The law of creditors' remedies in developed western economies has a dualcharacter. This title reviews the law & economics literature which addresses fourprinciple issues raised by this duality: First, when individualized remedies areappropriate vs. When collective proceedings are called for; Second, should theremedy system be asset-based, or rather should it be based on claimant type;Third, what explains the first-in-time and last-in-time priority system, and thepriority granted to secured creditors under nonbankruptcy law, and when shouldthat law be abandoned in favor of ratable sharing priorities; and finally, whatexplains the existence of corporate reorganization law under which investmentcontracts are modified ex post. The review points out that the existingexplanations found for the last three questions are all subsets of the answersgiven to the first question.

JEL classification: K10, G32,G33

Keywords: Creditors' Remedies, Priorities, Security Interests, BankruptcyLiquidations, Corporate Reorganization.

A. The Development of Creditors' Remedies: An Introduction

1. Legal Rights and Creditors' Remedies

Much of the private law of developed economies consists of the law of civil (asopposed to criminal) obligations. The law of contract, for example, will specifythe legal consequences of the failure to keep promises. Similarly, the law of tortprovides the outcomes when one person's substandard behavior harmssomeone else. The law of property regulates the interactions and relationshipsbetween persons and things, and grants certain entitlements to the "owners" ofthe property. The resulting private law legal "rights" (to have promisesperformed, not to be harmed by others, and to control one's property) naturallyimply legal duties or obligations on the part of the promise breaker, the tortfeasoror the trespasser. Private law not only describes the shape of these rights andduties. It also specifies what steps the state is willing to take on behalf of theright-holder against the persons who owe the resulting duties, in order to seethat the rights are vindicated. The doctrines which describe what steps the statewill take in order that private rights are given effect are known to lawyers as thelaw of creditors' remedies.

The most common legal recourse is substitutionary. Legal rights andobligations are, most often, expressed in terms of the obligation to pay or theright to collect money, calculated usually as the amount needed to compensatethe creditor for the difference between the market value of the creditor's positionin a world in which the debtor performs and the value of that position after thedebtor breaches his or her duty. The creditor's legal remedy necessarily involvesthe use of an agent of the state to seize assets owned by the debtor. The agentwill usually liquidate those assets in some sort of market (typically a localauction), distributing the proceeds of the liquidation sale to the creditor, insatisfaction of the debt.

2. The Relevance of Priority

As long as the legal issue involves only a single creditor disputing with a singledebtor, creditors' remedies can be viewed simply as the teeth which give legalbite to property rights. In any case, in a world in which each debtor had only onecreditor, the law would have no occasion to provide creditors with the rights toobtain security for their loans, nor would the issue of priority among multiplecreditors arise. Understanding financial security devices and priorities as amongcreditors must thus begin with the intuition that when more than one creditorhas claims against any debtor, there is a potential collective action problem tobe solved. Baird (1987a) . There is, indeed, a substantial literature whichquestions whether a serious collective action problem exists in the first place, Adler (1994b) and, if so, of just what must it necessarily consist, and if theproblem is adequately defined, just how adjusting priorities among creditorsaddresses it.

3. Property theory and Race Priority

In legal theory, once the individual creditors' remedy process was carried out,what used to be the debtor's property had become, in effect, the creditor'sinstead. This logic led, in cases with multiple seizing creditors, to a "race"system of priority. Once the first creditor had made item of property "A" his inthe process, item "A" was no longer available to be seized by competingcreditors, because "A" no longer was the debtor's property. Later seizingcreditors, accordingly, were left to look to items "B"...."N" or whatever was leftin the debtor's portfolio in order to satisfy their claims. The creditors' remedysystem was never designed to take A's property away from him and to use it topay B's debts. The priority system resulting from the application of the propertytheory of the law is "the devil take the hindmost."

4. Contractual Priority

Historically, creditors undoubtedly realized that the one-on-one private creditors'remedy of seizure and sale was adequate only in cases when the debtor hadplenty of valuable assets left to be seized. The earliest versions of securedlending were developed from the legal theory of property by the creation ofsimulated sales. The debtor "sold" the collateral to the creditor andsimultaneously, signed a side deal under which the property would bereconveyed to him upon a repayment of the putative "repurchase price" (amountloaned). Thereafter, the debtors' other creditors could not seize and sell thecollateral because it now "belonged" to the secured creditor until thereconveyance price had been paid. On the other hand, the debtor took acorresponding risk that the collateral could now be seized by the creditor's creditors, since it belonged to the creditor until reconveyed.

Lawyers had also developed the property theory of law to permit thefractionalizing of property interests in any asset. Alphonse and Gastogne, forexample, each could own a half interest in all of Blackacre, rather than eachseparately owning the respective north and south halves. At a very early timelawyers were able to extrapolate on the simulated sale technique by exploitingthe legal notion of fractionalized property rights to guarantee the availability totheir creditor client of assets to seize and sell, without subjecting the debtor tothe risk that the collateral might be lost to the secured creditor's own creditors.The "mortgage" interest developed into what was conceived of, in legal theory,as another sort of fractionalized property interest in the collateral, a conditionalright to seize and sell the collateral unless the loan was repaid. Nelson andWhitman (1985) If the debt wasn't paid, then, the creditor could exercise itsparticular fractionalized property right in the collateral (the contingent right toseize and sell the asset upon default) and thus could liquidate it himself toobtain repayment from the proceeds. Correspondingly, the debtor as only oneof the two co-owners of the aggregate rights in the property, could not conveythe collateral to anybody else either since the secured creditor owned thatimportant fractionalized interest in it, and so the creditor was assured that thecollateral would always be available to look to for repayment. Earlier seizingcreditors could seize the collateral but their seizure was effective only subject tothe secured creditor's rights because, until the debt was paid, the fractionalinterest consisting of the right to seize and sell it was "owned" by the creditorand not by the debtor.

B. From Property theory to Security to Bankruptcy Law

5. The Regulation of Contractual Priority

The simulated "sale" of the collateral gave rise to some obvious perverseincentives. After most of the debt had been repaid, for example, the creditor hadan incentive to provoke any default by the debtor so as to be able to assert aright to the collateral as its owner and to retain any funds actually repaid.Gradually, courts began to regulate the secured transaction, by requiring thecreditor to foreclose and sell the collateral, refunding any funds collected fromthe sale in excess of the balance due on the loan to the debtor. By the nineteenthcentury, the legal theory of a mortgage as a conditional property right retainedby the creditor became the ascendent view of the law of secured transactions.Probably because the creditor community sensed that its members would cometo rely on the apparent ownership of persons in possession of property, itbecame a legislated requirement that fractional, conditional interests like themortgage not be kept secret, so that the enforceability of the bargain for securitywas made contingent on the lender's giving of a public notice of the existenceof the mortgage interest. Baird (1983) The legal property rights theory of thevalue of security devices described above continues to be the favoredexplanation for their existence even today, by some commentators. Harris &Mooney (1994) .

6. The Emergence of Modern Bankruptcy Legislation

Finally, in the United States, in the twentieth century, the above describednonbankruptcy creditors' remedy system, with its race for priority feature,became supplemented (and often supplanted) by National bankruptcy legislationwhich provided for a collective proceeding to be conducted in which the debtorand all of his creditors settled the debtor's affairs in a single case. The federal1898 Bankruptcy Act was extensively revised in 1938, and then again in 1978 sothe last century has seen much evolution in the legal details of bankruptcy

proceedings. Nevertheless, the conventional legal view is that bankruptcy isrightfully seen as a staple feature of the background law which establishes theAmerican capital and asset markets. Warren (1987)

C. The Four Strands of the Law & Economics Research Agenda

As the above summary of legal doctrine suggests, there are really two systemsof remedies existing concurrently, the nonbankruptcy system which, in theUnited States, is a creature of the law of each of the 50 sovereign states, and theFederal law of Bankruptcy. The mission of Law and Economics scholarship isthus to explain the existence of each of the two systems, and justify the shapesof each. There is also the question of how to coordinate the two systems -- theissue of which system should govern and in what circumstances. Existing Lawand Economics Analysis, has tended to focus on four salient features of thenonbankruptcy system and how its outcomes tend to differ from the bankruptcyoutcomes. The four strands of the literature can be described as follows:

7. Individual vs. Collective Proceedings ?

First the nonbankruptcy system can be fairly characterized as a system ofremedies given to individuals. It focusses on a debtor and a creditor, and on theprocedures which effect only those two parties. Bankruptcy systems, incontrast, are inherently collective, involving all of the debtor's creditors in thesame legal proceedings. Thus it is fundamental to explain how these twodiametrically opposed approaches can both be justified and explained: Are thereidentifiable environments in which one of these alternative systems isappropriate and others in which the converse is more likely to yield efficientoutcomes?

