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The Authentic Consent Model: contractarianism, Creditors’ Bargain, and corporate liquidation

Published online by Cambridge University Press:  02 January 2018

Rizwaan Jameel Mokal
Rizwaan Jameel Mokal*
Affiliation:
Faculty of Laws, University College London
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Abstract

The first part of this paper asks if the Creditors' Bargain Model, long employed by insolvency scholars as the starting point for many an analysis, can explain or justify even the most distinctive and fundamental feature of insolvency law. After examining the defining features of the model's construction, the role of self-interest and consent in it, and its ex ante position, it is concluded that the Bargain model can neither explain nor legitimate the coercive collective liquidation regime. The second part of the paper develops an alternative model to analyse and justify insolvency law. The starting premise is that all (but only) those affected by issues peculiarly governed by insolvency law are to be given a choice in selecting the principles which would determine their rights and obligations. Once these parties have been identified, they are to be given equal weight in the selection process, since their legal status (whether they are employees, secured or unsecured creditors, etc), wealth, cognitive abilities, and bargaining strength are all morally irrelevant in framing rules of justice. This part of the paper introduces the notion of a constructive attribute, characteristics this society accepts its citizens should have in their role as legislators. So all parties affected by insolvency issues are regarded as free, equal, and reasonable. The model sketched out in this part of the article requires all principles to be selected from its choice position. Here, all the parties are deprived of any knowledge of personal attributes, and must reason rationally. It is shown that parties in the choice position would in fact choose the principles laying down the automatic stay on unsecured claims. The paper concludes with the demonstration that because of the construction of the choice position and the constructive attributes of the parties bargaining in it, the principles chosen are fair and just, and chosen in exercise of the parties' autonomy. As it happens, they are also efficient.

Type
Research Article
Information
Legal Studies , Volume 21 , Issue 3 , September 2001 , pp. 400 - 443
Copyright
Copyright © Society of Legal Scholars 2001

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References

1. Insolvency Act 1986, s 123.

2. Insolvency Act 1986, s 130(2), 127–128. See also s 112.

3. Insolvency Act 1986, s 130(4).

4. 34 & 35 Hen VIII, c 4.

5. The bar on creditors’ rights to pursue individual remedies is analytically quite distinct from the order in which they are paid under the collective regime: see section 12 below. This issue is discussed in greater detail in R J Mokal ‘Priority as Pathology’ (2001) CLJ (November).

6. 7 & 8 Vict, c110(1844) removed the need to obtain letters of patent from the Crown before a company could be set up, while 25 & 26 Vict (1862), c 90 confirmed that the presentation of a winding-up petition would cause all actions against the company to be suspended. See generally Markham, V Lester Victorian Insolvency: Bankruptcy, Imprisonment for Debt, and Company Winding-Up in Nineteenth-Century England (Oxford: Clarendon Press, 1995) ch 6Google Scholar.

7. Warren ‘Bankruptcy policymaking in an imperfect world’ (1993) 92 Michigan LR 336 at 338. Warren is one of the leading critics of the Bargain heuristic.

8. T Jackson ‘Bankruptcy, non-bankruptcy entitlements, and the Creditors’ Bargain' (1982) 91 Yale LJ 857; Jackson, T The Logic and Limits of Bankruptcy Law (Cambridge, Mass: Harvard University Press, 1986)Google Scholar; D Baird and T Jackson ‘Corporate reorganizations and the treatment of diverse ownership interests: A comment on adequate protection of secured creditors in bankruptcy’ (1984) 51 U Chicago LR 97; T Jackson and R Scott ‘On the nature of bankruptcy: An essay on bankruptcy sharing and the Creditors’ Bargain' (1989) 75 Virginia LR 155. See also D Baird ‘Loss distribution, forum shopping, and bankruptcy: A reply to Warren’ (1987) 54 U Chicago LR 775 at 815.

