Innovations in Bankruptcy—Pricing the Priority of Insolvency Claims

Abstract

Following the wave of recent financial turmoil, many developing countries have learned the value of an effective bankruptcy system in deterring excessive use of debt and providing an orderly way to resolve a debt crisis. As a result, they are now reforming their bankruptcy systems, generally modeling them on those of advanced countries. But there is dissatisfaction with bankruptcy frameworks in advanced countries too. Some alternatives have been proposed. One is an options-based approach that provides an objective way of pricing creditor claims according to priority. With allowances for local conditions, this approach offers developing countries a chance to leapfrog existing bankruptcy practices and their limitations. Effective bankruptcy systems have implications for corporate governance and for securities markets. For corporate managers and controlling shareholders, the cost of bankruptcy includes the loss of corporate control and the risk of personal liability. This threat serves as a restraint on the use of debt. In the event of default an efficient and orderly transfer of corporate control to creditors reduces the likelihood of asset stripping and looting by insiders. For creditors, available legal recourse makes it possible to extend credit at a reasonable cost. And in a cyclical downturn or in the face of financial distress, creditors are less likely to panic and liquidate securities on a massive scale.