Law and Economics of Insolvency

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Law and Economics of Insolvency

• Oliver Hart

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Law and Economics of Insolvency

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

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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 gt 1000
• Population gt 1.5 million
• Total 88 countries

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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
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Case Facts (contd)
Mirage owned 51 by Mr. Douglas No other
shareholder has gt 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 countrys GDP per
capita
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Case Facts (contd)
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
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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

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Figure 1 Options for Mirage
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Limitations of the Case

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

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(Tentative) Conclusions

• Lots of inefficiency in a very simple case wrong
  outcome, slow, high administrative costs
• How to do better?
• Encourage foreclosure and floating charge
• Circumscribe Appeals
• Discourage automatic cessation of operations
• Dont 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.