Risk Taking and Ruin: Bankruptcy and Investment Choice

Abstract

* Ely Professor of Law and Political Economy, Yale University. Helpful comments were received from seminar participants at the Law and Economics Workshop at the University of Chicago Law School, the School of Business of the University of Southern California, and the University of Michigan Law School and from Henry Hansmann, Lynn M. LoPucki, Roberta Romano, and J. H. Verkerke. Mitu Gulati and Nancy Neiman provided very useful research assistance, and J. H. Verkerke prepared the diagrams and developed the numerical example using the MATHCAD program. ' For evidence of this claim see Section IID infra. See also Ben S. Bernanke, Bankruptcy, Liquidity, and Recession, 71 Am. Econ. Rev. 155 (1981); Lynn M. LoPucki, A General Theory of the Dynamics of the State Remedies/Bankruptcy System, 1982 Wis. L. Rev. 311, 336, 361 (1982); and John C. Coffee, Jr., Shareholders versus Managers: The Strain in the Corporate Web, in Knights, Raiders, and Targets: The Impact of the Hostile Takeover 77, 82-83 (John C. Coffee, Jr., Louis Lowenstein, & Susan Rose-Ackerman eds. 1988). As many authors have pointed out, bankruptcy and liquidation are not identical (Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 340 (1976); Lynn M. LoPucki, The Debtor in Full Control-Systems Failure under Chapter 11 of the Bankruptcy Code? 57 Am. Bankruptcy L. J. 99 (1983)). My article deals with both major forms of corporate bankruptcy: liquidation and reorganization under Chapters 7 and 11 of Title 11 of the U.S. Code (1978). The analysis, however, abstracts from a major concern of bankruptcy lawyers: the allocation of benefits and burdens among different kinds of creditors. Thus it does not directly analyze the economic justification for bankruptcy law as distinct from the right to foreclose on overdue debts. That justification envisages the possibility of a Prisoner's Dilemma or common-pool problem where each creditor, seeing the firm's difficulties, tries to demand payment and in the process forces a firm to liquidate that which is actually more valuable to them as a going concern (Douglas G. Baird, The Uneasy Case for Corporate Reorganizations, 15 J. Legal Stud. 127, 131 (1986); Thomas H. Jackson, The Logic and Limits of Bankruptcy Law, 10-19 (1986)). Bankruptcy then provides a way out by permitting creditors to negotiate a settlement that may be, at least in principle, better for all of them than an undisciplined race for the firm's assets.