Judicial Discretion in Corporate Bankruptcy

Transcription

1 Judcal Dscreton n Corporate Bankruptcy Ncola Gennaol and Stefano Ross Ts verson: November 2008 Abstract We study a demand and supply model of judcal dscreton n corporate bankruptcy. On te supply sde, we assume tat bankruptcy courts may be based for debtors or credtors, and subject to career concerns. On te demand sde, we assume tat debtors (and credtors) can engage n forum soppng at some cost. Akeyfndng s tat stronger credtor protecton n reorganzaton mproves judcal ncentves to resolve fnancal dstress effcently, preventng a "race to te bottom" towards neffcent uses of judcal dscreton. Te comparatve statcs of our model sed lgt on a wealt of evdence on U.S. bankruptcy and yeld novel predctons on ow bankruptcy codes sould affect frm-level outcomes. JEL classfcaton: G33, K22. Keywords: Judcal Dscreton, Corporate Bankruptcy. Unverstat Pompeu Fabra, E-mal: ncola.gennaol@upf.edu; and Stockolm Scool of Economcs, E-mal: stefano.ross@s.se. We are grateful for elpful suggestons from partcpants at te Worksop n Publc and Prvate Resolutons of Fnancal Dstress n Venna, June 2007, at te Worksop n te Teory of Organzatons at te Unversty of Ccago GSB, at te Unversty of Brts Columba Wnter Conference at te Sauder Busness Scool, and at semnars at te Unversdad Carlos III, Madrd, te Stockolm Scool of Economcs, te Tanaka Busness Scool, te Tuck Scool of Busness at Dartmout College and te Unversty of Zurc. We ave receved elpful comments from Ken Ayotte, Antono Cabrales, Vedran Capkun, Douglas Damond, Espen Eckbo, Ron Gammarno, Mlton Harrs, Crstan Leuz, Cance Prendergast, Jos Rau, Lus Rayo, Pablo Ruz-Verdú, Andre Slefer, Alex Stomper, Per Strömberg, Amr Suf, Oren Sussman, Angel Vecana.

2 1 Introducton Judcal dscreton s a central feature of state-mandated bankruptcy procedures. Eter drectly or troug te appontment of admnstrators, bankruptcy judges routnely sape te approval of reorganzaton plans and te extent of dstressed fnancng, wc n turn can crucally sape te resoluton of fnancal dstress. 1 But ow does judcal dscreton work? Te leadng vew olds tat under dscreton judcal dosyncrases sape te resoluton of fnancal dstress (e.g. Wess and Wruck 1998). It s ndeed te case tat bankruptcy outcomes vary enormously across bankruptcy judges, sometmes favorng debtors, some oter tmes favorng credtors (Brs et al. 2006, Cang and Scoar 2006). However, ts vew cannot explan, among oter tngs, wy judcal dosyncrases do not average out just lke pure nose. For example, as Franks and Torous (1993) put t, U.S. Capter 11 s systematcally pro-debtor because t as strong ncentves to keep te frm as a gong concern even wen t s wort more n lqudaton. 2 We present a smple Econ101 demand and supply model of judcal dscreton tat parsmonously ratonalzes wy resolutons of fnancal dstress dffer across courts but do not average out wtn a gven code, and yelds an array of novel predctons on te workngs of court-supervsed bankruptcy procedures and ter mpact on frm level outcomes. One key fndng s tat te workngs of judcal dscreton are crucally saped by credtor protecton n reorganzaton: only wen credtor protecton s strong enoug does judcal dscreton generate a "race to te top" towards effcent resolutons of fnancal dstress. Pror semnal work on judcal dscreton n bankruptcy (Gammarno and Nosal 1994; Bernardt and Nosal 2004) focused on weter random judcal mstakes are desrable. We nstead explctly model judcal decson-makng by recognzng tat te forces of demand and supply sape te way bankruptcy judges use ter dscreton, as tey do wt market producers n tradtonal economc analyss. Our model nges on two man assumptons. On te supply sde, n lne wt Gennaol (2005) and Gennaol and Slefer (2007) we assume tat bankruptcy judges can be based n 1 For example, U.S. Capter 11 leaves bankruptcy courts dscreton on ssues suc as frst day orders, refnancng, extensons of exclusvty, appontments of trustees, and te fnal approval of a reorganzaton plan. As Glson (1991) puts t, Capter 11 "effectvely requres judges to set corporate operatng polces". Recent estmates suggest tat te prce of judcal dscreton n fnancal markets can be very large. Ayotte and Gaon (2006) fnd tat credt spreads ncreased by about 30 bass ponts for Capter 11-elgble securtzers mmedately after a controversal judcal decson n te Capter 11 bankruptcy of LTV Steel, n wc a securtzaton contract was unexpectedly treated by te judge as a secured loan, and as suc subject to automatc stay. 2 Poltcal economy teores (e.g. Skeel 2001, Bolton and Rosental 2002) explan te systematc pro-debtor bas of bankruptcy laws wt te poltcal preferences of legslators, but cannot explan wy resolutons of fnancal dstress vary across bankruptcy courts because tey assume judcal dscreton away. 1

3 favor of debtors or credtors. On te demand sde, we assume tat n fnancal dstress debtors and/or credtors can coose were to fle for bankruptcy ("forum soppng"), subject to some legal restrctons. Ts s consstent wt U.S. evdence, wereby about 60% of te large Capter 11 cases between 1980 and 2005 as been classfed as forum soppng (e.g. Lo Puck 2005, Ayotte and Skeel 2004). In our basc model we assume tat only debtors can forum sop, consstent wt te evdence tat about 95% of large U.S. Capter 11s flngs are ntated by debtors (Lo Puck 2005). We ten consder te general case were bot debtors and credtors can forum sop n Secton 5. In ts setup, we nvestgate te role of credtor protecton, parameterzed as te sare of reorganzaton proceeds tat can be pledged to credtors. Wle we tnk prmarly of credtor protecton as te extent of volatons of absolute prorty (Franks and Torous 1989), ts parameter can also capture prvate benefts of control (Agon and Bolton 1992) or even debtors tunnelng of corporate assets durng reorganzaton, especally n developng countres (Djankov et al. 2006). Secton 2 llustrates our statc model. In ts model, debtors naturally fle n pro-debtor courts tat over-reorganze bankrupt frms. Tus, te demand sde of our model can create a systematc pro-debtor bas of te bankruptcy code, even f ndvdual judges are on average unbased. Secton 3 ten presents a dynamc verson were judges also care about attractng future, large bankruptcy cases. Interestngly, under career concerns tere s a poolng equlbrum were even unbased and pro-credtor judges over-reorganze to establs a pro-debtor reputaton and try to attract future flngs. Tus, under career concerns te supply sde of our model can amplfy te systematc pro-debtor bas of te bankruptcy code. Our man fndng s tat stronger credtor protecton reduces te systematc pro-debtor bas of bankruptcy outcomes by sapng bot te supply and te demand of judcal dscreton. Tree effects are smultaneously at work n te same drecton. Frst, by reducng te rents earned by debtors n reorganzaton, ger credtor protecton reduces debtors ncentve to forum sop. Ts demand effect drectly reduces te systematc pro-debtor bas by dampenng te sortng of cases n pro-debtor courts. Second, under career concerns an ncrease n credtor protecton nduces a dynamc supply effect: antcpatng future lower demand, unbased and pro-credtor judges ave fewer ncentves to establs a pro-debtor reputaton, wc also reduces pro-debtor bas today. Fnally, ger credtor protecton reduces debtors rents n reorganzaton, n turn reducng te ncentve of pro-debtor judges to over-reorganze a bankrupt frm (te statc supply effect). Ts analyss yelds two mplcatons. Frst, our model predcts tat ger credtor protecton n 2

