Matching Bankruptcy Laws to Legal Environments

We study a model of optimal bankruptcy law in an environment where legal quality can vary along two dimensions: the ability of judges, and the quality of contract enforcement. We show that a judicially-influenced bankruptcy process can enhance the efficiency of incomplete contracts by conditioning the allocation of control rights in bankruptcy on ex-post information about firm quality when this is difficult to describe in a contract. We consider the optimal balance of debtor and creditor interests as a function of the legal environment, and show that the optimal degree of "creditor-friendliness" in the bankruptcy law increases as judicial ability to recognize firm quality falls and as the quality of contract enforcement deteriorates. Our model contributes to the existing law and finance literature in demonstrating that optimal bankruptcy laws, in particular the degree of optimal creditor protection, depends heavily on the existing legal environment. Our model is also able to explain cross-country patterns in the content and usage of bankruptcy laws around the world as reported in existing empirical research.