A fundamental question for corporate bankruptcy law is why it exists in the first place. Why are there special rules that apply only in financial distress? The conventional law-and-economics answer—known as the Creditors’ Bargain Theory—identifies two core purposes of bankruptcy law: recreating a hypothetical ex ante bargain and respecting creditors’ nonbankruptcy entitlements.

This Article challenges the Creditors’ Bargain Theory and presents an alternative: The sole purpose of corporate bankruptcy law is to solve the incomplete contracting problem that accompanies financial distress. Because financial distress is difficult to contract over, relationships involving a distressed firm are governed by incomplete contracts that allow parties to hold each other up. All distressed firms face this same value-destroying hold-up problem, and so pressure arises for a uniform solution. The purpose of corporate bankruptcy law is to provide that solution.

In the United States, Chapter 11 of the Bankruptcy Code implements this purpose in the form of a framework for ex post renegotiation of incomplete contracts. This framework imposes judicial oversight and allocates bargaining power to minimize hold up among those with interests in a distressed firm. In a sense, it puts in place guardrails that give the parties room to bargain while keeping them from engaging in extreme forms of hold up. While this framework is not based on any hypothetical ex ante bargain and gives no special deference to nonbankruptcy entitlements, it is the fundamental attribute of Chapter 11.

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Corporate bankruptcy presents a puzzle. Why does the law provide special rules that apply only in financial distress? One can imagine 1 See, e.g., Douglas G. Baird, A World Without Bankruptcy, 50 Law & Contemp. Probs. 173, 174 (1987) [hereinafter Baird, World Without Bankruptcy]. —or advocate for—a world in which no such rules exist. But that is not the world we live in. Bankruptcy laws do exist in the United States and in most major legal systems throughout the world. And so to confront the puzzle, one must identify the purpose that bankruptcy law serves. This Article attempts to do just that and then shows how United States bankruptcy law pursues that purpose.

In short, corporate bankruptcy law’s proper purpose is to solve the incomplete contracting problem that accompanies financial distress. And Chapter 11 of the United States Bankruptcy Code implements that purpose—perhaps imperfectly—by facilitating a structured renegotiation that allows parties to preserve value in the face of hold-up threats. 2 Chapter 11 is the part of the United States Bankruptcy Code setting forth the rules specific to the reorganization of business entities. 11 U.S.C.A. §§ 1101–1195 (West 2020). By contrast, Chapter 7 deals with businesses and individuals who are liquidating their assets. Id. §§ 701–784. Provisions of other Chapters, like Chapters 1, 3, and 5, apply to all bankruptcy cases. Barry E. Adler, Anthony J. Casey & Edward R. Morrison, Baird & Jackson’s Bankruptcy Cases, Problems, and Materials 31–35 (5th ed. 2020). This Article suggests that the creation of this bargaining framework for renegotiation is the fundamental attribute of Chapter 11.

Thus, contrary to the prevailing view, the purpose of bankruptcy law is not to vindicate or mimic some hypothetical ex ante bargain among creditors. 3 This prevailing view derives from the scholarship of Professors Douglas Baird and Thomas Jackson. See Douglas G. Baird & Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829, 835–36 (1985) (“The ambition of the law governing the debtor-creditor relationship . . . should provide all the parties with the type of contract that they would have agreed to if they had had the time and money to bargain over all aspects of their deal.”); Thomas H. Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors’ Bargain, 91 Yale L.J. 857, 860 (1982) [hereinafter Jackson, Non-Bankruptcy Entitlements and the Creditors’ Bargain] (arguing that bankruptcy law should “mirror the agreement one would expect the creditors to form among themselves were they able to negotiate such an agreement from an ex ante position”). More recently, Baird himself has criticized this theory. See Douglas G. Baird & Robert K. Rasmussen, Antibankruptcy, 119 Yale L.J. 648, 652–53 (2010) [hereinafter Baird & Rasmussen, Antibankruptcy] (discussing how today’s financial structures and reorganization process are “quite at odds with the standard account of corporate reorganizations”); Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751, 755 (2002) [hereinafter Baird & Rasmussen, End of Bankruptcy] (“Today’s investors allocate control rights among themselves through elaborate and sophisticated contracts that already anticipate financial distress. In the presence of these contracts, a law of corporate reorganizations is largely unnecessary.”). That idea—the Creditors’ Bargain Theory 4 See Jackson, Non-Bankruptcy Entitlements and the Creditors’ Bargain, supra note 3, at 858 (introducing and applying the Creditors’ Bargain Theory). —is, at best, a shorthand for the unexceptional claim that bankruptcy law should be efficient. In a hypothetical world of perfect information, zero transaction costs, and rational behavior, the interested parties (assuming one can define that category) would agree to efficient rules. But that is a truism that applies to almost any efficiency problem in law. All-knowing rational actors will always bargain to the efficient outcome when bargaining costs are zero. 5 Ronald H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1, 15 (1960) (“[I]f such market transactions are costless, such a rearrangement of rights will always take place if it would lead to an increase in the value of production.”).

