Bankruptcy on the Side

Judges in large corporate bankruptcies are increasingly being asked to resolve disputes regarding side agreements between creditors or other stakeholders in the debtor. A common example is an intercreditor agreement that allocates the rights to control the bankruptcy process amongst a subset of creditors. The enforcement of these agreements can change the outcomes in large corporate reorganization cases—not only the division of value, but also what happens to the company itself.

An important feature of these agreements is that they often include a promise by one party to remain silent – to waive some procedural right – at potentially crucial points in the reorganization process. For example, the agreements might require a lender to waive its objections to a proposed plan of reorganization or to abstain from supporting or presenting certain proposals for debtor-in-possession financing.

Our new paper, Bankruptcy on the Side, examines the question of how judges should interpret and enforce side agreements. Using simplified examples, we demonstrate the potential costs and benefits of side agreements. On the benefit side, we show that side agreements can provide effective work-arounds for some of the inefficient mandatory terms in the Bankruptcy Code, as well as solving problems caused by the inherent incompleteness of contracts. To give a concrete example, a second lien lender might agree to be silent in order to commit to not raising objections that – although allowed under the Bankruptcy Code – would stall a value-maximizing sale process.

On the cost side, however, we show that side agreements will not always maximize the value to all stakeholders. A promise not to extend new financing, for example, can affect the debtor’s reorganization prospects. Similarly, a promise not to object to a reorganization plan can rob the court of information that might benefit the other classes of creditors. In writing these side agreements, the parties to them will only maximize their joint value -- they will not take into account the effect the agreement has on the company’s other stakeholders. Moreover, the parties will lock these externalities in by inefficiently contracting for specific performance of the contract or excessive stipulated damages even when expectation damages would be the preferred remedy from an overall efficiency standpoint. As a result, the side agreements foreclose welfare enhancing deals during the bankruptcy process.

Our paper develops a simple proposal for dealing with each of these concerns. The proposal is consistent with the intent of the parties to the side agreement but also limits negative externalities. Specifically, we suggest that where there is a nontrivial potential for value-destroying externalities, the court should limit a nonbreaching party’s remedy to its expectation damages. On the other hand, if the agreement is unlikely to cause externalities, a court should enforce the agreement according to its terms.

While bankruptcy courts have invalidated potentially problematic agreements by construing them very restrictively, we suggest that courts should apply normal interpretative doctrines to the substance of the agreements but limit the use of special remedies like specific performance and stipulated damages.

The model in the paper also provides answers to questions about which courts should resolve disputes over intercreditor agreements and whether courts should enforce forum selection clauses. For example, because the bankruptcy courts have no specialized expertise for cases where the plaintiff seeks expectation damages, the court should defer to default venue rules and forum selection clauses. But where specific performance or stipulated damages are at issue, our model suggests that the dispute should be resolved exclusively in bankruptcy proceedings.

Kenneth Ayotte is a Professor of Law at the University of California.

Anthony J. Casey is a Professor of Law and Mark Claster Mamolen Teaching Scholar at the University of Chicago.

David A. Skeel Jr. is S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School.