The Solvency Assumption
Most of the time, the law assumes that private economic actors are solvent, that is, that their assets are worth more than the liabilities, and in most cases, also, that they are able to pay their debts as they come due. The law also generally assumes that economic actors engage in transactions calculated to provide substantially equivalent economic value and that they are attempting in good faith to make a profit rather than a loss.
These are the assumptions that make institutions like limited liability for business entities tolerable. The only economic actions they entities engage in that might harm creditors is the distribution of dividends for which they receive nothing in return, and most state laws, by statute, under common law rules, or under a fraudulent transfer statute, prohibit distributions of assets to owners of the entity when it is insolvent. Some states have at some times even gone so far as to impose fiduciary duties towards creditors upon the management of limited liability entities when the entity is insolvent.
Likewise, the creditor's rights laws that permit an unsecured creditor to seize an asset from a debtor without sharing those proceeds with other unsecured creditors, make perfect sense when a debtor is solvent but refuses to pay voluntarily, but provide a pretty unfair first in time, first in right rule when a debtor in insolvent.
Bankruptcy Compared
Bankruptcy law is based on a different set of assumptions. In general, owners of a bankrupt entity get nothing, and in general, the debts of all creditors without property rights in particular assets in the bankruptcy estate receive the same number of cents on the dollar from available assets. When the bankrupt is an individual, rather than an entity, certain exempt assets are preserved for the bankrupt individual (in a Chapter 7 case, including all future earnings of the individual), and the remaining assets and liabilities are included in the bankruptcy estate.
Thus, in bankruptcy, the main issues are the relative rights of creditors vis-a-vis each other. Many rules in bankruptcy are designed to prevent equally situated creditors or objects of the debtor's bounty from being treated differently.
Creditors who received unfairly excessive payments called "preferences" on the eve of bankruptcy (defined as 90 days before bankruptcy for outsider creditors and one year before bankruptcy for insider creditors) that improve their position vis-a-vis other creditors must return the excess portion to the bankruptcy estate to be shared with other creditors. Assets distributed or transferred for something less than substantially equivalent value that were intended to impair the rights of creditors or transferred when the debtor is insolvent, called fraudulent transfers, may also be restored to the bankruptcy estate.
The general rule of equality of creditor's claims is not absolute. Some creditors are deliberately given priority over others in the interest of fairness vis-a-vis each other.
Secured creditors and others who have property rights in the bankruptcy estate's collateral, or have setoffs against amounts due from the estate to them, rather than mere ordinary contractual claims, have priority in the assets in which they have property interests over other creditors. And, certain claims like those for family support, tax creditors, claims for wages up to a certain amounts, and claims related to the administration of the bankruptcy estate have priority. These claims, for one reason or another, are deemed more worthy of being paid, out of necessity or on purely moral worth grounds.
The Case For Additional Prioritization
The Case For A Trade Creditor Priority
In almost every Chapter 11 bankruptcy, there is a class of creditors, called "trade creditors" with whom ongoing functioning business interactions are necessary for the survival of the business. While they have no formal priority in bankruptcy, in practice, long term debt providers, like bondholders, almost always agree to subordinate themselves to trade creditors in a reorganization plan because their cooperation is necessary to the preservation of value in the company and that preservation of value makes it possible for them to realize a greater return for their impaired long term debt obligation than would have been possible in a simple liquidation of the company. I've argued that trade creditors should, in general, have priority in bankruptcy, because it reduces the need for creditors in non-financing transactions to evaluate the creditworthiness of the people with whom they dod business, and because it reduces systemic risk by reducing the likelihood of non-payments that are likely to trigger a cascade of defaults. Trade credit, like many of the other priority claims which receive priority, often amount of wages and salaries for the independent contractors who are providing it. A priority like this would simplify negotiations and transaction costs in the typical Chapter 11 case without changing the substantive results very much. And, this priority would also encourage long term lenders, who make more well informed and considered lending decisions than trade creditors, to exercise somewhat more caution in their lending which would also reduce systemic risk in the economy as well, since the creditorworthiness of leveraged companies would be greater. Effectively, this subordinates long term debt to trade credit, but that isn't unfair or unreasonable. This priority could be the lowest of all of the priority debts, so long as it is ahead of ordinary long term creditor's claims.
There are also a couple of classes of debts which should probably be subordinated.
The Case For Subordinating Insider Debt
One is insider debt. A person who starts a business entirely with equity financing is at a considerable disadvantage in bankruptcy relative to a business financed with a mix of debt and equity from the same investor. And, it isn't obvious that this distinction is appropriate. The bankruptcy code already acknolwedge this issue to some extent by having a longer period for preferential payments for insiders. And sophisticated lenders routinely require insiders to subordinate their claims to the lender's claims. Also, while default on amounts due on an insider claim has a good chance of not actually producing collection activity unless it would result in strategic advantage to the owners, default on amounts due to insiders often produces inconvenient collections activites. Thus, insider debt often has important features of equity investment (which has the lowest priority) that is lacking in outsider debt. One can also argue that insider debt through control deserves less protection than outsider debt. A subordination of insider debt creates an incentive for insiders to manage a business in a way that is more financially prudent.
The Case For Subordinating Non-Compensatory Debts
Another class of debt which deserves subordination based on the equities between ordinary general unsecured creditors is debt that is not compensatory in nature. Examples of non-compensatory debts include amounts due only on account of a default such as late fees and the incremental amount of interest due only on account of a default, punitive or exemplary damages (for example, for fraud or intentional torts), statutory damages which are a multiple of compensatory damages (for example, for civil theft or deceptive trade practices), statutory damages unrelated to the amount of harm suffered (for example, statutory damages for copyright violations, criminal fines, and civil penalties).
In general, these non-compensatory debts serve the valid purpose outside of bankruptcy of making it more likely that someone can settle their case for the actual compensatory value of their claim, given the imperfections of the civil litigation process, and of punishing a debtor for misconduct. But, neither of these considerations has continued logicial relevance in determining the relative priority of two general unsecured creditors. Yet, the current bankruptcy rules allows some creditors to profit by potentially receiving more than the dollar value of the harm they have suffered, while necessarily forcing others to receive a deeper discount on their claims. If funds are available, there is no harm in paying these claims to creditors rather than a debtor for their intended purpose to punish the debtor, but these non-compensatory payments are not appropriate to use to as a basis for one innocent creditor to deprive another from a recovery.
Indeed, these debts should even be subordinated to the compensatory portion on insider debt.
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