Saturday, June 09, 2007

Tough love

There is a certain tension in designing a bankruptcy code, where both extremes - of killing a firm too soon or too late - are bad, and the trick seems to be to find the right middle. In India, discussions about creditors rights are clouded by a bias in favour of being soft on an incumbent firm. There is a certain bleeding heart sentiment which comes into play, where the State tries to help a weak firm claw back to life, where it is felt that the death of firms is a bad thing.

Tom Chang and Antoniette Schoar have an important paper The effect of judicial bias on Chapter 11 reorganisation where they obtain new insights on these questions.

First, using US data they are able to watch judges repeatedly processing bankruptcy cases, and are able to identify some judges who are more lenient than others. This is, in itself, a fascinating case of the value of bringing economic reasoning to bear on legal thinking. Ideally, judges are not supposed to display such differences in behaviour, but bankruptcy proceedings constitute an opportunity to watch the same judge perform on many homogeneous cases and thus identify judge characteristics.

They go on to look at what happens to the firms which benefited from dealing with a lenient judge at the bankruptcy proceeding. These firms don't bounce back, they don't do well.

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