A Contract Theory Approach to Business Bankruptcy

Abstract

Business bankruptcy systems attempt to solve a coordination problem for the creditors of insolvent firms. Some insolvent firms cannot earn revenues sufficient to cover nonfinancing costs. The assets of these firms can be put to better uses elsewhere, so the assets should be sold off. Other insolvent firms earn revenues that exceed production costs but that are too low to service the firm's debt. These firms should be continued as going concerns under less leveraged capital structures. As is well known, an individual creditor is not interested in this distinction: The creditor would rather maximize returns by attaching assets sufficient to pay its claim in full. If every creditor attempts to attach assets, the firm will be liquidated piecemeal, whether it is efficient to continue the firm or not.