Corporate and Personal Bankruptcy Law

LS07CH08-White ARI 1 October 2011 17:47

Michelle J. White1,2

1Department of Economics, University of California, San Diego, La Jolla, California 92093; email: [email protected] 2Cheung Kong Graduate School of Business, and Research Associate, National Bureau of Economic Research, Cambridge, Massachusetts 02138

Annu. Rev. Law Soc. Sci. 2011. 7:139–64 Keywords The Annual Review of Law and Social Science is reorganization, liquidation, priority, absolute priority rule, default, online at lawsocsci.annualreviews.org exemptions, filtering failure, workouts, fresh start, foreclosure This article’s doi: 10.1146/annurev-lawsocsci-102510-105401 Abstract Copyright c 2011 by Annual Reviews. Bankruptcy is the legal process by which the debts of firms, individ- All rights reserved uals, and occasionally governments in financial distress are resolved. 1550-3585/11/1201-0139$20.00 by University of California - San Diego on 09/05/12. For personal use only. Bankruptcy law always includes three components. First, it provides a collective framework for simultaneously resolving all debts of the Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org bankrupt entity, regardless of when they are due. Second, it provides rules for determining how the assets and earnings used to repay are divided among creditors. Third, bankruptcy law specifies punishments intended to discourage debtors from defaulting on their debts and filing for bankruptcy. This review discusses and evaluates bankruptcy law by examining whether and when the law encourages debtors and creditors to behave in economically efficient ways. It also considers how bankruptcy law might be changed to improve economic efficiency. The review shows that there are multiple economic objectives of bankruptcy law because the law has very diverse effects. Some of these objectives differ for individuals versus corporations in bankruptcy.

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INTRODUCTION of time after filing.1 Another part of the pun- Bankruptcy is the legal process by which the ishment for bankruptcy is whether and when debts of firms, individuals, and occasionally filers’ liability to repay debts is discharged. In governments in financial distress are resolved. the United States, most bankruptcy filers re- Debtors file for bankruptcy because they can- ceive a quick discharge from debt, but in France not pay debts as they come due and/or because and Germany, discharges are issued only af- their liabilities exceed their assets. ter debtors use part of their earnings for 5 to Bankruptcy law always includes three com- 10 years to repay debts, and bankruptcy judges ponents. First, it provides a collective frame- can deny the discharge if they feel that debtors work for simultaneously resolving all debts of did not try hard enough to repay debts. In other the bankrupt entity, regardless of when the countries, debt discharge occurs only when the debts come due. Bankrupts may be required to debtor dies. For corporations in bankruptcy, use some or all of their assets to repay their debt is discharged quickly, but the corporation debts: Bankruptcy law includes rules determin- itself ceases to exist. ing which assets must be used to repay debts Bankruptcy procedures may involve ei- versus which assets bankrupts are allowed to ther liquidation or reorganization of the keep (if any). Bankrupts may also be required bankrupt entity. When corporations liquidate to use some of their future earnings to re- in bankruptcy, all of their assets are sold and pay debts, and bankruptcy law provides simi- the proceeds are used to repay creditors. Assets lar rules determining how much of their future may be sold piecemeal or as a going concern earnings must be used to repay debts. These if the corporation is still operating when it rules differ depending on whether bankrupts files for bankruptcy. The size of the pie in are corporations, individuals, or governments. bankruptcy liquidation is all of the corpora- Second, bankruptcy law provides rules for de- tion’s assets. When corporations reorganize termining how the assets and earnings used to in bankruptcy, they keep some or all of their repay debts are divided among creditors. This assets, continue to operate, and follow a plan to part of bankruptcy law also includes rules that use part of their future earnings to repay debt. limit creditors’ rights to grab assets and keep In this situation, the pie includes only part of those assets out of the collective debt resolu- the corporation’s assets, but it also includes tion procedure. Thus bankruptcy law deter- part of the corporation’s future earnings. For mines both the size of the pie in bankruptcy, individuals, bankruptcy never involves com- i.e., the total amount paid to creditors, and plete liquidation. Individual bankrupts may be the division of the pie among individual required to give up some of their assets; these creditors. by University of California - San Diego on 09/05/12. For personal use only. Third, bankruptcy law specifies how debtors 1There are other punishments for debtors who default but

Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org are punished for filing for bankruptcy. In do not file for bankruptcy, including credit collectors call- the United States, the main punishments for ing them, suing them, and garnishing their wages (see below bankruptcy are making filers’ names public and for further discussion). Past punishments for default were allowing the bankruptcy filing to remain on far more severe and included the death penalty, exile, selling debtors into slavery, and putting them in debtors’ prisons. their credit records for 10 years. These pun- Early bankruptcy laws also specified severe punishments for ishments stigmatize bankruptcy filers and harm filing, including debtor’s prison and the death penalty for them financially because they face greater diffi- filers who concealed assets. Debts were discharged only if creditors consented. See Efrat (2006) for multicountry infor- culty postbankruptcy in obtaining loans, rent- mation on punishments for default and bankruptcy. Sandage ing apartments, and sometimes obtaining jobs. (2005), Balleisen (2001), and Mann (2002) discuss attitudes In the United Kingdom, punishments include toward debt and default in the United States and the adoption of U.S. bankruptcy laws—there were several—in the nine- barring bankruptcy filers from managing firms teenth century. Skeel (2001) gives a history of U.S. personal or holding certain public offices for a period and corporate bankruptcy law during the twentieth century.

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are liquidated and the proceeds are used to on personal and small business bankruptcy.2 repay creditors. But individuals’ most valuable Corporate bankruptcy refers to the bankruptcy asset is usually their human capital—their of large- and medium-sized firms, which I as- education and training—and the only way to sume are organized as corporations. Personal liquidate human capital is to sell individuals bankruptcy refers to the bankruptcies of both into slavery. Because slavery is no longer individual debtors and small businesses. Small allowed, bankrupt individuals always keep their business bankruptcy is treated as part of per- human capital and the right to decide whether sonal bankruptcy because small businesses are and how to use it. Thus bankrupt individuals owned by individuals or partners who are legally always keep some of their assets. However, like responsible for their business debts. When corporations that reorganize, bankrupt individ- businesses fail, owners often file for personal uals may be obliged to use some of the future bankruptcy in order to have their business debts earnings that their human capital produces to discharged. Even when small businesses are in- repay creditors, usually for a fixed number of corporated, owners often guarantee the debts years. This means that bankruptcy procedures of their businesses, so personal bankruptcy law for individuals are always reorganizations, and applies. the size of the pie used to repay creditors is less than the value of bankrupt individuals’ I. CORPORATE BANKRUPTCY assets. This review discusses and evaluates Bankruptcy law affects the economic efficiency bankruptcy law by examining whether and of corporate behavior, both when corporations when the law encourages debtors and creditors are in financial distress and when they are fi- to behave in economically efficient ways. It nancially healthy. also considers how bankruptcy law might be changed to improve economic efficiency. The Effects of Priority Rules in Bankruptcy discussion abstracts from the details of U.S. and on Corporate Behavior other countries’ bankruptcy laws in order to Priority rules are rules for dividing repayment focus on common features of bankruptcy law, in bankruptcy among creditors and sharehold- and it also attempts to avoid use of legal terms. ers of a corporation. An important priority rule This review shows that bankruptcy law has a is the absolute priority rule (APR), which re- variety of economic objectives, some of which quires that unsecured creditors be repaid in full differ for individuals versus corporations. The before shareholders receive anything. When variety of economic objectives results from the there are multiple creditors, priority among fact that bankruptcy law has widespread effects: them is determined by whether creditors have by University of California - San Diego on 09/05/12. For personal use only. causing responses that change the supply and a secured interest in a particular asset owned demand for many types of credit; which finan-

Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org by the corporation or by whether creditors cially distressed ﬁrms shut down versus which have made agreements with the corporation continue to operate; corporate managers’ in- that specify a priority ordering. Suppose a centives to work hard, invest, and take risks; and corporation has creditors A and B and A’s individual debtors’ incentives to work hard, be- loan was made before B’s. If A’s contract with come entrepreneurs, take risks, buy insurance, and even get divorced. Bankruptcy also affects

competitors of ﬁnancially distressed ﬁrms and 2Owing to lack of space, governmental (“sovereign”) the welfare of debtors’ family members and bankruptcy is ignored. Much of the discussion concerns neighbors. the possibility of establishing a bankruptcy procedure for sovereign default that would have the three characteristics Section I discusses research on corporate discussed above (see McConnell & Picker 1993, White 2002, bankruptcy and Section II discusses research and Bolton & Jeanne 2007).

