Could Chapter 11 Redeem Itself? Wealth and Welfare Effects of the Redemption Option

Abstract

In its reform of the U.S. Bankruptcy Code, the American Bankruptcy Institute (ABI) is proposing to grant a redemption option to junior creditors and let them exit the bargaining process. A game-theoretic, continuous-time model of the leveraged firm under Chapter 11 is developed to assess the wealth transfers and welfare impacts of such an amendment. After fitting the model to the current outcomes of Chapter 11, numerical experiments show that junior creditors are overcompensated and that the redemption option replaces one type of Absolute Priority Rule violations with another. Importantly, the redemption option aligns junior creditors' interests with those of shareholders, thereby increasing the incentives for risk-shifting. While the ABI reform reduces bankruptcy costs, it also increases the risk of liquidation.