to the plan "or the business will not be able to be reorganized."   Then he contends, similarly bereft of empirical data, that "Financing has  experienced a sea change [such that] many debtors enter bankruptcy with their assets fully encumbered."  As I've shown before (see same link. and also read the posts from January of this year), that has been a common feature of reorganizations going back to the railroad reorganizations of our nation's past: in the reorganization of the Denver & Rio Grande Railroad that made multiple trips to the Supreme Court in the postwar years, all the reorganization value was allocated to secured creditors, while the unsecured creditors and equity were wiped out, yet neither the regulators, nor the judge presiding over the bankruptcy, nor 7 Justices of the Court, all of whom approved the reorganization plan, had any trouble with that fact.

He goes on in the usual horrified fashion -- continuing to eschew empirical evidence -- to say that secured lenders are "driving potentially viable debtors into bankruptcy" and "Controlling secured lenders are using chapter 11 as a vehicle to foreclose on their assets" - as if secured lenders had the ability to decide whether their debtor stayed out of bankruptcy!  Then he complains that, in these 363 sales, "important stakeholders, bondholders, trade creditors, tort victims, employees, and shareholders, to name but a few are excluded from any recovery but for the whims of the controlling secured creditor"  -- with no citation but to a 1996 law review article that itself contains no empirical data.

This is such utter nonsense: the vast majority of 363 sales pass the debtor as a going concern to the buyer; in them as in pretty much all prepackaged plans and even many "traditional" chapter 11s, most trade creditors and employees usually ride right through with little economic suffering at all.  Why the other constituencies he mentions -- bondholders and, of all things, shareholders --  should be able to invade the recovery of the secured creditor's collateral, Tabb conspicuously fails to even attempt to offer a rationale.  Instead, he resorts to that tired, minimal-effort debating tactic, the rhetorical question: "Outside of bankruptcy, the secured lender may have considerable difficulty capturing anything above liquidation value. If the bankruptcy process itself allows the recovery of more value, why should all of that excess go to the secured lender?"

This approach to arguing distributional matters -- rhetorically asking one recipient how its receipt is justified -- has become a sorry staple of debate.  If one objects to a relative distribution -- as between A & B -- as "unfair", analysis of "unfairness" requires more than just asking "what justifies A's receipt of the distribution?"  If it's a relative fairness issue, then you need to ask "What justifies B's receipt of the distribution?", and then compare the two justifications that get proffered.  One can't evaluate relative claims to a limited fund by looking at just one claim, anymore than you can understand a team's ranking in a league's standings by asking what is its record, and not find out the records of the other competition around it. 

So here is the simple retort to Tabb's rhetorical question:  Outside of bankruptcy, the unsecured creditor may have considerable difficulty capturing anything, period. If the bankruptcy process itself allows the recovery of more value, why should any of that excess go to the unsecured creditor?
The secured creditor has taken the appropriate steps under non-bankruptcy law to establish a right to take everything, and the unsecured creditor hasn't, for its own business reasons in the cases of all but the tort creditors (who often are paid through insurance outside of the bankruptcy). Further, in many cases the secured creditor will not act as the despotic tractor beam that Tabb supposes, sucking  up all the value in the estate, including the money earmarked for payroll and bouncing the checks that trade creditors try to cash.  In many cases, it will finance the debtor's operations out of either cash collateral or an interim DIP financing or both, enabling many of the "important stakeholders" Tabb worries about to remain economically unscathed by the bankruptcy.  Then compare what the secured creditor does to what the other constituencies do for the debtor during the case: what do the retirees do to generate value in a bankruptcy?  what do the bondholders do? Etc.  Tabb doesn't bother to try to look at the full picture of his distributional problem and for that reason, along with the utter dearth of empirical support for his laments, his policy advocacy falls well short of anything that ought to elicit anyone's concern.