Rethinking Freedom of Contract: A Bankruptcy Paradigm

"On these conditions following.... that Mephistophilis [the Devil's minister] shall be his servant and at his command[and] shall do for him and bring him whatsoever (he asks); . . , 1, John Faustus of Wittenberg, doctor, by these presents do give body and soul to Lucifer, prince of east, [the Devil, after) four-and-twenty years being expired ... . "' "Mephistophilis [twenty four years later, to Dr. Faustus]: What, weep 'st thou? `tis too later, despair! Farewell! Fools that will laugh on earth must weep in hell. "2 This Article tests the limits of private contracting by examining what it means to contract about bankruptcy. Bankruptcy law is governed by a statutory code that defines the relationship bet veen debtors and creditors when a debtor enters the bankruptcy regulatory scheme. May debtors and creditors contract in advance to change that relationship? Or would these contracts be "Faustian" bargains that the state should not enforce? Both courts and scholars are in conflict, yet the answer is critical because it affects not only bankruptcy costs but also the structuring of corporate reorganizations and securitization transactions. I maintain that the threshold question-what freedom should parties have to contractually override a statutory scheme?-has not yet been adequately addressed in this context. I first examine the principles by which parties should or should not be allowed to contractually alter statutory schemes. I then apply those principles to a model of prebankruptcy contracting by taking into account the policies underlying the bankruptcy code and also by analyzing the extent to which, under contract law, externalities should render a contract unenforceable. I conclude that, within defined limits, bankruptcy law should be viewed as default provisions and not as mandatory rules. Finally, I show that my model of prebankruptcy contracting can have important applications, not only to making corporate reorganizations and securitization transactions more efficient but also to understanding when parties should be allowed to contract about statutory schemes generally and when externalities should override freedom of contract. Introduction In recent years, bankruptcy courts have given conflicting answers to the question: May a prepetition debtor3 contractually waive bankruptcy protections?4 More recently, scholars have entered this debate by asking not only whether debtors should be allowed to waive these protections but also whether parties should be allowed to contract for bankruptcy procedures that are different from those supplied by the state.5 Some scholars argue that bankruptcy law should not be a mandatory regime because a single set of rules cannot meet the requirements of all the parties affected by a bankruptcy. Depending on the circumstances of a given bankruptcy case, some parties will profit and others will be harmed.6 The ability to structure their private arrangements in the bankruptcy process more creatively therefore may benefit the parties. The debate also is important because its outcome will affect the way that debtors and creditors act in debt negotiations and workouts that always precede, and often can circumvent, the costly bankruptcy process.' The National Bankruptcy Review Commission, for example, recently observed that "lenders increasingly include contingencies in loan documents, indentures, and workout, forbearance, and settlement agreements that waive certain [bankruptcy] rights of the borrower upon filing for bankruptcy. The possible enforceability of prebankruptcy waivers pervasively effects a wide range of private negotiations between lenders and borrowers . 8 In addition, the outcome of the debate is critical to the structuring of hundreds of billions of dollars of securitization9 transactions each year, which focus primarily on whether the parties have achieved a "bankruptcy remote" structure;'o and it also may influence choice of law issues in transnational bankruptcy cases. …