The Law and Economics of Investing in Bankruptcy in the United States

By Jared Ellias (UC Hastings)

When commentators describe American bankruptcy law as “the model to which European restructuring laws should aspire,” they are really speaking about an ‘American bankruptcy ecosystem’ of which law is only a significant part. The American bankruptcy ecosystem is best understood as a complex system inhabited by bankruptcy judges, law firms, investment bankers and activist investors. In this Report, I focus on one of the major components of this ecosystem: specialized investors that participate in the ‘bankruptcy claims trade.’ As I discuss, American bankruptcy courts today are best understood not as a place of shame and failure but rather as an integrated part of the capital markets, similar to the private equity firms of New York and the venture capital investors of Palo Alto. As this view of bankruptcy law took hold, investors, typically hedge funds, began to raise a large stock of capital to deploy in it. Importantly, while these investors were born of the bankruptcy bar’s development of institutions that situated bankruptcy courts within the capital markets, they have deployed their capital to accelerate it. This Report chronicles the rise of claims trading and the state of the academic literature on activist investing. In sum, the best interpretation of the available empirical evidence is that claims trading and activist investing have, at the very least, not harmed Chapter 11 or distressed corporations, and may have actually improved the capacity of the American bankruptcy system to reorganize distressed assets.

(*) This post was originally published on the Harvard Bankruptcy Roundtable.