Optimal Timing and Legal Decisionmaking: The Case of the Liquidation Decision in Bankruptcy

Abstract:     
Until the firm is sold or a plan of reorganization is confirmed, Chapter 11 entrusts a judge with the decision of whether to keep a firm as a going concern or to shut it down. The judge revisits this liquidation decision multiple times. The key is to make the correct decision at the optimal time. This paper models this decision as the exercise of a real option and shows that it depends critically on particular types of information about the firm and its industry. Liquidations take place too soon if we merely compare the liquidation value of the assets with the expected earnings of the firm. Moreover, existing law undermines effective decisionmaking. Even though the judge makes the liquidation decision, a number of rules prevent the judge from controlling the timing of the decision, and those who do control it lack the incentive to ensure it is made at the optimal time. The paper introduces a framework that can illuminate many areas of law, such as summary judgment motions, parole, and agency rule making.

Working Paper Series