26 - Is corporate bankruptcy efficient?

Summary

Corporate bankruptcy has two functions:

1. to deliver the penalty for failure by forcing a wrapping up when a business cannot pay its debts; and

2. to reduce the social costs of failure.

When a business fails, the legal process writes off claims that have become uncollectible, turns out managers and others responsible for the debacle, and pays the claims for which assets remain. Bankruptcy or a private substitute such as a workout succeeds when this happens quickly (before good money is thrown after bad) and with low transactions costs. Because the process of paying some claims and extinguishing others can lead to a race to carve up the carcass, which may still have a positive cash flow, bankruptcy combines a stay of self-help with a collective forum for the resolution of competing claims. Like the separation theorem of finance, the bankruptcy process divorces decisions about the optimal deployment of assets from decisions about the claims to those assets. If it works well, assets continue to be devoted to their most productive uses.

Bankruptcy certainly writes down claims, and Gilson (1990) finds that it leads to sanctions in the managerial labor market as well. Is the cost worth incurring? Every study of bankruptcy shows it to be expensive, as it is bound to be given creditors' incentives to stake out competing claims to whatever wealth remains. Weiss (1990) measures costs approximating 3 percent of the assets in the bankruptcies of substantial firms. Other estimates run between 3.4 percent and 21 percent for smaller firms.