A Model of Insolvency Resolution: When is Bankruptcy Inefficient?

Abstract

Information asymmetry about a firm's value has been identified in the literature as an obstacle in restructuring the debt of an insolvent firm. We explore the possibility of a restructuring under complete and symmetric information between a firm and its creditors in a creditor-friendly bankruptcy regime. Using a model, we determine the feasibility conditions for restructuring. Our results show that restructuring the firm's debts may not be possible even if it is known to the creditors that the firm's value under the present management is higher than that under a bankruptcy sale. The firm's value under restructuring must also be large enough to pay the full claim of the unsecured creditor and pay the secured creditor a little more than the claim payment they receive in a bankruptcy sale. The results highlight the role of creditors' legal rights in a creditor-friendly regime in leading a firm towards a bankruptcy sale even when the creditors know that the firm's value is more under the present management.

Keywords

• insolvency
• debt restructuring
• bankruptcy law
• liquidation