Contracting Externalities and Mandatory Menus in the US Corporate Bankruptcy Code

Antonio E. Bernardo, Alan Schwartz and Ivo Welch

The Journal of Law, Economics, and Organization, 2016, vol. 32, issue 2, 395-432

Abstract: Our article offers the first justification for the US bankruptcy code, in which firms are not allowed to commit themselves ex ante in their lending agreements either to (Chapter 7) liquidation or to (Chapter 11) reorganization in case of distress ex post. If fire-sale liquidation imposes negative externalities on their peers, then firms can be collectively better off if they are all forced into a no-opt-out choice (a mandatory "menu"). This is the case even though they would individually want to commit themselves to liquidation, and it is collectively better for them than voluntary contract choice or mandatory liquidation. Our article’s innovation is thus to show not when a later choice should be prohibited, but when a later choice should be mandatory. Equivalent analyses could justify when other ex post choices should remain inalienable (not contractible). (JEL G33, D62, K12)

Date: 2016
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