Bankruptcy and the financial crisis

Andrei ShleiferIMF presentation

May 26, 2009

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• Reorganization of insolvent firms is a crucial institution of a market economy

• It works poorly in most countries, especially developing ones

• The problem is critical now, in the middle of the crisis

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• Discuss a study of insolvency in 88 countries conducted with S. Djankov, O. Hart, C. McLeish (JPE 2008)

• Consider some implications for insolvency laws

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SetupHypothetical Case

Respondents: Insolvency Practioners fromInternational Bar Association Committee onBankruptcy

Date: January 2006 (several rounds before)

Total: 344 lawyers

All countries with: GDP per capita > $1000 Population > 1.5 million

Total: 88 countries

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Case FactsInsolvent Firm called “Mirage”Limited liability, domestically owned, medium-sized hotelLocated in most populous city201 employees50 suppliers (each owed money)

Five years ago, borrowed from BizbankLoan has collateral, i.e., is securedLoan has 10 year termMirage has met all obligations until nowLoan has seniority

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Case Facts (cont’d)

Mirage owned 51% by Mr. DouglasNo other shareholder has > 5%Mirage has a manager, with no special human capital

Mirage has 136 units of debtSuppliers, Tax Authorities, employees each owed 12These are unsecured creditorsBizbank is owed 100All normalized to country’s GDP per capita

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Case Facts (cont’d)Mirage has been losing money and is about to default due to industry shockAssume going forward can cover costsBut cannot cover debt payments

Version A: Going concern worth 100Piecemeal liquidation worth 70

Version B: Going concern worth 70Piecemeal liquidation worth 100

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DataTime = T

Cost = C

Whether get the efficient outcome: EO = 1

Efficiency =

Assume zero net revenue during procedure and costsincurred at end (but robust)

Also get structural features of procedure

TrCEOEO

)1(100*)1(*70*100

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Foreclosure

3 Procedures 2 Outcomes

Reorganizationfirst

Liquidation

Piecemeal sale

Going Concern

Figure 1: Options for Mirage

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Limitations of the Case

1. No informal workouts allowed2. Capital structure does not adjust to law3. Only one secured creditor Complex conflicts minimized (Indeed, foreclosure has correct incentives)4. Respondents know what is efficient from the start5. Do not need new financing6. No public interest, politics involved7. No tunneling (looting)

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(Tentative) Conclusions• Lots of inefficiency in a very simple case: wrong

outcome, slow, high administrative costs• How to do better?

Encourage foreclosure and floating charge Circumscribe Appeals Discourage automatic cessation of operations Don’t allow suppliers/customers to rescind contracts

• Reorganization seems a bad idea in poor countries, where, arguably, institutions are not good enough to support complex procedures.

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• What are the implications for today?• Assume bankruptcy reform cannot be done

on short notice• Massive bankruptcies would be terrible for

efficiency• Fire sale liquidations are bad for everyone• But also do not want debt forgiveness• Suggestion: encourage private

renegotiation, perhaps even subsidize it