9. The present author himself must accept some degree of culpability! See R J Mokal ‘An agency cost analysis of the wrongful trading provision’ (2000) CLJ 335.

10. On risk aversion generally, see Pindyck, and Rubinfeld, Microeconomics (New Jersey: Prentice-Hall, 4th edn, 1998) ch 5Google Scholar.

11. This summarises the arguments in Jackson, T The Logic and Limits of Bankruptcy Law (Cambridge, Mass: Harvard University Press, 1986) ch 2.Google Scholar

12. Ibid, p 17 fn 22; see pp 236–237.

13. R Posner ‘The ethical and political basis of the efficiency norm in common law adjudication’ (1980) 8 Hofstra LR 487.

14. Jackson and Scott, n 8 above, p 160 (emphasis added).

15. Posner, n 13 above, p 499.

16. Jackson, n 11 above, pp 59 fn 80, 15, 30 respectively.

17. Posner, n 13 above, p 499.

18. Jackson and Scott, n 8 above, p 160; see also the references from Jackson, n 16 above.

19. See section 13, ‘The Denouement’.

20. See again Jackson and Scott, n 8 above, p 160 and Jackson Bankruptcy, pp 59 fnn 80, 15 and 30, etc. See also Posner, n 13 above, p 499. These examples are merely illustrative, not exhaustive.

21. Jackson and Scott, n 8 above, p 178 (emphasis added).

22. Ibid, p 160.

23. In view of these preliminary points, and those to be made later, it might be observed those objecting to the view that Natural Ignorance is central to the Bargain model are sympathetic indeed towards that model, hoping to save Jackson and Scott from their own folly by suggesting an alternative reading, one which might override the manifest intentions of the model's expositors, but which the objectors consider more viable none the less. Alternatively, and less kindly, it might be said such objectors have paid insufficient attention to the details of the model's construction, or to its philosophical basis. As it happens, those denying any necessary link between the model and Natural Ignorance do not generally appear too sympathetic towards Jackson's (and Scott's) project as a whole.

24. The arguments in sections 4 and 5 draw frequently on Dworkin ‘Why efficiency?’ (1980) 8 Hofstra LR 563; Brudney ‘Hypothetical consent and moral force’ (1991) 10 Law and Philosophy 235; and Hardin ‘The morality of Law and Economics’ (1992) 11. Law and Philosophy 331.

25. Posner, n 13 above, p494.

26. See eg Jackson, n 11 above, pp 13, 15, 17 fn 22, etc.

27. See eg Hardin, n 24 above, 361.

28. Brudney, n 24 above, pp 239–240, considers a similar argument.

29. No reference can be made to Jackson's work here since the text asserts a negative. So the reader is invited to consult Jackson's work and confirm none of his substantive arguments turns on anything but self-interest.

30. Dworkin, n 24 above, p 511; and Brudney, n 24 above, pp 263–268.

31. Dworkin, n 24 above, p 578.

32. Posner, n 13 above, p 492 and the references cited therein; see also Mokal, n 9 above.

33. Under the collective regime, of course, he would have to accept whatever priority was given to his ‘type’ of creditor by insolvency law: see Mokal, n 5 above. Note also that this simple example is based on a transaction-specific view. The argument is broadened in section 5 to include the long-term interests of creditors.

34. In fact, he supports the pari passu principle for unsecured creditors; see n 11 above, pp 30–31.

35. T Jackson ‘Bankruptcy, non-bankruptcy entitlements, and the Creditors’ Bargain' (1982) 91 Yale LJ 857 at 863–864; see also n 11 above, p 15.