4 reorganzaton sould reduce te systematc pro-debtor bas of bankruptcy outcomes. By mprovng judcal ncentves, ger credtor protecton avods a race to te bottom towards any neffcent use of judcal dscreton. Interestngly, Secton 4 sows tat a smlar predcton follows from an ncrease n legal restrctons to forum soppng. Our model tus provdes two novel potental determnants of te varaton of systematc bas across bankruptcy codes. Second, our career concerns model sows tat exstng attempts to emprcally dentfy te consequences of forum soppng (Lo Puck 2005, Ayotte and Skel 2004), wc nge on comparng bankruptcy outcomes n dfferent courts, say Ccago and Delaware, are lkely to underestmate te consequences of forum soppng and te extent of pro-debtor bas because tey overlook tat forum soppng nduces an endogenous ncrease n te pro-debtor stance of all courts. Secton 5 augments our basc framework by studyng addtonal demand and supply sfters. Frst, we allow some courts to be faster tan oters. In ts setup, forum soppng benefcally allows te sortng of cases nto fast courts, wc n turn as conflctng effects on judcal career concerns. On te one and, te dynamc supply effect s amplfed as fast, pro-debtor courts face an even greater future demand, at least as long as speed and unbasedness are uncorrelated. On te oter and, snce fast courts can attract cases rrespectve of ter lqudaton polcy, ter wllngness to cater to debtors falls, reducng te possblty for a poolng pro-debtor equlbrum to arse. More generally, forum soppng to fast courts can be benefcal under farly general condtons. In ts context, strong credtor protecton and low legal restrctons to forum soppng create ncentves for benefcal competton among courts, tereby generatng a race to te top towards more effcent resolutons of fnancal dstress. Second, we study te case n wc even credtors can forum sop wt some probablty, and we sow tat under some condtons a systematc pro-credtor bas wll follow. In ts sense, our analyss sows tat te party n control of te venue coce as an ncentve to fle n a sympatetc court, tereby generatng a systematc bas. Trd, we study te case n wc judges observe a nosy sgnal of te frm s reorganzaton value and sow tat te costs of judcal bas and tus of forum soppng are greater for frms n more nnovatve ndustres, facng more uncertan future prospects. In sum, our demand and supply model of judcal dscreton provdes a flexble framework to study te determnants of te workngs of court-supervsed bankruptcy procedures, provdng predctons on te volume and composton of forum soppng, te sze and drecton of systematc bas, and on te varaton of bankruptcy outcomes across frms. Secton 6 llustrates ow our model can ratonalze a wealt of cross-secton and tme seres evdence on U.S. Capter 11. 3

5 2 Te Statc Model We now present a basc demand and supply analyss of judcal dscreton. An exstng frm s n fnancal dstress. Te frm as current cas flow of zero, as defaulted on ts debt, and as entered a formal bankruptcy procedure under court supervson. 3 To resolve fnancal dstress, t must be decded weter te frm s reorganzed or lqudated pecemeal. Here we focus on ex post outcomes n bankruptcy; Appendx 2 studes te ex ante consequences of court beavor, along wt some contractual reactons to judcal dscreton. Te value of te frm under pecemeal lqudaton s λ>0. Te reorganzaton value of te frm equals, a random varable takng values and wt probablty 1/2, were>λ>. As a result, lqudaton s ex post effcent f and only f te reorganzaton value s. Investors are pledged te full lqudaton value λ but only a fracton α of te reorganzaton proceeds. Te remanng sare (1 α) of te reorganzaton proceeds goes to te debtor. Tus, te debtor prefers reorganzaton to lqudaton even f te latter s socally effcent because under lqudaton e obtans zero wle under reorganzaton e obtans (1 α). Parameter α playsakeyrolenour analyss and can be tougt of as measurng credtor protecton n reorganzaton: f α s ger, credtors can obtan a larger sare of te reorganzaton proceeds. Parameter α can be gven several real-world nterpretatons. For nstance, t can measure te extent to wc credtors are protected aganst te volatons of ter contractual prortes n favor of te debtors, an mportant source of rents for debtors partcularly n te bankruptces of large, publcly lsted U.S. corporatons (e.g. Franks and Torous 1989, Wess 1990). 4 Alternatvely, α can measure credtor protecton aganst tunnelng (or oter forms of prvate benefts extracton) by debtors, wc s especally relevant n developng countres (Djankov et al. 2006). 5 3 We focus on te resoluton of fnancal dstress occurrng n a state-provded, court-supervsed bankruptcy procedure. As a result, we dsallow te partes to do away wt judcal dscreton by contract, consstent wt te cross-country emprcal evdence of Djankov et al. (2006) tat tere are many legal restrctons to dong so. Even f contracts were allowed, owever, Gennaol and Ross (2007) sow tat te optmal contract sometmes uses judcal dscreton and tat te msuse of judcal dscreton s costly for te partes. Our paper can tus be vewed as specfyng te nature of te costs of judcal dscreton n bankruptcy. 4 Interestngly, even f volatons of prorty was a coce varable n our model, so tat bankruptcy courts were allowed to dscretonally volate absolute prorty up to a sare (1 α) of a debtor s oblgatons, ten we would be essentally back to te current model because pro-debtor judges would always grant te maxmal volatons and ten dstort te reorganzaton decson to beneft debtors. Teonlydfference wt te current model would be tat pro-credtor judges would never volate absolute prorty and would tus attan te frst best. 5 Tese nterpretatons of α mply dfferent mappngs of te model wt realty. Te "volaton of prortes" nterpretaton does not nge on debtors beng n control, as te debtors may obtan reorganzaton rents troug equty stakes [Glson (1990) sows tat U.S. CEOs retan substantal equty stakes n bankrupt frms (average 10%)]. Te "tunnelng-prvate benefts" nterpretaton requres nstead tat te debtor controls te bankrupt frm for at least some perod. [Glson (1990) and Hotckss (1995) sow tat U.S. CEOs and board members retaned ter 4

