Bankruptcy
White (1989)
Bankruptcy – the closing down of firms that are inefficient,
use outdated technologies, or produce products that are in
excess supply.
The central question:
Does the bankruptcy process make sure that
• firms in bankruptcy are inefficient,
and that
• inefficient firms end up in bankruptcy?
Liquidation
• the basic bankruptcy procedure
• used by firms that are closing down and not able to
pay all their debts.
• Without it: a race by individual creditors in order to
secure claims
Crucial aspect: the priority rule
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 1
In practice (US): APR - the absolute priority rule.
Priority
0
secured creditors, with claim of particular assets
(or their values)
1
administrative expenses of the bankruptcy
process
2
claims with statutory priority (tax claims, unpaid
wages, etc.)
3
unsecured creditors’ claims (trade credit, damage
claims, long-term bonds)
- subordination agreements?
4
equity (shareholders, owners)
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 2
Three basic priority principles
“Me first”
• All creditors are assumed unsecured; no claims have
statutory priority
• Creditors are ranked in order of the date loans were
made, with earliest claims ranked highest.
• Anything remaining goes to equity holders.
“Last lender first”
• As “Me first” but with ranking in reversed order.
Equal priority
• All creditors have the same ranking and are therefore
paid the same fraction of their claims’ face values.
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 3
A model of the bankruptcy decision
Management makes decisions maximizing the value of
equity.
If the firm fails – the firm’s assets are insufficient to pay
current obligations – it obtains new financing from a shortterm lender called the “bank”. Decisions are now taken by
the coalition of equity and bank in order to maximize their
joint value.
Other creditors are called the “debt”.
A two-period model. No discounting.
A firm has no cash in hand.
But it has outstanding debt:
D1 due in period 1
D2 due in period 2
Liquidation value if liquidated in period 1: L
Liquidation not enough to cover period-1 debt: L < D1
In order to avoid bankruptcy in period 1, the firm must
obtain a new loan from the bank in period 1: B1 = D1
The firm is willing to give the bank all its equity to obtain
this loan, since without it, the firm has no value.
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 4
If loan is granted and the firm continues, its gross earnings
(i.e., before debt payments) equal P2.
Efficiency:
The firm should be continued at period 1 if P2 > L.
The firm should file for bankruptcy at period 1 if P2 < L.
How do the priority rules perform?
It depends on whether or not there is any uncertainty
involved.
No uncertainty
“Me first”
Bankruptcy: Coalition receives nothing, because L < D1.
Continuation: Coalition receives P2 in period 2, but must
pay old debt D2 and new debt B1.
Coalition chooses continuation if: P2 – D2 – B1 > 0.
This condition implies P2 > B1 + D2 > B1 = D1 > L.
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 5
→ Under the me-first rule, continuation will be chosen only
when it is economically efficient.
Coalition chooses bankruptcy if: P2 – D2 – B1 < 0.
• The bank is not willing to make the loan that would
make continuation possible.
But there are cases in which P2 – D2 – B1 < 0, at the same
time as P2 > L. In such cases, debt holders at period 1
would gain P2 – L if continuation were chosen.
L
B1 + D2
Efficiency
Me first
Under “Me first”, some firms end up in bankruptcy that
should continue from an efficiency viewpoint.
• When the coalition chooses to continue, it must share
the gain from continuation with the old debt holders
by paying them in full.
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 6
P2
Last lender first
The interesting case: B1 < P2 < B1 + D2
Now, the bank has higher priority than the debt.
The coalition earns zero in case of continuation: the bank is
paid in full, but there is nothing left for equity.
Thus, the coalition is indifferent between bankruptcy and
continuation.
L
B1
B1 + D2
Efficiency
Last lender
first
Summing up – no uncertainty
• All the priority rules lead to too much bankruptcy
• Liquidation imposes a cost on debt holders that is
ignored by the coalition
ƒ An externality problem
• The problem is greatest under the me-first rule since it
gives the most to the debt holders and thus creates the
greatest externality.
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 7
P2
Uncertain value of continuation
Suppose that if the firm continues, then, in period 2,
with probability p, it earns P2 + G;
with probability (1 – p), it earns P2 – G.
Assume: P2 + G > B1 + D2, and D1 < P2 – G < D2.
Does a higher value of G imply greater uncertainty?
- Not necessarily, since G affects both expectation and
variance of the period-2 value.
Me-first rule
With continuation, the coalition gets P2 + G – D2 in the
good outcome, nothing in the bad outcome.
Expected return from continuation: p(P2 + G – D2) – B1.
Continuation chosen if
p(P2 + G – D2) – B1 > 0, i.e.
p(P2 + G) > pD2 + B1 = pD2 + D1.
Efficient with continuation when:
p(P2 + G) + (1 – p)(P2 – G) – L > 0, i.e.
p(P2 + G) > L – (1 – p)(P2 – G).
Continuation chosen when bankruptcy efficient? – If so,
pD2 + D1 < p(P2 + G) < L – (1 – p)(P2 – G),
which requires that
L > pD2 + (1 – p)(P2 – G) + D1;
this cannot happen (contradicting White’s claim).
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 8
Last lender first
Since B1 = D1 < P2 – G, the bank gets fully repaid in bad
times under last lender first. So continuation is chosen if
p(P2 + G – D2 – B1) > 0, i.e.
p(P2 + G) > p(D2 + B1) = p(D2 + D1).
An extreme focus on the good outcome.
Continuation chosen when bankruptcy efficient requires
that
L > p(D2 + D1) + (1 – p)(P2 – G);
but even if p is very small, so that D1 is of little importance,
this cannot happen: By assumption, L < D1 < P2 – G.
Again, a contradiction of White’s claim.
Summing up – uncertainty
• In contrast to the case without uncertainty, we may
now get situations where continuation is chosen even
if bankruptcy would be efficient.
• But: The examples in White’s text do not show this.
Reorganization
Too many firms go bankrupt.
Scope for remedies to get firms through financial crises?
Reorganization – US and Norwegian law very different.
Voluntary reorganization – free-rider problem.
Better to let management decide when to reorganize?
Tore Nilssen – Economics of the Firm – Lecture 6 – slide 9