,,,Inequality and Equity in Bankruptcy Reorganization

Courts have developed a series of controversial doctrines that allow a debtor to depart from bankruptcy’s standard priority rules. In a recent decision, the Supreme Court signaled tolerance of one type of departure, the critical vendor payment, as long as it occurs early in the case and is what an economist would call a strict Pareto improvement: a payment that makes all creditors better off. This essay demonstrates that Pareto improvements appear in the stated tests governing other departures, including roll-ups and substantive consolidations. Some scholars, and a few courts, would apply much more permissive tests similar to economists’ Kaldor-Hicks standard and allow deviations as long as the winners gain more than the losers lose. Still other courts would do away with these doctrines entirely and allow departures only with the consent of the disfavored. Defending the judicial use of the Pareto standard in reorganizations, the essay further discusses some of the normative considerations in the choice between a Pareto standard, a Kaldor-Hicks standard, and an absolute prohibition.