The New Bargaining Theory of Corporate Bankruptcy and Chapter 11’s Renegotiation Framework
55 Pages Posted: 3 Apr 2019 Last revised: 18 Aug 2019
Date Written: March 16, 2019
This Article introduces the New Bargaining Theory of corporate bankruptcy. In that theory, the purpose of a well-functioning corporate bankruptcy system is to solve the incomplete contracting problem that accompanies financial distress. By its very nature, financial distress is difficult to contract over—the time horizon, the number of parties engaged in strategic bargaining, and the number of contingencies involved render the possible scenarios too numerous to predict, define, and negotiate in an ex ante contract. As a result, relationships involving a distressed firm are governed by incomplete contracts that allow parties to hold each other up. Because all firms face this same value-destroying problem, pressure arises for a uniform bankruptcy solution.
In Chapter 11 that solution takes the form of a framework of bargaining rules for ex post renegotiation. This framework is designed to minimize hold-up behavior among those with interests in a distressed firm. It does so by allocating power over certain decisions to one party while then imposing evidentiary burdens, price mechanisms, and other conditions on the use of that power. The initial allocation of power and conditions is based on the law’s assessment of where the hold-up risks lie. Within this framework and under the oversight of the court, the parties renegotiate their incomplete contracts.
This Article shows that widely-accepted alternative theories—which focus on a hypothetical ex ante creditors’ bargain and nonbankruptcy entitlements—are wrong. Chapter 11 is not a hypothetical bargain. And a proper bankruptcy system gives no special deference to nonbankruptcy entitlements. The ex post renegotiation framework is the fundamental attribute of Chapter 11 and its sole purpose is to solve Bankruptcy’s incomplete contracting problem.
Keywords: bankruptcy, corporate reorganization, chapter 11, creditors' bargain, corporate law, incomplete contracts, negotiation
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