Corporate Bankruptcy as a Filtering Device

Abstract

This article uses a game theoretic model of Chapter 11 bankruptcy and out-of-court debt restructuring to evaluate the economic efficiency of U.S. bankruptcy procedures. The model assumes that there are two types of failing firms: economically inefficient firms that should liquidate and economically efficient firms that should be saved. From an efficiency standpoint, the goal of corporate bankruptcy procedures is to liquidate the former under Chapter 7 and save the latter by reorganization under Chapter 11-that is, to filter out inefficient firms. However, it is difficult to identify which failing firms are inefficient, so bankruptcy procedures may operate with error. The model shows that a pooling equilibrium may occur in which both efficient and inefficient failing firms reorganize under Chapter 11. Adding restructuring as a bankruptcy alternative appears to make things worse, since the transactions cost savings in restructuring compared to reorganization makes the inefficient equilibrium more likely to occur.