America could use a competent history of bankruptcy law right now because the excesses of the past two decades are about to bring us a new round of debtors seeking refuge from their creditors, some desperate and some manipulative. One bill favored by credit card banks would let them hound some debtors for life, adding late fees every month and denying the fresh start that bankruptcy has traditionally brought. This bill would make it much harder for the average uninsured Joe to get out from under crushing medical bills, while still leaving open the gaping loopholes in the law that helped facilitate some of the current disasters and serving as an easy out for large corporations whose filings, the result of gross mismanagement, protect fat executive salaries.
If ever there was a moment ripe for a serious examination of bankruptcy in America, this is it. The last history was published in 1935, making a solid history of how we got here most welcome just now. Author David A. Skeel Jr., a University of Pennsylvania law professor, promises readers the untold story of how bankruptcy evolved as a uniquely American way of dealing with debtors who cannot pay their bills, a story that he writes was shaped by political forces and an elite section of the bar.
At the founding of the Republic, Alexander Hamilton and the Federalists pressed for a new idea of bankruptcy as renewal, not a time for debtor’s prison. Hamiltonians wanted to encourage credit to spur economic expansion, while the Jeffersonian Republicans wanted to protect farmers from foreclosure by bankers. This debate over how to deal with the insolvent and balance the interests of creditor and debtor, Skeel writes, has been waged for more than two centuries. A host of schemes have been tried, modified, and abandoned by Congress.
Now, as we learn to live in a global economy, the American idea of bankruptcy as renewal rather than ruin is gaining currency in other developed countries, but the down side of that system is becoming all too apparent in the United States. A critical examination of the confluence of forces—asset inflation, accounting rules, and changing partnership laws—is desperately needed. Unfortunately, Skeel’s book isn’t it.
When the dot-com bubble burst, we came to what may be the end of two decades of asset inflation encouraged by government policy and financial engineering. Asset values are falling and bankruptcy filings are rising to record levels. Enron, Global Crossing, Kmart, Sunbeam, and more dot-coms than this article has periods have had to seek refuge from creditors in federal bankruptcy court.
Avoiding bankruptcy, because they had enough cash in hand to hold creditors at bay, were Cendant, Lucent, Mercury Finance, and a host of other companies that reported fattening bottom lines quarter after sizzling quarter until all that profit suddenly evaporated. The corporate books had been finely cooked until investors were served up a most unsavory net wealth reduction.
The executives who mismanaged their companies gorged themselves on greenback soup while serving up the mock kind to anyone not lucky enough, or informed from the inside, to sell their shares before the final course. And through all of this, the Big Five auditing firms put on the garnish of their opinion letters, helping lure more share buyers at ever-higher prices until the collapse.
The willingness of the Big Five accounting firms to sell their reputations was driven not by the lowest-bid work of auditing the books, which is supposed to give shareholders a reasonably reliable picture of a company’s financial condition. What compromised their integrity was the big money they could get from these same companies selling “products” that make profits vanish from corporate income tax returns, as well as consulting. This is where the Big Five made their real profits.
And then there was an obliging Congress, which, along with the 50 state legislatures, gutted partnership laws in ways that made corner cutting and outright fraud more palatable in the halls of accountancy and law. Until a decade or so ago, each partner was liable for the acts of every other partner, which served as a powerful self-policing mechanism within the corporate professions. Then came the savings and loan scandals of the 1980s, a rich treasure of bankruptcy lore, in which not a few accountant partners let their greed get the better of their professionalism. Soon partners in these global firms, who may never have set foot in an S & L, found themselves taking out second mortgages to pay the damages awarded against the entire partnership.
The damages inflicted on all partners by the corrupt few should have prompted a new vigilance to ensure integrity. Instead, the accountants lobbied and donated their way into “reform” of the partnership laws. Now we have “limited liability” partnerships and corporations, which means that your partner down the hall can cheat left and right and your fortune remains safe so long as you do not inquire into his conduct and thereby make yourself a knowing, and thus liable, party to the chicanery. Thus, at least in the immediate term, market forces fail to correct misconduct.
A decade ago, the S & L crisis, together with the damage wreaked by Michael Milken’s schemes and other imprudent investments, caused a hiccup in the phenomenal growth since about 1982 of the gross national product—remember the Recession of ’91?
During that hiccup we were treated to two important developments affecting bankruptcy. One dealt with the benefits of regulation for a company eager to stiff its creditors. The other dealt with retirement pay in a precursor of everything that happened to Enron workers and their 401(k) plans, only worse.
In one well known example of the first scenario, we saw Donald Trump and Merv Griffin borrow millions in the corporate bond market, even though their own loan applications, in the form of prospectuses, made it clear that the money would not be paid back. One set of Trump bonds, underwritten by Merrill Lynch, defaulted almost before the ink dried.
