Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution

Abstract

This article discusses recent legal and financial innovations that may aid bankruptcy courts in assessing fraudulent transfer claims in large business bankruptcies. These innovations have the potential to diminish the importance of experts, increase consistency and predictability in fraudulent transfer law, de-bias and simplify judicial decision-making, and ultimately help stabilize the economy by deterring imprudent business decisions. Part II of this article discusses the dramatic increase in financial leverage throughout the economy during the last decade of prosperity, the recession that began in 2008, and why fraudulent transfer law may determine who will bear billions of dollars in losses. Part III of this article describes the historical and intellectual development of fraudulent transfer law, the expert-centered paradigm that prevailed during the last twenty years, experimental and real-world evidence of the problem of hindsight bias, and two recent decisions that suggest the emergence of a new market-centered paradigm. Part IV of this article explains how this new market-centered paradigm–coupled with recent innovations in the financial markets and finance theory–can enable fraudulent transfer law to more effectively achieve its historical policy objectives. Part V of this article includes original empirical analysis of the relationship between equity and CDS prices as debtors approach bankruptcy. Part VI explains how judicial adoption of the methods we suggest would improve credit decisions at banks and prevent destabilizing transactions.

Although this article focuses on fraudulent transfer law and CDS markets, its potential applications are much broader. Market-implied probabilities of default can assist courts in deciding any controversy that requires a judicial determination of corporate solvency, whether the controversy pertains to fraudulent transfer, preference, or corporate directors’ duties. Market-implied probabilities of default can be calculated from any debt instrument that is traded in a liquid and reasonably informed market and for which a yield to maturity can be calculated, whether the instrument is a credit default swap, a corporate bond, or a bank loan. The applications are diverse and the ramifications are potentially vast.