Restructuring vs. Bankruptcy

Abstract

We develop a model of a firm in financial distress. Distress can be mitigated by filing for bankruptcy (which is costly) or preempted by restructuring (which is impeded by a collective action problem). We find that bankruptcy and restructuring are complements, not substitutes: Reducing bankruptcy costs facilitates restructuring, rather than crowding it out. So does making bankruptcy more debtor-friendly, under a condition that can be written in terms of a few easily observable sufficient statistics. The model gives new perspectives on relief policies (e.g., subsidies to bankrupt firms) and on legal debates (e.g., the absolute priority rule).