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: [email protected]; and Stockolm Scool of Economcs, E-mal: [email protected]. 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

21 Proposton 6 Suppose tat te fracton of fast courts s ϕ =1/2. Ten, tere exsts a γ (α, c) suc tat fast courts always reorganze n te frst perod for γ γ (α, c). Suc poolng equlbrum s more lkely to arse tan n te career concern model were all judges are fast (.e. were η =1 or ϕ =0)fandonlyf(1 α) /c s suffcently small. optmal polcy. Slow courts always play ter statcally Relatve to te model of Secton 3.2, eterogenety n courts speed creates some forum soppng also n te "pro-debtor" poolng equlbrum (bot n te frst and second perod), from slow to fast bankruptcy venues. Ts effect mples tat slow courts wll lose cases rrespectve of ter adjudcaton. As a result, tey wll always follow ter statcally optmal strateges n equlbrum. Forum soppng to fast courts owever creates an ncentve for unbased and pro-credtor fast courts to devate from te "pro-debtor" equlbrum and play ter statc optmum, as ter speed would enable tem to attract cases anyway. However, tere s also a countervalng effect: because more debtors (even tose wo ended up n a pro-debtor but slow court) wll now engage n forum soppng, tere s a stronger ncentve for courts to pool because tey can attract more cases n te future. In oter words, wen only some courts are fast te dynamc supply effect s stronger. Proposton 6 sows tat ts last effect turns out to domnate wen α and/or c are suffcently large so tat forum soppng s not too strong. Wen forum soppng s very strong, nstead, fast courts wll obtan many cases n te frst perod due to ter ger speed and tus wll ave a large ncentve to adjudcate n a statcally optmal manner. Ts model terefore suggests tat wen courts dffer n an observable dmenson suc as speed ere, excessve forum soppng may nduce te courts to separate rater tan to pool. Furtermore, our model suggests tat te ntroducton of more competent (or less competent) courts n te populaton may actually enance te possblty for a poolng, pro-debtor equlbrum to emerge As Proposton 6 sows, we proved ts result for δ = 0 and ϕ = 1/2. It s muc arder to solve for te poolng equlbrum under more general condtons, partcularly because for δ>0 te number of ncentve constrants ncreases substantally. Neverteless, tere appear to be reasons to beleve tat also te case were δ>0 sould naturally go n te same drecton as Proposton 6. Indeed, f δ>0 debtors ave less to gan from forum soppng to fast courts, so tat even slow courts may ope to attract cases by sgnallng ter pro-debtor stance. In turn, ts effect reduces te ncentve of fast courts to devate from te poolng equlbrum. 20

22 5.2 Forum Soppng by Debtors and Credtors We now augment te model of Secton 2 by assumng tat wt probablty p te debtor controls te bankruptcy venue coce wle wt probablty 1 p te credtor s n control, were p (0, 1). 24 Wen debtors are n control we already know tat at natural venue β 0 te sare of frms wt n reorganzaton value forum soppng to pro-debtor courts s f,β d 0 mn 1, (1 α) c d 1 xβ0 () o, were d stands for "debtor". If nstead te credtor s n control e wll, f anytng, forum sop to pro-credtor courts. 25 If te dstrbuton of forum soppng costs s te same for credtors and n o debtors, te sare of credtors forum soppng s f,β k 0 mn 1, max λ α c k x β0 (), 0,werek stands for "credtor". Notce tat we assumed tat credtors and debtors forum soppng costs are drawn from potentally dfferent unform dstrbutons. In partcular, debtors forum soppng cost s on average lower tan te credtors f and only f c d <c k.wetenfnd: Proposton 7 Wt p>0, forum soppng allocates frms to bot pro-credtor and pro-debtor judges. Tere exsts a tresold p suc tat forum soppng creates a systematc pro-debtor bas f and only f p p,werep falls n c k /c d. Te systematc (pro-credtor or pro-debtor) bas falls n c k + c d. Te proof s n te Appendx. Wen also credtors can forum sop we wll observe many cases beng dstrbuted among very pro-credtor and very pro-debtor courts. Suc an allocaton wll cause not only te reorganzaton of unproftable busnesses but also te lqudaton of many vable frms. In turn, te frst outcome s more lkely to preval, and tus te systematc bas s more lkely to be pro-debtor, te ger s te probablty p tat te debtor s n control. 26 It s useful at ts pont to focus on te case α λ/ (te Appendx sows tat smlar results obtan for α>λ/), wereby te probablty tresold equals: 24 Notce tat credtor flng does not mply te possblty of a credtors run but only represents te possblty for tem to decde on te bankruptcy venue. In our model, wat rules out credtors runs s te fact tat we assume te exstence of a state-mandated bankruptcy procedure. Put dfferently, credtor runs on te frm s assets could only occur n te absence of suc procedure (Hart 1995, 2000). 25 Recently, te ssue of credtor control and credtor forum soppng as been central n te European Unon. For example Bank of Amerca fled for te Parmalat bankruptcy n Ireland, on te grounds tat Parmalat s subsdary Eurofood was ncorporated tere (McCaery 2006). Credtor control as also been central n recent years n Capter 11 -anssuetowcweturnnsecton6. 26 Altoug we do not formally study te career concern model under te assumpton tat also credtors can forum sop, t s reasonable to expect tat for g p reputatonal forces wll pus towards a pro-debtor poolng equlbrum, wle te opposte s lkely to occur at low p. For p close to 1/2 (and for c k close to c d ), n equlbrum pro-debtor and pro-credtor courts are lkely to separate wle unbased courts wll coose between poolng wt te former or te latter, dependng on bot te relatve demand faced by tese courts as well as on te average attractveness of lqudaton relatve to reorganzaton (.e. on weter E() λ). 21

23 p E β, (f,β k = ) E β, (f,β d + f,β k (6) ), Expresson (6) ntutvely sows tat weter te systematc bas turns out to be pro-debtor or procredtor crucally depends on te relatve extent to wc debtors, as opposed to credtors, forum sop on average. In partcular, for a gven probablty p of debtor control, te systematc bas s more lkely to be pro-debtor as long as debtors on average engage more n forum soppng tan credtors. Ts observaton glgts te potental role of dfferences n te cost of forum soppng. For t s te party for wc forum soppng s ceaper tat drves te demand for based courts and tus systematc bas, not necessarly te party more often controllng te bankruptcy venue decson. For example, te systematc bas could stll be pro-debtor even f p s small, provded c k /c d s suffcently large Estmaton Uncertanty We now consder wat appens f bankruptcy proceedngs produce a nosy estmate of te frm s reorganzaton value. Ts extenson allows us to obtan emprcal predctons on ow te resoluton of fnancal dstress sould vary across frms. Te dea s tat mature frmswtmorestablecas flows sould generate less uncertanty about ter reorganzaton value tan younger, nnovatve, "growt" frms wt more volatle cas flows. Te court now observes a nosy sgnal r of te frm s reorganzaton value, were r s normally dstrbuted wt mean and varance θ 2.Wecall θ "estmaton uncertanty" because t measures te nose wt wc outsders (.e. courts) assess te frm s reorganzaton value. 28 After observng r, te court cooses te probablty x(r) wt wc te frm s reorganzed to maxmze: max x(r) E r λ [1 x (r)] + α + βj (1 α) x (r) r, θ ª (7) As n te basc model, te court maxmzes a wegted sum of te partes payoffs but now ts objectve s averaged usng te condtonal dstrbuton of wt respect to r. It s easy to fnd 27 Emprcally, one reason for expectng c k /c d to be large s tat t s lkely to be easer for te debtor to transfer s eadquarters near s favorte court to be able to clam tat suc court s te natural venue. Ts arguments are of course magnfed n te presence of multple credtors wo can potentally dsagree on ter own favorte court. 28 Wle one may nterpret θ also as a measure of te court s experence wt smlar mplcatons, n wat follows we stress te estmaton uncertanty nterpretaton because t generates testable predctons for frm level resolutons of fnancal dstress. 22

