Skip to main content
SpringerLink
Log in

General Issues in Bankruptcy Law

  • Chapter
  • First Online:
The Economics of Bank Bankruptcy Law

  • 1068 Accesses

Abstract

The primary aim of this book is to understand bank bankruptcy law and to make suggestions on how to improve its design. In order to be able to do this, one first needs to understand the principles behind the general bankruptcy law.

This is a preview of subscription content, log in via an institution to check access.

Access this chapter

Log in via an institution
Chapter
USD 29.95
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
eBook
USD 84.99
Price excludes VAT (USA)
  • Available as EPUB and PDF
  • Read on any device
  • Instant download
  • Own it forever
Softcover Book
USD 109.00
Price excludes VAT (USA)
  • Compact, lightweight edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info
Hardcover Book
USD 109.99
Price excludes VAT (USA)
  • Durable hardcover edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info

Tax calculation will be finalised at checkout

Purchases are for personal use only

Institutional subscriptions

Notes

  1. 1.

    Encyclopedia Britannica defines bankruptcy as “Status of a debtor who has been declared by judicial process to be unable to pay his or her debts.” However, the question is why such a status of bankruptcy is needed in the first place.

  2. 2.

    We focus here on corporate bankruptcy law. See White (2005) for a comparison of corporate and personal bankruptcy law.

  3. 3.

    The existing creditors may also try to renew their loan after the bankruptcy has already started because in most bankruptcy laws this could automatically give them a super-senior status against all remaining creditors.

  4. 4.

    Institutional lenders can also coordinate on their own in order to prevent coordination problems. See Brunner and Krahnen (2008) for the case of bank pool formation in distressed lending in Germany.

  5. 5.

    An example is the UK corporate bankruptcy law.

  6. 6.

    In Bolton and Scharfstein (1990) and Hart and Moore (1994) a court cannot precisely verify which state of nature has occurred; hence, a contract contingent on the states of nature has no legal value because the court cannot determine the contingent obligations of creditors and debtors.

  7. 7.

    Davydenko and Franks (2008) show that French banks require more collateral to respond to a creditor-unfriendly bankruptcy code. However, they show that bank recovery rates remain remarkably different across countries with different bankruptcy laws.

  8. 8.

    However, Acharya et al. (2009) provide evidence that firms more often engage in value-destroying diversifying acquisitions under creditor-friendly bankruptcy codes. Excessive conservatism spurred by creditor-friendly bankruptcy codes also hinders innovation; see also Acharya and Subramanian (2009). Berkovitch et al. (1997) show that creditor-friendly bankruptcy law may allow creditors to appropriate a debtor’s rents and therefore diminish investment into firm-specific human capital.

  9. 9.

    Longhofer (1997) theoretically shows that creditor-friendly bankruptcy law enhances access to credit. Empirical evidence is provided by Berkowitz and White (2004). In order to lower the cost of debt, Cornelli and Felli (1997) show that bankruptcy law needs to move valuable control rights from the insolvent debtor to creditors before the start of the bankruptcy process. La Porta et al. (1997) show that countries with greater creditor protection have larger and more developed credit markets; see also Djankov et al. (2007).

  10. 10.

    Even though creditors may protect themselves against strategic defaults, such actions may increase the cost of debt and lower its availability. Long-term creditors may demand durable collateral and force the firm to match liabilities with assets (Hart and Moore 1994). In this sense, creditor-friendly bankruptcy law that mitigates strategic defaults allows for longer maturity of debt and less collateral.

  11. 11.

    Bisin and Rampini (2006) show that bankruptcy is especially important in an environment where the main creditor cannot monitor whether the debtor takes on additional debt from other creditors. They show that debtor-friendly bankruptcy law induces the debtor to declare bankruptcy in a timely manner. Bankruptcy adds value for the creditor because the court verifies the assets and liabilities of the debtor, liquidates the assets, and repays the senior creditor (the bank) first.

  12. 12.

    The estimates deviate substantially across empirical studies and range from 1.4% to 9.5% in Chapter 11 proceedings and from 6.1% to 8.1% in Chapter 7 proceedings; see Altman and Hotchkiss (2006).

  13. 13.

    Secured creditors are also specialized for monitoring the value of the collateral before the bankruptcy commences, which decreases the cost of debt financing.

  14. 14.

