Academic journal article The Yale Law Journal

Bankruptcy Contracting Reviewed

Academic journal article The Yale Law Journal

Bankruptcy Contracting Reviewed

Article excerpt

Western bankruptcy systems have two relevant features: (a) The systems are mandatory, that is, parties are required to use the state supplied system; and (b) each system has a number of mandatory rules. Until recently, reformers took these features as givens. The reformers' goal has been to improve the mandatory bankruptcy system and the mandatory rules within it.(1) Some scholars now contest the first relevant feature, arguing that requiring parties always to use one bankruptcy system is inefficient. In a recent essay,(2) challenged both of these features.

I made these claims:

(A) The only goal of a business bankruptcy law should be to reduce the cost of debt capital, which the law best does by maximizing the debt investors' insolvency state payoff.

(B) Regarding mandatory bankruptcy systems:

(i) Requiring parties always to use the mandatory state system increases a borrowing firm's cost of capital over the cost that would obtain in a world in which the firm and its creditors could contract for an alternative bankruptcy system.

(ii) If the rule against contracting for a preferred bankruptcy system were relaxed, parties would write "bankruptcy contracts" that would induce a borrowing firm to choose the system that would be optimal for it and its creditors were it to become insolvent.

(C) There should be few mandatory rules within bankruptcy systems. More precisely, [sections] 365(e) of the Bankruptcy Code, which prohibits the use of ipso facto clauses,(3) should be repealed. An analysis of this section also suggests that the wisdom of other mandatory rules should be rethought.

Professor LoPucki's reply(4) to my essay does not challenge claims (A) and (C) and explicitly accepts claim (B)(i). Professor LoPucki attempts to refute claim B(ii), and he makes a new, related claim. Regarding his refutation, I showed formally that parties would write bankruptcy contracts when all creditors (a) lend to the firm at the same time and (b) have the same preferences regarding bankruptcy systems. I then extended this result to argue that (a) parties would write these contracts when creditors lend at different times; and (b) creditor conflict regarding bankruptcy contracts would be rare if courts followed the absolute priority rule, and the few inefficient refusals to sign these contracts would be eliminated were the law to permit the preferences of a majority (in amount) of creditor claims to determine whether a bankruptcy contract became effective. My essay thus predicted that parties would write bankruptcy contracts if they were free to do so and if bankruptcy law were appropriately modified. This prediction is not testable today because bankruptcy contracts are unenforceable.(5) Hence, my essay attempted to motivate reform. If there is a possibility that free contracting over bankruptcy systems would increase welfare, and if there otherwise is nothing wrong with free contracting, then free contracting should be permitted.

Professor LoPucki argues that, even if one accepts the assumptions of my model, strategic behavior by borrowing firms would prevent the writing of bankruptcy contracts when the firm's creditors have the same preferences regarding bankruptcy procedures but lend at different times. He goes on to argue that actual creditors' preferences regarding bankruptcy systems almost always differ, so that creditors could not agree on a bankruptcy contract even if they lent at the same time. Taken together, these arguments lead Professor LoPucki to conclude that bankruptcy contracts seldom would arise if the prohibition on writing them were reversed.

This conclusion, if true, would be helpfully clarifying but would not count strongly against an argument for greater freedom of contract in the bankruptcy field. If free contracting over bankruptcy systems would be efficient in ideal conditions, then the fact that scholars today cannot plausibly show how real parties would write real contracts is not a serious refutation. …

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