24 tat court j reorganzes te frm (.e. sets x (r) =1) f and only f r r βj,were: r βj = E () θ2 ln β j (1 α) +(α λ) (λ α) β j (1 α) (8) Estmaton uncertanty s relevant only f β j (1 α)+(α λ) (λ α) β j (1 α) (0, ), wc s te case f β j (β mn,β max ) were β mn < 1 < β max are two sutable tresolds. Court j reorganzes a frm wort wt probablty Pr (r >r j ). Sncer à N, θ 2, suc probablty s equal to x βj () = ³ rβj 1 Φ, wereφ (.) s te standard normal c.d.f. As n Secton 2, te probablty of θ reorganzaton ncreases n β j and n. Assume for algebrac smplcty tat te ex post socal cost of over- and under-lqudaton are equal,.e. λ = λ. Ten, te mpact of θ on te reorganzaton polcy depends on judcal bas β j. In partcular, we obtan: Proposton 8 Agerθ ncreases te probablty of reorganzaton f and only f β j > 1. ger θ reduces repayment f β j > 1. A Te proof s n te Appendx. Estmaton uncertanty θ magnfes te role of bas. Courts cater even more to ter own preferences wen a frm s reorganzaton value s more nosy. Te ntuton s tat n gly uncertan envronments (wen θ s large) courts are aware of makng many mstakes and prefer to cater to ter own bas tan to err aganst ter preferred party. Tus, agerθ nduces more lqudatons f te court s pro-credtor (β j < 1) and more reorganzatons f te court s pro-debtor (β j > 1). As a result, repayment s also lower, especally wt pro-debtor courts. Secton 6.2 dscusses te emprcal mplcatons of ts fndng for te cross secton of frms. 6 Dscusson of Emprcal Evdence on U.S. Capter 11 A rapdly growng emprcal lterature documents te mportance of ndvdual judges n sapng te resoluton of fnancal dstress n U.S. Capter 11. For example, t as been sown tat judcal dosyncrases (e.g. Wess and Wruck 1998), judges dentty (e.g. Cang and Scoar 2006) and bankruptcy venue (Brs, Welc, and Zu 2006) matter for outcomes suc as extensons of exclusvty, probablty of reorganzaton, repayment to credtors and volatons of prorty. Te supply sde of our model of judcal dscreton s obvously consstent wt tese fndngs. 29 Tat 29 Our model also yelds te predcton, consstent wt evdence from Cang and Scoar (2006) tat a ger β j also ncreases te probablty of a bankruptcy re-flng,.e. te probablty tat a recently reorganzed frm fles 23

25 s, te smple presence of dosyncratc judcal bases for te debtor or te credtor s suffcent to ratonalze tese facts. Addng a demand sde to our model ten elps ratonalze also 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). Te mecansm leadng judcal dscreton to produce suc a systematc bas n our model s forum soppng by debtors. Consstent wt our model, not only s forum soppng wdespread n te U.S., but n te 1980s t manly rewarded te New York dstrct, were judge Burton R. Lfland and s colleagues were known to be strongly pro-debtor. Forbes magazne descrbed Judge Lfland A Bankrupt s Best Frend, [Forbes, Aprl 1, 1991, pp , see also Wess and Wruck (1998)]. Te New York court alone attracted 32% of te Capter 11 cases n te 1980s (LoPuck and Wtford 1991, Lo Puck 2005). More recently, te Delaware court took over, attractng 43% (31 out of 72) of large bankruptces between 1993 and 1996 (LoPuck and Wtford 1991, LoPuck and Doerty 2002). Some scolars argue tat te Delaware court s tself pro-debtor (e.g. Lo Puck 2005) 30, oters nstead stress tat te Delaware court manly attracted frms tanks to ts ablty to andle complex cases effectvely (Ayotte and Skeel 2004). Our demand and supply framework can contrbute to ts emprcal debate wt two observatons. Frst, te emprcal metodology used n ts debate (wc drectly compares bankruptcy outcomes n New York and Delaware wt tose n oter U.S. courts) may be unsuted to detect te systematc bas created by forum soppng. Papers n ts lterature tpcally regress varous bankruptcy outcomes (reorganzaton probabltes, recovery rates, and so on) on a dummy tat equals one for Delaware flngs, and oter controls (LoPuck 2005, Ayotte and Skeel 2004; see also Elul and Subramanan 2002, Wte 2006). Te debate s ten often on weter te coeffcent on tedummyfordelawarespostveandsgnfcant, n wc case t s argued tat forum soppng matters for bankruptcy outcomes. However, as sown n Secton 3, suc cross-courts comparsons agan for bankruptcy. However, te nterpretaton gven to re-flng depends on specfc assumptons. For example, f n reorganzaton corporate debt s restructured to a face value of α, te debtor s doomed to default and fle for bankruptcy agan, because e cannot repay more tan α. Intscase,re-flng s a symptom of over-reorganzaton, consstent wt Lo Puck and Kaln (2001). On te oter and, f n state tere s uncertanty about te future reorganzaton value (wc can eter be verygorverylowbutwtaveragevalue), ten re-flng wll agan be nevtable but not symptomatc of neffcency, consstent wt Ayotte and Skeel (2004). 30 LoPuck stresses tat one dmenson along wc te Delaware and oter courts ave been partcularly pro-debtor s te appontment of a trustee. Altoug 1104 of te U.S. code states tat "te court sall order te appontment of a trustee for cause, ncludng fraud, dsonesty, ncompetence, or gross msmanagement of te affars of te debtor by current management, eter before or after te commencement of te case," substantal flexblty s left to judges to determne weter tose condtons apply. However, U.S. courts ave almost never apponted trustees, not even n suc famous bankruptcy cases of corporate fraud as Enron, Worldcom, Global Crossng and Adelpa. 24

26 fal to account for judcal ncentves and tus for te unform ncrease n courts pro-debtor stance trggered by debtors forum soppng. In oter words, te coeffcent on Delaware may well be zero, but tat does not necessarly mply tat forum soppng does not affect bankruptcy outcomes. Second, our model of Secton 5.1 llustrates te role of judcal competence n sapng te dynamcs of forum soppng. At one level, our model suggests tat te ncreasngly mportant role of Delaware may be due to an over-tme trend n te complexty and/or sopstcaton of frms debt structures, ncreasng frms ncentve to fle n more competent courts. It may well be te case tat te Delaware court s faster and more effectve at dealng wt conflcts among multple credtors (Ayotte and Skeel 2004). However te model of Secton 5.1 sows tat unless a court s expertse and ts unbasedness are postvely correlated ts selecton of frms nto more competent courts does not necessarly mply a reducton n systematc pro-debtor bas. Indeed, Proposton 6 suggests tat te ablty of more competent bankruptcy courts suc as Delaware to attract bankruptcy cases n te 1990s may ave actually boosted te ncentves of tese courts to act n a pro-debtor manner by ncreasng ter potental future demand. Our model nstead suggests tat a systematc prodebtor bas sould be more senstve to sfts n varables suc as credtor control of te bankruptcy venue, manageral turnover n bankruptcy and volatons of prorty. 6.1 Recent Developments of U.S. Bankruptcy Our demand and supply model can also sed lgt on two recent canges n te pro-debtor bas of U.S. bankruptcy outcomes. Frst, Skeel (2001) documents a marked ncrease n pro-debtor bas after te ntroducton of te 1978 Bankruptcy Code. Second, Bard and Rasmussen (2003) document a marked reducton n te pro-debtor bas of U.S. bankruptcy courts around year Consder te frst fact. Skeel (2001) argues tat poltcal economy consderatons were paramount n te passage of a strongly pro-debtor Bankruptcy Code n 1978, generatng a systematc pro-debtor bas due to suc features as te automatc stay and debtor-n-possesson fnancng. Altoug ts and oter nterpretatons are possble, tere s also addtonal evdence consstent wt te mecansms of our model. For example, wle under te prevous 1938 Code (Candler Act) faled managers were automatcally dsmssed upon flng and replaced by a trustee, te 1978 Bankruptcy Code ncreased judcal dscreton on te appontment of trustees, as well as on te scope of te automatc stay and of debtor-n-possesson fnancng. Furtermore, te 1978 Code canged te rules on venue coce, ncreasng te optons avalable to debtors relatve to before. For example, only after te 1978 Code could a debtor fle n ts state of ncorporaton. Terefore, te 1978 Code 25