8. Asset or Claimant Based Remedies ?

Second, the nonbankruptcy creditors' remedy system focusses on discreteassets in the debtor's inventory. Creditors seize only specific assets, which arethen auctioned off. Likewise, security interests convey fractionalized propertyrights only in identified assets which are the collateral for the secured loan orcredit. The creation of collective remedies, on the other hand, opens thepossibility that priority ranking could be determined by the characteristics ofcreditors, and could be applied to all of the debtor's assets as a groupanalogously, for example, to the interests of common and preferred shareholdersin a firm. The issue is then to explain when and how asset-based as againstclaimant-type based systems are appropriate.

9. Justifying Priorities ?

Third, the priority system is a mixed one. As among creditors using ordinarylegal process to enforce their obligations, the first to complete the process andseize an asset has a priority right to the proceeds of the auction of that assetover the second to seize. Holders of security interests can finish in the racesystem, on the other hand, not in the order in which they seek to enforce theirrights, but rather in order roughly of the times at which they contracted for thoserights. In a collective proceeding, on the other hand, it is administrativelypossible to conceive of other priority systems which, to note the commonexample, adopt ratable sharing distributions as opposed to lexicographicpriorities. Explaining the contrasting systems, accordingly, requires thedevelopment of theories of priorities.

10. Reconfiguring Contractual Priorities Ex Post

Fourth, Chapter 11 of the U.S. Bankruptcy Code, which is thought to be a modelfor collective collection law devices applicable to corporate debtors in thedeveloped and developing world, features a system which alters contractuallyagreed priorities ex post. How can these such devices be justified and explained?

A complete economic analysis of creditors' remedies must explain each of thesefour features of the existing dual creditors' remedies system. It is fair to introducethe literature addressing these problems by observing that much explainingremains to be done. What the extant literature does contribute to understandingthese features is discussed, issue by issue, below.

D. Should Collection Law provide Individual Remedies or Should it ProvideCollective Proceedings?

11. The Costs and Benefits of Multiple Party Involvement

Nonbankruptcy law's preference for an individual versus a collective system ofcreditors' remedies is presumably based on the avoidance of unnecessary costs. Bowers (1990) argues that involving creditors (A,B,C,...M) in a dispute betweenthe debtor and creditor N is likely to be unnecessarily costly. If the systemprovides easy means for A,B,C,...M to intervene into the Debtor/N dispute, theirfailure to intervene is good evidence that involving them would be wasteful.Thus the historical face-to-face nature of creditors' remedy law can beunderstood. Nevertheless, there may be instances in which economies of scaleexist in the expenditure of collection effort. Kanda and Levmore (1994) argue inthose cases a residual pool of creditors would agree to employ common agentsto pursue collection efforts, and likewise agree to share in the costs of that effortby adopting a pro-rata distributional rule such as is commonly understood tocharacterize bankruptcy regimes. The issue thus framed is an empirical one. Thefact that the average recovery by creditors in all bankruptcy proceedings iseffectively zero (one cent on the dollar) LoPucki (1996) suggests that the casesin which the advantage rests with collective strategies are few.

12. The Collective Action Problem Model

The most famous law and economics analyst of bankruptcy systems made hisname by arguing that when a single debtor has multiple creditors, the creditorsmay have a collective action problem. The individual incentives of each are toact in ways contrary to the best interests of all. Jackson (1982) He thereforproposed that the creation of a mandatory collective remedy, which reflected theterms of an idealized multiple-creditor contract to cooperate, could be justifiableas a means of overcoming the collective action problem. Bankruptcy law couldbe explained if it actually incorporated the terms of that idealized "creditors'bargain." The literature developed in three directions from Jackson's basicinsight.

(a) Does the Law Correspond with the Model

First, there is a question whether the quest for efficiency (for example providinga legal solution to the"common pool" problem creditors face under his analysis)could plausibly be regarded as driving the substance of the actual, existingbankruptcy doctrine. This first line of inquiry was addressed by Jackson himselfwith his collaborator Douglas Baird. They first attempted to apply the creditors'bargain heuristic to predict the features that an efficient bankruptcy statutewould contain. In a series of pathbreaking articles, however, they discoveredthat the manner in which American Bankruptcy Judges were applying theprovisions of Federal Bankruptcy legislation differed from those predicted bytheir efficiency hypothesis. Jackson (1984) and (1985) , Baird & Jackson (1984) and (1985) . Jackson & Scott (1989) attempted to account for the previouslyobserved inefficiencies as an insurance mechanism, but conceded that themechanism was unlikely to prove workable.

(b) Is There Really a Serious Collective Action Problem after all -- Is the ModelItself Theoretically Sound?

Research in the second direction challenged the soundness of Jackson's initialanalysis. The "Creditors' Bargain" logic grew from the premise of an assumed"common pool" problem in which, when the debtor neared insolvency, assetsseized and sold by creditor A tended to directly harm creditor B becauseinsufficient assets were left behind to satisfy all remaining claims. This premiseis more than simply distributional. Jackson argued, for example that crediter Awould not take the costs to B,C,....N into account in making his decision tocollect. Thus A would not avoid taking actions which destroyed synergisticvalues to the assets in the debtor's portfolio. A creditor owed $100 might take avaluable earring whose stone could be sold for $100, even when it was a memberof a matched pair worth $300 when kept and sold together. Such losses wereavoidable, under Jackson's analysis, by forcing all the creditors to actcollectively. Thus, he argued, the nonbankruptcy system had created a systemof perverse incentives which, on the occasion of insolvency, were cured byswitching over to the bankruptcy model.

Influenced by empirical evidence that the adoption of bankruptcy law hadresulted in zero payouts to the supposedly cooperating creditors, Bowers (1990) argued that the Jackson's view was one-sided, because it looked only at theincentives facing the creditors and either ignored the existence of the debtors,or assumed implicitly that debtors were completely passive. Bowers argued thatdebtors had both the means at hand and the incentive to avoid the lossesJackson predicted would result from perverse creditor common pool incentives.Among the means available to a debtor under the nonbankruptcy system, wasthe power to optimally liquidate its assets, and, indeed, subsequent empiricalresearch on the behavior of financially distressed firms LoPucki & Whitford(1993b) , Gilson (1996) shows that they do, in fact, conduct substantial assetliquidations. Once the debtor's incentives are brought back into the picture, thehypothesized common pool problem disappears, leaving us once again withouta persuasive economic justification for the adoption of bankruptcy law.

(c) Are there Other, Better Solutions to the Collective Action Problem?

The third line of argument spawned by the Jackson "Creditors' Bargain" Thesistook the law & economics literature in a new direction. It argued that whateverex post collective action problem the nonbankruptcy system might create can beavoided by the use ex ante of optimal credit contracts. Adler (1993b) . Picker(1992) for example, justified the invention of security devices such as mortgagesby showing that the adroit use of security could eliminate common poolproblems. Bowers (1991) argued that the default terms of the existingnonbankruptcy system of secured and unsecured credit already provided theterms of optimal credit contracts, which tended to induce efficient distributionsof the distressed debtor's least critical assets first to its most vulnerablecreditors, thus minimizing the size of aggregate distress losses. Finally, a numberof scholars began to argue that the common pool or other perverse incentiveproblems which might occur in the nonbankruptcy system could be handled bycontract. Adler (1994c) Since corporate debtors probably dominate the economicimpact of the American bankruptcy system, corporate finance approaches to theproblem of understanding bankruptcy law have argued that borrowing firms arecapable of creating new kinds of securities with attendant options andcovenants, which can obviate any common pool problem Since this literaturetends also to address the issue of alteration of contractual priorities ex post, itwill be discussed below in connection with this last issue.

