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Abstract:
This article proposes a new mechanism for valuing firms in bankruptcy. Under the mechanism, a court would dilute the reorganized stock issued to senior claimants by issuing additional shares to junior claimants until there was no excess demand for the stock at a price that would implement absolute priority. This mechanism could also be adapted so that a court would issue additional debt to senior claimants until there was no excess supply of the debt at a price that would implement absolute priority. We show that the mechanism harnesses the private information of the claimants and of third parties to produce distributions consistent with absolute priority. The dilution mechanism can be superior to other information-harnessing devices (such as an option or auction approach) because it (i) is less susceptible to the problem of junior illiquidity than an option approach proposed by Lucian Bebchuk; (ii) is less susceptible to the problem of market manipulation and may better allocate control premia than a partial float proposal by Mark Roe; and (iii) may produce fewer transaction costs than a full auction approach proposed by Douglas Baird. Moreover, as a response to the Supreme Court's recent admonishment in LaSalle Street that bankruptcy courts employ market tests more often when creditors dissent to a reorganization plan, the dilution mechanism provides a uniquely workable solution within the current statutory framework.

Abstract:
This paper uses a principal/agent framework to analyze consumer bankruptcy. The bankruptcy discharge partly insures risk averse borrowers against bad income realizations, but also reduces the borrower's incentive to avoid insolvency. Among our results are: (a) High bankruptcy exemptions increase bankruptcy insurance but at the cost of reducing the borrower's incentives to stay solvent; (b) Reaffirmations -- renegotiations -- have ambiguous efficiency effects in general, but the right to renegotiate is especially valuable for relatively poor persons; (c) Giving consumers the ex post choice regarding which bankruptcy chapter to use also provides more insurance but, by making bankruptcy softer on debtors, has poor incentive effects; (d) Serious consideration should be given to expanding the scope of consumers' ability to contract about bankruptcy because private contracts are better than regulations at making context sensitive tradeoffs between risk and incentives.

Abstract:
The rules of bankruptcy reorganization in the United States permit a judge to permit a debtor's retention of collateral for a loan even over the objection of the secured creditor; the results may include continuation of inviable firms, violations of absolute priority, and high transactions cost. An alternative would grant a secured creditor the unfettered right to retain its collateral; the results might include liquidation of viable firms, violations of absolute priority, and high transactions cost. Proposed here is a mechanism that mediates between these imperfect options: junior interests would control the bankruptcy process and would, on behalf of the debtor, propose a reorganization plan that could include a take-it-or-leave-it offer for collateral, with certain liquidation of the collateral the consequence if the secured creditor rejects the plan. This process would preserve any significant debtor going-concern surplus and largely honor absolute priority. The mechanism would, therefore, promote ex post as well as ex ante efficiency. Moreover, because a take-it-or-leave-it offer process neither requires negotiation nor permits litigation, the parties would be spared the risk of bargaining expense or breakdown and would be saved the cost of persuasion or proof with respect to values the parties know or can reasonably estimate.

Bankruptcy, Corporate Finance, Secured Claim, Valuation, Uncertainty, Information Asymmetry

Abstract:
The Bankruptcy Reform Act of 1978 placed corporate managers in control of corporate debtors in bankruptcy and of the bankruptcy process. Although the act remains law, between 2000 and 2001 it became common for creditors to control financially distressed firms and the bankruptcy process. This study tests whether the change from manager to creditor control created or exacerbated managerial incentive to delay filing for bankruptcy or gave secured creditors an opportunity to delay such filing. We observe a significant and prolonged deterioration in the financial condition of firms that filed for bankruptcy after 2001 as compared to firms that filed before 2000. We alsoobserve patterns of operating losses and liquidations that suggest adverse economic consequences from such delay.

Bankruptcy, Incentives, Bankruptcy Initiation, Economic distress, Financial distress

