Conflicts of Interest and Market Illiquidity in Bankruptcy Auctions: Theory and Tests

Abstract

I develop and estimate a model of cash auction bankruptcy using data on 205 Swedish firms. The results challenge earlier arguments that cash auctions, as compared to reorganizations, (1) are immune to conflicts of interest between claim holders, but (2) lead to inefficient liquidations. I show that a sale of the assets back to incumbent management is a common outcome of the bankruptcy auction. Such salebacks are more likely when they favor the bank at the expense of other creditors. Hence, conflicts of interest can affect the outcome in cash auctions as well. On the other hand, inefficient liquidations are frequently avoided through salebacks when markets are illiquid, i.e. when industry indebtedness is high and the firm has fewer nonspecific assets. One conclusion is that cash auction procedures, when actually implemented, tend to work in a very similar way to reorganization procedures such as the Chapter 11.

JEL Classification: G33