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Title: 

Design of Efficient Bankruptcy Mechanisms

Authors: Nagarajan, S.
Issue Date: 1997
Series/Report no.: FIN-97-007
Abstract: This paper models efficient design of bankruptcy mechanisms under multi-lateral asymmetric information as a problem involving the joint-reallocation of i) existing debt claims of differing priority against the firm, and ii) the rights to control and run the firm in the event of a reorganization – when some or all claimholders may have private information. Such a unified approach yields a key insight – namely, that corporate governance structures, especially the allocation of control rights, and not just the repackaging of existing debt claims, are the main determinant of efficiency in the resolution of bankruptcy. Applying the mechanism design technique allows us to answer the question of if and when it is possible to efficiently reorganize or liquidate a financially distressed firm, in the context of a large family of bankruptcy games. It is shown that there exist incentive compatible bankruptcy mechanisms that are efficient not only ex ante, but also ex post. These are then characterized, and show to have the following properties: i) Conventional governance structures may not be efficient, and control rights may have to be allocated to minority share-holders; ii) There is no trade off between ex ante and ex post efficiency in resolving bankruptcy; iii) Only aggregate debt levels, not individual debt claims, matter; iv) All the creditors’ ex ante contractual rights will be respected, and hence cram-down is unnecessary; v) Efficient mechanisms are also strongly renegotiation-proof, in the sense that the claimholders will have no incentive to renegotiate their settlement ex post. These results hold for any type of bankruptcy game, whether bankruptcy is involuntary or strategic for any firm with any set of existing debt claims, and are independent of distributional assumptions.
URI: http://hdl.handle.net/2451/26678
Appears in Collections:Finance Working Papers

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