ArticlePDF Available

Who Should Pay for Bankruptcy Costs?

Authors:

Abstract and Figures

The fees of experts (financial advisors, lawyers, accountants) are a substantial fraction of bankruptcy costs. Scholars have considered how best to reduce these costs, but have not considered how they should be allocated among creditors. The allocation issue is important because creditors can spend redistributionally (to violate or uphold absolute priority) and productively (to increase the value of the bankrupt firm). An efficient bankruptcy cost allocation scheme should discourage redistributional and encourage productive creditor spending. We consider the desirability of various allocation schemes in a model in which senior and junior creditors can engage in both types of spending but the bankruptcy court cannot distinguish productive from rent seeking activities. We suppose that the senior claim is at or in the money. This implies that the seniors have an incentive to spend only to defend their position while the juniors have both good and bad incentives: to spend productively on value improvement because they are residual claimants and to spend redistributionally because they are partly or totally out of
Content may be subject to copyright.
Yale Law School
Yale Law School Legal Scholarship Repository
Faculty Scholarship Series Yale Law School Faculty Scholarship
1-1-2005
Who Should Pay for Bankruptcy Costs?
Alan Schwartz
Yale Law School
Arturo Bris
Ivo Welch
This Article is brought to you for free and open access by the Yale Law School Faculty Scholarship at Yale Law School Legal Scholarship Repository. It
has been accepted for inclusion in Faculty Scholarship Series by an authorized administrator of Yale Law School Legal Scholarship Repository. For
more information, please contact cesar.zapata@yale.edu.
Recommended Citation
Schwartz, Alan; Bris, Arturo; and Welch, Ivo, "Who Should Pay for Bankruptcy Costs?" (2005). Faculty Scholarship Series. Paper 304.
http://digitalcommons.law.yale.edu/fss_papers/304
295
[Journal of Legal Studies, vol. 34 (June 2005)]
2005 by The University of Chicago. All rights reserved. 0047-2530/2005/3402-0010$01.50
Who Should Pay for Bankruptcy Costs?
Arturo Bris, Alan Schwartz, and Ivo Welch
ABSTRACT
The fees of professionals (financial advisors, lawyers, accountants) are a substantial fraction
of bankruptcy costs. Scholars have considered how best to reduce these costs but have not
considered how they should be allocated among creditors. Creditors can spend redistribu-
tionally (to violate or uphold absolute priority) or productively (to increase the value of the
bankrupt firm). An efficient bankruptcy cost allocation scheme should discourage redistri-
butional and encourage productive creditor spending. We consider the desirability of various
allocation schemes in a model in which senior and junior creditors can engage in both types
of spending. We show that (1) the current U.S. cost allocation system is unsatisfactorybecause
the scheme partially reimburses junior expenses for professionals but does not reimburse
senior expenses and (2) a cost allocation scheme that approaches the first-best solution and
is implementable would delegate the issue of professionals’ cost reimbursement to the debtor
in possession.
1. INTRODUCTION
The fees of professionals—lawyers, accountants, investment bankers,
financial advisors, and turnaround specialists—drain substantial re-
ARTURO BRIS
is the Robert B. and Candice J. Haas Associate Professor of Corporate
Finance at Yale School of Management.
ALAN SCHWARTZ
is Sterling Professor of Law at
Yale Law School and Yale School of Management.
IVO WELCH
is Professor of Finance and
Economics at Brown Economics Department and a member of the National Bureau of
Economic Research. We thank Samuel Bufford, Edward Morrison, Eric Posner, Avri Ravid,
David Skeel, Jeremy Stein, Eric Talley, our anonymous referee, and seminar participants
at New York University, Columbia University, USC, the American Law and Economics
Association, and the Allied Social Science Association for valuable comments.
296 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
sources from the estates of large bankrupts.
1
The scholarly literature
considers how total bankruptcy costs are best reduced but devotes little
attention to how the costs of professionals should be allocated. There
are three candidates for bearing these costs: the creditors, the bankrupt
estate, or the government. The U.S. Bankruptcy Code implicitly rules
out the government but then is almost completely unilluminating with
respect to the optimal allocation of costs between the parties and the
estate. Instead, the code confers a large discretion on the bankruptcy
courts.
2
In this paper, we open the subject of how professional costs should
be allocated. Creditors
3
spend on professionals for two reasons: junior
creditors (or juniors) spend to capture a larger part of the estate than
the absolute priority rule (APR) would otherwise grant to them, and
senior creditors (or seniors) spend to fend off the redistributional efforts
of others and to increase the value of the estate. The cost allocation
problem would be trivial if value-increasing and redistributive efforts
1. The magnitude of direct professional expenses in bankruptcy can be significant.
Warner (1977) finds that the direct costs of bankruptcy—compensation provided tolawyers,
accountants, consultants, and expert witnesses—are about 4 percent of the market value
of the firm 1 year prior to the default. Altman (1984) calculates these costs to be about
7.5 percent of firm value using a broader sample of 19 bankrupt companies from 1974 to
1978. In a sample of 22 firms from 1994, Lubben (2000) calculates the cost oflegal counsel
in Chapter 11 bankruptcy to represent 1.8 percent of the distressed firm’s total assets, with
percentages above 5 in some cases. In the average case, the debtor spends $500,000 on
lawyers, and creditors spend $230,000. LoPucki and Doherty (2004) study a sample of
48 cases from 1998 to 2002, mostly from Delaware and New York cases, and report that
professional fees were 1.4 percent of the debtor’s total assets at the beginning of the
bankruptcy case. Evidence from administrative fees from 105 Chapter 11 cases from the
Western District of Oklahoma in Ang, Chua, and McConnell (1982) suggests that admin-
istrative fees are about 7.5 percent of the total liquidating value of the bankrupt corpo-
ration’s assets. Weiss (1990) and Betker (1997) have similar estimates. Fees can be large
in absolute terms for large, complex bankruptcies. Advisors (whom we call experts) to
MCI, the former WorldCom, Inc., have applied to collect about $600 million in fees, and
Enron’s Chapter 11 plan estimates that fees to bankruptcy advisors’ will ultimately reach
$995 million (Pacelle 2004).
2. Subsection 330(a)(1) of the U.S. Bankruptcy Code authorizes the bankruptcy court
to compensate professionals by awarding “reasonable compensation for actual, necessary
services.” The court, in making its award, is to consider “the nature, the extent and the
value of such services taking into account all relevant factors.” These factors include time
spent, rates charged, comparable fees for nonbankruptcy cases, and “whether the services
were necessary to the administration of, or beneficial...towardthecompletion of, a
case.” The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 makes no
material changes in any of the code sections cited in this paper.
3. The equity interest has the same incentives as do junior creditors. Hence, we refer
only to juniors and seniors for convenience.
BANKRUPTCY COSTS / 297
were separate and courts could distinguish between them: courts then
would reimburse only productive creditor efforts. We make the realistic
assumption that courts cannot draw this distinction for two reasons.
First, the same actions can have both productive and redistributional
effects. For example, business continuation may increase firm value but
also can redistribute wealth in favor of the juniors and against the sen-
iors. Continuation increases the value of the juniors’ call option on the
firm, while liquidation may fully pay off the seniors’ claims. Also, efforts
by juniors to establish the firm’s value can be productive, because an
accurate valuation is necessary to create a viable business plan, but the
juniors have an incentive to inflate value to increase their payout. Second,
courts usually cannot observe the parties’ production functions for effort
and therefore cannot assess the optimality of the parties’ actions. For
these reasons, when bankruptcy courts cannot tell the difference, the
public policy problem is to allocate the costs of professionals in such
fashion as to reward productive and to dampen redistributional creditor
efforts. This turns out to be a difficult problem, and our early effort
here tries to isolate the relevant considerations.
The incentive problem that bankruptcy law has to solve is created
by the parties’ priority rankings. The seniors have too little incentive to
spend on productive activities because, at the inception of a bankruptcy,
their claim is partly or totally in the money. The seniors’ primary motive
to spend thus is defensive—to fend off the redistributional efforts of the
juniors. The juniors, in contrast, have an incentive to spend too much
on professionals. Because the juniors are the residual claimants, they
have an incentive to spend optimally on value-increasing activities, but
because junior efforts also decrease the probability that the APR will be
followed (as we assume), the juniors have an additional incentive to
spend redistributionally. The policy task thus is to allocate the costs of
professionals such that the seniors spend more, some of which would
be productive, and the juniors spend less to curb their socially inefficient
rent seeking.
We show that the three corner solutions are not optimal:
1. It is inefficient for the government to pay for all professional ex-
penses because that would subsidize spending on both value-increasing
activities and redistributional activities. This would increase firm value
but reduce social welfare, because subsidies induce excessive professional
representation.
2. It is inefficient for the firm to pay for all professional expenses
298 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
because that would permit the seniors to spend the juniors’ money to
prevent redistributional efforts by juniors. This is socially wasteful. On
the other hand, some subsidized senior spending would likely preserve
absolute priority, thereby making the juniors purely residual claimants.
Under APR, juniors then invest optimally in value-increasing activities.
3. It is inefficient for creditors to pay their own professional expenses.
The seniors’ claim would be partly or totally in the money, so they would
spend primarily to fend off the redistributional efforts of the juniors but
not enough to increase value. The juniors, on the other hand, would
spend both to increase value and to undermine absolute priority. Thus,
the seniors would spend too little and the juniors would spend too much.
The failure of the three corner solutions to achieve efficiency suggests
that partial-reimbursement schemes are best. Any such scheme should
partially reimburse only the seniors. This would increase their incentive
to invest in value-increasing activities. Also, because increased senior
spending increases the probability that the APR will be followed, sub-
sidizing the seniors would discourage junior redistributional efforts. Re-
grettably, the precise partial percentage for a senior subsidy to achieve
efficiency is parameter specific, and the parameters likely would be dif-
ficult for an administrator, such as a bankruptcy judge, to recover. Thus,
the policy problem is to choose among second-best schemes.
The current U.S. Bankruptcy Code is unsatisfactory because, with
one exception, it does not expressly reimburse senior spending but ex-
pressly reimburses an important category of junior spending, that in-
curred by creditor committees.
4
The exception is section 506(b), which
provides that “there shall be allowed to the holder” of a secured claim
that is in the money “any reasonable fees, costs or charges provided for
under the agreement under which such claim arose.” Section 506(b)
clearly authorizes the reimbursement of a secured creditor’s attorney fee
expenses that are incurred in connection with repossessing or otherwise
4. A Chapter 11 creditors’ committee is composed of creditors “that hold the seven
largest claims against the debtor of the kinds represented on such committee” (11 U.S.C.S.
sec. 1102[b][1]). A creditors’ committee “with the court’s approval...mayselect and
authorize the employment of one or more accountants, attorneys or other agents, to rep-
resent or perform services for such committee.” These services may include the investigation
of “the acts, conduct, assets, liabilities and financial condition of the debtor, the operation
of the debtor’s business, and the desirability of such business, and any other matter relevant
to the case or formulation of a plan” (secs. 1103[b] and 1103[c]). The court is authorized
to award “reasonable compensation for actual, necessary services rendered by
[a]...professional person” who has been employed under section 1103.
BANKRUPTCY COSTS / 299
protecting the collateral, but otherwise the scope of the section is un-
clear.
5
A bankruptcy court may use its inherent powers, and some courts
do, to reimburse other senior expert expenses that are incurred during
the course of a Chapter 11, but the extent and scale of this practice are
unknown. As a legal matter, then, the Bankruptcy Code encourages
junior spending, which we claim is bad, and provides little encourage-
ment for senior spending. The code thus responds inadequately to the
agency problems this paper uncovers.
Our paper suggests a partial-reimbursement scheme that is plainly
better. Under our scheme, the debtor in possession is given discretion to
reimburse creditor spending on professionals. To the extent that the
debtor in possession can be given incentives to maximize the value of
the firm, the management would have no incentive to subsidize junior
redistributional spending. Any dollar spent by managers on reimbursing
creditors’ professionals would provide a greater increase in value if given
to the seniors instead. As a consequence, our scheme does much better
than current law at reducing strategic spending by the juniors. But man-
agers will purchase (subsidize) productive senior professional spending
to the extent that it enhances firm value. Thus, our scheme also does
better than current law at enlisting the seniors in the task of value max-
imization.
Our scheme will not produce a first-best solution for three reasons.
