On the Efficient Design of Corporate Bankruptcy law
Calcutta Law Times
20 Pages Posted: 13 May 2020
Date Written: April 18, 2020
This paper explains the nature of corporate bankruptcy law as a collective action problem. The basic principles are discussed first. The first objective of the law should be the ex post efficiency principle of maximization of asset value for the creditors in bankruptcy states. Next, the law should focus on removing the bias towards restructuring. After this step is completed, the law should remove the barriers to restructuring. Last, secured creditors like commercial banks and asset rich investment banks have to be given real incentives to refinance the bankrupt company and make it viable and efficient. Substantive law is discussed next. There should be mechanisms like early warning signals and adequate incentives for information disclosure. This paper discusses the reasons why automatic stay and absolute priority rule should almost always be upheld. While the substantive law discusses and elaborates on liquidation and reorganization, the choice between the two is determined by economic cost-benefit analysis. The recent theoretical literature suggests liquidation as a more efficient and fair option but this paper argues for reorganization in three scenarios. First, if the expected liquidation value is less than the expected value from reorganization then claimants should vote for reorganization. Second, liquidation value will be comparatively low due to imperfect capital markets and it should be noted that even though bargaining in reorganization is time consuming and costly, reorganization does generate substantial value from case to case. Third, financial innovations and risk sharing induced by reorganization increase the welfare of the stakeholders of the firm. These three arguments warrant the existence of the reorganization chapter of any corporate bankruptcy code in my view.
Keywords: Corporate Bankruptcy, Law, Design
JEL Classification: E
Suggested Citation: Suggested Citation