27 can be vewed as promotng bot an ncrease n judcal dscreton and a reducton n flng restrctons to forum soppng, wc our model suggests sould bot ncrease te debtors ncentves to forum sop. Consstent wt our model, a strkng surge n forum soppng took place sortly after te ntroducton of te 1978 Bankruptcy Code. Indeed, we are not aware of any account of forum soppng before te early 1980s, and our model offers one explanaton for ts stylzed fact. Turnng to te second fact, t as been argued tat te pro-debtor stance of U.S. bankruptcy courts as decreased substantally snce For example, Capter 11 seems to no longer provde a safe arbor for faled managers, as 80% of CEOs are replaced wtn two years of te bankruptcy flng (Ayotte and Morrson 2007), and lqudatons appear to be far more common after 2001 tan n te past (Adler et al. 2006). Interestngly, also judcal atttudes seem to ave canged, as judges ave become more lkely to approve lqudaton of bankrupt frms, tereby nducng a zero return to pre-bankruptcy sareolders (Adler et al. 2006). Puzzlngly, ts marked sft n te workngs of Capter 11 as occurred n te absence of any statutory canges to te bankruptcy code (e.g. Adler, Capkun and Wess 2006). Wat can tus explan te cange of systematc bas over tme? Our model can ratonalze bot ts cange n judcal atttudes and te cange n bankruptcy outcomes as beng te result of demand and supply forces, and n partcular as te result of an ncrease n credtors control n bankruptcy. Indeed, several scolars (e.g. Skeel 2001, Bard and Rasmussen 2003, Ayotte and Morrson 2007) document tat credtors are now n control of te reorganzaton process. 31 On te one and, greater credtor control may mply a greater ablty to select te bankruptcy venue (akn to a smaller p n te context of Secton 5.2). On te oter and, greater credtor control may mply a greater ablty to replace fnancally dstressed managers n bankruptcy and lower devatons from absolute prorty, wc translates drectly to a ger α n te context of our model. It s ndeed te case tat manageral turnover n Capter 11 as ncreased sarply, from around 50% n te 1980s (Glson 1990) and 1990s (Hotckss 1995), to about 80% n recent years (Ayotte and Morrson 2007), and tat very few recent reorganzaton plans devate from absolute prorty (Ayotte and Morrson 2007). Consstent wt te evdence, our model suggests tat bot of te above canges would reduce te systematc pro-debtor bas of bankruptcy by reducng judges ncentve to act n a pro-debtor manner, and also by reducng te ablty and te ncentves of debtors to forum sop 31 Interestngly, ts cange as occurred wtout substantal canges to te extent of judcal dscreton, altoug wt te possble excepton of DIP fnancng (Ayotte and Morrson 2007, Adler et al. 2006), mplyng tat natural canddates for explanng tese canges are te ncentves of judges to use ter dscreton. 26

28 (altoug wtout necessarly reducng observed forum soppng). 6.2 Addtonal Frm Level Predctons Our model of judcal dscreton also delvers addtonal testable predctons on frm level outcomes. Altoug some of tese predctons are sared wt alternatve teores, t s stll nterestng to see tat our parsmonous framework can generate so many mplcatons consstent wt te emprcal evdence on debt fnance and resolutons of fnancal dstress across frms. Secton 5.3 delvers te novel predcton tat te dentty of bankruptcy judges sould especally matter for nnovatve and more volatle ndustres were uncertanty about te frm s prospects s greater. Ceters parbus, ts also mples tat forum soppng sould be especally wdespread n tose ndustres were avng te rgt judge s of te essence for debtors. Addtonally, and turnng to ex ante ssues, Secton 5.3 mples tat te cost of debt fnance sould be especally large for frms n nnovatve and volatle ndustres, wc sould terefore be assocated wt a greater use of equty fnance. Ts predcton of our model s sared wt te tradtonal vew tat nnovatve ndustres are more lkely to use equty to avod debt overang problems (Myers 1977). However, ts vew s ncomplete, because Capter 11 s precsely a mecansm to allow bankrupt frms to rase DIP fnancng and undertake postve NPV projects. Our model tus provdes a ratonale for wy Capter 11 may be more costly for more nnovatve and volatle frms: judcal dscreton may be a probtvely costly mecansm to resolve fnancal dstress for frms wt uncertan prospects. More standard frm-level predctons of our model concern te captal structure, wc sould eavly rely on equty (wc s peraps subject to less pro-debtor enforcement) so as to avod te costs of judcal dscreton n bankruptcy. 32 Tus, judcal dscreton and debtors forum soppng may be responsble for te puzzlng observaton tat debt levels n U.S. corporatons are usually tougt to be muc lower tan would be expected gven te large tax benefts of ssung debt as opposed to equty (Graam 2000, Warner 1977, Parrno and Wesbac 1999). A more drect, formal test of ts conjecture would owever requre a cross-sectonal comparson of frm-level leverage across a large number of countres and over a long tme seres. 33 Anoter emprcal predcton of 32 Ts effect may be due to te dfferent dynamcs of forum soppng for equty contracts. For example, a frm s ncorporaton decson mgt be a credble way for managerstocommttoacourtmaxmzngtevalueofequty. In contrast to debt, were te bankruptcy venue s cosen ex post, ts would create a benefcal competton among judges to properly enforce equty contracts. 33 For example, a rapd glance at te Federal Reserve Bulletn statstcs does sow tat te percentage of debt among te total new securtes ssued by U.S. non-fnancal, non-real-estate corporatons experenced a dramatc and 27

29 our model concerns prvate workouts, as under forum soppng credtors ave a strong ncentve to make concessons to debtors so as to avod tat fnancal dstress s resolved by a very prodebtor judge. Tus, our model elps explan wy U.S. credtors typcally try to avod Capter 11 va prvate negotatons and workouts (Glson, Jon and Lang 1990), despte te fact tat suc workouts are very costly n practce because tey lead to asset sales at below market prces (Asqut, Gertner and Scarfsten 1994) Conclusons We ave presented a supply and demand model of judcal dscreton n corporate bankruptcy tat parsmonously explans a wealt of emprcal evdence on resolutons of fnancal dstress and frm-level outcomes, and also yelds novel predctons on te workngs of court-supervsed bankruptcy procedures. One key result s tat stronger credtor protecton mproves judcal ncentves, promotng a "race to te top" n court competton towards te most effcent uses of judcal dscreton. Clearly, drawng normatve mplcatons s beyond te scope of our paper. Indeed, one normatve message of our model s tat bankruptcy reforms tat do not explctly take nto account judcal ncentves may be doomed to fal. However, t s not obvous wat s n practce te best way to do so. For example, t as been argued tat partes sould be allowed to specfy te bankruptcy venue already n te debt contract (e.g. Scwartz 1997). Our model clearly sows tat wle ts provson may benefcally reduce te demand for based adjudcaton and systematc bas, suc reform s unlkely to drectly mprove te supply of unbased adjudcaton; f te number of unbased courts s not very large, some cases wll nevtably end up n pro-credtor or pro-debtor courts, undermnng effcency. In oter words, contractng about te bankruptcy venue s lkely to dampen te costs of systematc bas but mgt not be able to avod tose of judcal dosyncrases. Wle ts relatve effectveness may be debated, owever, our model does suggest tat allowng te partes to contract about te bankruptcy venue ex ante may be an effectve way to trgger a race to te top towards more effcent resolutons of fnancal dstress. steady declne from te md- 70s (82% n 1974) to te begnnng of te 80s (52% n 1983). Of course, ts and smlar evdence can only be suggestve, as any tme seres observaton based on aggregate yearly data suc as ts one s necessarly gong to be plagued by suc ssues as low power, smultanety of many macroeconomc events, and so on. 34 Our model can also sed lgt on te tmng of bankruptcy flngs because, consstent wt Bernardt and Nosal (2004), pro-debtor bas promotes early bankruptcy flngs by dscouragng entrepreneurs to de fnancal dstress for fear of beng ousted by credtors. Te formal proof s avalable upon request. 28