But what should the law do when bargaining costs are high and information is limited? That is the bankruptcy question. Or, to be a little more precise, what should the law do when a particular set of relationships repeatedly presents the same problem of high bargaining costs and limited information? To that question, the hypothetical bargain is not responsive. It assumes perfect information and zero bargaining costs in a world where neither can ever be achieved. In a sense, the parties cannot write a complete contract because of uncertainty, and the Creditors’ Bargain Theory responds by instructing lawmakers—who face the same uncertainty—to write a complete contract for them. 6 See Jackson, Non-Bankruptcy Entitlements and the Creditors’ Bargain, supra note 3, at 860 (explaining that the Creditors’ Bargain approach involves “view[ing] bankruptcy as a system designed to mirror the agreement one would expect the creditors to form among themselves were they able to negotiate such an agreement from an ex ante position”).

Even worse, the Creditors’ Bargain framework often leads scholars to focus on the wrong questions. For example, by focusing attention on the initial bargain, the framework attracts reform proposals designed to bring all creditors to the ex ante bargaining table. 7 See, e.g., Barry E. Adler & Marcel Kahan, The Technology of Creditor Protection, 161 U. Pa. L. Rev. 1773, 1794–809 (2013) (proposing a mechanism to facilitate remedies against third parties); Robert K. Rasmussen, Debtor’s Choice: A Menu Approach to Corporate Bankruptcy; 71 Tex. L. Rev. 51, 100–11 (1992) [hereinafter Rasmussen, A Menu Approach to Corporate Bankruptcy] (offering a menu system to facilitate investor assent); Alan Schwartz, Bankruptcy Workouts and Debt Contracts, 36 J.L. & Econ. 595, 630–31 (1993) (advocating for private resolutions in place of mandatory rules); David A. Skeel, Jr., Rethinking the Line Between Corporate Law and Corporate Bankruptcy, 72 Tex. L. Rev. 471, 524–25 (1994) (arguing for state law systems to encourage private ordering). But the real problem for any bankruptcy contract—or legislation—is not in convening the bargainers. It is in dealing ex post with the incomplete terms those parties actually drafted. This is a classic problem in law, 8 In contract law it leads to incomplete contracts. Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale L.J. 87, 92–93 (1989) [hereinafter Ayres & Gertner, Filling Gaps]; Oliver Hart & John Moore, Incomplete Contracts and Renegotiation, 56 Econometrica 755, 756 (1988). In public law it leads to vague standards. Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 Duke L.J. 557, 562–63 (1992). and the Creditors’ Bargain Theory distracts from its importance. 9 Similarly, the framework attracts projects attempting to predict what creditors have or would have agreed to. That is not a relevant inquiry. See infra section I.D.

