Working Paper

Nearsighted justice

Abstract: Chapter 11 structures complex negotiations between creditors and debtors that are overseen by a bankruptcy court. This paper identifies conditions under which it is optimal for the court to sometimes err in determining whether a firm should be liquidated. Such errors can affect the optimal action choices by both good and bad entrepreneurs. We first characterize the optimal error rate without renegotiation, providing conditions under which it is optimal for the court both to sometimes mistakenly liquidate \"good firms,\" but not \"bad firms.\" When creditors and debtors can renegotiate to circumvent an error-riven court and creditors have all of the bargaining power, we show that for a broad class of action choices, a blind court--one that ignores all information and hence is equally likely to liquidate a good firm as a bad one--is optimal.

Keywords: Bankruptcy;

https://doi.org/10.26509/frbc-wp-200304

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers (Old Series)

Publication Date: 2003

Number: 0304