First, the managers of a debtor may attempt to maximize private benefits
rather than firm value. Fortunately, bad managers are often replaced in
bankruptcy, and compensation contracts can create incentives for man-
5. The contract that section 506(b) contemplates is a Uniform Commercial Code
(U.C.C.) security agreement. Section 9-615(a)(1) of the U.C.C. permits the secured party
to recover out of “the cash proceeds of disposition under sec. 9-610...thereasonable
expenses of retaking, holding, preparing for disposition, processing and disposing, and to
the extent provided for by agreement and not prohibited by law, reasonable attorney’s fees
and legal expenses incurred by the secured party.” There is a general rule that bankruptcy
takes state law rights as it finds them unless there is a federal reason not to follow state
law. Under this rule, section 506(b) would permit a secured party to recover only legal
fees incurred in connection with liquidating the collateral. There would be no right to
recover any expert expenses incurred in a Chapter 11 because no collateral is liquidated
then. Two recent cases (In re Kord Enterprises II, 139 F.3d 684 [9th Cir. 1998]; In re
Schriock Const., Inc., 104 F.3d 200 [8th Cir. 1997]), however, held that the meaning of
the word “agreement” in section 506(b) is a federal law question and permitted the secured
creditor to recover attorney’s fees provided for in the parties’ contract, although state law
prohibited their recovery. Whether these cases would be applied to the type of attorney’s
fees considered here or to the fees of other experts is unclear, especially as the cases did
not specify a federal reason for overriding the U.C.C. and as the Supreme Court has
frequently affirmed the general rule.
300 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
agers to lead firms out of Chapter 11 (Skeel 2003). Second, other
asymmetric-information and agency problems may prevent the firm man-
agers from making first-best contracts to secure professional services.
Third, the juniors may spend their own money on redistributionalefforts,
which the managers cannot prevent.
Nevertheless, our scheme responds directly to the actual incentive
problems that professional spending in bankruptcy poses and thus
should materially improve efficiency. Also, although our proposal is rad-
ical in one way (taking professional reimbursement decisions largely out
of the hands of bankruptcy judges), it is traditional in another. The
debtor in possession today already has discretion to make many business
decisions. We add to this discretion only the ability to take charge of
the creditors’ professional reimbursement process, which will result in
choices that enlist professionals more efficiently in the task of value
maximization.
Our paper proceeds as follows: Section 2 provides a numerical ex-
ample of our results. Section 3 sets out the model. Section 4 derives the
first-best solution, and Section 5 introduces the influence component.
Sections 6 and 7 analyze the three corner solutions and the current U.S.
system. Section 8 works out our proposed solution. Section 9 considers
a utopian omniscient-government-financed partial-reimbursement scheme,
and Section 10 concludes.
2. NUMERICAL ILLUSTRATION
Suppose the value of a firm is $100 without professional effort. The firm
has two creditors: a senior creditor who is owed $40 and a junior creditor
who is owed $80. Each creditor can spend a maximum of 20 hours on
professionals. Professionals play two roles: they may tilt the court’s final
decision on how to split the $100 in their favor, and they may potentially
increase the value of the firm.
The professionals’ efforts sway the court in a particular way: if the
senior creditor expends enough professional time, the APR is upheld;
6
if the senior creditor spends nothing on professionals, then the parties
are paid pro rata; and if both parties spend moderately on professionals,
the allocation will be between these two choices. The extent to which
the APR is upheld is represented by the parameter v.
6. The basis for this assumption is that the U.S. Bankruptcy Code requires the court
to follow the absolute priority rule (APR), so calling the court’s attention to its legal duty
is likely to be effective.
BANKRUPTCY COSTS / 301
Figure 1. The absolute priority rule ( ) and the pro rata priority rule ( )vp1vp0
Naturally, the senior prefers the APR ( ), while the junior prefersvp1
a pro rata priority rule (PPR) ( ).
7
In this example, the courts’ choicevp0
of vis a specific function of the number of professional hours hired by
each creditor:
js
v(s,j)p11,(1)
() ()
[]
20 20
where 20 is the maximum number of hours for which a creditor can
hire a professional. This function states that if the senior hires profes-
sionals for 20 hours, then APR obtains regardless of what the(vp1)
junior does. If the senior hires professionals for fewer than 20 hours,
then the junior’s professionals can influence the court. For example, if
the senior hires professionals for 0 hours and the junior hires profes-
sionals for 20 hours, a PPR obtains . If the senior hires profes-(vp0)
sionals for 10 hours and the junior hires professionals for 20 hours, an
outcome halfway between a PPR and the APR comes about: the senior
receives $36.67, and the junior receives the remaining $63.33, as indi-
cated by the middle arrow in Figure 1.
Professionals also can increase the value of the estate. Our profes-
sionals increase the value of the firm by dollars if they spend xhours
2x
at work.
8
Professionals are expensive and charge $.50 per hour. We can
now consider the costs and benefits of different professional hiring
schemes, summarized in Table 1.
In the social first-best outcome, it would not be optimal for a creditor
to hire 20 hours of professional work, because this costs 20#$.50 p
. This outweighs the benefit of . Instead, society
$10.00 $2 20 p$8.94
would want each creditor to hire 4 hours worth of professionals. Each
7. Although we constrain vto be between zero and one (for the functional specification
to make sense over the entire domain), the solutions are interior. Therefore, if wepermitted
payouts in which the senior were to receive more than Sor the junior were to receive better
than the pro rata amount, the same optimal solutions would still emerge.
8. We assume that it is more efficient for creditors to spend individually than it is for
them to pool their resources and spend jointly, at least on the types of expenses that we
are considering. We motivate our assumption in more detail below.
Table 1. Costs and Benefits of Various Professional Hiring Schemes
Senior Junior APR
Allocation
(%)
Senior
Payoff
($)
Junior
Payoff
($)
Net
Welfare
($)
Ongoing
Firm
Value
($)Hours
Cost
($)
Benefit
($) Hours
Cost
($)
Benefit
($)
Benchmark: first-best solution 4.00 2.00 4.00 4.00 2.00 4.00 . . . . . . . . . 4.00 104.00
Government pays all professionals 20.00 10.00 8.94 20.00 10.00 8.94 100.0 40.00 77.88 2.11 117.89
Firm reimburses all professionals 20.00 10.00 8.94 4.00 2.00 4.00 100.0 40.00 60.94 .94 100.94
Creditors pay own professionals .14 .07 .75 9.11 4.56 6.04 54.8 37.94 64.23 2.16 106.78
Firm reimburses only junior creditor (current
U.S. system) 2.22 1.11 2.98 20.00 10.00 8.94 11.1 33.53 67.28 .82 101.92
Firm reimburses only senior creditor (outcome
like “firm pays all”) 20.00 10.00 8.94 4.00 2.00 4.00 100.0 40.00 60.94 .94 102.94
Partial-reimbursement system:
Ex ante: firm reimburses senior to maximize
welfare, 84.6% of senior’s expenses 4.54 2.27 4.26 7.09 3.55 5.33 72.6 38.52 65.25 3.77 107.67
Ex post: firm reimburses senior to maximize
firm value, 81.5% of senior’s expenses 3.16 1.58 3.56 7.46 3.73 5.46 68.6 38.42 65.28 3.71 107.73
Optimal scheme: government carries 81.0% of
senior’s expenses 4.60 2.30 4.29 6.39 3.19 5.06 75.4 38.69 67.02 3.85 109.35
Note. The per-hour cost of professional advice is $.50. Each creditor can accumulate no more than 20 hours of such advice. Firm value improvement
due to professionals is , where sand jare the number of professionals’ hours (units) hired by senior (S) or junior (J) creditors. Given this
冑冑
$2 s$2 j
value-improvement function, for a given number of hours, benefits are highest if they are split equally between creditors. Courts are swayed by
professionals in a way that depends on senior and junior expenses, , where implies absolute priority allocationv(s,j)p1(j/20)[(1 s)/20] vp1
and implies face-value pro rata allocation. APR pabsolute priority rule.vp0
BANKRUPTCY COSTS / 303
creditor increases the firm value by at a cost of $2, for a net
$4($2 4)
benefit of $2 per creditor.
1. If the government reimburses professionals, but they are hired by
the creditors, each creditor would spend a maximum of 20 hours at a
cost of $10. This would improve firm value by $8.94. Hence, a govern-
ment full-reimbursement scheme would induce creditors to spend too
much. Government reimbursement of professionals would reduce social
welfare by $2.12.
2. If the firm reimburses professionals, the senior will spend 20 hours,
because this ensures that the court will uphold the APR and her claim
will be fully satisfied. The junior then becomes the residual claimant and
fully internalizes both costs and benefits of any professionals he hires.
Thus, he will spend the optimal 4 hours of his professionals’ time. The
total value of the professionals will be , but at
冑冑
$2 4 $2 20 p$12.94
a cost of . The professionals’ total social4#$.50 20 #$.50 p$12
contribution is a positive $.94—which is not as high as the social op-
timum but higher than if the government reimburses professionals.
3. If creditors pay for their own professionals, the junior will over-
spend on professionals in order to sway the courts away from the APR,
thus attacking the senior’s claim. Some professional benefits would ac-
crue to the senior because, in equilibrium (see below), the court’s allo-
cation ends up between the APR and a PPR. In addition to this partic-
ipation in the social gain, the senior expenses help defend her claim
against the junior’s professionals. The senior’s objective function is
1
冑冑
v(s,j)#$40 [1 v(s,j)] #($100 $2 s$2 j)s#$.50.
[]
3
The junior receives relatively more of the residual claim than the
senior. Also, each dollar of expense on professionals shifts the court
more in his favor. This means that the junior is more eager to hire
professionals than is the senior. The junior’s objective function is
冑冑
v(s,j)#[($100 $2 s$2 j)$40]
2
冑冑
[1 v(s,j)] #($100 $2 s$2 j)j#$.50.
[]
3
In the unique Nash equilibrium, the senior thus hires .14 hours of
advice; the junior hires 9.11 hours of advice. As a consequence, the court
chooses 54.8 percent APR and 45.2 percent PPR; the senior receives
$37.94, and the junior receives $64.23. The net social professional con-
304 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
tribution is therefore $2.16. This is the highest that can be achieved in
a non-partial-reimbursement system. Still, the problem remains that sen-
ior creditors underspend, while junior creditors overspend.
4. In the current U.S. system, the court primarily reimburses juniors.
9
A naive and incorrect intuition is that this case is similar to the previous
case because the junior is the residual claimant (so firm reimbursement
or self-reimbursement is the same for the junior) and the senior pays for
her own expenses. This is incorrect because when the junior spends a
lot on professional advice (and in equilibrium, he does) and the senior
does not spend a lot on professional advice (and in equilibrium, she does
not), then the court leans away from the APR. Thus, under the current
U.S. system, junior creditors “morph” from being residual claimants into
becoming more pro rata claimants.
10
In this equilibrium, the junior spends up to the limit, 20 hours, be-
cause his own professional expenses are fully reimbursed by the firm.
The junior’s objective function is
冑冑
v(s,j)#[($100 $2 s$2 jj#$.50) $40]
2
冑冑
[1 v(s,j)] #($100 $2 s$2 jj#$.50) .
{}
3
The senior maximizes her payoff with respect to the amount of spending
on professionals she chooses to purchase, holding fixed the level of junior
spending. Because the subsidized junior spends the maximum 20 hours,
the senior’s objective function becomes
v(s,j)#$40 [1 v(s,j)]
1
冑冑
#[($100 $2 s$2 j)j#$.50] s#$.50.
{}
3
The senior thus spends only 2.22 hours (at a cost of $1.11) on profes-
sionals, which increases only slightly the probability that the APR will
be followed.
In equilibrium, the court chooses 11.1 percent APR and 88.9 percent
PPR; the senior receives $33.53, and the junior receives $67.28. The
9. In the United States, juniors first request reimbursement, which the court may or
may not grant. LoPucki and Doherty (2004) find that, on average, courts reimburse 97.91
percent of the fees and professional expenses sought by creditors.
10. If the junior can commit himself ex ante not to seek court reimbursement in ex-
change for better loan terms, the U.S. case becomes like the previous case, in whichcreditors
pay for their own professionals. Table 1 shows that this is an improvement, but not a
major one.
BANKRUPTCY COSTS / 305
social net professional benefit from professionals is $.82. This allo-
cation system is worse than when creditors self-pay, because it is coun-
terproductive to subsidize the junior’s professionals.
There are three potential improvements to the U.S. system.
1. The simplest improvement to the U.S. system would be to reverse
the U.S. system, that is, to have the court reimburse the seniors instead
of the juniors. In our model, from the senior’s perspective, this is equiv-
alent to having the firm pay all: a senior is the full first claimant in
equilibrium (spending 20 hours). The junior remains the residual claim-
ant and spends efficiently.
