Abstract

We study theoretically how creditor protection affects the parties’ ability to resolve financial distress by contract. Our central finding is that better creditor protection allows parties to write more sophisticated contracts, including options and court intervention - as opposed to cash auctions - to decide whether to liquidate or continue a financially distressed project, thereby attaining higher welfare. Our analysis yields novel predictions on how debt contracts and debt structure should vary around the world. We reconcile current conflicting proposals for bankruptcy reform, and rationalize resolutions of financial distress around the world as a function of creditor protection. The normative implication of our analysis is that bankruptcy law should facilitate contractual resolutions of financial distress by providing an ex post enforcement mechanism to deter debtors’ self-dealing and tunneling activities.