6 But ow s t decded weter te frm s reorganzed or lqudated? Our basc premse s tat te bankruptcy procedure gves bankruptcy judges some dscreton on ts dmenson. 6 In te next subsecton, we present a model to study te consequences of judcal dscreton for te resoluton of fnancal dstress. 2.1 Te Supply Sde: Bankruptcy Courts Decson-Makng We study judcal decson-makng under dscreton by takng te sortcut tat bankruptcy courts decde weter to reorganze or lqudate te frm. 7 Trougout our paper, we old constant suc judcal power to affect bankruptcy outcomes and study wc factors affect judges wllngness to use t n one way or anoter. For now we assume tat courts perfectly observe te frm s reorganzaton value but mgt stll be unwllng to do te rgt tng. Secton 4.3 studes te more general case were courts observe a potentally nosy sgnal of. After observng, court j maxmzes a wegted sum of te debtor and credtor s utltes. Te non-negatve parameters β j,c and β j,d ndcate te wegts te court attaces to te credtor s and te debtor s welfare, respectvely. 8 As a result, te court s pro-debtor 9 bas β j = β j,d /β j,c fully dentfes bankruptcy court j. frm s reorganzed to solve: At any, courtβ j cooses te probablty x βj () wt wc te max λ 1 x βj () + α + β j (1 α) x βj () (1) x βj () seat after emergng from bankruptcy n about 50% of cases n te 1980s and early 1990s, Ayotte and Morrson (2007) sow tat suc percentage as recently decreased to about 20%]. Tus, defned π as te extent to wc credtors clams are volated, ψ as te probablty tat a bankrupt debtor s mmedately replaced, e as s equty stake, t and b as te amount of tunnelng and prvate benefts, respectvely, one can combne te two nterpretatons by defnng α 1 πe (1 ψ)(t + b). Secton 5 uses ts decomposton of α to ratonalze, n lgt of our model, te evoluton of U.S. bankruptcy outcomes. 6 Several sources of judcal power can ultmately affect te way fnancal dstress s resolved. Consder extensons of exclusvty. If te judge extends te exclusvty perod were only debtors are allowed to fle a reorganzaton plan, t s arder for te credtors to move te case forward wtout te debtor s consent, reducng te lkelood of lqudaton. Smlar reasonng apples to te appontment of a trustee and to te grantng of frst day orders. To be sure, judges mgt affect te above decsons not only by exercsng ter legal rgt to do so but also by explotng dscreton n fndng facts (Gennaol 2005; Gennaol and Slefer 2006), especally f te socal value of alternatve decsonssunverfable and debtors and credtors dsagree. 7 Wtout loss of generalty, n wat follows we assume tat eac court as only one judge and terefore we use te terms court and judge ntercangeably. 8 Defnng judcal bas wt respect to te partes welfare mples tat n our model judcal bas translates drectly nto devatons from frst-best effcency. We do so because our man goal s to understand te postve consequences of judcal dscreton, not to assess te desrablty of judcal mstakes as n Berkovtc, Israel and Zender (1998), Bernardt and Nosal (2004) and Gammarno and Nosal (1994). 9 Strctly speakng, β j s te judge s relatve bas n favor of te debtor controllng an eventual flng decson. In closely-eld frms one can nterpret te bas as beng pro-ceo, n wdely-eld frms one can nterpret te bas as beng eter pro-ceo, pro-board of drectors or pro-controllng sareolders. 5

7 Consstent wt ntuton, expresson (1) ndcates tat f te frm s lqudated (.e. x βj () =0), ten te credtor obtans λ wle te debtor obtans zero. If nstead te frm s reorganzed (.e. x βj () =1) ten te credtor obtans α and te debtor obtans (1 α). Te court evaluates te desrablty of suc lqudaton polces n bot state and by comparng te partes utltes under lqudaton and reorganzaton n eac state. By solvng (1) one fnds tat n state court j reorganzes te frm (.e. x βj () =1)fand only f β j β λ α (1 α),wlenstate court j reorganzes te frm (.e. x β j () =1)fandonly f β j β λ α (1 α). Intutvely, a judge wt ger β j s more lkely to reorganze rrespectve of so as to allow te debtor to extract reorganzaton rents. At te same tme, lqudaton s more lkely at,.e.β β because judges are less wllng to rule for te debtor f reorganzaton mposes a large loss on te credtor. Fgure 1 below llustrates te adjudcaton polces for dfferent judges as a functon of ter bas β j. Fgure 1 - Dscreton and Bas β β β j Always Lqudate Lqudate ff state s Always Reorganze For ntermedate values of judcal bas (.e. for β β,β ), judges ave te ncentve to take te effcent decson, tat s to lqudate n state and to reorganze n state. By contrast, gly based judges wll always cater towards ter preferred party, rrespectve of te frm s reorganzaton value: pro-debtor judges wt β j β always reorganze, pro-credtor judges wt β j β always lqudate. In state a court wt bas β reorganzes a frm wt probablty x β () I β>β,were I (.) s te ndcator functon. Te frm s lqudated wt probablty 1 x β (). Te probablty of reorganzaton ncreases n te frm s reorganzaton value. It s mmedate to fnd tat: Proposton 1 A ger β ncreases te probablty of reorganzaton and reduces repayment. Ex post effcency ncreases as β approaces 1 from below and ten decreases as β moves beyond 1. Intutvely, more pro-debtor courts (.e. wt larger β) are more lkely to reorganze all frms, 6

