Asian Review of Financial Research Vol.24 No.1 pp.133-164
The Reorganization Game of Bankruptcy Courts
Key Words : Corporate Bankruptcy,Bankruptcy Courts,Judicial Discretion,Optimal Bankruptcy Law,Perfect Bayesian Equilibrium
What is the economic role of the bankruptcy court(judge)? The general answer is that it serves to play key roles in valuation, distribution, and procedure. Yet, the bankruptcy courts are often considered passive and procedural participants in bankruptcy game literature. Indeed, the mainstream themes are more often focused on the optimal bankruptcy law than the court's strategic role with primary emphasis on the workout negotiation game between the debtor firm and its creditors in the shadow of the bankruptcy law. This paper, therefore, examines the game between the bankruptcy court and the firms that file for bankruptcy protection (Chapter 11). The adopted model is a dynamic game under incomplete information. The perfect Bayesian equilibrium concept is used to refine the resulting equilibriums. By doing so, we construct that the player's movement is determined according to the sequential rationality and the Bayesian consistency, thereby disallowing empty threats in the process. In this paper, for simplicity, the creditors are assumed to be made of only one class of passive participants; when the firm is liquidated, they receive the proceeds first, and when the firm is reorganized, they are given new equity. The debtor firm chooses between self-liquidation and filing for bankruptcy protection. The self-liquidation leaves something for the debtor firms, but the ex-post liquidation leaves nothing because of bankruptcy costs which reduce the liquidation value. The bankruptcy court maximizes the social welfare which is the sum of the debtor firm's and the group of creditors' gains. The court is assumed to have the authority to set the recovery ratio and to reject the petition. Here, the recovery ratio means the ratio between the original debt amount and the value of new equity that is paid to the creditors when the firm is reorganized. In the case of rejection, the firms are assumed to be liquidated(Chapter 7). The judicial intervention or discretion means the strategic decision of the court in the corporate bankruptcy game. There are two types of firms: good firms and bad firms. Good firms' going concern value is higher than the liquidation value; vice versa for bad firms. The proportion of the two types of firms is determined by nature. The firms know their own type but that information is not verifiable to a the third party. The court only knows the ex-ante probability distribution of the firm types. Therefore, there is a possibility that the two types are pooled, and the court cannot distinguish between them, which leads to the pooling equilibrium. Sometimes, however, the bankruptcy court has strategic measures to prevent the bad firms from filing for bankruptcy protection, which leads to the separated equilibrium. Based on the recovery ratio set by the bankruptcy court, which subsequently becomes common knowledge, the bankrupt firms decide whether to file for bankruptcy protection. Sometimes, the firm type can be publicly revealed as a good or bad one before the court decision is made. In that case, generally good firms are reorganized and bad ones are liquidated. The court can also decide whether to reorganize the firm or reject the petition. If rejected, the firm is liquidated, and the proceeds are paid to the creditors. Because of the bankruptcy costs, the ex-post liquidation leaves nothing for the debtor firms. Reorganization means the debt-equity swap, i.e., the new equity claim, claim is given to the creditors according to the preset recovery ratio. Using the above game structure, this paper provides the following implications. First, the bigger the difference between the expected going-concern value and the liquidation value, the more important the strategic role of bankruptcy court becomes. On the contrary, when the expected going concern value and the liquidation value are the same (or similar), the strategic role of the bankruptcy court does not make any difference. In that case, it does not matter whether the firm is reorganized or liquidated. Second, when the going-concern value is higher, the court decision should be made favorable to the reorganization. This policy implication is especially important when systemic bankruptcy occurs. In that case, many good firms could go bankrupt due to the externality of macroeconomic shocks. Third, when the liquidation value is higher, the court should set the recovery ratio higher and take more selective approach when reviewing the petitions. These measures could help discern the opportunistic behaviors of bad firms. Fourth, when the bankruptcy law is pro-debtor, the strategic role of bankruptcy court gains more importance. In this paper, we can interpret the lower recovery ratio as the proxy for the pro-debtor law. When the recovery ratio is deemed low, the court should reject the petition more often than when the ratio is high. Fifth, the better the court's information capability is, the higher the social welfare becomes. This result suggests that the court and judges should improve their expertise. This also implies that any legal uncertainties can produce significant impacts on the overall process of corporate bankruptcy.