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the corporation speciﬁes that its claim will when corporations are economically efﬁcient, take priority in bankruptcy over the claims the best outcome is for them to continue oper- of later creditors, then A’s claim is paid in ating outside of bankruptcy because this keeps full in bankruptcy before B receives anything. the assets in their current use. Filtering failure Alternatively, suppose A has a secured claim occurs when corporations that should liquidate on the corporation’s computer. Then A can continue to operate or vice versa. Assume that take the computer in bankruptcy, which means managers and creditors are fully informed that A’s claim is paid up to the value of the about the value of the corporation’s assets in computer before B receives anything. If there their current use and also in alternate uses.

is no contractual agreement, then A and B Suppose the corporation owes a debt of DA have equal priority in bankruptcy and the APR dollars to creditor A, which is due in period 1,

requires that they be paid the same proportion and a debt of DB to creditor B, which is due in

of their claims. The legal justiﬁcation for the period 2. Total debt D equals DA + DB .The APR is that it treats creditors in bankruptcy corporation has no cash on hand. The liquida- according to the contracts they made with tion value of the assets in period 1 is L, and the corporation outside of bankruptcy. “Devi- because L < D, the corporation is insolvent. ations from the APR” refer to paying positive Managers can either ﬁle for bankruptcy and liq- amounts to lower-priority creditors or share- uidate in period 1 or continue to operate the holders in bankruptcy when higher-priority corporation outside of bankruptcy until period creditors receive less than full repayment. 2. In the latter case, assume that the corpora-

Priority rules affect both the size and the dition will earn P2 with certainty in period 2, but vision of the pie. Changes in priority among the liquidation value of its assets falls to zero. Ig- creditors have no effect on the size of the pie, noring the time value of money, continuation in

but they do change the division of the pie. period 1 is economically efﬁcient if P2 > L and When creditors receive less than full repayment liquidation is economically efﬁcient otherwise. and shareholders receive positive payment, then To avoid bankruptcy in period 1, managers deviations from the APR occur and they reduce must repay creditor A, and the only way they can the size of the pie. do so is to obtain a new loan from creditor C for

Priority rules affect the economic efficiency the amount DC = DA. The new loan will be due of corporate behavior. Consider first how in period 2. If managers obtain the new loan, the they affect whether corporate managers make corporation will continue to operate until pe- economically efficient bankruptcy decisions. riod 2, when it will shut down and distribute its Assume that the corporation is in financial dis- assets according to the APR. Depending on the tress and managers—representing the interests terms of creditor B’s and C’s contracts with the

by University of California - San Diego on 09/05/12. For personal use only. of shareholders—must choose between filing corporation, either creditor could take priority for bankruptcy or continuing to operate outside under the APR, or they could have equal prior- Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org of bankruptcy. The only bankruptcy procedure ity. Assume first that creditor B takes priority, is liquidation. Corporations in financial distress i.e., priority is in chronological order. may be either economically efficient or eco- In period 1, creditor C and managers are nomically inefficient. They are economically ef- assumed to make the corporation’s bankruptcy ficient (despite being in financial distress) when decision jointly, so that creditor C makes the the most valuable use of their assets is the cur- loan if it and shareholders jointly gain when rent use, and they are economically inefficient the corporation continues to operate. If liqui- when their assets are more valuable in some dation occurs in period 1, then all of the cor- other use. When corporations are economically poration’s assets go to pay creditors, and share- inefficient, the best outcome is liquidation be- holders receive nothing. If creditor C makes the cause liquidation frees the corporation’s assets loan and the corporation continues to operate, to move to more valuable uses. Conversely, then creditor C and shareholders together will

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receive max[P2 − DB ,0]−DC in period 2. For corporations if by doing so they can jump over creditor C and shareholders to prefer continu- earlier lenders in the priority ordering (see ation, this expression must be positive, which Bebchuck & Fried 1996 and Stulz & Johnson

implies that P2 > DB + DC = D. But be- 1985 for discussion).

cause D > L, this also means that P2 > L. Now suppose corporations’ future earnings Thus creditor C and shareholders choose con- are uncertain rather than certain. Suppose the tinuation only when it is economically efﬁcient. corporation’s earnings, if it continues to op-

But they may choose liquidation when contin- erate until period 2, are P2 + G or P2 − G, uation is more efﬁcient: This outcome occurs each with 0.5 probability. Suppose creditor B if creditor C and managers choose liquidation has priority over creditor C, and assume that

because max[P2 − DB ,0]−DC is negative, or if earnings in the good outcome are sufﬁcient to P2 < D, but continuation is economically efﬁ- repay creditor B in full, whereas earnings in the

cient because L < P2. Thus some efﬁcient cor- bad outcome are not. If creditor C lends and porations liquidate in bankruptcy—an example the corporation continues to operate, creditor of ﬁltering failure. This result occurs because C and shareholders’ joint expected return in pe-

choosing continuation increases the amount re- riod 2 is .5(P2 + G − DB ) − DC .CreditorC paid to creditor B, but managers and creditor lends and the corporation continues to operate C ignore this gain because they do not share if this expression is positive, but continuation

it. Overall, when priority among creditors is in is economically efficient if P2 ≥ L. This means chronological order, too much liquidation oc- that as the corporation’s earnings become more curs in bankruptcy.3 uncertain (G rises), inefficient continuation is Now suppose priority among creditors B more likely to occur. This is because creditor and C is reversed, so that it is in reverse chrono- C and shareholders get the additional earnings logical order. Then creditor C is more likely to in the good outcome, but creditor B bears the lend, and therefore financially distressed cor- additional losses in the bad outcome. This re- porations are more likely to continue rather sult illustrates the fact that corporate managers than liquidating. But the condition for contin- and shareholders often prefer risky over safe in- uation to be economically efficient remains the vestments even when risky projects offer lower same. Thus when priority is in reverse chrono- expected returns because shareholders gain dis- logical order, fewer economically efficient cor- proportionately from risky projects if they suc- porations liquidate in bankruptcy. But now ceed. This effect applies both to corporations’ the opposite type of filtering failure may oc- bankruptcy decisions and to their investment cur because more inefficient corporations avoid decisions generally (see Stiglitz 1972 and Jensen bankruptcy and continue operating. & Meckling 1976 for discussion in the non-

by University of California - San Diego on 09/05/12. For personal use only. These examples show that priority rules af- bankruptcy context). fect whether filtering failure occurs and may re- Now suppose reorganization is an alter- Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org sult in either too much liquidation or too much native bankruptcy procedure.4 Managers of continuation. Too much liquidation is likely corporations in financial distress are now as- when priority among lenders is in chronological sumed to choose among continuing outside order, whereas too much continuation is likely of bankruptcy, liquidating in bankruptcy, and when priority is in reverse chronological order. The latter result implies that lenders have an incentive to make loans to financially distressed 4In the United States, managers of corporations in bankruptcy generally have the right to choose between reorganization or liquidation, but in other countries the decision 3This result is an application in bankruptcy of Myers’s (1977) is usually made by a bankruptcy court appointee who also “debt overhang” problem. For discussion of the effects of replaces the manager. See Franks et al. (1996), White (1996), priority rules in bankruptcy, see Bulow & Shoven (1978), Berkovitch & Israel (1998), and Franks & Sussman (2005) for White (1980), and Schwartz (1981). comparison of bankruptcy law across countries.

