Bankruptcy Decision Making

When a firm encounters financial distress, there is a significantpossibility that, at some point, the firm itself should be shutdown and its assets put to better use. But Chapter 11 and indeedall market-mimicking reorganization regimes other than a speedyauction entrust the shutdown decision to a bankruptcy judgewho lacks information and expertise, as well as the abilityto control the timing of her decisions. Understanding the costsof entrusting the shutdown decision to a bankruptcy judge iscentral to assessing any law of corporate reorganizations. Thisarticle models the shutdown decision as the exercise of a realoption. The model suggests that the shutdown decision may loomso large in the early parts of the bankruptcy case that it erasesany significant difference between Chapter 11 and many alternativemarket-mimicking regimes. All these regimes take more time thanmandatory auctions and thus increase the cost of taking theshutdown decision away from a market actor. Moreover, the realoption itself gives parties an incentive to withhold information.Only a system of mandatory auctions both limits the amount oftime the shutdown option resides with an inexpert decision makerand forces insiders to give that decision maker sufficient informationto value the option while it is in her hands.