E. Asset vs. Creditor-type as the Basis for Remedies (Herein of the Law &Economics of Security Devices)

13. The Legal Justification for Security

Simultaneously with the bankruptcy debate discussed above, the law &economics literature was also engaged in a vigorous debate about thejustification for granting contracted-for priority rights to secured creditors. Thelegal view of the justification, as exemplified in Kripke (1985) and Carlson (1994) was that security, by reducing the credit risk borne by the secured lender,tended to make loans available that creditors would not make on any other basis,and so security interests could be justified on the same grounds that justifiedthe extension of credit itself. In what is, perhaps, the most important article in thelaw & economics literature concerning priority and security issues, Jackson &Kronman (1979) first developed and used the "creditors' bargain" theory soinfluential in the bankruptcy literature, to provide an economic explanation forthe development and use of security devices. They argued that an aspect of thecreditors' collective action problem was a perverse tendency for creditors toexpend duplicate efforts thus over-monitoring the debtor. Security, theyconcluded, if issued to the least efficient monitors, relieved them of the impulseto monitor, curing the perverse incentive, reducing unnecessary monitoringcosts because only the most efficient monitors would have any remainingincentive to do so.

14. The Secured Debt Puzzle

In 1981, however, Alan Schwartz (1981) showed that given some typicaltheoretical economic assumptions (completely informed, risk neutral creditors,with homogeneous expectations of the probability of default), the grant ofsecurity to a secured creditor tended to do more than just reduce risk to thatlender (thus reducing the incentive to conduct duplicative monitoring). In fact,the grant transferred risks onto unsecured creditors, who, under thesetheoretical assumptions, would demand as much compensation for accepting thetransfer, as the secured party was likely to give as a discount on the interestpremium for being granted the security. The corollary, as applied to the Jackson& Kronman monitoring thesis was that to the extent secured creditors couldsafely reduce their monitoring efforts, the grant of security correlativelyincreased the need for unsecured creditors to monitor, so that the theory couldnot predict any savings in aggregate monitoring costs either. Following JamesScott (1977) Schwartz argued security was in theory simply a zero sum game. Ifthe confection of security interests is costly, then, the mystery is, why woulddebtors ever grant them when they stand to gain nothing by it. This analysis,Schwartz pointed out, was simply an application of the famous Miller/ModiglianiTheorem of the irrelevance of capital structure, Miller & Modigliani (1958) . Theargument created what he named, and what has since been known as "ThePuzzle of Secured Debt. Schwartz (1984) . Just as firms obviously invest muchenergy in designing and adapting their capital structures, they also issuesecured debt in the teeth of theories which predict they won't. Schwartzconcluded, however, that none of the then-existing theoretical explanations forthe employment of short-term security devices could be squared with theempirical evidence, the patterns of secured lending actually observed.

15. Possible Efficient Puzzle Solutions

The Schwartz thesis, that granting security is costly to debtors, and gains themnothing is, of course, contradicted by the observation that much securedlending and borrowing actually occurs. It has been observed Shupack (1989) that the costliness question is relative - i.e. the Schwartz argument loses someof its punch if it is more costly to contract for unsecured lending than to take asecurity interest. Nevertheless, any explanation for the grant of security mustprobably show that the issuing of security is likely to be efficient, so that someprivate gains to the borrower and secured lender must be hypothesized.Theories which explain the private gain as coming from externalizing risks ontouncompensated unsecured creditors, of course, are normatively unattractive. Schwartz (1984) examined several proposed more benign explanatory answersproposed to his original puzzle, including those of Levmore (1982) (proposingthat secured parties receive priority in payment for the external benefits theirmonitoring of the debtor confers on other creditors) and White (1984) (arguingthat creditors differ in their levels of risk aversion so that security is arguably anefficient means of reducing risk to the most risk averse). Schwartz dismissedsuch theories which, by explaining the existence of private gains to borrowers,however, generate predictions that all borrowing will be conducted on a securedbasis, such that all of every borrower's available assets will be encumberedbefore any unsecured borrowing occurs. All such theories, Schwartz argued, willbe embarrassed by the fact that much unsecured lending takes place toborrowers with unencumbered assets. It thus seems likely that an eventualpersuasive theory will have to show that security is both costly and beneficial,or else that unsecured lending achieves previously unknown gains, in order forit to explain the observed mixture of types of borrowings. A number of suchtheories have been proposed, which argue that the institution of security islikely to be efficient, including Adler (1993a) , Bowers (1991) , Buckley (1986) and (1992) , Kanda & Levmore (1994) , Picker (1992) , Scott (1986) , Stulz & Johnson(1985) and Triantis (1992) and (1994) . Without some strong empiricalconfirmation of any of the competing theories, however, none has yetcommanded a general level of acceptance in the Law & Economics Community.Indeed, the current majority view is probably that the debate over the puzzle ofsecured transactions has been inconclusive. Scott (1994)

16. Inefficient Solutions to the Puzzle

The inconclusiveness of the search for "benign" explanations for securitydevices, which explain the use of security as justified by the creation of efficientoutcomes, has led to a recent spate of arguments that the institution of securedcredit is not only unproven as an efficient practice, but, to the contrary, ispositively exploitative, and thus inefficient. Schwartz (1981) had initiallyconsidered that security devices were employed by lenders and borrowers asmeans of exploiting creditors, like tort claimants, or consumers who wereunsophisticated about the impact that security might have on their claims andwho would, therefore not increase the risk premiums they charged for becomingunsecured creditors. The distributive thesis, Schwartz argued, could only beproven by showing that firms whose creditors were likely to be unsophisticatedwere more apt to grant security interests than were borrowers whose othercreditors were less easy to exploit. Such behavior should even be evident, andthe fact that it isn't led him to dismiss the exploitation hypothesis. Nevertheless, LoPucki (1994) and Bebchuck & Fried (1996) have recently proposed that thepriority extended to secured lenders be partially or wholly abolished to preventthe externalization of risk onto unsophisticated unsecured lenders. Scott (1994) has also suggested that the incentive structures inherent in the privatelaw-proposing organizations which produced the American uniform law onsecurity devices may also create perverse legal doctrine. Adler (1994a) arguesthat the Scott hypothesis results from a one-sided analysis. Harris & Mooney(1984) and Carlson (1986) have urged that in view of the inconclusive nature ofthe economic debate, that the institution of secured credit can be justified byresort to the historical legal theories which have been accepted by courts andlawyers. None of the exploitative or political theories of secured lending have yetgained general acceptance among scholars, as explanations for the institutionof security. The Puzzle, thus still remains to be solved, or, to say the same thingin another way, none of the existing theories which attempt to explain theinstitution, has yet been proven correct.