30 Peraps te most effectve reform proposal emergng from our analyss would be to mprove credtor protecton n reorganzaton, as sown n Secton 4. Ts reform would reduce te demand of based adjudcaton and te frms ncentves to forum sop, tereby dampenng systematc bas. Unlke oter reforms owever, suc as for example ncreasng legal restrctons to forum soppng, ncreasng credtor protecton would also reduce te costs of judcal dosyncrases. Tere are several ways n wc credtor protecton could be ncreased n practce. 35 Here, consstent wt recent U.S. evdence, we ws to stress te possblty of ncreasng credtor protecton wt flexble contractual nstruments allowng credtors to exert more control n bankruptcy. Te possblty of usng tose nstruments s owever often lmted n many countres, because of legal restrctons to dong so (Djankov et al. 2006). In ts respect, and n lne wt Gennaol and Ross (2008), one way to nterpret our results s tat we provde addtonal arguments n favor of ncreasng freedom of contract n te resoluton of fnancal dstress. In te current context, contracts would complement rater tan substtute formal bankruptcy procedures by mprovng te workngs of judcal dscreton. 35 One example would be automatc removal of faled managers. Not only would ts mprove judcal ncentves by reducng debtors payoff from forum soppng, but t may also reduce te supply of based adjudcaton, because pro-debtor judges mgt be less sympatetc to fnancal dstress experts tan to faled managers wo devoted tme and effort to rescue ter frms. Interestngly, recent market-based developments lne up wt ts dea, suc as for example te ncreasng use of turnaround specalsts (Byers, Lee, Martn and Parrno 2007) n te reorganzaton of fnancally dstressed frms. 29

31 Appendx 1. Proofs ProofofProposton3. Let us now study te equlbra tat can arse n te career concern verson of our model wt respect to frst perod adjudcaton (n te second perod courts follow ter statc optmum). To do so, consder Fgure 2 below, wc represents te courts strategy space n te frst perod: Fgure 2 - Te Courts Pure Strateges x ( ) U = (1,0) D = (1,1) C = (0,0) K = (0,1) x( ) Te vertcal and orzontal axes respectvely measure te proporton of frms wt value and reorganzed by a court. Pont D represents pro-debtor courts statcally optmal strategy, pont C represents tat of pro-credtor courts, pont U tat of unbased courts, pont K represents a crazy polcy lqudatng frms wt = and reorganzng frms wt =. Tese four ponts represent te pure strateges avalable to a court. We focus on pure strategy equlbra, namely on equlbra were courts frst perod strateges are dstrbuted among ponts U, D, C and K. For brevty, we wll often descrbe te acton of a court of type j = cr, de, un (were cr stands for pro-credtor, de for pro-debtor wle un for unbased) by te symbol X j.wetendefne an equlbrum as a profle (X cr,x de,x un ) were X j {D, C, U, K}. Any equlbrum confguraton requres a specfcaton of te assocated out-of-equlbrum belefs. Suc belefs lnk eac out-of-equlbrum strategy n Fgure 2 to a potentally dfferent dstrbuton over courts type. Gven te overwelmng number of possble out-of-equlbrum belefs n ts game, our analyss focuses on te subset of belefs suc tat a devatng court s beleved to be pro-debtor f t plays D and pro-credtor oterwse. We later sow tat ts belef structure s 30

32 reasonable n te sense tat playng D s often equlbrum domnated for pro-credtor (and even unbased) judges. Trougout we assume tat unbased judges ave β =1. Intsproof, wefrst study wen specfc equlbra can arse and ten evaluate te global propertes of te equlbrum set, wt partcular reference to te unqueness of te poolng equlbrum of Proposton 3. Let us now start by consderng te man equlbra of te model. We begn wt Poolng equlbra, contnue wt sem-separatng equlbra and fns wt separatng equlbra. We frst study some equlbra and later dscuss wy te equlbra we neglected cannot exst. 1. Poolng Equlbra 1.1) X cr = X de = X un = D. Ts s te most nterestng equlbrum from te standpont of our paper, namely te poolng equlbrum were all courts play D,.e. adjudcate n a pro-debtor manner. Under te assumed belefs structure, any court devatng from ts equlbrum strategy s beleved to be pro-credtor. A court poolng obtans n cases n perods 1 and 2, ganng a per-case dscounted utlty flow (.e. a total utlty flow dvded by n): V poolng j E () δ (1 + γ) E ()+γ (λ + ) /2 E () δ + γλ f j = pro-debtor f j = unbased f j = pro-credtor were δ [α + β de (1 α)] and δ [α + β cr (1 α)]. Callf (α, c) mn 1, 2(1 α) 3c 1, (1 α) 3c and f (α, c) mn [ f (α, c) decreases n c and α]. An unbased court devatng to U loses a sare n o f (α, c) of frms, obtanng (λ + ) /2+γ λ 1 f (α, c) + [1 f (α, c)] /2. A pro-credtor n o court devatng to C loses te same sares, obtanng λ 1+γ 2 f (α, c) f (α, c) /2. Because at te assumed out-of-equlbrum belefs tese are te most proftable devatons, an equlbrum were all courts play D n te frst perod exsts provded: n E ()+γ (λ + ) /2 (λ + ) /2+γ E () δ + γλ λ n 1+γ 1 f (α, c) λ 2 f (α, c) f (α, c) o + [1 f (α, c)] o /2 /2 (9) (10) By (9) an unbased court prefers to pool rater tan to be as perceved pro-credtor. By (10) a pro-credtor courts prefers to be perceved as pro-debtor tan as pro-credtor. Bot condtons are 31

33 equvalent to: γ (λ )/ γ 2[λ E () δ] /λ λf (α, c)+f (α, c) f (α, c)+f (α, c) (11) (12) Intutvely, a poolng equlbrum can only arse f courts weg te future suffcently. Bot condtons are arder to meet f α and c are larger, as lower future forum soppng reduces te ncentves of unbased and pro-credtor courts to mmc pro-debtor ones [moreover, snce n (12) β j < 1, also te denomnator of (12) ncreases n α]. To see wen a poolng equlbrum exsts, suppose tat α = c =0. In ts case, forum soppng s maxmal [.e. f (α, c) =f (α, c) =1] and condtons (11) and (12) are met for γ (λ )/ (λ + ) and γ [λ E () δ] /λ. Notcetat(λ ) < (λ + ) and [λ E () δ] <λ, mplyng tat tere always exsts a dscount factor γ<1 satsfyng condtons (11) and (12) f α = c =0.Ifnsteadα =1, and/or c =, tenf (α, c) =0and tere exsts no γ satsfyng te condtons for a poolng equlbrum. By contnuty of f (α, c), onecandefne a tresold z suc tat for (1 α) /c z tere s a tresold γ (α, c) < 1 and te poolng pro-debtor equlbrum can be sustaned f and only f γ γ (α, c). Notce tat γ (α, c) ncreases (weakly) n bot α and c. 2. Sem-separatng Equlbra X cr = C; X de = X un = D. Tus, unbased and pro-debtor judges pool n D wle pro-credtor judges play C. Call f UD mn 1, (1 α) 2c. In ts equlbrum a sare of f UD frms wt = and a sare f UD =mn 1, (1 α) c of frms wt = leave pro-credtor courts n te second perod and relocate to pro-debtor and unbased courts. Suc forum soppng s equally sared among pro-debtor and unbased courts. In equlbrum eac court obtans: V semud j E () δ + γ (1 + f UD E()+γ λ(1 + f UD λ + γλ(2 f UD /2) + (1 + f UD /2) δ/2 f j = pro-debtor /2) + (1 + f UD /2) /2 f j = unbased f UD )/2 f j = pro-credtor Clearly, a pro-debtor court never fnds t proftable to devate. If an unbased court adjudcates accordng to U (te most proftable devaton) t also loses cases, obtanng (λ + )/2 + γ (1 f UD )+λ(1 f UD ) /2. A pro-credtor court devatng to D nstead gans cases, obtan- 32

