Who Should Pay for Bankruptcy Costs?

45 Pages Posted: 1 May 2003  

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Arturo Bris

IMD International; European Corporate Governance Institute (ECGI); Yale University - International Center for Finance

Alan Schwartz

Yale Law School

Date Written: February 17, 2004

Abstract

The fees of experts (financial advisors, lawyers, accountants) are a substantial fraction of bankruptcy costs. Scholars have considered how best to reduce these costs, but have not considered how they should be allocated among creditors. The allocation issue is important because creditors can spend redistributionally (to violate or uphold absolute priority) and productively (to increase the value of the bankrupt firm). An efficient bankruptcy cost allocation scheme should discourage redistributional and encourage productive creditor spending.

We consider the desirability of various allocation schemes in a model in which senior and junior creditors can engage in both types of spending but the bankruptcy court cannot distinguish productive from rent seeking activities. We suppose that the senior claim is at or in the money. This implies that the seniors have an incentive to spend only to defend their position while the juniors have both good and bad incentives: to spend productively on value improvement because they are residual claimants and to spend redistributionally because they are partly or totally out of the money under absolute priority. A good bankruptcy cost allocation scheme thus should induce the seniors to spend more and the juniors to spend less.

We show: (i) The current US cost allocation system is unsatisfactory because the scheme partially reimburses junior expenses on experts but does not reimburse seniors at all; (ii) Full reimbursement schemes that imposes all costs on one set of parties, such as seniors, juniors or the government, are dominated by partial reimbursement schemes, because these can be better tailored to encourage the right and discourage the wrong kind of spending; and (iii) A cost allocation scheme that approaches first best and is implementable would delegate the issue of expert cost reimbursement to the debtor in possession. The incentive of Chapter 11 debtors to survive would induce them partly to reimburse senior spending but not to reimburse junior spending.

Suggested Citation

Welch, Ivo and Bris, Arturo and Schwartz, Alan, Who Should Pay for Bankruptcy Costs? (February 17, 2004). Yale Law & Economics Research Paper No. 277; Yale ICF Working Paper No. 03-08. Available at SSRN: https://ssrn.com/abstract=401300

Ivo Welch (Contact Author)

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Arturo Bris

IMD International ( email )

Ch. de Bellerive 23
P.O. Box 915
CH-1001 Lausanne
Switzerland

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Yale University - International Center for Finance ( email )

Box 208200
New Haven, CT 06520
United States

Alan Schwartz

Yale Law School ( email )

P.O. Box 208215
New Haven, CT 06520-8215
United States
203-432-4030 (Phone)
203-432-8260 (Fax)

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