Neither The Donald nor the Merv was at risk of having unpaid creditors seize their temples of chance, however, just because they skipped their mortgage payments. That’s because they held gambling licenses and the bondholders did not. Both the New Jersey Attorney General’s Division of Gaming Enforcement and the Casino Control Commission demonstrated the benefits of regulation to the regulated when they found a way around a most simple rule. That rule said that an Atlantic City casino must be solvent to stay in business. The rule defined solvency as the ability to pay bills as they come due. It might seem that Trump and Griffin failed that test when they missed their interest payments, but the creative regulators took the view that once a bankruptcy deal was in the works the interest payments were no longer due and, thus, the casino companies were solvent.
Welcome to strategic bankruptcy, forever to be a part of our future, unless Congress intervenes. It is what Kmart did when it filed Chapter 11, not because it was out of cash, but because it wanted out of leases and the landlords wanted their promised monthly rent. Corporate bankruptcy can be contract renegotiation by other means.
The second egregious bankruptcy practice emerged when management ran into the ground such once great companies as Morrison-Knudsen, builders of Hoover Dam, and Carter Hawley Hale, operator of department stores from Santa Monica to Sacramento. These companies all had as their retirement plans a pool of their own stock, just as Enron had. Companies deduct the value of stock or cash they put in these accounts, where the money is safe from the company’s creditors, but not from the risk that the investments will lose value.
But highly paid workers get an extra dollop of stock put into their “executive deferred compensation plan” that is not subject to any limits. These plans also do not generate an immediate tax deduction for the company. By law the money that executives defer can be seized by creditors if the company goes bankrupt, which would seem to create a powerful incentive for the executives to run the company prudently. It does not.
At Morrison-Knudsen, Carter Hawley Hale, and eight other companies, the workers whose funds were safe from creditors were wiped out when their company’s stock sank to zero. The executives, however, pocketed 100 cents on the dollar. How?
The executives got paid in full because when the creditors came in to take over the bankrupt companies and rehabilitate them in the Hamiltonian fashion, they needed these executives to hang around and help until they had full control of the enterprise. And what did the executives demand as the price to stay? That their deferral accounts pay off. Bill Agee demanded that Morrison-Knudsen pay him to the penny. He walked away with $367,062.30. Department store mogul Phil Hawley pocketed several million dollars.
These bankruptcy developments were both front-page news. The Trump and Griffin cases were covered in detail, under my byline, in The Philadelphia Inquirer, author David A. Skeel Jr.’s hometown newspaper, and in other major news outlets. And the executives like Agee and Hawley who kept dry while their companies sank were the subject of the first two parts of “Rushing Away From Taxes,” a 1996 series in The New York Times that was the paper’s biggest investigative effort since the Pentagon Papers.
Despite their relevance to bankruptcy history, readers will not find a word about these matters in Debt’s Dominion. If that were all that was missing, it would be of little significance. But there is more, much more, that Skeel left out. Skeel’s readers will learn nothing about partnership law “reform” or savings and loan chicanery and its role in bankruptcy law. Indeed, they will not even learn about the very first federal bankruptcy law, enacted in 1800, simply because Skeel finds it inconvenient to address what that first law did. He writes lamely that “for simplicity, and because involuntary-only disappeared as a viable option by the middle of the nineteenth century, however, I will banish it from discussion.”
The issue of whether a debtor could declare himself bankrupt or only his creditors could was, by Skeel’s own account, a major issue in the history of pre-Civil War bankruptcy, which makes this omission nothing short of astonishing. But then it may be that Skeel simply did not want to do the work to understand the 1800 law.
The evidence for this lies in the sloppy way that Skeel identifies and writes about key historic figures in bankruptcy law and in his lack of logical organization. Asking for narrative may be a bit much, but how about simple chronology, the most basic format for history? Instead of marching straight forward from 1800 and describing our nation’s experiments with bankruptcy, Professor Skeel flits back and forth across decades, often incoherently, giving some dates, hinting at others and sometimes forgetting to say in just what era he is wandering.
Again and again, Skeel tells the reader what he is going to argue or what he has just argued, an annoying device that fills at least 1 percent of his book. He mentions bimetallism, but wastes no words explaining the reasons that a monetary system based on silver and gold could have resulted in inflation that benefited debtors and hurt creditors in the late 19th century, a major issue at the time of William Jennings Bryan’s “Cross of Gold” speech.
Skeel cites neither the Currency Act of 1792, which made bimetallism government policy for the next 141 years, nor the discovery of the Comstock Lode, whose rich veins flooded the late 19th century world with so much silver that it altered the relative prices of the two precious metals. Without context, what he writes on bimetallism is worthless. Unfortunately, the totality of what the reader gets from Debt’s Dominion is almost unimaginable: a history that is ahistorical.
That an undergraduate would hand in such a sloppily written, disorganized, and half-baked mess is reality. That a professor of law at the University of Pennsylvania would do so, and that Princeton University Press would publish it along with the author’s encomium to his editor, is sad evidence of another kind of bankruptcy at both academic institutions.
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David Cay Johnston, a reporter for The New York Times, won the Pulitzer Prize last April for his coverage of inequities and loopholes in the tax system.
