Law and Economics of Insolvency Oliver Hart

2 Law and Economics of Insolvency Most firms do not provide their own insolvency procedures, but rely on the state to do so. How good are these procedures? Do they achieve efficient outcomes, i.e., are “good” firms saved and “bad” firms closed down? Are creditors paid according to the priority of their claims (absolute priority)? I will describe an empirical study, “Debt Enforcement Around the World,” carried out with Simeon Djankov and Caralee McLiesh (World Bank), and Andrei Shleifer (Harvard), which investigates these questions by presenting insolvency practitioners in different countries with a hypothetical case.

3 Setup Hypothetical Case Respondents: Insolvency Practioners from International Bar Association Committee on Bankruptcy Date: January 2006 (several rounds before) Total: 344 lawyers All countries with: GDP per capita > $1000 Population > 1.5 million Total: 88 countries

4 Case Facts Insolvent Firm called “Mirage” Limited liability, domestically owned, medium- sized hotel Located in most populous city 201 employees 50 suppliers (each owed money) Five years ago, borrowed from Bizbank Loan has collateral, i.e., is secured Loan has 10 year term Mirage has met all obligations until now Loan has seniority

5 Case Facts (cont’d) Mirage owned 51% by Mr. Douglas No other shareholder has > 5% Mirage has a manager, with no special human capital Mirage has 136 units of debt Suppliers, Tax Authorities, employees each owed 12 These are unsecured creditors Bizbank is owed 100 All normalized to country’s GDP per capita

6 Case Facts (cont’d) Mirage has been losing money and is about to default due to industry shock Assume going forward can cover costs But cannot cover debt payments Version A: Going concern worth 100 Piecemeal liquidation worth 70 Version B:Going concern worth 70 Piecemeal liquidation worth 100

7 Data Time = T Cost = C Whether get the efficient outcome: EO = 1 Efficiency = Assume zero net revenue during procedure and costs incurred at end (but robust) Also get structural features of procedure

8 Figure 1: Options for Mirage

9 Limitations of the Case 1. No informal workouts allowed 2. Capital structure does not adjust to law 3. Only one secured creditor Complex conflicts minimized (Indeed, foreclosure has correct incentives) 4. Respondents know what is efficient from the start 5. Do not need new financing 6. No public interest, politics involved 7. No tunneling (looting)

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18 (Tentative) Conclusions Lots of inefficiency in a very simple case: wrong outcome, slow, high administrative costs How to do better? –Encourage foreclosure and floating charge –Circumscribe Appeals –Discourage automatic cessation of operations –Don’t allow suppliers/customers to rescind contracts Reorganization seems a bad idea in poor countries, where, arguably, institutions are not good enough to support complex procedures.