11
The net social professional benefit is $.94.
2. In our first improved partial-reimbursement scheme, the firm can
commit in its lending agreement to reimburse the creditors in a manner
that maximizes professional benefits. In our model, managers are as-
sumed to want to maximize firm value but are not interested in how
much or little creditors spend. They will want to calibrate their reim-
bursement policy to subsidize the senior, but not excessively so. They
want the senior to hire more professional hours than when the senior
has to pay herself (in which case the senior does not contribute enough,
only .14 hours) and fewer professional hours than when the firm gives
the senior a blank check (in which case the senior overcontributes, the
full 20 hours). In our example, the firm is best off if it reimburses 84.6
percent of the senior’s professionals. In equilibrium, the senior then
spends 4.54 hours on professionals. Her objective function is
v#$40
1
冑冑
(1 v)#[($100 $2 s$2 j).846(s#$.50)]
{}
3
.154(s#$.50).
The junior spends 7.09 hours. His objective function is
冑冑
v#[($100 $2 s$2 j).846(s#$.50)] $40
{ }
2
冑冑
(1 v)#[($100 $2 s$2 j).846(s#$.50)]
3
j#$.50.
Both professionals overspend, a direct consequence of the firm’s intent
to maximize its value ex ante with its reimbursement policy.
11. This result follows from our assumption that the APR is protected with certainty
when the senior spends, and it may not hold under more general assumptions. The more
general insight is that senior creditors would overspend in this regime.
306 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
It would not be optimal for the firm to reduce the senior reimburse-
ment proportion. Doing so would encourage the senior to reduce her
professional hours toward her socially optimal professional choice of 4
hours. But it would also induce the junior to spend more than 7.09 hours
on professionals. (In equilibrium, junior and senior professional en-
gagements are substitutes.) In equilibrium, the senior creditor does not
enjoy the full APR, but she receives a higher share of the firm than when
she has to pay for her own expenses. In this equilibrium, professionals
contribute a social gain of $3.77.
This scheme relies on ex ante professional reimbursement contracts.
However, first, the firm may not know the appropriate model parameter
values at the time that it borrows money. Second, ex ante contracts that
constrain the power of the bankruptcy court to manage the process are
seldom legally enforceable. And third, the firm will not have social max-
imization as its objective after bankruptcy has occurred. Instead, the
firm will want to maximize its value at the time of bankruptcy regardless
of any precommitment it may have made. (Naturally, it will still not
take into account any professional expenses not charged to the firm.)
This leads to the following suggested scheme:
3. In our second improved partial-reimbursement scheme, the firm
itself makes compensation decisions, subject to the approval of the court,
ex post. Compared to the previous case, the firm is a bit more reluctant
to reimburse the senior creditor. Thus, if the firm reimburses 81.5percent
of the senior’s expenses (rather than 84.6 percent), the senior will choose
to reduce her professionals’ value enhancement to the firm somewhat.
Although this slight reduction is socially undesirable from the managers’
perspective, it is offset by the lower sum the firm now pays out in total
expenses. Managers do not mind junior professional spending: even if
these professionals’ cost is socially excessive, management welcomes any
professional contributions because they increase firm value. After all,
the firm does not reimburse the junior creditor.
In equilibrium, the senior hires 3.16 hours of professional advice,
which is below the social optimum of 4 hours. Her objective function
is
v#$40
1
冑冑
(1 v)#($100 $2 s$2 j).815(s#$.50)
[]
3
.185(s#$.50).
BANKRUPTCY COSTS / 307
Induced by the senior’s smaller professional retention, the junior now
spends 7.46 hours. His objective function is
冑冑
v#[($100 $2 s$2 j).815(s#$.50)] $40
{ }
2
冑冑
(1 v)#[($100 $2 s$2 j).815(s#$.50)]
3
j#$.50.
Compared to the case in which the firm can commit itself to the
socially optimal reimbursement, the professionals’ contribution to social
welfare at $3.71 is lower than the earlier $3.77, because the managers
cannot precommit to a higher reimbursement rate. And the improvement
in social value is not as great as in the social optimum, because this
scheme suffers from the same difficulties as the ex ante scheme: the firm
also does not have the socially correct incentives but wants to maximize
its own value. On the other hand, although the firm may be unable to
observe all of the economic parameters ex post, these parameters are
more likely to be observable after insolvency. In our model, the firm
makes one upfront hiring/reimbursement choice. In real life, manage-
ment can continuously evaluate creditor professionals for their contri-
butions to firm value and terminate professionals when they cease their
usefulness. Thus, our reform proposal may work better in practice than
the model implies.
Both of our partial-reimbursement schemes ignore that management
has just run the firm into bankruptcy and therefore may be either in-
capable or too conflicted to make good choices. However, old manage-
ment is often replaced with new management in Chapter 11. Our so-
lutions also ignore that management may prefer to continue firm
operation, even if liquidation is optimal. (We ignore this by assuming
that management wants to maximize firm value, regardless of contin-
uation or termination.) In a more general model, this would lead man-
agement not to adequately reimburse senior creditors for professionals,
which might establish socially optimal termination. (Recall that senior
creditors will almost invariably argue in favor of termination!) However,
the current U.S. system suffers from the same problem: senior creditor
expenses to convince the court that termination is optimal must already
be borne by senior creditors themselves. Appendix A completes our nu-
merical examples by illustrating a utopian second-best scheme, in which
an omniscient government can fine-tune reimbursement.
308 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
Table 2. Variables and Conditions
Variable Condition
SFace value of claim of senior creditor; exogenous
JFace value of claim of junior creditor; exogenous
VValue of the firm before professional activity; exogenous
P
S
Payoff to senior claimant; exogenous
P
J
Payoff to junior claimant; exogenous
sUnits of professional representation purchased by senior
creditor; endogenous
jUnits of professional representation purchased by junior
creditor; endogenous
hPer-unit firm value enhancement; exogenous
cParameterization of cost of professional representation;
exogenous
v{v(s,j) Adherence of the court to the absolute priority rule,
specified in equation (6): ;v(j,s)p1j#(1 s)
exogenous
WSocial welfare (value enhancement net of professional
expenses) ; derived
22
W{h#(sj)c#(sj)
Policy choices (model
with optimal
reimbursement
[Sec. 9]):
1g
S
Fraction of senior’s costs paid by government to senior
creditor
1g
J
Fraction of junior’s costs paid by government to junior
creditor
d
S
Postgovernment : fraction of remaining costs paid byg
S
senior creditor herself
d
J
Postgovernment : fraction of remaining costs paid byg
J
junior creditor himself
* Designates a best policy
Imposed conditions:
SJ{1 Normalization
Sand J!V!
S
J
Creditors in the money; financial distress
and0sj1 Limited professional expense
V2h!1 Firm still in distress after maximum value enhancement
V2c10 Firm still worth something after maximum professional
expense
V2h2c1
S
Secured creditors’ claim is satisfied even after maximum
professional expenditures
3. THE FIRM AND PROFESSIONALS
3.1. The Firm
The firm is financed with equity and debt. Debt claims can be either
senior (for example, secured) or junior (unsecured) and have a face value
of and , respectively. (All variables are summarized in Table 2.) TheSJ
securities are issued to finance a risky project. If the project succeeds,
BANKRUPTCY COSTS / 309
all creditors are fully repaid without financial distress and without any
professional representation. Our model is concerned with the state in
which the project fails and the total debt cannot be paid off, that is,
, and we normalize the claims to add up to 100 percent
V!
S
J
( ). We assume that project proceeds are sufficient to repay
SJ{1
either the senior creditors or the junior creditors ( ).
12
(V1
S
)V1
J
3.2. Professionals’ Contributions to Firm Value
Senior creditors and junior creditors engage sand junits
13
of professional
representation, respectively. We assume and , where
¯
¯
0ss0jj
. Creditors’ professionals increase the value of the firm in a
¯
¯
s{j{1
linear fashion. The expected value of the firm after enhancement but
before professional payout (if applicable) is ,
冑冑
V(s,j){Vhshj
where . Thus, his a parameter measuring professional effectiveness.
h10
The cost of professional representation is parameterized by c().
c10
Senior and junior creditors pay and for professionals, respectively.
cs cj
We work exclusively with the monotonic transformation and
s{s
, so the value function is and professional
j{jV(s,j){Vhs hj
costs are and for senior and junior creditors, respectively. That
22
cs cj
is, our model with its linear improvements and quadratic costs isidentical
to a model with square-root improvements and linear costs.
Our specification deliberately assumes that it is not optimal for cred-
itors to pool resources and hire all professional advice jointly:
222
h#(sj)c#(sj)!hs hj cs cj .(2)
This is largely a domain assumption. Conflict among creditors, the pos-
sible possession by creditors of different private information about the
effect of creditor efforts on the firm’s prospects, and different types of
creditor expertise will make creditor specialization efficient some of the
time. When specialization would be inefficient, the firm, representing all
creditor classes, can hire its own professionals (as firms sometimes do).
12. A senior creditor would wear two hats if, say, she expected the Chapter 11 plan
to give her a lien for part of the value of the senior claim and equity for the remainder. It
would be interesting to extend our model to this case. Our introductory analysis here
focuses on the basic case, but we note that bank creditors are prohibited from holding
equity and that firms usually emerge from Chapter 11 with as much debt as before or
more. As a consequence, the practical significance of this possible extension is unclear.
13. These units are measured in terms of time in our model, but they also could be
measured in terms of quality. For example, they could equally well represent hiring a better
and more expensive professional.
310 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
In sum, we assume that there are reasons for having professionals on
both sides instead of a single dedicated professional team workingjointly
on behalf of the creditors. (If this were not so, the current U.S. system
would be utterly nonsensical.)
We make four assumptions regarding the costs and benefits of hiring
professionals:
Assumption 1: . This ensures that, if the APR isV2h2c1S
satisfied, senior creditors always fully recover their claim . In otherS
words, if both groups of creditors spend on professionals andspjp1
the firm reimburses their expenses, the value of the firm is sufficient to
pay the senior creditors’ claim .S
We motivate this assumption as follows: if the senior claim is sub-
stantially out of the money, junior claims will obviously be worthless.
In such cases, the senior will be allowed to take her collateral, and the
firm will be liquidated in Chapter 7. Our paper focuses on Chapter 11
reorganizations, in which both types of creditors can engage in the value-
increasing and redistributional activities we model.
Assumption 2: . This restriction states that evenV3h!SJ{1
with exceptional professional contributions, the firm remains in bank-
ruptcy. This includes the less restrictive condition that the firm remain
in default even with maximal professional participation, V2h!S
.
14
Jp1
Assumption 3: . There is an unconstrained optimum for cred-h!2c
itors’ professional expenses.
Assumption 4: . Creditor expenses can be reimbursed outV2c10
of the firm’s assets.
4. SOCIALLY OPTIMAL PROFESSIONAL EXPENSES
The socially optimal spending on professionals trades off gains in firm
value against the costs of professional representation without regard to
redistributional properties. This is the solution to
22
max W{h#(sj)c#(sj). (3)
s,j
14. Although we assume that professionals of both groups of creditors are equally
efficient, we have solved the case in which professionals are differentially efficient. The
results are qualitatively the same.
BANKRUPTCY COSTS / 311
Proposition 1. The first-order conditions show that it is socially
optimal for both senior and junior creditors to hire professional advice
of
hh
s*pand j*p.(4)
2c2c
The resulting welfare Wis
2
h
W*p.(5)
2c
We use an asterisk throughout the paper to denote solutions under
the socially first-best case. Our model specification was chosen to pro-
duce these closed-form interior solutions. The optimal expenses are such
that, for every creditor, the marginal revenue of using professionals h
equals its marginal costs and .
2cj 2cs
If such first-best equilibrium behavior could be forced upon the two
creditors, we can determine how their behavior changes with the two
key parameters, the professionals’ costs cand the professionals’ benefits
h. The optimal choice of professionals increases with benefit and de-
creases with cost, in terms of both units (quantity or quality) and ex-
pense, as Figure 2 shows.
Although this is only a hypothetical benchmark, in the numerical
illustration earlier and the model later we posit a function for how senior
and junior professionals sway the equilibrium between two extremes: a
pro rata allocation and an absolute priority allocation .
(vp0) (vp1)
In this benchmark, the in-equilibrium APR violation probabilities are
highest for intermediate values of professional costs: with very low costs,
senior creditors fully defend their claim. With very high costs, junior
creditors “attack” less. Figure 3 shows the APR violation in equilibrium
as a function of expert parameters, cand h.
