Velvet bankruptcy

Theoretical Inquiries in Law

Volumn 7, Issue 2, 2006, Pages

  Hahn, David ^a  

^a BAR ILAN UNIVERSITY   (Israel)

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EID: 33751047386     PISSN: 15653404     EISSN: 15653404     Source Type: Journal    
DOI: 10.2202/1565-3404.1135     Document Type: Review

References (156)

1. This problem with personal bankruptcy affects business-related debtors and consumer-related debtors alike. Thus, the ultimate correction of the debt-relief process ought to come through a general reform of personal bankruptcy law and a change of the social-cultural perceptions of and attitude towards bankruptcy. While such a general reform is welcome, realistically such a change is likely to take years to implement, as it requires legal as well as extralegal changes. See infra Section III.B. Empirically, in certain jurisdictions around the world, business-related insolvencies comprise a significant percentage of total individual insolvencies. See Rafael Efrat, The Rise and Fall of Entrepreneurs: An Empirical Study of Individual Bankruptcy Petitioners in Israel, 7 Stan. J.L. Bus. & Fin. 163, 170 (2002). Focusing on the potential constructive role of debt-relief on the borrowing market, and acknowledging the widespread phenomenon of business-related insolvencies, I believe that certain legal measures proposed in this Article ought to be adopted to encourage business debt-relief and to improve the overall functioning of the corporate credit market, even if overall personal bankruptcy reform is years away. Moreover, a mini-reform, as proposed herein, may later serve as a catalyst for the desired overall reform.
2. Paul L. Davies, Gower and Davies' Principles of Modern Corporate Law 27-34 (7th ed. 2003); John H. Farrar & Brenda M. Hannigan, Farrar's Company Law 66-81 (4th ed. 1998).
3. Henry Hansmann & Reinier Kraakman, The Essential Role of Organizational Law, 110 Yale L.J. 387(2000).
4. Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law 44-49 (1991).
5. Phillip I. Blumberg, Limited Liability and Corporate Groups, 11 J. Corp. L. 573, 587-95 (1986).
6. See Charles J. Tabb, The Scope of the Fresh Start in Bankruptcy: Collateral Conversions and the Dischargeability Debate, 59 Geo. Wash. L. Rev. 56, 100 (1990);
7. Richard A. Posner, The Rights of Creditors of Affiliated Corporations, 43 U. Chi. L. Rev. 499, 503 (1975).
8. Larry E. Ribstein, Limited Liability and Theories of the Corporation, 50 Md. L. Rev. 80 (1991).
9. For such an analysis, see Mitchell F. Crusto, Extending the Veil to Solo Entrepreneurs: A Limited Liability Sole Proprietorship Act (LLSP), 2001 Colum. Bus. L. Rev. 381.
10. Robert Parrino & Michael S. Weisbach, Measuring Investment Distortions Arising From Stockholder-Bondholder Conflicts - An Analysis of Bond Covenants, 53 J. Fin. Econ. 3 (1999).
11. For elaboration on different meanings of "overinvestment" in the financial literature, see Evgeny Lyandres & Alexei Zhdanov, Underinvestment or Overinvestment: The Effects of Financial Leverage on Investment (Dec. 1, 2005) (Simon School Working Paper No. FR 03-28), available at http://ssrn.com/abstract=446681.
12. See, e.g., Joshua Aizenman, Capital Mobility in a Second-Best World: Moral Hazard with a Costly Financial Intermediation, 11 Rev. Int'l Econ. 1 (2003);
13. David de Meza, Overlending?, 112 Econ. J., at F-17 (2002);
14. David de Meza & David Webb, Wealth, Enterprise and Credit Policy, 109 Econ. J. 153 (1999).
15. See Seung-Hyun Lee et al., Bankruptcy Law and Entrepreneurship Development: A Real Options Perspective, Acad. Mgmt. Rev. (forthcoming), available at http://www.utdallas.edu/sxl029100/LeePengBarney040904_final.pdf (June 2004);
16. Stijn Claessens & Leora F. Klapper, Bankruptcy Around the World: Explanation of Its Relative Use, 7 Am. L. & Econ. Rev. 253, 254 (2005) (a good insolvency regime is measured, inter alia, by its preserving entrepreneurship in the economy in the sense that it does not stifle risk-taking);
17. Kenneth M. Ayotte, Bankruptcy and Entrepreneurship: The Value of a Fresh Start (2002) (CEPR working paper), available at http://www.cepr.org/meets/wkcn/ 5/582/papers/ayotte.pdf (concluding that a liberal discharge of debts for distressed entrepreneurial firms enhances entrepreneurial activity).
