Optimal Bankruptcy Law Research Articles

Personal bankruptcy law, debt portfolios, and entrepreneurship

Bankruptcy provides entrepreneurs with insurance against the financial consequences of failure at the cost of worsened credit conditions. Using a quantitative general equilibrium model of entrepreneurship, we show that the presence of secured credit in addition to unsecured credit substantially alters this trade-off. If secured credit is not available the optimal bankruptcy law is harsh since the negative effect dominates. If secured credit is available the optimal law is lenient since entrepreneurs rationed out of the unsecured credit market can still obtain secured credit, lowering the costs of worse credit conditions. We find significant welfare gains from reforming the law.

Personal Bankruptcy Law, Debt Portfolios, and Entrepreneurship

Every year 400,000 entrepreneurs fail and 60,000 file for personal bankruptcy. The option to declare bankruptcy provides entrepreneurs with insurance against the financial consequences of business failures. However, it comes at the cost of worsened credit market conditions. In this paper, we construct a quantitative general equilibrium model of entrepreneurship to show that the presence of secured credit in addition to unsecured credit substantially alters the trade-off between insurance and credit conditions. A lenient bankruptcy law always worsens credit conditions, in particular for poor entrepreneurs. If secured credit is not available, their credit conditions are so bad that many prefer to become workers. In that case, we show that the optimal bankruptcy law is very harsh because the benefits from better credit conditions dominate the worsened insurance. However, if secured credit is available, entrepreneurs who might be rationed out of the unsecured credit market can still obtain secured credit. Therefore, they can run larger firms, which makes entrepreneurship more attractive. Since the presence of secured credit lowers the cost of a generous bankruptcy law, we find that the optimal law is lenient in this case; exactly the opposite result as obtained in the model version without secured credit.

Personal Bankruptcy Law, Debt Portfolios, and Entrepreneurship

Every year 400,000 entrepreneurs fail and 60,000 file for personal bankruptcy. The option to declare bankruptcy provides entrepreneurs with insurance against the financial consequences of business failures. However, it comes at the cost of worsened credit market conditions. In this paper, we construct a quantitative general equilibrium model of entrepreneurship to show that the presence of secured credit in addition to unsecured credit substantially alters the trade-off between insurance and credit conditions. A lenient bankruptcy law always worsens credit conditions, in particular for poor entrepreneurs. If secured credit is not available, their credit conditions are so bad that many prefer to become workers. In that case, we show that the optimal bankruptcy law is very harsh because the benefits from better credit conditions dominate the worsened insurance. However, if secured credit is available, entrepreneurs who might be rationed out of the unsecured credit market can still obtain secured credit. Therefore, they can run larger firms, which makes entrepreneurship more attractive. Since the presence of secured credit lowers the cost of a generous bankruptcy law, we find that the optimal law is lenient in this case; exactly the opposite result as obtained in the model version without secured credit.

An experimental investigation on optimal bankruptcy laws

We performed an experimental investigation to assess whether the “restricted auction” mechanism proposed by Berkovitch, Israel and Zender in 1997 works effectively as an optimal bankruptcy law or not. An optimal bankruptcy law is a commitment device that implements efficient choices both before (ex ante) and after (ex post) financial distress, even if moral hazard is binding. We designed an experiment focused on ex ante efficiency and we found that the restricted auction mechanism was able to direct an optimal amount of effort toward entrepreneurial activities. This result confirms the theoretical predictions. Nonetheless, we found that under a plain unrestricted auction mechanism our experimental subjects chose to allocate into their firms a larger amount of effort than that predicted by theory. Although difficult to justify on theoretical grounds, this experimental evidence is robust. Our behavioral interpretation is that this result is due to “moral sentiments”, such as the natural propensity of subjects toward socially desirable behaviors. In fact, we show that it vanishes once these motives are removed.