The creditors’ relative payoffs are determined by both the cost-benefit
contribution of professionals and the implicit APR violation. Senior cred-
itors end up being better off with less professional participation, junior
creditors with more. Thus, Figure 4 shows that senior creditors arebetter
off and junior creditors worse off in equilibria with high professional
costs and low professional benefits.
312
Figure 2. In-equilibrium expert costs and benefits
313
Figure 2. continued
314
Figure 3. In-equilibrium absolute priority rule violation
315
Figure 4. In-equilibrium claim satisfaction
316 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
5. THE INFLUENCE COMPONENT
The current U.S. Bankruptcy Code suffers from a confusion. Its intent
is appropriate enough, as in section 330(a)4A: “The court shall notallow
compensation for . . . [services] that were not reasonably likely to ben-
efit the debtor’s estate.” Unfortunately, it defines an admissible reim-
bursable value enhancement to be any professional activity that enhances
the unsecured creditor’s estate. But the junior estate could increase not
only if the total estate increases but also if the junior can redistribute
wealth from the senior. This creates an incentive for the junior to engage
in redistributional activities, such as discovering minor flaws in senior
liens. The statute thus should define benefit to the estate as actual in-
creases in the value of the insolvent firm. This naturally brings us to the
core of our paper: the redistributional nature of some professional ac-
tivities.
Professionals not only enhance firm value but also try to convince
the court to take a more favorable view toward their clients. A profes-
sional hired by the junior creditor thus may advocate that the firm has
a higher value than previously thought, so junior creditors deserve a
larger fraction of the recapitalized claims. Professionals hired by the
senior creditor will respond by advocating that the firm has a lower
value. If the court overestimates firm value, then it in effect violates the
APR in favor of junior creditors.
In our model, courts allocate the residual value of the firm in a fashion
that is influenced by professional activities. To be precise, courts allocate
either according to the APR, or pro rata, or somewhere in between. If
the court is “APR oriented,” the proceeds fully satisfy the seniorcreditors
first and then repay the junior creditors with the remainder. The payoffs
to senior creditors are ;the payoffs to junior creditors are
Pp
S
Pp
SJ
,where and denote the allocation to senior and junior cred-
V
S
PP
SJ
itors, respectively. If the court is “anti-APR oriented,” the firm’s cash
flows are distributed proportionally; that is, and
Pp[S/(SJ)]Vp
S
V
S
.
Pp[J/(SJ)]Vp
J
Vp(1 S)V
J
The parameter determines the extent to which one or the
v[0, 1]
other of these allocation schemes is followed. Thus, vcan be interpreted
as the probability that the court upholds the APR, or as a compromise
fractional allocation between the APR and non-APR, or both. Both sen-
ior and junior creditors’ professionals influence the reorganization pa-
rameter v. We specify the outcome of the senior-junior conflict as
v(j,s)p1j#(1 s). (6)
BANKRUPTCY COSTS / 317
This functional form implies that
1. If the junior creditors do not spend money on professionals, the
court is APR oriented irrespective of the senior creditors’ behavior
( ). This assumption is consistent with the law and practicejp0vp1
in the United States.
2. The more resources that junior creditors spend on professionals,
the less APR oriented the court is: .v/jp(1 s)0
3. Senior creditors can mitigate or even completely(v/spj0)
undo the juniors’ efforts by spending on professionals ( ).sp1vp1
6. FULL-PAYMENT SYSTEMS
Before we proceed to systems in which professional costs are shared by
participants, it is instructive to compare schemes in which all profes-
sional fees are paid for by one party. This highlights the incentive issues
that arise later. The next sections consider partial-reimbursement re-
gimes.
6.1. Government Pays Professionals
If the government fully pays for all professionals retained by creditors
(GP), the senior and junior creditors would solve, respectively,
S
max P{v(s,j)
S
[1 v(s,j)] V(s,j)(7)
sS
()
S
J
and
J
max P{v(s,j)[V(s,j)
S
][1 v(s,j)]V(s,j) . (8)
jJ
()
S
J
Because we have exogenously imposed a limit on expenditures in our
model,
GP GP
¯
¯
sps{1 and jpj{1. (9)
Relative to the first-best solution (5), both creditors overspend on rep-
resentation. The court is APR oriented, so and .Pp
S
PpV2h
S
SJ
Social welfare is a low . Fortunately, although it may be2h2c!0
realistic to presume that the government carries some expenses caused
by professionals (for example, in maintaining a court system), it is neither
realistic nor desirable to have the government pay for all creditor pro-
fessionals.
318 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
6.2. Firm Pays Professionals
If professionals’ fees are reimbursed at the court’s discretion out of firm
value, senior creditors solve
22
max P{v(s,j)min[
S
,V(s,j)cs cj ]
sS
S
22
[1 v(s,j)][V(s,j)cs cj ].
(10)
()
S
J
This equation assumes that even if the maximum amount is spent on
professionals ( , ), creditors still receive some value. Similarly,
¯
¯
spsjpj
22
max P{v(s,j)max[V(s,j)cs cj
S
,0]
jJ
J
22
[1 v(s,j)][V(s,j)cs cj ].(11)
()
J
S
Proposition 2. If the firm fully pays for creditors’ expenses (FP),
senior creditors overspend on representation, and junior creditors spend
optimally:
FP FP
¯
spsand jpj*, (12)
where is the maximum expense possible. Further, .
FP GP
¯
sW
1W
Proof. See Appendix B.
Because the senior spends a lot, the APR is followed, so the junior
becomes a pure residual claimant.
6.3. Creditors Pay Professionals
If each creditor pays for his own professionals, senior creditors solve
S
2
max P{v(s,j)
S
[1 v(s,j)] V(s,j)cs . (13)
sS
()
S
J
and junior creditors solve
J
2
max P{v(s,j)[V(s,j)
S
][1 v(s,j)] V(s,j)cj . (14)
jJ
()
S
J
Proposition 3. If creditors pay for their own expenses (CP), junior
creditors overspend on representation,
CP
j1j*. (15)
BANKRUPTCY COSTS / 319
Senior creditors underspend on professional advice
CP M
s!s*if
S
!
S
, (16)
where . This is a (mild) sufficient but not
M2
S{2c/[1 Vh(3h)/2c]
necessary condition. Further, .
CP FP
W1W
Proof. See Appendix B.
When the APR is violated, senior creditors share in the residual claim.
Hence, they are better off when firm value increases and will contribute
some improvement, although too little from a social perspective. Among
all full-pay schemes, this regime, in which creditors pay for their own
expenses, is best. Unlike the earlier schemes, it does not induce either
creditor to spend the maximum amount.
7. ASYMMETRIC FULL-PAYMENT SYSTEMS
7.1. The Current U.S. System: Full Junior Creditor Reimbursement
The U.S. Bankruptcy Code fails expressly to reimburse most senior
expert expenses and does expressly reimburse substantial junior expert
expenses. We continue to analyze this system here under the convenient,
and largely on the mark, assumption that the seniors are not recom-
pensed while the juniors are. Our results are similar to those of Welch
(1997). When the junior claim is out of the money, junior creditors are
indifferent between bearing costs themselves or being reimbursed by the
court. However, if spending on professionals tilts the court against the
APR, senior creditors ultimately bear part of the juniors’ professional
expenses. The next proposition shows that junior creditors overspend
with respect to the case in which costs are paid for by the creditors. In
addition, senior creditors will overspend in order to overcome the jun-
iors’ efforts.
Proposition 4. Under the U.S. system, both creditors spend more
than when neither is reimbursed. In addition, the senior underspends
and the junior overspends relative to the social optimum.
CP US CP US
s!s!s* and j*!j!j. (17)
Social welfare in this case is not higher than when creditors pay them-
selves .
US CP
(WW)
Proof. See Appendix B.
320 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
The intuition is that the junior creditor attempts to cause APR vio-
lations, knowing that the senior creditor will typically not find it in her
interest to hire enough professionals to fully defend the APR. Still, unlike
in the self-financing expenses case, senior creditors spend more in this
system than when creditors self-reimburse. This is because when the
junior is subsidized, he will overspend, thereby increasing the likelihood
that the senior will be partly a residual claimant. The senior creditor
then becomes more concerned about junior expenses that reduce the
value of the firm and her own claim. Her optimal response is to increase
spending.
7.2. Another Poor Alternative: Full Senior Creditor Reimbursement
As our numerical illustration showed, reversing the current U.S. reim-
bursement system (so that senior creditors rather than junior creditors
are reimbursed) is not a panacea. Indeed, because the APR isfully upheld,
the solution is the same as when the firm fully reimburses professionals
from both parties. In our model, we can show
US reverse US F P CP
W!WpW!W. (18)
This system can be better than the current U.S. system because it at least
attempts to correct reimbursement in the right direction. However, be-
yond the context of our model, it will depend on how bad excessive
senior spending in such a system would be relatively to howbad excessive
junior spending is in the current U.S. system.
8. SYSTEMS WITH PARTIAL REIMBURSEMENT BY FIRMS
Unlike earlier schemes, we now allow society to set more flexible rules
for who pays for professional expenses. These schemes may permit firm
managers the discretion to decide how creditors are reimbursed for their
professionals’ contributions. Any unreimbursed expenses must be carried
by the creditors themselves.
We consider two schemes. In the first, the firm can set reimbursement
rules at the time of loan origination. In the second, the firm can set
reimbursement rules only at the time of bankruptcy. In both cases, the
debtor’s managers are presumed to maximize the value of the firm.
8.1. Socially Optimal Partial Reimbursement by the Firm
Proposition 5. Managers that can commit to reimburse creditors’
expenses will contract for a scheme that maximizes firm value ex ante
BANKRUPTCY COSTS / 321
(at loan origination). In this scheme, the firm agrees partially to reim-
burse senior creditors but will not reimburse junior creditors.
Both creditors overspend in equilibrium:
FRA FRA
s1s* and j1j*, (19)
where FRA indicates that the firm agrees ex ante to reimburse. Social
welfare in this case is higher than when creditors pay for their own
expenses ( ).
FRA CP
W1W
Proof. See Appendix B.
When the firm borrows, it will fully internalize the costs and benefits
of any allocation scheme. As we have seen, it is optimal for the firm to
reimburse some senior expenses but no junior expenses. Maximizing
managers will offer creditors the optimal contract because this minimizes
the cost of capital.
In numerical experiments, this scheme yields solutions that are usually
close to the first-best situation when compared with the current U.S.
bankruptcy regime. To see why, recall that the social problem in bank-
ruptcy is that senior creditors contribute too little because most residual
benefits accrue to the junior. The junior creditors spend toomuch because
they not only internalize most of the professional’s residual value en-
hancement but also receive the additional redistributional part of the
pie from the senior creditors’ claims. The social goal is thus to subsidize
the senior creditors in order to enhance their incentives to hire profes-
sionals while dampening junior spending. The trick is to avoid subsi-
dizing the senior too much, that is, not to reimburse all senior expenses.
If the firm reimburses senior creditors, it will find it in its interest to
suitably constrain the senior’s reimbursement. In equilibrium, the junior
creditor still chooses to hire too much representation because the senior
creditor does not spend enough to defend the APR fully. The junior
creditor thus should not be subsidized by the estate.
Although this system is better than all single-payor systems and the
current U.S. bankruptcy system, it still fails to reach the first-best so-
lution. The problem is that firms can only subsidize and not tax pro-
fessionals’ participation. In our model, in equilibrium, senior and junior
professionals are substitutes: more spending by one leads to less spending
by the other. Because the junior cannot be further restrained from seeking
redistribution, the best reimbursement system induces the senior creditor
to overspend a little on professional representation, in order to reign in
the junior creditor’s rent seeking.
322 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
8.2. Self-Seeking Partial Reimbursement by Firm
We have explained the difficulties that plague any compensation scheme.
Therefore, we consider an alternative scheme in which managers not
only are free to contract ex ante for reimbursement schemes but may
choose a reimbursement scheme in bankruptcy that maximizes firm
value. Such an ex post firm-value-maximizing system is time consistent,
relatively simple to implement, and robust with respect to different pa-
rameter values.
15
Although this scheme is inferior to an ex ante con-
tracted-for firm-value-maximizing system, the difference is often sur-
prisingly small, for example, as in our numerical illustration.
Proposition 6. Managers who are permitted to reimburse creditors’
expenses ex post will not maximize benefits because managers fail to
internalize enough of the senior professional costs. Their objective leads
them to partially reimburse senior creditors (less than in the FRA case)
but not to reimburse junior creditors.
