Following the rapid demise of socialism, Eastern European countries have been grappling with the question of what kind of market economy is best suited to their future needs. Should they incorporate capitalism whole sale, and, If so, which kind: American, European, Japanese, or some new version? How should problems of the transition be handled? What kinds of institutional structures and laws are most appropriate for their situation?
This paper is concerned with an aspect of this last question: the choice of bankruptcy law. The decision facing Eastern European countries on this question is both important and far from straightforward. It is generally recognized by economists and lawyers in the West that bankruptcy law has an important role to play in ensuring a timely resolution of the problems of insolvent or financially distressed firms and a socially efficient disposition of such firms' assets. Yet both practitioners and academics are dissatisfied with current Western procedures, which are regarded either as favoring the piece-meal liquidation of healthy firms (in the case of Chapter 7 of the U.S. Bankruptcy Code, or the receivership system in the U.K.) or as being administratively very inefficient and costly (in the case of Chapter 11 reorganizations in the U.S.).
Nor is there any consensus about how to improve these procedures. Thus It is far from obvious that Eastern European countries should simply pick 'the best available Western procedure" (whatever that may be).
In this paper, we propose a new bankruptcy procedure which we believe avoids some of the main pitfalls of existing procedures. The procedure is a simple one. First, when a firm goes bankrupt, all of the firm's debts are cancelled; and an individual a Judge, say is appointed to supervise the procedure. The judge has two immediate tasks. (A) He (or she) must solicit cash and non cash bids for all or part of the 'new' firm. He must allocate rights to the shares in this new firm: each former claim holder is either allocated quity In the new company (in the case of senior creditors) or given an opt ion to buy equity (in the case of junior creditors or shareholders), according to the amount or priority of his (or her) claim.
These two tasks could be carried out in parallel, and completed within a prespecified period of time: e.g. , three months. After this, in the light of the bids received, there is a further short period (of a month, say) in which people can exercise (and even trade) their options. Finally, the shareholders (recall that all claia holders are now shareholders) vote on whether to select one of the cash bids or to maintain the company as a going concern (either under existing management or under some alternative management team).
The firm then exits from bankruptcy.
In essence, our proposed scheme is a decentralized variant on Chapter 7, in which non cash (as well as cash) bids are allowed; and ownership of the firm is homogenized (to all equity),so that the owners can decide (by vote) which of the bids to accept. What is less essential to our scheme is the precise mechanism by which equity is allocated; in Section 8 below we present some alternative mechanisms for allocating equity which are simpler than using options.
We believe that this procedure is relatively easy to implement and avoids the main disadvantages of existing procedures. First, it eliminates costly bargaining between various creditor groups, and the large legal fees and expensive use of court time which are the feature of many Chapter 11 proceedings. Second, the mechanism is not biased in favor of maintaining the firm as a going concern under incumbent management, again as many commentators feel that Chapter 11 is. In fact, we believe that, in practice, if an attractive outside offer is made for part or all of the company, it is likely that shareholders will vote to sell or liquidate the company. Third. however, the procedure gives claim holders the option of maintaining the firm as a going concern if the company's bad fortunes are the result of bad luck rather than bad management.
