Bankruptcy Law and Corporate Investment Decisions

Abstract

This paper contributes to the debate on optimal bankruptcy reform by providing a set of results that challenge the wisdom that "soft" bankruptcy codes have necessarily positive effects. The model hinges on the key idea that "soft" bankruptcy allows a poor performing entrepreneur to renegotiate the terms of the initial contract with a lender. In the presence of moral hazard, the optimal arrangement requires the hampering of project's continuation as punishment for poor performance. However, if the lender can increase recovery rates in bankruptcy such punishment is not renegotiation-proof. Clearly, this exacerbates the agency problem and creates a tension between ex-post and ex-ante efficiency that may impede the implementation of longterm projects.