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reorganizing in bankruptcy. When corpora- sion is positive, and they prefer reorganization tions reorganize in bankruptcy, managers are over continuing to operate the ﬁrm outside of

assumed to remain in control at least temporar- bankruptcy because .5(P2 +G−rDE )+.5(αDE ) ily, and unsecured debt payments are suspended exceeds .5(P2 + G − DE ). But reorganizing

until a reorganization plan is adopted. This is economically efficient only if P2 > L,and temporary debt holiday improves corporations’ this condition is unaffected by introducing cash flow and helps them to continue operating. reorganization. Thus introducing reorgani- Assume that the reorganization plan requires zation in bankruptcy causes more filtering corporations to pay all creditors a fraction r of failure because more corporations continue to their claims in period 2. Also assume that the operate, some of which should liquidate. corporation has only one creditor, creditor E, Introducing reorganization in bankruptcy

whose claim of DE is due in period 1. Because also affects managers’ incentive to choose safe of the debt holiday, the corporation no longer versus risky investment projects. When cor- needs a new loan in period 1 to continue oper- porations are in ﬁnancial distress, suppose the ating. If it reorganizes, assume that its earnings probability of the bad outcome increases in our

will still be P2 ± G in period 2, each with 50% example from 0.5 to 0.9. Shareholders’ return probability, and its assets will still be worthless thus comes mainly from their payoff of αDE in at the end of period 2. the bad outcome. When deviations from the

Introducing reorganization allows us to ex- APR are zero, then αDE = 0 and shareholders amine the effects of deviations from the APR. get nothing in the bad outcome. This means Deviations from the APR often occur when that managers have an incentive to invest in U.S. corporations reorganize in bankruptcy be- very risky projects (those with high G), because cause reorganization plans must be approved shareholders receive a payoff only when the by vote of shareholders as well as creditors. risky investment project is chosen, it succeeds,

Shareholders must therefore receive some pay- and its return .5(P2 +G− DE ) is large enough to ment or else they would vote against the plan.5 save the corporation. Managers therefore pre- Suppose shareholders are promised a payment fer risky projects even when they have low ex-

equal to a fraction α of creditors’ claims, or αDE . pected returns and are economically inefﬁcient. If α is positive, then there are deviations from But deviations from the APR give shareholders the APR; higher values of α imply that the pay- a positive return even when the bad outcome off rate r to creditors is lower. occurs and the ﬁrm fails, so that managers’ in- If the corporation reorganizes, shareholders’ centive to select excessively risky investment

expected return becomes .5(P2 + G − rDE ) + projects is smaller. Thus deviations from the .5(αDE ), where P + G + rDE and αDE rep- APR improve efﬁciency when corporations are

by University of California - San Diego on 09/05/12. For personal use only. resent the payments that shareholders receive in financial distress by reducing managers’ in- in the good and bad outcomes, respectively. centive to choose extremely risky investments.6 Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org Deviations from the APR raise α and lower r,so This discussion shows that introducing that they both increase shareholders’ expected reorganization as an alternative bankruptcy return and reduce their risk. Because share- procedure increases filtering failure by saving holders receive nothing if the firm liquidates in more financially distressed corporations when period 1, managers prefer reorganization over they should be shut down.7 But the option of liquidation in bankruptcy as long as this expres-

6But deviations from the APR have the opposite effect on 5Deviations from the APR can alternately be seen as pay- managers’ incentives when corporations are not in ﬁnancial ments by creditors to prevent shareholders from delaying distress. See Bebchuk (2002) and Cornelli & Felli (1997) for the reorganization process. See Bebchuk & Chang (1992) discussions. for a model and Bebchuk (1998) for discussion of the U.S. 7See Weiss & Wruck (1998) for a discussion of Eastern Air- reorganization process generally. lines as an example of an inefﬁcient corporation that was saved

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reorganizing reduces managers’ incentives like to accept all workout plans offered by to invest in excessively risky investment insolvent corporations and reject all workout projects when their corporations are financially plans offered by solvent corporations. If they distressed, so that reorganization has mixed could do so, then insolvent corporations would effects on economic efficiency. The discussion always use nonbankruptcy workouts, whereas also suggests that none of the commonly solvent corporations would never default. This used priority rules in bankruptcy always give outcome would be efficient because no strategic corporate managers an incentive to make both default and no costly bankruptcy would occur. efficient bankruptcy decisions and efficient But models of strategic default assume that investment choices. there is asymmetric information about corporations’ financial status, meaning that managers know whether their corporations are solvent, Other Effects of Bankruptcy Law: but creditors do not. Under this assumption, Strategic Default and creditors cannot identify individual corpora- Managerial Effort tions’ types and they must respond in the same Now turn to the effect of bankruptcy law on way to all workout offers. Creditors have an whether corporations default on debt obliga- incentive to accept workout proposals because tions when they are not in financial distress— bankruptcy costs are assumed to be high, and called strategic default. Suppose there are two therefore creditors receive little if corporations types of corporations, solvent and insolvent. As- file for bankruptcy. But they also have an sume that the most efficient outcome for both incentive to reject workout proposals in order types of corporations is to continue operating. to discourage strategic default. In equilibrium, Managers of both types of corporations decide creditors reject some or all workout proposals, whether to repay in full or default. If they de- and this means that at least some insolvent cor- fault, they offer to pay creditors a fraction of porations end up in bankruptcy. Asymmetric their claims, and creditors must decide whether information thus implies that there will always to accept or reject. If creditors accept, then be either some strategic default or some costly the new debt agreement goes into effect—it is bankruptcy, or a combination of both (see called a nonbankruptcy workout. If creditors re- Schwartz 1993, Gertner & Scharfstein 1991, ject, then managers of insolvent corporations and White 1994 for discussions). file for bankruptcy, whereas managers of sol- Financial contracting models extend this vent corporations remain out of bankruptcy and analysis earlier in time to when creditors and repay in full. Because bankruptcy is assumed managers first negotiate the terms of their to be costly, the most efficient outcome is for loans (see Hart & Moore 1998 and Bolton

by University of California - San Diego on 09/05/12. For personal use only. insolvent corporations to use nonbankruptcy & Scharfstein 1996b for discussions). Often workouts to resolve their ﬁnancial distress. Sol- these models assume that corporations are just Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org vent corporations should repay their loans in being established, with entrepreneurs that have full because the supply of credit is larger when investment projects but no cash to ﬁnance them fewer defaults occur. and creditors/investors that have cash but no Suppose managers of insolvent corpora- investment projects. Suppose a creditor lends tions always default and propose workouts, D dollars to an entrepreneur in period 0. In whereas managers of solvent corporations may period 1, the project either succeeds or fails. In either default or repay in full. Creditors would period 2, it either succeeds and earns a return

of R2 > D, or it fails and earns zero. In period 3, it earns R3 regardless. Also assume that the in bankruptcy reorganization when it should have liquidated. project’s assets have positive liquidation value See Lang & Stulz (1992) and Borenstein & Rose (2003) for discussions of the effect of airline bankruptcies on competi- L in period 2, but they are worthless in period > tion in the industry. 3. Since R3 L, it is always efﬁcient for the

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project to continue until period 3, which means they are less likely to strategically default. This that bankruptcies in period 2 are inefficient. is because each individual creditor has the right Information is now assumed to be incom- to liquidate the corporation following default, plete, but symmetric. All parties are assumed so that strategic default only succeeds if no to observe the corporation’s return each creditor liquidates, and this outcome becomes period, but creditors and entrepreneurs are less likely as the number of creditors increases. assumed unable to make a contract based on However, the cost of nonstrategic default rises these returns because they are not verifiable when there are more creditors. Berglof & von in court. But creditors and entrepreneurs can Thadden (1994) consider a similar model in make enforceable contracts specifying that which the project has both short-term and creditors must receive fixed dollar payments at long-term debt. Creditors holding short-term particular times and that they have the right to versus long-term debt have differing stakes in liquidate the corporation otherwise. Suppose the corporation because only those holding the contract specifies that the entrepreneur long-term debt benefit from its future earn- will pay creditors D in period 2; otherwise, ings. As a result, short-term creditors are more creditors have the right to liquidate the cor- likely to liquidate following default. Berglof poration and collect L. Under this contract, & von Thadden show that entrepreneurs are entrepreneurs never default strategically; they less likely to default strategically if some of repay D in period 2 if the project succeeds the corporation’s creditors hold only short- and default if it fails. Entrepreneurs repay in term debt. (Other articles that explore the ef- period 2 whenever they can because they gain fects of financial contracts when bankruptcy from retaining control of the corporation and may occur include Webb 1991, Bester 1994,

collecting R3 in period 3. The contract does Bolton & Scharfstein 1996a, and Hart & Moore not call for entrepreneurs to pay anything to 1998). investors in period 3—any obligation by en- Other papers consider how bankruptcy law trepreneurs to pay in period 3 is unenforceable affects whether entrepreneurs use the econom- because the corporation has zero liquidation ically efficient level of effort in managing their value and therefore investors cannot punish corporations. Povel (1999) develops a model to entrepreneurs for defaulting. analyze how bankruptcy law affects the trade- This type of contract eliminates strategic off between entrepreneurs’ effort levels and default but causes some bankruptcies to occur whether the number of bankruptcy filings is ef- in period 2. This is because creditors liquidate ficient. In his model, corporations may have ei- corporations that default in period 2, even ther high or low earnings. The best outcome is though liquidation is inefficient. Otherwise, for them to file for bankruptcy when earnings

by University of California - San Diego on 09/05/12. For personal use only. managers would have an incentive to strate- are low and to avoid bankruptcy when earnings gically default. Investors alternatively might are high. Entrepreneurs make the bankruptcy Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org play mixed strategies and only sometimes liq- decision. They also decide whether to use high uidate corporations that default—this reduces or low effort, where high effort increases the bankruptcy but causes some strategic default to probability of high earnings. But creditors can- occur. Thus when information is incomplete, not observe entrepreneurs’ effort levels, and no contract can eliminate both bankruptcy and they also do not observe a signal that arrives strategic default. concerning the project’s quality. Several papers in the ﬁnancial contract- There are two possible bankruptcy laws: ing literature consider alternative ways of re- soft versus tough, corresponding to reorga- ducing strategic default. Bolton & Scharfstein nization versus liquidation in bankruptcy. (1996b) extend the model to consider the op- Entrepreneurs are assumed to keep their jobs timal number of creditors and ﬁnd that, when under the soft bankruptcy law and lose them entrepreneurs borrow from multiple creditors, under the tough bankruptcy law.

