Bankruptcy on the Side

Side agreements between creditors of a corporate debtor can dictate how those creditors act when the debtor files for bankruptcy. For example, intercreditor agreements commonly include a promise by one party to remain silent – to waive some procedural right that the party would otherwise have under the Bankruptcy Code – at potentially crucial points in the reorganization process. Because these agreements can alter bankruptcy outcomes even for those outside of the agreement, they are controversial. In a forthcoming article, “Bankruptcy on the Side,” we provide a framework for analyzing these agreements.

Using simplified examples, we show that side agreements create benefits in some instances, but parties to a side agreement may have incentives to contract for specific performance or excessive stipulated damages that impose negative externalities on non-parties to the agreement. A promise not to extend new financing, for example, can affect the debtor’s reorganization prospects to the detriment of non-party creditors.

We develop a simple proposal that honors the intent of the parties to the side agreement and preserves the efficiency benefits they create, while limiting negative externalities. In short, the agreements should always be enforceable for expectation damages.  Specific performance or damages in excess of expectation damages should be enforceable only when the court is confident that performance will impose no externalities on the other creditors.

This proposal is superior to the current approach in the case law—which focuses on tougher contract interpretation standards instead of limitations on remedies—for several reasons. For example, it allows parties to capture the benefits of intercreditor agreements while limiting the potential for externalities.  That cannot be said of interpretation standards that result in no enforcement. Moreover, tougher standards for interpreting the language of contracts are likely to distort the substance of those contracts. Parties will demand agreements that go beyond what they actually desire just to be sure that the agreement is enforceable at all.

We also propose an answer to the increasingly vexing questions of whether intercreditor agreement disputes should be resolved by the bankruptcy court or outside bankruptcy, and whether forum selection clauses should be enforced. Our model shows that the optimal enforcement for these agreements is for expectation damages and that such enforcement minimizes procedural externalities. This tells us that if our proposal was adopted, the main arguments for resolving these cases exclusively in bankruptcy court would disappear. And so, if the non-breaching party asks for expectation damages, the bankruptcy court has no particular expertise and should defer to forum selection clauses that might take the case elsewhere. Where specific performance or stipulated damages are at issue, by contrast, our model suggests that the dispute should be resolved exclusively in bankruptcy proceedings.

This post comes to us from Professor Kenneth Ayotte at the University of California , Berkeley – School of Law, Professor Anthony Casey at the University of Chicago Law School, and David Skeel at the University of Pennsylvania Law School. It is based on their recent paper, “Bankruptcy on the Side,” available here.