The prevailing theory of corporate bankruptcy law states that its purpose is to vindicate or mimic the agreement that creditors would have reached if they had bargained with each other to write their own rules. That idea—the Creditors’ Bargain theory—has held a central place in the minds of lawyers, judges, and scholars for almost forty years. At the same time, Creditors’ Bargain theorists have struggled to explain what actually prevents creditors from bargaining with each other and how efficient rules that interfere with creditors’ bargained-for rights fit into the theory.
Meanwhile, in other areas of the law, scholars have long recognized the limits of hypothetical contract theories. Notably, scholars have shown that when parties have limited or asymmetric information and incentives to bargain strategically, their contracts will be incomplete in ways that the law cannot remedy with a hypothetical contract. Bankruptcy scholars have never squarely addressed this challenge.
Taking aim at these issues, my article, ‘The New Bargaining Theory of Corporate Bankruptcy and Chapter 11’s Renegotiation Framework’, proposes a new law-and-economics theory of corporate bankruptcy. Financial distress routinely presents uncertainty that is not contractible. By its very nature—given the number of parties engaged in strategic bargaining and the number of contingencies—financial distress poses questions that are impossible 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.
Corporate bankruptcy law’s purpose is to solve this hold-up problem. The problem is familiar in law, but its frequency in the distress context invites a special bankruptcy solution. The noncontractible uncertainty associated with financial distress is a recurring characteristic across all firms. Because every relationship of this type is incomplete and requires judicial intervention upon the occurrence of the same event, a uniform bankruptcy system that deals with those relationships will produce consistency, efficiency, and market predictability.
In Chapter 11, that uniform system takes the form of a structured renegotiation framework. Because of the high level of ex ante uncertainty, the system relies mostly on procedural protection rather than specific substantive prescriptions. The framework allows parties to renegotiate their relationships within a system that imposes prices and burdens on the bargaining process and then subjects the results to high-level judicial oversight. The specifics of this framework are targeted at reducing the worst and most likely instances of hold up that block renegotiation efforts.
Bankruptcy, then, is not about mimicking a hypothetical ex ante bargain. It is about facilitating an actual ex post bargain. The normative claim of my article is that bankruptcy law’s core purpose is to solve the hold-up problem. The descriptive claim is that the ex post renegotiation framework is the fundamental attribute of Chapter 11. The remaining normative question is whether Chapter 11 succeeds at its purpose. This New Bargaining Theory of corporate bankruptcy can help identify the metrics by which to answer that question.
Anthony J. Casey is a Professor of Law and Mark Claster Mamolen Teaching Scholar at the University of Chicago.