34 ng E () δ + γλ(2 + f UD /2+f UD /2)/2. Tus, ts equlbrum exsts wen: γ (2/3) (λ )/ λf UD +f UD (13) γ (2/3) [λ E () δ] /λ(f UD /2+f UD /2) (14) Te frst nequalty mples tat unbased judges optmally play D, te second tat pro-credtor judges play C. Intutvely, ts equlbrum exsts wen γ s ntermedate. Also, notce tat greater forum soppng (.e. lower α and c) makes bot condtons above arder to meet. Fnally, notce tat for δ <te frst tresold s always smaller tan te second tresold and terefore bot of te above condtons can be met at te same tme X cr = X de = D; X un = U. Tus, pro-credtor and pro-debtor judges pool n D wle unbased judges play U. Call f CD mn. Ten, after te frst perod, pro-debtor and pro-credtor courts lose a sare f CD 1, (1 α) 2c frms wt =. A court devatng to C loses a sare f UD of frms wt =. In equlbrum, eac court obtans: of frms wt = wle unbased courts lose a sare f UD of frms wt = and a sare f UD of V semcd j E () δ + γ (1 f CD ( + λ)/2+γ λ(1 f UD E () δ + γλ(2 f CD )+(1 + f UD /2) )+(1 + 2f CD ) δ/2 f j = pro-debtor /2 f j = unbased + f UD /2)/2 f j = pro-credtor It s easy to ceck tat an unbased court never devates to D (ts court s most proftable devaton). A pro-debtor court devatng to U (ts court s most proftable devaton) obtans (δ + λ)/2 + γ (1 f UD )+(1 + 2f CD ) δ/2. A pro-credtor court devatng to U or C obtans (δ + λ)/2+ γλ(2 f UD +2f CD )/2 and λ + γλ(2 f UD 2f UD )/2, respectvely. Te condton suc tat a pro-credtor court prefers to play D rater tan devate to U can be wrtten as: γ3λ( f CD + f UD /2) (λ δ) (15) It s mmedate to see tat snce f CD f UD /2 and tat for pro-credtor courts λ δ 0, condton (15) s never met. Because pro credtor courts gan bot statcally and dynamcally from devatng, ts equlbrum cannot exst. equlbra, tat because f CD Notce also, and ts s mportant for dscardng oter potental f UD /2 pro-debtor courts dynamcally beneft from devatng to te unbased courts strategy. As a result, an equlbrum were pro-debtor and pro-credtor courts 33

35 pool cannot exst f te former can statcally gan from devatng. 2.3 X cr = X un = D; X de = K. Tus, pro-credtor and unbased judges pool n D wle pro-debtor judges play te crazy strategy K x() =1,x() =0, namely reorganze n and lqudate n. Pro-credtor and unbased courts eac lose sares f K =mn 1, (1 α) c and f CD of frms wt low and g reorganzaton value, respectvely. All tose frms ten fle n pro-debtor courts mplyng tat n equlbrum eac court obtans: V semcu j (δ + λ)/2+γ (1 + 2f CD )+(1 + 2f K ) δ/2 f j = pro-debtor E ()+γ λ(1 f K )+(1 f CD ) /2 f j = unbased E () δ + γλ(2 f K f CD )/2 f j = pro-credtor If a pro-debtor court devates to D t obtans E () δ + γ (1 f K )+(1 f CD ) δ/2. If an unbased court devates to K t obtans (λ+)/2+γ (1 + 2f CD )+λ(1 + 2f K ) /2. A pro-credtor court devatng to K or C nstead obtans (δ +λ)/2+γλ(1+f CD +f K ) or λ+γλ(2 f K f K)/2, respectvely. Consder now two necessary condtons for ts equlbrum to exst: γ δ λ /3(f CD + f K )δ (16) γ ( λ) /3(f CD + λf K ) (17) Inequalty (16) mples tat pro-debtor courts are better off playng K tan devatng to D, wle nequalty (17) mples tat unbased judges prefer to play D rater tan devate to K. After some algebra, one can fnd tat tere exsts no γ satsfyng bot condtons provded (δ 1)f CD +(δ λ)f K 0, wcsalwaystecasebecause for pro-debtor judges δ 1 0 and δ λ 0. Tus, ts equlbrum does not exst. 2.4 X cr = X de = D; X un = K. Tus, pro-credtor and pro-debtor judges pool n D wle unbased judges play te crazy strategy K. Ts equlbrum s smlar to equlbrum 2.2, except tat ere unbased judges play K rater tan U. However, t s mmedate to see tat, because pro-credtor judges always prefer lqudaton to reorganzaton (tat s, λ δ > 0), tey obtan a statc beneft by devatng to K. But ten, snce te analyss of equlbrum 2.2 establsed tat tey also obtan a dynamc beneft by actng as unbased, ten ts equlbrum cannot exst. 2.5 X cr = X de = K; X un = D. Tus, pro-credtor and pro-debtor judges pool n K wle unbased judges play D. Pro-debtor and pro-credtor courts lose a sare f CD of frms wt = wle unbased courts lose a sare f UD of frms wt =. A court devatng to C loses a sare 34

36 f UD of frms wt. In equlbrum, eac court obtans: V semcd j (δ + λ)/2+γ (1 f CD E()+γ λ(1 f UD (δ + λ)/2+γλ(2 f CD )+(1 + f UD /2) δ/2 f j = pro-debtor /2 f j = unbased )+(1 + 2f CD ) + f UD /2)/2 f j = pro-credtor An unbased court devatng to K and C obtans ( + λ)/2 +γ and λ + γ (1 f UD E()δ + γ (1 f UD E()δ + γλ(2 f UD )+λ(1 + f UD ) )+(1 + 2f CD ) +2f CD (1 f CD )+λ(1 + f UD /2) /2 /2, respectvely. A pro-debtor court devatng to D obtans δ/2. A pro-credtor court devatng to D or C obtans )/2 and λ+γλ(2 f UD f UD )/2, respectvely. Te condton ensurng tat pro-debtor courts prefer to play K rater tan devate to D canbewrttenas: γ3 f CD + f UD /2 δ (δ λ) It s mmedate to see tat snce f CD f UD /2 and tat for pro-debtor courts δ λ 0, te above condton s never met. As a result, ts equlbrum cannot exst. 2.6 X cr = X un = C; X de = D. Tus, pro-credtor and unbased judges pool n C wle prodebtor judges play D. Pro-credtor and unbased courts eac lose sares f CD =mn 1, (1 α) c and f CD =mn 1, (1 α) 2c of frmswtlowandgreorganzatonvalue,respectvely.alltose frms ten fle n pro-debtor courts mplyng tat n equlbrum eac court obtans: V semdc j E () δ + γ (1 + 2f CD λ + γ λ(1 f CD λ + γλ(2 f CD )+(1 + 2f CD ) δ/2 f j = pro-debtor /2 f j = unbased )+(1 f CD ) f CD )/2 f j = pro-credtor If an unbased court devates to D or U t obtans E () +γ (λ + ) /2 +γ λ(1 f CD obtans E () δ + γλ(1 + f CD )+(1 f UD ) (1 + 2f CD )+λ(1 + 2f CD ) /2 or /2, respectvely. A pro-credtor court devatng to D + f CD ). Ts s terefore an equlbrum provded: γ 2[λ E ()] /3(f CD γ ( λ) /(f UD γ 2[λ E () δ] /3λ(f CD + λf CD ) (18) f CD ) (19) + f CD ) (20) 35

