Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution

Sunday, January 15th, 2012 at 7:55 am by Michael Simkovic & Benjamin S. Kaminetzky

Michael Simkovic & Benjamin S. Kaminetzky, Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution, 2011 Colum. Bus. L. Rev. 118.

In the wake of recent financial crises, credit default swaps (“CDS”) have become the financial instrument that scholars, journalists, government officials, and even some prominent financiers love to hate. However, even some of the CDS market’s harshest critics have acknowledged its power to draw attention to hidden financial risk. As credit default swaps mature from cutting edge financial innovations into transparent, standardized, and regulated instruments, they may provide valuable insights to regulators and courts tasked with preventing and managing insolvency. In particular, credit default swaps may help bankruptcy courts solve one of the most challenging problems of fraudulent transfer law: determining whether a corporate debtor who has filed for bankruptcy was solvent at a particular point in the past.

Fraudulent transfer law enables bankruptcy courts to void certain pre-petition transfers that depleted a debtor’s estate. The standard of liability for constructive fraudulent transfer is that (1) the transfer was made for less than “reasonably equivalent value,” and (2) the debtor either (i) was insolvent at the time of the transfer or was rendered insolvent by the transfer; (ii) was inadequately capitalized; or (iii) believed it would be unable to pay its debts as they matured.

Fraudulent transfer law fills an important gap in U.S. regulations of corporations. Although corporate law makes limited liability widely available and inexpensive for businesses, it has relatively few mechanisms to prevent excessive and socially destructive risk taking. Although it may seem sensible to enforce minimum capital requirements before granting limited liability, such prospective minimum capital regulation is generally only applied to firms in the financial sector. For most other firms, fraudulent transfer law is the closest thing to a minimum capital requirement.

Important counterparties can pressure the debtor corporation to raise capital in order to resume business if they determine that the risk of fraudulent transfer liability is too high. Fraudulent transfer law forces parties who deal with financially vulnerable institutions to tread cautiously.

There has recently been a surge in fraudulent transfer litigation. During the credit boom that started in 2003 and peaked in 2007, banks issued a remarkable volume of loans and bonds, and an astounding volume of highly leveraged transactions were financed. As these debts become due and financially strapped businesses struggle to refinance, the result will almost certainly be a wave of defaults, bankruptcies, and intercreditor disputes–including fraudulent transfer litigation.

The decisions of bankruptcy courts in adjudicating these disputes will cause tens, if not hundreds, of billions of dollars to change hands over the next few years. If bankruptcy courts make prudent decisions, they can help shape credit policy at U.S. banks for a generation. Unfortunately, the methods that bankruptcy courts have traditionally used to adjudicate fraudulent transfer claims have at times led to inconsistent, unpredictable, and inadvertently biased outcomes for two reasons. First, courts’ reliance on experts introduces tremendous subjectivity and complexity into the process. Second, well-established features of human psychology–which cannot be overcome, despite the good intentions of bankruptcy judges–taint the decision-making process with legally impermissible hindsight bias.

This article discusses recent legal and financial innovations that may aid bankruptcy courts in assessing fraudulent transfer claims in large business bankruptcies. These innovations have the potential to diminish the importance of experts, increase consistency and predictability in fraudulent transfer law, de-bias and simplify judicial decision-making, and ultimately help stabilize the economy by deterring imprudent business decisions. Part II of this article discusses the dramatic increase in financial leverage throughout the economy during the last decade of prosperity, the recession that began in 2008, and why fraudulent transfer law may determine who will bear billions of dollars in losses. Part III of this article describes the historical and intellectual development of fraudulent transfer law, the expert-centered paradigm that prevailed during the last twenty years, experimental and real-world evidence of the problem of hindsight bias, and two recent decisions that suggest the emergence of a new market-centered paradigm. Part IV of this article explains how this new market-centered paradigm–coupled with recent innovations in the financial markets and finance theory–can enable fraudulent transfer law to more effectively achieve its historical policy objectives. Part V of this article includes original empirical analysis of the relationship between equity and CDS prices as debtors approach bankruptcy. Part VI explains how judicial adoption of the methods we suggest would improve credit decisions at banks and prevent destabilizing transactions.

Although this article focuses on fraudulent transfer law and CDS markets, its potential applications are much broader. Market-implied probabilities of default can assist courts in deciding any controversy that requires a judicial determination of corporate solvency, whether the controversy pertains to fraudulent transfer, preference, or corporate directors’ duties. Market-implied probabilities of default can be calculated from any debt instrument that is traded in a liquid and reasonably informed market and for which a yield to maturity can be calculated, whether the instrument is a credit default swap, a corporate bond, or a bank loan. The applications are diverse and the ramifications are potentially vast.

Author Information

Michael Simkovic, Associate Professor, Seton Hall Law School; J.D., Harvard Law School; B.A., Duke University. Benjamin S. Kaminetzky, Partner, Davis Polk & Wardwell LLP; J.D., New York University School of Law; B.A., Yeshiva University.