    A typical example of the use of the floating charge is UK bankruptcy law. A floating charge holder could, upon reneging on a loan contract, conduct a private liquidation and have full control over the appointment of a receiver. In 2003 the power of the floating charge holder was somewhat decreased (Armour et al. 2007). In fixed charge debt security, only specific assets are pledged as collateral.

  15. 15.

    Acharya et al. (2007) show that practically only reorganizations and virtually no liquidations occur during industry distress. Reorganizations also last substantially longer during industry distress.

  16. 16.

    See Altman and Hotchkiss (2006, p. 224) for more details on management compensation in U.S. bankruptcy proceedings and Gilson et al. (2000) for evidence on how a manager may respond to various compensation packages.

  17. 17.

    Existing managers may have a hard time adjusting to the new role. Filtering failure may occur, in which the manager may file for reorganization even though the first optimal decision would be to liquidate. In the framework of asymmetric information, White (1994) shows that filtering failure may become more pronounced if the majority of corporations in bankruptcy are ripe for liquidation.

  18. 18.

    To prevent bankruptcy and repay debt, the manager can also sell off profitable parts of a business even though fire sales at depressed prices may result in huge losses.

  19. 19.

    Two proxies for liquidation value are used: (i) firm’s assets specificity, and (ii) the ratio of intangible assets on the balance sheet.

  20. 20.

    In an underdeveloped system, creditor- and debtor-friendly chapters of bankruptcy law should coexist as well, but debtors should be given even more power in bankruptcy.

  21. 21.

    Claessens and Klapper (2005) provide evidence that creditor rights and judicial efficiencies act as substitutes. Higher creditor rights (except for an automatic stay) increase the number of bankruptcy procedures.

References

  • Acharya, V., & Subramanian, K. (2009). Bankruptcy codes and innovation. Review of Financial Studies, 22, 4949–4988.

    Article  Google Scholar 

  • Acharya, V., Sundaram, R., & John, K. (2008) Cross-country variations in capital structures: The role of bankruptcy codes, Journal of Financial Intermediation 20(1), 25–54.

    Google Scholar 

  • Acharya, V., Bharath, S., & Srinivasan, A. (2007). Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries. Journal of Financial Economics, 85, 787–821.

    Article  Google Scholar 

  • Acharya, V., Amihud, Y., & Litov, L. (2009, April 6). Creditor rights and corporate risk-taking, 3rd Annual Conference on Empirical Legal Studies Papers.

    Google Scholar 

  • Altman, E. I., & Hotchkiss, E. (2006). Corporate financial distress and bankruptcy: Predict and avoid bankruptcy, analyze and invest in distressed debt. Hoboken: Wiley Finance.

    Google Scholar 

  • Andrade, G., & Kaplan, S. N. (1998). How costly is financial (not economic) distress? Evidence from highly leveraged transactions that became distressed. Journal of Finance, 53, 1443–1493.

    Article  Google Scholar 

  • Armour, J., Cheffins, B. R., & Skeel, D. A. (2002). Corporate ownership structure and the evolution of bankruptcy law: Lessons from the UK. Vanderbilt Law Review, 55, 1699–1785.

    Google Scholar 

  • Armour, J., Hsu, A., & Walters, A. (2007). The costs and benefits of secured creditor control in bankruptcy: Evidence from the U.K. Working Paper 332. Centre for Business Research, University of Cambridge.

    Google Scholar 

  • Ayotte, K. (2007). Bankruptcy and entrepreneurship: The value of a fresh start. Journal of Law, Economics, and Organization, 23(1), 161–185.

    Article  Google Scholar 

  • Ayotte, K., & Yun, H. (2009). Matching bankruptcy laws to legal environments. Journal of Law, Economics, and Organization, 25(1), 2–30.

    Article  Google Scholar 

  • Baird, D. G. (1991). The initiation problem in bankruptcy. International Review of Law and Economics, 11(2), 223–232.

    Article  Google Scholar 

  • Baird, D. G., & Bernstein, D. S. (2006). Absolute priority, valuation uncertainty, and the reorganization bargain. Yale Law Journal, 115(8), 1930–1970.

    Article  Google Scholar 

  • Bebchuk, L. A. (2002). The ex ante costs of violating absolute priority in bankruptcy. Journal of Finance, 57, 445–460.

    Article  Google Scholar 

  • Berkovitch, E., & Israel, R. (1999). Optimal bankruptcy laws across different economic systems. Review of Financial Studies, 12(2), 347–377.

