How Does Bankruptcy Punishment Impact on Renegotiable Debt Contracts?

Abstract

This research investigates how legal sanctions prevailing under bankruptcy impact on debt contracting and on investing decision, when companies may engage faulty management. Unlike most papers considering a passive behavior of the bank in case of default of the borrower, the creditor and the debtor actively trade off between private renegotiation and costly bankruptcy procedure.

The model focuses on three possible equilibriums. The derived propositions are linked to empirical findings from a French database on 240 distressed firms. The first equilibrium encompasses situations when the firms behave honestly (economic efficiency) and the bankruptcy costs are avoided through private renegotiation (legal efficiency): yet, the legislator cannot directly implement this equilibrium as it does not depend on the level of legal sanctions. A second equilibrium cover situations when the firms turn to the less profitable and riskiest project (economic inefficiency) and the default is still privately solved (legal efficiency): a minimal level of sanctions may prevent the occurrence of such equilibrium. Last, we consider mixed strategies on the investment policy (partial economic efficiency): in case of financial distress, two bargains prevail (pooling or separating) and costly bankruptcy may occur (legal inefficiency).

Simulations illustrate how the bank finally chooses between these equilibriums while the legal environment becomes more severe. For moderate values of legal sanctions, banks may accept a certain level of moral hazard from their debtors, expecting to take advantage of bankruptcy punishment. An increase of sanctions changes the story, as it incites the companies to respect more their commitments. But once the optimal equilibrium prevails, any additional increase of sanctions is worthless as the decision variables do not depend on the legal environment anymore. As a result, extreme severity is not needed to ensure both economic and legal efficiency. In addition, an increase of legal sanctions is likely to reduce the contractual interest rate, as the bank is more protected by the law. A noteworthy consequence is the debtors may benefit of increased severity. Last, we find a slight modification of the law may involve a drastic adjustment of financial variables and lead to financial instability.

Keywords: Corporate Bankruptcy, Credit Lending, Interest Rate, Moral Hazard, Legal Sanctions

JEL Classification: G33, D82, D21