According to the principles of microeconomic analysis, the decisions concerning the future destiny of a bankrupt company must, to the greatest possible degree, be separated from those concerning the dis tribution of incomes (or property) among interested parties. So far, a number of sound considerations have been offered concerning optimal bankruptcy procedures and possible areas for the practical implemen tation of appropriate reforms.
The majority of economists and lawyers agree that the bargaining, which in fact goes on directly between all the participants in bankruptcy, must be limited in favor of open auctioning procedures (see Section 1).
L. Bebchuk 32, followed by P. Aghion, O. Hart and J. Moore (hereinafter referred to as AHM)33, offered the following solution to this problem:
bankruptcy procedures must lead to the creation of a new corporation, wherein all interested parties may become shareholders. Such a com pany is much less in debt; the stale debts of the bankrupt company (fully, or at least in part) are traded for shares in the new corporation.
Among the decisions to be taken by shareholders, the following two, in AHM’s opinion, should be specifically mentioned: 1) whether the Bebchuk L. A New Approach to Corporate Reorganizations. – “Harvard Law Review”, 1988. Vol. 101, pp. 775–804.
Aghion P., O. Hart, J. Moore Insolvency Reform in the UK: A Revised Proposal. – “Insol vency Law and Practice”, 1995 Vol. 11, pp. 67–74.
company should be reorganized or liquidated, and 2) what should be the percentages for exchanging the former debts for shares. In accor dance with the procedures suggested by these authors, the issue of making a choice between maintaining or liquidating a company be comes to a much greater degree separated from that of income and property redistribution.
The issue concerning the future destiny of a bankrupt company, ac cording to AHM’s initial plan, must be resolved through open auction ing34. The proposals put forth during such auctioning may include not only considerations concerning the company’s reorganization, but also the terms for buying it out, which have been submitted for the consid eration by a shareholder meeting. Thus, the CEOs of another company may offer a certain price for the bankrupt company, using as a means of payment (as it often happens in reality) shares in the company for which these CEOs are working. Such a proposal under certain conditions may imply, in fact, a takeover of the insolvent company effectuated within the framework of bankruptcy procedures.
Free bidding at an auction must ensure a free choice among the widest range of possible variants envisaging different ways for utilizing the assets owned by the bankrupt company. An overall supervision over the auctioning is effected by an arbitrage court, while the decision con cerning the submitted proposals (including the proposals to liquidate the company and to purchase its property) is to be made by a share holder meeting and to be submitted for the approval of appropriate ju dicial agencies.
The submitted projects are also aimed at limiting distortions caused by the asymmetry of the informational structures. The judicial agencies responsible for supervision must carefully see to it that each of an auc tion’s participants (or potential shareholders) have free access to all the data contained in the company’s accounting reports.
In accordance with the scheme suggested by L. Bebchuk, conflicts between the owners of mortgage notes and other creditors may be set tled in the following way: the owners of preferred debt notes receive (in As D. Baird has shown, the more developed the capital markets, the stronger is the inclination of the bankruptcy procedure toward auction bidding (Baird D. The Uneasy Case for Corporate Reorganizations. – “The Journal of Legal Studies”, 1986. Vol. 15, pp. 127–147.
accordance with the amount of a specific debt) shares in a newly organized company, whereas all the other creditors, in exchange for their debt notes, are to be given options for purchasing shares in the new company. In the event when the value of a bankrupt company ex ceeds the amount of money needed for satisfying claims of all the creditors registered in a settlement in bankruptcy (or determined by a court decision), the owners (or shareholders) of the bankrupt com pany, posterior to the least preferred creditors, also receive options.
As for the cost of option implementation, it may be different for each of the specified groups of participants. Before voting, the owners of options make a decision as to which possibilities, out of those granted by their options, they are willing to implement, and, accordingly, which portion of shares they are going to buy out from the owners of pre ferred debt notes35.
