Bankruptcy’s trilemma: a unifying framework

Abstract We propose a unified framework to explain the key problems underlying corporate bankruptcy law. Creditor rights take two primary forms: the right to take assets from the debtor and the right to block transfers involving the debtor. Taking and blocking rights control agency problems, such as value-diverting transfers by management. But in financial distress, one creditor’s rights can impose costs on the others. Multiple taking rights create the well-known commons problem: creditors can race to the debtor to collect, potentially forcing the liquidation of a valuable firm. Bankruptcy law can stay the creditor race, but a stay introduces one of two alternative problems. Replacing taking rights with blocking rights creates an anticommons problem of holdout and costly delay. Holdout problems can be mitigated by removing blocking rights for some creditors. But without taking or blocking rights, creditors lose essential protection against the very agency problems their contracts try to prevent. Bankruptcy law’s changes to nonbankruptcy rights come in three major forms: a stay (to address commons problems), forced exchanges of rights (to address anticommons), and limits on controllers’ transacting powers (to address agency). But each intervention exacerbates at least one of the other two problems. Thus, we call these three problems—commons, anticommons, and agency—bankruptcy’s trilemma: the law cannot solve all three at once. Our framework provides a powerful lens for analyzing complex contemporary issues, such as “Texas two-step” bankruptcy filings, and for understanding differences in bankruptcy laws across countries.