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Working Paper

Protection for Whom? Creditor Conflicts in Bankruptcy

In this article we provide a rationale for bankruptcy law that is based on the conflicts among creditors that occur when a debtor’s liabilities exceed its assets. In the absence of a bankruptcy law, the private debt-collection remedies that creditors pursue when a debtor is insolvent result in an ad hoc disposal of the debtor’s assets, thereby reducing the aggregate value of creditors’ claims. We show that coordination clauses can be used by creditors in their loan agreements that will result in coordination, ex post. Although all creditors would benefit from including these clauses in their contracts, they nevertheless choose not to in precisely those circumstances in which it is desirable to coordinate. This is an important insight because previous theories supporting a role for a bankruptcy law are based on the notion that creditors want to contract about bankruptcy, but cannot. In contrast, we demonstrate that creditors will choose not to coordinate ex ante, even though it is in their best interest ex post.

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Longhofer, Stanley, and Stephen R. Peters. 1999. “Protection for Whom? Creditor Conflicts in Bankruptcy.” Federal Reserve Bank of Cleveland, Working Paper No. 99-09.