37 It s mmedate to see tat ts equlbrum exsts (.e. te above condtons are mutually compatble) only f λ>[3 + E ()] /4. As a result, ts equlbrum for nstance does not exst wen λ = E (). For λ>[3 + E ()] /4 ts s a feasble equlbrum confguraton, at least provded (f UD f CD ) s large enoug. 2.7 X cr = X un = U; X de = D. Tus, pro-credtor and unbased judges pool n U wle prodebtor judges play D. Pro-credtor and unbased courts eac lose sares f CD =mn 1, (1 α) c and f CD =mn 1, (1 α) 2c of frmswtlowandgreorganzatonvalue,respectvely.alltose frms ten fle n pro-debtor courts mplyng tat n equlbrum eac court obtans: V semdc j E () δ + γ (1 + 2f CD (λ + )/2+γ λ(1 f CD (λ + δ)/2+γλ(2 f CD )+(1 + 2f CD ) )+(1 f CD ) δ/2 f j = pro-debtor /2 f j = unbased f CD )/2 f j = pro-credtor If an unbased court devates to D t obtans E () +γ (1 + 2f CD )+λ(1 + 2f CD ) /2. A procredtor court devatng to D or C respectvely obtans E () δ +γλ(1+f CD f CD f UD )/2. Ts s terefore an equlbrum provded: +f CD ) and λ+γλ(2 γ (λ )/3(f CD γ (λ δ)/3λ(f CD γ (λ δ)/λ(f UD + λf CD ) (21) + f CD ) (22) f CD ) (23) It s mmedate to see tat condton (22) s redundant and ts equlbrum does not exst (.e. te above condtons are mutually exclusve) wen 6(λ δ) λ(λ ). Ts condton s satsfed provded δ s suffcently small, for example f δ <. If 6(λ δ) < λ(λ ), te equlbrum mgt exsts, at least provded (f UD 3. Separatng Equlbra. f CD ) s suffcently large. 3.1 X cr = C; X de = D; X un = U; In ts equlbrum, eac court plays ts statc optmum and by te above out-of-equlbrum belefs structure any court playng outsde of C, U, D s beleved to be pro-credtor. Tus, no court fnds t proftable to play outsde of C, U, D, wc consttute te only possble devatons. In ts equlbrum, a pro-credtor court loses a fracton f K (α, c) of frms, an unbased court loses a fracton f K (α, c) of frms wt = wle t gans a fracton f K (α, c) /2 of frms wt =. A pro-debtor court gans a fracton 2f K (α, c) of frms 36

38 wt = and a fracton f K (α, c) /2 of frms wt =. In equlbrum, eac court obtans: V separatng j E () δ + γ (1 + f K/2) + (1 + 2f K ) δ/2 f j = pro-debtor (λ + ) /2+γ λ(1 f K )+(1 + f K/2) /2 f j = unbased λ + γλ(2 f K f K )/2 f j = pro-credtor A pro-debtor court never devates. An unbased court may only beneft byplayngd, wc allows te court to obtan E ()+γ (1 + f K/2) + λ(1 + 2f K ) /2. A pro-credtor court playng D obtans E () δ + γλ(2 + f K/2+2f K )/2 wle t obtans (λ + δ) /2+γλ(2 f K playng U. As a result, te separatng equlbrum exsts wen: + f K /2)/2 by (λ + ) /2+ 1 λ(1 2 γ f K )+(1 + f K /2) E ()+ 1 (1 2 γ + f K /2) + λ(1 + 2f K ) (24) λ γλ(2 f K f K ) E () δ γλ(2 + f K /2+2f K ) (25) λ γλ(2 f K f K ) (λ + δ) / γλ(2 f K + f K /2) (26) constrant (24) makes sure tat unbased courts prefer U to D, constrants (25) and (26) respectvely make sure tat pro-credtor courts prefer C to U and D. Tese condtons can be rewrtten as: γ (λ )/λ3f K (27) γ 2[λ E () δ] /λ(3f K /2+3f K ) (28) γ 2(λ δ)/λ3f K (29) Intutvely, a separatng equlbrum can arse wen courts are mpatent. Because all expressons on te rgt and sde are postve, a separatng equlbrum always exsts provded γ s suffcently low,temoresotesmallerareα and c. 3.2 X cr = C; X de = K; X un = D; In ts equlbrum, pro-credtor courts play C, unbased courts play D and pro-debtor courts play K. In ts equlbrum, pro-credtor courts lose fracton f K (α, c) of cases, unbased courts lose fracton f K (α, c) of frms wt = wleteyganfracton f K (α, c) /2 of frms wt =. Pro-debtor courts gan fracton 2f K (α, c) of frms wt = and 37

39 a fracton f K (α, c) /2 of frms wt =. In equlbrum, eac court obtans: V separatng j (δ + λ)/2+γ (1 + f K/2) + (1 + 2f K ) δ/2 f j = pro-debtor E()+γ λ(1 f K )+(1 + f K/2) /2 f j = unbased λ + γλ(2 f K f K )/2 f j = pro-credtor If a pro-debtor court devates to D t obtans E()δ + γ (1 f K )+(1 + f K/2) δ/2. If an unbased court devates to K t obtans (+λ)/2+γ (1 + f K/2) + λ(1 + 2f K ) /2. A pro-credtor court devatng to D or K obtans E()δ+γλ(2 f K +f K /2)/2 or (δ+λ)/2+γλ(2+f K /2+2f K )/2, respectvely. As a result, ts separatng equlbrum exsts wen: γ (δ λ)/3f K δ (30) γ ( λ) /3λf K (31) γ 4[λ E () δ] /3λf K (32) γ (λ δ)/3λ(f K /2+f K ) (33) Constrant (30) makes sure tat pro-debtor courts prefer K to D, constrant (31) makes sure tat unbased courts prefer D to K, constrants (32) and (33) make sure tat pro-credtor courts prefer C to D and K, respectvely. After some algebra one can see tat condton (30) s nconsstent wt (31), and tus tere s no γ fulfllng te condtons for ts equlbrum provded δ(λ ) λ(λ δ), wcsalwayssatsfed because λ > 0 and λ δ <0. Terefore, ts separatng equlbrum cannot occur. 4) Oter Equlbra. Equlbra 1.1 (X cr = X de = X un = D), 2.1 (X cr = C; X de = X un = D), 2.6 (X cr = X un = C; X de = D), 2.7 (X cr = X un = U; X de = D), and 3.1 (X cr = C; X de = D; X un = U), tat s one poolng, tree sem-separatng and one separatng, are te only equlbra n pure strateges tat can be sustaned. Te reason bend ts result s tat under te assumed out-of-equlbrum belefs structure, D must be played n equlbrum. Oterwse, pro-debtor courts would beneft by devatng to t because by dong so tey would mprove bot ter current and future payoff. 36 Ts consderaton alone elmnates te 3 poolng equlbra n U, 36 It s nterestng to see tat playng D can be equlbrum domnated for bot pro-credtor and unbased judges, wc mples tat t s reasonable to assume tat a court devatng to D s beleved to be pro-debtor [notce tat ts argument s a specal nstance of te more general Co and Kreps (1987) refnement crteron]. Consder for example an equlbrum were all courts pool n U. In ts equlbrum, a pro-credtor court obtans (λ + δ j) /2+γλ. Suppose now tat suc court devates to D and t s beleved to be pro-debtor. Ts s te most favourable stuaton 38

40 C or K, te3 2=6separatng equlbra nvolvng only play of U, C, K as well as te 3 2 2=18 sem-separatng equlbra nvolvng only play of U, C or K, for a total of 27 equlbra. Next, we note tat n all (sem-separatng and separatng) equlbra were pro-credtor courts separate temselves from te oter two te pro-credtor courts must play C oterwse tey would always ganbydevatngtoc (or arbtrarly close to t f C s played by anoter court). Ts consderaton elmnates 5 addtonal sem-separatng equlbra and 14 addtonal separatng equlbra. We ave tus already elmnated = 46 equlbra. Anoter consderaton restrctng te equlbrum set s tat f n a separatng equlbrum te pro-debtor court sgnals tself by playng U, ten unbased courts wll devate to U, wc elmnates an addtonal equlbrum. Also, n any sem-separatng equlbrum were D s played by procredtor and unbased courts and pro-debtor courts sgnal temselves by playng U (resp. C), ten unbased (resp. pro-credtor) courts devate from te poolng to ter preferred U (resp. C), wc elmnates two addtonal equlbra. In addton, f n a sem-separatng equlbrum pro-debtor and pro-credtor courts pool n ) C, )U or ) K wle unbased courts separate temselves n ) U or D, )D or ) U or D, ten pro-debtor courts ave an ncentve to devate to te unbased courts strategy because suc devaton entals a statc gan and, just as n te case of equlbrum 2.2, a dynamc gan, too. Ts consderaton elmnates two addtonal equlbra, for a total of 51 equlbra elmnated so far. Let us now move to some fnal consderatons. An equlbrum were pro-credtor and unbased courts pool n K wle pro-debtor courts separate n D cannot exst because an unbased court gans bot statcally and dynamcally by devatng to D. Accordngly, a separatng equlbrum were unbased courts play K cannot exsts because tose courts would gan, bot statcally and dynamcally, by devatng to D (wc must be played, f suc equlbrum exsts, by pro-debtor courts). A sem-separatng equlbrum were pro-debtor and pro-credtor courts pool n D wle unbased courts play C s also mpossble because, by te same argument used to dscard equlbrum 2.2, pro-credtor courts gan bot statcally and dynamcally from devatng to C. Ts elmnates 3 n wc te pro-credtor court can devate to D. Ten, te court obtans a number nf U of frms wt = and a number nf U of frms wt =, weref U (α, c) mn 1, (1 α) and f U 3c (α, c) mn 1, 2(1 α).asaresult,by 3c devatng to D te pro-credtor court obtans E()δ j + γλ(1 + f U + f U )/2. Aslongasγ (λ δ j )/λ(f U + f U ) te pro-credtor court does not fnd t proftable to devate to D, even under te most favourable confguraton of belefs. Ts condton s surely met provded f U s suffcently small, namely provded (1 α)/c s suffcently small. A smlar argument can be used to sow tat D s often equlbrum domnated for unbased courts as well, altoug most of our analyss goes troug even f tat were not te case. Indeed, te key feature of our out-of-equlbrum belefs s tat pro-debtor courts can separate temselves from pro-credtor ones (toug not necessarly from unbased ones) by playng D. Ts feature prevents te exstence of a poolng equlbrum n U. 39

