Contracting Externalities and Mandatory Menus in the U.S. Corporate Bankruptcy Code

Our paper offers the first justification for the U.S. bankruptcy code, in which firms are not allowed to commit themselves ex-ante in their lending agreements either to (Chapter 7) liquidation or to (Chapter 11) reorganization in case of distress ex-post. If fire-sale liquidation imposes negative externalities on their peers, then firms can be collectively better off if they are all forced into a no-opt-out choice (a mandatory “menu”). This is the case even though they would individually want to commit themselves to liquidation, and it is collectively better for them than voluntary contract choice or mandatory liquidation. Our paper’s innovation is thus to show not when a later choice should be prohibited, but when a later choice should be mandatory. Equivalent analyses could justify when other ex-post choices should remain inalienable (not contractible). JEL Codes: G33 (Bankruptcy, Liquidation). D62 (Externalities). K12 (Contract Law). Commercial law usually sets out default procedures for structuring private arrangements but does not require their use. For example, the Delaware Corporate Code permits entrepreneurs to choose among seven default business structures.1 Entrepreneurs can contract for the form that best suits their enterprise and even choose alternatives completely different from these defaults. Article 2 of the Uniform Commercial Code, America’s leading commercial statute, permits parties to alter every term, except those regulating transactions for procedural fairness. This seems broadly consistent with an economically-minded approach to regulation. Contract theory suggests that when information is symmetric and transactions do not create externalities, the state cannot improve the welfare of the contracting parties by substituting the regulator’s view for the parties’ view. The commercial laws facilitate this, because courts and legislatures believe that these two conditions—symmetric information and no externalities—commonly obtain. Bankruptcy law is different. Although bankruptcy law provides an insolvent debtor with a menu, under which it can liquidate under Chapter 7 or reorganize under Chapter 11, this menu is mandatory. A borrower cannot agree with its creditors in the lending agreement that it will use one or the other of these two procedures if it becomes distressed. Instead, the law always preserves the insolvent borrower’s freedom to choose ex-post.2 In addition, the U.S. Bankruptcy Code contains a large number of other mandatory rules. For example, a buyer cannot agree in a long-term procurement contract to excuse a solvent seller from further performance if the buyer becomes insolvent during the term. Instead, the distressed buyer can “assume” the contract, and thereby require the seller to perform the rest of it (Che and Schwartz (1999)). Why should professional borrowers and lenders not be allowed ex-ante to contract for the insolvency procedure that they themselves deem best for them? After all, could the parties not internalize ex-ante any ex-post externalities that attend their debt contracts? Bankruptcy law therefore remains an apparent anomaly. By the logic of common commercial law, the procedures in the bankruptcy menu should be defaults that firms could 1The structures are the general (i.e., public) corporation, the close corporation, a limited liability (LLC) company that can be owner-managed or manager-managed, a general partnership, a limited liability partnership (LLP), a limited liability limited partnership (LLLP), and a statutory business trust. 2The prohibition on bankruptcy contracting is generally descriptive (see Schwartz (1993, note 10)). Even carve-out and collateralized securities as well as leased assets nowadays provide no more than a partial opportunity for firms to opt out of Chapter 11. Any Federal bankruptcy filing stays asset repossession. The creditors can take collateral only if (a) the debtor has no equity in the asset, and (b) the collateral is not necessary for a successful reorganization.