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Section 365, Mandatory Bankruptcy Rules and Inefficient Continuance

Author

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  • Che, Yeon-Koo
  • Schwartz, Alan

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 exist costlessly. Further, an ipso factor 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, our analysis suggests that stakeholders such as contract partners of bankrupt firms may have important roles to play in inducing efficient bankruptcy decisions through their abilities to stop unproductive projects that bankrupt firms may otherwise continue. Copyright 1999 by Oxford University Press.

Suggested Citation

  • Che, Yeon-Koo & Schwartz, Alan, 1999. "Section 365, Mandatory Bankruptcy Rules and Inefficient Continuance," Journal of Law, Economics, and Organization, Oxford University Press, vol. 15(2), pages 441-467, July.
  • Handle: RePEc:oup:jleorg:v:15:y:1999:i:2:p:441-67
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    Cited by:

    1. Adler, Barry & Polak, Ben & Schwartz, Alan, 2000. "Regulating Consumer Bankruptcy: A Theoretical Inquiry," The Journal of Legal Studies, University of Chicago Press, vol. 29(2), pages 585-613, June.
    2. Andreoni, James & Miller, John H., 2008. "Analyzing Choice with Revealed Preference: Is Altruism Rational?," Handbook of Experimental Economics Results, Elsevier.
    3. Alan Schwartz & Joel Watson, "undated". "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.
    4. Alan Schwartz, 2004. "The Law and Economics of Costly Contracting," Journal of Law, Economics, and Organization, Oxford University Press, vol. 20(1), pages 2-31, April.
    5. Alan Schwartz, "undated". "A Normative Theory of Business Bankruptcy," American Law & Economics Association Annual Meetings 1037, American Law & Economics Association.

    More about this item

    JEL classification:

    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • K22 - Law and Economics - - Regulation and Business Law - - - Business and Securities Law
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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