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Bankruptcy’s Uneasy Shift to a Contract Paradigm

A generation ago, the Creditors’ Bargain theory provided the first comprehensive normative theory of bankruptcy. 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. 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. 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. 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. 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.

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. 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.

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.