Maximizing the value of distressed assets: Bankruptcy law and the efficient reorganization of firms

We argue that the main role of corporate bankruptcy is to mitigate bargaining frictions in financial distress. Bankruptcy law can improve ex post bargaining efficiency by (1) verifying assets and liabilities; (2) improving coordination among claimholders; (3) protecting third-party claimants; (4) maintaining asset value during bargaining; and (5) alleviating the impact of liquidity constraints among claimants and potential acquirers of the distressed firm’s assets. In improving ex post efficiency, however, bankruptcy law will also affect the bargaining power of the claimants, which may have unintended consequences on ex ante efficiency. We apply this framework to analyze bankruptcy systems in six representative countries. With the exception of the third-party protection, the U.S. Chapter 11 system goes the farthest in addressing ex post bargaining frictions. Other reorganization codes lack important key features, which seems to have discouraged the use of these codes, often in favor of reorganizing firms in the traditional liquidation-oriented chapter. We then turn to ex ante efficiency and argue that this issue can be best understood by looking at a context where private contracting works well and bankruptcy law is not needed. We propose that venture capital contracting is such an environment. Preliminary evidence suggests that venture capital reorganizations share many key features with the U.S. Chapter 11, with the exception that less power is given to equity-holders and other junior claimants. Since recent evidence suggests that the real impact of the equity-holder bias in Chapter 11 is small, however, we argue that it is unlikely that the U.S. system has significant ex ante inefficiencies. We conclude by discussing some lessons and limitations of our results for designing bankruptcy law in developing countries. * Division of International Finance, Board of Governors of the Federal Reserve System. Mailstop 19, 20th and C Streets NW, Washington, DC 20551. E-mail: [email protected]. ** Graduate School of Business, University of Chicago, 1101 East 58th Street, Chicago, IL 60637. E-mail: [email protected]. This paper was prepared for the World Bank conference on Systemic Financial Distress. The opinions expressed here do not necessarily reflect those of the Federal Reserve Board or its staff. We would like to thank our discussants Simeon Djankov and David Skeel for insightful input, Ulf Axelson, Douglas Baird, Luc Laeven, Steve Kaplan, Frederic Martel, Stefan Sundgren, and Arne Wittig for helpful discussions, and Guillermo Noguera for research assistance. We are grateful to Lynn Lopucki for providing us with his Chapter 11 data and Leora Klapper for sharing her international bankruptcy statistics.