Insider Guaranties in Bankruptcy: A Framework for Analysis

This article presents an economic analysis of insider guaranties in small business finance and bankruptcy, explaining their role in the panoply of legal and contractual devices used to control financial agency costs. It then uses this model to examine two areas of concern in the bankruptcy treatment of insider guaranties (the Deprizio preference problem and the enforceability of springing and exploding guaranties) and to explore some of the wider implications of insider guaranties for small business bankruptcy. Building on the fact that insider guaranties are typically used less to increase the assets available for repayment of the debt than to bond firm management to act in the best interest of the guarantied creditor, the article provides a new perspective on the insider preference dilemma, justifying the Deprizio doctrine (and critiquing amended Bankruptcy Code Section 550(c)) by focusing on the positive effects of insider liability rather than the purported negative effects of creditor leverage. This same perspective, however, argues against the enforceability of springing guaranties, which create disproportionate and therefore inefficient incentives to avoid bankruptcy. The article also demonstrates that insider guaranties play several underappreciated roles in the functioning of small business bankruptcies. First, insider guaranties, by reducing the value of the cramdown threat, can significantly alter bargaining power within the bankruptcy case and may be partly responsible for the large number of small business bankruptcy failures. Second, chapter 11 provides an identical bankruptcy regime for small and large businesses, but this reorganization-focused system is inappropriate for many smaller firms. Insider guaranties may in part be a market-generated corrective, a means of resegmenting business bankruptcy into separate schemes for smaller versus larger firms