The Creditors’ Bargain Theory has also nurtured the fallacy that bankruptcy law is primarily about preserving nonbankruptcy entitlements. 10 “Nonbankruptcy entitlements” refers to rights that parties have when bankruptcy law does not apply. These rights exist by operation of statute, contract, or any other source of law unconnected with the bankruptcy system. Jackson, Non-Bankruptcy Entitlements and the Creditors’ Bargain, supra note 3, at 858 & n.8. This idea—the Butner Principle 11 Baird and Jackson coined the term by “grabbing onto a phrase from an otherwise forgettable Supreme Court case [Butner v. United States].” Thomas H. Jackson, A Retrospective Look at Bankruptcy’s New Frontiers, 166 U. Pa. L. Rev. 1867, 1872 (2018) [hereinafter Jackson, A Retrospective Look] (citing Butner v. United States, 440 U.S. 48 (1979)). The Court’s opinion in Butner presented a rather vanilla canon of textualist interpretation: The Bankruptcy Code only includes provisions that are found in or implied by its text. Butner, 440 U.S. at 54–55. Baird and Jackson consciously transformed this idea into a broader normative statement of a core bankruptcy principle. See Jackson, A Retrospective Look, supra, at 1872–73 & n.18. —is a corollary to the Creditors’ Bargain Theory and is often viewed as an additional source from which to derive bankruptcy’s core purpose. 12 For the original formations of the Butner Principle, see Thomas H. Jackson, The Logic and Limits of Bankruptcy Law 20–33 (1986) [hereinafter Jackson, Logic and Limits] (explaining the justification for respecting nonbankruptcy entitlements); Douglas G. Baird & Thomas H. Jackson, Corporate Reorganizations and the Treatment of Diverse Ownership Interests: A Comment on Adequate Protection of Secured Creditors in Bankruptcy, 51 U. Chi. L. Rev. 97, 110 (1984) [hereinafter Baird & Jackson, Corporate Reorganizations] (noting that bankruptcy is primarily focused on “recognizing nonbankruptcy entitlements”); Jackson, Non-Bankruptcy Entitlements and the Creditors’ Bargain, supra note 3, at 859–60. On its predominance as a core theory, see Barry E. Adler, The Questionable Axiom of Butner v. United States, in Bankruptcy Law Stories 11, 11 (Robert K. Rasmussen ed., 2007) (questioning the principle’s place as an “uncontested axiom” (quoting Douglas G. Baird, Bankruptcy’s Uncontested Axioms, 108 Yale L.J. 573 (1998))); Kenneth M. Ayotte & David A. Skeel Jr, Bankruptcy Law as a Liquidity Provider, 80 U. Chi. L. Rev. 1557, 1565 (2013) (describing the principle as the second element of the theoretical foundation of corporate bankruptcy); David Gray Carlson, Bankruptcy Theory and the Creditors Bargain, 61 U. Cin. L. Rev. 453, 466 (1992) (critiquing the principle); Jackson, A Retrospective Look, supra note 11, at 1872–73 (identifying the Butner Principle as the starting point that brought clarity to the Creditors’ Bargain Theory); Melissa B. Jacoby & Edward J. Janger, Ice Cube Bonds: Allocating the Price of Process in Chapter 11 Bankruptcy, 123 Yale L.J. 862, 892 (2014) [hereinafter Jacoby & Janger, Ice Cube Bonds] (proposing a system with “careful attention to the scope of non-bankruptcy entitlements”); Melissa B. Jacoby & Edward J. Janger, Tracing Equity: Realizing and Allocating Value in Chapter 11, 96 Tex. L. Rev. 673, 682–83, 734 (2018) [hereinafter Jacoby & Janger, Tracing Equity] (deriving bankruptcy’s core principles by tracing creditors’ state-law entitlements); Ronald J. Mann, Bankruptcy and the Entitlements of the Government: Whose Money Is It Anyway?, 70 N.Y.U. L. Rev. 993, 1000 (1995) (presenting a bankruptcy theory that “starts from entitlements of the parties that exist before the bankruptcy system comes into play”); Bruce A. Markell, Fair Equivalents and Market Prices: Bankruptcy Cramdown Interest Rates, 33 Emory Bankr. Devs. J. 91, 127 (2016) (deriving cramdown rules from nonbankruptcy entitlements); Charles W. Mooney, Jr., A Normative Theory of Bankruptcy Law: Bankruptcy as (Is) Civil Procedure, 61 Wash. & Lee L. Rev. 931, 934 (2004) (“[B]ankruptcy law should exist, essentially, in order to serve the interests of the holders of nonbankruptcy legal entitlements.”); Juliet M. Moringiello, When Does Some Federal Interest Require a Different Result?: An Essay on the Use and Misuse of Butner v. United States, 2015 U. Ill. L. Rev. 657, 665 (noting the iconic stature of the principle and that it has been cited thousands of times). But this gets things wrong. The bankruptcy system functions almost exclusively by doing the opposite of what the Butner Principle instructs—it achieves its purpose by directly interfering with nonbankruptcy entitlements.

This fallacy—that the Butner Principle is fundamental to bankruptcy theory—arises, perhaps, from a misunderstanding of bankruptcy’s efficiency goal. An efficient bankruptcy law should create more value than it destroys, accounting for consequences in and out of bankruptcy. That requires a balancing of effects across all states of the world, but it does not require any special protection for nonbankruptcy entitlements. In short, bankruptcy law should not be put into effect unless it creates net value. 13 If Butner is read to present this efficiency concept, it is a circular direction that bankruptcy law should pursue its efficiency purpose (by altering nonbankruptcy rights) only when it is efficient to do so. Jackson, A Retrospective Look, supra note 11, at 1872 n.18 (noting that the principle yields to “a clearly defined bankruptcy-related reason for doing so” (emphasis omitted)); see also Robert E. Scott, Through Bankruptcy with the Creditors’ Bargain Heuristic, 53 U. Chi. L. Rev. 690, 692 (1986) (“The cornerstone of this [creditors’ bargain heuristic] is the normative claim that pre-bankruptcy entitlements should be impaired in bankruptcy only when necessary to maximize net asset distributions to the creditors as a group . . . .”).