Abstract:
In a common commercial pattern, the seller of a standard product contracts with one buyer and then sells to another at the contract price after the initial buyer breaches. Sellers argue, and courts largely agree, that the seller could have served the contract buyer as well as the later buyer; hence, the seller is entitled to retain a down payment to the extent of, or sue to recover, the profit - price less cost - that it would have realized on the initial sale had that sale been completed. Some courts and many scholars disagree, arguing that resale of the contract product at the contract price is fully compensatory; consequently, the seller is not entitled to damages. In this paper, we show that sellers in these "lost volume" contexts may use non-refundable down payments and later transaction prices in an attempt to practice second degree price discrimination. Sellers select among combinations of low down payment and high transaction price - which maximize the number of contracts as these serve low-value buyers, who are relatively unlikely to trade and pay the transaction price but who would be deterred by a significant down payment - and combinations of high down payment and low transaction price - which maximize the likelihood of transaction given a contract and serve high value buyers, who are relatively undeterred by a high down payment as they expect to benefit from increased trade at the low transaction price. These disparate preferences sometimes enable sellers to induce separation among the buyers by offering contracts that differ in their down payment/transaction price combinations. As a positive matter, we identify a form of price discrimination that does not require the seller to vary either the quantity or the quality of goods sold to an individual buyer. As a normative matter, we argue that a rule enforcing price discrimination contracts - i.e., restricting sellers to retention only of the down payment - is preferable to any mandatory rule on the treatment of liquidated damages as well as to the current majority default rule, which permits sellers to recover lost profits when they exceed the down payment, or the current minority default rule, which permits sellers to recover nothing.

Contracts, Damages, Remedy, Commercial Law, UCC

Abstract:
Abstract. In the late 1980s and early 1990s, contract-law scholars introduced and debated the merits of what has become known as "penalty-default theory." This theory, founded on the venerable case of Hadley v. Baxendale, suggests that lawmakers should fill gaps in contracts with punitive rules designed to elicit information from recalcitrant parties. The theory has been controversial, as it advances an untraditional role for contract default rules. Despite the controversy, to-day penalty-default theory is widely accepted as a plausible approach to the issues presented by incomplete contracts. The ambition of this essay is to upset the accepted wisdom. The paper demonstrates that the structure of penalty-default theory rests on a faulty implicit premise. The premise is that damages from breach of contract are certain. In fact, damages are stochastic. Con-sequently, the standard penalty-default model underestimates the incentive of a party to conceal information even though the party is subject to a penalty-default rule. The robust nature of this incentive, which is shown to exist generally, greatly complicates the evaluation of a default rule's efficacy. Thus, a lawmaker should be skeptical of her ability to choose an efficient penalty-default rule, the seeming simplicity of the Hadley case notwithstanding.

Abstract:
Named for the Supreme Court opinion in Butner v. United States, the Butner principle holds that bankruptcy law should be merely procedural and should honor state law entitlements rather than impose a set of substantive federal priority rules. The Butner principle has become a cherished axiom, but it is founded on the faulty premise that destructive forum shopping would be the result if bankruptcy law provided its own entitlements. The Butner principle should be discarded and courts or Congress should adopt a sensible federal priority regime, one that includes super-priority for tort victims.

Bankruptcy, Priority, Tort, Federalism

Abstract:
In North LaSalle Street, the Supreme Court took an important step in insisting that new-value contributions in Chapter 11 bankruptcy reorganizations be tested by competitive market forces. This paper argues that, although the Court's statutory reading of the absolute priority rule is flawed, its policy decision to limit the debtor's exclusive right to propose a purchase of new equity by old shareholders is a step in the right direction. By analogy to the repricing of executive stock options, the paper shows that the conditions under which the continued equity participation by old owners is efficient - even in the case of owner-managed firms - are very narrow. Therefore, the decision to effectively reprice equity interests (by reducing the firm's debt and extending its maturity) should be left to negotiation among the parties rather than imposed by law as a default. The paper concludes with the hope that courts will seize on the implicit signal of the Supreme Court's decision and extend market-based checks to a broader range of judicial valuation determinations in Chapter 11 cases.

Abstract:
A party in breach of contract cannot sue the victim of breach to recover what would have been the victim's loss on the contract. The doctrinal rationale is simple: A violator should not benefit from his violation. This rationale does not, however, provide an economic justification for the rule. Indeed, efficient breach theory is founded on the proposition that a breach of contract need not be met with reproach. Yet the prospect of recovery by the party in breach - that is, the prospect of negative damages - has received scant attention in the contracts literature. Close analysis reveals potential costs to disallowance of negative damages, particularly where a party with private information about the benefits of termination also has an incentive to continue under the contract. These costs can arise both ex post, at the time of a performance-or-termination decision, and ex ante, in anticipation of that decision. Nevertheless, allowance of negative damages could impose its own costs, where background information would create an incentive to repudiate a contract before either party could gather more information, for example. Ex ante contractual provisions, such as liquidated-damages or specific-performance clauses, permit parties some latitude to balance the costs of disallowance and allowance of negative damages, albeit imperfectly. Common law limitations on the mitigation duty may be seen as a mechanism to approach this balance in the absence of an explicit contractual solution.

Contracts, Efficient Breach, Remedies, Damages