The Design of Bankruptcy Law: A Case for Management Bias in Bankruptcy Reorganizations
Posted: 15 Sep 1999
Date Written: September 1994
Abstract
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 restrictions 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. It is shown that the bankruptcy court can use two types of mechanism 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 truthful revelation of information so that distress results in an ex post efficient allocation of resources, and most importantly establish a bias towards the manager in reorganizations that provides correct ex ante decision making incentives.
JEL Classification: G33
Suggested Citation: Suggested Citation