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When bankruptcy law is soft, Povel (1999) bankruptcy in the United States should be shows that entrepreneurs file for bankruptcy reformed to eliminate deviations from the whenever the signal suggests that earnings are APR and reduce filtering failure. More specif- likely to be bad because they are treated well ically, the argument is that reorganization in in bankruptcy. But because they have a soft bankruptcy sets up a negotiation between man- landing in bankruptcy, they use less effort. agers and creditors that overvalues corporate In contrast, when bankruptcy law is tough, assets, which results in deviations from the APR entrepreneurs avoid bankruptcy regardless occurring and inefficient corporations being of the signal because filing for bankruptcy saved. The reform proposals advocate substi- costs them their jobs. But then they have an tuting market-based methods to value corpo- incentive to use high effort to increase the rate assets in bankruptcy, so that the APR is probability that earnings will be high. Thus fil- followed (without deviations). They also argue tering failure trades off against entrepreneurs’ that old managers should not be allowed to de- effort level: A tough bankruptcy law results in cide whether corporations in bankruptcy shut too many bankruptcies but efficient effort by down or continue to operate. entrepreneurs, whereas a soft bankruptcy law As an example of how inaccurate valuations results in the opposite. Depending on whether lead to deviations from the APR, suppose the efficient effort by entrepreneurs or efficient true value of a corporation’s assets is $8 million levels of filtering failure is more valuable, and it has $8 million in high-priority claims and either a soft or a tough bankruptcy law could $4 million in low-priority claims. If the assets be more economically efficient.8 are valued at $8 million or less, then high- To summarize, theoretical models of priority creditors receive all of the assets of the bankruptcy law show that bankruptcy affects reorganized corporation, whereas low-priority managers’ incentive to use effort, to default creditors and the firm’s old shareholders receive strategically, to file for bankruptcy at the ef- nothing. But if the assets instead are valued at, ficient time, and to make efficient investment say, $14 million, then high-priority creditors decisions. The models consider both the effects receive only $8 million of the $14 million, on economic efficiency of changing the priority or 57% of the assets, low-priority creditors rules in bankruptcy and changing bankruptcy receive 29%, and old shareholders receive law in other ways. The results show that, ex- 14%. Thus a high valuation leads to deviations cept in special cases, no one bankruptcy proce- from the APR. In the United States, negotia- dure results in economically efficient outcomes tions over reorganization plans in bankruptcy along all the dimensions considered. frequently use inflated valuations because the voting procedure for adopting a reorganization

by University of California - San Diego on 09/05/12. For personal use only. Proposed Reforms of Bankruptcy Law: plan requires that low-priority creditors and Auctions, Options, and Bankruptcy old shareholders vote in favor, and they only Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org by Contract do so if they receive some payment. But if A number of authors have argued that the a reorganization plan is adopted, then the procedure for reorganizing corporations in corporation continues to operate even if it is inefﬁcient.

8Berkovitch et al. (1997) explore how bankruptcy law affects Auctions. One reform proposal is to auction managers’ incentives to invest in firm-specific human capital, all corporations in bankruptcy. If corporations and Berkovitch & Israel (1999) explore whether creditors or entrepreneurs should have the right to initiate bankruptcy. are operating when they file, then they would Triantis (1993) explores how bankruptcy law affects the ef- be auctioned as going concerns, and if they ficiency of buyers’ and sellers’ incentives to breach contracts have shut down, then their assets would be auc- and to make reliance investments. Gertner & Scharfstein (1991) explore how bankruptcy law affects investment and tioned piecemeal. The proceeds of the auction when additional investment is economically efficient. would be distributed to creditors and equity

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according to the APR, without deviations. The the options approach, each owner of an old winner of the auction—rather than the old share is given an option to purchase a new managers—would decide whether to continue share for $1. These options must be exercised to operate the corporation or shut down. Auc- at a particular date. If old shareholders think tions would eliminate the distinction between that the new shares will be worth less than $1, reorganization and liquidation in bankruptcy. they will not exercise their options. Then the Auctions have a number of advantages. They bankrupt firm’s debt is converted into shares improve economic efficiency by allowing new in the reorganized corporation, so that each buyers to decide whether distressed corpora- creditor ends up with one new share worth less tions liquidate or reorganize. Although man- than $1 and old shareholders receive nothing. agers and old shareholders always prefer reor- But if old shareholders think that the new ganization, buyers have an incentive to make shares will be worth more than $1, then they economically efficient choices because they will exercise their options. Each creditor then have their own funds at stake. Using auctions ends up with $1 and each old shareholder ends also eliminates the overvaluation of corporate up with 1 new share of the reorganized firm assets because all valuations are market based. minus $1. A market for the options would op- The reorganization process is also quicker and erate before the exercise date, so that creditors less costly because there is no need to negoti- and shareholders would have a choice between ate and vote on reorganization plans (see Baird exercising their options or selling them to 1986, 1987, 1993; Roe 1983; Jackson 1986; outside investors. Regardless of whether the Shleifer & Vishny 1992; Berkovitch et al. 1997, options are exercised, the APR is followed. 1998; Baird & Rasmussen 2002; and LoPucki This is because regardless of who ends up 2003 for arguments in favor and against using owning the new shares, the old shareholders auctions in Chapter 11). receive nothing unless creditors are repaid in But a number of problems with bankruptcy full. The same procedure can be extended to auctions have been noted. One example is, if multiple classes of creditors, where each class few bankrupt firms are auctioned, then buyers of creditors is given options to purchase the may assume that they are lemons and respond claims of the next highest class of creditors. with low bids. This problem may become less In Bebchuk’s proposal, there is no explicit severe as more auctions occur. Another exam- method for determining whether the old man- ple is that auctions may increase market power agers will be replaced and how the reorganized in an industry because the most likely buyers for firm’s assets will be used. After the options are assets of bankrupt corporations are other firms exercised, the new shareholders elect a board in the same industry. Finally and most impor- of directors that hires a manager—the same

by University of California - San Diego on 09/05/12. For personal use only. tantly, the theoretical models discussed above procedure as is followed by nonbankrupt firms. do not support the idea that strict application of Aghion et al. (1992) and Hart et al. (1997) ex- Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org the APR in bankruptcy reorganization increases tended Bebchuk’s options scheme to include a efficiency. Instead, using the APR without de- vote by the new shareholders on how the reor- viations may result in too much liquidation oc- ganized firm’s assets will be used. Under their curring, rather than too much reorganization. proposal, the bankruptcy judge solicits bids that could involve either cash or noncash offers for Options. Bebchuk (1988, 2000) proposed the reorganized firm’s new shares or simply of- using options to value the assets of corporations fers to manage the firm with the new share- in bankruptcy and eliminate deviations from holders retaining their shares. The bids are an- the APR. To illustrate, suppose a bankrupt firm nounced at the same time that the options are has 100 shares of equity and 100 creditors who issued, so that the parties can use the informa- are each owed $1. Also suppose the reorganized tion contained in the bids in deciding whether firm will have 100 new shares of equity. Under to exercise their options. After the options are