41 addtonal equlbra, for a total of 54 equlbra already elmnated, leavng exactly te 10 equlbra analyzed n 1), 2) and 3) above. 5) Unqueness of te poolng pro-debtor equlbrum. We ave seen tat under te assumed structure of out-of-equlbrum belefs tere exst 3 possble equlbra n pure strateges: a poolng were all courts play D, a sem-separatng were pro-debtor and unbased courts pool n D wle pro-credtor courts play C, and a separatng were eac court plays ts statcally optmal strategy. We now ask weter te poolng equlbrum, tat s te most nterestng equlbrum from te standpont of our analyss, s unque wenever t exsts. It turns out tat te answer s yes. To see tat, notce tat te poolng 1.1 cannot coexst wt te sem-separatng 2.1 because condton (14) mples tat n te latter equlbrum te dscount factor γ sould always be smaller tan te smallest level allowed for a poolng to exst as dentfed by condton (12). In algebrac terms, t s easy to see tat tere s no γ jontly satsfyng (14) and (12) f and only f 2mn 1, (1 α) 3c wc s always satsfed. +2mn 1, 2(1 α) 3mn 1, 3c (1 α) 2c +3mn 1, (1 α), c Fnally, t s stragtforward to see tat te sem-separatng equlbra 2.6 and 2.7 as well as te separatng equlbrum 3.1 cannot as well coexst wt te poolng 1.1 because tere s no γ satsfyng at te same tme (11) and (18), (11) and (21), as well as and (12) and (28), respectvely. Tus, under te assumed out-of-equlbrum belefs structure, n te parameter range were te poolng equlbrum exsts, suc equlbrum s te unque equlbrum n pure strateges. ProofofCorollary2. We study te mpact of α and c wtn a gven equlbrum outcome,.e. for gven strateges x β () followed by courts. Ex post welfare s: W (α, c) =E β, {λ + x β ()( λ)+f,β (α, c)( λ)[1 x β ()]} n A.1 mples tat: dw (α, c)/dc = (1 α)e 2 β, λ [1 x β ()] 2o /c 2. After some algebra one fnds dw (α, c)/dc E( 2 ) λe() Pr(β β ) 2 λ Pr β ³β,β /2. Gven < λ, dw (α, c)/dc > 0 for any B(α) (even for Pr(β β ) = 1)ff E( 2 ) λe(). Snce Var() =E 2 E () 2, te condton s λ E () Var() /E (). By contrast, dw (α, c)/dα = E β, n 2 λ [1 x β ()] 2o /c E ( λ)[1 f,β (α, c)] b(β )dβ /dα ª /c,wereb(β ) s te densty functon of β evaluated at te tresold β. We know from above tat te frst term s 40

42 postveandtseasytofnd tat te second term s negatve as well. Indeed, λ<0 and dβ /dα > 0, wle λ >0 and dβ /dα < 0. Asaresult,weavetatfλ E () Var() /E (), also dw (α, c)/dα s postve. Notce also tat lm c W (α, c) =E β, {λ + x β ()( λ)} wle lm α 1 W (α, c) =(λ + )/2. ProofofProposton5. Te overall proporton of reorganzed frms s equal to: E β,δ, {f β,δ, (α, c)+[1 f β,δ, (α, c)] x β ()} = E β,δ, {x β ()+f β,δ, (α, c)[1 x β ()]} 1/2 (34) As a result, also n ts case tere s a systematc pro-debtor bas. Suc bas falls n legal restrctons c, as te dervatve of (34) wt respect to c s equal to E β,δ, {f β,δ, (α, c)[1 x β ()]} /c < 0. Ex post socal welfare s equal to: W (α, c) =E β,δ, {f β,δ, (α, c) + δ [1 f β,δ, (α, c)] [λ + x β ()( λ)]} (35) Takng nto account tat δ =0, te dervatve of (35) wt respect to c s proportonal to: (1 ϕ)e 2 n E( ϕ 2 ) λe() Pr(β β )+ 2 λ o Pr β ³β,β /2 Snce E 2 λe () λ E () Var() /E () > 2 λ /2, dw/dc 0 for every B(β) provded (1 ϕ) E 2 ϕ 2 λ /2 0, wc s true wenever ϕ ϕ 2E 2 / 2 λ. Notce tat ϕ > 1 rrespectve of te sgn of λ E () Var() /E (). ProofofProposton6. Ts proof focuses on te poolng pro-debtor equlbrum (te more general propertes of te equlbra of ts model easly follow from te proof of Proposton 3). Suppose tat η =0and ϕ =1/2. Gven δ =0, all debtors allocated to slow natural venues try to fle n fast courts grantng reorganzaton. In te frst perod, a fracton f of frms leaves eac slow court and fles n te correspondng fast court. Defne e f { f, +f }. A slow court as e f = f, a fast courts as e f =+f. In te second perod, te outcome depends on te equlbrum prevalng n te frst perod. In a poolng equlbrum, te same flow from slow to fast court occurs, mplyng tat n ts equlbrum eac court obtans: V poolng j (1 + f e )+(1 + f e ) δ(1 + γ)/2 f j = pro-debtor (1 + f e )+(1 + f e ) /2+γ (1 + f e )+λ(1 + f e ) /2 f j = unbased (1 + f e )+(1 + f e ) δ/2+γλ(2 + f e + f e )/2 f j = pro-credtor 41

43 Ts s an equlbrum f courts are better off by poolng tan by playng ter statc optmum. Under te out-of-equlbrum belefs of Proposton 3 an unbased court devatng to ts statc optmum s beleved to be pro-credtor and loses a fracton f of frms rrespectve of weter t s slow or fast, obtanng (1 + f e )+λ(1 + f e ) /2+γ λ(1 f )+(1 f ) /2. A pro-credtor court devatng to ts optmal statc polcy also loses f frms and does not attract debtors from slow courts, obtanng λ(2 + e f + e f )/2+γλ(2 f f )/2. Becausewtη =0slow courts obtan te same cases outflow of pro-credtor courts, tey wll always play ter statcally optmal polcy n equlbrum. As a result, te equlbrum for slow courts s always separatng. Wat about fast courts? Tey all beave as pro-debtor provded: γ (λ )(1 + f )/2(f + λf ) (36) o γ n2[λ E()δ]+(λ δ)f +(λ δ)f /2λ(f + f ) (37) It s easy to ceck tat (36) s always easer to meet tan (11) wle (37) s easer to meet tan (12) f and only f (1 α)/c s suffcently small tat tere s lttle forum soppng. In oter words, te poolng pro-debtor equlbrum among fast courts s easer to attan tan te poolng of Proposton 3 provded tere s suffcently lttle forum soppng. Te ntuton s tat forum soppng from slow to fast courts can boost te courts ncentves to select ter statcally optmal polcy n te frst perod. ProofofProposton7. Te total sare of reorganzed frms s equal to: E β, pf D + 1 (1 p) f C pf D xβ () ª After some algebra, te above expresson becomes: 1/2+p E β, f D + Eβ f C /2+E β f C (1 Z) /2 E β f C /2+E β f C (1 Z) /2 (38) Were Z s an ndcator functon takng value 1 wen α>λ/ and 0 oterwse. Ten, p s equal to: p = E β f C /2+E β f C (1 Z) /2 E β, f D + Eβ f C /2+E β f C (1 Z) /2 Notce tat p [0, 1]. Consder ow systematc bas vares wt c. Te dervatve of (38) wt respect to c s equal to p n o E β, f D + Eβ f C /2+E β f C (1 Z) /2 E β f C /2+E β f C (1 Z) /2 /c, 42