All of this is to say, the law-and-economics theory of corporate bankruptcy needs to be restated. Though many scholars and lawyers invoke the Creditors’ Bargain Theory and the Butner Principle, very few rely on the truth of their substance. The building blocks of a new theory can be found in much of today’s bankruptcy scholarship, which usually advocates general efficiency goals, 14 See Ayotte & Skeel, supra note 12, at 1566 (invoking the Creditors’ Bargain Theory but advocating a general “Efficiency Principle”). often notes the importance of ex post bargaining, 15 See G. Eric Brunstad, Jr. & Mike Sigal, Competitive Choice Theory and the Broader Implications of the Supreme Court’s Analysis in Bank of America v. 203 North LaSalle Street Partnership, 54 Bus. Law. 1475, 1483–85 (1999) (noting bankruptcy creates “a better decision-making environment”); Daniel J. Bussel & Kenneth N. Klee, Recalibrating Consent in Bankruptcy, 83 Am. Bankr. L.J. 663, 669 (2009) (arguing bankruptcy alters nonbankruptcy rights to facilitate consent); Diane Lourdes Dick, The Chapter 11 Efficiency Fallacy, 2013 BYU L. Rev. 759, 766 (2013) [hereinafter Dick, Efficiency Fallacy] (noting but critiquing the common view that bankruptcy law facilitates efficient renegotiation); Omer Tene, Revisiting the Creditors’ Bargain: The Entitlement to the Going-Concern Surplus in Corporate Bankruptcy Reorganizations, 19 Bankr. Devs. J. 287, 396 (2003) (arguing that bankruptcy should provide a platform for negotiation). and sometimes emphasizes the importance of procedure over substance. 16 See Pamela Foohey, Jevic’s Promise: Procedural Justice in Chapter 11, 93 Wash. L. Rev. Online 128, 128–29 (2018) (discussing the importance of process in ensuring that bankruptcy law does not “disregard[] the interests and voices of parties en masse, potentially subverting the very tenet of value maximization”); Mooney, supra note 12, at 934­–35 (providing an overview of a “procedure theory” of bankruptcy law). Many scholars and lawyers also agree—at least implicitly—that corporate bankruptcy has something to do with facilitating ex post cooperation among stakeholders. 17 See Alan Schwartz, A Contract Theory Approach to Business Bankruptcy, 107 Yale L.J. 1807, 1808 (1998) [hereinafter Schwartz, Contract Theory] (stating that bankruptcy solves a coordination problem). Baird sometimes describes bankruptcy as a solution to the collective action problem facing creditors racing after assets. E.g., Douglas G. Baird, Loss Distribution, Forum Shopping, and Bankruptcy: A Reply to Warren, 54 U. Chi. L. Rev. 815, 827 (1987) [hereinafter Baird, Loss Distribution]. Subsequent scholarship has, however, shown that bankruptcy reaches far beyond that problem. See infra section I.A.

This Article does not depart from the current literature on these basic points. The challenge is in clearing away the distracting brush of old theories to discover a full and proper theory. Thus, this Article presents and justifies the New Bargaining Theory of corporate bankruptcy and demonstrates that Chapter 11’s renegotiation framework is consistent with a rough attempt to implement that theory.

This Article presents two claims, one normative and one descriptive. The normative claim is that bankruptcy’s proper purpose is to solve a specific contracting failure. That failure arises because financial distress presents uncertainty that is not contractible. 18 See infra section II.A. For a business firm, financial distress involves too many parties with strategic bargaining incentives and too many contingencies for the firm and its creditors to define a set of rules for every scenario. Moreover, the terms the parties do contract for will often be unenforceable because the relevant contingencies are impossible to verify to a court. 19 See Ayres & Gertner, Filling Gaps, supra note 8, at 92–93 (noting that contracts can be incomplete because of the costs associated with verifying to a court that a contingency has occurred). Incomplete contracts therefore govern a firm’s various relationships when distress arises. 20 Hart & Moore, supra note 8, at 756 (describing the incomplete contract problem). The parties in those relationships can then take advantage of the incompleteness to extract individual gains from each other—to hold each other up. Any party who has specifically invested in its relationship with the debtor is vulnerable to this hold-up threat. 21 Oliver Hart, Incomplete Contracts and Control, 107 Am. Econ. Rev. 1731, 1733 (2017) (describing the hold-up problem); see also Hart & Moore, supra note 8, at 757 (describing issues of “lock-in” after the parties have made initial investments pursuant to a contract).

