A bankruptcy proceeding is a day of reckoning for all parties with ownership interests in an insolvent firm. Ownership interests are valued, the assets are sold, and the proceeds are divided among the owners. Bankruptcy proceedings take one of two forms, depending on whether ownership rights to the assets are sold on the open market to one or more third parties or whether ownership rights to the assets are transferred to the old owners in return for the cancellation of their prebankruptcy entitlements. The first kind of bankruptcy proceeding, a liquidation, is governed by chapter 7 of the Bankruptcy Code; the second kind, a reorganization, is governed by chapter 11. A bankruptcy proceeding always involves a sale of assets followed by a division of the proceeds among the existing owners. In a chapter 7 proceeding the sale is real; in a chapter 11 proceeding the sale is hypothetical.

An analysis of the law of corporate reorganizations should properly begin with a discussion of whether all those with rights to the assets of a firm (be they bondholders, stockholders, or workers) would bargain for one if they had the opportunity to negotiate at the time of their initial investment. Properly understood, a bankruptcy proceeding itself can be seen as the back end of the “creditors' bargain.” If they had the opportunity, investors in a firm might bargain to accept a bankruptcy proceeding in advance in order to avoid a destructive race to a firm's assets that could arise when several investors exercise their right to withdraw their contribution to the firm.