Revisiting the Contracts Scholarship of Stewart Macaulay, Post VI: Jonathan Lipson

This is the sixth in a series of posts in our online symposium on the Contracts Scholarship of Stewart Macaulay.  More about the online symposium can be found here.  More information about this week’s guest bloggers can be found here. 

Jonathan Lipson is the Harold E. Kohn Professor of Law at Temple University’s Beasley School of Law.

Relational Reorganization

AlthoughStewart Macaulay’s contributions to the literature on relational contractingcannot be overstated—for practical purposes, he invented the field—its insightshave been absent from an equally important body of literature that also looksat contracts in action:  That ofbankruptcy reorganization.

At firstglance, the reasons for the disconnect may seem obvious.  Relational contracting is concerned with,well, ongoing relationships.  Bankruptcyreorganization, by contrast, implies the termination or fundamental alterationof those relationships.  Relationalcontracting imagines a world in which formal law is subordinate to actual customand practice.  Bankruptcy reorganization,again in contrast, is sometimes said to be the “acid test” for the enforceability(or not) of contracts, where there will be pressure to use special (formal)legal powers to avoid or break those that are burdensome to the debtor and lessthan “perfect” (in both UCC Article 9 and more general respects) in order toincrease recoveries for creditors whose contracts do pass muster.

And, yet itseems to me that relational contracting literature has much to offer those whothink about bankruptcy reorganization, and corporate reorganization generally(that is, outside of a formal bankruptcy process). 

Corporatereorganization is usually the response to a cascade of actual or potentialcontractual breakdowns—general financial default.  In most cases, it would seem that practicefollows Macaulay’s observations: creditors do not race to court to enforce broken debt contracts.  Instead, as I have discussed elsewhere,the parties—the debtor and its major creditors—usually jawbone.  Sometimes (most times, I would venture) theyrenegotiate the contracts and go on about life.  While the original debt contracts may have providedall sorts of elaborate remedies for the creditor, she will ignore them if she receivesa satisfactory substitute promise not contemplated by the original agreements.

When thatdoesn’t work, whether because some of the debtor’s creditors hold out, or thedebtor’s management can’t get its act together, or the debtor defaults on thesubstitute promises, a formal bankruptcy filing under chapter 11 mayensue.  Chapter 11 creates a complexenvironment in which both formal law and informal relationships have high salience. Chapter 11 can be seen as a form of institutional“braiding,”to paraphrase Gilson, Sabel and Scott, in which courts, markets, communitiesand legislatures (Congress), weave together sets of protocols for rewriting enmasse the corporate debtor’s debt (and other) contracts.  Relational contracting is vital to theeffectiveness of these protocols, even as the larger environment that uses andcreates these protocols is undergoing major change.  Consider three examples.

First,there is the relational contract among the corporate debtor and its manystakeholders.  When Congress enactedchapter 11 in 1978, it probably had an intuitive sense of the relationships itwanted to preserve:  Those betweenworkers, managers and corporate stakeholders. Thus, unlike prior law, chapter11 presumed that management would remain in possession and control of thedebtor while it formulated a reorganization plan that would keep the debtor agoing concern (and thus its basic relationships intact). If the plan gainedsufficient support (evidenced by creditor voting as well as a number of other formalcriteria) it could be confirmed by the bankruptcy court. If not, a trusteemight replace management and/or the debtor would be liquidated (thus likely terminatingthe relational contract).

In order toreach a consensual plan, a significant amount of bargaining would have tooccur.  Reorganization is, per Galanter,a “litigotiation”:constant bargaining on courthouse steps (virtual or actual).  A lawyer I knew once referred to chapter 11as “New York’s largest floating craps game.” This, in turn, bespeaks a second example of relational contracting inchapter 11: that among the lawyers who manage the process. 

Animportant goal of the 1978 Bankruptcy Code (which is still in effect) was toremove the stigma associated with bankruptcy practice.  Large law firms were quick to recognize that thispractice could be lucrative.  Asophisticated bar of bankruptcy practitioners in high profile cases emerged inNew York and Delaware.  This communitycreates bargaining networks in which repeat players seem to have both a strongsense of formal (e.g., bankruptcy and commercial) law and the capacity andtemperament to compromise in order to produce a plan if possible, and toresolve the case otherwise (e.g., through liquidation) if not.

Yet, evenas Congress may have imagined that reorganization would preserve a certainclass of long-term relationships involving the corporate debtor and itsstakeholders, change was afoot.  At aboutthe time the current Bankruptcy Code was coming into force, a market in “claimstrading” was beginning to develop. “Claims trading” is the practice whereby “distress investors” (often privateequity or hedge funds) will purchase claims against debtors. 

You mightwonder why anyone would want to purchase defaulted debt.  The answer, in most cases, is to make money,either on the spread between what the claims trader buys the claim for and whatit ends up being worth in the bankruptcy, or because the trader ends up with acontrolling position in the debtor’s bankruptcy (as noted above, claimantsoften get to vote on the chapter 11 plan).

Claimstrading began as an obscure corner of chapter 11, but has now become veryimportant.  Billions of dollars in claimstrade regularly.  It seems safe to saythat professional claims traders take significant positions in most largecorporate reorganizations.

What doesclaims trading have to do with relational contracting?  The world of distress investors is small,insular and bespoke, a club of sophisticated players in what I havecharacterized elsewhere as an unregulatedsecondary securities market.  Whilelittle is known about the actual contracting (or extra-contractual, promissory)practices of claims traders, it would appear that they are by and large repeatplayers. Their relationships increasingly influence the formal and informalcontracts that determine the outcome of the chapter 11 process. 

            Thistransformation bespeaks a third example of relational contracting in reorganization:  professional distress investors bound bycomplex ties, tensions, and loyalties in contracts of varying degrees offormality. Increasingly, and to some disturbingly, the incentives of this groupare to dismantle or auction the debtor rather than to reorganize it internally,as Congress seems to have envisioned in 1978. The relational contract of distress investors effectively replaces therelational contract of the debtor, its employees, and other stakeholders. 

This thirdrelational contract also suggests that lawyers may play an increasinglysubordinate role, executing investors’ strategies, but not necessarily devisingor negotiating them.  That many claimstraders were once bankruptcy lawyers may in part explain this shift:  even if they have become “clients,” distressinvestors often know as much formal (and informal) law as their lawyers.

Therelational contract in reorganization is, like all other contractingenvironments, neither purely formal nor purely informal.  That this literature has not influenced thelarge—and frequently “contractual”—literatureon reorganization is not a knock on Macaulay’s contribution or the subject ofthis Symposium, Revisiting the Contracts Scholarshipof Stewart Macaulay: On the Empirical and the Lyrical. 

Rather, my goal here is tosuggest ways to use his work, and that of the excellent contributions to Revisiting, in a related and importantcontext. Although Stewart Macaulay’s work has not yet been formallyintroduced to the world of corporate reorganization, it seems to me it could bethe basis of a beautiful relationship.

[Posted, on Jonathan Lipson’s behalf, by JT]