17. Asset-Based Security as an Individual Remedy

Schwartz (1989) attempted to change the focus of the argument he himself hadcreated by arguing for the grant of first priority over all of the debtor's assets infavor of the the borrowing firm's earliest-to-lend financier. Under his analysis,the grant of priority, which is the functional equivalent of the grant of securityin all the borrower's assets, can be an efficient way for firms with good projectsto signal that they differ from firms with poor prospects. Since the first-in-timepriority scheme he proposes resembles the priorities created under the existinglaw of secured credit, his argument reduces to a plea that the priority system cutloose from the asset-based nature it carries under existing security device law,and that a creditor-based priority scheme be substituted therefor. His argumentfor this change is based, in part, on his assessment that the process of tyingpublic notice to particular assets in the current regime is unduly costly. Bowers(1995) discusses some theoretical reasons why filing systems might imposeexcessive costs. Kanda & Levmore (1994) , on the other hand, argue that noticeis especially important only in asset-based priority schemes, and is thus, not soimportant if priorities are based on creditor characteristics as Schwartz proposes.Schwartz does not address the inevitable aspect of his proposal, however, thatit must necessarily trigger some sort of collective collection proceeding in almostevery case of nonpayment. Any second-to-lend creditor whose contract entitleshim to be first to collect (as for example when a short term trade creditor isseeking to collect against a debtor who has financed himself with a relativelylong term loan from the first-to-lend creditor) must involve the long termfinancier as well as the debtor in any claim that his debt ought to be satisfied outof any of the debtor's assets in all of which, under Schwartz's proposal, thefirst-to-lend financier has a priority interest. Although Schwartz offered hisproposal on a conceptual basis only and so can't be faulted for not havingworked through the multitude of legal details which its adoption wouldinevitably necessitate, it is difficult to imagine that the debtor could evenvoluntarily pay the second-to-lend creditor with assets in which the first-to-lendhad a superior interest. This look into Schwartz's latest proposal, on the otherhand, does generate an explanation for the character of current security devicelaw which is asset-based, and not creditor based. In an asset based system, inwhich all the debtor's assets are encumbered, every unsecured creditor must dealwith the prior secured lender in order to realize payment of his claim out of anyof the debtor's assets. In that kind of case, an asset-based priority system canbe seen as requiring a collective determination of the relative rights of at leasttwo creditors every time only one wishes to collect. Unlike a creditor-basedsystem, however, an asset based system permits debtors to retain someunencumbered assets which creditors can resort to without having to trigger acollective proceeding. The choice of asset vs. Claimant-based priority rules,then, can be seen as another aspect of the choice between adoptingindividualized vs, collective creditors' remedies. Particularly when priority rulesare claimant rather than asset-based, and claimants exist in large classes (suchas, for example, when there are many shareholders and many unsecured creditorswho share strata of priority), for any individual member of any class to collect,a legal proceeding almost necessarily must involve all the members of theclaimant's own class, as well as all the members of any competing class in theprocess.

F. The Economic Analysis of Creditor Priorities

18. Nonbankruptcy First-In-Time Priority

As has been previously set out, existing legal doctrine contains two different,but concurrent priority paradigms. The nonbankruptcy system of individualremedies is, principally, one of temporal priority. Early lending secured creditorsand early seizing creditors prevail over later ones. There are, however,exceptions. One of the chief deviations is in favor of later lending secured partieswho are granted a "purchase-money" priority over earlier lenders claimingsecurity interests in the same collateral. Certain statutory lien claimants alsoprevail over earlier perfecting secured lenders. In admiralty, there are manylater-in-time but first-in-priority claims to interests in vessels. Lawyers probablydeem the first-in-time priority as the general rule, and the last-in-time prioritycases as exceptional. Probably for that reason, the law and economics analysishas begun by attempting to understand the general rule first. Very little progresshas been made in explaining the last-in-time priority cases. Before discussingwhat there is on that score in the literature, therefore, we will first address thetemporal priority scheme in general.

(a) Capricious Factors influencing racing outcomes

The outcome of the race among unsecured creditors can be influenced by avariety of arbitrary factors. Among the most capricious is the variance amongcourts in time-lags for obtaining judicial relief. The race is normally won bysuccessfully completing a lawsuit, after which a judgment can be entered. Theright to seize and sell the debtor's assets is usually assertable only afterjudgement has been obtained. Ceteris paribus, then, creditors suing injurisdictions which have a year or more delay between the time a suit iscommenced and the time at which it will be called for trial, will be disadvantagedin the race as compared with competing creditors who are capable of maintainingtheir actions in venues with shorter trial calendars. Perhaps to eliminate thecapricious effects of these arbitrary factors, the common law developed a set ofdevices under which a creditor can, at the time of commencing judicialproceedings, reserve an early place in the order of finish, conditional only oncompleting the judicial proceedings.

(b) Finish-place reserving devices and investments in collection

The race system's prejudgment finishing-place-reserving devices such as writsof attachment or sequestration, or notices of lis pendens, if freely available,would make the race among unsecured creditors more closely resemble the orderin which their causes of action arose, and thus susceptible of more reliableplanning at the time credit is initially extended. The creditor making the first loanto become due would be more likely to become the first-in-line. In the last 30years, however, the use of prejudgment writs has been restricted in the UnitedStates on constitutional grounds in a series of important U.S. Supreme Courtcases: Snaidach v. Family Finance Corp . 395 U.S. 337 (1967); Fuentes v. Shevin 407 U.S. 67 (1972); North Georgia Finishing, Inc. V. Di-Chem Inc. 419 U.S. 601(1975). The court found the writs objectionable, however, only on grounds thatthey invaded constitutional interests of the debtor. Their impact on the priorityas among creditors was not attacked, and it is conceivable that constitutional,prejudgement priority-reserving devices could still be designed to meet thatneed. Indeed, however, the recording of public notice of a security interest is anequally effective way of reserving a priority position at the time credit isextended, and thus may have rendered the prejudgement collection writssuperfluous in any case.

Much unsecured credit is extended on a demand basis, however, so that aninitial lending unsecured creditor cannot easily assure himself a head-start in therace system if he lends for a fixed term. Later demand-basis lenders will alwaysbe able to get the jump on him. Typical loan agreements attempt to enhance thelikelihood of a more nearly even starting time, however, by permitting lenders toaccelerate the due date upon adverse information, for example the calling in ofa demand loan by another creditor. Thus, while one might argue that thenonbankruptcy priority system has a tendency to favor the earliest to lendcreditor, it is more likely that it favors the earliest to discover the circumstancesputting the debtor in default. This tendency of the unsecured creditors' racingsystem to induce careful creditor monitoring of the debtor has been regarded inthe literature as a mixed blessing. Monitoring tends to reduce debtormisbehavior, but the system also tends to induce creditors to monitor eachother, a potentially wasteful expenditure in light of the possibilities that creditorscould agree to cooperate rather than compete with each other in monitoring.Indeed, however, Picker (1992) has shown that the use of security devices tendsto enable creditors to avoid some of the expenses of monitoring each other. Bowers (1991) on the other hand, has argued that those creditors who are mostvulnerable to losses from debtor default will be apt to invest in contract termswhich permit early starts in the race, and will also make the greatest investmentin racing, and thus tend to obtain proportionately greater recoveries than willcreditors who are less vulnerable. Thus, it is arguable, that the tournament-likesystem of the race among unsecured creditors has a tendency toward efficientoutcomes. Those who invest in winning the race are presumably the moreefficient creditors, and will be rewarded by the existing nonbankruptcy system.

(c) Payments as Priorities and the law of Preferences

The far more promising strategy for unsecured creditors to planning on winninga race through the judicial process, is rather to create incentives to inducedebtors to voluntarily repay their debts. Credit contracts can and do frequentlycontain provisions which are designed to induce a debtor to pay a particulardebt instead of other ones. Discounts for prompt payments and penalty orlate-fees, are common such devices. Creditors with whom the debtor does repeatbusiness are also in positions of leverage, capable of cutting off profitable futurebusiness if past debts remain too long unpaid. The utility companies, by threatto cut off power and water to their deadbeat customers are only the mostobvious examples of creditors who can employ such strategies as substitutes forjudicial collection effectively. Nevertheless, even if the collection tournamentincludes nonjudicial strategies, it is still arguable that those creditors mostvulnerable to loss will invest the most in designing contractual inducements forvoluntary preferential repayment, and will invest most in post-default collectionactivity, and are thus likely to be preferred.

One typical structural feature of bankruptcy law, however, is a doctrine thatsets aside preferences. In order to discourage premature dismemberment ofpotentially viable firms, it is argued, measures need to be taken to discouragecreditors from "opting out" of the bankruptcy fixed priority scheme in advanceof the bankruptcy proceedings. Jackson (1986 at 125) . If the tournament-likeresults of debtor preferences are likely to produce efficient results, (payments tothe most vulnerable creditors first, and in such a way as to maximize the valueof the debtor's remaining portfolio left available to the remaining creditors) thenthe need for an efficient collective regime, particularly one to be protected bypreference law, is questionable. What is more, Adler (1995) has shown inaddition, that for corporate borrowers, the existence of a collective actionproblem itself impedes the effectiveness of any rules which attempt to prohibitdebtors from making preferential transfers to creditors, and that preferenceprohibitions may in fact diminish the value of the debtor's estate available tosatisfy the claims of its creditors.

