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New article by Skeel argues against requiring equal treatment of creditors in bankruptcy

October 03, 2018

In a new article, University of Pennsylvania Law School professor David A. Skeel upends one of the key notions in bankruptcy law, arguing that equal treatment of creditors should not be a legal mandate. The notion that similarly situated creditors should be treated equally is widely understood to be a foundational principle of bankruptcy law but, Skeel argues, in practice the creditor equality norm is consistently undermined.

Rather than trying to resuscitate it, in an article published in a recent issue of the University of Pennsylvania Law Review, Skeel urges judges, lawyers, and scholars to abandon the equality principle and turn their attention instead to the concerns that actually underpin modern bankruptcy law: avoiding self-dealing by debtors, and increasing the efficiency of the bankruptcy process by encouraging transparency about differential treatment of creditors.

His article, “The Empty Idea of ‘Equality of Creditors,’” begins by examining the history of American bankruptcy laws, including their English predecessors, to determine how the equality norm arose. “Bankruptcy advocates envisioned that the assets of an insolvent debtor would be turned over to a trustee … . The trustee or assignee would then sell the assets and distribute the proceeds to the debtor’s creditors,” writes Skeel. “In return for fully cooperating, the debtor would no longer be responsible for his prebankruptcy obligations; they would be discharged. The equality of creditors norm emerged as an increasingly important feature of this story.”

Thus, in the nineteenth century, bankruptcy laws penalized debtors who sought to give “preference” to certain creditors by making payments to them shortly before filing for bankruptcy, thereby leaving fewer assets to be divided among those remaining. Under the 1841, 1867, and 1898 Bankruptcy Acts, creditors who received preference payments could be forced to return them, “and a debtor that had made a preferential payment could be denied access to bankruptcy.”

While the early Bankruptcy Acts confined the principle of equality of creditors to “individual and small business bankruptcy cases,” in the 1930s Congress brought large-scale corporate reorganization within the ambit of federal statutory bankruptcy law. As a result, the scope of the equality principle expanded. Indeed, the current Bankruptcy Code, enacted in 1978, reflects the norm “in the preference provision, in the general rule that unsecured creditors are entitled to a pro rata share of the debtor’s assets, and in the prohibition on unfair discrimination” among creditors in corporate reorganizations.

However, Skeel writes, “[i]t turns out that current bankruptcy law provides numerous devices for privileging one creditor or group of creditors over another.” Skeel describes five of the most important methods. First, the prohibition on preference payments may be easily evaded by carefully timing the payment and the subsequent filing for bankruptcy, as the “preference period” in the statute lasts for 90 days prior to filing. Thus, a preference payment made 91 days before filing is rendered “immune from attack by the trustee.” The bankruptcy statute also provides “safe harbors” for what would otherwise be considered preference payments, among them protection for payments “made in the ordinary course of business.”

Debtors may also rely on the “executory contract” rule to favor a particular creditor when there exists “an unpaid obligation under an ongoing contract between” the parties. The debtor company can either reject or assume such a contract in bankruptcy, with assumption requiring full payment of any obligations. Thus, Skeel explains, “[b]y assuming Creditor A’s contract, while rejecting Creditor B’s … [the company] can thus arrange favorable treatment for Creditor A.”

A debtor may also arrange to pay a favored creditor in full by designating them as a “critical vendor,” arguing that it “desperately needs Creditor A’s services and fears that Creditor A will stop providing them” unless paid. Once “a limited exception to the equality of creditors norm,” use of the critical vendor loophole “is now commonplace in large cases.”

Asset sales and reorganization plans also provide opportunities to treat creditors unequally. Debtors may agree to sell their assets to a buyer that would assume the debtor’s obligations to a particular creditor and pay them in full. Within a reorganization plan, a debtor might arrange a “gifting” transaction, wherein a “senior creditor agrees to cede part of its recovery to a lower priority class of claims or interests.”

Using its broad discretion to structure reorganization, Skeel explains, a debtor may also simply put creditors into separate classes, “and can propose to give Creditor A’s class a bigger payout than Creditor B’s.” Despite the abundant workarounds, Skeel suggests that simple statutory revisions and more stringent enforcement of existing rules could easily restore the equality of creditors norm.

However, he argues, “[i]n bankruptcy, equality is not everything it’s imagined to be.” Rather, the notion of equality among creditors is merely an indirect method of addressing other, more salient concerns. “In each of the contexts where it figures most prominently, the real normative issues are preventing self-dealing or secret liens, or addressing other concerns, not equality,” he writes.

Self-dealing might involve a business owner who is “tempted to repay loans from family members, or repay themselves, shortly before their business fails.” When a debtor can quietly favor a particular creditor by exploiting loopholes to the equality norm, Skeel writes, it effectively creates an implicit or “secret lien whose contours are not known when the debtor or other plan proponent proposes a reorganization plan.” Such conduct undermines the fairness and efficiency of the bankruptcy process.

However, Skeel argues, these concerns could be addressed by rules targeted directly at the problematic conduct rather than through the overly broad stroke of the equality norm. Such rules would permit unequal treatment of creditors in those cases where it does not pose a problem. 

Skeel is the S. Samuel Arsht Professor of Corporate Law, and focuses his scholarship on bankruptcy, corporate law, financial regulation, and other topics.

“In bankruptcy, the equality norm has become a costly distraction,” he writes. “Bankruptcy judges, professionals, and scholars would do well to foreswear the language of equality, and direct their attention to the principles that still matter.”