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exercised, new shareholders vote to determine The process would continue until the corpora- which bid is selected. tion is solvent again. These changes would pre- serve the APR. Creditors would no longer have Contracting about bankruptcy. Bankruptcy the right to sue corporations for repayment fol- is a mandatory procedure in the sense that, lowing default. As an example, suppose a cor- when firms become insolvent, the state- poration’s assets are worth $1,000,000, but it supplied bankruptcy procedure must be used. is insolvent because it has $900,000 in senior Debtors and creditors are not allowed to con- debt and $500,000 in junior debt. Then the se- tract for any alternative dispute-resolution pro- nior debt would remain intact, the junior debt cedure or for any limits on managers’ right would be converted into equity, and the old eq- to file for bankruptcy and to choose between uity would be eliminated. liquidation and reorganization in bankruptcy. The proposal has a number of obvious prob- They also cannot contract out of use of the lems. The most important is strategic default: APR in bankruptcy liquidation. In this sense, managers gain from getting rid of the corpora- bankruptcy differs from other aspects of com- tion’s debt, so that they have an incentive to mercial law, where the law provides a set of invoke the procedure too often. The lack of default rules, but the parties are generally al- a penalty for default would undermine credit lowed to reject the default rules by agreeing on markets and greatly reduce credit availability. In alternatives. A number of authors have argued addition, inefficient corporations would never that efficiency would be enhanced if creditors be forced to shut down because they could and debtors could choose their own bankruptcy always convert their debt to equity. Overall, procedure, with the choice being made when the proposal suggests the importance of hav- they negotiate their debt contracts. This argu- ing a mandatory bankruptcy procedure. Al- ment makes sense in light of the contracting though it might improve efficiency to allow models discussed above, which show that the debtors and creditors to contract about specifics most economically efficient bankruptcy proce- of bankruptcy, it would not improve efficiency dure may vary depending on circumstances. to eliminate bankruptcy completely. For example, in the Povel (1999) model dis- Schwartz (1997) considers a model in which cussed above, the most economically efficient bankruptcy reorganization retains its current bankruptcy law could be either soft or tough, form, but debtors and creditors can contract depending on circumstances.9 in advance to change specific aspects of the The most radical approach to bankruptcy law. In particular, creditors could contract in contracting was suggested by Adler (1993), who advance to pay shareholders a predetermined proposed completely abolishing bankruptcy. amount if managers choose liquidation rather

by University of California - San Diego on 09/05/12. For personal use only. Instead, debt contracts would incorporate a than reorganization in bankruptcy. In effect, procedure to deal with financial distress, which this means that the parties could contract in ad- Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org Adler calls “chameleon equity.” If a corpora- vance to deviate from the APR in bankruptcy. tion became insolvent, its lowest-priority debt All other aspects of bankruptcy law would claims would be converted to equity and old remain unchanged. equity would be eliminated. If the corpora- Schwartz shows that this type of contract can tion was still insolvent, the next-higher-priority reduce filtering failure by reducing the number debt claims would be converted into equity and of corporations that reorganize in bankruptcy lower-priority debt claims would be eliminated. when they should liquidate. This is because the predetermined payment causes managers of inefficient corporations to change their preferences from liquidation to reorganization, 9Other contracting models discussed above also consider optimal bankruptcy law. See also Aghion & Hermalin (1990) whereas managers of efficient corporations still and Rasmussen (1992). prefer reorganization because it generates a

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larger return than the predetermined payment. bankruptcy and the size and frequency of de- But the result is somewhat fragile because viations from the APR.11 if the predetermined payment is too high, then even managers of efficient corporations Bankruptcy costs. Bankruptcy costs can be will prefer liquidation over reorganization. divided into direct and indirect costs. Direct Thus allowing contracting over some aspects costs include the legal and administrative costs of bankruptcy law can sometimes improve of bankruptcy, whereas indirect costs include economic efficiency relative to the current all the costs of bankruptcy-induced disrup- mandatory bankruptcy regime. tions, including asset disappearance, loss of key employees, reduced access to capital, and in- Financial crises and “systemic” bankruptcy. vestment opportunities forgone because man- The previous discussion assumes that bankrupt- agers’ time is spent on the bankruptcy. Weiss cies occur in isolation. However, in a financial (1990) studied 37 corporate reorganizations crisis, many corporations experience financial during the early 1980s and found that the di- distress simultaneously because credit becomes rect costs of bankruptcy averaged 3.1% of the unavailable or interest rates drastically increase. combined value of debt plus equity. Bris et al. Many of the corporations that are financially (2006) found that bankruptcy costs were sim- distressed during financial crises would be prof- ilar in liquidations and reorganizations. Indi- itable in normal conditions. In this situation, rect bankruptcy costs are not reported and must the main goal of bankruptcy policy changes be inferred, but they are likely to be much from that of reducing filtering failure to that greater than direct bankruptcy costs. White of keeping financially distressed corporations in (1983) solved for upper-bound expressions on operation because shutdown spreads economic indirect bankruptcy costs; her results suggest disruption and worsens the severity of the cri- that indirect costs may be as high as 20 times sis. Stiglitz (2001) and Miller & Stiglitz (2010) the direct costs of bankruptcy. Other studies discuss the possibility of a “super Chapter 11” provide evidence that bankruptcy is very dis- bankruptcy procedure that would be put into ruptive to corporations, which implies that in- effect during financial crises. It would keep fi- direct bankruptcy costs must be very high. Ang nancially distressed corporations operating by & Chua (1981) and Gilson (1990) found that the speeding up bankruptcy procedures, retaining turnover rates of top executives and directors existing managers, and converting corporate were much higher for large corporations that debt into equity. This type of procedure would reorganized in bankruptcy than for corpora- also reduce the need for government-financed tions not in bankruptcy. Carapeto (2000) found bailouts of distressed corporations in times of fi- that when large corporations in bankruptcy of-

by University of California - San Diego on 09/05/12. For personal use only. nancial crisis and provide governments with an fer multiple reorganization plans, the total pay- additional tool for stabilizing the economy.10 off offered to creditors declines by 14% between Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org the first and the last plan. This implies that the marginal costs of remaining in bankruptcy Empirical Research on longer increase quickly. Hotchkiss (1995) found Corporate Bankruptcy that reorganizing in bankruptcy does not nec- Empirical research on corporate bankruptcy essarily solve the financial problems of dis- has concentrated on measuring the costs of tressed corporations because one-third of her sample of firms that successfully reorganized

10Chapter 11 is the U.S. bankruptcy procedure for saving financially distressed corporations. See Claessens et al. (2001) 11There is little empirical research on the effect of bankruptcy and Halliday & Carruthers (2009) for discussions of corpo- law on credit markets for large corporations (but see rate bankruptcy procedures in the context of the Asian finan- Davydenko & Franks 2008, which uses cross-country data). cial crisis and the 2008 financial crisis. I discuss this topic in detail in the next section.

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required further restructuring within a few This relationship has been estimated by years. Her results suggest that some ineffi- White (1989), Betker (1995), and Bris et al. cient firms are reorganizing in bankruptcy even (2006). As predicted, the results show that though they should liquidate (see also Ang et al. shareholders receive a minimum payoff of about 1982, LoPucki 1983, and Franks & Torous 5% of unsecured creditors’ claims, and that 1989). their payoff rate increases as unsecured creditors’ payoff rises.12 Betker also finds that devi- Deviations from the absolute priority rule. ations from the APR are smaller when a higher Several papers provide evidence concerning the proportion of the firm’s debt is secured. Bris frequency and size of deviations from the APR et al. (2006) also find that deviations from the in corporate reorganizations. The size of devia- APR are larger when managers own more eq- tions from the APR is measured by the amount uity in the corporation (Gilson et al. 1990, paid to equity in violation of the APR divided by Franks & Torous 1994, Tashjian et al. 1996, the total amount distributed to creditors under and Morrison 2009 provide empirical evidence the reorganization plan. For example, suppose comparing out-of-bankruptcy workouts to in- a corporation in bankruptcy owes $1,000,000 bankruptcy reorganizations). to creditors, but its reorganization plan pays creditors $500,000 and gives old shareholders $50,000. Then deviations from the APR II. PERSONAL BANKRUPTCY amount to $50,000/500,000 or 10%. Like corporate bankruptcy law, personal Weiss (1990) examined 31 corporations that bankruptcy law determines the total amount adopted reorganization plans in bankruptcy, of that individual debtors must repay—the size which 28—or 90%—involved deviations from of the pie—and how the pie is divided among the APR. Eberhart et al. (1990), LoPucki & creditors. A larger pie benefits future borrowers Whitford (1990), Betker (1995), and Carapeto by increasing the future supply of credit and (2000) similarly found deviations from the APR lowering interest rates. But a larger pie is costly in around three-quarters of large corporations’ to existing debtors because high repayment bankruptcy reorganization plans. Eberhart obligations may reduce debtors’ consumption et al. (1990) and Betker (1995) found that the to the point that illnesses go untreated and average deviation from the APR was in the turn into disabilities, debtors’ families lose range of 3% to 7%. their homes and their neighborhood ties, and How do deviations from the APR relate debtors’ children leave school in order to work. to the financial condition of corporations in High repayment obligations may also cause Chapter 11? This relationship can be estimated debtors to work less and may change their by regressing the amount paid to equity as by University of California - San Diego on 09/05/12. For personal use only. decisions concerning whether to consume or a fraction of unsecured creditors’ claims on invest their wealth and whether to choose safe

Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org the amount paid to unsecured creditors as a or risky investments. The division of the pie fraction of their claims (i.e., the payoff rate to also has efficiency implications. When debtors unsecured creditors). If the APR was always default, creditors have an incentive to race perfectly followed, the estimated relationship against each other to be first to collect, because would run along the horizontal axis as long bankruptcy filings terminate collection efforts. as the payoff rate to unsecured creditors was But aggressive collection efforts can harm less than 100%, but would become vertical at a payoff rate of 100%. But when there are

deviations from the APR, shareholders are 12These results are also consistent with the bargaining model likely to receive something even when unse- of Chapter 11 described by Bebchuk & Chang (1992), in cured creditors’ payoff rate is low, and their which equity gets a low payoff in return for giving up its right to delay adoption of the reorganization plan and gets payoff is likely to increase quickly as unsecured more as equity’s option on the corporation comes closer to creditors’ payoff rate approaches 100%. being in the money.

