Bankruptcy on the Side

Abstract

This article provides a framework for analyzing side agreements in corporate bankruptcy, such as intercreditor and “bad boy” agreements. These agreements are controversial because they commonly include a promise by one party to remain silent – to waive some procedural right they would otherwise have under the Bankruptcy Code – at potentially crucial points in the reorganization process.

Using simplified examples, we show that side agreements create benefits in some instances, but parties to a side agreement may have incentive to contract for specific performance or excessive stipulated damages that impose negative externalities on non-parties to the agreement. A promise not to extend new financing, for example, can affect the debtor’s reorganization prospects to the detriment of non-party creditors.

We develop a simple proposal that honors the intent of the parties to the side agreement and preserves the efficiency benefits they create, while limiting negative externalities. If a side agreement is unlikely to cause externalities, a court should enforce the agreement according to its terms. But if there is a nontrivial potential for value-destroying externalities, the court should limit a nonbreaching party’s remedy to its expectation damages. Our proposal is superior to the current approach in the case law, which focuses on tougher contract interpretation standards instead of limitations on remedies.

We also use our model to derive an answer to the increasingly vexing questions of whether intercreditor agreement disputes should be resolved by the bankruptcy court or outside bankruptcy, and whether forum selection clauses should be enforced. If the non-breaching party asks for expectation damages, the bankruptcy court has no particular expertise and should defer to forum selection clauses. Where specific performance or stipulated damages are at issue, by contrast, our model suggests that the dispute should be resolved exclusively in bankruptcy proceedings.