Goals of a Bankruptcy Procedure

Nothing so far implies that the formal bankruptcy procedure needs to be provided by the state rather than by the parties themselves. In a world of costless contracting, debtors and creditors would anticipate the possibility of default and the consequent collective action problems and specify as part of their initial contract what should happen in a default state--in particular, whether the company should be reorganized or liquidated and how its value should be divided up among various claimants.

In practice, transaction costs may be too large for debtors and creditors to design their own bankruptcy procedure contractually, particularly in situations where debtors acquire new assets and new creditors as time passes. Instead, parties may prefer to rely on a 'standard form' state-provided bankruptcy procedure. It is a long way from this observation, however, to any conclusions about the nature of an optimal standard-form procedure. The problem is that a satisfactory analysis of an optimal procedure requires a theory both of why contracts are incomplete, and of how the state can overcome this incompleteness.

As mentioned above, the analysis does not proceed from first principles. However, economic theory suggests that the following are desirable goals for a bankruptcy procedure.

1. A good bankruptcy procedure should achieve an ex post efficient outcome (that is, an outcome that maximizes the total value of the proceeds--measured in money terms--received by the existing claimants).

2. A good bankruptcy procedure should preserve the (ex ante) bonding role of debt by penalizing managers adequately in bankruptcy states. However, bankruptcy should not be soharsh that managers try to avoid it at any cost, e.g. by 'gambling' with the company's assets.

3. A good bankruptcy procedure should preserve the absolute priority of claims; that is, the most senior creditors should be paid off before anything is given to the next most senior creditors, and so on down the ladder (with ordinary shareholders at the bottom).