Can Complex Contracts Effectively Replace Bankruptcy Principles? Why Interpretation Matters.

Author:Munoz, David Ramos

In bankruptcy, the administration and liquidation of an insolvent estate is carried out by a trustee or administrator under court supervision. Parties in a debt transaction may wish to do away with the strictures of a bankruptcy proceeding, which are time consuming, costly, and sometimes unpredictable. Yet they cannot do away with the need to appoint an agent or trustee to administer their collective interests, which comes with the corresponding need to delineate a set of powers, functions, and duties of that trustee. Yet no matter how detailed the transactional documents are, there may be unanticipated circumstances that the parties did not address in their contract. And when conflicts arise, especially inter-creditor conflicts, most trustees are risk adverse enough to seek guidance from the court before acting unilaterally. Thus, no matter how hard the parties attempt to insulate themselves from court supervision, they will often end up in a courtroom fighting about the intended meaning of their transactional documents. This article explores the inherent tendency of courts to address gaps or conflicts in contract provisions with underlying default or background principles drawn from debtor-creditor law, trust law, and implied duties imposed by common law when dealing with oppressive majority control. These tendencies are relevant for parties who may more effectively anticipate and address them in their documentation, and lawmakers who may gain better insight into the interplay between contract and consent and legal principles in bankruptcy law.


    Imagine we could create a bankruptcy procedure from scratch. Which aspects would be different and which inevitable? Such questions have inspired academic debate for years. Advocates of bankruptcy reform based on more flexible, contract-based rules relied on the superiority of their models. (1) Critics retorted that reality is more complex and that seemingly too elegant ideas tend to be unfeasible or lead to unfair results. (2) These debates have also informed international best practices, (3) and the reform of parts of that system. (4) The current trend is towards encouraging preventive measures that facilitate more flexible, contractual means of restructuring. (5) Contract-like solutions are, thus, a key aspect of bankruptcy policy and theory.

    Less noticeably, the market in debt transactions has been developing and implementing contract tools to tackle bankruptcy-like problems in practice: staying individual executions, administering assets, achieving restructuring by dealing with holdouts, liquidating, and distributing. There has been a partial implementation of these tools in sovereign-debt and corporate-debt markets through the use of contract clauses: the stay of enforcement, the management of collective interests via a trustee, and the coordination of those interests through majority voting, including decisions on restructuring.

    Then, the market in bankruptcy-remote transactions has created the most advanced experiment there is in the substitution of contract clauses for bankruptcy rules, since virtually all the functions are achieved outside bankruptcy law. Sophisticated parties use a series of contractual and corporate innovations to insulate a pool of assets from a bankruptcy of the transaction's sponsor by transferring them (or their risk) to a "vehicle," i.e. a dummy corporation or trust (known as "basic bankruptcy remoteness"). (6) They also exclude the possibility of the vehicle entering formal bankruptcy proceedings (referred as "enhanced bankruptcy-remoteness"). (7) Once the parties succeed at this, contract provisions can fully regulate the triggers for the acceleration of claims, the administration, restructuring or liquidation, and distribution processes.

    Moreover, contract documents are carefully designed not to tread on the aspects that usually render the debate on bankruptcy policy more complex and intractable. Coordination mechanisms affect only the parties that have purchased the debt under these terms and, thus, accepted the terms of the debt offering. Furthermore, in bankruptcy-remote transactions the issuer/ debtor is a dummy vehicle and all creditors are holders of notes or securities. Thus, there is no issue with non-consenting creditors, employees, or other interests that could render a contact-based solution controversial. The only creditors are financial creditors. There is no "debtor's interest" as such. Thus, the parties have created the perfect conditions under which to test the limits of the contractual substitutions for bankruptcy, which this author refers to as the "pure contract solution." Or have they?

