Optimal "Soft" or "Tough" Bankruptcy Procedures

TLDR: In this paper, the authors describe optimal bankruptcy laws in a framework with asymmetric information, and reinterpret much of the evidence on the performance of Chapter 11, the "rather soft" U.S. reorganization procedure, questioning many negative conclusions.

Abstract: This article describes optimal bankruptcy laws in a framework with asymmetric information. The key idea is that the financial distress of a firm is not observed by its lenders for quite a while. As early rescues are much cheaper than late rescues, it may pay if the creditors are forgiving in bankruptcy, thereby inducing the revelation of difficulties as early as possible. Either “tough” or “soft” bankruptcy laws can be optimal, depending on the parameters. This implies that mandatory one-size-fits-all bankruptcy procedures cannot be optimal. “Hybrid” procedures, which try to combine elements of soft and tough procedures, are found to be redundant, and possibly harmful. Absolute priority rules may be helpful as a part of tough procedures, but their introduction is (partly) inconsistent with the design of soft procedures. The article also reinterprets much of the evidence on the performance of Chapter 11, the “rather soft” U.S. reorganization procedure, questioning many negative conclusions.