In Finding Nemo: Rediscovering the Virtues of Negotiability in the Wake of Enron, Adam Levitin has cast light on what may seem an arcane issue that would bring a smile only to the bankruptcy cognoscenti. In reality, the issue has great practical importance and should be of interest to anyone who cares about corporate finance. As he points out, the market for claims against bankrupt debtors is huge, probably in the hundreds of billions of dollars. While investing in claims against a bankrupt may seem a poor financial choice, big money can be made by paying cents on the dollar for a claim that eventually receives a distribution for more cents on the dollar. Because the original claimant can exit its position without having to participate in lengthy and complex bankruptcy proceedings, its expected ex ante bankruptcy costs are lower, and it should engage in more lending at lower prices. The increased liquidity and lower prices redound to everyone’s benefit.

Levitin is right to say that many bankruptcy judges, lawyers, and law professors have been hostile to bankruptcy claims trading. Most of this hostility, however, arises out of issues that might present themselves in consumer cases or with claims purchased from small trade creditors. Because we have only "one Code to rule them all," doctrines that might originate in large corporate cases have a way of infiltrating consumer cases and vice versa. Thus, the hostility is understandable, although I think ultimately misguided in the business context. It was not clear how far Levitin would go with his proposals. My comments here are limited to transactions between sophisticated commercial actors. Because the readers to this blog probably have various levels of exposure to these issues and to Levitin’s paper, a little background may be in order.

A ruling in the Enron bankruptcy motivated Levitin’s exploration of how the doctrine of equitable subordination fits with bankruptcy claims trading. When Creditor A has a valid claim but also has done something bad—let’s say wrongfully exercise control or recklessly lend—to Debtor, equitable subordination allows the bankruptcy court to lower the priority of Creditor A’s claim against Debtor, often leaving Creditor A with no recovery. Of course, the Debtor could just sue Creditor A for damages stemming from the badness of Creditor A’s conduct, but adjusting priorities in the bankruptcy case accomplishes the same practical result more expeditiously, more cheaply, and within the bankruptcy proceeding. The Supreme Court has made clear that the subordination can occur only to the extent necessary to rectify the harm caused by Creditor A’s wrongful conduct, but in most cases (like Enron) that will be Creditor A’s entire claim.

In the Enron bankruptcy, Creditor A had engaged in bad conduct but had sold its claim to Transferee B. (There actually were several Transferee B’s and sometimes a Transferee C or D, but we can ignore those details.) Enron wanted to subordinate the claim now in the hands of Transferee B, reasoning that the claim would be subordinated if the claim had not been sold. The bankruptcy court agreed, much to Levitin’s dismay. He convincingly persuaded me that prior doctrine did not make the bankruptcy court’s decision inevitable. At the same time, I was not persuaded that the bankruptcy court’s decision was necessarily wrong based on prior doctrine. Either outcome would have been a reasonable interpretation of the doctrine, and the paper would be stronger if it did not work so hard in an attempt to persuade its reader that the bankruptcy court did not understand the law.

Rather, a better way to think about the case is the functional inquiry of whether Enron or Transferee B should have to sue Creditor A. If we subordinate the claim, then Transferee B may have a claim back against Creditor A for selling an essentially worthless claim. If we do not subordinate the claim, then Enron, acting as the representative of all its creditors, will want to sue Creditor A for damages it may have caused. Between the two choices, it would seem much more desirable to have Transferee B sue. The bankruptcy estate will have the cost, uncertainty, and delay of a lawsuit. At the time of the transfer, however, Transferee B was in a position to protect itself contractually, through representations and warranties from Creditor A in the document transferring the claim. Levitin dismisses this possibility, noting it can be difficult to negotiate representations and warranties in a transfer of a claim and that ultimately some deals fall through because the parties cannot agree upon the reps and warranties. This objection is precisely the point. If the transferring parties cannot agree on the reps and warranties necessary to assure the transferee that the claim is valid, why should a court later give them the equivalent by cutting off any defenses the debtor might have had to the claim?

That is exactly the proposal that Levitin advances, arguing that transfers of bankruptcy claims should cut off most defenses the debtor would have had against the transferor. Using the example above, Transferee B would take free of the equitable subordination claim. As he recognizes, this is essentially a proposal for negotiability of bankruptcy claims. Levitin argues that negotiability would greatly help liquidity in the markets for distressed debt. My reading of legal history (and Friedman for that matter) says that the negotiability doctrine arose because of the need for drafts and bills of exchange that could function as money-like substitutes in a frontier economy where real money was in short supply. It is not clear why the courts should supply a similar doctrine for the distressed debt markets when the parties in these markets could do so themselves through contract.

In fact, the apparent failure of participants in the distressed debt markets to contract for something resembling negotiability suggests that these markets do not actually value the rule that Levitin would hand to them. I can say only "apparent failure" because we lack a good empirical description of how these markets work. A better understanding of how the distressed debt markets function would ultimately be most persuasive in assessing whether Levitin’s proposal truly would be beneficial. Levitin assures us that the distressed debt markets reacted unfavorably to the Enron ruling, but we lack any hard evidence to know exactly how they did react. If Levitin is correct, then the Enron ruling should have resulted in an almost immediate and dramatic drop in the price at which distressed debt was trading.

Despite my disagreement with his prescriptions, Levitin offers a strong and provocative examination of claims trading and equitable subordination. I commend the paper to those interested in corporate bankruptcy or finance. It is great to see someone with this level of analytical insight coming into the field. I will look forward to seeing his work in the future.

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