BANKRUPTCY'S UNEASY SHIFT TO A CONTRACT PARADIGM.

• Author: Skeel, David A., Jr.
• Position: Symposium on the Fortieth Anniversary of the 1978 Bankruptcy Code

INTRODUCTION 1778 I. THE MANDATORY (AND PERMISSIVE) STRUCTURE OF THE BANKRUPTCY CODE 1783 II. Ex ANTE AND EX POST CONTRACTING: THEORY AND CURRENT PRACTICE 1789 III. ASSESSING THE NEW CONTRACT PARADIGM IN PRACTICE 1799 A. Chapter 11's Voting and Cramdown Rules 1799 B. Contracting on Confirmation: Intercreditor and Restructuring Support Agreements 1805 1. Intercreditor Agreements 1806 2. Restructuring Support Agreements 1807 3. Why the Different Treatment? 1808 C. Substantive Consolidation 1811 CONCLUSION 1816 INTRODUCTION

A generation ago, the Creditors' Bargain theory provided the first comprehensive normative theory of bankruptcy. (1) Not least of its innovations was the fact that it put bankruptcy theory on a contractual footing for the first time. Earlier commentators had recognized that bankruptcy law can prevent a "grab race" or "race to the courthouse" by creditors of a financially troubled debtor as they attempt to collect what they are owed, and that bankruptcy can provide a less chaotic and more even-handed distribution of the debtor's assets than might otherwise be the case. (2) The articles that introduced the Creditors' Bargain were the first to suggest that bankruptcy's solution to these concerns was resolutely contractual in nature.

According to the Creditors' Bargain theory, bankruptcy can be seen as the product of an implicit--or hypothetical--bargain among the creditors of a debtor. (3) In practice, the argument went, creditors are too dispersed to effectively contract with one another over the best response to a debtor's financial distress. (4) But if they were able to contract, they would agree to provisions that put a halt to the race to the courthouse and provide for a collective solution to financial distress. (5) Although a few creditors might fare better in a grab race, creditors as a whole would suffer because the creditors' collection efforts could dismember an otherwise viable business. By preempting the race, bankruptcy law supplies the terms of a contract that the parties would agree to if they could contract directly. (6)

In addition to justifying the collective proceeding, the hypothetical contract had important implications for every other feature of bankruptcy as well. As Baird and Jackson envisioned it, the hypothetical contract would pursue a "sole owner" standard--that is, the approach that a sole owner of all of the debtor's assets would favor--and thus would seek to maximize the value of the debtor's assets without regard to the effect of the resolution decision on any particular constituency. (7) The hypothetical contract would protect the parties' nonbankruptcy entitlements--especially property rights--except to the extent necessary to achieve a collective solution to financial distress that would preserve the debtor's value as a going concern. If bankruptcy were to alter rights otherwise, the reasoning went, the debtor and its creditors would engage in costly efforts to maneuver disputes toward their preferred fora. (8)

As the hypothetical bargain terminology suggests, the Creditors' Bargain theory focused on implicit rather than actual contracting and did not conceive of bankruptcy as a set of default rules that the parties would be free to contract around. This was because the theory was addressing a world of creditors so dispersed that they were unable to contract. The most dramatic development in the decades since the model was devised has been the increasing use of actual contracts to shape the bankruptcy process. Some of the increase in contracting is due to the rise in relative prominence of secured creditors since the inception of the Creditors' Bargain theory. Unsecured creditors are less likely to be the key constituency in current cases than they were a generation ago, and the traditional collective action problems are correspondingly less relevant in many cases. (9) Another important change has been the rise of sophisticated activists who purchase and aggregate bankruptcy claims or provide new financing with a view toward influencing the course of the bankruptcy. The body of creditors is far more dynamic than a generation ago and tilted toward creditors that can and do contract.

A debtor's creditors might agree to bankruptcy rules at the time they extend credit, after the debtor becomes insolvent or files for bankruptcy, or at any point in between. For simplicity, we refer to contracting before insolvency as "ex ante" and that which occurs afterward as "ex post." Much bankruptcy-related contracting does in fact occur ex ante--particularly before or at the time credit is extended. Notably, the debtor assigns priority rights among its creditors. It may do so by granting security interests or liens, or by having some creditors agree to be subordinated to others. A firm may also allocate priority among its creditors through its corporate structure, particularly the division of assets among parent and subsidiary entities.

