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

Published online by Cambridge University Press:  06 April 2009

Elazar Berkovitch ,
Ronen Israel  and
Jaime F. Zender
Elazar Berkovitch
Affiliation:
Tel Aviv University, Tel Aviv, Israel
Ronen Israel
Affiliation:
University of Michigan, School of Business Administration, 701 Tappan St., Ann Arbor, MI 48109
Jaime F. Zender
Affiliation:
University of Utah, David Eccles School of Business, Salt Lake City, UT 84112
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Abstract

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 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. 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 establish a bias toward the manager in reorganizations that provides correct ex ante decision making incentives.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 33 , Issue 4 , December 1998 , pp. 441 - 464
Copyright
Copyright © School of Business Administration, University of Washington 1998

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