19. First-to-Perfect Priority Among Secured Creditors

The first-wins priority scheme for secured creditors is explainable on a morestraightforward basis. In it, each creditor can fix his or her place in the race forthe debtor's assets at the time credit is extended. Those making later loans willbe on notice that they will come in second in the race, and can thus adjust theamount they choose to lend and the terms of their credit contracts to account forthat fact. The expenses of earlier lenders in accounting for later creditors is likelyto be exorbitant since the facts about later loans cannot be learned at the timethe contracts are entered into. Thus, the basic secured creditor priority systemcan be explained as the one which permits the creditors to adjust to each othermost cheaply. To the extent that this rationale is explanatory, however, it alsomakes the few instances in which last-to-lend creditors are given priority, evenmore mysterious.

20. Nonbankruptcy Later-In-Time Priorities

The earliest attempt to provide an economic explanation for a later-in-timepriority involved the so-called "purchase-money-priority" of lenders who takeas collateral, the very assets purchase of which their extensions of creditfinanced. In an asset-based lending system, this transaction might be viewed asa first-in-time transaction because the taking of security in the asset occurs atthe very first instant at which the collateral became part of the debtor's estate.The American Uniform Commercial Code, however, contemplates that borrowerscan grant security interests to earlier lenders in after-acquired assets. Thepriority of the purchase-money lender, consequently, simply means that thepurchase-money financier prevails over the after-acquired property interest ofthe earlier lender. Thus, what looks like a last-in-time priority may also be seenas nothing more than a limitation on the powers of debtors to pledge, and oflenders to take security in future assets. None of the investigations to date,however, has asked whether there are efficient limits to the pledge ofafter-acquired assets. Jackson & Kronman (1979) addressed purchase moneypriority as if it were a preferred default clause in the credit contract which createdthe earlier security interest in after-acquired collateral. Unless it could grantpurchase-money priority to future lenders, they argued, the debtor waseffectively committed to obtain all future financing from the initial lender. Sincefew debtors would willingly grant situational monopolies to lenders withoutasking for significant other concessions, they hypothesized that the parties tothe initial credit contact would choose a purchase-money escape hatch clausein their contract, and were saved the expenses of doing so by the priorityprovisions of the Code. Schwartz (1989) in his proposal to permit first priority tothe first significant financier in all of the debtor's assets also argues that theparties might bargain for purchase money priority exceptions for sufficientlyinsignificant after-acquired asset purchases.

The latest attempt to explain later-in-time wins priority provisions is Levmore& Kanda (1994) .They begin by espousing the recent trend in the law &economics literature, to assume that existing doctrine was intended to addressthe problems of corporate borrowers. They then argue that the basic first-in-timegets priority rule is justifiable as a means of protecting early lending creditorsfrom the perverse incentives which attract the equity owners of corporateborrowers to overinvest in excessively risky projects. Not all investments in thefirm necessarily exacerbate the overinvestment incentive, however, and, Levmore& Kanda surmise, later lenders have an informational advantage over earlierlenders about new investments the firm is undertaking. When, then, theinformational advantage is significant, and the environment is such thatoverinvestment is not likely to to be a serious risk, they argue, one might expectto see a later-in-time priority rule to displace the basic scheme, as a means ofencouraging investment in the firm's latest prospects by well-informed lenders.This approach to explaining the mystery of late-in-time priority rules seemspromising. On the other hand, the argument that each existinglater-lender-gets-priority rule can be explained as being confined to anenvironment in which overinvestment risk is minor is, empirically speculative.

21. Liquidation Bankruptcy Priority

The shape of the asset-based, first-in-time nonbankruptcy priority systemconforms to the underlying assumption that the collection of obligations shouldbe regarded as an individual matter, strictly between the debtor and the creditor.They are free to write credit contracts which meet their individual needs, and topursue the remedies they have bargained for on the basis of their individualcircumstances. Particularly, however, once the debtor nears insolvency, theactions taken by any individual creditor arguably create a risk of external impactson the welfare of competing creditors. Nothing in the contracting system inwhich the extension of credit is bargained-for requires any creditor to modify theterms of his contract in order to coordinate his contract rights, or his ultimatelegal remedy, with others who may have an interest in the debtor's fortunes.American lawyers intuit that on the occasion of insolvency, some sort ofcoordination among creditors is required and on that basis have built their basicunderstanding of the justification for bankruptcy law.

The basic priority system in the collective regime is complicated by the factthat, in theory, bankruptcy is designed to partially enforce the rights creditorsacquire in the nonbankruptcy system. Thus, for example, secured creditors aretechnically entitled to recover the value of the collateral securing their debt tothe extent that it is less than or equal to the amount owed. The extent to whichthis entitlement is enforced in actual bankruptcy proceedings, however, dependson whether the particular bankruptcy is a reorganization or a liquidation case.Reorganizations are discussed in part VII. below. Since the legal priority ruleswhich nominally create the baselines for distributions in reorganizations are thepriorities which prevail in liquidation cases,, it is useful to discuss these rulesfirst.

(a) Class-Based Distribution

The archetypical bankruptcy proceeding is Chapter 7 of the U.S. BankruptcyCode. It can be initiated by either the debtor or a group of creditors, and oncethe proceedings commence, all individual collection activity by all creditors isstopped by the issuance of an automatic injunction. Almost immediately, thebankruptcy trustee, an agent to represent all the claimants, is appointed, andgiven control over all of the debtor's assets. The trustee then liquidates theassets, either in the ordinary course of the debtor's business, or else by auction,converting all of them into cash. The proceeds from the sale of collateral are paidto secured creditors. The remaining cash is distributed to various creditorsaccording to the Chapter 7 priority scheme, which first sets up a set of severalclasses of creditors holding "priority claims." The claims of the first priority arepaid in full, and only in the event there is cash remaining, are distributions madeto the next class, and so-on until all claims are paid. Creditors in the last class forwhom the assets are sufficient for a distribution, but not enough to satisfy all theclaims in the class, receive partial payments of the sum left undistributed in thedebtor's estate, but are paid among themselves in proportion to the size of theirclaims -- the so called "pro-rata equality" formula.

The literature has not addressed the question whether the existing fixedpriority scheme of liquidation bankruptcy regimes can be economicallyexplained. The first priority class are so-called "administrative priority" claims.The preference shown to these claims can probably be understood best asanswering the need that the costs of the collective proceeding must be paid ifthere is to to be any proceeding, but in fact, the bulk of all U.S. Bankruptcy casesare those of individual debtors whose assets have no remaining distributablevalue once they enter bankruptcy. Bowers (1990) argues that debtors attemptingto maximize the value of their assets will self-liquidate, before their creditors forcethem to do it involuntarily, and that the result of such self-liquidations will bethat only highly specialized assets, and those which have the highesttransaction costs to liquidate will remain in the debtor's inventories as of the timethey are surrendered to creditors. The fact that the bankruptcy estates ofindividual debtors are basically empty can thus be explained.

(b) Sympathetic Classes

The remaining classes of priority claims are more difficult to justify on efficiencygrounds. Unpaid employees, certain farmers and fishermen, and some consumershaving made deposits on undelivered merchandise are sympathetic creditorswho might to be expected to find favor in the legislative arena in whichbankruptcy legislation has traditionally been crafted. Tax collectors get priorityfor similar easy-to-understand political reasons, even if they do not merit muchsympathy. The existing list of priority creditors does not exhaust the list ofpossibly sympathetic claimants. The omissions inspire demands that tort-victimsof the debtor be given priority, even over the claims of secured creditors, forexample LoPucki (1994) .

