Who Should Pay for Bankruptcy Costs?

Abstract:     
The fees of experts (financial advisors, lawyers, accountants) are a substantial fraction of bankruptcy costs. Scholars have considered how best to reduce these costs, but have not considered how they should be allocated among creditors. The allocation issue is important because creditors can spend redistributionally (to violate or uphold absolute priority) and productively (to increase the value of the bankrupt firm). An efficient bankruptcy cost allocation scheme should discourage redistributional and encourage productive creditor spending.

We consider the desirability of various allocation schemes in a model in which senior and junior creditors can engage in both types of spending but the bankruptcy court cannot distinguish productive from rent seeking activities. We suppose that the senior claim is at or in the money. This implies that the seniors have an incentive to spend only to defend their position while the juniors have both good and bad incentives: to spend productively on value improvement because they are residual claimants and to spend redistributionally because they are partly or totally out of the money under absolute priority. A good bankruptcy cost allocation scheme thus should induce the seniors to spend more and the juniors to spend less.

We show: (i) The current US cost allocation system is unsatisfactory because the scheme partially reimburses junior expenses on experts but does not reimburse seniors at all; (ii) Full reimbursement schemes that imposes all costs on one set of parties, such as seniors, juniors or the government, are dominated by partial reimbursement schemes, because these can be better tailored to encourage the right and discourage the wrong kind of spending; and (iii) A cost allocation scheme that approaches first best and is implementable would delegate the issue of expert cost reimbursement to the debtor in possession. The incentive of Chapter 11 debtors to survive would induce them partly to reimburse senior spending but not to reimburse junior spending.

Working Paper Series