8 ncludng tose wt poor prospects. In addton, β reduces expected repayment to credtors because te most pro-credtor courts fully focus on maxmzng credtor repayment. Concernng ex post welfare, f te bankruptcy court s unbased, t effcently reorganzes te frm n state and lqudates t n state. If nstead te court s based (β 6= 1), ten ex post effcency falls as pro-debtor judges reorganze too often, wle pro-credtor judges lqudate too often. 10 A stragtforward consequence of judcal dscreton s tus to allow judcal bases to affect te resoluton of fnancal dstress. As we sall dscuss n Secton 6, te supply sde of our model s consstent wt a wealt of evdence on te varaton of several bankruptcy outcomes across U.S. courts (e.g. Cang and Scoar 2006, Brs, Welc, and Zu 2006). A drawback of te current model s tat t cannot explan te knd of systematc bases n te resoluton of fnancal dstress prevalng under dfferent bankruptcy codes and documented by bankruptcy scolars (Skeel 2001, Franks and Torous 1989, 1993). Typcally, some courts wll be unbased, some wll be pro-debtor and some pro-credtor. Tus, f cases are randomly allocated across courts, judcal dscreton would manly cause dosyncratc varaton of bankruptcy outcomes and not a systematc bas. We formalze ts argument by fully caracterzng te supply sde of our model. Assume tat tere s a measure 1 of bankruptcy courts dstrbuted n β, β,wereβ β <β β, wt c.d.f. B(β). To underscore te nterplay of supply and demand, a useful bencmark for our analyss s a dstrbuton were te average reorganzaton outcome s unbased [.e. were E β, [x β ()] = 1/2], but our results go troug under more general assumptons. In words, some courts always reorganze, oters always lqudate, te rest takes te effcent decson, but courts are on average unbased. We now sow tat addng a demand sde to our model can generate a systematc bas n te resoluton of fnancal dstress over and beyond te dosyncrases of ndvdual judges. 2.2 Te Demand Sde: Debtors Forum Soppng Te demand sde of our model reles on te assumpton tat frms can self-select nto ter preferred bankruptcy courts ("forum soppng"). 11 In ts Secton, we provde a sarp llustraton of te 10 For now we focus on te outcomes of court proceedngs, but Appendx 3 sows tat judcal bas s stll costly even f we allow te partes to enter nto prvate workouts. Intutvely, even f te workout succeeds, judcal bas consttutes an out-of-equlbrum treat allowng debtors to renegotate on favorable terms wt credtors, reducng repayment. 11 Altoug most bankrupcy codes contan provsons amed at restrctng "forum soppng", substantal flexblty stll exsts, especally for large companes. For example, te U.S. bankruptcy venue statute recognzes four connectons between a debtor and s bankruptcy court. Te court must eter be: (1) at te domcle or resdence of te 7

9 workngs of our model by assumng tat debtors drectly coose te bankruptcy venue ex post, but Secton 5.2 sows tat our demand and supply analyss easly extends to te case were also credtors can forum sop. 12 Te assumpton tat debtors forum sop s realstc: 94% of all large U.S. Capter 11 cases from 1980 to 2005 (678 out of 722) were ntated by debtors, and 57% (411 out of 722) ave been classfed as forum soppng (Lo Puck 2005). 13 Forum soppng s also ncreasngly pervasve n Europe (Enrques and Gelter 2006), and around te world, especally among multnatonal frms (Rasmussen 2007, Guzman 2000). We assume tat upon observng te reorganzaton value of s frm debtor can coose were to fle by bearng a forum soppng cost c tat s unformly dstrbuted n [0,c]. Emprcally, a ger c captures a bankruptcy code placng strcter legal restrctons to forum soppng. We study te allocaton of cases to bankruptcy courts by leavng asde te ssues potentally arsng from court congeston, but our man results contnue to old f courts can attract at least some cases from oter courts. Intally, eac debtor s randomly allocated to s "natural" bankruptcy venue β 0 β, β. At suc court, te expected payoff of a debtor wt reorganzaton value s equal to (1 α) x β0 (), namely te debtor s reorganzaton rents tmes te probablty tat reorganzaton takes place. If te debtor engages n forum soppng, ten e fles n a more pro-debtor court β wt x β () >x β0 (), as tere s no ncentve for m to fle n a court tat s equally or less favorable tan te natural one. In partcular, debtors would naturally want to forum sop n courts tat surely reorganze,.e. courts wt β β. Once forum soppng s consdered, judcal dscreton naturally mples tat debtors seek relef from credtors by strategcally flng n a favorable bankruptcy courts. At any gven, debtor forum sops f c (1 α) 1 x β0 () and stcks to court β 0 oterdebtor, (2) at te debtor s prncpal place of busness, (3) at te locaton of te debtor s prncpal assets, or (4) were te bankruptcy case of an afflate s already pendng. In practce, companes ave been able to get around te flng restrctons n dfferent ways. For example, LoPuck and Wtford (1991) fnd tat n te 1980s large pre-bankrupt frms from all over te U.S. began transferrng ter eadquarters n small offces n Manattan to be able to fle at te New York court. 12 Debtors flng power may come from two sources. Frst, te U.S. bankruptcy code stpulates tat bot debtors and credtors can fle for bankruptcy, altoug credtors ave to meet stronger standards, e.g. 301, 303. Second, debtors are lkely to enjoy a frst mover advantage n flng for bankruptcy because tey are nformed before and more accurately tan ter credtors about ter frms fnancal problems. [Jensen and Mecklng (1976) stress tat suc frst mover advantage may jeopardze credtors clams by allowng debtors to engage n asset substtuton.] Crucally, even f credtors callenge te venue coce, t s te debtor-cosen court to ave te fnalsay,oftenresultngnte pro-debtor court retanng te case. 13 See LoPuck s data at ttp://lopuck.law.ucla.edu/ndex.tm. Forum soppng s wdespread n varous oter areas of te law, too. For example, Wte (2006) fnds tat wen asbestos lawsuts are fled n sx partcularly favorable jursdctons, plantffs expected returns from tral ncrease by $800,000 to nearly $4 mllon. See Proposton 3 for an argument as to wy tese (and smlar) estmates may underestmate te mpact of forum soppng. 8

10 wse. Te debtor engages n forum soppng wenever te cost s less tan te beneft ofdongso. n Tus, te sare of frms forum soppng at β 0 s equal to f,β0 (α, c) mn 1, (1 α) c 1 xβ0 () o. Intutvely, debtors endowed wt a relatvely less favorable natural bankruptcy venue (.e. wt lower β 0 ) are more eager to forum sop to very pro-debtor courts. Ts consderaton as mmedate mplcatons for te systematc bas of bankruptcy outcomes. In partcular, te aggregate sare of reorganzatons n our model s equal to: Z β β E f,β0 (α, c)+ 1 f,β0 (α, c) x β0 () ª db (β 0 ), (2) Te above expresson takes nto account te fact tat for debtors stckng wt ter natural venue [wc occurs wt frequency 1 f,β0 (α, c)] tefrm s reorganzed wt probablty x β0 (), wle for debtors forum soppng to pro-debtor courts [wc occurs wt frequency f,β0 (α, c)] tefrm s reorganzed wt probablty one. In ts context, t s natural to caracterze te systematc bas of bankruptcy outcomes nduced by forum soppng as te dfference between expresson (2) and te aggregate sare of rerganzatons E β, [x β ()] obtaned under random allocaton of frms to bankruptcy courts. Forum soppng ten generates a systematc pro-debtor (resp. pro-credtor) bas wen te dfference s postve (resp. negatve). Wen te dfference s zero, forum soppng does not generate any systematc bas. It s tus stragtforward to fnd: Proposton 2 Wen debtors fle for bankruptcy, forum soppng creates a systematc pro-debtor bas even f bankruptcy judges are on average unbased. By promotng forum soppng by debtors, judcal dscreton n bankruptcy sould, ceters parbus, be assocated wt an ncrease n te aggregate bas n te resoluton of fnancal dstress. 14 In ts sense, our demand and supply framework can reconcle judcal dscreton wt te systematc bases of court-supervsed bankruptcy procedures, not only wt dosyncratc varaton across courts. Ts result s te startng pont of our analyss. In Secton 4 we sow tat ts demand and supply framework yelds several nterestng comparatve statcs results, wc n Secton 6 we argue 14 Lookng at te entre populaton of courts and frms, te aggregate reorganzaton polcy s unbased f E β, [x β ()] = 1/2 (as 1/2 s te total sare of reorganzatons n te frstbest). Itsmmedatetocecktat for ts to be te case t must old tat Pr(β β )=Pr(β β ), namely te number of pro-credtor courts must be equal to te number of pro-debtor courts. 9

