Bankruptcy on the Side

By Kenneth Ayotte (University of California – Berkeley School of Law), Anthony J. Casey (University of Chicago Law School), David A. Skeel, Jr. (University of Pennsylvania Law School)


Side agreements—such as intercreditor and “bad boy” agreements—are increasingly at the center of major bankruptcy disputes. Litigation around these disputes can be costly and the results of that litigation can dramatically alter the landscape within which the stakeholders bargain over reorganization.

These agreements commonly include a promise by one party to remain silent by waiving some procedural right they would otherwise have under the Bankruptcy Code. Those waivers are invoked at crucial points in the reorganization process, including the approval of debtor-in-possession financing and plan confirmation.

In our new paper, Bankruptcy on the Side, we show that while side agreements have beneficial potential, the parties entering them often impose negative externalities on outsiders. 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.

The paper presents a simple model to derive a proposal that is consistent with the intent of the parties to the side agreement but also limits negative externalities. The core of the proposal is 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. Our proposal is different and superior to the approach taken by most courts, which invokes a narrow interpretative standard to invalidate side agreements. We focus instead on enforcing the provisions under normal interpretative doctrines while limiting the use of special remedies like specific performance and stipulated damages.

The insights of our paper also provide a new answer to thorny questions involved in choosing which courts should resolve disputes over intercreditor agreements, and in deciding whether forum selection clauses should be enforced. Specifically, the bankruptcy courts have no specialized expertise for cases where the plaintiff seeks expectation damages. In those cases, the court should defer to default venue rules and forum selection clauses. Where specific performance or stipulated damages are at issue, by contrast, our model suggests that the dispute should be resolved exclusively in bankruptcy proceedings.