Bankruptcy Law as a Liquidity Provider
68 Pages Posted: 16 Mar 2013 Last revised: 9 Sep 2014
Date Written: 2013
Since the outset of the recent financial crisis, liquidity problems have been cited as the cause behind the bankruptcies and near bankruptcies of numerous firms, ranging from Bear Stearns and Lehman Brothers in 2008 to Kodak more recently. This paper expands the prevailing normative theory of corporate bankruptcy — the Creditors’ Bargain theory — to include a role for bankruptcy as a provider of liquidity. The Creditors’ Bargain theory argues that bankruptcy law should be limited to solving problems caused by multiple, uncoordinated creditors, but focuses almost exclusively on the problem of creditor runs. We argue that two well-known problems that cause illiquidity — debt overhang and adverse selection — are also caused by multiple creditor coordination problems. As such, bankruptcy law is justified in solving these problems in addition to creditor run problems.
With this insight in hand, we argue that many of bankruptcy’s existing rules, including debtor-in-possession financing, sales free and clear of liens, and coerced loans can be seen as liquidity-providing rules that target either debt overhang problems, or adverse selection problems, or both. Using bankruptcy to solve liquidity problems can create costs, however, such as the risk of continuation bias. We suggest rules of thumb for judges to use in balancing the benefits and costs of these rules. We also connect our theory to the use of bankruptcy for financial institutions, where liquidity concerns loom large.
Keywords: bankruptcy, liquidity, creditors' bargain, debt overhang, adverse selection
JEL Classification: G32, G33
Suggested Citation: Suggested Citation