11 can parsmonously ratonalze a wealt of evdence on te resoluton of fnancal dstress n te U.S. and elsewere. Before movng to tose comparatve statcs, we present a dynamc verson of our model were we derve a dynamc supply effect tat accounts for addtonal emprcal facts. 3 Te Supply of Bas under Career Concerns Besdes sapng te demand for based adjudcaton, debtors forum soppng may also affect ts supply by affectng te ncentves of courts to use ter dscreton n a pro-debtor manner. To see ow ts works, assume tat bankruptcy courts beneft not only from tryng current cases, but also from attractng future ones. A court attractng many flngs may be vewed as more prestgous, t may allow te judge to coose te "best" case and obtan for example more coverage n te press, but t may also affect more mundane ncentves suc as ncrease te revenue of local bankruptcy lawyers as well as te judge s probablty of re-electon (Lo Puck 2005). In a survey of bankruptcy judges, Cole (2002) fnds tat "almost all of te judges suggested tat tere s a level of prestge and satsfacton tat attaces to earng and decdng mportant cases. Bg Capter 11 cases are nterestng as well as prestgous." In suc a world, judges ave an ncentve to use ter dscreton to establs a favorable reputaton and tus attract future cases, very muc lke n Holmström s (1999) career concern model. Formally, assume tat tere are two perods and debtors do not observe te court ntrnsc prodebtor bas but only te polcy vector x 1,βj x 1,βj (),x 1,βj tat results from adjudcatng a large number of cases smultaneously n perod 1. Among all cases adjudcated by court β j n perod 1, x 1,βj () [resp. x 1,βj ] represents te total sare of frms wt reorganzaton value (resp. ) tatcourtβ j decded to reorganze. 15 After observng x 1,βj, debtors update ter prors and form a posteror expectaton of te court s second-perod adjudcaton E ³x 2,βj.Based x1,βj on tese nferences, n te second perod debtors decde were to fle, judges coose x 2,βj and te game ends. Gven ts tmng, at t =2eac court wll play ts statcally optmal strategy of Secton 2. We assume tat future flngs affect te judge s utlty as n (1), and tat judges dscount te future by a factor γ 1. Wle parsmonous, ts last assumpton s not mportant. Our man results would go troug also under te assumpton tat judges utlty from tryng future cases s 15 We are mplctly assumng tat te reorganzaton value of an ndvdual frm s observed by all frms. Ts s consstent wt te dea of footnote 6 tat judcal dscreton arses from te unverfablty of. In oter words, altoug observable by everybody, cannot be verfed objectvely. As a result, ts assessment s left to te dscreton and potental bas of te courts. 10

12 fxed and ndependent from te court s adjudcaton polcy. For ease of exposton, suppose tat tere are tree types of judges: one trd s pro-credtor wt a certan bas β β, one trd s unbased wt β =1, te rest s pro-debtor wt β β. Tere s a populaton of measure one of faled debtors and a sare 1/3 of tem s naturally allocated to eac court type. Do pro-debtor, pro-credtor and unbased courts ave an ncentve to always reorganze so as to mmc pro-debtor courts and avod losng future cases? To answer ts queston we caracterze weter and under wc condtons tere may exst a pure strategy equlbrum were n te frst perod some or all judges pool by adjudcatng n a pro-debtor fason [.e. by settng x () =x =1]. To do so we restrct our attenton to te pure strategy equlbra tat can be sustaned under te followng famly of out-of-equlbrum belefs: Out-of-Equlbrum-Belefs: f strategy x () =x =1snotplayednequlbrumanda judge devates to t, ten tat judge s beleved to be pro-debtor. If a judge devates to any oter out-of-equlbrum strategy, ten tat judge s beleved to be pro-credtor. Besdes allowng us to sow n te starkest way ow forum soppng can create an ncentve for unbased or pro-credtor judges to establs a pro-debtor reputaton, ts famly of out-ofequlbrum belefs turns out to sustan a number of nterestng equlbra 16 : Proposton 3 Tere exsts a tresold γ (α, c) ncreasng n α and c and strctly smaller tan one for some (α, c) suc tat, for γ>γ(α, c) tere exsts a unque equlbrum were all courts pool by reorganzng all frms n te frst perod. If nstead γ γ (α, c) te equlbrum can be one of tree types. For ntermedate γ tere may exst a sem-separatng equlbrum were pro-debtor courts always reorganze n te frst perod wle unbased courts eter pool wt pro debtor courts or tey pool wt pro-credtor ones. For low γ tere exsts a separatng equlbrum were no systematc pro-debtor bas arses and eac court plays ts statcally optmal strategy. Te proof s n Appendx Under judcal dscreton debtors forum soppng may be a 16 Gven tat n ts game tere are four pure strateges and tree types of players, te number of possble equlbrum profles equals 4 3 =64. It s clearly beyond te scope of ts paper to evaluate weter and wen all of tese profles can be sustaned as equlbra under all possble out-of-equlbrum belefs. In our current analyss, te assumpton tat a court always reorganzng s beleved to be pro-debtor elps drastcally reduce te number of possble equlbra. Moreover, te proof of Proposton 3 sows tat suc assumpton can be often justfed wt refnement arguments based on equlbrum domnance. We also beleve tat one could obtan smlar results under dfferent out-of-equlbrum belefs. For example, n a prevous draft we sowed tat one could obtan smlar results by addtonally assumng tat a judge playng x() =0,x() =1 s beleved to be unbased. Of course, tere mgt also be "perverse" equlbra were all judges ave an ncentve to beave n a somewat pro-credtor manner. For nstance, a poolng pro-credtor equlbrum were all judges adjudcate accordng to x 1 () =0,x 1 () =0 could be sustaned by out-of-equlbrum belefs wereby only judges adjudcatng n favor of credtors at t =1are beleved to be pro-debtor. We do not feel te latter type of equlbra to be very realstc. 17 In te Appendx we sow tat tere mgt be tree possble sem-separatng equlbra. In te frst, pro-debtor 11

