The EconomistJuly 25th 2020 Finance & economics 59Buttonwood Snake in the grass
I
n the early1980s Houston lived
through a real-estate frenzy. Then the
oil price crashed. Humble Place, a 30-acre
tract divided into land parcels, was one
of many unfinished projects. The devel-
oper filed for Chapter 11 bankruptcy. By
the start of the 1990s, his creditors were
still unpaid. A court heard that his recov-
ery plan amounted to “mowing the grass
and waiting for the market to turn”.
Such cases shaped a particular view of
Chapter 11, the bit of America’s bankrupt-
cy code directed at preserving businesses
rather than winding them up. It was
widely seen as a way to enrich lawyers
and a means for debtors to frustrate
creditors endlessly. The growing case-
load in the wake of the covid-19 recession
is likely to give new life to critics of Chap-
ter 11. There are serial users. NorthEast
Gas Generation, of Texas, recently joined
the “Chapter 33” club. It has filed three
times in six years.
A perennial bugbear is that Chapter 11
keeps the debtor in possession of the
business. If unpaid debts do not spell the
sack for management, say critics, then
where is its incentive to be prudent? Yet a
system that leans towards keeping a firm
alive helps preserve its value. Bankruptcy
is no longer creditor versus debtor, if it
ever was. It is—as it should be—a wrangle
between creditors. And these days it is
secured bondholders who appear to be in
control of the process.
Why involve the courts at all? In the
case of a single debtor and a single credi-
tor, there is not much to adjudicate. A
property firm owes $2m to a bank. It
defaults. The bank seizes the assets. Case
closed. Things become messier when
there are lots of competing claims on a
troubled company. There is then an
incentive for creditors to rush to get their
money out while they can, which canundermine the business and destroy value
for other creditors. Bankruptcy allows for a
stay on legal action while the parties sort
out what happens to the business and
decide who gets what.
The first goal of a bankruptcy process is
to maximise the proceeds. For a business
that is bleeding cash, the best option may
be liquidation: selling off buildings,
equipment, patents and other assets. But a
lot of the value of an enterprise is tied up
in intangible assets, such as the skills of its
workforce or its relationships with suppli-
ers and customers. So getting the most
value often means selling the business as a
going concern, or finding other ways for it
to continue. The second goal is to preserve
the priority of claims so that senior credi-
tors are paid first and common-equity
holders paid last. This is vital to the work-
ing of capital markets. Securities should be
priced according to their risks.
A third goal may be ensuring that a
firm’s managers pay a penalty for its going
bankrupt. But that may clash with the first
goal. Managers who know a business are
probably best placed to preserve its value.A big sticking point is working out
just how much value is in the business.
Take Broke nHungry, a hypothetical
casual-dining chain, which has filed for
Chapter 11. It has two creditors, Narcissus
Capital, which owns $100m of senior
debt and CovLite Capital, which owns
$100m of junior debt. The liquidation
value of Broke nHungry’s assets is
$100m. But there is uncertainty about its
value as a going concern. There is a 50-50
chance that a vaccine for covid-19 is
found. If it is found, Broke nHungry is
worth $200m; if not, the business is
worth $50m. The expected value of it is
thus $125m. The right decision is to keep
it going. But Narcissus will not see it that
way. In a liquidation it is sure to get its
money back. If the business carries on, it
gains nothing extra if things go well and
loses $50m if things go badly. So it will
favour liquidation, denying CovLite the
chance to get its money back.
Reality is trickier still. The uncertain-
ty is greater and there are many different
classes of debt. But today senior creditors
seem to be getting the upper hand. Per-
haps that is because more and more of
them are savvy distressed-debt special-
ists, often from the world of private
equity. They buy up the secured debt of
troubled firms with the aim of becoming
owners. They offer a financing package
to tide the business over. And they make
a bid to buy out other creditors.
Do the unsecured bondholders get a
raw deal? “Put it this way”, deadpans a
law professor, “everybody wants to be a
senior secured creditor.” The power in
Chapter 11 ebbs and flows. The shift
might even be traced back to the Humble
Place case. An appeals-court judge even-
tually ruled against the debtor. The case
notes do not record whether a lawn-
mower was one of the seized assets.Chapter 11 is no longer a haven for deadbeat debtorsto affected areas. And they could offer con-
sumption rebates depending on how and
where the money is spent.
Yet these newfound powers would have
drawbacks. For the cbdcto be a conduit for
negative rates, countries would probably
need to have eliminated cash, otherwise
people could still opt for physical over vir-
tual money. Moreover, if the cbdc does
have a deeply negative interest rate, people
might lose confidence in it. Savers could
demand another currency or a different as-
set, such as gold. As for targeted interven-
tions, there is a danger in programming toomany special features into digital curren-
cies. They would start to resemble securi-
ties with specific purposes, undermining
the fungibility that has been a feature of
money since the days of cowrie shells.
Central banks would also have to pay
heed to new vulnerabilities. In the event of
a panic, savers could convert their bank de-
posits into their cbdcaccounts, adding to
stresses on the financial system. Even
without a panic, strong demand forcbdcs
could chip away at banks’ deposit bases,
making them more reliant on wholesale
funding, which is often more costly andless stable. Some economists argue that
limits on withdrawals and on issuance
might help avoid some of these effects.
In any case, the policy ramifications are
the stuff of monetary fiction for now. A
more practical concern is whether central
banks can succeed in building sturdy, easy-
to-use cbdcs. The past few months have
brought several examples of failures in
public technology, from overwhelmed un-
employment websites in America to an
abandoned coronavirus-tracing app in
Britain. No government wants to see its
currency crash, even if only virtually. 72