In this scheme, both creditors overspend in equilibrium. Compared
to the professional-benefit-maximizing choices (case FRA), senior cred-
itors receive less reimbursement and thus hire less professional advice,
and junior creditors spend more, taking advantage of less senior resis-
tance:
FRP FRA FRP FRA
s!s*!sand j1j1j*, (20)
where FRP indicates that the firm agrees ex post to reimburse. Social
welfare is lower when the firm maximizes ex post than when it can
maximize ex ante, .
FRP FRA
W!W
Proof. See Appendix B.
8.3. Discussion
Because our results suggest that it is appealing to allow the managers
of insolvent firms to choose how to compensate creditors in bank-
ruptcy—for such reasons as simplicity, decentralized decision making,
and relative social outcome—our paper suggests closer consideration of
such a scheme.
Figure 5 plots the contribution of professionals to the social good
and to the value of the firm as a proportion of senior expenses that are
15. Because the economic intuition is solid, this system is also robust with respect to
many other functional specifications.
BANKRUPTCY COSTS / 323
Figure 5. Professionals’ contribution to social good and firm value
reimbursed by the firm. The figure shows that there is a modest but
steady improvement in professionals’ contribution, both to firm value
and to social value, over a wide range of reimbursement fractions. As
our propositions and figure show, the social gain is strictly higher when
firms are permitted discretion in reimbursement than when one party
fully pays for the expenses. If reimbursement is 0 percent, this case reverts
to one in which creditors self-pay—a modestly bad scheme. If reim-
bursement is 100 percent, this case reverts to one in which the firm fully
reimburses creditors, in which case senior creditors overspend dramat-
ically—a very bad scheme.
Figure 5 also shows that there is little difference in the optimal choice
of reimbursement between the case in which reimbursement rates are
set by the firm at the time the contract is written or at the time of
bankruptcy. When the firm “shaves” the reimbursement proportion, it
has to pay a little less to the senior creditor, but it also gains less from
the senior creditor’s value improvement. Because all of the value im-
provement provided by senior creditors is internalized in the firm man-
ager’s objective function, the difference between the optimal reimburse-
ment fractions when set ex ante (72 percent) and ex post (69 percent)
is small.
324 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
The remaining figures consider the comparative statics of the model
when managers choose the optimal reimbursement for senior creditors
at the time of bankruptcy (see also Appendix C).
16
Figure 6 shows that
our scheme has the desirable characteristic that professional retention
in equilibrium decreases with cost cand increases with value effectiveness
h. For low enough professional costs, senior professionals should be 100
percent reimbursed. (Junior creditors will similarly hire 100 percent pro-
fessionals for very low c.)
Figure 7 shows how social benefits decrease with cand increase with
h. There is a kink in professional expenses because for low enough costs
c, senior creditors are 100 percent reimbursed and thus max out on
professional advice. Any increase in costs just increases the total cost.
Beyond such very small values of c, professional retention decreases in
c, and with it total professional expenses in equilibrium. However, the
professionals’ net contribution to both social and firm value always
declines with higher costs. Figure 8 shows that when senior creditors do
not max out on their professionals (the optimal reimbursement fraction
is below 100 percent), the APR is violated in equilibrium with positive
probability.
Putting together professional expenses and APR violations in equi-
librium, we can compute the relative satisfaction of senior and junior
claims. Figure 9 shows that for very low costs cand very high value
improvement h, the professionals provide sufficiently valuable improve-
ments in equilibrium to keep both creditors’ recovery rates relatively
high. For medium costs cand medium value improvement h, junior
creditors succeed in capturing some value from senior creditors. Still,
both creditors are worse off. If costs are very high and improvement
very low, junior creditors find it less worthwhile to influence the court.
They are thus worse off. Senior creditors, however, benefit from the
reduced aggressive behavior of junior creditors and are thus better off.
Our analysis suggests that it is desirable to allow value-maximizing
managers to set creditor reimbursement fractions. The debtor in pos-
session today incurs the bulk of expert expenses, so our recommendation
expands the scope of the debtor’s discretion: it would continue to be
able to use its own experts but also would be able to enlist creditors in
the value-maximization task. Senior creditors sometimes may have more
16. The figures are practically identical if the consideration for senior professionals is
decided ex ante (at the time of loan initiation). When plotting as a function of c, we hold
Vequal to .9, hequal to .05, and Sequal to .4. When plotting as a function of h, we hold
Vequal to .9, cequal to .05, and Sequal to .4.
Figure 6. In-equilibrium expert retention
326
Figure 7. In-equilibrium costs and benefits
327
Figure 8. In-equilibrium absolute priority rule violation
Figure 9. In-equilibrium claims satisfaction
BANKRUPTCY COSTS / 329
expertise than the debtor when the relevant issues involve valuation,
restructuring, or asset disposition. Seniors may share this expertise with
the debtor, and this sometimes happens, but perfect cooperation in bank-
ruptcy contexts is not always to be expected, and the seniors may want
to perform a supervisory role regarding expert performance. To be sure,
our assumptions that managers are competent and objective value max-
imizers with knowledge of the parameters may not always be satisfied.
It seems reasonable to presume that even if managers do not have full
knowledge of professionals’ effectiveness, their knowledge of the effects
of professional advice on firm value (the parameters) is likely to be better
than that of a court or the government. Further, in this solution, in
contrast to a theoretically better system in which a court or government
maximizes social value (see below), the firm needs to judge only how
reimbursement influences its own value. The firm is buying a service and
does not have to know creditor costs in order to make its reimbursement
decision.
A more serious concern relates to our assumption that the managers
of a debtor in possession want to maximize the value of the insolvent
firm. Managers sometimes have a continuation bias. This bias could
yield two types of bad behavior. First, the firm couldchoose professionals
who are good at delay or who will help to propose overly optimistic
reorganization plans. Second, if matters look bleak, the managers could
enlist professionals in a collusive scheme with junior claimants to cause
the firm to overinvest. We nevertheless prefer the firm over the court as
principal decision maker. Bankruptcy courts also have a continuation
bias, so letting the firm decide is unlikely to make matters worse. Of
greater importance, that the managers who brought the firm into bank-
ruptcy sometimes have poor incentives now is widely recognized. Cred-
itors who are residual claimants thus have an incentive, more frequently
acted on than heretofore, to replace the old managers with new ones,
whose compensation and reputations are tied to success at reorganiza-
tion. These new managers should act to promote efficient and to dampen
bad creditor spending.
9. SYSTEMS PERMITTING PARTIAL REIMBURSEMENT BY THE GOVERNMENT
We still have one degree of freedom that we have not exploited: what
if the government is also allowed to pay a part of professionals’ costs?
Suppose that both the government and the firm can reimburse different
330 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
proportions of senior and junior creditors’ claims. The remainder, un-
reimbursed by government and firm, is carried by creditors themselves.
Further, we assume that not only the firm, but also the government, has
zero administrative cost, is benevolent, and is omniscient about the
model parameters. Call this case GR.
Proposition 7. If both the government and the firm can reimburse
creditors, the optimal solution is for the government to reimburse a part
of the senior creditor’s expense and nothing of the junior creditor’s
expense. The firm should not reimburse either creditor. The remainder
of the expenses should be borne by the creditors themselves.
Even in this scheme, both creditors overspend on professional rep-
resentation,
GR GR
s1s* and j1j*. (21)
The professionals’ welfare contribution is higher in this scheme than in
schemes considered earlier, inferior only to the first-best solution.
Proof. See Appendix B.
Senior creditors need to be encouraged. Either the firm or government
reimbursement schemes can be tuned to achieve an almost socially op-
timal first-best senior professional participation. The remaining problem
is how to limit junior creditors from overretaining professionals. The
problem when the firm reimburses is that the junior creditors’ residual
claim becomes smaller, inducing them to become more aggressive in
seeking the larger senior share.
Naturally, with the extra degrees of freedom, this scheme can ap-
proach the social optimum better than previous schemes. However, even
four degrees of freedom are not enough to fine-tune the choices so that
junior creditors do not overspend. First-best could be achieved only if
one could “tax” the junior creditors’ professional expenses.
17
We consider such optimal government reimbursement schemes to be
academic. It is doubtful that governments can fine-tune their reimburse-
ments appropriately to attain this second-best solution.
18
The optimal
reimbursement fraction depends on the professionals’ production func-
tion (cand h), which is not only model specific but unlikely to be ac-
17. Note that this would need to be a tax on junior creditors’ expenses, which is
different from forcing junior creditors to subsidize senior creditors’ expenses.
18. In the real world, the government subsidizes the court system, so we have something
of a partial-reimbursement system now.
BANKRUPTCY COSTS / 331
cessible to either legislators or courts.
19
Otherwise, a simpler system that
achieves the first-best solution would be one in which the court (or the
government) fully reimburses creditors’ expenses when they spend ex-
actly the social optimum and zero otherwise. Thus, we are reluctant to
advocate such government involvement in the bankruptcy reimburse-
ment system.
10. CONCLUSION
Our model describes the trade-offs faced in designing an optimal pro-
fessional reimbursement process in bankruptcy: good solutions must bal-
ance the value-increasing benefits of professionals against the value-
decreasing distortions caused by creditors’ rent-seeking activities. When
the government fully reimburses creditors’ professional expenses, both
types of creditor spend too much money (in rent seeking) from a social
perspective. When the firm fully reimburses both creditors’ expenses,
senior creditors’ expenses are effectively subsidized by junior creditors
(the residual claimants), and both parties end up spending excessively
on professionals. When creditors fully pay for their own professionals’
expenses, senior creditors fail to provide a sufficient contribution to the
corporate value-enhancement process.
Partial-reimbursement systems work better. A robustcharacterization
is that some, but not all, possible senior creditors’ expenses should be
reimbursed, while junior creditors should not receive any subsidy. We
close our paper with our judgment on which solutions can reasonably
be implemented.
1. The first-best solution can be obtained only if redistributional ac-
tivities of all production function parameters are observable by the par-
ties and the court. However, if redistributional activities can remain
hidden, or production functions remain unobservable, the first-best so-
lution is not attainable. A second-best solution, in which the government
pays part of the senior creditors’ professional expenses, and does so
without introducing other distortionary incentives into the process, sim-
ilarly suffers from an inability to observe the relevant parameters.
2. A third-best solution, often nearly as good as the first-best solu-
tion, can be obtained if managers are permitted to reimburse creditors,
either ex ante or ex post. Firm-value-maximizing managers wouldchoose
19. Simple comparative statics, which can be derived, are not sufficient for guidance.
332 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
to partially reimburse senior creditors but not junior creditors. This
scheme can be implemented by a simple amendment to the bankruptcy
code. The amendment would provide that creditors do not apply to the
court for reimbursement but instead apply to the firm. The court then
would review firm decisions only to ensure that they are not made in
an arbitrary fashion. This scheme not only increases the amount of
productive professional spending but, by substantially dampening re-
distributional spending, will also reduce the total amount of spending
on professionals. Our two proposed schemes strike us as feasible and
efficient bankruptcy reimbursement systems.
3. The current U.S. practice, in which junior creditors are reimbursed
from the estate and senior creditors are not, is counterproductive. Junior
creditors end up seeking redistributional rents (a bigger share of the
estate), and senior creditors end up not spending enough on professional
advice. (Also, within the current U.S. system, it would make sense to
change the definition of redistributional activities to encompassthe entire
estate, not just the junior lien.)
We conclude by noting three promising areas for future research.
First, the functional form we use for relating expenses to the probability
that the court will follow the APR is deterministic: hours spent on pro-
fessionals affect the probability in a predefined, quantified way. Credi-
tors, however, may be able to direct spending relatively more toward
productive or rent-seeking activities. This could in turn endogenize our
vfunction. Second, although creditor committees coalesce multiple jun-
ior creditors into one party, it would be interesting to allow for more
creditors (Bris and Welch, forthcoming) and allow creditors to form
coalitions. Third, our proposed reform should dampen creditor rent
seeking, and this will increase the likelihood that courts will follow the
APR. A bankruptcy procedure that awards the equity nothing, however,
may worsen prebankruptcy investment incentives (Povel 1999). Thus, a
more complete treatment should ask whether the reform we advocate
would be an improvement, all things considered.
20
20. Schwartz (forthcoming) analyzes the trade-offs between the ex ante efficiency effects
of following the APR strictly and the possible ex post inefficiency effects of discouraging
use of the bankruptcy process.
BANKRUPTCY COSTS / 333
APPENDIX A: NUMERICAL EXAMPLE CONTINUATION
For completeness, we now extend the numerical illustration of Section 2 to an
even better partial (senior) reimbursement scheme, in which a benevolent om-
niscient government maximizes social welfare. We do not suggest this to be a
feasible improvement.
