The Economics of Bankruptcy: An Introduction to the Literature

This essay surveys important contributions to the economics of bankruptcy. It is an introductory chapter for a forthcoming volume (from Edward Elgar Press) that compiles the work of legal scholars as well as economists working in the field of corporate finance. The essay begins with the foundational theories of Baird, Jackson, and Rea and then collects scholarly work extending, testing, or revising those theories. At various points I identify questions that merit further study, particularly empirical testing

Rules of Thumb for Intercreditor Agreements

Intercreditor agreements frequently restrict the extent to which subordinated creditors can participate in the bankruptcy process by, for example, contesting liens of senior lenders, objecting to a cash collateral motion, or even exercising the right to vote on a plan of reorganization. Because intercreditor agreements can reorder the bargaining environment in bankruptcy, some judges have been unsure about their enforceability. Other judges have not hesitated to enforce the agreements, at least when they do not restrict the voting rights of subordinated creditors. This essay argues that intercreditor agreements are controversial because they pose a trade-off: they reduce bargaining costs (by limiting the participatory rights of subordinated creditors), but can give senior lenders outsized influence over the bankruptcy process, to the detriment of investors who were not party to the intercreditor agreement. The essay proposes several rules of thumb that might help judges navigate this trade-off

Coasean Bargaining in Consumer Bankruptcy

During my first weeks as a graduate student in economics, a professor described the Coase Theorem as “nearly a tautology:” Assume a world in which bargaining is costless. If there are gains from trade, the Theorem tells us, the parties will trade. The initial assignment of property rights will not affect the final allocation because the parties will bargain (costlessly) to an efficient outcome. “How can that be a theorem?,” I remember thinking at the time

Bankruptcy Decision Making: An Empirical Study of Continuation

Many small businesses attempt to reorganize under Chapter 11 of the U.S. Bankruptcy Code, but most are ultimately liquidated instead. Little is known about this shutdown decision. It is widely suspected that the bankruptcy process exhibits a continuation bias, allowing failing businesses to linger under the protection of the court, which resists liquidation even when it is optimal. This paper examines the shutdown decision in a sample of Chapter 11 bankruptcy cases filed in a typical bankruptcy court over the course of a year. The presence of continuation bias is tested along several dimensions – the extent of managerial control over the bankruptcy process, the accuracy and speed with which viable and nonviable businesses are distinguished, and the characteristics of the hazard of shutdown compared with the predictions of a formal model. Contrary to conventional wisdom, the paper finds that continuation bias is either absent or empirically unimportant

Judicial Review of Discount Rates Used in Regulatory Cost-Benefit Analysis

The discount rate is a critical element of cost-benefit analysis. The value of cost-benefit analysis in improving regulatory decisions depends, in large part, on the reasonableness of the discount rate. Small variations in the discount rate can significantly bias the analysis. Despite the importance of the discount rate, courts have failed to develop a standard of review for agency discount rate choices. this is particularly troubling in light of evidence that agency practice exhibits wide-ranging, and generally unexplained, variation in discount rates. Not only do different agencies employ different rates, but the same agency will sometimes apply different rates to different regulations without explanation. This comment seeks to strengthen cost-benefit analysis by providing a framework for judicial review of agency discount rates. As a threshold matter, courts should find, as a matter of law, that an agency acts unreasonably if it fails to discount future costs and benefits, even if they accrue to future generations. Additionally, courts should take a "hard look" at agency discount rates and ask three basic questions: Is there a record for the agency's choice? Did the agency explain its choice between the alternative approaches to discounting, the SRTP and OCC? Did the agency consider the relevant factors in applying the chosen method? While these questions are standard fare in hard look review, they would represent a significant advance in judicial review of discount rates. More importantly, hard look review would provide strong incentives for agencies to adopt morally and economically sensible discount rates

Coasean Bargaining in Consumer Bankruptcy

During my first weeks as a graduate student in economics, a professor described the Coase Theorem as “nearly a tautology:” Assume a world in which bargaining is costless. If there are gains from trade, the Theorem tells us, the parties will trade. The initial assignment of property rights will not affect the final allocation because the parties will bargain (costlessly) to an efficient outcome. “How can that be a theorem?,” I remember thinking at the time

Bankruptcy's Rarity: An Essay on Small Business Bankruptcy in the United States

Most nations have enacted statutes governing business liquidation and reorganization. These statutes are the primary focus when policymakers and scholars discuss ways to improve laws governing business failure. This focus is misplaced, at least for distressed small businesses in the United States. Evidence from a major credit bureau shows that over eighty percent of these businesses liquidate or reorganize without invoking the formal Bankruptcy Code. The businesses instead invoke procedures derived from the laws of contracts, secured lending, and trusts. These procedures can be cheaper and speedier than a formal bankruptcy filing, but they typically require unanimous consent of senior, secured lenders. This essay identifies the conditions under which a business owner is able to obtain lender consent. The empirical findings point to an important balance between a nation's formal insolvency statutes and alternative modes of liquidation and reorganization. This balance, the essay argues, should play a central role in any discussion of insolvency-law reform

Bargaining Around Bankruptcy: Small Business Workouts and State Law

Federal bankruptcy law is rarely used by distressed small businesses. For every 100 that suspend operations, at most 20 file for bankruptcy. The rest use state law procedures to liquidate or reorganize. This paper documents the importance of these procedures and the conditions under which they are chosen using firm-level data on Chicago-area small businesses. I show that business owners bargain with senior lenders over the resolution of financial distress. Federal bankruptcy law is invoked only when bargaining fails. This tends to occur when there is more than one senior lender or when the debtor has defaulted on senior debt (harming trust-based relationships with lenders). These findings raise questions about the design of and need for federal bankruptcy law