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debtors because they may quit their jobs if one personal bankruptcy procedure that obliges creditors garnish wages or lose their jobs if bankrupts to repay from both financial wealth creditors repossess their cars. and postbankruptcy earnings, but provides ex- Some of the economic objectives of personal emptions for both. (These assumptions differ versus corporate bankruptcy are the same, from U.S. bankruptcy law, where the most com- but there are important differences. Because monly used personal bankruptcy procedure ex- individuals in bankruptcy never liquidate, empts all future earnings from the obligation to there is no issue of filtering failure in personal repay—this is referred to as the “fresh start.”15) bankruptcy. Also, an important objective Not assuming that all future wages are exempt of personal bankruptcy law that does not allows us to consider whether/when the fresh exist in corporate bankruptcy is to provide start is economically efficient. partial consumption insurance to bankrupts. Assume that the wealth exemption in Bankruptcy-provided consumption insurance bankruptcy is X dollars, regardless of the form makes individuals worse off when their ability of the wealth, and the exemption for fu- to repay is high and better off when their ability ture earnings is x percent of postbankruptcy to repay is low. earnings (Hynes 2002 discusses alternate ways Personal bankruptcy law specifies a set of of taxing debtors’ post-bankruptcy earnings). exemptions that determine how much of their Debtors are obliged to repay from earnings for financial wealth and future earnings individual a fixed number of years. Filing for bankruptcy bankrupts are allowed to keep. Exemptions exist costs debtors S dollars. Debtors in bankruptcy only in personal bankruptcy; as discussed above, are required to use all of their nonexempt there are no bankruptcy exemptions for cor- wealth and earnings to repay prebankruptcy porations.13 Although higher exemption lev- debt, up to the amount owed. Whatever debt els reduce the size of the pie, they benefit is unpaid at the end of the repayment period is debtors by raising their minimum consumption discharged. levels. Exemptions also affect debtors’ incen- Suppose in period 1, individuals borrow a tives to work and use their human capital after fixed amount B at interest rate r from a sin- bankruptcy. gle lender, to be repaid in period 2. The interest rate is determined by the lender’s zero profit constraint. In period 2, wealth is uncer- Insurance and Work Effort Effects tain. Individual debtors learn their actual wealth of Personal Bankruptcy Law at the beginning of period 2, they then decide Most models of economically efficient personal whether to file for bankruptcy, and, finally, they bankruptcy law14 solve for optimal bankruptcy choose their period 2 labor supply. Period 2

by University of California - San Diego on 09/05/12. For personal use only. exemption levels, i.e., the optimal size of the labor supply depends on whether they file for pie. They ignore the question of how the pie bankruptcy. (Period 2 is assumed to last for the Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org should be divided by assuming that bankrupts entire period when they are obliged to repay in have only one creditor. Suppose there is only bankruptcy.) Individuals’ utility depends positively on consumption and negatively on labor supply in 13Corporations that reorganize in bankruptcy are allowed to each period, and they are assumed to be risk keep some of their assets, but the justification is that these corporations will pay creditors more from their future earnings than creditors would receive in liquidation. 14This section draws on Rea (1984), Jackson (1986), White 15The U.S. bankruptcy procedure that exempts all future (2005), Fan & White (2003), Wang & White (2000), and earnings is Chapter 7, whereas the procedure that requires Adler et al. (2000). Rea (1984) was the first to suggest the in- individual bankrupts to use future earnings to repay is surance justification for personal bankruptcy law. See Livshits Chapter 13. Since 2005, some higher-income bankrupts have et al. (2007) and Athreya (2002) for general equilibrium mod- been barred from filing under Chapter 7. See White (2007) els of personal bankruptcy law. for discussion of bankruptcy reform.

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averse. They have an incentive to work less af- C ter filing for bankruptcy because their earnings are subject to the “bankruptcy tax” of x%. But they also have an incentive to work more after filing because bankruptcy reduces their wealth. Economists generally assume that the former effect exceeds the latter (the substitution effect exceeds the wealth effect), so that individuals are predicted to work less following bankruptcy. Debtors decide whether to file for bankruptcy depending on which alternative maximizes their utility. There is a threshold level of period 2 wealth Wˆ where they are indifferent between filing or not filing; they file if their wealth is below the threshold and Region 1 Region 2 Region 3 do not file otherwise. When debtors’ earnings are higher, the threshold wealth level rises. W Figure 1 shows debtors’ period 2 consumption Wˆ X+S as a function of their period 2 wealth. Con- sumption is divided into three regions: region Figure 1 3 where debtors repay in full, region 2 where The insurance effect of bankruptcy. The diagram shows period 2 consumption they file for bankruptcy and repay from both on the vertical axis and period 2 wealth on the horizontal axis. Labor supply is assumed to be higher outside of bankruptcy than in bankruptcy. Debtors file wealth and future earnings, and region 1 where for bankruptcy in regions 1 and 2 and avoid bankruptcy in region 3. they file for bankruptcy and repay only from future earnings because all of their wealth is exempt. The boundary between regions 2 and region 1 where it is lowest. In addition, 3 occurs at Wˆ . There is a discontinuous drop debtors work more following bankruptcy when in consumption at Wˆ because debtors work the earnings exemption is higher because less and earn less in bankruptcy. their earnings are less highly taxed. Debtors How do the wealth and earnings exemptions therefore repay more in bankruptcy when x is provide debtors with consumption insurance? higher, which reduces the cost of consumption Raising the wealth exemption X reduces insurance. debtors’ consumption in region 3 because These results suggest that optimal personal creditors raise interest rates on loans, but bankruptcy law should have a relatively high

by University of California - San Diego on 09/05/12. For personal use only. increases debtors’ consumption in region 2 exemption for earnings and a relatively low because more of their wealth is exempt. Con- exemption for wealth because the earnings ex- Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org sumption is unaffected in region 1 because all of emption provides more valuable consumption debtors’ wealth is exempt. In contrast, raising insurance and because a higher earnings exemp- the earnings exemption reduces debtors’ con- tion causes debtors to work more in bankruptcy. sumption in region 3 for the same reason, but The higher value of the earnings exemption increases debtors’ consumption in both regions relative to the wealth exemption suggests an 2 and 1 because they keep a higher percent of economic justiﬁcation for the fresh start.16 their earnings. This means that the consumption insurance provided by a higher earnings exemption is more valuable than the consump- 16See Wang & White (2000) for a simulation. The earnings tion insurance provided by a higher wealth exemption would not necessarily provide more valuable consumption insurance if a range of low earnings were entirely exemption because only a higher earnings exempt in bankruptcy because earnings in this range would exemption raises debtors’ consumption in be unaffected by the exemption level.