    Article  Google Scholar 

  • Berkovitch, E., Israel, R., & Zender, J. (1997). Optimal bankruptcy laws and firm specific investments. European Economic Review, 41, 487–497.

    Article  Google Scholar 

  • Berkowitz, J., & White, M. J. (2004). Bankruptcy and small firms’ access to credit. RAND Journal of Economics, 35(1), 69–84.

    Article  Google Scholar 

  • Bisin, A., & Rampini, A. (2006). Exclusive contracts and the institution of bankruptcy. Economic Theory, 27(2), 277–304.

    Article  Google Scholar 

  • Bolton, P., & Scharfstein, D. S. (1990). A theory of predation based on agency problems in financial contracting. American Economic Review, 80, 94–106.

    Google Scholar 

  • Bolton, P., & Scharfstein, D. S. (1996). Optimal debt structure and the number of creditors. Journal of Political Economy, 104(1), 1–25.

    Article  Google Scholar 

  • Bris, A., & Welch, I. (2005). The optimal concentration of creditors. Journal of Finance, 60(6), 2193–2212.

    Article  Google Scholar 

  • Bris, A., Welch, I., & Zhu, N. (2006). The costs of bankruptcy: Chapter 7 Liquidation versus Chapter 11 Reorganization. Journal of Finance, 61(3), 1253–1303.

    Article  Google Scholar 

  • Brunner, A., & Krahnen, J. P. (2008). Multiple lenders and corporate distress: Evidence on debt restructuring. Review of Economic Studies, 75(2), 415–442.

    Article  Google Scholar 

  • Claessens, S., & Klapper, L. (2005). Bankruptcy around the world: Explanations of its relative use. American Law and Economic Review, 7(Spring), 253–283.

    Article  Google Scholar 

  • Cornelli, F., & Felli, L. (1997). Ex-ante efficiency of bankruptcy procedures. European Economic Review, 41(3–5), 475–485.

    Article  Google Scholar 

  • Davydenko, S., & Franks, J. (2008). Do bankruptcy codes matter? A study of defaults in France, Germany and the U.K. Journal of Finance, 63, 565–608.

    Article  Google Scholar 

  • Djankov, S., McLiesh, C., & Shleifer, A. (2007). Private credit in 129 countries. Journal of Financial Economics, 84(2), 299–329.

    Article  Google Scholar 

  • Djankov, S., Hart, O., McLiesh, C., & Shleifer, A. (2008). Debt enforcement around the world. Journal of Political Economy, 116(6), 1105–1149.

    Article  Google Scholar 

  • Eberhart, A., & Senbet, L. (1993). Absolute priority rule violations and risk incentives for financially distressed firms. Financial Management, 22(3), 101–116.

    Article  Google Scholar 

  • Franks, J., & Sussman, O. (2005). Financial distress and bank restructuring of small to medium size UK companies. Review of Finance, 9(1), 65–96.

    Article  Google Scholar 

  • Gale, D., & Hellwig, M. (1985). Incentive-compatible debt contracts: The one-period problem. The Review of Economic Studies, 52, 647–663.

    Article  Google Scholar 

  • Gamboa-Cavazos, M., & Schneider, F. (2007, June 1). Bankruptcy as a legal process Working Paper. Department of Economics, Harvard University.

    Google Scholar 

  • Gertner, R., & Scharfstein, D. (1991). A theory of workouts and the effects of reorganization law. Journal of Finance, 46, 1189–1222.

    Google Scholar 

  • Gilson, S. C., Hotchkiss, E. S., & Ruback, R. S. (2000). Valuation of bankrupt firms. Review of Financial Studies, 13(1), 43–74.

    Article  Google Scholar 

  • Hackbarth, D., Hennessy, C. A., & Leland, H. E. (2007). Can the trade-off theory explain debt structure? Review of Financial Studies, 20(5), 1389–1428.

    Article  Google Scholar 

  • Hart, O., & Moore, J. (1994). A theory of debt based on the inalienability of human capital. Quarterly Journal of Economics, 109(4), 841–879.

    Article  Google Scholar 

  • Hart, O., & Moore, J. (1998). Default and renegotiation: A dynamic model of debt. Quarterly Journal of Economics, 113, 1–41.

    Article  Google Scholar 

  • Hotchkiss, E. S., John, K., Mooradian, R. M., &Thorburn, K. S. (2008). Bankruptcy and the resolution of financial distress In Handbook of Empirical Corporate Finance, Volume 2. Elsevier.

