The most dramatic development in twenty-first century bankruptcy practice has been the increasing use of contracts to shape the bankruptcy process. In our article, we assess—and try to make sense of—this striking shift in large scale reorganization practice.
Because the antecedents of the new contract paradigm seem to lie in the 1978 Bankruptcy Code itself, we begin by exploring the structure of Chapter 1. Although the Bankruptcy Code has long been viewed as mandatory, its voting and cramdown rules, among others, invite considerable contracting. The emerging paradigm is asymmetric, however. While the Code and bankruptcy practice allow for ex post contracting (after the onset of distress or default), ex ante contracts (around the time of investment or credit extension) are viewed with suspicion.
We next use contract theory to assess the two modes of contracting. The principal benefit of ex post contracting stems from the parties’ inability to anticipate each possible future contingency. Whereas an ex ante contract faces the challenge of providing for many possible future states of the world, an ex post contract can provide for the one that materialized. Ex ante contracting also provides distinct benefits, however, even if it is incomplete. It can encourage reliance on investments by the parties, efficiently allocates risk, and establishes incentives. Given time-inconsistent preferences of the parties, the prospect of ex post contracting can prevent the parties from exploiting these benefits. Contract theory has shown that it is difficult in practice for parties to prevent renegotiation or otherwise avoid this outcome.
We apply these insights to a number of key areas of current bankruptcy contracting including: the ex post contracts facilitated by the voting and confirmation rules of the Code itself; the use (and contrasting judicial treatment) of intercreditor and restructuring support agreements to contract around ostensibly mandatory Chapter 11 provisions; and substantive consolidation of the cases of a debtor and its affiliates. Even if all of the relevant parties consent, an ex post renegotiation may be inefficient if it undermines the parties’ ex ante arrangements. Yet, bankruptcy encourages such ex post contracting while discouraging ex ante attempts to avoid this outcome. We conclude that courts are too hostile to ex ante contracting, and they should subject ex post contracts to more careful review.
David Skeel is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School.
George Triantis is the Charles J. Meyers Professor of Law and Business at Stanford Law School.