In this scheme, the government would reimburse the senior for 81.0 percent
of the senior’s expense and none of the junior’s expense. The firm would re-
imburse nothing, and a creditor who would want to spend more on professionals
would have to fund such professional hours herself.
This case has an interesting intuition. Recall the case in which the firm’s
intention was to maximize professional contribution (case A). If the senior cred-
itor had been reimbursed for 83.6 percent of her expenses, she would have spent
the social optimum of 4 hours, but the junior would have hired about 7.23
hours. Increasing the senior reimbursement from 83.6 percent to 84.6 percent
meant that she would hire a little bit more than the optimal 4 hours, but at a
social cost of second-order importance (guaranteed by the envelope theorem).
Because the junior and senior expenses are substitutes in equilibrium, this reduces
the junior’s professionals from 7.5 to 7.09 hours, which raises welfare.
Still, the problem in equilibrium remains that both creditors overspend. But
reducing the firm reimbursement to senior creditors increases the junior’s in-
centive to rent seek. The reason is of course that when the firm reimburses some
senior expenses, the pro rata payoffs become worse for the junior creditors, and
rent seeking becomes relatively more attractive. If the government instead of the
firm reimburses the senior creditor, the junior is less eager to assail the senior
claim and will spend less (socially inefficiently) on professionals. Thus, a better
equilibrium can be achieved when the government reimburses creditors than
when the firm reimburses creditors.
The optimal government reimbursement proportion for seniors is 81.0 per-
cent, which is similar to the proportions when the firm reimburses creditors.
The senior spends 4.6 hours. Her objective function is
1
冑冑
v#$40 (1 v)#($100 $2 s$2 j).207(s#$.50).
[]
3
The junior still finds it optimal to attack the senior claim and spends 6.39 hours.
His objective function is
冑冑
v#[($100 $2 s$2 j)$40]
2
冑冑
(1 v)#($100 $2 s$2 jj#$.50.
)
[]
3
Thus, both creditors overspend on representation. In this system, the court
chooses 75.4 percent APR and 24.6 percent PPR; the senior receives $38.69,
and the junior receives $67.02.
334 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
Therefore, in the case, the social net professional benefit is $3.85. Unfortu-
nately, although this is the best partial-reimbursement system, an optimal gov-
ernment reimbursement is probably not feasible. It relies on governmental knowl-
edge of parameters and unbiased, uninfluenceable decisions—abilities and
tendencies that we are not willing to attribute to courts.
APPENDIX B: PROOFS
Proof of Proposition 2. If senior creditors do not pay for their profes-
sionals, they maximize their profits by spending because in that case the
sp1
APR is upheld for sure and they receive . Consequently, junior creditors maxi-
S
mize
22
max P{V(sj)hcs cj
S
,(B1)
jJ
which is maximized when . Finally, because , then
GP GP GP
j1h/2cspjp1Wp
. Hence, . Q.E.D.
GP FP
arg min WW!W
s,j
Proof of Proposition 3. Differentiating equation (14) with respect to j
yields
P
J
pS(1 s)[1 Vsh 2hq]h2cj. (B2)
j
The first term in (B2) is positive if . Hence, it must be that
V3h!1h
for . Therefore, . Solving for sin the partial derivative
2cj*!0P/jp0j1h/2c
J
yields
P/sp0
S
j
S
[1 Vh#(1 j)]
sp. (B3)
2j
S
h2c
Note that this expression is decreasing in j. Therefore, because ,
j1h/2c
j
S
[1 Vh#(1 j)] h
S
[1 Vh#(1 j)] h
sp!!(B4)
()( )()
2
2j
S
h2c2c(
S
h)/c2c2c
when . Because , the condition is
2
S[1 Vh(1 j)]/[(Sh/c)2c]!1j1h/2c
equivalent to . To prove that , note that
2CPFP
S!2c/[1 Vh(3h/2c)] W1W
and . Therefore, using the envelope theorem,
CP CP CP
s/j10j/s!0W/s!0
for all and , and for all and . Hence, because
CP CP CP
js1h/2cW/j!0sj1h/2c
and , it follows that . Q.E.D.
FP FP FP CP
jph/2csp1W!W
Proof of Proposition 4. In proposition 3, because
CP
j/s!0
. In addition, because
2CP
P/jsp2Shs
S
h
S
V2j
S
h
S
!0s/j10
J
. Under a system in which
2
P/sjp
S
S
[V(sj)h]j
S
h(1 s)
S
h10
S
BANKRUPTCY COSTS / 335
the firm reimburses junior creditors only and senior creditors pay for their own
expenses,
22
Ppv(s,j)
S
[1 v(s,j)]
S
[V(s,j)cj ]cs (B5)
S
and
22
Ppv(s,j)[V(s,j)cj
S
][1 v(s,j)](1 S)[V(s,j)cj ], (B6)
J
which implies .
US US 2
spj
S
[1 Vh(1 j)cj ]/(2j
S
h2c)
From proposition 3, . Therefore,
CP CP
spj
S
[1 Vh(1 j)]/(2j
S
h2c)
for a given j. Suppose now that sis given. In equation (B6), it means
US CP
s1s
that for given s. This is so because qincreases as more jis financed by
US CP
j1j
the firm. Therefore, because and , and because for
CP CP US CP
j/s!0s/j10s1s
a given jand for a given s, it must be that . Moreover, differ-
US CP US CP
j1js1s
entiating (B6),
P
J
p(h2cj){1 S[1 v(s,j)]}
j
2
(1 s)(1 S)[V(s,j)cj
S
]p0,
(B7)
which implies that because the second term in (B7) is positive andj1h/2c
. To prove that , and using propositions 3 and 2,
US CR
S[1 v(s,j)] !1WW
and . Therefore, for all and . Simi-
CP CP CP CP
s/j10j/s!0W/s10js1h/2c
larly, for all and . Hence, because and ,
CP CP US US
W/s!0sj1h/2cj1h/2cs1
then . Q.E.D.
US CP
WW
Proof of Proposition 5. Let and be the percentage of creditors’dd
SJ
expenses that are paid by themselves; the rest are paid by the company. From
propositions 3 and 2, and . Therefore, jis increasing in .
CP FP
j1h/2cjph/2cd
S
From the proof of proposition 7, jis also increasing in . Therefore, the optimald
J
constrained reimbursement policy is and .0!d!1dp1
SJ
From the proof of proposition 7, it must be that forg(1 d)p0s*p
SS
. If the government cannot subsidize creditors, then ; hence, it musth/2cgp1
S
be that for to be minimum. However, for , anddpdp1j*dpdp1s*p1
SJ SJ
, which can never be optimal. Therefore, it cannot be that whenj*ph/2cdp1
S
. Therefore, . However, this implies that because sis de-gp1d!1s*1h/2c
SS
creasing in . Finally, for and , from propositions 4d0!d!1dp1j*1h/2c
SSJ
and 7. Finally, to prove that , note that the FRA policy is the optimal
FRA CP
W1W
reimbursement policy among those in which the firm reimburses creditors, in-
cluding the one in which the firm reimburses nothing (the CP policy). Q.E.D.
Proof of Proposition 6. If the firm reimburses a percentage gof the senior
expenses, then the firm’s objective function is
2
Fph#(sj)cgs. (B8)
336 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
Similarly, senior and junior creditors maximize, respectively,
22
Ppv
S
(1 v)S[Vh#(sj)cgs]c(1 g)s(B9)
S
and
2
Ppv[Vh#(sj)cgs
S
]
J
22
(1 v)(1 S)[Vh#(sj)cgs]cj .
(B10)
The first-order conditions are
Fsj
FRP FRP FRP2
p(h2cgs)cs hp0,
ggg
P
SFRP FRP FRP FRP
pjSj
S
Vj(1 s)
s
FRP FRP FRP FR P
#
S
(h2cgs)2c(1 g)sp0,
(B11)
P
JFRP FRP FRP FRP
pS(1 s)(1 V)[1 j
S
(1 s)]h2cj p0,
j
where . From (B11), it cannot be that
FRP FRP FRP FRP2
VpVh(sj)cgsh
because, using the envelope theorem, and because from
FRP FRP
2cgs!0j/s!0
the second condition in (B11), Falways increases by reducing s,soh
.
FRP FRP
2cgs10
Therefore,
2
P
SFRP

S
(1 V)j
S
h
2
s
s
FRP FRP FR P

(1 s)
S
(h2cgs)g
s

FRP
(1 V)S(1 s)
2
Jg


FRP FRP FRP
(h2cgs)j
S
h
2
j

FRP FRP2 FRP FRP FRP FRP
S
cj s 2cs j (1 s)
S
2cs

p.
(B12)

FRP FRP2
S
(1 s)cs

Note that it must be that to satisfy the second-order conditions.
22
S/S!0
Moreover, . Since
FRP FRP2 FRP FRP FRP FRP FRP FRP
Scj
S
2cs j (1 s)
S
2cs 10h2cgs1
, then , and using (B11), it must
FRP FRP FRP FRP
0S(1 V)j
S
h(1 s)
S
(h2cgs)
be that .s/g10j/g!0
Finally, from (B8) it must be that , and using the previous result,
FRP FRA
g!g
this implies that and . Moreover, because the FRA policy
FRP FRA FRP FRA
S!Sj1j
maximizes social welfare for all policies in which the firm reimburses creditors,
then .
FRP FRA
W!W
BANKRUPTCY COSTS / 337
To show that , we can rewrite the firm’s objective function as follows:
FRP
s!h/2c
22 2
Fph(sj)cgspWcj c(1 g)s. (B13)
Because Wis maximized for , then differentiating Faround andsph/2csph/2c
using the envelope theorem,
2
Fh[c(1 g)s]jh
spp 2cj s p
() ()
FF
g2csg2c
sh jh
2
p2sc(1 g)spcs 2cj s p.
(B14)
() ()
FF
g2cg2c
Suppose that . Then it must be that , which implies,
FRP
sh/2c(F/g)Fsph/2c10
from (B14), that because . Now, differen-(s/g)Fsph/2cs/[2(1 g)] j/g!0
tiating Fwith respect to saround , from (B13), yieldssph/2c
Fh shjh
2
sp(h2cgs)sphspcs p0 (B15)
() () ()
FFF
g2cg2cg2c
for , which is greater than or equal to zero for . Finally, using
FRP
sph/2csh/2c
the condition that results in
(s/g)Fsph/2cF(sc)/[2(1 g)]
sjh
2
(h2cgs)hspcs 10, (B16)
()
FF
2(1 g)g2c
which implies that
s
2
(h2cgs)cs 10 (B17)
2(1 g)
because . This is equivalent to , which contradicts the
(j/g)Fsph/2c!0s!h/2c
initial assumption. Therefore, it must be that . Q.E.D.
FRP
s!h/2c
Proof of Proposition 7. Let and be the percentage of cred-
1g1g
SJ
itors’ expenses that are paid by the government; the rest are paid by either the
creditors or the company. Similarly, let and be the percentage of the re-
dd
SJ
maining expenses that are paid by the creditors themselves.
The maximization program for this problem is
22
max G{h(s*j*) c(s*j* ), (B18)
g,d
where
s*arg max P(s){v
S
(1 v)S[Vsh j*h
s,jS
222
cg(1 d)scg(1 d)j*]gdcs
(B19)
sSJJ sS
338 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
and
22
j*arg max P(j){v#[Vs*hjh cg(1 d)s*cg(1 d)j
S
]
jJsSJJ
2
(1 v)(1S)[Vs*hjh cg(1 d)s* (B20)
sS
22
cg(1 d)j*]gdcj .
JJ JJ
First, note that only when . From propositions 3 and 2,
j*ph/2cs*p1j1
for any , , and , and it is closest to when . To
h/2cgd s*(1h/2cg*pd*p1
SS JJ
see that jis minimized for , note that is decreasing in , so it
g*pd*p1j*g*
JJ J
must be that . Let be the value of the junior creditors’ claim when
c
g*p1P
JJ
professional fees are paid for by the creditors. Similarly, is the value of the
f
P
J
junior debt when professional fees are financed by the firm. It is straightforward
to show that and . Besides, and satisfy
2f 2c f c
P/js!0P/js!0PP
JJ Jj
fc
PP
JJ 22
pc(1 s)(1 S)(s3j) (B21)
jj
for all sand j. Suppose that . Then, because
fc 2 2
spsc(1 s)(1 S)(s3j)10
and for , , it must be that . Because , it is
cccf fcfc
P/jp0jpjspspsj!js1s
J
still true that because is decreasing in . Therefore, it must be that
fc c c
j!jj s
.
d*p1
J
Substituting these values in the first-order condition for the junior creditors
yields
P
JGR GR GR
p(1 s)
S
(1 L)h[1 j(1 s)
S
]2cj p0, (B22)
j
where and GR is the scheme in which the gov-
2
LpVsh jh cg(1 d)s
sS
ernment partially reimburses the creditors.