13 suffcent condton to trgger a pro-debtor adjudcaton, rrespectve of a court s ntrnsc preferences for te debtor or te credtor. Te ntuton s tat now even unbased or pro-credtor courts ave an ncentve to adjudcate n a pro-debtor manner to establs a reputaton for beng pro-debtor and tus attract future cases, especally f attractng future cases s valuable (.e. f γ g). To llustrate ts effect, consder frst te debtors out-of-equlbrum belefs we used to prove Proposton 3. In a poolng pro-debtor equlbrum a court lqudatng some frms s beleved to be pro-credtor. Consder now te dlemma faced n te frst perod by an unbased court. Under te stated out-of-equlbrum belefs, te best devaton for suc a court would be to play ts statcally optmal strategy x 1 () =0, x 1 () =1. Of course, devatng to suc polcy entals a loss of future flngs because te court s beleved to be pro-credtor. It turns out tat an unbased judge prefers to beave n a pro-debtor rater tan n an unbased manner provded: γ λf (α, c)+f (α, c) λ (3) Te left and sde of (3) s te future dscounted payoff te unbased court derves from adjudcatng n a pro-debtor manner. Suc payoff obtans from lqudatng n perod 2 ameasuref (α, c) of frms wt poor prospects and from reorganzng a measure f (α, c) of frms wt good prospects. Indeed, tose frms wll leave f te court devates, sgnallng of beng pro-credtor. Te rgt and sde of (3) s te statc cost for te unbased court of reorganzng frms wt poor prospects. If forum soppng s suffcently wdespread and te judge s suffcentlypatent,tenewllprefer to pool wt te oter pro-debtor courts rater tan to separate but lose future cases. Te proof sows tat a smlar reasonng olds wt respect to a pro-credtor court. Te proposton makes clear tat suc a poolng pro-debtor equlbrum s sustaned wen courts are suffcently patent. As courts patence falls, te beneft of attractng future flngs falls and pro-credtor and unbased judges start separatng temselves from pro-debtor ones. In one possble equlbrum confguraton, separaton s partal, wt unbased courts stll adjudcatng n a pro-debtor manner. In te oter possble confguratons separaton s full. Besdes stressng te role of judcal career concerns, te general nsgt of ts analyss s tat debtors forum soppng can generate a systematc pro-debtor bas even absent any courts and unbased courts pool by reorganzng all frms n te frst perod, wle pro-credtor courts always lqudate. In te second and trd ones, pro-credtor and unbased courts pool n te frst perod by eter lqudatng all frms or by playng te unbased strategy, wle pro-debtor courts always reorganze. Wle te separatng equlbrum always exsts, and te poolng equlbrum always exsts for suffcently low α and c, for some parameter values some sem-separatng equlbra may not exst for every α and c -seeappendx1 for detals. 12

14 dosyncratc pro-debtor preferences. Tus, under judcal dscreton forum soppng may generate a systematc pro-debtor bas not only by sortng on te demand sde cases nto pro-debtor courts, but also by gvng on te supply sde judges te ncentve to use ter dscreton n a pro-debtor manner. As we sall dscuss n Secton 6, tsfndng as mportant mplcatons for te emprcal lterature on bankruptcy because t suggests tat emprcal comparson of bankruptcy outcomes across courts may fal to emprcally dentfy te extent of te systematc bas nduced by judcal dscreton. 4 Comparatve Statcs and Welfare We now study te mpact of credtor protecton α, legal restrctons to forum soppng c and oter parameters on te equlbrum supply and demand of judcal dscreton n bot our statc and dynamc models. Secton 4.1 focuses on forum soppng, Secton 4.2 on te systematc bas of bankruptcy outcomes, and Secton 4.3 on socal welfare. 4.1 Credtor Protecton, Flng Restrctons and Forum Soppng We start by studyng te determnants of te demand for based adjudcaton. By dervng te expresson for f,β0 (α, c) t s mmedate to fnd: Corollary 1 In te statc model forum soppng by debtors falls n α and c. In te career concerns model, owever, ncreases n α and c sftng te equlbrum from poolng to separatng cause a dscontnuous ncrease n forum soppng n te second perod. In te career concerns model second perod forum soppng (weakly) falls n γ. Intutvely, te demand for pro-debtor courts depends negatvely on bot te strctness of flng rules c and on te strengt of credtor protecton n reorganzaton α, as bot parameters reduce te debtors net beneft from forum soppng. As a result, n te statc model ncreases n α and c reduce observed forum soppng. Wle te demand effects of α and c also old wtn te separatng equlbrum n te career concerns model, tey do not mply tat also n our dynamc setup ncreases n α and c always reduce forum soppng. In contrast, ncreases n α and c trggerng a sft from te poolng to te separatng equlbrum wll reduce observed forum soppng. An mmedate mplcaton of Proposton 3, ts result s due to a feedback between te supply and demand sde of te model: f α and c are so g tat γ γ(α, c), ten debtors ave lttle ncentves 13

15 to forum sop and courts wll separate at t =1, n turn nducng more forum soppng at t =2. If nstead α and c are so low tat γ>γ(α, c), ten debtors ave strong ncentves to forum sop and courts pool at t =1, wt no forum soppng takng place n equlbrum at t =2. In oter words, f α and c are low, forum soppng s potentally very strong. Ts leads to completely omogeneous judcal beavor today wc n turn avods any forum soppng n te future. Tus, altoug an ncrease n credtor protecton and legal restrctons often reduce forum soppng, n general te effect s ambguous. Fnally, n te career concerns model forum soppng also depends on judges dscount rate γ. Wen judges attac a large value to attractng future cases, ten a poolng equlbrum s lkely to arse at t =1, wc n turn reduces te amount of observed forum soppng at t =2. Our model can also yeld nsgts on wc frms are to be expected to forum sop dependng on ter reorganzaton value. Sould we expect te best or te worst frms to forum sop n equlbrum? Answerng ts queston s key for attempts to estmate emprcally te reorganzaton ablty of judges, as self-selecton of frms nto bankruptcy courts may be a potental source of bas. For smplcty, assume tat <c, so tat te fracton of frms engagng n forum soppng s always strctly smaller tan 1. Ten, total forum soppng ncludes bot an overall sare [(1 α)/c]pr β β of proftable frms and an overall sare (1 α) /c Pr(β <β ) of unproftable frms. Tese expressons sow tat two conflctng effects are at work. On te one and, forum soppng ncentves ncrease n te debtors rents from control, so one sould expect te most proftable frms to forum sop (te demand effect). On te oter and, forum soppng ncentves ncrease n te lkelood tat te frm s lqudated under ts natural venue, so one sould expect te least proftable frms to forum sop (te supply effect). Te set of bankruptcy flngs dsproportonately conssts of frms wt poor prospects f and only f te supply effect domnates. To see ts, assume tat tere s an equal sare x of pro-debtor and pro-credtor courts. Ten unproftable frms forum sop more often wen: x + (4) Intutvely, f only few courts are based, ten te most proftable frms wll be reorganzed even n ter natural venue. As a result, te supply effect domnates because unproftable frms wll stll ave strong ncentves to forum sop away from a near-certan lqudaton under unbased courts. If nstead many courts are based, ten te opposte s true because te least proftable frms 14

