The privatization of bankruptcy: evidence from financial distress in the shipping industry

Current bankruptcy legislation in many countries tends to follow the US model of Chapter 11, whereby the courts have the authority to stay the contractual rights of the secured creditors. The alternative approach of freedom of contracting whereby the privately negotiated debt contract defines a contingency that the courts strictly implement in the event of financial distress, is largely ignored. We study the resolution of financial distress in shipping, where the ex-territorial nature of assets have distanced the industry from on-shore bankruptcy legislation. We have four main findings. First, we demonstrate how contracts and other private institutions have adapted to the industry’s special circumstances so as to deliver effective resolution of financial distress. Second, we use vessel arrest as a proxy for the economic cost of financial distress. We show that the level of arrests are low and mostly originating in companies that are going bust. Third, we estimate the expected economic life of vessels (conditional on age) in financial distress, and show that it is significantly shorter than the rest of the vessel population, reflecting under-maintenance of the vessel prior to arrest. This provides a signifcant test for Myers (1977) under-investment hypothesis. Finally, our estimates of the under-maintenance effect, suggest that fire sale discounts reported in the literature using standard methods may be seriously overstated. In summary, the shipping industry provides a rare opportunity to study the evolution of legal institutions in an environment of conflicting jurisdictions, one that may be described as being generated by a Hayekian spontaneous order. “There is only one law in shipping: there is no law in shipping”. Sami Ofer (shipping magnate)