    Google Scholar 

  • Jackson, T. H. (1986). The logic and limits of bankruptcy law. Cambridge: Harvard University Press.

    Google Scholar 

  • Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance and takeovers. The American Economic Review, 76(2), 323–329.

    Google Scholar 

  • La Porta, R., Lopez de Silanes, F., Shleifer, A., & Vishny, R. (1997). Legal determinants of external finance. Journal of Finance, 52, 1131–1150.

    Article  Google Scholar 

  • Longhofer, S. D. (1997). Absolute priority rule violations, credit rationing, and efficiency. Journal of Financial Intermediation, 6(3), 249–267.

    Article  Google Scholar 

  • Longhofer, S. D., & Carlstrom, C. T. (1995). Absolute priority rule violations in bankruptcy. Federal Reserve Bank of Cleveland, Economic Review, 31, 21–30.

    Google Scholar 

  • Melitz, M. J. (2003). The impact of trade on intra-industry reallocations and aggregate industry productivity. Econometrica, 71(6), 1695–1725.

    Article  Google Scholar 

  • Myers, S. C. (1984). The capital structure puzzle. Journal of Finance, 39, 575–592.

    Article  Google Scholar 

  • Povel, P. (1999). Optimal “soft” or “tough” bankruptcy procedures. Journal of Law, Economics, and Organization, 15, 659–684.

    Article  Google Scholar 

  • Pulvino, T. C. (1998). Do asset re-sales exist: An empirical investigation of commercial aircraft sale transactions. Journal of Finance, 53(3), 939–978.

    Article  Google Scholar 

  • Ramey, V. A., & Shapiro, M. D. (2001). Displaced capital: A study of aerospace plant closings. Journal of Political Economy, 109(5), 958–992.

    Article  Google Scholar 

  • Shleifer, A., & Vishny, R. W. (1992). Liquidation values and debt capacity: A market equilibrium approach. Journal of Finance, 47, 1343–1366.

    Article  Google Scholar 

  • Syverson, C. (2004). Market structure and productivity: A concrete example. Journal of Political Economy, 112(61), 1181–1222.

    Article  Google Scholar 

  • Townsend, R. (1979). Optimal contracts and competitive markets with costly state verification. Journal of Economic Theory, 21, 265–293.

    Article  Google Scholar 

  • von Thadden, E.-L., Berglöf, E., & Roland, G. (2010). The design of corporate debt structure and bankruptcy, Review of Financial Studies, 23(7), 2648–2679.

    Google Scholar 

  • White, M. J. (1994). Corporate bankruptcy as a filtering device: Chapter 11 reorganizations and out-of-court debt restructurings. Journal of Law Economics and Organization, 10(2), 268–295.

    Google Scholar 

  • White, M. J. (2005, August), Economic analysis of corporate and personal bankruptcy law, and NBER Working Paper 11536.

    Google Scholar 

  • Winton, A. (1995). Costly state verification and multiple investors: The role of seniority. Review of Financial Studies, 8(1), 91–123.

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Faculty of Economics Department for Money and Finance, University of Ljubljana, Kardeljeva pl. 17, 1000, Ljubljana, Slovenia

    Matej Marinč

  2. Amsterdam Center for Law & Economics (ACLE), University of Amsterdam, Roeterstraat 11, 1018WB, Amsterdam, The Netherlands

    Matej Marinč

  3. De Nederlandsche Bank, 98, 1000 AB, Amsterdam, The Netherlands

    Razvan Vlahu

Authors
  1. Matej Marinč
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Razvan Vlahu
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Matej Marinč .

Rights and permissions

Reprints and permissions

Copyright information

© 2012 Springer-Verlag Berlin Heidelberg

About this chapter

Cite this chapter

Marinč, M., Vlahu, R. (2012). General Issues in Bankruptcy Law. In: The Economics of Bank Bankruptcy Law. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-21807-1_2

Download citation

  • DOI: https://doi.org/10.1007/978-3-642-21807-1_2

  • Published:

  • Publisher Name: Springer, Berlin, Heidelberg

  • Print ISBN: 978-3-642-21806-4

  • Online ISBN: 978-3-642-21807-1

  • eBook Packages: Business and EconomicsEconomics and Finance (R0)

Publish with us

Policies and ethics

Search

Navigation