Matching Bankruptcy Laws to Legal Environments

We study a model of optimal bankruptcy law in an environment where legal quality can vary along two dimensions: the expertise of judges and the quality of contract enforcement. We analyze a model in which a judicially influenced bankruptcy process can enhance the efficiency of incomplete contracts by conditioning the allocation of control rights in bankruptcy on firm quality. We consider the optimal balance of debtor and creditor interests as a function of the legal environment and show that the optimal degree of creditor-friendliness in the bankruptcy code increases as judicial ability to recognize firm quality falls and as the quality of contract enforcement deteriorates. Our model shows that a bankruptcy law that attempts to preserve going-concern value, such as US Chapter 11, requires judicial expertise to be effective. Where such expertise is unavailable, a law that focuses more on creditor recovery is preferred. (JEL D86, G33, G34, K22) The Author 2007. Published by Oxford University Press on behalf of Yale University. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Matching Bankruptcy Laws to Legal Environments

We study a model of optimal bankruptcy law in an environment where legal quality can vary along two dimensions: the ability of judges, and the quality of contract enforcement. We analyze a model in which a judicially-influenced bankruptcy process can enhance the efficiency of incomplete contracts by conditioning the allocation of control rights in bankruptcy on firm quality. We consider the optimal balance of debtor and creditor interests as a function of the legal environment, and show that the optimal degree of creditor-friendliness in the bankruptcy code increases as judicial ability to recognize firm quality falls and as the quality of contract enforcement deteriorates. Our model contributes to the existing bankruptcy law design literature in demonstrating that a debtor-friendly law that focuses on preserving going-concern value, such as U.S. Chapter 11, requires judicial expertise to be effective. Where such expertise is unavailable, a law that focuses more on creditor recovery is preferred. Our model is also able to explain cross-country patterns in the content and usage of bankruptcy laws around the world as reported in existing empirical research.

Optimal Bankruptcy Laws Across Different Economic Systems

We model fundamental differences across economic systems and propose optimal bankruptcy laws. We show that creditor-debtor relationships in a given economy are affected by the ability of creditors to obtain information about fundamentals and the managers' ability to strategically use their private information. An optimal bankruptcy law utilizes creditors' information while minimizing managers' use of strategic information. Our proposed laws for a developed bank-based system like Germany include a creditor chapter only, for a developed market-based system like the United States include both a creditor chapter and a debtor chapter, and for an underdeveloped system include both a creditor chapter and a debtor chapter that gives the manager more protection than in a market-based system. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Optimal Bankruptcy Laws Across Different Economic Systems

We model fundamental differences across economic systems and propose optimal bankruptcy laws. We show that creditors-debtors relationships in a given economy are affected by the ability of creditors to obtain information about fundamentals and the managers' ability to strategically use their private information. An optimal bankruptcy law utilizes creditors' information, while minimizing managers' use of strategic information. Our proposed laws for a developed bank-based system like Germany includes a creditor chapter only for a developed market-based system like the U.S.A. includes both a creditor chapter and a debtor chapter, and for an under-developed system includes both a creditor chapter and a debtor chapter that gives the manager more protection than in a market-based system.

The Design of Bankruptcy Law: A Case for Management Bias in Bankruptcy Reorganizations

In an incomplete contracting environment, bankruptcy is considered to be a renegotiation of the firm's financial contracts. An optimal bankruptcy law is derived as optimal restric? tions on the environment within which the claimants to a distressed firm bargain. The law is used as a commitment device to ensure actions that are ex ante optimal but not subgame perfect. We show that the bankruptcy court can use two types of mechanisms to implement the optimal bankruptcy outcome: direct restrictions on the bargaining game between the claimants, and the use of a restricted auction. In both cases, the restrictions prevent the strategic use of bankruptcy by firms not in financial distress, provide for truthful revelation of information so that distress results in an ex post efficient allocation of resources, and es? tablish a bias toward the manager in reorganizations that provides correct ex ante decision making incentives.

Optimal bankruptcy law and firm-specific investments

In this paper we characterize an optimal bankruptcy law that takes into consideration the incentives of managers to invest in firm-specific human capital. We show that the optimal bankruptcy law is biased towards the management team, and may be implemented by the use of a ‘restricted auction’ mechanism, in which creditors have the right to refuse bankruptcy, but are not allowed to bid for the firm. The bankruptcy law is needed as a commitment device to implement the optimal outcome.