18. Such reform initiatives may involve insolvency law (the ex post law) or corporate law (the ex ante law). An example of the former reform initiative may be found in the UK. The goal of the Enterprise Act, 2002, c. 40 (Eng.) was, inter alia, to facilitate entrepreneurship by reducing the adverse effects of personal bankruptcy. See The Insolvency Service, supra note **, para. 1.1. As an example of the latter reform initiative one should explore legislative reforms in US business organization legislation. In the US, corporate law, along with tax law, has been reformed in recent years to facilitate the formation of new types of entities, such as LLCs, through which investors can enjoy the benefits of limited liability along with certain tax benefits not available in the form of a regular corporation. See Larry E. Ribstein, Limited Liability Unlimited, 24 Del. J. Corp. L. 407 (1999).
19. On the importance of entrepreneurship to the economic market process, see John M. Czarnetzky, Time, Uncertainty, and the Law of Corporate Reorganizations, 67 Fordham L. Rev. 2939, 2956-60 (1999).
20. Qimiao Fan et al., Whither SME Policies?, in World Bank Special Report: A Better Investment Climate for Everyone, available at http://www1.worldbank.org/ devoutreach/mar05/article.asp?id=286 (Mar. 2005): Policy-makers need to be cognizant of the fact that while improving the investment climate will help all firms, the same investment climate policies may have different impacts on SMEs due to their size. Specific market and institutional failures facing SMEs means that additional policies beyond general investment climate improvements may be needed to strengthen the SME sector. Such policies would not provide special preferences or subsidies to SMEs, rather they would help level the playing field for firms of all sizes.
21. See Allen N. Berger & Gregory F. Udell, Relationship Lending and Lines of Credit in Small Firms Finance, 68 J. Bus. 351, 355 (1995) [hereinafter Berger & Udell, Relationship Lending];
22. cf. Allen N. Berger & Gregory F. Udell, A More Complete Conceptual Framework for SME Finance (2004) (World Bank conference paper), available at http://www.worldbank.org/research/projects/sme/Financing_Framework_berger_udell. pdf.
23. Ronald J. Mann, The Role of Secured Credit in Small-Business Lending, 86 Geo. L.J. 1, 12-13, 22-24 (1997).
24. Id.
25. Note that the collateral figure includes both corporate collateral and the owner's personal collateral. Berger & Udell, Relationship Lending, supra note 15, at 361.
26. Cf. John D. Leeth & Jonathan A. Scott, The Incidence of Secured Debt: Evidence from the Small Business Community, 24 J. Fin. & Quantitative Analysis 379, 379 (1989) (reporting that the 1982 Interagency Task Force on Small Business Finance study found that almost 80% of dollar volume of large and small business loans were secured, and that the 1983 National Federation of Independent Business study found that 78% of total volume of small-business loans were secured).
27. Robert B. Avery et al., The Role of Personal Wealth in Small Business Finance, 22 J. Banking & Fin. 1019, 1058-60 (1998).
28. Id. at 1059.
29. See Robert E. Scott, A Relational Theory of Secured Financing, 86 Colum. L. Rev. 901, 948-50 (1986);
30. cf. Berger & Udell, Relationship Lending, supra note 15.
31. See Tabb, supra note 6, at 101 ("limited liability for individuals running small businesses is a myth because the individual principals almost always have to guarantee personally the corporate debts").
32. To the extent the lender is concerned about priority at the owner's personal level (i.e., vis-à-vis the owner's other creditors), it will likely insist on personal collateral in addition to the guarantee.
33. Avery et al., supra note 19, at 1059.
34. See Easterbrook & Fischel, supra note 4.
35. Cf. Jay L. Westbrook, Two Thoughts About Insider Preferences, 76 Minn. L. Rev. 73, 79 n.30 (1991).
36. At least with respect to a corporation's tort creditors, it has been suggested that limited liability should be replaced by a pro rata unlimited shareholders' liability. See Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 Yale L.J. 1879 (1991).
37. Cf. David W. Leebron, Limited Liability, Tort Victims, and Creditors, 91 Colum. L. Rev. 1565, 1643-50 (1991);
38. Hanoch Dagan, Restitution In Bankruptcy: Why All Involuntary Creditors Should be Preferred, 78 Am. Bankr. L.J. 247 (2004) (suggesting that tort creditors be accorded priority within the corporate bankruptcy case).
39. Daniel R. Fischel, The Economics of Lender Liability, 99 Yale L.J. 131, 136 (1989);
40. Marshall E. Tracht, Insider Guaranties in Bankruptcy: A Framework for Analysis, 54 U. Miami L. Rev. 497, 516-24 (2000);
41. Alberto F. Pozzolo, The Role of Guarantees in Bank Lending (2004) (Economics and Statistics Discussion Paper No. 21/04), available at http://www.unimol.it/progetti/repec/mol/ecsdps/ESDP04021.pdf.
42. In an empirical study conducted in Spain, the authors found similarly that collateral-backed credit is associated with greater probability of default, thus suggesting that the taking of collateral is intended to combat moral hazard risks of debtor misbehavior. See Gabriel Jimënez & Jësus Saurina, Collateral, Type of Lender and Relationship Banking as Determinants of Credit Risk, 28 J. Bank. & Fin. 2191 (2004).
43. Mann, supra note 16, at 10;
44. Douglas G. Baird, The Politics of Article 9: Security Interests Reconsidered, 80 Va. L. Rev. 2249, 2263-66 (1994);
45. Avery W. Katz, An Economic Analysis of the Guaranty Contract, 66 U. Chi. L. Rev. 47 (1999).
46. Cf. Saul Levmore, Monitors and Freeriders in Commercial and Corporate Settings, 92 Yale L.J. 49 (1982) (analyzing the justification of security interests in light of potential free-riding by creditors).
47. Peter A. Alces, An Essay on Independence, Interdependence, and the Suretyship Principle, 1993 U. Ill. L. Rev. 447, 457.
48. An unlimited guarantee obligates the guarantor for the entire amount owed by the primary debtor to the creditor. Often, such guarantees are also continuous, that is: they cover present and future advances of credit by a lender.
49. See Neil B. Cohen, Striking the Balance: The Evolving Nature of Suretyship Defenses, 34 Wm. & Mary L. Rev. 1025, 1043 (stating that effectively, all lenders possess sufficient market power against borrowers);
50. Cf. Westbrook, supra note 26, at 80-86 (differentiating between economically legitimate insider's guarantees of corporate loans and unjustifiable "pure-leverage" guarantees demanded by the lending banks).
51. But see Peter A. Alces, Rethinking Professor Westbrook's Two Thoughts About Insider Preferences, 77 Minn. L. Rev. 605, 621-23 (1993) (questioning Westbrook's dichotomy of "good" and "bad" guarantees and opining that all guarantees are "ugly" and stand on a continuum between pure economically justified guarantees and extreme, unjustified, ones).
52. On the financing problems of entrepreneurs in concentrated banking markets, see Nicola Cetorelli, Real Effects of Bank Competition, 36 J. Money Credit & Banking 543 (2004);
53. Sandra E. Black & Phillip E. Strahan, Entrepreneurship and Bank Credit Availability, 57 J. Fin. 2807 (2002);
54. Emilia Bonaccorsi di Patti & Giovanni Dell'Ariccia, Bank Competition and Firm Creation (2001) (International Monetary Fund, Working Paper WP/01/21), available at http://www.imf.org/external/pubs/ft/wp/2001/wp0121.pdf
55. Nicola Cetorelli & Phillip E. Strahan, Finance as a Barrier to Entry: Bank Competition and Industry Structure in Local U.S. Markets (Oct. 2004) (NBER Working Paper No. W10832), available at http://papers.nber.org/papers/wl0832. pdf;
56. Marianne Bertrand et al., Banking Deregulation and Industry Structure: Evidence from the French Banking Reforms of 1985 (2004) (CEPR Discussion Papers, 4488), available at http://www.cepr.org/pubs/dps/DP4488.asp (finding that distortions in bank lending as a result of the banking structure create artificial barriers to entry in the real sectors of the economy).
57. See Cameron Half, Note, Funding Growth: Leasing and Small and Medium Enterprise Financing in Russia, 43 Harv. lnt'1 L.J. 469, 477 (2002).
58. This phenomenon is known as "relationship banking." See Allen N. Berger et al., The Ability of Banks to Lend to Informationally Opaque Small Businesses § 2 (2001) (World Bank Working Paper No. 2656), available at http://wdsbeta.worldbank.org/external/default/WDSContentServer/IW3P/IB/2001/11/ 22/000094946_01090804015360/Rendered/PDF/multi0page.pdf;
59. Arnoud W.A. Boot, Relationship Banking: What Do We Know?, 9 J. Fin. Mediation 7 (Oct. 14, 1999), available at http://www1.fee.uva.nl/fm/papers/ Awaboot/english/Relationship_banking_know_JFI.pdf.
60. Cf. Curtis J. Milhaupt, The Small Firm Financing Problem: Private Information And Public Policy, 2 J. Small & Emerging Bus. L. 177, 182 (1998) (noting also that the contracting costs for a loan are relatively fixed, and thus small sized financing, which is typical in SMEs, imposes disproportional financing burdens on SMEs);
61. Margaret Miller & Dina Rojas, Improving Access to Credit for SMEs: An Empirical Analysis of the Viability of Pooled Data SME Credit Scoring Models in Brazil, Colombia & Mexico (Oct. 2004) (conference paper), available at http://siteresources.worldbank.org/INTFR/Resources/475459-1107891190953/ 661910-1108584820141/Miller_ImprovingAccesstoCredit.pdf (noting that in concentrated banking markets a bank that already provides credit to a small business and obtains certain information on the creditworthiness of that business often chooses to withhold such information and thus exacerbates the borrowers' dependency problem);
62. Eric de Bodt et al., Credit Decisions and Adverse Selection: An Empirical Study of Banking Behavior (July 2000) (SSRN Working Paper Series), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=244555 (noting that relationship banking creates an effective monopolistic position for the bank, which may be exploited to extract rents from the borrower).
63. But see Ed Vos et al., The Happy Story of Small Business Financing (Feb. 2005) (Working Paper), available at http://papers.ssm.com/sol3/papers.cfm? abstract_id=671263 (arguing that small businesses do not suffer from a shortage of financing, as they can also obtain equity-based financing).
64. See Robin Broadway & Jean-Francois Tremblay, Public Economics and Startup Entrepreneurs (Apr. 2003) (Workshop on Venture Capital, Entrepreneurship and Public Policy paper), available at http://www.econ.queensu.ca/pub/faculty/ boadway/bt-cesifo.pdf.
65. See Allen N. Berger & Gregory F. Udell, Small Business Credit Availability and Relationship Lending: The Importance of Bank Organisational Structure, 112 Econ. J. at F32 (2002);
66. Mitchell A. Petersen & Raghuram G. Rajan, The Benefits of Lending Relationships: Evidence from Small Business Data, 49 J. Fin. 3 (1994).
67. See Alvaro Ruiz Navajas, Credit Guarantee Schemes: Conceptual Frame (Nov. 2001) (Financial System Development Project), available at http://www.fondesif. gov.bo/CGS-Conceptual%20Frame.pdf;
68. Latimer Asch, Credit Scoring: A Tool for more Efficient SME Lending, 1(2) SME Issues 1 (Nov. 2000), available at http://info.worldbank.org/etools/docs/ library/159695/smetech/pdf/CreditScoring_SMELending.pdf.
69. But see Gines Hernandez Canovas & Pedro Martinez Solano, Bank Relationships: Effects on the Debt Terms of the Small Spanish Firms (Jan. 2003) (EFMA 2003 Helsinki Meetings) (finding that in Spain banks take guarantees from, and reduce interest rates to, those borrowers who have established a significant relationship with them).
70. See Joseph E. Stiglitz & Andrew Weiss, Credit Rationing in Markets with Imperfect Information, 71 Am. Econ. Rev. 393 (1981).
71. Cf. de Bodt et al., supra note 38 (finding a behavioral pattern of banks to gradually acquire information over time. However, in early stages of the borrowers' businesses there is no effective separation of information on borrowers).
72. Katz, supra note 30, at 87.
73. On ineffective signaling and resultant rat races in the labor market, see George Akerlof, The Economics of Caste and of the Rat Race and Other Woeful Tales, 90 Q.J. Econ. 599 (1976);
74. Renee M. Landers et al., Rat Race Redux: Adverse Selection in the Determination of Hours of Work in Law Firms, 86 Am. Econ. Rev. 329 (1996);
75. Stuart S. Rosenthal & William C. Strange, The Urban Rat Race (May 2003) (CEPR working paper), available at http://www.cepr.org/meets/wkcn/2/2328/ papers/strange.pdf (discussing modern life's long working hours as the "urban rat race");
76. A.A. Sampson, Weekenders and Workaholics, 18 European J. Pol. Econ. 193 (2002)
77. (same); Dan Bernhardt & Steeve Mongrain, The Layoff Rat Race (Feb. 1, 2005) (SSRN Working Paper Series), available at http://ssrn.com/abstract= 658422.
78. But see Scott A. Baker et al., The Rat Race as an Information Forcing Device (May 25, 2005) (NYU Law and Economics Research Paper No. 04-034;
79. UNC Legal Studies Research Paper No. 05-01;
80. Georgetown Law and Economics Research Paper No. 649083), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=649083 (discussing the potential information revelation virtue of rat race employment tournaments).
81. Olarn Chaipravat & Pongsak Hoontrakul, Thai Credit Market Failures: The 1997 Aftermath, 15 Thail. Dev. Res. Inst. Q. Rev. 16, 23 (2000).
82. Although the lending agreement can contractually cap the guarantee at a certain monetary amount, the banks' common practice is nonetheless to obtain a personal guarantee for the entire business loan. See Allen N. Berger & Gregory F. Udell, Small Business and Debt Finance, in Handbook of Entrepreneurship Research: An Interdisciplinary Survey and Introduction 305 n.7 (Zoltan J. Acs & David B. Audretsch eds., 2003).
83. Indeed, banks won't accept capped-guarantees because they wish, inter alia, to secure from the outset all future advancements of credit to the borrowing corporation, the total amount of which is unknown at the time. See supra note 33. Indeed, to an extent, a non-capped guarantee is in itself evidence of the standardization of the lending practice. However, even if banks were to cap the guarantees, the core problem of demanding guarantees when the moral hazard potential of the controlling shareholder does not justify this means would still exist.
84. For a similar analysis of the potential counterproductive effects of secured lending that banks would insist be the terms for any loan to a small firm, see Henry Hansmann & Reinier Kraakman, Hands-Tying Contracts: Book Publishing, Venture Capital Financing, and Secured Debt, 8 J.L. Econ. & Org. 628, 648-50 (1992).
85. Paul Dunn et al., A Comparison of the Perceptions of Experienced and Inexperienced Counselors on the Advantages of Incorporating a Small Business (1999) (ASBE research paper), available at http://www.sbaer.uca.edu/research/ asbe/1999/15.pdf.
86. See Eric Grouse, Banks, Bonds and Risk: The Mycal Bankruptcy and Its Repercussions for the Japanese Bond Market, 12 Duke J. Comp. & Int'l L. 571, 572 (2002) (noting the reluctance of Japanese banks to sustain losses for bad debts of their borrowing firms and write off those debts);
87. Ross Cranston, Credit, Security and Debt Recovery: Law's Role in Reform in Asia and the Pacific, 39 St. Louis L.J. 759, 761 (1995).
88. Cf. Katz, supra note 30, at 88 (discussing the potential strengthening of borrowers' financial statements when their loans are guaranteed).
89. See the discussion in supra Section II.B.
90. It should be noted that some of the market failures described above, such as the banks' market power in concentrated banking economies, appear not only through the excessive use of personal guarantees. They may also lead to other inefficiencies, such as excessive interest rates. While other inefficiencies may be combated, inter alia, through the corporation's insolvency proceedings, the guarantee's effects may be combated only through proceedings pertaining to the shareholder. Because this Article analyzes the triangular relationship among limited liability, personal guarantees, and shareholders' bankruptcies, the main text focuses on these inefficiencies as they pertain to personal guarantees.
91. See Brian Wu & Anne Marie Knott, Entrepreneurial Risk and the Entry Decision (Aug. 2005) (Wharton Working Paper), available at http://www.olin. wustl.edu/workingpapers/pdf/2005-08-013.pdf (proving that entrepreneurs are risk-averse with respect to exogenous market volatility risks, but risk-seeking and overconfident with respect to endogenous capability uncertainties. As a result, there would be instances where entrepreneurial risk aversion would dominate entrepreneurial confidence and result in insufficient entry);
92. Andrew F. Newman, Risk-Bearing, Entrepreneurship and the Theory of Moral Hazard (Dec. 1999) (workshop paper), available at http://www.econ.ucl.ac.uk/ downloads/newman/risk.pdf (arguing that "even though entrepreneurs are less risk averse than workers, they are still risk averse, and would be better off if they could share risks").
93. Cf. John Czarnetzky, The Individual and Failure: A Theory of the Bankruptcy Discharge, 32 Ariz. St. L.J. 393, 414 (2000) (discussing a potential entrepreneur's concern that he would be subject to contract enforcement by external creditors even in circumstances of non-fault failure as a barrier to entrepreneurship);
94. Hongwel Xu & Martin Ruef, The Myth of the Risk-Tolerant Entrepreneur, 2 Strategic Org. 331 (2004). To the extent that an increase in personal wealth reduces risk-aversion, entrepreneurship would be correlated with personal wealth.
95. See Robert Cressy, Credit Rationing or Entrepreneurial Risk Aversion? An Alternative Explanation for the Evans and Jovanovic Finding, 66 Econ. Letters 235 (2000).
96. Cf. Richard A. Posner & Kenneth E. Scott, Economics of Corporation Law and Securities Regulation 269 (1980).
97. A similar analysis is found in the literature concerning the inefficiencies of secured credit. One of the inefficiencies of secured credit is the risk of overinvestment. That is, because the bank's claim is secured by collateral, the bank becomes relatively indifferent to the corporation's actions. As a result, it reduces its monitoring efforts over the corporation's behavior and thus allows debtor misbehavior to go undetected. Lucian A. Bebchuk & Jesse Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 Yale L.J. 857, 902-03 (1996).
98. Cf. Arturo Bris et al., Who Should Pay for Bankruptcy Costs?, 34 J. Legal Stud. 295 (2005) (discussing partial reimbursement of bankruptcy costs to senior creditors as an incentive to invest in value-increasing activities). While personal guarantees protect the bank similarly, they do not increase the danger of overinvestment as much as secured credit. Unlike in the case of secured credit, it is primarily the personal undertaking of the entrepreneur, rather than the actual monitoring of the corporate behavior by the bank, that deters the entrepreneur from allowing corporate misbehavior. The guarantee, unlike the security interest, forces the entrepreneur to internalize some of the costs of corporate failure.
99. See Charles J. Tabb, The Historical Evolution of the Bankruptcy Discharge, 65 Am. Bankr. L.J. 325 (1991).
100. Douglas G. Baird et al., Bankruptcy - Cases, Problems and Materials 469-70 (rev. ed. 2001).
101. But see Thomas H. Jackson, The Fresh-Start Policy in Bankruptcy Law, 98 Harv. L. Rev. 1393, 1441-42 (1985) (questioning whether a complete denial of the discharge is justified whenever a debtor has engaged in creditor defrauding activity).
102. See Jackson, supra note 58;
103. Charles J. Tabb, The Scope of the Fresh Start in Bankruptcy: Collateral Conversions and the Dischargeability Debate, 59 Geo. Wash. L. Rev. 56 (1990).
104. Of course, any after-the-fact judicial determination is liable to be biased. That is, there is a concern that the court would determine bad faith and excessive risk-taking because it already is faced with the eventual outcome of insolvency. See Baruch Fischhoff, Hindsight ≠ Foresight: The Effect of Outcome Knowledge on Judgment Under Uncertainty, 1 J. Experimental Psych.: Human Perception & Performance 288 (1975)
105. reprinted in 12 Qual. Saf. Health Care 304 (2003);
106. Baruch Fischhoff, For Those Condemned to Study the Past: Heuristics and Biases in Hindsight, in Judgment Under uncertainty: Heuristics and Biases 335 (Daniel Kahneman et al. eds., 1982). But the legal system is aware of this potential bias and its impact is less destructive than it seems at first glance.
107. See Jeffrey J. Rachlinski, A Positive Psychological Theory of Judging in Hindsight, 65 U. Chi. L. Rev. 571, 573 (1998).
108. See supra Section II.C.2.
109. Of course, even if bankruptcy were to work optimally, the equilibrium between bankruptcy and personal guarantees would not be perfect. While the banks' screening process is enhanced by the discharge in bankruptcy, nonetheless banks cannot always correctly assess the economic prospects of all business ideas introduced to them. Thus, some degree of information asymmetry would remain. See supra Section II.C.2.
110. Id.
111. Id.
112. See John Armour & Douglas Cumming, Bankruptcy Law and Entrepreneurship (Mar. 2005) (ESRC Centre for Business Research, University of Cambridge, Working Paper No. 300), available at http://www.cbr.cam.ac.uk/pdf/ WP300.pdf.
113. See, e.g., Jacob S. Ziegel, Facts on the Ground and Reconciliation of Divergent Consumer Insolvency Philosophies, 7 Theoretical Inquiries L. 299 (2006);
114. Jason Kilborn, Behavioral Economics, Overindebtedness and Comparative Consumer Bankruptcy: Searching for Causes and Evaluating Solutions (June 2005) (Cegla Center conference paper), available at http://ssrn.com/abstract=690826.
115. A policy goal to promote entrepreneurship through bankruptcy law may be found in France and Belgium. See Hortense Trendelenburg, Discharge in Germany from an International Point of View, 9 Int'l. Insol. Rev. 111, 116 (2000). Indeed, a recent European empirical study corroborates the intuitive thought that lax bankruptcy laws, in the sense of reduced time periods for obtaining the discharge of debts, serve as an important drive of entrepreneurship.
116. See Armour & Cumming, supra note 65.
117. Cf. John King, Moving Beyond the "Hard"-"Easy" Tug Of War: A Historical, Empirical and Theoretical Assessment of Bankruptcy Discharge, 28 Melbourne U. L. Rev. 654 (2004) (analyzing the effect of fast-track discharges in various jurisdictions).
118. See Karen Gross, Failure and Forgiveness 94 (1997) ("Debtors who have submitted to the bankruptcy process have, in a sense, admitted failure.");
119. Id. at 249 ("Currently, the word bankrupt is often used to mean 'morally bereft.'").
120. European Commission, Bankruptcy and A Fresh Start: Stigma on Failure and Legal Consequences of Bankruptcy § 4.2.3 (July 2002) (Phillipe & Partners Study), available at http://europa.eu.int/comm/enterprise/ entrepreneurship/support_measures/failure_bankruptcy/stigma_study/stigma_study. pdf: A country's sociological perception of failure plays a huge role in the development of a stigma surrounding a distressed debtor. Strong publicity and availability of information to the public may not create stigma in a society where business partners, consumers and investors do not attach any importance to the potential failure of an enterprise. This is generally the case in the US where commencement of reorganisation procedures is not perceived negatively and can even have a positive effect on the outcome of the debtor. On the other hand, in the EU Member States, where society generally distrusts businesses facing financial difficulties, even limited publicity may be a strong factor in generating a stigma.
121. Teresa A. Sullivan et al., Twenty-First Century Bankruptcy: Two Decades of Evidence About Consumer Debt and the Stigma of Bankruptcy (June 2005) (Cegla Center conference paper), available at http://www.utexas.edu/law/news/ colloquium/papers/20%20years%20later%20and%20Table%20A.pdf.
122. Cf. Gordon Bermont, Bankruptcy By The Numbers: What's Stigma Got To Do With It?, 22-6 Am. Bankr. Inst. J. 22 (July/Aug. 2003);
123. Kartik Athreya, Shame As It Ever Was: Stigma and Personal Bankruptcy, 90 Fed. Res. Bank Rich. Econ. Q. 1 (Spring 2004), available at http://www. richmondfed.org/publications/economic_research/economic_quarterly/pdfs/ spring2004/athreya.pdf (suggesting that the rise of unsecured debt and bankruptcy filing in the US is not a result of the decline of the bankruptcy stigma, but rather a result of the implicit reduction in costs of intermediation that has occurred over the past two decades).
124. But see Rafael Efrat, The Evolution Bankruptcy Stigma, 7 Theoretical Inquiries L. 365 (2006).
125. See Armour & Cumming, supra note 65.
126. See, e.g., Austin Sarat & Thomas R. Kearns, Beyond the Great Divide: Forms of Legal Scholarship and Everyday Life, In Law in Everyday Life 21 (Austin Sarat & Thomas R. Kearns eds., 1995);
127. Anna-Maria Marshall & Scott Barclay, In Their Own Words: How ordinary People Construct the Legal World, 28 Law & Soc. Inquiry 617 (2003).
128. Cf. Robert W. Gordon, Critical Legal Histories, 36 Stan. L. Rev. 57, 110-16 (1984).
129. As mentioned in Section III.B, while the deficiencies of personal bankruptcy affect the personal affairs of all individual debtors, this Article focuses on their effects on the entrepreneur, the lending bank, and their mutual business relationship.
130. See supra Section II.C.1.
131. See supra Section III.A.
132. In this sense, the court would differentiate between insolvent and solvent debtors and avail only the former of the Velvet Bankruptcy relief. The court's role here is similar to the role it plays in declaring a debtor bankrupt under the existing personal bankruptcy procedure.
133. The maximum discounting of the lender's claim may be determined by statute.
134. As mentioned earlier, the discharge will be available only for bona fide economic failures, but not for willful excessive risk-takings. See supra Section III.C.
135. It is imperative that this discharge be obtained in Velvet Bankruptcy within a matter of several months, not years. As explained above, shortening the time period for obtaining a discharge is a focal point of contemporary bankruptcy law reforms around the world. Its efficiency is corroborated empirically by Armour & Cheffins, supra note 65. Also, the amicable resolution of the shareholder's liability would require regulation of the report of Velvet Bankruptcy by credit reporting bureaus.
136. In the US, courts were at times willing to extend the bankruptcy automatic stay to non-debtor parties based on the courts' equitable powers, conferred by section 105 of the Bankruptcy Code, 11 U.S.C. § 105 (2000). See, e.g., Paul H. Deutch, Expanding the Automatic Stay: Protecting Nondebtors In Single Asset Bankruptcy, 2 Am. Bankr. Inst. L. Rev. 453 (1994); A.M. Robins Co. v. Piccinin, 788 F.2d 994 (4th Cir. 1986); MacArthur Co. v. Johns-Manville, Corp. (In re Johns-Manville, Corp.), 837 F.2d 89 (2d Cir. 1988); Manville Corp. v. Equity Sec. Holders Committee (In re Johns-Manville, Corp.), 801 F.2d 60 (2d Cir. 1986).
137. See 11 U.S.C. § 1301 (a) (2000). Chapter 13 of the U.S. Bankruptcy Code is titled "Adjustment of Debts of an Individual with Regular Income."
138. The statutory baseline is that only the debtor enjoys a discharge, and no other entity is relieved of its liabilities along with the debtor. See 11 U.S.C. § 524(e) (2000).
139. For a discussion of the option of releasing non-debtor entities, see, for example, Deborah A. Crabbe, Are Non-debtor Releases/Permanent Injunctions Authorized Under the Bankruptcy Code?, 22-4 Am. Bankr. Inst. J. 34 (May 2003);
140. Jeffrey W. Warren, Requirements for the Approval of Third-Party Non-debtor Releases, 22-3 Am. Bankr. Inst. J. 34 (Apr. 2003).
141. But see Peter M. Boyle, Non-Debtor Liability in Chapter 11: Validity of Third-Party Discharge In Bankruptcy, 61 Fordham L. Rev. 421 (1992) (criticizing the release of non-debtor joint tortfeasors);
142. Ralph Brubaker, Bankruptcy Injunctions and Complex Litigation: A Critical Reappraisal of Non-Debtor Releases in Chapter II Reorganizations, 1997 U. Ill. L. Rev. 959.
143. See also the discussion in infra Section IV.D.
144. See the discussion in supra Section III.A.
145. Cf. Bebchuk & Fried, supra note 56, at 917 (noting that security interests confer certain non-priority benefits to the secured creditor, and that these benefits would not be frustrated under the authors' proposal to substitute partial priority for the current full priority regime).
146. See the discussion in supra Part II.
147. Cf. Lucian A. Bebchuk & Jesse Fried, The Uneasy Case For Priority of Secured Claims in Bankruptcy: Further Thoughts and a Reply for Critics, 82 Cornell L. Rev. 1279, 1328-32 (1997) (arguing that the authors' proposal to modify secured creditors' priorities reacts to inefficiencies of secured lending, and thus the efficiencies created by their proposal may more than offset any financing costs imposed by lenders as a result thereof).
148. For characterizing the principle of shareholder limited liability as a nonrecourse loan arrangement, see Jason W. Neyers, Canadian Corporate Law, Veil-Piercing, and the Private Law Model Corporation, 50 U. Toronto L.J. 173, 235 (2000);
149. Easterbrook & Fischel, supra note 4, at 41.
150. Another possible critique of Velvet Bankruptcy would be that lenders would circumvent this proposal by instead lending directly to shareholders, who would in turn lend the amount borrowed to the corporation. However, in my eyes, this critique bears little if any merit. I believe that such back-to-back loan agreements ought to be interpreted by the courts substantively as comprising a loan to the corporation that is backed by a shareholder's guarantee. Thus, such arrangements would also be subject to Velvet Bankruptcy. See Bebchuk & Fried, supra note 88, at 1336-40 (arguing the same in defense of their call for partial priority for secured credit).
151. On the cost efficiency of procedural consolidation of separate bankruptcy cases, see Jonathan Hightower, The Consolidation of the Consolidation in Bankruptcy, 38 Ga. L. Rev. 459, 465-66, 469 (2003).
152. The US is not the prototypical country to which this article relates. The comparison to its law drawn in the main text is intended merely to establish that the tools that would be applied in applicable countries under the reform proposed herein are tools that are already in use in certain bankruptcy laws, despite the different context.
153. 11 U.S.C. § 302 (2000); Fed. R. Bankr. P. 1015(b). Procedural consolidation is to be distinguished from substantive consolidation. The former entails merely a joint administration of the bankruptcy cases of multiple debtors, that is, the issuing of joint judicial orders and the like, but maintains the legal separation between the different debtors, the estates created in the property of each, and the creditors' claims of each. The latter, however, takes another step in that it combines the estates of the various debtors and pools together all of their creditors, to create in essence one enlarged case. See J. Stephen Gilbert, Substantive Consolidation In Bankruptcy: A Primer, 43 Vand. L. Rev. 207, 211 (1990).
154. Jacob S. Ziegel, Corporate Groups and Crossborder Insolvencies: A Canada-United States Perspective, 7 Fordham J. Corp. & Fin. L. 367, 370 (2002) (noting that in Canada over 70% of bankruptcy cases of corporations that belong to corporate groups are procedurally consolidated).
155. See supra Section III.A.
156. Indeed, a personal bankruptcy filing automatically allows the debtor to enjoy a stay of all proceedings pending against him (until the conclusion of the case whether by a discharge or by its denial). However, under the Velvet Bankruptcy proposal the entrepreneur would enjoy a stay imposed against the lender's collection efforts only if the court (adjudicating the corporate bankruptcy case) would find the entrepreneur worthy of such a stay. Velvet Bankruptcy is a proceeding that is discretionary in nature. See supra Section IV.A.