36. Ibid.

37. Jackson, n 11 above, p 15 fn 18.

38. Ibid.

39. Jackson and Scott, n 8 above, p 499. Note yet again this crystal-clear endorsement of Natural Ignorance.

40. This paragraph draws on Gauthier Morals by Agreement (Oxford: Clarendon Press, 1986) ch 5. It develops Gauthier's insight that in a bargain between rational self-interested parties, Party X may not claim any part of the pay-off enjoyed by Party Y in the ‘initial bargaining position’ (which here is the non-insolvency, debt-collection system), but only some part of the ‘co-operative surplus’ . So, eg, bank-creditors would attempt to retain at least as much as they could get for themselves without a collective system. If they could not, they would still wish to minimise the amount they would have to give up. (On this last point, the position taken here departs from Gauthier's, since here we imagine a bargain, even though there is no co-operative surplus from the bank's perspective.)

41. Dworkin, n 24 above, p 575, who warns the term ‘authentic consent’ can be ‘misleading’.

42. Rawls, J A Theory of Justice (Cambridge, Mass: Harvard University Press, 1971)Google Scholar.

43. Rawls, J Political Liberalism (New York: Columbia University Press, 1996)Google Scholar.

44. Kymlicka Contemporary Political Philosophy (Oxford: Clarendon Press, 1990) p 128, contrasting Rawls’ approach with ‘mutual advantage’ theories.

45. D Korobkin ‘Contractarianism and the normative foundations of bankruptcy law’ (1993) 71 Texas LR 541.

46. Rawls, n 43 above, Lecture 1; see esp pp 3–5.

47. Korobkin, n 45 above, p 546.

48. Ibid.

49. Ibid.

50. Ibid, p 554.

51. Ibid, p 548.

52. Ibid, p 548.

53. Ibid, p 555.

54. Ibid, p 558.

55. Ibid, p 570.

56. Ibid, pp 550–551.

57. This observation mirrors Baird ‘A world without bankruptcy’ (1987) SO LCP 173, 185: ‘Requiring those with rights against a firm's assets to take account of the interests of the workers is tantamount to giving the workers rights to the firm's assets.’

58. This, at least on one very plausible view, is partly what happens in proceedings governed by Ch 11 of the US Bankruptcy Code, which Korobkin supports both in the article under discussion and elsewhere.

59. Insolvency Act 1986, s 123. It is very important to note that, in fact, this argument is broader: B, C and D never invoke any special procedure designed to deal with companies in ‘financial distress’, and remain subject only to general company, employment, and social security laws, etc. So this argument applies with equal force to any Korobkinian changes either to liquidation or to so-called ‘rescue’ regimes (the latter may only be available in a firm's insolvency; alternatively, they might be open to invocation without the need to demonstrate insolvency). The real contrast is between ‘ordinary’ law which deals with companies throughout their existence, and special provisions which may be invoked only when a firm is in crisis.

60. Anyone suggesting special protection for displaced employees of insolvent businesses would have to face the fact that 12 times as many businesses close down without defaulting on their debt obligations (and therefore without invoking any formal insolvency procedure) as those which do become unable to pay multiple debts: see Bank of England Finance for Small Firms: A Sixth Report (January 1999) p 22 including fn 24, citing Storey, ‘Firm size and performance’, in Acs and Audretsch (eds) The Economics of Small Firms (London: Kluwer, 1990). So proposals of the sort made by Korobkin, which are meant to protect (say) employees, but which apply only to employees of insolvent businesses, would leave up to 90% of their target population unprotected. This objection holds for all the other groups Korobkin wishes to ‘protect’.

61. Korobkin, n 45 above, p 571.

62. This discussion should dispose of arguments similar to Korobkin's, made by Warren ‘Bankruptcy policy’ (1987) 54 U Chi LR 775 (arguing that the role of insolvency law is to (re-)distribute losses associated with business failure; however, the sort of losses Warren is concerned with can and do accrue to the same types of parties without their becoming subject to insolvency law at all), and Gross Failure and Forgiveness: Rebalancing the Bankruptcy System (New Haven: Yale University Press, 1997) (arguing that insolvency law must protect ‘community interests’; again, though, such community interests can be and are threatened in an identical way without insolvency law being implicated). A similar argument is mentioned by Finch ‘The measures of insolvency law’ (1997) 17 OJLS 227 at 234: ‘[I]nsolvency [law] does and should recognize the interests of parties who lack formal legal rights in the pre-insolvency scenario not least because parties with formal legal rights never bear the complete costs of a business failure’ [footnote omitted]. Again, Finch fails to recognise that such ‘costs’ can fall on parties without legal rights even when the business in question shuts down without ever becoming subject to insolvency law. To avoid arbitrariness, Finch (and Warren and Gross) should be making such an argument in the context of general company law (or indeed that of employment or social security law).

