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Section 365, Mandatory Bankruptcy Rules and Inefficient Continuance

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  • Yeon-Koo Che

    ()
    (Department of Economics)

  • Alan Schwartz

    ()
    (Law School)

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

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Bibliographic Info

Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm94.

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Date of creation: 24 Jun 1998
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Handle: RePEc:ysm:somwrk:ysm94

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Web page: http://icf.som.yale.edu/
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Cited by:
  1. Andreoni,J. & Miller,J.H., 1998. "Analyzing choice with revealed preference : is altruism rational?," Working papers 14, Wisconsin Madison - Social Systems.
  2. Alan Schwartz & Joel Watson, . "The Law and Economics of Costly Contracting," Yale Law School John M. Olin Center for Studies in Law, Economics, and Public Policy Working Paper Series yale_lepp-1004, Yale Law School John M. Olin Center for Studies in Law, Economics, and Public Policy.
  3. Alan Schwartz, . "A Normative Theory of Business Bankruptcy," American Law & Economics Association Annual Meetings 1037, American Law & Economics Association.

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