    This article argues that the concept of a pure contract solution remains elusive. Even if the clauses are well-conceived and well-drafted, the sophisticated parties employing them overestimate their effectiveness by underestimating three things: (1) the potential for "gaps," i.e. situations not expressly covered by the clauses; (2) the link between meaning and function in the process of interpretation, whereby what a clause means is inherently linked to what the clause does; and (3) a court's need to be satisfied that the contract solution is fair, procedurally speaking. These factors may persuade courts to, expressly or impliedly, imbue the interpretation of these contract clauses with the principles that fulfill a similar function in bankruptcy law or corporate law. Thus, the problem is not one of balancing party autonomy and public interest, or contract freedom and mandatory rules. It is a more complex problem about "background" or "default" principles, whose pervasive logic may transcend their natural field of application in bankruptcy proceedings or corporate transactions and apply in contexts where the parties regulate the issue through contract provisions. This article discusses the evidence of this interpretative challenge, relying on court precedents, primarily from the United States and the United Kingdom, and the debt markets where the relevant conflicts have arisen.


    First, this Section studies the tools in debt contracts that fulfill a function akin to that of bankruptcy provisions, with special focus on bankruptcy-remote transactions (2.1). Then, it explains why contracting parties may rely too much on the clauses' express language, underestimating the avenues through which principles and background rules common to bankruptcy law may come into play (2.2). Finally, it analyzes the background rules selected by the parties as a supplement of contract provisions in debt transactions, and what we can expect of them in bankruptcy-like scenarios, especially in cases involving creditor-creditor conflict (2.3).


    In analyzing how courts deal with complex contract clauses that fulfill a function similar to a bankruptcy process, this article does not include the market in sovereign debt. Although the attention given to Collective-Action Clauses ("CACs"), (8) and pari passu clauses (9) is well-deserved, these clauses are not similar to, nor do they provide an alternative to bankruptcy because there is currently no regime for the bankruptcy of sovereigns. Even if there were, the idiosyncratic features of a situation involving a sovereign debtor are difficult to escape, (10) which means that any conclusion reached in the interpretation of those clauses would be difficult to extrapolate to scenarios with private debtors.

    Drawing such parallels is not only difficult but also unnecessary. Corporate debt markets customarily resort to contract tools, which substitute for bankruptcy rules that regulate the administration of collective interests, such as the role of the trustee and majority decision-making rules, commonly dealt with by the courts. They will be discussed in this article, together with the contract tools in bankruptcy-remote transactions, which will be the subject of special attention. To understand why these transactions will be used to illustrate a large part of the discussion in this article, a little context is needed. Bankruptcy-remote transactions remain a financial and contractual innovation by which, unlike regular shares or bonds, the return on the notes or securities is not tied to a business, but to a pool of assets, usually mortgage loans, receivables, bonds, or other credit instruments. These assets are packaged together and transferred by their owners to a Special Purpose Entity ("SPE") or vehicle ("SPV"), which has a corporate, trust, or LLC form, and which issues notes or securities backed by the assets. (11)

    Although the pathologies of securitization, a bankruptcy-remote transaction par excellence, became evident during the 2007'2009 financial crisis, (12) bankruptcy-remote transactions are a key instrument of financial markets, which help financial and other firms obtain liquidity, and allow investors the opportunity to be exposed to the purportedly more predictable stream of revenues from a specific asset pool, which is insulated by the SPV, rather than to the complexities and vagaries of a large and complex firm. To achieve that insulation, however, the transaction needs to be bankruptcy-remote. In a general sense, this means that the pool must be shielded from the bankruptcy of the originator of the assets and the transaction sponsor ("basic bankruptcy remoteness"). Beyond that, it can also mean that the SPV is itself kept from entering formal, statutorily-based bankruptcy proceedings ("enhanced bankruptcy remoteness").

    Since bankruptcy law is statutory, achieving a kind of de facto bankruptcy waiver is difficult. Thus, the waiver is not explicit. (13) It is combined with a contractual alternative that achieves the same goal. If a...

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