63. Finch, n 62 above, p 237. Finch attributes this ‘response’ (and the one discussed below) to ‘communitarians’ . Since she does not name particular communitarians willing to own up to these views, it might reasonably be assumed she is making a ‘communitarian’ argument herself.

64. See Mokal, n 5 above.

65. It should be obvious the argument here is not meant to apply to the plight of any of these parties qua creditors.

66. Finch, n 62 above, p 237 (emphasis in the original).

67. And of course if the issues are not identical and one arises only in insolvency, then we would not be violating the prescription that insolvency law should only deal with issues peculiar to insolvency.

68. Rawls, n 43 above, p 16.

69. This paraphrases in Gibbard ‘Constructing justice’ (1991) 3 Philosophy and Public Affairs 264 at 269.

70. Barry Justice as Impartiality (Oxford: Clarendon Press, 1995) p 50; the significance is that Barry is one of the leading critics of ‘justice as reciprocity’ theories.

71. Ibid, p 50.

72. Ibid. See also Kymlicka, n 44 above, p 129.

73. Gibbard, n 69 above, p 272.

74. This is subject to the parties’ being equal. The following two sections explain the concept of equality, which is the necessary condition for admission to the choice position. That and the criterion discussed here together constitute the sufficient conditions for admission.

75. Nagel, ‘Rawls on justice’, in Daniels, (ed) Reading Rawls: Critical Studies on Rawls' ‘A Theory of Justice’ (Stanford: Stanford University Press, 1989) p 4.Google Scholar

76. See also Finch, n 62 above, pp 238–239. The position of those who are not faced with peculiar insolvency issues, but who are affected nevertheless by insolvency law, is dealt with in section 11(b) below.

77. Jackson, n 11 above, pp 32–33; Jackson and Scott, n 8 above, at 160–162, but see at 194–196.

78. Jackson, 11 above, p 868 fn 52.

79. Jackson and Scott, n 8 above, p 177.

80. Section 214.

81. Mokal, n 9 above, analyses these issues using a method which can be regarded as lying half-way between the Creditors’ Bargain and the ACM. All its material conclusions would remain unaltered if put to the test within the framework being laid out here.

82. Korobkin, n 45 above, p 554.

83. Incidentally, this also counters criticism of the sort levelled against Korobkin by Finch (n 62 above, p 235) that ‘principles of insolvency law designed by a veiled and highly inclusive group are liable to be so protective of so many interests, and as a result so uncertain, that the effects on the cost of credit would be catastrophic’ . The ACM certainly does not face this problem. Those invited to participate in the choice position here are all parties affected by corporate insolvency in a unique way. The interests to be protected are interests either threatened only in the debtor's insolvency, or threatened by it in a manner peculiar to insolvency. The categories of such interests are unlikely to be wide. In fact, Finch's criticism is unfair even to Korobkin, who himself seems to recognise his approach is hopelessly wide and attempts to respond. After framing what is supposedly the foundational principle of his model, the so-called ‘principle of inclusion’ which opens the door to ‘virtually all persons in society’, he goes on effectively to deny this principle any significance at all: see Korobkin, n 45 above, pp 574–575, esp fn 162, p 581, etc.

