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Control Rights, Debt Structure, and the Loss of Private Benefits: The Case of the UK Insolvency Code

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  • Julian R Franks
  • Kjell G Nyborg

Abstract

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.

Suggested Citation

  • Julian R Franks & Kjell G Nyborg, 1994. "Control Rights, Debt Structure, and the Loss of Private Benefits: The Case of the UK Insolvency Code," CEPR Financial Markets Paper 0047, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
  • Handle: RePEc:cpr:ceprfm:0047
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    Cited by:

    1. Calcagno, Riccardo & Renneboog, Luc, 2007. "The incentive to give incentives: On the relative seniority of debt claims and managerial compensation," Journal of Banking & Finance, Elsevier, vol. 31(6), pages 1795-1815, June.
    2. Nicola Gennaioli & Stefano Rossi, 2013. "Contractual Resolutions of Financial Distress," Review of Financial Studies, Society for Financial Studies, vol. 26(3), pages 602-634.
    3. Renneboog, L.D.R. & Simons, T. & Wright, M., 2005. "Leveraged Public to Private Transactions in the UK," Discussion Paper 2005-60, Tilburg University, Center for Economic Research.
    4. Stanley D. Longhofer & Stephen R. Peters, 2000. "Protection for whom? creditor conflicts in bankruptcy," Working Paper 9909R, Federal Reserve Bank of Cleveland.
    5. Bignon, Vincent & Vuillemey, Guillaume, 2016. "The Failure of a Clearinghouse: Empirical Evidence," CEPR Discussion Papers 11630, C.E.P.R. Discussion Papers.
    6. Feldhütter, Peter & Hotchkiss, Edith & Karakaş, Oğuzhan, 2016. "The value of creditor control in corporate bonds," Journal of Financial Economics, Elsevier, vol. 121(1), pages 1-27.
    7. Eckbo, B. Espen & Thorburn, Karin S., 2004. "Bidding in mandatory bankruptcy auctions: Theory and evidence," Discussion Papers 2004/16, Norwegian School of Economics, Department of Business and Management Science.
    8. Anderson, Ronald W. & Nyborg, Kjell G., 2011. "Financing and corporate growth under repeated moral hazard," Journal of Financial Intermediation, Elsevier, vol. 20(1), pages 1-24, January.
    9. Hege, Ulrich, 2003. "Workouts, court-supervised reorganization and the choice between private and public debt," Journal of Corporate Finance, Elsevier, vol. 9(2), pages 233-269, March.
    10. Calcagno, R. & Renneboog, L.D.R., 2004. "Capital Structure and Managerial Compensation : The Effects of Remuneration Seniority," Discussion Paper 2004-015, Tilburg University, Tilburg Law and Economic Center.
    11. Renneboog, Luc & Simons, Tomas & Wright, Mike, 2007. "Why do public firms go private in the UK? The impact of private equity investors, incentive realignment and undervaluation," Journal of Corporate Finance, Elsevier, vol. 13(4), pages 591-628, September.
    12. Blazy, Regis & Chopard, Bertrand, 2004. "Ex post efficiency of bankruptcy procedures: A general normative framework," International Review of Law and Economics, Elsevier, vol. 24(4), pages 447-471, December.
    13. Gennaioli, Nicola & Rossi, Stefano, 2008. "Optimal Resolutions of Financial Distress by Contract," CEI Working Paper Series 2008-6, Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University.
    14. Benjamin, David, 2006. "Fast bargaining in bankruptcy," Discussion Paper Series In Economics And Econometrics 0601, Economics Division, School of Social Sciences, University of Southampton.
    15. Kazuo Ogawa & Elmer Sterken & Ichiro Tokutsu, 2013. "The trade credit channel revisited: evidence from micro data of Japanese small firms," Small Business Economics, Springer, vol. 40(1), pages 101-118, January.

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