In some cases, the ex ante contracting goes further to address procedural rights if the debtor should file for bankruptcy. In one common form of ex ante contract discussed below--intercreditor agreements between senior and junior lienholders--the junior lienholders may agree to forgo objections to a plan the senior lienholders support, or may agree to vote as instructed by the senior lienholders. (10) As we discuss in this Article, however, the courts have limited the degree to which the parties can effectively bind themselves and the courts through such ex ante contracts.

Contracting is also ubiquitous after insolvency and the initiation of bankruptcy (ex post). For several decades, debtor-in-possession (DIP) financers have been using the terms of their DIP loans to contract around key provisions of the Bankruptcy Code, and to steer the course of the Chapter 11 case. (11) More recently, debtors and their creditors have entered into restructuring support agreements to dictate the terms of an anticipated reorganization plan. These agreements often include many of the principal creditor groups, and effectively lock in the terms of the plan. (12) Given the growing market for claims against a debtor in bankruptcy, many of the agreements are among parties that did not extend the credit initially but subsequently purchased outstanding claims. The courts have been far more receptive to such ex post than ex ante contracts that attempt to settle reorganization terms.

In this Article, we attempt to make sense of bankruptcy's new contract paradigm. We begin by taking a closer look at the contractual structure of the Bankruptcy Code of 1978. The wave of contracting has taken place against the backdrop of a bankruptcy law framework that has been generally viewed as mandatory in structure. As we suggest in Part I below, a closer look reveals that the Code is not nearly as mandatory in practice as was once thought. The language of some of the Code itself contemplates and even encourages contracting during bankruptcy as an alternative to judicial decisionmaking in an adversarial process. The essence of the Chapter 11 plan confirmation process is a set of voting rules that enables a class of creditors or shareholders to bind potential holdouts to the will of the majority. The cramdown rules authorize the court to enforce an ex post bargain over the objections of one or more classes of creditors. Yet, bankruptcy practice has taken contracting even further, permitting parties also to contract around provisions whose language is not permissive in this sense. Parties present consent orders for approval by the court, and these are given considerable deference. (13) Indeed, this practice has evolved even when the Code explicitly gives the discretion to the court, such as in the authorization of DIP financing. (14)

While the Code and bankruptcy practice allow for ex post contracting, they provide little encouragement for ex ante contracts. This has presented a stark contrast to related areas of business law that had become increasingly permissive in the years before the Code was enacted. Delaware's sweeping overhaul of its General Corporation Law in 1967 made corporate law principally a set of default rules that a firm can contract around if it wishes. Similarly, the Uniform Commercial Code is replete with provisions that apply "unless the parties otherwise agree." There are very few provisions in the Bankruptcy Code inviting the parties to "otherwise agree" by contract, (15) and in some contexts the Code explicitly overrides ex ante contracts. (16) Bankruptcy courts also view ex post contracting more favorably than ex ante contracts. We present examples of the bias toward ex post contracting in Part III by noting that, while courts have been quite skeptical of (ex ante) intercreditor agreements (17) and have sometimes declined to honor the corporate boundaries established by the parties, (18) they have usually been willing to approve (ex post) restructuring support agreements (19) and the terms of new DIP loans that purport to regulate the restructuring process.

The enforcement of ex post contracts yields important benefits. Contracts are incomplete in that they usually cannot anticipate the optimal obligations in each possible future contingency Precise (rule-like) contract terms may become inefficient in unanticipated states of the world. One design response to incompleteness is the use of standards that delegate authority to a court, which will have the benefit of hindsight and knowing what state has materialized ex post. This explains why contracts in risky environments and statutes like the Bankruptcy Code are replete with standards (such as "good faith," "reasonable care," and "material"). Another approach is to allow the parties to contract more specifically after uncertainty is resolved, recognizing that the parties have even better information ex post than courts. (20) Whereas an ex ante contract faces the challenge of providing for many...