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Bankruptcy Courts and How They Fit into the US Bankruptcy Landscape

Dechert – Around the globe, bankruptcy courts are constituted in different ways. In the United States, they are constituted as courts of equity. For anyone who wishes to have some sense of the logic of the US bankruptcy system, it is helpful to understand both what this means and how it fits into the larger landscape of US bankruptcy law and practice.

As a historical matter, equity as a distinct jurisprudential system has long been criticised as inherently arbitrary. In the 17th century, jurist and scholar John Selden famously quipped that “equity is a roguish thing” administered entirely “according to the conscience of him that is Chancellor”. Selden complained that the measure of the chancellor’s conscience would inevitably be no less capricious than the happenstance length of his foot, remarking “one Chancellor has a long foot, another a short foot, a third an indifferent foot. ’Tis the same thing in the Chancellor’s conscience.” Over a century later, however, the judge and politician William Blackstone took aim at the central premise of Selden’s criticism, arguing rhetorically (and dismissively) in his Commentaries on the Laws of England that “if a Court of Equity in England did really act, as many ingenious writers have supposed it (from theory) to do, it would rise above all law, either common or statute, and be a most arbitrary legislator in every particular case.” For Blackstone, equity “in its true and genuine meaning, is the soul and spirit of all law”, and far from being unbridled or unprincipled, is necessarily “bound by law”.

In the 19th century, US jurist Joseph Story likewise rejected Selden’s critique, but explained the subject in a more complex and ambitious way. In his treatise on equity jurisprudence, Story expanded Aristotle’s concept of equity as “justice that goes beyond the written law” into the idea that equity is best conceived as “the correction of the law, wherein it is defective by reason of its universality”. Story went on to explain that, because “every system of laws must necessarily be defective… cases must occur, to which the antecedent rules cannot be applied without injustice, or to which they cannot be applied at all”. As it happens, this description captures perfectly the world of insolvency.

It is axiomatic that debtors should pay their debts. When insolvency strikes, however, it is by definition no longer possible for the defaulting debtor to do so, at least not immediately. Rather, the defaulting debtor’s insolvency typically generates the kind of impossibility that Story had in mind with his conception of equity. The question becomes what to do about the debtor’s embarrassed circumstances. One possibility, of course, would be simply to leave insolvent debtors to the mercy of their creditors and the processes of ordinary debt-collection devices, such as execution, garnishment, and foreclosure. But this has long been regarded as giving rise to a host of additional problems and injustices unique to the insolvency setting, and it is these problems and injustices that collectively define the need for a discrete bankruptcy law.

To begin with, there is the basic problem of how to divide value among the parties under circumstances in which not everyone can be paid in full, including what property should be left in the hands of the debtor free from the creditors’ claims. A corollary problem is deciding what should be done if an insolvent debtor prefers some claimants over others, resulting in distributional disparities among them. Another problem is determining what should be done if an insolvent debtor transfers property for less than fair value. Next is the common problem of an insolvent debtor’s incentives to gamble with his assets in the typically vain hope of recovering his position, and otherwise to delay his creditors. A corresponding problem is the creditors’ incentives to race to the courthouse and pick the debtor apart through the use of ordinary debt-collection mechanisms, even if doing so reduces the overall value of the debtor’s assets as a whole. The list goes on. The point is that insolvency generates a host of unique problems that ordinary legal mechanisms are ill equipped to address adequately – hence the need for a special “equitable” body of bankruptcy law.

Some of these problems, of course, are readily susceptible to relatively standardised bankruptcy solutions in the form of statutory mandates. For example, the prevailing bankruptcy law might stipulate, across the board, how much and what kinds of property an individual debtor may exempt from the creditors’ reach; the kinds of debts that may be discharged; the claims that are entitled to priority in the distributional scheme; the kinds of pre-bankruptcy payments that may be recovered as preferential; and so on. But in addition to administering such garden-variety solutions, bankruptcy courts in the United States are frequently asked to take on insolvency-related problems of a fundamentally different dimension.

Consider, for example, the problems associated with an insolvent air carrier with thousands of employees and billions of dollars in assets. Left to ordinary debt-collection mechanisms, insolvent firms like this would often be doomed to piecemeal liquidation. We sometimes ask our bankruptcy courts to save these businesses as going concerns, and in the process address a multitude of problems associated with rehabilitating them, including labour difficulties, regulatory concerns, financing challenges, and so on. Ideally, we do this when the business is worth saving, which in itself can be difficult to pin down.

It is a sad fact of life that every business eventually fails, and most shut their doors within four years of their founding. Most of these failed businesses are not worth saving because they characteristically suffer from economic distress: they lack a viable operational core capable of generating a profit, and so would never be successful. Some insolvent enterprises, however, suffer merely from financial distress: they are capable of generating a profit, but suffer from excessive indebtedness. These businesses are sometimes worth saving, especially if they represent large, complicated combinations of physical assets and dedicated human capital like our hypothetical airline. Businesses like these are potentially worth saving because they are characteristically difficult to assemble and sometimes even more difficult to replace.

Even more potentially complex are the problems of insolvent municipal debtors like the City of Detroit. In the United States, we ask our bankruptcy courts to reorganise these debtors, too. Once again, we do this on the theory that municipalities are worth saving. And our law approaches these cases as matters properly administered by courts of equity ultimately for a very practical reason: to facilitate complex problem-solving.

In the United States, our peculiar collection of state and federal courts can be divided into two different camps: traditional courts that resolve disputes through traditional adjudicative mechanisms; and problem-solving courts that administer non-traditional forms of relief. Bankruptcy courts fall into the latter group. Our bankruptcy process creates a distinct reorganisation market in its own right superintended by a judge assigned the responsibility of overseeing its operation. To be sure, bankruptcy judges adjudicate some disputes in the traditional way: they take evidence, hear argument, and issue judgments as neutral arbiters. But that is not how salvageable complex businesses and municipalities are actually reorganised in bankruptcy. The reorganisation process as a whole transcends ordinary adjudicative methods and requires a careful balancing of competing considerations.

Chief among them is the tension between accuracy and speed. It is of course important in any bankruptcy case to determine accurately such things as the identity of the creditors, the amount of their claims, and their relative payment entitlements. Typically more pressing, however, is stabilising the debtor and placing it back on its own two feet – which in many cases involving large businesses and municipalities will be a highly customised process. The payment of claims is certainly significant to creditors, but in the insolvency context typically amounts to little more than a wealth transfer. What is truly wealth enhancing is the successful rehabilitation of a viable firm or municipality.

Another concern is the problem of access. Bankruptcy relief should be welcoming enough so that debtors who truly need it, and will make use of it for the rights reasons, do so in a timely manner, but not so welcoming that it becomes an attractive nuisance. Bankruptcy judges help guard the gates to help ensure that this occurs, but the problems they encounter in performing this function can be challenging in their own right.

A third concern is how best to mediate conflicts between stakeholders with radically conflicting agendas. Some may hold interests diametrically at odds with the rehabilitative goals of bankruptcy law. In turn, their relative stakes in the process may turn on complex questions of valuation. The list continues.

Viewed in this way, it is perhaps easier to see why bankruptcy law has endured in the United States as an equitable creation, and why bankruptcy courts are fundamentally courts of equity. It is also perhaps easier to understand why they are, at least in certain key respects, problem-solving courts. It is certainly true that they are (and should be) bound by the dictates of our written Bankruptcy Code; but that same Code, in many of its features, properly demands problem-solving discretion. At least as a general matter, Joseph Story would have approved.

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