84. A contract between X and Y might be fair, even though X is immensely rich and Y immensely poor. But a necessary (though perhaps not sufficient) condition for it to be so is that the law giving effect to the contract does not accord certain privileges to X on account of his wealth which are not given to Y, nor apply disabilities to Y on account of his poverty which do not apply to X.

85. Members of the cast are really ‘in character’ only once on stage.

86. The terminology and the discussion borrow vaguely from Dworkin’ s exposition of a constructive coherence theory of morality in ‘The Original Position’ in Daniels, n 75 above, 16, p 27ff. The idea is developed further, in the context of Dworkin's theory of legal adjudication, in Dworkin Law's Empire (London: Fontana, 1986). See also Rawls, n 42 above, p 18.

87. This list is merely illustrative.

88. The phrase is Rawls’; see Rawls, n 43 above, p 29.

89. See Rawls, n 42 above, pp 261–265 and 5 84 for the phrase ‘ideal of the person’. See also Scanlon ‘Rawls’ theory of justice’, in Daniels, n 75 above, p 177.

90. Rawls, n 43 above, p 29 and fn 31.

91. Compare Dworkin in Daniels, n 75 above, p 28, describing the ‘constructive model’.

92. See Rawls, n 43 above, pp 29–35.

93. Ibid, p 30.

94. Ibid, p 19.

95. Ibid, p 30.

96. See eg Korobkin, n 45 above, p 570.

97. Rawls, n 43 above, p 32. Note the exclusion from the text of the adjective ‘self-authenticating’, which is used by Rawls as appropriate to natural persons. The label is not appropriate as applied to companies, and this is explained in the text.

98. Ibid.

99. Ibid, p 33.

100. Rawls, n 43 above, pp 33–34.

101. Ibid, p 79.

102. See section 8(b), above.

103. Rawls, n 43 above, p 79.

104. Dworkin in Daniels, n 75 above, p 50.

105. This paraphrases Dworkin, ibid, p 49.

106. Rawls, n 43 above, p 49.

107. Ibid, p 50.

108. Ibid, pp 76–77.

109. Barry Theories of Justice (Berkeley: University of California Press, 1989) p 338, in the context of Rawls’ assumption in Rawls, n 42 above that people in the original position care about the welfare of their descendants.

110. For a similar idea, see the comment by Rawls about liberty and the ‘primary goods’ (discussed below) in Rawls, n 42 above, p 143.

111. Ibid, p 50.

112. Ibid, pp 50–51.

113. Rawls, n 42 above, p 141.

114. Rawls, n 43 above, p 24.

115. Ibid. p 25.

116. Ibid, p 24.

117. Rawls, n 43 above, p 104.

118. Ibid, p 72.

119. Ibid, pp 79, 305.

120. Ibid, pp 104,305–306.

121. One quite hopeless ground for criticism can be dismissed straight away. Carlson ‘Philosophy in bankruptcy’ (1987) 85 Michigan LR 1345, 1344, describes theories based on conditions similar to Dramatic Ignorance as ‘ineffective’ because One cannot really fathom a time when people are so disembodied from their histories that they have no idea whether they are more likely to be investment bankers or widows.‘This sort of criticism has force against any attempt to rescue the Creditors’ Bargain by depriving all creditors of knowledge of who they are in the ex ante position. But against the ACM, this objection would be bizarre and entirely beside the point. Dramatic Ignorance is based on moral considerations, as explained in the text, and is not supposed to be a description of some actual ‘historical’ state, amnesic or amnestic. This issue is taken up again in section 13 below.

122. The first deals with the preference functions of those regarded as being in Dramatic Ignorance. Rawls deals with this problem by stipulating people in this state want certain ‘primary goods’ no matter what else they want, and the model developed here makes the same assumption about the insolvent's assets. This is discussed below.

