This paper, focusing on the UK insolvency code, shows how the efficiency of reorganization is affected by the distribution of control rights. Control rights raise particular problems when creditors have different incentives to keep the firm as a going concern. Such differences may arise from the possession of private benefits by particular creditors; e.g. valuable business relationships which are lost if the debtor firm is liquidated. We show that the incidence of inefficient liquidations, resulting from the failure to preserve private benefits, is influenced by the size and seniority of creditors' claims. The current UK code is widely thought to give rise to inefficient liquidations (see, for example, Aghion, Hart and Moore (1992), Webb (1991), and White (1992)). This view is based upon the creditor oriented nature of the code. We show, however, that the inefficiency depends upon whether the controlling creditor in formal bankruptcy has private benefits. Our model yields predictions which are similar to the empirical findings for the United States: deviations from absolute priority are larger in workouts than in formal reorganization (Chapter 11). This is a symptom of any code where one party has a credible threat to take the firm into formal reorganization and waste assets, imposing a disproportionate cost on some creditors.
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Paper provided by European Science Foundation Network in Financial Markets, c/o C.E.P.R, 53--56 Great Sutton Street, London EC1V 0DG in its series CEPR Financial Markets Paper with number
0047.
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