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Journal of Law, Economics, and Organization Advance Access originally published online on October 25, 2007
Journal of Law, Economics, and Organization 2009 25(1):2-30; doi:10.1093/jleo/ewm048
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Right arrow D86 - Economics of Contract: Theory
Right arrow G33 - Bankruptcy; Liquidation
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© The Author 2007. Published by Oxford University Press on behalf of Yale University. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org

Matching Bankruptcy Laws to Legal Environments

Kenneth Ayotte*

Northwestern University School of Law

Hayong Yun**

University of Notre Dame

* Northwestern University School of Law. Email: k-ayotte{at}law.northwestern.edu.

** University of Notre Dame. Email: hyun{at}nd.edu.

We study a model of optimal bankruptcy law in an environment where legal quality can vary along two dimensions: the expertise of judges and the quality of contract enforcement. We analyze a model in which a judicially influenced bankruptcy process can enhance the efficiency of incomplete contracts by conditioning the allocation of control rights in bankruptcy on firm quality. We consider the optimal balance of debtor and creditor interests as a function of the legal environment and show that the optimal degree of "creditor-friendliness" in the bankruptcy code increases as judicial ability to recognize firm quality falls and as the quality of contract enforcement deteriorates. Our model shows that a bankruptcy law that attempts to preserve going-concern value, such as US Chapter 11, requires judicial expertise to be effective. Where such expertise is unavailable, a law that focuses more on creditor recovery is preferred. (JEL D86, G33, G34, K22)


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