When setting the prospects for reforming UK bankruptcy legislation, AHM have somewhat modified this scheme36.
The first step in implementing these procedures could become the replacement of a bankrupt company’s CEOs by an independent expert experienced in dealing with issues of bankruptcy – a “bankruptcy prac titioner”37. It is this expert and his office who put forth the company’s reorganization plan (or its sale as a going concern, or termination of its business operations and liquidation of its property). The practitioner may, of course, abstain from offering any rigid recommendations and simply present a document estimating the faults and merits of each available variant. As in the latter case, the ultimate decision is to be made by a shareholder meeting, and then be submitted for the approval of the judicial agencies.
When making a general review and critical estimation of the previ ously applied bankruptcy schemes, O. Hart, R. La Porta, F. Lopez de Silanes and J. Moore in 1997 suggested a new plan. The shares that used to be part of the former procedures were now given a new name – Bebchuk L. “Using Options to Divide Value in Corporate Bankruptcy”. NBER Working Paper ¹7614, Cambridge, Mass, 2000.
Aghion P., O. Hart, J. Moore Insolvency Reform in the UK: A Revised Proposal. – “Insol vency Law and Practice”, 1995. Vol. 11, pp. 67–74.
Under UK conditions, the functions of such an expert could be performed, according the authors, by one of investment or commercial banks, while in Germany or Japan – by the “head bank” of a financial industrial group.
“reorganization rights”. The distribution of these rights is to be effected through auction bidding.
At an “internal” auction, these rights may be purchased by a bank rupt company’s creditors, while the terms of such purchase, naturally, depend on the “degree of preference” of each of the claims. An “exter nal” auction is a public one, where any person, and primarily investors convinced in the need for the company’s reorganization, may purchase these rights from the bankrupt’s creditors. And finally, one more auc tion takes place, during which the decision as to the future destiny of the bankrupt company is made – whether it is to be liquidated or main tained – is held by a meeting of the owners of the reorganization rights38.
In the above mentioned (as well as in some other) plans, one com mon feature can be discerned: their authors are always eager to place bankruptcy procedures in the mainstream of ordinary corporate gov ernance patterns, given that after the implementation of options and final distribution of shares, a newly formed corporation will strongly re semble an ordinary joint stock company, which will have to make deci sions concerning possible ways for overcoming its financial difficulties (it should also be noted that in contrast to the former (bankrupt) com pany the new one will be free from debts that are too heavy to shoul der).
In accordance with this bankruptcy procedure, a participant (or group of participants) interested in reorganization will have to spend certain funds in order to purchase – at a more or less preferential price – the amount of shares, or “reorganization rights”, that would enable them to ensure the passing of a certain decision at a shareholder meet ing. This must induce investors to examine the real prospects for the planned reorganization with especial care. Among the drawbacks of such a scheme, one may point out the privileges (which are not neces sarily justified) granted in this instance to the owners of “the most pre ferred” obligations: these owners will be able to appropriate, without any risk, a substantial portion of the incomes resulting from the com pany’s reorganization.
In more detail this plan is described in: Hart O., R. La Porta Drago, F. Lopez de Silanes, J. Moore A New Bankruptcy Procedure That Uses Multiple Auctions. – “European Eco nomic Review”, 1997. Vol. 41, pp. 461–473.
The option based methods of settlement, suggested by Professor of Harvard University L. Bebchuk, and openness of information make these procedures more flexible. The interested parties thus get an op portunity for a certain (naturally, not very long) period of time to review the available economic data and, after evaluating the prospects for re organization, make more efficient market based decisions.
The general orientation of the above mentioned reforms can hardly be met with any serious objections. The suggested changes in bank ruptcy procedures may contribute to a more sound settlement of the central issue – that of a choice between a bankrupt company’s liquida tion or reorganization. A more clear and consistent implementation of the principle of auction bidding, both at the stage of forming the core owners of “reorganization rights” and at the stage of collecting propos als as to the company’s destiny, could, without any doubt, improve the efficiency of bankruptcy procedures.