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This model of bankruptcy yields several White (1998b) used an asymmetric informa- testable hypotheses. First, in jurisdictions that tion model to examine whether, in equilibrium, have higher wealth exemptions in bankruptcy, debtors may default but not file for bankruptcy. consumption is more fully insured and there- The model assumes that there are two types of fore is predicted to be less variable. Second, debtors, As and Bs. Both types decide whether in jurisdictions that have higher wealth exemp- to default, and, following default, creditors tions, lending is less profitable because default decide whether to garnish debtors’ wages. rates are higher. Therefore lenders are pre- Garnishment is assumed to be costly for cred- dicted to charge higher interest rates and re- itors. The two types of debtors differ in how duce the supply of credit. Third, if debtors are they respond to garnishment: type As repay in risk averse, then they are predicted to borrow full, whereas type Bs file for bankruptcy and more when the downside risk of borrowing is repay nothing. Creditors are assumed unable lower. This means that demand for credit is pre- to identify individual debtors’ types when they dicted to be higher in jurisdictions with higher default, so they must respond in the same way wealth exemptions. Similarly, if potential en- to all defaults. I show that, in equilibrium, all trepreneurs are risk averse, then they are more type B debtors default, at least some type A willing to take the risk of going into business debtors also default, and creditors play mixed if higher wealth exemptions reduce the cost strategies of sometimes instituting garnish- of business failure. Jurisdictions with higher ment in response to default and sometimes not. wealth exemptions are therefore predicted to This means that, in equilibrium, some debtors have more entrepreneurs. These predictions default but do not file for bankruptcy. These have been tested (see below). debtors obtain the benefit of debt forgiveness without having their wages garnished and without filing for bankruptcy. The model Other Theoretical Issues suggests that having a personal bankruptcy Models of the effects of personal bankruptcy system encourages some debtors to default law have posed a number of other issues, even when they can afford to repay their debts. including whether debtors default without filing for bankruptcy, whether bankruptcy Waiving the right to file for personal law should allow debtors to waive their right bankruptcy. In the corporate bankruptcy to file for bankruptcy, whether bankruptcy context, researchers have argued that debtors encourages strategic behavior by debtors, and should be allowed to contract with creditors how the right to file for bankruptcy can be about bankruptcy procedures (see the dis- valued as an option. Some of these issues cussion above). In the personal bankruptcy

by University of California - San Diego on 09/05/12. For personal use only. are similar to issues already discussed in the context, the issue is whether efficiency could context of corporate bankruptcy law. be improved by allowing debtors to waive their Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org right to file for bankruptcy.17 Default versus bankruptcy. In the previous Would individual debtors ever choose to section, debtors were assumed to choose be- issue waivers when making loan contracts? tween defaulting and filing for bankruptcy ver- Doing so would mean that debtors could still sus repaying in full. But in reality, debtors may default, but they could not end creditors’ default without filing for bankruptcy or default collection efforts by filing for bankruptcy. The first and file for bankruptcy later. When debtors main advantage to debtors of issuing waivers default, creditors attempt to collect, and their most important legal weapon is garnishment of 17 a fraction of debtors’ earnings. Debtors often In the United States, waivers are unenforceable and the rules of bankruptcy cannot be changed by contract. See Rea respond to garnishment by filing for bankruptcy (1984), Jackson (1986), Adler et al. (2000), and Hynes (2004) because filing ends garnishment. for discussions.

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is that more credit would be available at lower years, they gain from timing their bankruptcy interest rates because debtors are less likely to decisions. default. But debtors who issued waivers would White (1998a) calculated the value of the face more risk in their period 2 consumption, option to file for bankruptcy for a representa- i.e., consumption would be higher in region tive sample of U.S. households during the early 3ofFigure 1 and lower in regions 1 and 2. 1990s. The results showed that at the time, Debtors who issued waivers would probably many more households had a positive option work more to reduce their risk. This suggests value of filing for bankruptcy than actually filed. that risk-averse debtors would not issue waivers, but risk-neutral debtors might. Bankruptcy and incentives for strategic be- However, there are a number of external- havior. A problem with personal bankruptcy ity arguments that support the current policy law—particularly in the United States—is that of prohibiting waivers. First is that waivers may it may encourage debtors to behave strategi- make individual debtors’ families worse off be- cally by filing even when they can afford to re- cause spouses and children bear most of the pay their debts. Strategic behavior by debtors cost of reduced consumption if the debtor’s undermines the goal of punishing debtors for wealth turns out to be low, but debtors may bankruptcy. In general, the higher are the not take this into account in deciding whether wealth and earnings exemptions in bankruptcy, to issue waivers. Second, debtors may underes- the stronger are debtors’ incentives to be- timate the probability of having low wealth in have strategically. In the United States post- the future, so that they may issue waivers when bankruptcy earnings are completely exempt for it is against their self-interest. Third, prohibit- most debtors, and some U.S. states also have ing waivers benefits the government because high or unlimited exemptions for wealth. As a its expenses for social safety net programs are result, many debtors in the United States gain lower when debtors can file for bankruptcy and from behaving strategically. Using the previ- 18 avoid repaying their debts. Finally, allowing ous notation and assuming that the earnings waivers might have adverse macroeconomic ef- exemption is 100%, debtors’ financial benefit fects. This is because if many debtors simulta- from filing for bankruptcy is neously had a bad draw on wealth, all would reduce their consumption simultaneously and Financial benefit the economy might go into a recession. = max{D − max[W − X , 0], 0}−S. 1.

The option value of bankruptcy. Debtors’ Here D is the amount of debt discharged right to ﬁle for bankruptcy can be expressed as in bankruptcy, max[W−X,0] is the value of

by University of California - San Diego on 09/05/12. For personal use only. a put option. If debtors’ future wealth turns out nonexempt assets that debtors must give up in to be high, they repay their debts in full, but bankruptcy, if any, and S is the cost of filing. Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org if their future wealth turns out to be low, they White (1998a,b) calculated the financial can exercise their option to “sell” the debt to benefit of filing for bankruptcy for a representa- creditors by filing for bankruptcy. The price of tive sample of U.S. households, using data from exercising the put option is the cost of filing plus the early 1990s. Bankruptcy costs were assumed the amount that debtors are obliged to repay in to be zero. The results showed that approx- bankruptcy. Also, because debtors in the United imately one-sixth of U.S. households would States can only file for bankruptcy once every six benefit from filing for bankruptcy. If debtors pursued various strategies to increase their financial gain from filing, then the proportion that benefited from bankruptcy rose from one- 18Posner (1995) discusses the relationship between the insurance provided by bankruptcy and government-provided sixth to one-half. These results provide some social insurance programs. explanation for why the United States has high

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bankruptcy filing rates, but raise the oppo- for all U.S. states over a 20-year period. Then site question of why filing rates are not even they estimated a regression explaining the higher. change in the variance of consumption as a function of exemption levels by state-year, plus control variables. They found that in Empirical Research on Personal and states with higher exemption levels, changes Small Business Bankruptcy in the variance of consumption were lower, Most of the empirical research on personal thus supporting the hypothesis that higher bankruptcy uses U.S. data and makes use of exemption levels provide households with the fact that exemption levels for wealth vary additional consumption insurance. widely across U.S. states. (Other aspects of U.S. bankruptcy law are uniform across states.19) Insurance effects of bankruptcy: en- This variation allows researchers to investigate trepreneurial behavior, divorce, and health how differences or changes in wealth exemp- insurance. When individuals start or own un- tions across states affect a variety of behaviors incorporated businesses, they incur business by debtors and creditors. The studies include debts for which they are personally liable. This research on how bankruptcy law affects behav- makes entrepreneurs’ wealth more risky be- ior and on the determinants of bankruptcy fil- cause wealth increases if the business succeeds ings. In this section, I review empirical research and falls if it fails. The personal bankruptcy on personal and small business bankruptcy. system provides partial insurance for this type of risk because if failure occurs, entrepreneurs Bankruptcy law as insurance for consump- can file for personal bankruptcy and have both tion and wealth. The model discussed above their business and personal debts discharged. showed that higher exemption levels provide States that have higher wealth exemptions debtors with additional insurance against provide even more wealth insurance through negative financial shocks that would reduce bankruptcy; in those with the highest exemp- their wealth and their consumption levels. This tions, entrepreneurs can keep their homes even is because when negative shocks occur, debtors if their businesses fail. Thus risk-averse individ- living in states with higher exemption levels uals are predicted to be more likely to own or can have their debts discharged in bankruptcy start businesses if they live in states with higher while keeping more of their assets. This means wealth exemptions. that the variance of household consumption Fan & White (2003) tested this hypothesis, over time in particular U.S. states should be focusing on home equity exemptions—which smaller, i.e., less risky, in states with higher are the largest exemptions in most U.S. states.

