Chapter 11 structures complex negotiations between creditors and debtors that are overseen by a bankruptcy court. This paper identifies conditions under which it is optimal for the court to sometimes err in determining whether a firm should be liquidated. Such errors can affect the optimal action choices by both good and bad entrepreneurs. We first characterize the optimal error rate without renegotiation, providing conditions under which it is optimal for the court both to sometimes mistakenly liquidate “good firms,” but not “bad firms.” When creditors and debtors can renegotiate to circumvent an error-riven court and creditors have all of the bargaining power, we show that for a broad class of action choices, a blind court—one that ignores all information and hence is equally likely to liquidate a good firm as a bad one— is optimal. For another class of action choices, the optimal court design places the burden of proof on the entrepreneur. The robust feature is that in the optimal court design, the court sometimes errs in determining whether a firm should be liquidated.
JEL Classification: G33, D80
Key Words: bankruptcy judge, moral hazard, adverse selection
Suggested citation: Nosal, Ed, 2003. “Nearsighted Justice,” Federal Reserve Bank of Cleveland, Working Paper, no. 03-04.