Law and Economics of Insolvency

Oliver Hart

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Law and Economics of Insolvency

• Most firms do not provide their own insolvency procedures, but rely on the state to do so. How good are these procedures? Do they achieve efficient outcomes, i.e., are “good” firms saved and “bad” firms closed down? Are creditors paid according to the priority of their claims (absolute priority)?

• I will describe an empirical study, “Debt Enforcement Around the World,” carried out with Simeon Djankov and Caralee McLiesh (World Bank), and Andrei Shleifer (Harvard), which investigates these questions by presenting insolvency practitioners in different countries with a hypothetical case.

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SetupHypothetical Case

Respondents: Insolvency Practioners fromInternational Bar Association Committee onBankruptcy

Date: January 2006 (several rounds before)

Total: 344 lawyers

All countries with: GDP per capita > $1000 Population > 1.5 million

Total: 88 countries

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Case FactsInsolvent Firm called “Mirage”Limited liability, domestically owned, medium-sized hotelLocated in most populous city201 employees50 suppliers (each owed money)

Five years ago, borrowed from BizbankLoan has collateral, i.e., is securedLoan has 10 year termMirage has met all obligations until nowLoan has seniority

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Case Facts (cont’d)

Mirage owned 51% by Mr. DouglasNo other shareholder has > 5%Mirage has a manager, with no special human capital

Mirage has 136 units of debtSuppliers, Tax Authorities, employees each owed 12These are unsecured creditorsBizbank is owed 100All normalized to country’s GDP per capita

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Case Facts (cont’d)

Mirage has been losing money and is about to default due to industry shockAssume going forward can cover costsBut cannot cover debt payments

Version A: Going concern worth 100Piecemeal liquidation worth 70

Version B: Going concern worth 70Piecemeal liquidation worth 100

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Data

Time = T

Cost = C

Whether get the efficient outcome: EO = 1

Efficiency =

Assume zero net revenue during procedure and costsincurred at end (but robust)

Also get structural features of procedure

Tr

CEOEO

)1(

100*)1(*70*100

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Foreclosure

3 Procedures 2 Outcomes

Reorganizationfirst

Liquidation

Piecemeal sale

Going Concern

Figure 1: Options for Mirage

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Limitations of the Case

1. No informal workouts allowed

2. Capital structure does not adjust to law

3. Only one secured creditor

Complex conflicts minimized

(Indeed, foreclosure has correct incentives)

4. Respondents know what is efficient from the start

5. Do not need new financing

6. No public interest, politics involved

7. No tunneling (looting)

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(Tentative) Conclusions

• Lots of inefficiency in a very simple case: wrong outcome, slow, high administrative costs

• How to do better?– Encourage foreclosure and floating charge– Circumscribe Appeals– Discourage automatic cessation of operations– Don’t allow suppliers/customers to rescind contracts

• Reorganization seems a bad idea in poor countries, where, arguably, institutions are not good enough to support complex procedures.