Tracing Equity: Realizing and Allocating Value in Chapter 11

Law and economics scholars have long argued that efficiency is best served when a firm’s capital structure is arranged as a single hierarchical value waterfall. In such a regime, claimants with seniority are made whole before the next-junior stakeholders receive anything. To implement this single waterfall approach, those scholars envision a property-based mechanism: a blanket lien on all of a firm’s assets, and therefore all of its value (including as a going-concern). This view informs current proposals for contractual bankruptcy and relative priority. Coincident with this scholarship, lawyers, scholars, and judges have largely accepted at face value the proposition that Article 9 of the Uniform Commercial Code implements the single waterfall. In other words, they assume that the law allows a secured lender to write contracts that enable it to capture all of a distressed company’s going-concern value. This assumption has placed “senior” secured lenders firmly in the driver’s seat when a firm falls into distress. So-called “senior” creditors claim priority in all of the value, and control over all of the cash. They often advocate a quick sale of the firm as a going concern, or liquidation of its assets, followed by a structured dismissal of the case, giving all of the value to the secured lender. In this article, we illustrate that Article 9 does not, in fact, implement the single waterfall principle. Instead, both Article 9 and the federal Bankruptcy Code maintain a distinction between priority based on the firm’s assets and claims to the residual value of the firm. Whenever the firm continues in operation, there will be two value waterfalls – one tied to assets, and the other not. The second waterfall consists of the going-concern and other value of the firm Chapter 11 preserves. The key legal (often forgotten) concept that maintains this distinction is “equitable tracing” – required by both Article 9 and Chapter 11. The terms “equitable principles” in Article 9 and “equities of the case” in Chapter 11 refer to equitable tracing principles, that, in turn, inform secured creditors’ “fair and equitable” baseline entitlement in a Chapter 11 plan. On the petition date, the value of the firm is therefore divided into two categories: value traceable to encumbered assets; and, other value. This relationship must then be managed over time, as the value of the firm changes. Chapter 11, accordingly, treats realization of value as a two-step process that we call “Equitable Realization.” Equitable Realization uses tracing principles to allocate a firm’s value between asset-based and firm-based claimants and to preserve that allocation over time. First, it fixes the relative positions of secured and unsecured claims when a bankruptcy petition is filed. Second, it delays the fixing of the value of secured claims until collateral is sold or a Chapter 11 plan is confirmed. The value of the secured creditor’s collateral may increase, but the secured creditor’s entitlement to any bankruptcy-created value extends only to “identifiable proceeds” – value that can be traced to assets encumbered on the petition date. As a result, increases in going-concern value of the company in this period, and other bankruptcy-created value more generally, are not within a lender’s collateral package. Any going-concern value created or preserved by Chapter 11 is allocated to the bankruptcy estate for the benefit of all stakeholders—workers, retirees, customers, and more. We then address whether Article 9 and the Bankruptcy Code took the right approach by choosing Equitable Realization over the single waterfall. Many scholars, all the way back to Grant Gilmore, have questioned the wisdom of the single waterfall. Joining and expanding on those scholars’ concerns, we explain the benefits of Equitable Realization, and how the concept resonates with a large family of corporate and commercial law rules that guard against undercapitalization and judgment proofing. Equitable Realization not only implements the Bankruptcy Code’s core goal of equitable treatment of creditors, but, by properly identifying firms’ residual claimants, limits a firm’s ability to externalize risk and increases the prospect of reorganizing troubled companies. The last task of this article is to test our insights against the value-allocation proposals in the Final Report of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, as well as priority-related proposals in academic scholarship. Many of the Commission’s proposals are consistent with Equitable Realization. But one proposal in particular, redemption option priority, allocates too much to secured creditors relative to our interpretation of current law.