Chapter 11’s Renegotiation Framework and the Purpose of Corporate Bankruptcy
56 Pages Posted: 3 Apr 2019 Last revised: 27 Feb 2020
Date Written: March 16, 2019
A fundamental question for corporate bankruptcy law is why it exists in the first place. To put it another way, why do we have special rules that apply only in financial distress? The conventional law-and-economics answer—known as the Creditors’ Bargain Theory—identifies two core purposes of bankruptcy law: recreating a hypothetical ex ante bargain and respecting creditors’ nonbankruptcy entitlements.
This Article challenges the Creditors’ Bargain Theory and presents an alternative: The sole purpose of corporate bankruptcy law is to solve the incomplete contracting problem that accompanies financial distress. Because financial distress is difficult to contract over, relationships involving a distressed firm are governed by incomplete contracts that allow parties to hold each other up. All distressed firms face this same value-destroying hold-up problem, and so pressure arises for a uniform solution. It is the purpose of corporate bankruptcy law to provide that solution.
In the United States, the pursuit of this bankruptcy purpose takes the form of a structured framework for ex post renegotiation of incomplete contracts. This framework—grounded in Chapter 11 of the United States Bankruptcy Code—imposes judicial oversight and allocates bargaining power in an attempt to minimize hold-up among those with interests in a distressed firm. In a sense, Chapter 11 puts in place guardrails that give the parties room to bargain while keeping them from taking positions that veer toward extreme hold up. This framework—which is not based on any hypothetical ex ante bargain and gives no special deference to nonbankruptcy entitlements—is the fundamental attribute of Chapter 11, and its sole purpose is to solve the incomplete contracting problem.
Keywords: bankruptcy, corporate reorganization, chapter 11, creditors' bargain, corporate law, incomplete contracts, negotiation
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