Resolution of Financial Distress under Chapter 11: A Dynamic Game Approach (Preliminary version)

This paper examines the reorganization process under Chapter 11 of the U.S. bankruptcy code. We model the strategic interaction between claimants under Chapter 11 as a multiple-stage costly bargaining process, and solve it in a game theory setting. Using a structural framework, we show that our model generates di¤erent ranges of equilibrium strategies: reorganization, liquidation and continuation of the negotiation process. We …nd that these strategies are a¤ected by the characteristics of the negotiation game, such as the judge’s behavior, as well as the volatility of the assets. Moreover, our results demonstrate that the …rm is always reorganized at the …rst round when there are no constant bankruptcy costs, and always liquidated at the …rst round if these costs are elevated. For moderate bankruptcy costs cases, the game lasts for more than one bargaining round if the equityholders are favored and the likelihood of having more rounds is inversely related to the volatility. Finally, implied spread levels respect the subordination feature between the classes of debt, and are an increasing function of the volatility of the assets, which is in-line with the empirical literature on credit risk. JEL classi…cation: C61, C7, G33, G34.