by University of California - San Diego on 09/05/12. For personal use only. exemption levels. Grant & Koeniger (2009) They found that homeowners are 35% more tested this hypothesis by computing the vari- likely to own businesses if they live in states Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org ance of household consumption by state-year with high or unlimited home equity exemptions rather than low exemptions. They also found a similar effect for renters. Armour & Cumming (2008) found similar results using data for 15 19The U.S. bankruptcy reform of 1978 adopted uniform exemption levels for wealth in bankruptcy, but allowed states countries in Europe and North America. to opt out of the federal exemptions and choose their own. The additional wealth insurance provided All states did so by around 1980, but around one-third of by bankruptcy in states with higher exemp- the states allow bankruptcy ﬁlers to choose between the state and the federal exemption levels. Other aspects of bankruptcy tion levels also affects behavior in other ways. law are uniform across states, because the U.S. Constitu- Being married provides individuals with insur- tion reserves for the federal government the right to adopt ance against negative ﬁnancial shocks because bankruptcy laws. See Posner (1997) for discussion of the history and political economy of the 1978 reform. Hynes et al. shocks are unlikely to affect both spouses at (2004) estimate a model that explains states’ exemption levels. the same time. But the insurance provided by

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marriage is less valuable to individuals living likely to file for bankruptcy when their financial in states with higher exemption levels because benefit from filing is higher. More specifically, bankruptcy in these states provides more of the debtors’ financial benefit from filing depends on same type of insurance. Couples in these states the amount of debt discharged in bankruptcy, therefore gain less from marriage and have their wealth relative to the wealth exemption, stronger incentives to get divorced. Traczyn- and bankruptcy costs. But their financial bene- ski (2011) tested the divorce hypothesis and fit does not depend on their future earnings. An finds that increases in state exemption levels alternative model of bankruptcy decisions, pro- from 1989 to 2005 resulted in 200,000 addi- posed by Sullivan et al. (1989), is that debtors tional divorces during the period. Similarly, in- file only when their earnings fall or their ex- dividuals have less incentive to buy health insur- penses rise to the point where it is impossible for ance if they live in states with higher exemption them to repay. In this view, debtors do not plan levels. Having health insurance provides them in advance for bankruptcy, so that the impor- with financial protection against negative med- tant factors affecting the bankruptcy decision ical shocks, but the insurance is less valuable if are ability to pay and whether adverse events— they live in states with higher exemption levels such as job loss, illness, or divorce—have re- because bankruptcy provides more of the same cently occurred. type of insurance. Mahoney (2011) shows that The two models can be tested against each individuals are less likely to buy health insur- other because the financial benefit model pre- ance if they live in states with higher exemption dicts that wealth and debt levels determine levels. whether debtors file for bankruptcy, whereas the adverse events model predicts that ability Effects of bankruptcy on postbankruptcy la- to pay and adverse events are the most im- bor supply. In the theoretical model discussed portant determinants. Fay et al. (2003) tested above, debtors were predicted to work less after the two models using household-level panel filing for bankruptcy if they are required to re- data. They found that debtors are significantly pay debt from future earnings. However, U.S. more likely to file for bankruptcy when their law differs from the assumptions of the model financial benefit from filing is higher. But they discussed above because most bankruptcy filers also found evidence that ability to pay affects are not required to repay from postbankruptcy bankruptcy decisions—households with higher earnings, but are often subject to wage gar- incomes were less likely to file and those whose nishment outside of bankruptcy. This means income fell were more likely to file. They that filing for bankruptcy reduces rather than also tested whether adverse events affect the increases their obligation to repay debt from bankruptcy decision and found that neither job

by University of California - San Diego on 09/05/12. For personal use only. earnings, and as a result they are predicted to loss nor illness of the household head or spouse work more after filing. Han & Li (2007) ex- in the previous year was significantly related Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org amined empirically how filing for bankruptcy to bankruptcy. But a divorce in the previous affects debtors’ labor supply. They found that year was found to increase the probability of debtors did not increase their labor supply after bankruptcy. Thus the study supports the hy- filing for bankruptcy. Their results thus under- potheses that financial benefit and ability to pay mine the argument that debtors should have a affect the bankruptcy decision, but it does not fresh start in bankruptcy (a 100% exemption for support the hypothesis that adverse events trig- postbankruptcy wages) because the fresh start ger bankruptcy filings.20 does not increase debtors’ postbankruptcy work effort. 20In more recent papers, Keys (2009) argues that job loss increases debtors’ probability of filing for bankruptcy in the What triggers bankruptcy? The model dis- following year and Fisher & Lyons (2006) argue that divorce cussed above implies that debtors are more increases the probability of bankruptcy.

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Researchers have also examined how stigma attractive. Creditors respond by raising interest affects bankruptcy filings. Fay et al. (2003) rates and/or reducing the supply of credit. But used the aggregate bankruptcy filing rate in the higher wealth exemptions reduce the downside household’s region during the previous year as risk of borrowing and therefore cause debtors— an inverse proxy for the level of bankruptcy if they are risk averse—to demand more credit. stigma. The idea is that when more filings Gropp et al. (1997) examined the effect of occur in a region, people are more likely to wealth exemptions on consumer credit markets. hear about bankruptcy from friends or rela- They found that households were significantly tives and they interpret the additional infor- more likely to be turned down for credit if they mation as implying that less stigma is attached lived in states with high- rather than low-wealth to bankruptcy. Fay et al. found that, in regions exemptions. Interest rates were also found to be with lower bankruptcy stigma, households were higher in states with high-wealth exemptions, significantly more likely to file (other stud- but the size of the effect depended strongly on ies of the effect of stigma and information on debtors’ wealth. Low-wealth households paid bankruptcy filings include Gross & Souleles higher interest rates if they lived in states with 2002 and Cohen-Cole & Duygan-Bump 2009). high- rather than low-wealth exemptions, but Ausubel & Dawsey (2004) used credit high-wealth households paid the same interest card data to examine debtors’ decisions to rates regardless of the exemption level. In ad- default and to file for bankruptcy. In their dition, households with low wealth borrowed model, debtors first decide whether to default, less if they lived in states with high- rather than and then, conditional on default, they decide low-wealth exemptions, but households with whether to file for bankruptcy. They refer high wealth borrowed more. These results sug- to default without bankruptcy as informal gest that when states adopt high-wealth exemp- bankruptcy. Ausubel & Dawsey find that tions, lenders respond by redistributing credit wealth exemptions mainly affect debtors’ from low-wealth to high-wealth households. default decisions, whereas restrictions on Thus although policy-makers often think that the fraction of wages that can be garnished high-wealth exemptions help the poor, in fact mainly affect debtors’ bankruptcy decisions. they appear to harm poor debtors and help rich These results are not surprising because ones. wealth exemptions apply both in bankruptcy Other studies examine the effect of wealth and out of bankruptcy, whereas garnishment exemptions in bankruptcy on specialized credit restrictions only apply outside of bankruptcy markets, of which one is the market for small (because filing for bankruptcy ends wage business loans. Loans for small businesses are garnishment completely). Ausubel & Dawsey’s predicted to be affected by wealth exemptions

by University of California - San Diego on 09/05/12. For personal use only. results provide empirical evidence supporting because these loans are personal liabilities of the both the economic model of the bankruptcy business owner whenever the business is non- Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org decision and the hypothesis that some debtors corporate. Berkowitz & White (2004) found default without filing for bankruptcy (other that small businesses were more likely to be papers that examine the bankruptcy filing turned down for loans if they were located in decision include Buckley 1994, Buckley & states with high-wealth exemptions. Also small Brinig 1998, Domowitz & Sartain 1999, Fisher businesses paid higher interest rates for loans 2009, and Lefgren & McIntyre 2009). in these states. These results, combined with the effect of bankruptcy on entrepreneurial be- Bankruptcy and credit markets. Wealth ex- havior, suggest that higher wealth exemptions emptions also affect both demand for and are a double-edged sword for small businesses: supply of credit. When wealth exemptions They encourage more individuals to become are higher, debtors are more likely to file self-employed, but reduce their businesses’ ac- for bankruptcy, and this makes lending less cess to credit.

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One credit market in which wealth ex- borrow to save in states with higher wealth emptions are less likely to be important is the exemptions. market for mortgages. Wealth exemptions are predicted not to affect the terms of mortgage Bankruptcy and homeowning. Prior to because when a house is sold following mort- 2005, homeowners in financial distress could gage default, the proceeds are used to repay use bankruptcy to save their homes. Because the mortgage in full before the homeowner unsecured debts are discharged in bankruptcy, benefits from the wealth exemption. But ex- filing increased homeowners’ ability to make emptions affect the mortgage market indirectly their mortgage payments and keep their homes. because bankruptcy delays foreclosure and But in 2005, a reform of bankruptcy law therefore makes it more expensive for lenders. raised the cost of filing and forced some filers Berkowitz & Hynes (1999) and Lin & White with high earnings to use some of their post- (2001) both examined this issue, but found bankruptcy income to repay unsecured debt. contradictory results. