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

Although Stewart Macaulay’s contributions to the literature on relational contracting cannot be overstated—for practical purposes, he invented the field—its insights have been absent from an equally important body of literature that also looks at contracts in action:  That of bankruptcy reorganization.

At first glance, the reasons for the disconnect may seem obvious.  Relational contracting is concerned with, well, ongoing relationships.  Bankruptcy reorganization, by contrast, implies the termination or fundamental alteration of those relationships.  Relational contracting imagines a world in which formal law is subordinate to actual custom and 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 less than “perfect” (in both UCC Article 9 and more general respects) in order to increase recoveries for creditors whose contracts do pass muster.

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

Corporate reorganization is usually the response to a cascade of actual or potential contractual breakdowns—general financial default.  In most cases, it would seem that practice follows 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) they renegotiate the contracts and go on about life.  While the original debt contracts may have provided all sorts of elaborate remedies for the creditor, she will ignore them if she receives a satisfactory substitute promise not contemplated by the original agreements.

When that doesn’t work, whether because some of the debtor’s creditors hold out, or the debtor’s management can’t get its act together, or the debtor defaults on the substitute promises, a formal bankruptcy filing under chapter 11 may ensue.  Chapter 11 creates a complex environment 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, communities and legislatures (Congress), weave together sets of protocols for rewriting en masse the corporate debtor’s debt (and other) contracts.  Relational contracting is vital to the effectiveness of these protocols, even as the larger environment that uses and creates these protocols is undergoing major change.  Consider three examples.

First, there is the relational contract among the corporate debtor and its many stakeholders.  When Congress enacted chapter 11 in 1978, it probably had an intuitive sense of the relationships it wanted to preserve:  Those between workers, managers and corporate stakeholders. Thus, unlike prior law, chapter 11 presumed that management would remain in possession and control of the debtor while it formulated a reorganization plan that would keep the debtor a going concern (and thus its basic relationships intact). If the plan gained sufficient support (evidenced by creditor voting as well as a number of other formal criteria) it could be confirmed by the bankruptcy court. If not, a trustee might replace management and/or the debtor would be liquidated (thus likely terminating the relational contract).

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

An important goal of the 1978 Bankruptcy Code (which is still in effect) was to remove the stigma associated with bankruptcy practice.  Large law firms were quick to recognize that this practice could be lucrative.  A sophisticated bar of bankruptcy practitioners in high profile cases emerged in New York and Delaware.  This community creates bargaining networks in which repeat players seem to have both a strong sense of formal (e.g., bankruptcy and commercial) law and the capacity and temperament to compromise in order to produce a plan if possible, and to resolve the case otherwise (e.g., through liquidation) if not.

Yet, even as Congress may have imagined that reorganization would preserve a certain class of long-term relationships involving the corporate debtor and its stakeholders, change was afoot.  At about the time the current Bankruptcy Code was coming into force, a market in “claims trading” was beginning to develop.  “Claims trading” is the practice whereby “distress investors” (often private equity or hedge funds) will purchase claims against debtors. 

You might wonder 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 what it ends up being worth in the bankruptcy, or because the trader ends up with a controlling position in the debtor’s bankruptcy (as noted above, claimants often get to vote on the chapter 11 plan).

Claims trading began as an obscure corner of chapter 11, but has now become very important.  Billions of dollars in claims trade regularly.  It seems safe to say that professional claims traders take significant positions in most large corporate reorganizations.

What does claims 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 have characterized elsewhere as an unregulated secondary securities market.  While little is known about the actual contracting (or extra-contractual, promissory) practices of claims traders, it would appear that they are by and large repeat players. Their relationships increasingly influence the formal and informal contracts that determine the outcome of the chapter 11 process. 

            This transformation bespeaks a third example of relational contracting in reorganization:  professional distress investors bound by complex ties, tensions, and loyalties in contracts of varying degrees of formality. Increasingly, and to some disturbingly, the incentives of this group are 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 the relational contract of the debtor, its employees, and other stakeholders. 

This third relational contract also suggests that lawyers may play an increasingly subordinate role, executing investors’ strategies, but not necessarily devising or negotiating them.  That many claims traders were once bankruptcy lawyers may in part explain this shift:  even if they have become “clients,” distress investors often know as much formal (and informal) law as their lawyers.

The relational contract in reorganization is, like all other contracting environments, neither purely formal nor purely informal.  That this literature has not influenced the large—and frequently “contractual”—literature on reorganization is not a knock on Macaulay’s contribution or the subject of this Symposium, Revisiting the Contracts Scholarship of Stewart Macaulay: On the Empirical and the Lyrical. 

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

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