However, the implementation of these proposals, even in developed market economies, usually encounters resistance on the part of those creditors and CEOs who can benefit greatly from the existing system of bankruptcy. At the same time, the implementation of such reforms is fraught with some practical difficulties (the need to change bank ruptcy’s legislative base, the shortage of highly qualified independent experts who are playing a central role in all abovementioned plans, the inevitably high expenditures involved in the organization of proposed auctions, etc.).
Lately, there have appeared quite a few theoretic studies on the de velopment of optimal bankruptcy procedures39. In some of them, a comparatively more flexible approach can be detected: for different economic systems, similarly different optimal bankruptcy rules are of See, e.g., Povel P. “Optimal “Soft” and “Tough” Bankruptcy Procedures” Financial Mar kets Group. Discussion Paper No. 240, London School of Economics: London, 1996;
Berkovich E., R. Israel, J. Zender Optimal Bankruptcy Law and Firm Specific Investments. – “European Economic Review”, 1997. Vol. 41, pp. 487–497; Berkovich E., R. Israel, J.
Zender The Design of Bankruptcy Law: a Case for Management Bias in Bankruptcy Reor ganizations. – “Journal of Financial and Quantitative Analysis”, 1998. Vol. 33, pp. 441– 464.
fered. Below we are going to discuss in somewhat more detail one of such models40.
The central role in this model is played by the quality of the borrower company’s management (which reveals itself, in particular, in the de gree of efficiency of the investment project chosen by a CEO) and the asymmetrical structure of information flows. The main actors, as be fore, are the Creditor and the Manager.
In the theoretic model discussed by the authors, the group of vari ables that influence cash inflow to the company contains ì, which char acterizes the project’s “quality” at moment t=1. By that time, the credit contract has already been signed (it is signed at moment t=0). The Manager succeeds in obtaining timely information (at t=1) concerning the value of ì. At moment t=1 the Creditor, who does not possess direct information as to the value of ì, makes a decision, in accordance with which he may expect debt settlement at moment t=2 or initiate pro ceedings in bankruptcy against the borrower.
This signal model is reflexive: an important role is played therein not only by the question as to how high the possibility is that the Creditor will be able to find out the true value of ì (in accordance with the model’s assumptions, the probability that the Creditor will be able to find out the exact value of ì is 1–r), but also by another question that as to what the Manager may know about the actual estimation of the value of ì having been made by the Creditor. Therefore, two types of information structures are distinguished: those where the Manager at moment t=knows only structural characteristics (1–r), that is, only the probability that after the realization of a random value of ì the Creditor, shortly af ter the Manager, will be able to determine its value (this type of informa tion in named “soft information” by the authors), and those where the Manager, by taking advantage of the existing economic institutions, is able to know exactly the Creditor’s notions as to the value of ì (hard information).
The classification of economic, or, more exactly, financial systems in this paper is rather traditional; the authors apply well known schemes Berkovich E., R. Israel Optimal Bankruptcy Laws Across Different Economic Systems. – “The Review of Financial Studies”, 1999. Vol. 12, pp. 347–377.
suggested in the mid 1990s by F. Allen and D. Gale41. The following main groups are singled out:
1. Systems based on the capital market’s functioning. This type of the economy is characterized by the greatest “depth” in the develop ment of financial markets, in particular the securities markets. The best example of such a system, in the authors’ opinion, is the US economy.
In these systems, soft information structures prevail, while probability (1–r) must be high enough.
2. Systems where the central role is played by large financial inter mediaries, primarily banks (in the terminology of Allen and Gale, “the German model”). Owing to active monitoring, banks possess a vast body of information, which, according to the authors, predetermines high values of probability (1–r). At the same time, close economic links between banks and non financial companies make it possible to as sume that there exists the prevalence of hard information structures.