(c) Behavior Invariant Loss Sharing Rules

The principally important feature of the statutory priority system, however,including the catch-all pro-rata formula for the bottom priority creditors is thatit is fixed in advance, and thus, will not vary with creditor behavior. In thenonbankruptcy race system, for example, a creditor stands to make gains fromobtaining information earlier than competing creditors so as to get a head-startin the race for the debtor's assets. The payouts in the collective regime, howeverare fixed in advance, and will not vary much according to creditors' investmentsin monitoring or collection efforts. A creditor who carefully monitors the debtor,thus must share with the other creditors the gains from early detection if acollective proceeding ensues. If over-monitoring is a potential problem Jackson& Kronman (1979) , or if racing costs are viewed as potentially wasteful Jackson,(1982) , then the fixed priority system imposed by bankruptcy law, might bejustified as a cure for the adverse effects of those perverse incentives. On theother hand, it has been shown in other contexts, that mandatory equal sharingrules can block co-owned assets from being moved to higher valued uses. Easterbrook & Fischel (1991, p. 118) , Kahan (1993) , Harris & Raviv (1988) . Thesharing regime gives some creditors incentives to free ride on the efforts of othercreditors to monitor and force an ultimate liquidation. In the face of empiricalcomplaints that bankruptcy proceedings might thus not be initiated soonenough, there are proposals in the literature to pay a bounty to the creditor whotriggers the collective proceeding. Jackson (1986) , LoPucki (1981) . Of course,bounties are difficult to design, and may give rise to races for the bounty,over-monitoring so as to to be able to win the race to the bounty, etc. Theperfectly designed, happy medium liquidation bankruptcy structure whichavoids both sets of perverse incentives, however, has not yet been developedin the literature.

G. Corporate Reorganization Bankruptcies and Ex Post Modification ofContractual Priorities

22. The Problem of the Corporate Borrower

The most heavily studied aspect of the issues raised in this title, is the questionof what should be done when corporate borrowers incur financial distress.Although the bankruptcy code applies to individuals and other kinds of entitieswhich become borrowers, the law and economics literature on this question hastypically attempted to explain bankruptcy solely as a means of solving thecollective action problem which corporate investors will forseeably face. Untilrecently, the literature has assumed that the archetypical corporate bankruptcylaw was Chapter 11 of the U.S. Bankruptcy Code. The collective action problemis seen as the result of the content of the borrower's ex ante credit contracts andthe nonbankruptcy law of creditors' remedies which permits creditors to race for,seize and sell the firm's assets. Bankruptcy law could be justified and understoodif it addresses the collective action problem by refusing to enforce thesuboptimal prebankruptcy market credit contracts and altering their terms ex postso that the set of post-reorganization claims against any debtor firm will moreclosely approximate an optimal capital structure.

Recently, however, the companion literature on comparative corporategovernance has raised the interesting possibility that Corporate reorganizationmight be just an American problem. Mark Roe (1994 - Ch 11) has shown thatGerman and Japanese firms, for example, are subject to a great deal ofmanagement control by their financing banks, who also wield influence with thefirm's other suppliers and customers. The relational lending regimes which resulthave the potential to essentially privatize the process of reorganizing financiallydistressed firms. Roe points out that the relational techniques have beenpolitically outlawed in the U.S. which might explain the American preoccupationwith corporate bankruptcy law.

23. The Illusive Problem of Optimal Capital Structure Design

Presumably since any given firm's optimal capital structure cannot be specifiedin advance, the law of corporate reorganization replaces the nonbankruptcy andliquidation bankruptcy result of predetermined priorities with anon-predetermined scheme. The priority rights in the reorganized firm are notspelled out in the statute. Rather, it provides an extensive set of proceduresunder which a "plan of reorganization" is developed and adopted for eachbankrupt firm. The actual priorities awarded the claimants holding prebankruptcycontracts, then, is specified only ex post, in the plan. It is well understood, thatthe procedures under which such plans are developed dilute the value ofcontracts which provide for the claimant to receive high priority, and,correlatively, enhance the distributions to those whose contracts called for themto have the lowest priorities. What is not so well understood, however, is howaltering the prebankruptcy priority contracts contributes to the solution of anycollective action problem. Adler (1992)

From a law & economics viewpoint, the efficacy of this legal strategy foravoiding the collective action problem depends on whether we have developeda comprehensive theory of optimal capital structure for any given type of firmin the first place. If a firm's optimal capital structure is determinable, on the otherhand, the coherence of the bankruptcy scheme must rest on some unarticulatedexplanations for why the investors' contracts cannot be expected to have alreadyprovided for the optimal outcome such that the resulting contracted-for prioritiesshould not be enforced in the bankruptcy reorganization. As the law &economics literature has refined its definition of the issues needed to understandbankruptcy's corporate reorganization provisions, it has become increasinglyobvious that these questions have not yet been answered. The answers arelikely to come from the subfield of corporate finance.

24. Nonbankruptcy Organizational Solutions to the Structural Problem

To begin with, firms need incur the prospect of collective action problems onlyby choice. Business projects can be organized in all-equity entities or thosewhich are solely owned by a single investor, and which pursue whateverprojects that controlling investor deems most efficient. Baird (1994) . It is evenprobable, based on the beginnings of relational theory in the literature, Scott(1986) , Eric Posner (1996) , Bowers & Bigelow (1996) , to suppose that relationalbehavior can solve all the parties' collective action problems. Multiple investorswho are also actively relationally involved with each other can join together ina business partnership venture and function as if they were a sole investor, solong as the necessary acts of relating reduce transaction costs sufficiently asamong them, to invoke the Coase Theorem. Coase (1960) . Since most corporatereorganizations in the United States are of small firms Bufford, (1994) which arethus, arguably unlikely to face significant collective action problems, it isprobable that U.S. Corporate Reorganization law cannot be justified andexplained by the need to solve small firms' problems.

25. The Contributions of Well-Functioning Capital Markets to the Problem ofCapital Structure Design

The law & economics literature has focussed almost entirely on the optimalcapital structure problems of firms of significant size, and thus has assumed thatCorporate Bankruptcy Reorganization law must be intended to address theproblems of such firms for whom serious collective action problems are likely toexist. The debate over the significance of these problems has been recountedearly in this title -section D- discussing the justifications for development ofcollective remedy systems. Nevertheless, early in the debate Douglas Baird, Baird (1986) argued that the existence of well-functioning markets largelymitigated the possibility of any serious collective action problems for large,listed firms. The debate over what purposes corporate reorganization bankruptcymight serve has been conducted ever since between groups who on the onehand believe that almost all market results are inferior to bureaucraticdecision-making, LoPucki (1992) , Warren (1992a) and those on the other hand,who are persuaded that the existing Capital Markets function fairly well. Bowers(1993) The latter scholars have concluded from the data that Chapter 11 of theBankruptcy code has been punishing to investors, Bradley & Rosenzweig(1992) , without obviously assisting other recognizable groups of claimants. Bowers (1994b)

26. The Valuation Problem with Bureaucratic Solutions

The logic underlying the corporate reorganization provisions of the U.S.Bankruptcy Code ("Chapter 11") has always been that firms, even those infinancial distress, have so-called "going-concern" values which are lost if thefirm is broken up by having its assets sold off piecemeal. The collective actionproblem is seen as the incentives of individual creditors to race to dismember thefirm on the first suspicion that it is headed for insolvency thus possiblydestroying that going concern value. Baird (1987a) , Eisenberg & Tagashira(1994) . The structure of Chapter 11 is consistent with this explanation. When afirm files for Chapter 11 relief, all individual creditor actions to seize any of thebankrupt's assets are automatically enjoined, and the assets are never, in fact,liquidated. Instead, the firm is recapitalized, with its old creditors becoming itsnew shareholders. Stock in the reorganized firm is swapped for the original debt.This result cannot obtain, in legal theory, however, unless the equitiesdistributed to the former creditors exceed the estimated value the creditor wouldhave obtained in a hypothetical liquidation bankruptcy. In other words, theexpectation is that the claimants' new interests in the firm will exceed theliquidation value of their interest in the unreorganized firm, presumably by theamount of the saved going concern surplus.