123. Posner, n 13 above, pp 498–499.

124. Rawls, n 43 above, p xliv.

125. Ibid, p 104.

126. Obviously, the argument is based on the assumption that ‘unproductive’ people are capable of being productive but choose not to be. As for people who are unproductive simply because they are unable to work (due to disability, etc), parties selecting general, society-wide principles (not just those applicable in corporate insolvency situations) would anticipate they might turn out to suffer from such incapacity, and would choose principles accordingly. Such principles might lead to a welfare state of some description. Discussion of this is of course beyond the scope of this paper.

127. Cheffins Company Law: Theory, Structure and Operation (Oxford: Clarendon Press, 1997) pp 305–306.

128. Piercy v S Mills & Co (1920) Ch77; Hogg v Cramphorn Ltd (1967) Ch 254; Bamford v Bamford (1970) Ch 212; Charterbridge Corporation Ltd v Lloyds Bank Ltd (1970) Ch 62; see also Rackham v Peek Foods Ltd (1990) BCLC 895 and Aveling Barford Ltd v Perion Ltd (1989) BCLC 626.

129. For the purposes of this paper, this should be taken to mean no more than that, under the general law, creditors have priority over shareholders, and that insolvency law needs a reason to depart from this position. See further Kinsela v Russell Kinsela Property Ltd (in liq) (1986) 4 NSWLR 722 at 730 per Street CJ; quoted with approval by Dillon LJ in West Mercia Safetywear Ltd (in liq) v Dodd and another (1988) BCLC 250 at 252–253; Morse (principal ed) Palmer's Company Law (London: Sweet & Maxwell, 25th edn, 1992) para 8.506, and the authorities therein cited; finally, see Insolvency Act 1986, s 214.

130. Dworkin, n 75 above, p 49.

131. Ibid.

132. Rawls, n 43 above, pp 75–76.

133. Ibid.

134. Korobkin, n 45 above, p 571.

135. Rawls, n 42 above, pp 21–22.

136. Rawls, n 43 above, p 26; emphasis added to indicate a standpoint in actual society, free of the artificial constraints of Dramatic Ignorance.

137. Ibid, p 8.

138. See also Westbrook ‘The globalisation of insolvency reform’ (1999) New Zealand LR 401, 406–407.

139. Compare Insolvency Act 1986, ss 175, 386 and Sch 6. But note that the employee-creditor example is merely illustrative. No position is taken in this article on the priority of employee claims in corporate insolvency.

140. Carlson, n 5 above, p 13.52, makes a similar point. For a qualification, see Mokal, n 9 above. The argument is taken up again in Mokal, n 5 above.

141. See the first part of this paper.

142. Rawls, n 43 above, p 77.

143. See the first part of this paper.

144. This is where Carlson's comments, n 121 above, p 1344, concerning widows and investment bankers, noted above, are relevant.

145. Contrast Gauthier, n 40 above, pp 243–244.

146. Kymlicka, n 44 above, p 126, about mutual advantage theories in general.

147. Contrast Gauthier, n 40 above, p 222.

148. See Gauthier's own attempt in n 40 above, Ch VIII, esp pp 265–267.

149. See Gauthier. n 40 above, p 256: ‘The real individual… has his own particular and defining characteristics - capacities, talents, attitudes. preferences. He acts taking these as given, and his rationality is expressed in his endeavour to maximize the fulfilment of his preferences given his capacities and other traits of character, in the circumstances, whatever they may be, in which he finds himself… [T]here is no other conception of the person involved.’ This is, as it were, a textbook definition of Natural Ignorance; it is also the creed of mutual advantage theories like the Creditors' Bargain.

150. As already noted, of course, the ambit of the claims made by the model are restricted to a particular type of society. This, it should be made clear, is motivated not by any belief in moral relativism on this author's part, but only by the desire to avoid the argument being intolerably lengthy.

151. See eg Carlson, n 121 above, pp 1354 and 1364 fn 79 for one view of why the Bargain model is not neutral.

152. The final sentence paraphrases Kymlicka, ibid, p 128.

153. Brudney, n 24 above, p 262 (fn omitted).