Bankruptcy Law and Corporate Investment Decisions
29 Pages Posted: 18 Mar 2009 Last revised: 24 Apr 2011
Date Written: May 26, 2010
Major European countries have recently adopted bankruptcy codes that strengthen entrepreneurs' power to renegotiate outstanding liabilities. Renegotiation in bankruptcy allows lenders to increase recovery rates, however it also weakens the contract's ability to solve the repeated moral hazard problem embedded in the production project. Hinging on this basic trade-off, I show in which circumstances a soft bankruptcy law that resembles Chapter 11 in the balance of lenders' and entrepreneur's rights encourages the choice of investments that privilege the achievement of long-term results. However, I also show that, in contrast to the common wisdom, soft bankruptcy can lead to the choice of investments that are biased towards the achievement of short-term outcomes.
Keywords: Bankruptcy Law, Financial Contracts, Limited Commitment, Soft budget constraint, Short-termism
JEL Classification: D82, G33, K22
Suggested Citation: Suggested Citation