44 wc s postve for p<p and negatve oterwse. Tus, as ndcated by Proposton 7, te total proporton of reorganzed frms ncreases f te systematc bas s pro-credtor and decreases oterwse. It s mmedate to ceck tat an ncrease n c k /c d (leavng contant c k + c d ) reduces te value of p wle an ncrease n c k + c d (leavng constant c k /c d )leavestunaffected. ProofofProposton8. It s useful to start by recallng tat r j maxmzes te court s utlty E {λφ j + v j (1 Φ j )}, were we ave labeled v j = α + β j (1 α). Te frst order condton o mples tat E n(λ v j )Φ 0 j =0. Consder now te effect of θ j on te probablty of lqudaton Φ j. Frst, by dervng expresson (8) t s easy to see tat dr j /dθ j = 2θ ln β j (1 α)+(α λ) (λ α) β j (1 α) wose sgn s negatve f and only f β j > 1. It follows tat dφ j dθ j = E ( Φ 0 j " #) ½ (dr j /dθ j ) θ j r j + θ 2 = E Φ 0 j 1 j ln β ¾ j (1 α) +(α λ) (λ α) β j (1 α) were te last equalty explots te court s frst order condton n settng r j and te defnton of r j. Tus, te effect of θ j on te probablty of lqudaton s postve f and only f β j > 1. Fnally, te dervatve of expected repayment (E {λφ j + α(1 Φ j )}) wt respect to θ j s equal to: ª ( ) ½ E (λ α) Φ 0 (dr j /dθ j ) θ j r j + j θ 2 = E β j (1 α) Φ 0 j 1 j ln β ¾ j (1 α) +(α λ) (λ α) β j (1 α) were te equalty explots te court s frst order condton n settng r j. Tus repayment falls n θ j. f and only f β j > 1. Appendx 2. Ex Ante Consequences of Judcal Dscreton To study te mpact of judcal dscreton on debt fnancng and nvestment, suppose tat s te productvty attaced to te concave producton functon f (I) under reorganzaton, λ te productvty under lqudaton. I 0 s te level of ex ante nvestment and f (.) satsfes te usual Inada condtons. Consder te case were only debtors can forum sop. Ten, f te expected probablty of reorganzaton s equal to ex () =[1 f,β ] x β () +f,β, te debtor proposes te credtor a fnancal contract solvng: 43

45 max A,I A + E {(1 α) ex ()} f (I) (39) s.t. E {λ [1 ex ()] + αex ()} f (I) A + I (40) A 0 (41) Te contract maxmzes te debtor s payoff by stpulatng tat te credtor sould fnance nvestment I and advance to te debtor an addtonal payment A wc s set so as to ensure credtor break-even (we are assumng tat tere s perfect competton among credtors). Te constrant A 0 smply reflects te fact tat te debtor as no ntal wealt. Snce te payment A renders te debtor full resdual clamant to te profts of te frm, te above problem bols down to: max E {λ [1 ex ()] + ex ()} f (I) I I (42) s.t. E {λ [1 ex ()] + αex ()} f (I) I (43) Tat s, te optmal contract maxmzes te frm s expected profts (42) [.e. s average revenues under te expected reorganzaton polcy mnus nvestment costs] subject to te credtor s break even constrant (43). Te frst order condton of te problem s: ½ E λ [1 ex ()] + 1+αμ ¾ ex () f 0 (I) 1+μ = 1 (44) μe {λ [1 ex ()] + αex () f (I) I} = 0 (45) were μ 0 s te Lagrange multpler attaced to te credtor s break even constrant. μ measures te tgtness of te break even constrant. It s ten mmedate to fnd: Proposton 9 If te break even constrant s bndng (.e. μ>0) debt and ex ante nvestment ncrease n c and n α. Forum soppng reduces debt and nvestment by reallocatng cases to judges wt ger β j. Te logc bend ts result s smple. If μ>0, debt and nvestment are determned by (44) and tey ncrease n te expected repayment to te credtor, wc n turn falls wt ex () for every, as sowed by Proposton 1. Clearly, te expected probablty of reorganzaton falls n c and α as bot parameters reduce forum soppng to pro-debtor courts. Broadly speakng, Proposton 9 suggests tat under judcal dscreton, debtors forum soppng 44

46 ncreases te ex ante costs of debt fnance by undermnng repayment. An mmedate reacton to tese costs could be for entrepreneurs to relax ter fnancal constrants by ssung equty, wc s peraps less subject to pro-debtor enforcement. An alternatve reacton to te cost of forum soppng may be for te partes to contract ex ante about te bankruptcy venue. Tese contracts are often legally forbdden (Scwartz 1997), but t s stll nterestng to see wat would be te outcome f tey were allowed. Ex ante, te partes solve te above contractng problem by pckng an optmal reorganzaton polcy ex () among tose mplemented by bankruptcy courts. It s wortwle stressng tat n ts case te venue coce would be formulated ex ante and tere would tus be no forum soppng ex post. Te optmal coce of ex () for every adds to (44) and (45) te followng frst order condton: λ(1 + μ)+(1 + αμ) 0 (46) Te partes set ex () =1f and only f (46) olds. It s mmedate tat ts can only be true at. As a result, te partes wll coose an unbased or pro-credtor judge. In partcular, for α λ te partes coose an unbased judge. By contrast, for α <λte partes coose an unbased judges provded μ ( λ)/(λ α) and a pro-credtor judge oterwse. Te ntuton s tat t s optmal for te partes to ex ante commt to always lqudate te project wen te credtor s break even constrant s gly bndng. By so dong, te partes proftably ncrease ex ante nvestment. Ts model of ex ante contractng predcts tat onlyonetypeofcourt(unbasedorpro-credtor dependng on parameters) wll be used n equlbrum. Tus, n a career concerns verson all courts wll try to mmc tat one. Not surprsngly, n ts model of ex ante contractng competton among courts s benefcal and trggers effcent outcomes. Appendx 3. Prvate Workouts Suppose tat before gong to court te debtor and te credtors can negotate a prvate workout. Assume for smplcty tat te nvestor as all te barganng power. Ten, a frm of type wc ended up before a judge reorganzng t wt probablty x() s spared neffcent reorganzaton, as te nvestor can offer an amount (1 α) x() of lqudaton proceeds to te entrepreneur. Tus, te workout s successful and ex post effcency s attaned. Consder now te case of a frm of type wc ended up before a judge reorganzng t wt probablty x(). Because te entrepreneur s cas constraned, to avod unproftable lqudaton, e can promse to te nvestor at most α of reorganzaton proceeds. As a result, te workout goes troug and te frm s reorganzed f 45

47 andonlyfα λ. If nstead α<λ/, te workout fals and te frm s over-lqudated wt probablty 1 x(). From ts analyss, and consstent wt Gammarno (1989), t s clear tat wle workouts can soften some of te ex post costs of judcal bas, tey cannot prevent pro-debtor bas from reducng ex ante repayment and tus debt capacty and welfare. Even f α λ, wc s assocated to workouts gvng full ex post effcency, expected repayment to credtors s (1/2) α + λ x()(1 α),wcfallsnx() and tus n β j. As a result, n lne wt Appendx 2 above, altoug workouts mprove ex post effcency and mgt sometmes nduce full ex post effcency, tey do not elmnate te ex ante cost of judcal bas. 46

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