The problem cannot be solved by ex ante rules—in a contract or in a statute. 22 See infra section II.A.2. Indeed, the issue arises precisely because no one can write such rules. This is a familiar problem, but the law treats it differently in the bankruptcy context. And for good reason. The noncontractible uncertainty associated with financial distress is a recurring characteristic across all firms. Where every relationship of a certain type is incomplete and requires judicial intervention upon the occurrence of the same event, a uniform bankruptcy system that deals with those relationships will produce consistency, efficiency, and market predictability. 23 See infra section II.B.

The descriptive claim of this Article is that Chapter 11 is an attempt—albeit an imprecise one—at such a system. 24 See infra Part III. It creates a renegotiation framework designed to minimize the parties’ ability and incentives to hold each other up. The framework imposes judicial oversight and substantive outer limits on the parties’ decisions. It also allocates power over certain decisions to one party while subjecting the exercise or removal of that power to evidentiary burdens, pricing mechanisms, and other conditions targeted at proving the absence of hold-up behavior. The initial allocation of power and conditions is based on the perceived likelihood that the decision in question is subject to incomplete contracting and hold-up problems. In light of substantive uncertainty, the system relies mostly on procedural protections, giving judges wide discretion to define the bargaining parameters while leaving most substantive decisions to ex post bargaining among the parties. In a sense, the law puts in place guardrails that give the parties room to bargain while keeping them from taking positions that veer toward extreme hold up.

Bankruptcy law, then, is not about mimicking a hypothetical bargain. It is about facilitating an actual bargain. This is the New Bargaining Theory of corporate bankruptcy stated generally. Consistent with this theory, Chapter 11 implements a renegotiation framework to facilitate ex post bargaining. 25 See infra Part III. This Article provides specifics on this theory and demonstrates that questions of cramdown, executory contracts, forum shopping, the automatic stay, third-party releases, intercreditor agreements, priority rules, and the like can all be understood and explained by a proper application of the New Bargaining Theory.

Two key features are worth highlighting now: First, ex post bargaining is front and center. That is where bankruptcy law happens. To be clear, the New Bargaining Theory does not reject the idea of ex ante efficiency. An efficient bankruptcy system is focused on solving the ex post problem if, but only if, it can do so without creating bigger problems in other states of the world. This focus presents a meaningful limitation on the implementation of any bankruptcy measure. 26 See infra sections II.C, III.C. Second, Chapter 11’s renegotiation framework relies heavily on judicial discretion and procedural measures that facilitate the ex post bargain. 27 See infra section II.B. Substantive measures—including value redistribution and deviations from nonbankruptcy priority—do, however, come into play to facilitate the bargain by realigning incentives or minimizing distortions that might otherwise occur. 28 See infra Part III.

Notably, this Article does not claim that Chapter 11 operates perfectly—judicial error and misaligned incentives do exist. But the New Bargaining Theory coherently explains the major aspects of Chapter 11 and reveals the questions necessary to assess whether it achieves its purpose. For example, it provides insight into Chapter 11’s proper scope. Because the potential for hold up arises when parties have made investments specific to relationships that involve or link in some way to the going-concern value of the debtor, 29 Going-concern value generally refers to the value derived from keeping an enterprise together. See Baird & Rasmussen, End of Bankruptcy, supra note 3, at 758 (“We have a going-concern surplus . . . only to the extent that there are assets that are worth more if located within an existing firm. If all the assets can be used as well elsewhere, the firm has no value as a going concern.”). Thus, a firm has positive going-concern value when the whole of the business is worth more than the sum of its separate parts. Id. A firm without going-concern value is one that should be liquidated because its assets can be put to more valuable use elsewhere. See id. Chapter 11 should focus exclusively on regulating ex post behavior that might take advantage of those relationship-specific investments.

This Article proceeds in four Parts. Part I explores the usefulness and shortcomings of the Creditors’ Bargain Theory, the Butner Principle, and other heuristics that have been used to describe the core purpose of bankruptcy law. Part II provides the foundation for the New Bargaining Theory of corporate bankruptcy. Part III describes Chapter 11’s renegotiation framework. Part IV demonstrates the usefulness of this emerging theory by applying it to current issues of debate in bankruptcy law.