16 now stand a cance to be reorganzed under ter natural venue. As a result, te demand effect domnates as proftable frms wll dsproportonately try to forum sop away from a near-certan lqudaton under pro-credtor courts. Ts dscusson suggests tat attempts to estmate te reorganzaton ablty of courts sould properly control for te above mentoned demand and supply effects. For example, f te preemnent courts suc as Delaware dsproportonately attract frms wt poor prospects, ten te costs of pro-debtor bas are lkely to be vastly exaggerated because te frms managed by tese courts are not a representatve sample of te populaton of dstressed frms. 18 Te opposte s true f proftable frms dsproportonately engage n forum soppng. 4.2 Judcal Incentves and Credtor Protecton Consder now te determnants of te systematc bas of bankruptcy outcomes. analyss mples: Te prevous Proposton 4 In bot te statc and te career concern models, te systematc pro-debtor bas of bankruptcy falls n α. Te systematc pro-debtor bas falls also n c. Crucally, credtor protecton n reorganzaton mproves te workngs of judcal dscreton. 19 Before provng wy ts s te case, t s wort stressng tat our result does not nge on artfcally assumng tat credtor protecton reduces judcal dscreton. Trougout our analyss we old te extent of judcal dscreton constant by assumng tat te judge controls te reorganzaton v. lqudaton decson. In our model ger credtor protecton only reduces te ablty of judges to redstrbute resources n favor of debtors by reorganzng bankrupt frms, tereby affectng te ncentves of judges to use ter dscreton n a pro-reorganzaton or pro-lqudaton manner. Ts result combnes two supply effects and one demand effect. Te frst dynamc supply effect arses n te career concerns model, were ger α makes t more lkely tat a separatng equlbrum wt no systematc bas arses as opposed to a poolng equlbrum were all judges beave n a pro-debtor fason. Te ntuton s tat, antcpatng lower future demand, unbased judges ave fewer ncentves to establs a pro-debtor reputaton, tereby reducng systematc bas. 18 Ts s especally te case f te lqudaton value s tself stocastc but perfectly correlated wt te reorganzaton value (e.g. f <λ= λ <λ() =λ<). In ts case, evaluatng te socal costs of over-reorganzaton by usng te estmated average lqudaton value λ + λ /2 may severely overestmate suc costs because t does not take te selecton of bad frmsntoaccount. 19 In te context of te career concerns model, te above proposton clearly focuses on te systematc bas emergng at t =1, gven tat only suc systematc bas s affected by te career concerns of bankruptcy judges. 15

17 But even wtn separatng equlbra (or for tat matter n te statc model), ger α reduces systematc bas. On te demand sde, ger credtor protecton reduces debtors ncentve to forum sop, wc n turn drectly reduces te systematc pro-debtor bas by dampenng te sortng of cases n pro-debtor courts. On te supply sde, ger credtor protecton also exerts a drect effect on adjudcaton by renderng even gly pro-debtor judges less wllng to over-reorganze a bankrupt frm. Ts statc suppy effect can be gauged by notcng tat an ncrease n α ncreases β and decreases β, tereby expandng te regon were judges mplement te frst best. Because wt g credtor protecton debtors end up gettng very lttle anyway, tere s lttle or no reason even for gly pro-debtor courts to sgnfcantly dstort te decson weter to reorganze or lqudate te frm. In te lmt were α =1ts effect s so strong tat all courts beave lke unbased ones. At ts pont, courts preferences for debtors or credtors no longer affect ter resoluton of fnancal dstress, wc becomes fully effcent. To see te latter effects, notce tat te systematc pro-debtor bas equals Z β β E f,β0 (α, c) Z β db (β 0 )+(1/2) f,β0 (α, c) db (β 0 ) β Ts measure of pro-debtor bas reflects te extent of reorganzatons followng forum soppng by debtors towards pro-debtor judges, as compared wt te extent of reorganzatons tat would occur under a random allocaton of frms to judges. Te dervatve of systematc bas wt respect to α s tus equal to: Z β β ½ 1 E xβ0 () ¾ d dα f,β 0 (α, c) db (β 0 )+ 1 d 2 E f,β (α, c) dα β < 0 (5) Te formula takes nto account tat f,β (α, c) =0(namely, debtors always stck wt court β, te least pro-debtor one among tose always reorganzng). Te frsttermofteaboveexpresson s negatve because forum soppng (weakly) falls wen credtor protecton ncreases. Ts s te demand effect. But also te second term s negatve because ger credtor protecton reduces te tresold β, as fewer judges are wllng to act n a pro-debtor manner. Ts s te statc supply effect. In sum, credtor protecton n reorganzaton prevents a "race to te bottom" wereby judcal dscreton generates a pro-debtor bas n te resoluton of fnancal dstress. Wen credtor protecton s low, forum soppng by debtors s wdespread and judges ave strong ncentves to dstort 16

