Conflicts of Interest and Market Illiquidity in Bankruptcy Auctions: Theory and Tests

I develop and estimate a model of cash auction bankruptcy using data on 205 Swedish Þrms. The results challenge arguments that cash auctions, as compared to reorganizations, are immune to conßicts of interest between claimholders but lead to inefficient liquidations. I show that a sale of the assets back to incumbent management is a common bankruptcy outcome. Salebacks are more likely when they favor the bank at the expense of other creditors. On the other hand, inefficient liquidations are frequently avoided through salebacks when markets are illiquid, i.e. when industry indebtedness is high and the Þrm has fewer nonspeciÞc assets. The problem of designing an efficient bankruptcy law has received considerable attention in the last decade. Much of the debate has centered around the optimality of two different stylized bankruptcy procedures: cash auctions, such as the US Chapter 7 code, and structured bargaining, represented by the US Chapter 11 reorganization code. Recently, several European countries (including France, Germany and Britain) have changed their bankruptcy regulation by introducing reorganization procedures similar to Chapter 11. At the same time, the Chapter 11 code has been criticized by academics, including Baird (1986), emphasizing that the bargaining procedure frequently results in long and wasteful negotiations. These critics argue that Chapter 11 should instead be replaced with a mandatory auction procedure. Other researchers, such as Aghion, Hart and Moore, (1992) and Shleifer and Vishny (1992), have pointed out that a cash auction is likely to suffer from considerable inefficiencies arising from transaction costs and market illiquidity. The nature and costs of the Chapter 11 procedure are fairly well documented. In contrast, the degree to which the inefficiencies of the cash auction are economically important is still an unresolved empirical question. This paper tries to Þll this gap by developing a model of cash auction bankruptcy and estimating it using data from Swedish bankruptcies. Thanks to a unique data set and the simplicity of the Swedish institutional environment, the cash auction bankruptcy resolution can be modeled and estimated in a consistent manner. As a result, the economic impact of both market liquidity and of conßicts of interests between claimholders in the cash auction procedure can be assessed. Most previous bankruptcy studies analyze structured bargaining codes like the Chapter 11. In a structured bargaining procedure, the Þrm does not cease to exist upon entering bankruptcy. Instead, the Þrm continues to operate, subject to rules regarding asset sales, new Þnancing, creditor protection, etc. Meanwhile, the Þrm’s equity and debtholders negotiate on whether the operations should be continued or liquidated, and on the design of the Þrm’s new capital structure. The