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Protection for whom? creditor conflicts in bankruptcy

  • Stanley D. Longhofer
  • Stephen R. Peters
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    Revised. In this article we provide a rationale for bankruptcy law that is based on the conflicts among creditors that occur when a debtor’s liabilities exceed its assets. In the absence of a bankruptcy law, the private debt-collection remedies that creditors pursue when a debtor is insolvent result in an ad hoc disposal of the debtor’s assets, thereby reducing the aggregate value of creditors’ claims. We show that coordination clauses can be used by creditors in their loan agreements that will result in coordination, ex post. Although all creditors would benefit from including these clauses in their contracts, they nevertheless choose not to in precisely those circumstances in which it is desirable to coordinate. This is an important insight because previous theories supporting a role for bankruptcy law are based on the notion that creditors want to contract about bankruptcy, but cannot. In contract, we demonstrate that creditors will choose not to coordinate ex ante, even though it is in their best interest ex post. ; We also examine a variety of other contractual mechanisms, including covenants and seniority, and show that although including these terms in loan contracts can improve creditors’ incentives to write coordination clauses, they do so only in special circumstances. Our analysis of creditor conflicts and the potential for private contracting remedies provides an economic rationale for the existence of a bankruptcy law that mandates ex post coordination among the creditors of an insolvent debtor.

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    Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 9909R.

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    Date of creation: 2000
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    Handle: RePEc:fip:fedcwp:9909
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