The Privatization of Bankruptcy: Evidence from Financial Distress in the Shipping Industry

Abstract

Current bankruptcy legislation in many countries tends to follow the US model of Chapter 11, whereby the courts have the authority to stay the contractual rights of the secured creditors. The alternative approach of freedom of contracting whereby the privately negotiated debt contract defines a contingency that the courts strictly implement in the event of financial distress, is largely ignored. We study the resolution of financial distress in shipping, where the ex-territorial nature of assets have distanced the industry from on-shore bankruptcy legislation. We have four main findings. First, we demonstrate how contracts and other private institutions have adapted to the industry's special circumstances so as to deliver effective resolution of financial distress. Second, we use vessel arrest as a proxy for the economic cost of financial distress. We show that the level of arrests are low and their overall cost is modest, mostly originating in dysfunctional owners. Third, we estimate the expected economic life of vessels (conditional on age) in financial distress, and show that it is significantly shorter than the rest of the vessel population, reflecting under-maintenance of the vessel prior to arrest; this provides a significant test for Myers (1977) under investment hypothesis. Finally, our estimates of the under-maintenance effect, suggest that fire sale discounts estimated in the literature using standard methods may be seriously over-estimated. In summary, the shipping industry provides a rare opportunity to study the operation of legal institutions generated by an Hayekian spontaneous order.