Section 365, Mandatory Bankruptcy Rules and Inefficient Continuance

Yeon-Koo Che and Alan Schwartz

Yale School of Management Working Papers from Yale School of Management

Abstract: Section 365 of the Bankruptcy Code prohibits enforcement of the once common "ipso facto" clause." The clause excuses the solvent party from performance of the contract when the other party becomes insolvent. We show that the ability of insolvent firms to continue bad projects is enhanced by the absence of ipso facto clauses. Without such a clause, the firm can exploit the inability of courts always to assess expectation damages accurately to compel a solvent party to stay in a bad deal. An ipso facto clause would preclude this outcome because the clause permits the solvent party to exit costlessly. Further, an ipso facto clause improves the managers' incentive to exert effort to avoid financial distress. These results have two broader implications. First, that the important mandatory rule regulating the ability of solvent parties to exit is inefficient suggests that the justifications for the Bankruptcy Code's other mandatory rules should be rethought. Second, under free contracting, the inefficient continuance of insolvent firms would be less of a problem than it now is because the ability of contract partners to withhold future performances sometimes would stop bad projects

JEL-codes: G33 G34 G38 K22 (search for similar items in EconPapers)
Date: 1998-06-24
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=101128 (application/pdf)

Related works:
Journal Article: Section 365, Mandatory Bankruptcy Rules and Inefficient Continuance (1999)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ysm:somwrk:ysm94

Access Statistics for this paper

More papers in Yale School of Management Working Papers from Yale School of Management Contact information at EDIRC.
Bibliographic data for series maintained by ().