Heterogeneous Beliefs and the Choice between Private Restructuring and Formal Bankruptcy

Abstract

We present a theory for the puzzling issue regarding why certain firms in financial distress, prefer a costlier formal bankruptcy procedure over direct renegotiations. We show that claimholders' heterogeneous beliefs about the results of a formal plan and about judicial discretion may lead to such a preference. The proposed model predicts which resolution would be chosen under claimholders' beliefs about the determinants driving the outcome of a formal procedure, such as the extent to which firm value is affected by bankruptcy, the likelihood of deviation from the absolute priority rule, and the probability of the court adopting a reorganization plan.

Keywords: formal procedure, informal process, heterogeneous beliefs, judicial discretion, bankruptcy, liquidation

JEL Classification: G12, G32, G33