Introduction: From Scandal to Solution
In the early 2000s, corporate governance in the United States appeared to be in free fall. Scandals involving Enron, WorldCom, and other major corporations shattered public trust and exposed the limits of traditional oversight mechanisms. Amid this crisis, bankruptcy—once the object of skepticism and scorn—emerged unexpectedly as a site of institutional renewal. David A. Skeel, Jr., in his influential work Creditors' Ball: The “New” New Corporate Governance in Chapter 11, argues that the structure of corporate governance within Chapter 11 bankruptcy proceedings has undergone a radical transformation, evolving from a manager-protective process into a market-driven arena dominated by creditors. This blog post analyzes Skeel's thesis, unpacks the mechanisms of this transformation, and assesses its normative implications.
Chapter I: From the Chandler Act to the 1978 Code – Historical Foundations
The history of American corporate bankruptcy governance begins with the Chandler Act of 1938, which instituted court-appointed trustees to manage debtor corporations during reorganization. This approach reflected skepticism toward debtor management and emphasized judicial control.
The Bankruptcy Reform Act of 1978 marked a profound shift. It replaced the trustee system with a debtor-in-possession (DIP) model, allowing existing managers to retain control during Chapter 11 proceedings. This "new" governance regime was intended to preserve going-concern value and managerial expertise. However, it also allowed entrenchment and rent-seeking by insiders, particularly in complex corporate bankruptcies.
Criticism of Chapter 11 peaked in the 1990s, as high-profile cases suggested abuse of the process by incumbent managers. Yet by the early 2000s, a strange silence had fallen. Despite continued public outrage over corporate misconduct, Chapter 11 was no longer a scapegoat. Skeel asks: Why?
Chapter II: The Rise of the “New” New Governance Model
Skeel contends that the structure of Chapter 11 has fundamentally changed. What he dubs the “new new” governance model is no longer dominated by judges or managers, but by creditors, particularly through contractual mechanismsthat function as de facto tools of corporate control.
The heart of this new model lies in two levers:
DIP Financing as Governance
Performance-Based Executive Compensation
Together, these instruments shift decision-making power toward creditors, particularly secured lenders, transforming the bankruptcy process into a market-based system of governance that mirrors, in some respects, the hostile takeover mechanism of traditional corporate law.
Chapter III: DIP Financing – Control Through Liquidity
DIP financing, or postpetition lending, has become a central feature of modern Chapter 11 cases. It grants super-priority status to new lenders, effectively placing them ahead of all other creditors in repayment. But DIP financing is not simply a liquidity solution—it is a governance contract.
Lenders frequently include restrictive covenants, sale milestones, and veto rights that grant them substantial control over the debtor’s strategy. Skeel notes that this often leads to:
Asset sales rather than reorganizations, particularly when lenders seek to recover value quickly.
Control over management decisions, including strategic direction and board composition.
Potential conflicts of interest, especially when prepetition lenders offer DIP loans to enhance their own status (e.g., through “roll-ups”).
Critically, DIP financing reshapes the traditional bankruptcy bargain: creditor influence replaces judicial oversight, raising both efficiency and fairness questions.
Chapter IV: Executive Compensation – Aligning Interests or Rewarding Failure?
The second major innovation in the new governance model is performance-based executive compensation, including Key Employee Retention Plans (KERPs) and incentive packages tied to reorganization outcomes.
Skeel distinguishes between two forms:
Pre-bankruptcy bonuses, often opaque and potentially abusive. These may violate fraudulent conveyance laws if they do not provide "reasonably equivalent value."
Post-bankruptcy performance incentives, which are more defensible and increasingly tied to metrics such as speed of reorganization or asset sale value.
While the trend toward aligning manager incentives with creditor goals is normatively positive, problems persist:
The exclusive focus on speed may distort incentives, leading managers to prioritize quick exits over value maximization.
Stock-based incentives, which could align long-term performance with managerial rewards, are rarely used due to creditor preferences and managerial risk aversion.
Despite these drawbacks, performance-based compensation represents a significant improvement over the entrenchment problems of the old model.
Chapter V: Benefits of the Creditor-Driven Governance Model
Skeel identifies several virtues of the creditor-dominated Chapter 11:
Faster and more efficient reorganizations, reducing administrative costs.
Reduced managerial entrenchment, thanks to creditor oversight and the threat of replacement.
Improved asset allocation, as DIP lenders push for the sale of underperforming divisions.
Market-based governance, where capital providers replace courts as oversight agents.
Ex ante discipline, as managers modify behavior in anticipation of creditor review in bankruptcy.
This model arguably produces stronger corporate discipline than outside bankruptcy, particularly when traditional governance mechanisms (like the SEC or shareholder activism) fail.
Chapter VI: The Risks – Overreach, Liquidation Bias, and Market Failures
Despite its advantages, the new governance model is not without dangers. Skeel identifies several:
Overinvestment in bad projects, encouraged by the super-priority status of DIP lenders.
Premature liquidation, driven by lenders’ desire to minimize risk and recover capital.
Loss of antitrust benefits, as major competitors (e.g., WorldCom) emerge leaner and more dominant post-bankruptcy.
Judicial oversight erosion, as courts defer to “negotiated” DIP terms that mask coercion.
Unfair blocking of competing bids, through DIP covenants that entrench lender control.
In some respects, these risks mirror the agency problems of traditional governance—only now the agents are creditors rather than managers. The challenge is to balance efficiency with fairness, especially for junior creditors and non-financial stakeholders.
Chapter VII: Normative Evaluation and Proposed Reforms
Skeel explores several proposals to mitigate the downsides of the new governance structure:
Restricting DIP terms that entrench prepetition lenders or block competition.
Allowing creditor voting on financing arrangements to improve alignment of incentives.
Enhancing judicial scrutiny, especially of DIP provisions that impact third-party interests.
The most realistic reform, according to Skeel, is revitalized judicial oversight. Courts must be empowered—and willing—to reject DIP agreements that serve creditor self-interest at the expense of fairness and reorganization potential.
He also encourages experimentation with alternative compensation metrics, including stock-based pay, to incentivize long-term value creation rather than just speedy exits.
Conclusion: The “Creditors’ Ball” as Governance Laboratory
Skeel’s thesis is as bold as it is timely: Chapter 11 has become a functioning system of corporate governance, not merely a legal mechanism for resolving distress. In an era where regulators struggle and boards often fail, the bankruptcy process offers a surprising degree of discipline, efficiency, and accountability—albeit at the price of creditor dominance.
The implications of this shift are profound. If Chapter 11 can serve as a governance model in crisis, it may also offer lessons for solvent firms. Yet caution is warranted. Creditors are not always disinterested stewards of value, and the architecture of bankruptcy must ensure that market control does not eclipse justice.
In the end, the "creditors’ ball" is not a celebration of collapse, but a choreographed dance of power and restructuring—one that reflects the evolving logic of American capitalism in its most distressed, and yet strangely dynamic, form.
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