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E-MailThe following post comes to us from Eric Posner, Kirkland & Ellis Distinguished Service Professor of Law and Aaron Director Research Scholar at the University of Chicago, and E. Glen Weyl, Assistant Professor in Economics at the University of Chicago.
Chapter 11 bankruptcy is a dizzyingly complex and inefficient process. Voting on potential reorganization plans take place by class, rules are based on achieving majorities and super-majorities by different standards, and a judge must evaluate the plan to ensure it respects pre-bankruptcy entitlements appropriately. Plan proponents can gerrymander plans in order to isolate creditors; hedge funds can buy positions that pay off if plans fail while allowing them to exert influence over the negotiation process; and judges are often unable to stop such gaming. To cut through this morass, lawyers and economists have proposed reforms, such as holding an auction for the firm or offering options to junior creditors that enable them to buy out senior creditors.
While these reforms could make important steps towards improving Chapter 11, they neglect a crucial problem the current system is designed to address: that of collective action. The current owners of various claims on the firm are usually well-suited to play the particular roles they are playing within the capital structure. Because of sunk investments in learning about the firm or their risk-preferences they are the most valuable investors to hold the assets they hold. A reorganized firm that does not have their appropriate participation may not be nearly as valuable as one that does. In fact, it may be better to liquidate the firm, even if reorganization could be efficient, than to reorganize it with the wrong owners.
How can a bankruptcy system capture these benefits of collective decision-making while still obeying the logic of economic efficiency? Until recently no practical mechanism existed for efficient collective decisions and thus the very crude voting rules currently used in Chapter 11 seemed to be the best we could do. However, recently one of us (Weyl) has proposed a new mechanism, Quadratic Voting (QV) that allows efficient collective decision-making in any setting where a group must choose among options. This mechanism can be used to improve Chapter 11, as we argue in a new paper.
Under QV every stakeholder may purchase votes from the firm by paying the square of the votes that she buys. We propose a simple three-stage procedure in which 1) plans are nominated using petitions based on QV, 2) a single reorganization plan is selected using QV, and 3) a final vote is taken on whether this reorganization plan should go forward or the firm should be liquidated. We argue that this system has a number of advantages:
- 1. The firm will (with high probability) be reorganized if and only if this is efficient.
- 2. One of the most efficient reorganization plans will be selected.
- 3. Among the most efficient plans, the one selected will be that which does the best job of assuring no individual is worse off than he or she would be under liquidation, thus respecting pre-bankruptcy entitlements better than an ill-informed judge would be able to, as occurs under Chapter 11.
- 4. The system provides optimal incentives for creditors to invest in improving the firm and acquiring information about it in many circumstances.
While it sounds a bit exotic, we show that, if the judge can assess the value of the firm in liquidation (as is necessary presently), QV can be implemented through an even simpler system in which every individual receives tokens equal to her in-liquidation payout that she can spend on votes at each stage at quadratic cost. Effectively each individual has votes equal to the square root of her claims.
The basic logic of QV is that when people participate in a collective decision, they should be forced to internalize the effect of their choices on others. Under the voting rules of Chapter 11, a majority of creditors who own a supermajority of claims have strong incentives to design plans that transfer value from minorities to themselves. Chapter 11 tries to reduce these incentives by forcing plan proponents to classify like creditors alike, holding class-by-class votes, and requiring judges to enforce various norms, but these second- and third-order rules simply reward the most sophisticated creditors—increasingly, hedge funds which buy distressed debt—who figure out how to game the rules. Under QV, these perverse incentives are eliminated. The more that a creditor seeks to influence the outcome, the more she must pay, while the quadratic cost of voting forces her to equalize the marginal benefit of the vote to herself and the marginal cost to others.
Our system offers the prospects of dramatically simplifying Chapter 11 while avoiding the weaknesses that have limited previous reform proposals, their inability to address the problem of collective action.
The full paper is available for download here.