Because Lis decreasing in , then, using the second-order conditions,
g(1 d)
sS
it must be that . Given , Gis maximized with the lowest j,
GR
j/[g(1 d)] 10s
SS
so it must be that , which implies either or .g(1 d)p0dp1gp0
sSSS
1. If , then and solve
GR GR GR
dp1jg
SS
P
SGR GR 2 GR
pj
S
j
S
[V2cs*jh]
s
GR GR GR GR
j(1 s)
S
h2cs gp0
(B23)
S
and
P
JGR 2 GR GR
p(1 s)
S
[1 (V2cs*2jh)] h2cj p0. (B24)
j
BANKRUPTCY COSTS / 339
Note that because the first term in the previous expression is positive.
GR
j1h/2c
Then, from (B23),
GR GR 2 GR GR GR
j
S
j
S
[V2cs*jh]j(1 s)
S
h
GR
gp. (B25)
S
2cs
2. If , then and define a system of equations
GR
gp0P/sp0P/jp0
SSJ
where only jis unknown and therefore lead to an absurd conclusion. Therefore,
Gis maximum where and .
GR GR GR
dpg*pdp1g10
SJJ S
3. To prove that , let us assume that . Using the envelope
GR
s1h/2cs*ph/2c
theorem, an infinitesimal decrease in increases because, from proposition
GR GR
sj
4, . Therefore, decreases. However, for
GR GR 2 2
j*/s!0G{h(sj)c(s*j*)
an infinitesimal increase in , increases, and therefore Gincreases. There-
GR GR
sj
fore, the optimal must be such that and .
GR GR GR
g10s1h/2cj12/2c
S
APPENDIX C: NUMERICAL BACKGROUND FOR FIGURES
This appendix computes the base values for the figures in the text. The base
parameters are
value of the firm before enhancement: ,Vp.9
senior creditor claim: ,Sp.4
junior creditor claim: ,Jp.6
per-unit professional value enhancement: , andhp.05
cost of professionals: .cp.05
Because the professional fees are subtracted from the firm value, V2h
. If the APR were to hold (when , , for instance), firm value2cp.9 !1sp1jp0
would be , and junior creditors would receive onlyVhcp.9 (.9
percent of their claim. If instead the APR is completely.5)/(1 .4) p66.66
violated, junior creditors could be able to recover percent of their.6(.9/.6) p90
claim. Both junior and senior creditors can improve firm value up to .9
. Note that this is possible only if , in which case the.05 .05 p1spjp1
probability of an APR violation is , senior creditors receive .4j#(1 s)p0
(100 percent of their claim), and junior creditors receive (100 percent1.4 p.6
of their claim).
With these parameters, we have the following:
Socially Optimal. The optimal first-best solution entails that s*pj*p.5
and total welfare ; the APR is violated with a probability of 25W*p.025
percent.
Government Pays. If the government assumes all the professional expenses,
, and social welfare is zero, because too much is spent in pro-spjp1Wp0
fessionals; the APR is always upheld.
340 / THE JOURNAL OF LEGAL STUDIES / VOLUME 34 (2) / JUNE 2005
Creditors Pay. If creditors finance their own expenses, then ,sp.23 jp
, and social welfare is ; the probability of violating the APR is 45.59 Wp.021
percent.
Firm Pays. If the firm finances creditors’ expenses, then , , andsp1.0 jp.50
social welfare is ; the probability of violating the APR is 0 percent.Wp.0125
U.S. System. If the firm finances junior creditors’ expenses only and seniors
finance their own expenses, then , , and social welfare issp.33 jp.75 Wp
; the probability of violating the APR is 49.26 percent..0203
Partial Senior Reimbursement: Socially Optimal. The second-best solu-
tion with firm reimbursement of only senior expenses yields second-best values
of , , and welfare . In the optimal reimbursementsp.505 jp.556 Wp.0248
policy, the firm reimburses a fraction of the senior professional1dp.72
S
expenses; the APR is violated with a probability of 28 percent.
Partial Senior Reimbursement: Managerial Firm-Value Maximization.
The second-best solution, with partial senior reimbursement to maximize firm
value, yields second-best values of , , and welfare . Insp.47 jp.56 Wp.0247
the optimal reimbursement policy, the firm reimburses senior creditors a percentage
percent of their professional expenses, and the rest is financed by the1dp69.1
creditors themselves. Junior creditors carry their own expenses; the APR is violated
with a probability of 29.4 percent.
Government Partial Asymmetric-Reimbursement System. The second-
best solution with multipayor reimbursement and asymmetric creditor treatment
yields second-best values of , , and welfare . In thesp.51 jp.54 Wp.0249
optimal reimbursement policy, the government reimburses a fraction 1gp
S
of the senior professional expenses; the APR is violated with a probability.31
of 27 percent.
REFERENCES
Altman, Edward I. 1984. A Further Empirical Investigation of the Bankruptcy
Cost Question. Journal of Finance 39:1067–89.
Ang, James S., Jess H. Chua, and John J. McConnell. 1982. The Administrative
Costs of Corporate Bankruptcy: A Note. Journal of Finance 37:219–26.
Betker, Brian L. 1997. The Administrative Costs of Debt Restructurings: Some
Recent Evidence. Financial Management 26:56–68.
Bris, Arturo, and Ivo Welch. Forthcoming. The Optimal Concentration of Cred-
itors. Journal of Finance.
LoPucki, Lynn M., and Joseph W. Doherty. 2004. The Determinants of Profes-
sional Fees in Large Bankruptcy Reorganization Cases. Journal of Empirical
Legal Studies 1:111–41.
BANKRUPTCY COSTS / 341
Lubben, Stephen J. 2000. The Direct Costs of Corporate Reorganization: An
Empirical Examination of Professional Fees in Large Chapter 11 Cases.Amer-
ican Bankruptcy Law Journal 509:508–52.
Pacelle, Mitchell. 2004. Enron Bankruptcy Specialist to File for Additional Pay-
ment; on Top of $63.4 Million, “Success Fee” to Be Sought of Additional
$25 Million. Wall Street Journal, September 3, p. A2.
Povel, Paul. 1999. Optimal “Soft” and “Tough” Bankruptcy Procedures. Journal
of Law, Economics, and Organization 15:659–84.
Schwartz, Alan. Forthcoming. A Normative Theory of Business Bankruptcy. Vir-
ginia Law Review.
Skeel, David. 2003. Creditor’s Ball: The New “New” Corporate Governance in
Chapter 11. Pennsylvania Law Review 152:917–51.
Warner, Jerold B. 1977. Bankruptcy Costs: Some Evidence. Journal of Finance
32:337–47.
Weiss, Lawrence A. 1990. Bankruptcy Resolution: Direct Costs and Violations
of Priority Claims. Journal of Financial Economics 27:285–314.
Welch, Ivo. 1997. Why Is Bank Debt Senior? A Theory of Priority Based on
Influence Costs. Review of Financial Studies 10:1203–36.
... They show that senior (junior) debt holders have an incentive to undervalue (overvalue) the firm to obtain the maximum value under reorganization. Bris, Schwartz, and Welch (2005) model the allocation of professional costs in the bankruptcy process. Courts cannot distinguish between professional expenditures that increase value and those that result only in a redistribution of the assets of a bankrupt company. ...
... This is consistent with several versions of a pecking order theory, and can be justified by tax effects. However, admittedly, we are not looking for a complete security design framework (see Bris, Schwartz, and Welch (2005) for similar assumptions). ...
... The difference between senior and junior debt is in the priority treatment upon bankruptcy. Following papers such as Welch (1997) or Bris et al. (2005), and as discussed earlier, we assume that courts uphold the Absolute Priority Rule (APR) with probability 1−θ, 0 < θ < 1. The cost and benefit of professional effort are both zero. ...
Article
We present a model that shows how interactions between creditor groups in bankruptcy can affect the debt issuance decisions of firms, and test the most important implications of the theory. In particular, we show that firms that issue debt with a specific seniority level may tend to keep issuing debt at the same level to avoid the costs of conflicts in bankruptcy. Our model also has predictions as to what types of firms may change seniority level in sequential issues. We also find that as costs of conflict increase, firms will tend to issue more junior debt. The empirical implications of our model are consistent with the somewhat surprising fact that most firms issue debt at one seniority level only, and quite a few of them cluster at the senior subordinated level. Our probit analysis shows that companies that issue subordinated debt are much smaller than those that issue senior debt, while those that issue at both levels are intermediate on most financial measures. These empirical regularities are broadly consistent with our theoretical analysis. Our model is also supported by the fact that companies that issue only senior debt pay lower spreads than companies that issue at both levels. Finally, we find some support for our theory in an analysis of bankrupt firms.
... Different parameter values may induce monitoring by one class of creditors or no class at all. In Bris et al. (2005) Courts cannot distinguish between professional expenditures that increase value and those that result only in a redistribution of the assets of a bankrupt company. Therefore, subsidies for professional costs should be designed to encourage only value-enhancing activities. ...
... The difference between senior and junior debt is in the priority treatment upon bankruptcy. Following papers such as Welch (1997) or Bris et al. (2005), we assume that courts uphold the Absolute Priority Rule (APR) with probability  The cost and benefit of professional effort are both zero. Let S and J be the face values of the senior and junior claims. ...
... Let S and J be the face values of the senior and junior claims. Welch (1997) and Bris et al. (2005) assume that if APR is violated, the equal (proportional) priority rule (EPR or PPR) will be used. We will follow this assumption here, although most of our conclusions will follow regardless of the specific form of APR violation. ...
Article
We present a model that shows how interactions between creditor groups in bankruptcy can affect the debt issuance decisions of firms. In particular, we suggest that deviations from APR should be priced and can affect the issuing decisions of junior and senior debt. Our model suggests that once firms issue debt with one level of seniority, they have an incentive to alternate, and subsequent issues will have a different seniority level. When we introduce explicit costs of conflict in our model, we find that as these costs increase, firms will tend to stay with one class of debt. The empirical implications of our model are consistent with the somewhat surprising fact that most firms issue debt at one seniority level only, and quite a few of them never issue any senior debt. We also find that companies that issue only senior subordinated debt are much smaller than those that issue senior debt, while those that issue at both levels are intermediate on most financial measures. This is broadly consistent with our theoretical analysis. Our model is also supported by the fact that companies that issue only senior debt pay lower spreads than companies that issue at both levels. Finally, we study a sample of firms in bankruptcy and again find significant relationships between corporate characteristics and the types of debts that they issue, as predicted by the model.
... They show that senior (junior) debtholders have an incentive to undervalue (overvalue) the firm to obtain the maximum value under reorganization. Bris, Schwartz, and Welch (2005) model the allocation of professional costs in the bankruptcy process. Courts cannot distinguish between professional expenditures that increase value and those that result only in a redistribution of the assets of a bankrupt company. ...
... The difference between senior and junior debt is in the priority treatment upon bankruptcy. Following papers such as Welch (1997) or Bris et al. (2005), we assume that courts uphold the Absolute Priority Rule 5 (APR) with probability 1−θ, 0 < θ < 1. The cost and benefit of professional effort are both zero. ...
... In default, it is not possible that both junior and senior creditors are in the money, so S + J > qI . Welch (1997) and Bris et al. (2005) assume that if APR is violated, the equal (proportional) priority rule (EPR or PPR) will be used. In this case, if S and J are the face values of the senior and junior debts, and V= qI is the value available to be distributed, then the senior are junior creditors receive S ...
Article
We present a model that shows how interactions between creditor groups in bankruptcy can affect the debt issuance decisions of firms. In particular, we show that firms that issue debt with a specific seniority level may tend to keep issuing debt at the same level to avoid the costs of conflicts in bankruptcy. Our model also has predictions as to what types of firms may change seniority level in sequential issues. We also find that as bankruptcy costs increase, firms will tend to issue more junior debt. The empirical implications of our model are consistent with the somewhat surprising fact that most firms issue debt at one seniority level only, and quite a few of them cluster at the senior subordinated level. We also find that companies that issue subordinated debt are much smaller than those which issue senior debt, while those that issue at both levels are intermediate on most financial measures. These empirical regularities are broadly consistent with our theoretical analysis. Our model is also supported by the fact that companies that issue only senior debt pay lower spreads than companies that issue at both levels.
