Improved Creditor Protection and Verifiability in the U.S

The dissatisfaction with the U.S. bankruptcy law is largely due to its excessive focus on distribution
rather than efficiency issues. The existence of dispersed creditors and different classes of debt make out-of-court restructuring harder and often result in rejections of reorganization plans in Chapter 11. In these cases, creditors' recovery values crucially depend on the level of verifiability of assets in place in court, the strategic uncertainty among lenders, and the debtor's uncertainty about the outcome of out-of-court renegotiations. Building on the work by Diamond (2004) and Ayotte and Gaon (2011), we develop a model that incorporates these three sources of uncertainty and examines the effect of verifiability on bankruptcy filing and firm financing. We show that higher verifiability increases both the probability of Chapter 11 filings and debt capacity. The model also predicts the effect on debt capacity to be increasing in verifiability. We test these predictions exploring an exogenous variation in one of several forms verifiability, namely, the ability of courts to price assets in place. We use the natural experiment provided by a Supreme Court ruling in 1999 stating that shareholders in Chapter 11 must auction their equity interest whenever they propose a restructuring plan contributing cash to the firm but violating creditor absolute priority. This change effectively precludes shareholders from making cash contributions below the market value of the assets, and thus substantially increasing asset verifiability. Our results strongly support our predictions. Chapter 11 filings for affected firms more than doubled after the Supreme Court ruling (from 0.63% to 1.73%), while control firms remained largely unaffected. The positive market reaction surrounding this event is also increasing in verifiability. Results are robust to various specifications and tests. Our theory and empirical work help clarify and quantify some of the channels by which creditor protection increases firm value.