Proposal for a new bankruptcy procedure in emerging markets

Abstract

There is widespread dissatisfaction with existing bankruptcy procedures around the world. We propose a fast and cheap bankruptcy mechanism which leaves little room for court discretion and meets the desiderata of a good procedure. Our scheme has four essential building blocks. The first part consists of the reorganization offers for the firm and/or its pieces. Reorganization offers can be made not only in cash but also in non-cash securities, which facilitates the best allocation of assets in the presence of capital market imperfections. Additionally, since reorganization offers may be placed by both firm insiders and outsiders, our mechanism preserves the ex-ante bonding role of debt by penalizing poor management while granting debtor protection when financial difficulties are the result of fortuitous events. In the second part of our scheme, the insider cash auction, the various claims on the firms’ assets are transformed into one common security, reorganization rights (RRs), thereby aligning the objectives of all claimants. The insider cash auction has the goal of offering preferential treatment to existing claimants, protecting them in cases where bad functioning or non-competitive auction markets may allow third parties to reap benefits at their expense. The third part of our procedure consists of a public cash auction for RRs, which reduces the probability that credit constraints will result in a bankruptcy allocation that is unfair to claimants. The final part of the procedure consists of a simple vote by the newly assembled group of shareholders on which reorganization offer to accept.

We are grateful to Lemma Sembit, Andrei Shleifer and the participant of the conference on “The Future of Emerging-Market Capital Flows” for their comments. We are also grateful to Fernando Salas for helpful conversations. Part of this paper draws on our proposal to modify bankruptcy law in Mexico (Hart et al., 1995).