... Macroeconomic conditions and financial fundamentals influence the likelihood of falling into financial distress (Bris, Schwartz, and Welch 2005;Fan, Huang, and Zhu 2013;Tinoco and Wilson 2013;Bhattacharjee and Han 2014), which may lead to an endogeneity issue-selection bias for firm performance. Therefore, we adopt the Heckman Twostage regression procedure to control for potential endogeneity arising from the inclusion of the above Table 4. ...
... Similar to Section 4.3.2, we regard ICP world, Consistent, Age, Leverage, Size and Industry fixed-effects as instruments for the likelihood of falling into financial distress (Bris, Schwartz, and Welch 2005;Fan, Huang, and Zhu 2013;Tinoco and Wilson 2013;Bhattacharjee and Han 2014). The Panel A of Table 8 shows that these instruments are related to financial distress, confirming the significant impacts of macroeconomic conditions and financial fundamentals on financial distress. ...
Article
We examine the impact of political connections on firm performance, financial distress, and its resolution. We focus on China, over 1999 to 2015, a country where government influence over stock markets has been demonstrated to be considerable. Our findings suggest that although political connections had limited impact on the emergence of financial distress, such connections assisted distressed firms in gaining increments to debt financing and contributed to a higher likelihood of recovery. This indicates that Chinese authorities follow market economy principles, and only intervene in firms' operations after they fall into financial distress. In addition, central and local government political connections have different impacts on distress recovery. We conduct additional analyses on differences in distress outcomes for various ownership (State–owned enterprises, SOEs, and non–SOEs) and sample sub–periods (1999–2007 and 2008–2015). Our results are robust to potential endogeneity issues and to alternative measures of financial distress.
... Between 2008 and 2009 interest rates were considerably reduced.4 The non-conventional measures consist of: offer of unlimited liquidity at a fixed rate to the Eurozone banks; extension to twelve months of the refinancing operations; increase of the assets used as a guarantee; purchase of guaranteed obligations, that is, covered bonds. ...
... The most commonly considered explanation is asymmetric information between creditors and managers or equity holders, which impedes the information revelation process regarding the true value of a financially distressed firm (Hotchkiss et al. 2008;Giammarino 1989;Li and Li 1999;Mooradian 1994;White 1994). Further studies analyse the influence of biased judges (Bris et al. 2005;Baird 1986) or the quality and judicial discretion of judges on the ex post outcome of a bankruptcy procedure (Ayotte and Yun 2007;Bernhardt and Nosal 2004). Another issue discussed in the literature is the conflict of interest among multiple creditors (Blazy and Chopard 2004) or the problems due to multiple classes of creditors (Bulow and Shoven 1978;White 1989;Gertner and Scharfstein 1991). ...
Article
Full-text available
An insolvency administrator replaces the manager of an insolvent firm to devise and organize a liquidation or reorganization plan in the creditors’ interest. In the course of the process, the insolvency administrator presents the most favourable option from his perspective, and the creditors choose to accept or reject this plan. Conflicts of interest arise because the insolvency administrator, as the better-informed party, considers in his proposal liability risks and reputational issues that are beyond the creditors’ scope. We model this conflict as a Bayesian game and find that, under those compensation schemes typically used in real-world regulations, optimal creditor satisfaction and efficient decisions concerning the economic future of the insolvent firm will never be achieved simultaneously.
... The rest of the parameters are determined as follows. Recent empirical studies estimate bankruptcy costs to vary within the interval 2-15% of the firm value at bankruptcy (Strebulaev, 2007;Bris, Welch, and Zhu, 2006;Bris, Schwartz, and Welch, 2005). We only consider direct bankruptcy costs as the indirect costs of financial distress have a very high variation; even direct costs of bankruptcy procedure could change substantially depending on firm-specific characteristics, e.g. ...
... 3 Our analysis focuses on how debt priority structure influences investment and financing decisions outside bankruptcy. There is a considerable amount of related work, however, that examines how debt securities with different priorities influence the costs, mode (Chapter 7 or 11), and outcome of the bankruptcy process (see, e.g., Gilson, John, and Lang 1990;Gilson, Hotchkiss, and Ruback 2000;Bris, Schwartz, and Welch 2005;Bris, Welch, and Zhu 2006;Broadie, Chernov, and Sundaresan 2007;Bris, Ravid, and Sverdlove 2008). ...
Article
Full-text available
We examine the optimal capital structure and priority structure of multiple classes of debt using a dynamic model where firms face a tradeoff between bankruptcy costs, interest tax shield benefits, and investment benefits. As a base case, we first analyze jointly optimal policies for a firm initially constrained to a single class of debt, which results in underinvestment in the growth option. Surprisingly, this standard case produces several novel predictions, such as, financial leverage ratios need not be inversely related to a firm's investment opportunities, and reliance on credit spreads to gauge agency costs of debt is inappropriate when it is hard to identify whether debt policy is endogenous or not. Relaxing the firm's constraint, we then study jointly optimal policies for initial debt and additional debt used to finance the growth option. Ironically, equityholders' optimal strategy in this unconstrained case results in overinvestment in the growth option. As a result, we obtain an interior optimum for priority structure as an important financial contracting device. One of the paper's key implications is that priority structure plays a critical and heretofore unrecognized role in helping to resolve bondholder-shareholder conflicts over investment policy. This financial contracting perspective offers other potentially fruitful insights to better understand the effects of optimal capital structure and debt structure on corporate investment policy.
... The question that we seek to answer in this paper is how firms react to financial distress given such power? Given the extensive games played between different stakeholders and dynamic operating and financing decisions in financial distress, we find 2 For example, Baird et al., 2007, Bris et al. 2005, 2006, Franks and Torous, 1986, Khal 2002, Stromberg, 2000, Thorburn, 2000, Weiss, 1990, Wruck 1990, among others. 3 Pulvino, 1999, Shleifer and Vishny 1992, Weiss and Wruck, 1998 Eckbo and Thorburn, 2003, Gilson 1997, Hotchkiss, 1995, Maksimovic and Phillips, 1998 it particularly interesting and important to study how institutional forces shape the behavior of distressed companies in such markets. ...
Article
We investigate how institutional factors influence the behavior of distressed firms in emerging markets, where bankruptcy laws are often weak and debtors have greater bargaining power in distress. By studying two comprehensive samples of distressed firms in China, we find that local government quality and corporate ownership structure matter considerably to firm performance during distress. Distressed companies facing stronger institutional discipline and with greater private ownership have relatively better operating performance and are more likely to recover. Our results remain robust when we control for the endogeneity of entering distress, use different institutional proxies, and implement various definitions for distress.
Article
Full-text available
This article describes optimal bankruptcy laws in a framework with asymmetric information. The key idea is that the financial distress of a firm is not observed by its lenders for quite a while. As early rescues are much cheaper than late rescues, it may pay if the creditors are forgiving in bankruptcy, thereby inducing the revelation of difficulties as early as possible. Either "tough" or "soft" bankruptcy laws can be optimal, depending on the parameters. This implies that mandatory one-size-fits-all bankruptcy procedures cannot be optimal. "Hybrid" procedures, which try to combine elements of soft and tough procedures, are found to be redundant, and possibly harmful. Absolute priority rules may be helpful as a part of tough procedures, but their introduction is (partly) inconsistent with the design of soft procedures. The article also reinterprets much of the evidence on the performance of Chapter 11, the "rather soft" U.S. reorganization procedure, questioning many negative conclusions. Copyright 1999 by Oxford University Press.
Article
Full-text available
This Article will view bankruptcy through the lens of a single theory. Scholars, especially those of an economic bent, are coming to agree that a business bankruptcy law should function to reduce the cost of capital for firms. There appear to be few papers, however, that evaluate the basic structure of a modern bankruptcy code by a cost of capital yardstick alone. This is due in part to disagreement about whether a bankruptcy law should pursue goals in addition to capital cost reduction. The novelty of this Article will lie in its single-minded application to bankruptcy of the cost of capital metric and in its argument that only this metric should matter. The Article will focus on U.S. law for convenience. Its conclusion will hold that a bankruptcy law committed exclusively to capital cost reduction would be considerably smaller and less centralized than the law we now have.
Article
This paper provides a theory why bank debt is universally senior, consistent with the presence of conflict (lawyers) and absolute priority violations in financial distress: banks would more strongly contest the priority structure in financial distress if they were junior, because they are both better organized than public debt and more appreciative of a toughness reputation in repeat relationships with other clients. This paper identifies the conditions under which firms find it efficient to award the ex-post stronger lobbyist/litigant ex-ante priority, because "deterrence" can reduce total creditors' expenses associated with a priority contest. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and can even suggest one rationale for the absolute priority rule (APR). The paper further shows that overall creditors' contest expenses can be lower when the firm pays, thus providing a rationale for Chapter 11 creditor reimbursement procedures.
Article
This article reports on one of the most extensive studies to date of the professional fees and expenses awarded by U.S. bankruptcy courts in the reorganizations of large, public companies.
Article
I present new evidence on the direct costs of bankruptcy and violation of priority of claims. In a sample of 37 New York and American Stock Exchange firms that filed for bankruptcy between November 1979 and December 1986, direct costs average 3.1% of the book value of debt plus the market value of equity, and priority of claims is violated in 29 cases. The breakdown in priority of claims occur primarily among the unsecured creditors and between the unsecured creditors and equity holders. Secured creditors' contracts are generally upheld.
Article
Printout. Caption title. Thesis (LL. M.)--Harvard Law School, 2000. Includes bibliographical references.
Article
This theory can explain why bank debt is universally senior, consistent with the presence of conflict (lawyers) and absolute priority violations in financial distress: Better organized banks would more strongly contest priority in financial distress if they were junior. Because “deterrence” can reduce creditors’ total expenses in a priority contest, the ex post stronger lobbyist/litigant should be senior ex ante. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and can even suggest one rationale for the absolute priority rule (APR). This article further shows that Chapter 11 creditor reimbursement procedures can lower overall costs.
Article
How much does it cost to restructure a firm's debt? What factors can explain differences in restructuring costs across firms? The central thesis of the paper is that restructuring costs should be lower when there is less competition among creditors. Understanding the size and determinants of direct financial distress costs is important for two reasons. Under the "static trade-off" theories of capital structure, financial distress costs can be an important determinant of firms' optimal capital structures. Documenting the nature of financial distress costs is essential to understanding and testing these theories. Also, the debt restructuring process has been criticized for becoming increasingly inefficient and costly. Understanding the determinants of restructuring costs is necessary before policymakers can discuss ways to reduce these costs.
Article
University of Rochester. The author wishes to thank M. Gruber, R. Hamada, F. Jen, M. Jensen, E. H. Kim, E. Kitch, M. Scholes, J. Siegel, C. Smith, B. Stone, H. Stoll, and J. Williams for their comments on previous drafts. I am indebted to N. Gonedes and especially M. Miller for their encouragement and for their criticisms of previous versions of the paper.
Article
In the 1980s and early 1990s, many observers believed that the American corporate bankruptcy laws were desperately inefficient. The managers of the debtor stayed in control as "debtor in possession" after filing for bankruptcy, and they had the exclusive right to propose a reorganization plan for at least the first four months of the case, and often far longer. The result was lengthy cases, deteriorating value and numerous academic proposals to replace Chapter 11 with an alternative regime. In the early years of the new millennium, bankruptcy could not look more different. Cases proceed much more quickly, and they are much more likely to result in auctions or other sales of assets than in previous decades. This transformation is due in part to a change in the major corporations that file for bankruptcy. Rather than industrial, bricks-and-mortar firms, many of the new debtors are knowledge-based firms with transient assets. Much more important, however, has been the adjustments creditors have made in an effort to reassert control in bankruptcy. In this Article, I focus on the two most important contractual developments: lenders' use of debtor-in-possession financing agreements as a governance lever; and the so-called pay-to-stay arrangements which give key managers bonuses for meeting specified performance goals (such as quick emergence from bankruptcy or the sale of important assets). Both of these developments can be seen as adjustments by creditors to counteract bankruptcy's interference with the shift in control rights that would ordinarily occur at the time of financial distress. As I have discussed elsewhere, chapter 11 functioned somewhat like an antitakeover device in the 1980s. Creditors have now neutralized its effects. Of the two new contractual approaches, pay-to-stay agreements have proven much more controversial, prompting heated complaints about excessive managerial pay in cases like Enron, Polaroid and Kmart. The controversy is similar in o