18 te resoluton of fnancal dstress. Wen credtor protecton s g, debtors forum soppng falls and judges ncentves become more algned wt socal effcency. Proposton 4 also sows tat smlar effects are assocated wt ncreases n te legal restrctons on forum soppng c. Ager c reduces forum soppng, dampenng bot debtors demand for based adjudcaton and judges ncentves to establs a pro-debtor reputaton. More generally, our demand and supply analyss sows tat under judcal dscreton, credtor protecton n reorganzaton and legal restrctons to forum soppng may be crucal determnants of observed dfferences n te resoluton of fnancal dstress under dfferent codes or over tme under te same code. To te best of our knowledge, ts ypotess as not been artculated before. In Secton 6 we argue tat ts ypotess may elp ratonalze a wealt of emprcal evdence on bankruptcy outcomes n te U.S. 4.3 Welfare Analyss We now derve some welfare propertes of our model. We focus on ex post welfare and leave ex ante ssues to Appendx 2. To smplfy te algebra, from now on we assume: Assumpton 1: c>. Ts (reasonable) assumpton mples tat, at every reorganzaton value and at any natural venue β 0,terearesomefrms for wc t s too costly to forum sop. It s ten easy to fnd: Corollary 2 Ex post socal welfare ncreases n c and α for every B(β) f and only f λ E () Var() /E (). ExpostsocalwelfaretendstoE β, {λ + x β ()( λ)} as c and to (λ + )/2 as α 1. Te proof s n te Appendx. Ts result as two mplcatons. Frst, forum soppng by debtors s detrmental wen te socal losses of over-reorganzaton are suffcently large. Tus, f λ s suffcently larger tan E (), ncreasesnc and α mprove welfare. Te ntuton s tat n ts case te set of frms tat wll forum sop ex post can be expected to be dsproportonately frms wt poor prospects tryng to escape certan lqudaton n ter natural venue. Tus, t s welfare maxmzng to ncrease credtor protecton, or even to forbd forum soppng altogeter. Second, ncreasng credtor protecton α s more effectve tan ncreasng restrctons to forum soppng c. Ts result s due to te statc supply effect: agerα reduces, ceters parbus, te extent to wc judges dstort te reorganzaton v. lqudaton decson. If credtor protecton s gest (.e. α =1), all judges ave an ncentve to adjudcate n an unbased manner, tereby yeldng 17

19 a frst-best effcent resoluton of fnancal dstress. Parameter c does not trgger ts effect as t affect judges ncentves only ndrectly, va forum soppng. Tus, f forum soppng s forbdden altogeter (.e. f c ), some frms wll be stuck n based courts and tus socety wll bear te costs of judcal dosyncrases. Of course, ts concluson would not be so stark n a model were credtor protecton as potentally negatve effects on welfare. However, besdes our specfc modellng assumpton, te broad pont of ts result s tat ncreasng legal restrctons to forum soppng may not be te most effectve way to mprove te workngs of judcal dscreton because suc restrctons could also prevent some benefcal forum soppng from takng place. Te next secton formalzes ts last pont. 5 Addtonal Demand and Supply Sfters We now study tree extensons to our basc setup. Secton 5.1 studes te effect of forum soppng wen judges dffer also n speed, not only n bas. Secton 5.2 studes te case were also credtors, not only debtors, may be able to forum sop wt postve probablty. Secton 5.3 studes te case were judges perceve a nosy sgnal of te frm s reorganzaton value. In Secton 6 we wll dscuss ow te demand and supply sfters of Sectons 4 and 5 can elp account for te emprcal evdence on U.S. bankruptcy outcomes. 5.1 Courts Speed and Potental Benefts of Forum Soppng Besdes dfferng n bas, suppose tat courts dffer also n ter speed, wc proxes for te deadwegt costs of ter decson-makng. A court can be slow or fast. A slow court delays te resoluton of fnancal dstress, generatng for te partes only ηλ n case of lqudaton and η n case of reorganzaton [te debtor stll retans a sare (1 α) of reorganzaton proceeds], were η<1 captures te deprecaton of frms assets occurrng durng bankruptcy. A fast court resolves fnancal dstress quckly, yeldng to te partes te same payoffs as n Secton 2.1. Relatve to te prevous model, forum soppng can now arse bot towards courts wt te same bas but dfferent speed levels and towards courts wt dfferent bases and speed levels. Suppose tat tere are tree types of judges pro credtor, pro-debtor and unbased and tat a fracton ϕ of courts s fast wle te rest s slow. We assume tat speed s uncorrelated wt bas, as tere s no partcular reason to assume oterwse Our man results (especally tose obtaned under symmetrc nformaton) contnue to old f unbased judges 18

20 Consder te full nformaton verson of ts model. Call η 0 {η, 1} te speed of te natural venue. For algebrac smplcty set η =0. Ten, a debtor wose frm as reorganzaton value forum sops to fast, pro-debtor courts f x (1 α) 1 η 0 x β0 (). Tus, te sare of frms n forum soppng from (β 0,δ 0 ) equals f,β0,η 0 mn 1, (1 α) c 1 η0 x β0 () o.itseasytofnd: Proposton 5 Forum soppng creates a systematc pro-debtor bas wc falls n c. Socal welfare ncreases n α but falls n c, even f λ E () Var() /E (). Fullexposteffcency s attaned at α =1and c =0. Te proof s n te Appendx. A systematc pro-debtor bas contnues to arse, as debtors now forum sop to fast, pro-debtor courts, not to unbased ones. 21 Accordngly, te systematc prodebtor bas falls n c. More nterestngly, Proposton 5 sows tat wen courts dffer n speed and not only n bas, forum soppng s benefcal (te proof sows tat ts s especally te case f te proporton of fast judges s not very large). Indeed, f many courts are slow, forum soppng to fast courts reduces socal deadwegt costs, tereby mprovng welfare. One consequence of ts dea s tat now attanng ex post effcency requres bot strong credtor protecton wc reduces courts pro-debtor bas and perfect forum soppng, wc mnmzes deadwegt costs. Ts result stands n sarp contrast wt Corollary 2: provded credtors are protected enoug n reorganzaton, wen courts also dffer n ter ablty forum soppng does not generate bas but s nstead needed to attan a frst-best resoluton of fnancal dstress! In ts sense, we confrm tat credtor protecton s lkely to be more effectve tan legal restrctons to forum soppng: provded credtor protecton s large enoug, competton among bankruptcy courts to attract more flngs can generate a "race to te top" towards more effcent resolutons of fnancal dstress. 22 Consder now te career concern verson of ts model were debtors are unnformed about te bases of dfferent courts but perfectly nformed about ter speed. Does eterogenety n speed reduce or ncrease te possblty to attan a poolng equlbrum were all courts adjudcate n a pro-debtor fason? We obtan: tend to be faster tan te oters. 21 Notce tat qualtatvely smlar results old for η>0. In partcular, altoug n tat case forum soppng would not always be benefcal, te proof of Proposton 5 sows tat one would generally expect forum soppng to be benefcal provded te total proporton of slow courts ϕ s suffcently large. Wt η>0, even assumng perfect correlaton between speed and (lack of) bas, tat s only fast courts are unbased and vceversa, tere would stll be debtors wllng to forum sop to slow but favorable courts because wen te frm as reorganzaton value te debtor always prefers a slow reorganzaton rater tan a fast lqudaton. 22 In te context of our model wt exogenous dfferences n speed, by race-to-te-top we mean te (ncentves of te) partes to fle n fast courts, not tat courts select ter speed. 19