July 30, 2001
Over the past 15 years, lawyers and economists have tried to make bankruptcy laws more efficient. A recent article analyzes the objectives of bankruptcy and offers a way to make it more efficient.
Bankruptcy has three goals:
- To maximize the total value available for distribution among claimants;
- To penalize those responsible for failing to service the debt -- so that shareholders and managers have incentives to repay debts and creditors have incentives to lend;
- And to preserve the absolute priority of the debt, while reserving a portion of equity for former shareholders so that creditors get repaid and shareholders do not engage in extremely risky investments.
The primary impediment to efficient bankruptcy is haggling between shareholders who want to repair the company and continue, and creditors who attempt to liquidate the assets to repay their debts. Under current bankruptcy laws, this results in the worst of both worlds. The partitioning of assets takes an enormous amount of time, while the company cannot function well. This results in fewer assets to divide and an inefficient outcome.
One way to prevent this haggling would be to convert the creditor's debt into shares. In this way, the conflict of interest would be eliminated. Then the large group of shareholders could choose among three options:
- The company could be put up for auction and the shareholders could vote on which bid to accept.
- The shareholders could vote on a plans of restructuring or closing.
- Standard corporate governance procedures could take over without the need to auction the firm or appoint a bankruptcy practitioner.
In all three cases, the first goal is met; a homogenous group that focuses on maximizing value, rather than dividing it up, decides the company's future.
Source: "Making Bankruptcy Efficient," Economic Intuition, Winter 2001; based on Oliver Hart, "Different Approaches to Bankruptcy," Governance, Equity and Global Markets, Proceedings of the Annual Bank Conference on Development Economics in Europe, June 21-23, 1999 (Paris: La Documentation Francaise, 2000).
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