11 - A simple noncooperative bargaining model of corporate reorganizations

Summary

The traditional view of bankruptcy law begins with the idea that diverse general creditors of a firm face a collective action problem when their corporate debtor becomes insolvent. These general creditors now are the firm's residual owners. Under the traditional view, bankruptcy law is designed in the first instance to allow them to act collectively. This characterization of bankruptcy, however, fails to capture what is often at stake when a closely held firm needs to rearrange its capital structure. The debt owed a single senior creditor may well exceed the value of the firm. Because of its security interest in all the firm's assets, this creditor is entitled to priority over the general creditors. Frequently, bankruptcy serves principally to frame the negotiations between this senior creditor and the firm's manager-shareholder.

A bankruptcy proceeding is needed largely because these negotiations cannot be entirely the province of private contracting. If the firm is worth less than what the most senior creditor is owed, the general creditors should receive nothing, but some mechanism, perhaps a judicial one, is needed to decide whether this condition holds, as the manager-shareholder and the senior creditor cannot be relied on to protect the rights of third parties. Before a court can extinguish the claims of the junior creditors, it must be satisfied that these creditors, in fact, are entitled to nothing. In the case of a closely held firm, bankruptcy does not solve a collective action problem that the general creditors of a firm face when they are its residual owners.