The theory behind the provisions, however, has failed the test of practicalapplicability. Since going concern value is necessarily, the present market valueof the firm minus the amount the assets would have sold for if liquidated, andthe firm is never presently sold on the market nor are its assets ever liquidated,going concern value for any firm in Chapter 11 is simply a hypotheticalconstruct. Hypothetical liquidation values estimated for use in the proceedings,in particular, are quite problematical because they are apt to to be extremelycontext contingent. If you ask me to estimate how much I can sell GeneralMotors for, but specify that I must sell it in the next 5 minutes, its liquidationvalue is equivalent to my estimate of the maximum amount of cash in heaviestpurse of the 23 persons within hailing distance. Prebankruptcy holders of thelowest priority claims (usually common equity) have an incentive to overstatethe hypothetical going concern value of the firm so as to buttress their claim tohave part of the reorganized firm distributed to them. They likewise have astrong incentive to understate the liquidation value of the firm's assets becausethat minimizes the baseline distributional entitlements of the creditors in thereorganized firm. The costs of trying to value the firm, without conducting anyactual market transactions, are thought to to be extremely high, Altman (1984) , Bhagat, et.al. (1994) , Opler & Titman (1994) . The actual values which thebankruptcy judge might determine the assets would have sold for, and what thereorganized firm will be worth, are sufficiently uncertain that the multipleclaimants are not inclined to want to litigate them. Since managementrepresenting the common shareholders remains in control of the firm while therenegotiation of its capital structure is ongoing, Chapter 11 confers onmanagement and common equity something akin to a legal right to engage inhold-out behavior. As a consequence, it is common knowledge, that theinterests in the reorganized firm, are not distributed to the claimants inaccordance with their prebankruptcy contract priority rights. Those empoweredto hold out commonly improve their ex ante contractual priority at the expenseof creditors. Eberhart, et.al . (1990) , LoPucki & Whitford (1990) , Warner (1977) , Weiss (1990) .

27. Proposals for Curing the Valuation Problem

Much scholarly creativity has been thrown into the effort to develop a betterway to avoid the collective action problem, and at the same time cheaply andaccurately value the firm, or avoid the incentives to engage in ex postrent-seeking built into the current Chapter 11. Roe (1983) proposed an initialpublic offering of a small portion of the securities intended to to be distributedto claimants in the reorganization as a more accurate way of evaluating whetherthe securities being swapped for debt had incorporated any real going concernvalue. Bebchuck (1988) proposed instead that each claimant be granted anoption to buy the rights of the next most superior priority level at their face valueor else lose their interest in the firm. Thus, the lowest priority level not boughtout would end up holding the residual claims to the firm. Merton (1990) offereda similar proposal. Aghion, Hart & Moore (1992) and (1994) proposed stillanother refinement on the Bebchuck scheme. They suggested that the Chapter11 court, once having identified the appropriate holders of the residual interestin the firm from the exercise of the Bebchuck-type options, thereafter permit themto vote on new capital structure proposals offered by competing managementgroups. Baird (1986) proposed instead of elaborate and expensive recontracting,that the firm simply be auctioned off in Chapter 11, with the auction proceedsbeing distributed in accordance with priorities fixed in the claimants'pre-bankruptcy investment contracts. Whatever going concern values the firmhad would presumably be saved by being included in the price the winningbidder was willing to pay, buying the firm as an intact unit. Since the auctionproceeds could be distributed in accordance with all the claimants'prebankruptcy priority contracts, the auction argument also showed that thesolution to the collective action problem did not necessitate ex postmodifications of those contracts. Auctions are, nevertheless, known to entailtheir own transaction costs and imperfections. Baird (1993) , Crampton &Schwartz (1991) , French & McCormick (1984) .

Adler (1993b) and Bradley & Rosenzweig (1992) both proposed that firmsmight issue new types of securities which automatically erase the lowest priorityclaims upon a default of an obligation to the next higher priority class, andsimultaneously place that next-higher class in control of the firm. Adler'sproposal also was to eliminate the individual collection rights of holders of anyof the contingent securities, thus eliminating any right, and therefore anyincentive for individual creditors to take action to dismember the debtor, thuspowerfully eliminating any justification for Chapter 11 if it was designed toameliorate the collective action problem which arises when creditors have rightsto act individually.

All of these proposals to reform Chapter 11, on the other hand, seemimplicitly to accept that permitting individual creditors to enforce their creditcontracts under nonbankruptcy law creates such significant collective actionproblems that a mandatory collective type proceeding is required as a solution.Some proposals offer the possibility that hybrid collective/individual typeprocesses might improve on Chapter 11. Baird & Picker (1991) propose that acollective stay be imposed on smaller creditors while permitting a single majorfinancing creditor to individually decide whether to liquidate or continue thefirm. Perhaps the most comprehensive proposals were those of Rasmussen(1993) and Schwartz (1993) under which individual firms would to be obliged tospecify the details of the collective program claimants against them would to berequired to adhere to.

All of these proposals share the strategic presupposition that firmsthemselves can, in the design of their credit contracts or securities also includecontract terms which will ameliorate the collective action problems which mightarise thereafter, by specifying a collective procedure in which the claims wouldto be processed. Adler (1994b) The fact that firms never seem to have attemptedto use these devices then gives rise to some interesting empirical inferences.Perhaps, the theoretically alarming collective action problem is not, in practice,as dreadful as armchair theorists and congressmen have feared. Adler (1993a) argues that automatically recapitalizing securities, at least, may not have beenadopted for a variety of unrelated tax, tort, and corporate law reasons. A recentstudy, Gilson (1996) showed the most astonishing difference between failingfirms which recapitalized using Chapter 11 and those recontracting outside of aregulated bankruptcy proceeding was that the net-operating-loss carry forwards("NOLS") of the chapter 11 firms were nearly 5 times larger than those whichrecapitalized privately. This suggests that Chapter 11 may provide a techniquefor obtaining favorable corporate income tax treatment, a justification far afieldfrom those currently speculated about. It is not easy to see, however, why adistressed firm should to be required to undergo the details of a Chapter 11reorganization before being entitled to these particular tax benefits. Such anunderstanding would have to proceed first by elaborating on the desirability ofthe creation of NOLS in the first place.

28. Bankruptcy and Investment Incentives

As the previous discussion showed, the collective action problem faced by afirm's creditors can be addressed without altering the investors' prebankruptcypriority plans ex post ( Schwartz, 1994 ), and Rasmussen (1994) proposed thatrefusing ex post to honor investors prebankruptcy priority contracts, might beexplained by their affects on the firm's near-insolvency investment incentives.They both concluded that none of the proposed contractual means ofaddressing the potential collective action problems could be judged better onthis a priori basis, however. The inconclusiveness of these affects, they deemedas a strong argument for giving individual firms their own ability to chooseamong a "menu" of different possibilities for the proposal which best suited theconcerns of that particular firm.

Even if a one-size-fits-all bankruptcy regime could be improved upon byallowing each firm to tailor-make its own procedure, however, in the absence ofa comprehensive understanding of how to create an optimal capital structure, itis not easy to know how investors could value the differing choices on theresulting menus. The theoretical difficulties of knowing why capital structuresmight even matter raised by the Miller/Modigliani irrelevance theorem M & M(1958) have begun to be overcome, largely as an offshoot of the theory ofagency costs has developed. Jensen & Meckling (1976) It is now understoodthat debt in a firm's capital structure contributes to the firm's value by imposingdiscipline on managers whose personal incentives do not coincide with thedesires of their principals, the equity investors. Fixed obligations impose ameasurable task on management either to operate the firm profitably enough toraise the cash needed to meet the fixed obligation, or else to subject themselvesto the discipline of the financial market in order to obtain the funds they need tooperate the business. Grossman & Hart (1982) , Jensen (1986) , Triantis (1994) , Easterbrook (1984) . Since only firms with debt can incur financial distress, theoverall expected gains from reduction of management misbehavior must begreater than the prospective losses which the existence of debt may create.

(a) Entrenchment

Aside from the ex post collective action problems supposedly met by Chapter11, it is also known that the existence of debt in the firm's capital structure hassome downsides. First, just as debt is thought to reduce agency costs bycontrolling management's powers over the firm's free cash flow, it is alsorecognized that the existence of debt gives rise to the positive probability of afinancial default. Managers may fear that if the firm is to to be liquidated upondefault, they will lose their valuable positions, including some firm-specificinvestment in human capital. This reasoning gives rise to the perverse incentiveknown as management entrenchment. When the firm has issued debt, managerswill tend to warp the firm's investment decisions in favor of those projects inwhich managers can make themselves indispensable, even though these projectsare not necessarily those with the highest net present values to investors.Shleifer & Vishny, (1989), Bebchuck & Picker (1993)

(b) Overinvestment

Second, it is now well understood that especially as the firm nears insolvency,that low priority claimants have a perverse incentive to gamble with the firm'sassets, since they can pay off the higher priorities with the winnings and keepthe profits for themselves, but all the losses will be imposed on the higherpriority claimants. This set of perverse incentives is known as the Jenson &Meckling (1976) "overinvestment" problem. The current bankruptcy regime issometimes thought to ameliorate this incentive by refusing to enforce theinvestors' ex ante contracts which require that equity to be totally subordinatedto debt claimants. If, as is known to to be the case Chapter 11 distributionsdeviate from the absolute priority rule, then the managers and equity may begambling with some of their own money when they undertake risky projects, andwill be less inclined to do so. Insofar as these risky investments were likely tobe in negative net present value projects, then the deviation from absolutepriority might even be applauded as a means of avoiding socially detrimentalwasteful investment decisions. On the other hand, it has also been shown thatpriority redistributions in bankruptcy creates a classic case of moral hazard for solvent firms. By insuring management and equity against losses if insolvencyeventuates, it is likely to aggravate the tendency of equity-holders and theirmanagers to undertake undue risk during the periods when the firm is solvent. Adler (1992)

(c) Underinvestment

The third perverse incentive known to haunt capital structures which containdebt is the so-called debt-overhang, or Myers (1977) "underinvestment" risk. Ifthe firm is nearly insolvent and is presented with a promising investmentopportunity, equity (and management, their agents) may decided to forgoinvesting in it because the payoffs are likely to to be captured entirely by thehigher priority creditors. In that way, the existence of debt may cause the firm toforgo the opportunity to invest in positive net present value projects. For firmswith investable internal funds, then, eliminating the claims of the higher prioritycreditors ex post in order to make distributions to the lowest priority claimants,(equity) is a way of permitting equity to share in the returns from those valuableprojects ( Rasmussen, 1994 ). Once in bankruptcy proceedings, the bankruptcyjudge may approve subordinating senior claims to those of new financiers inorder to overcome this underinvestment incentive. Triantis (1993a)

Nevertheless, Schwartz (1994) has shown that if the firm must resort to thecapital markets in order to obtain the financing for positive net present valueprojects, then the failure to enforce pre-bankruptcy priority contracts creates anunderinvestment incentive even for solvent firms, and exacerbates thoseincentives for nearly insolvent firms. Generally, he argues, outside financiers,aware that their nonbankruptcy priority will not be honored in a Chapter 11 willinsist not only on market returns for their investments, but also will insist onextra returns for being forced to bear the costs of the bankruptcy redistribution.The extra returns they will insist upon will render otherwise positive net valueprojects not worthwhile to undertake at the margins. It is thus an empirical issuewhether the extra underinvestment risks which bankruptcy reorganizationimposes on solvent firms, and on those who must resort to the capital marketsto finance their projects and are near insolvency, are outweighed by themitigation of those risks to nearly insolvent firms with internal investable capital.

In summary, the current American corporate reorganization scheme has not yetbeen satisfactorily explained. In the first place, the collective action problems itseems designed to address may not to be so serious after all, and in the secondplace, even if they are serious, they are capable of being addressed more cheaplyby altering the contractual terms of credit contracts and securities. Finally,corporate reorganization's failure to honor prebankruptcy contractual prioritiesdoes not seem to address management entrenchment, the first set of perverseincentives which inhere in corporate capital structures. The impact of denyingenforcement to prebankruptcy contractual priority is, at best, ambiguous withrespect to both the overinvestment and underinvestment perverse incentives.

29. Structures with Preplanned Liquidations

Barry Adler (1997) has recently suggested that the failure of law & economicsscholarship to develop a satisfactory explanation for corporate reorganizationbankruptcy may to be due to a flawed initial premise generated by a faulty expost point of view. He suggests that asking why and how investors would liketo to be able to salvage going concern values, as looked at from the point in timewhen the debt obligations of the firm go into default themselves ignore asignificant feature of any business's necessarily prior decision to select itscapital structure. The ex ante point of view, from the time the structure isdesigned, he suggests might offer a more fruitful perspective. Investors, at thetime the firm is structured may purposely design the firm so that it experiencesfinancial distress whenever it is also likely to become economically inviable. Bowers (1991) had, in a similar vein, proposed that firms might employ securityinterests in a manner which would build self-executing optimal liquidating plansinto their capital structures.

Firms whose projects have no economic value ought not to be reorganized.Instead their assets ought to to be redeployed to higher and better uses. It is acommonplace that ex post, managers, Rose-Ackerman (1991) , and lower priorityclaimants Bebchuck & Chang (1992) , have an incentive to fuzz the distinctionsbetween economic and financial viabilities simply to milk the higher prioritycreditors for the last available dime before the firm must cease business and thatthey apparently succeed in doing so ( White, 1994 ). Describing the optimalmoment at which management's control over the assets should be eliminated isa formidable task. Buckley (1992) . Even if the initial capital structure design doesnot perfectly separate the economically from the merely financially inviable firmsex post, however, the gains from rehabilitating a few firms may not to be worththe losses from attempting to save a multitude of unsalvageable ones. Chapter11's record for rehabilitating firms is not a stellar one. Hotchkiss (1996) . Thepotential for an Out-of-Court workout also provides a failsafe mechanism if thecapital structure turns out, ex post to have been an especially bad predictor. Fitts, et. al. (1991) , Haugen & Senbet (1988) , Gilson et. al. (1990) .

30. Nonbankruptcy Law's Responses to Perverse Investment Incentives

This insight might in fact explain the nonbankruptcy creditors remedy systemin which, if creditors are unpaid, they can trigger a liquidation which will sendthe firm's assets back into the market to to be reallocated to better uses. Thenonbankruptcy system also can address some of the perverse incentives builtinto typical capital structures having a debt component. The overinvestmentincentive is addressed by permitting creditors to seize the assets of the firm.Once the assets are seized, equity and its management can no longer gamblethem on risky ventures. Furthermore, even management entrenchment can beresisted under the nonbankruptcy system. Creditors who can effectivelyprecommit to a version of the "grim" strategy, to seize and sell whatever assetsthe managers invest in, can eliminate the incentives of managers to invest inthem even if such investments owe a lot of their value to information which isprivate to the managers. It is only the prospect of a job in the reorganized projectwhich permits the entrenchment incentive to operate. An absolute commitmentto liquidate rather than reorganize thus makes entrenchment prospectivelyunprofitable. In that sense, then, one of the most serious of the perverseincentives is created by the law of bankruptcy reorganization..

The final perverse incentive that arises under capital structures whichinclude debt, so-called underinvestment, may also not be of the sort which caneasily be resolved by altering the terms of credit contracts. The potentialpositive net present value project which might not be exploited in the future, isdifficult for the initial investors to describe in their present contracts. Theunderinvestment incentive isn't addressed by corporate reorganizationbankruptcy doctrine either. The problem thus, may be practically intractable. Inthat case, the investors may conclude that if the firm suffers distress, its assetsought not to to be deployed in any new projects in a firm still laden with the oldcapital structure. The best alternative may to be to liquidate the old firm and tostructure a new one in order to pursue the new investment opportunities. Itseems unlikely that a satisfactory explanation and justification for any sort ofcorporate reorganization law will be possible until such time as a generallyacceptable model of optimal initial organization is developed. While the shapeof such a model might be inferable from the actual behaviors of investors andexecutives, the empirical literature to date has not succeeded in distinguishingthe essentials from the noise. Nor has the theory of corporate financial structureyet advanced to the point of offering a satisfying understanding.

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