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Nearsighted justice

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  • Dan Bernhardt
  • Ed Nosal

Abstract

Chapter 11 structures complex negotiations between creditors and debtors that are overseen by a bankruptcy court. This paper identifies conditions under which it is optimal for the court to sometimes err in determining whether a firm should be liquidated. Such errors can affect the optimal action choices by both good and bad entrepreneurs. We first characterize the optimal error rate without renegotiation, providing conditions under which it is optimal for the court both to sometimes mistakenly liquidate "good firms," but not "bad firms." When creditors and debtors can renegotiate to circumvent an error-riven court and creditors have all of the bargaining power, we show that for a broad class of action choices, a blind court--one that ignores all information and hence is equally likely to liquidate a good firm as a bad one--is optimal.

Suggested Citation

  • Dan Bernhardt & Ed Nosal, 2003. "Nearsighted justice," Working Paper 0304, Federal Reserve Bank of Cleveland.
  • Handle: RePEc:fip:fedcwp:0304
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    References listed on IDEAS

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    1. Spier, Kathryn E, 1994. "Settlement Bargaining and the Design of Damage Awards," Journal of Law, Economics, and Organization, Oxford University Press, vol. 10(1), pages 84-95, April.
    2. Shin Hyun Song, 1994. "The Burden of Proof in a Game of Persuasion," Journal of Economic Theory, Elsevier, vol. 64(1), pages 253-264, October.
    3. Grossman, Gene M & Katz, Michael L, 1983. "Plea Bargaining and Social Welfare," American Economic Review, American Economic Association, vol. 73(4), pages 749-757, September.
    4. Michael J. Fishman & Kathleen M. Hagerty, 1990. "The Optimal Amount of Discretion to Allow in Disclosure," The Quarterly Journal of Economics, Oxford University Press, vol. 105(2), pages 427-444.
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    1. repec:spr:busres:v:10:y:2017:i:2:d:10.1007_s40685-017-0047-x is not listed on IDEAS
    2. Franks, Julian R & Lóránth, Gyöngyi, 2005. "A Study of Inefficient Going Concerns in Bankruptcy," CEPR Discussion Papers 5035, C.E.P.R. Discussion Papers.
    3. Nicola Gennaioli & Stefano Rossi, 2010. "Judicial Discretion in Corporate Bankruptcy," Review of Financial Studies, Society for Financial Studies, vol. 23(11), pages 4078-4114, November.
    4. Sami, Hind, 2009. "Random monitoring in financing relationships," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 239-252, May.
    5. Dominique Demougin & Claude Fluet, 2008. "Rules of proof, courts, and incentives," RAND Journal of Economics, RAND Corporation, vol. 39(1), pages 20-40.
    6. Ronel Elul & Piero Gottardi, 2015. "Bankruptcy: Is It Enough to Forgive or Must We Also Forget?," American Economic Journal: Microeconomics, American Economic Association, vol. 7(4), pages 294-338, November.
    7. 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.

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    Keywords

    Bankruptcy;

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