Abstract
Contractual resolution of large-enterprise corporate insolvency offers potential advantages over judicial valuation or auction, particularly in transitional economies, perhaps including China, where courts and markets may be unaccustomed to valuation of large enterprises. This is not a claim that contractual resolution is a panacea. But a contractually implemented Chameleon Equity capital structure as proposed here—like the bail-in structures adopted in Europe—could serve as an efficient tool in the transition of state-owned enterprises to privately financed entities.

I. Introduction

The standard approach to corporate insolvency in the United States is known as Chapter 11. The idea behind Chapter 11 is straightforward: because firms can fail financially but nonetheless retain economic viability it may be beneficial to investors and to employees that an insolvent firm be restructured or sold as a going concern rather than liquidated piecemeal. Consequently, upon a company’s filing of a Chapter 11 petition, creditor collection efforts are suspended and a bankruptcy court supervises the disposition of the company’s assets.

Such disposition may be the cancellation of pre-bankruptcy claims and interests replaced by new (less burdensome) debt and new equity, with these new claims and interests distributed to the holders of old claims based on the priority of such claims. Or the disposition may be a sale of the debtor’s assets—with the company’s business intact—free and clear of old claims and interests, with the sale proceeds distributed to holders of old claims, again based on the priority of such claims. Only if the bankruptcy process reveals that the company is worth more in piecemeal liquidation than as a going concern will the assets of the debtor be sold independently of one another with the proceeds then distributed to creditors, once more according to claim priority. In principle, then, Chapter 11 works ideally. An insolvent company’s assets are put to their highest and best use—whether that use is facilitated through liability restructuring or sale—and the value generated by such use are assigned to the pre-bankruptcy creditors who might not be paid in full but will be paid as much as possible. Practice, however, may not follow this principled ideal.

Consider, for instance, the restructuring option, where the debtor’s assets are held together, and old claims and interests are replaced by new. Until the turn of the 21st century, this process was routine in the resolution of insolvency among large, publicly traded United States companies. A court faced with a decision of whether to restructure an insolvent debtor needs to estimate the value of the debtor’s assets. Such valuation serves two purposes. First, valuation serves the need to determine whether the assets are worth more kept together than sold off separately, otherwise no restructuring should be approved, and the assets should simply be liquidated. Second, assuming that restructuring is appropriate, valuation serves the need to determine the relevant entitlement of the pre-bankruptcy creditors and shareholders: the greater the value of a debtor’s assets the greater the distribution to junior pre-bankruptcy claims or interests.

So judicial valuation is essential to restructuring, but the valuation process can be fraught, with holders of senior claims arguing for low valuation while holders of junior claims argue for high valuation. The court is forced to cull truth from advocacy and the difficulty in doing so has led many scholars and other commentators to recommend that the law discard corporate restructuring in favor of a judicial auction conducted by a bankruptcy court. In such an auction, potential purchasers can bid for the company’s assets as a going concern or piecemeal with the court approving a sale on the bid or bids that generate the most value for the bankruptcy estate and, thus, for the pre-bankruptcy creditors. Under this process, valuation is determined by the market, where bidders put their own money on the line, rather than by a disinterested judge who might lack the wherewithal accurately to estimate value despite her best efforts and intentions.

Although critics of a sale alternative to bankruptcy restructuring point to the costs of selling large firms and the limited reliability of markets, in recent years, proponents of the sale option have largely won the day. Although many United States firms are still restructured in bankruptcy, and although there has been no significant statutory change, there has been a strong trend away from liability adjustment and toward using the corporate reorganization process simply to auction a debtor’s assets for the benefit of creditors. Frequently such sales are of assets as a going concern, though it is not uncommon for firms to undergo liquidation sales instead.

There is an ongoing debate in the United States over whether the shift from restructuring to auctions is a positive or a negative development. Proponents of auctions argue that markets are more accurate and less costly than judicial valuations. Proponents of restructuring argue the opposite.

Often overlooked in the debate over method of insolvency resolution is the fact that for the United States and other established capitalist economies, there may be little at stake in the argument. Judges in the United States and perhaps in other countries with similar economies have experience in asset valuation as part of the legal process, not only in bankruptcy law but in other fields as well, such as corporate law. Moreover, though choosing among valuation arguments made by litigants and their experts is not an exact science, judges in countries accustomed to an adversarial system in business litigation have years of precedent to rely on in separating message from noise in valuation disputes. Therefore, it may be that in the United States and similar jurisdictions, judicial valuation, while imperfect, is effective. Similarly, in the same established capitalist jurisdictions, market actors have vast experience in valuing all sorts and sizes of business assets for purchase or sale. Thus, in these countries, auctions, while never costless, may also be effective.

Matters may be quite different, however, in economies that are in transition between central planning and capitalist competition. A government in such a jurisdiction might, for instance, wish to convert a state-owned enterprise into a privately organized firm subject to success or failure in the consumer marketplace. If such a firm becomes unable to meet all its obligations, there must be a process in place to address its financial distress. But what process? Corporate restructuring of liabilities on the traditional Chapter 11 model? An auction consistent with the modern trend under Chapter 11? Either option might be disadvantageous in a country with a judicial system inexperienced in the valuation of business assets and a market unaccustomed to the sale of large-scale enterprises.

For transitional economies, a third option might be the best approach. This option, which, in prior scholarship, I’ve referred to as “Chameleon Equity” would have a company and its investors agree in advance to the ramifications of insolvency and the consequent default on obligations. Under a Chameleon Equity approach, a judge would not be asked to value a debtor’s assets or auction them in the marketplace, but would instead, upon an uncured default, simply allocate the firm’s assets according to the design of the contract among the debtor and its investors, who would then have only themselves to blame—not an uninformed court or unreliable market—for an unhappy resolution. Even in the United States or countries with similar judicial systems and economies, Chameleon Equity or some other contractual approach to corporate insolvency may offer advantages over a bankruptcy process that relies on judicial valuation or auctions. In transitional economies, though, such advantages have the potential to be more significant. This fact has been overlooked in existing scholarship that focuses on developed market economies such as that in the United States.

The case for contractual insolvency resolution in a transitional economy is made below in steps. Next, the proposal for a contractual insolvency process is described in more detail as such proposal would apply as an alternative to current bankruptcy law in the United States. Then, a brief elaboration is offered on how transitional economies might take special advantage of a contractual insolvency approach such as Chameleon Equity. Finally, a conclusion is offered.