Auctions in Bankruptcy
37 Pages Posted: 3 Jul 1999
Date Written: April 1999
A number of proposals for reforming Chapter 11 suggest that a mandatory cash auction of the bankrupt firm would lead to more efficient investment outcomes than a reorganization based system. However, recent empirical work describing reorganizations in European countries which mandate the sale of the bankrupt firm suggests that inefficient investment outcomes persist even in these settings - the investment outcomes from these auctions are strikingly similar to reorganizations in the U.S. in several respects. This evidence has motivated us to examine more carefully from a theoretical perspective the bidding process for bankrupt firms, in order to sort out the relative merits (or inefficiencies) of a reorganization versus a mandatory auction based system.
We first model a mandatory cash auction bankruptcy. We show that aggressive bidding by a coalition of incumbent management and pre-bankruptcy creditors may deter outside bidders, may result in the coalition paying more than its valuation to acquire the firm, and may result in assets remaining in a lower value use. We then examine a bankruptcy law similar to Chapter 11, where management may voluntarily seek an auction. Management's choice to seek an auction conveys information about the coalition's valuation, which facilitates competition. When management is aligned with junior creditors and the assets of the bankrupt firm are more valuable to an outsider, a transfer of control may in fact be more likely to occur in Chapter 11 than with a mandatory auction.
Our results show that even under a mandatory auction bankruptcy system, the outcome is not independent of the firm's claims structure, and assets are not always transferred to the highest valued use. Overall, our model points out several sources of potential inefficiencies in mandatory auctions versus Chapter 11 and contributes toward defining the issues to be considered in designing an efficient bankruptcy mechanism.
JEL Classification: D44, G32, G33, G34
Suggested Citation: Suggested Citation