Nearsighted Justice

36 Pages Posted: 31 Oct 2007

See all articles by Dan Bernhardt

Dan Bernhardt

University of Illinois at Urbana-Champaign - Department of Economics

Ed Nosal

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Date Written: June 2003

Abstract

Chapter 11 structures complex negotiations between creditors and debtors that are overseen by a bankruptcy court. This paper identifies conditions under which it is optimal for the court to sometimes err in determining whether a firm should be liquidated. Such errors can affect the optimal action choices by both good and bad entrepreneurs. The authors first characterize the optimal error rate without renegotiation, providing conditions under which it is optimal for the court both to sometimes mistakenly liquidate good firms, but not bad firms. When creditors and debtors can renegotiate to circumvent an error-riven court and creditors have all of the bargaining power, the authors show that for a broad class of action choices, a blind court - one that ignores all information and hence is equally likely to liquidate a good firm as a bad one - is optimal. For another class of action choices, the optimal court design places the burden of proof on the entrepreneur. The robust feature is that in the optimal court design, the court sometimes errs in determining whether a firm should be liquidated.

Keywords: bankruptcy judge, moral hazard, adverse selection

JEL Classification: G33, D80

Suggested Citation

Bernhardt, Dan and Nosal, Ed, Nearsighted Justice (June 2003). FRB of Cleveland Working Paper No. 03-04. Available at SSRN: https://ssrn.com/abstract=1026313 or http://dx.doi.org/10.2139/ssrn.1026313

Dan Bernhardt

University of Illinois at Urbana-Champaign - Department of Economics ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-5708 (Phone)

Ed Nosal (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

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