Bargaining Around Bankruptcy: Small Business Workouts and State Law
68 Pages Posted: 25 Jan 2008 Last revised: 2 Feb 2008
Date Written: January 2008
In the United States, few failing businesses invoke the Bankruptcy Code to reorganize or liquidate. Most use non-bankruptcy procedures to accomplish the same purposes. These procedures include voluntary agreements between the debtor and its creditors (workouts) and formal devices such as friendly foreclosures, bulk sales, and assignments for the benefit of creditors. This paper documents the importance of non-bankruptcy procedures using firm-level data from Cook County, Illinois. I find that these procedures are used by eighty percent of distressed small businesses. The paper also identifies the conditions under which a business chooses federal bankruptcy law over non-bankruptcy procedures. I model this choice - theoretically and empirically - as the outcome of a bargaining game between the debtor's owner and its senior lenders. The parties are more likely to consent to non-bankruptcy procedures when bargaining costs are low and when the debtor has maintained a close relationship with senior lenders, who trust the information provided by the owner. When the number of senior lenders is relatively large (raising bargaining costs) or when the debtor has defaulted on senior debt (thereby harming its relationship with lenders), senior lenders are more likely to push for a federal bankruptcy filing. Owners may also prefer a federal filing when in-bankruptcy rules give greater priority to particular creditors whom the owner would like to favor. These findings suggest that federal bankruptcy reforms, such as the Bankruptcy Abuse and Protection Act of 2005, will have two effects on distressed small businesses: They will impact outcomes in federal courts (intensive margin) as well as the debtor's choice between bankruptcy and non-bankruptcy procedures (extensive margin). Variation along the extensive margin can neutralize reforms in federal law, as when a reform designed to protect unsecured creditors raises the cost of federal law and induces businesses to use cheaper non-bankruptcy procedures instead.
Keywords: Bankruptcy, small business, corporate reorganization, debt collection, state law, assignment for the benefit of creditors, empirical
JEL Classification: K29, G33
Suggested Citation: Suggested Citation