The efficient resolution of financial distress calls for liquidating unprofitable firms and reorganizing those firms that are only temporarily insolvent, while at the same time making sure creditors are repaid. To achieve these goals, firms and investors could include in their debt contracts clauses and procedures dealing with the possibility of financial distress in the most efficient manner. The incomplete contracts approach to bankruptcy (e.g. Hart 1995) assumes that such contracts cannot be written, either because of writing costs or because of the unpredictability of financial distress. As a result, an optimal bankruptcy procedure should be provided by the state (Hart 2000).
The importance of state-provided bankruptcy procedures is widely recognized. In this paper we instead explore theoretically the idea that parties try to resolve financial distress by contract but the extent of creditor protection shapes their ability to do so. Indeed, recent empirical evidence shows that better legal protection allows the parties to write more sophisticated financial contracts, including for example more convertibility clauses in private equity contracts (Lerner and Schoar 2005), and more covenants in debt contracts (Qian and Strahan 2004). This evidence suggests that poor legal protection may hinder courts’ ability to enforce efficient but sophisticated contractual procedures to resolve financial distress. As a result, the parties may prefer to use procedures that are less efficient but more likely to be enforced under weak creditor protection.
Three main procedures have been proposed to resolve financial distress, namely options (e.g. Aghion, Hart and Moore 1992), court intervention (e.g. Bolton and Rosenthal 2002) and cash auctions (e.g. Jensen 1989). We present a simple model where each of these three procedures emerges as part of the optimal contract depending on creditor protection, and then we show that these contracts cannot be dominated. Our model helps rationalize and evaluate existing resolutions of financial distress around the world as a function of creditor protection, and yields several novel empirical predictions. The normative implication is that bankruptcy law should accommodate rather than supersede contractual resolutions to financial distress.
In our model creditor protection shapes the ability of courts to enforce contractual repayment and is parameterized by the share of the firm’s cash flows that courts can pledge to creditors. This parameter captures the extent to which creditors are protected against managerial self-dealing or tunneling (Shleifer and Vishny 1997, Djankov et al. 2005). These activities range from outright theft to related-parties transactions, transfer pricing, and so on. As a result, those who control a corporation can divert its profits to themselves without repaying investors, and may even precipitate financial distress. In turn, weak creditor protection against self-dealing and tunneling may undermine the bonding role of debt. One form of tunneling that is particularly relevant in the context of bankruptcy is the strategic acquisition of personal assets by the debtor with the creditors’ money. For example, three Enron executives started building million-dollar homes in Texas with Enron money before the Enron bankruptcy filing, because in Texas “the law permits a debtor to fraudulently invest ill-gotten gains in a homestead to beat his or her creditor” (LoPucki 2005, p. 150).
Consistent with this example, Berkowitz and White (2004) document that across U.S. states greater homestead exemption in bankruptcy is associated with reduced access to credit by small firms. Creditor protection against managerial self-dealing depends not only on the law in the books (La Porta et. al 1998), but also on the quality of courts because, especially if the law is unclear or requires interpretation, courts may lack the ability to detect managerial misbehavior (Glaeser et al. 2001). The magnitude of these problems is likely to be much amplified in transition and emerging economies, where underfinanced, incompetent or even corrupt courts cannot be expected to effectively resolve difficult cases of managerial self-dealing, reducing creditors’ ability to seize the project’s cash flows. In such cases, the only way for creditors to recoup money from a financially distressed firm may be to oust its management and liquidate its physical assets.
In addition to creditor protection, we consider another determinant of parties’ ability to contract about financial distress, namely courts’ ability to efficiently liquidate or continue a financially distressed project. We model this aspect of courts’ expertise as the precision of the bankruptcy courts’ estimates of the project’s continuation value. The precision of courts’ estimates may depend for example on whether bankruptcy judges are former bankruptcy practitioners, on the training of judges or on the strictness of disclosure rules, which also varies across countries (e.g. Djankov et al. 2006). In turn, courts’ ability to choose the efficient liquidation policy may affect the parties’ willingness to delegate such power to the courts by contract.
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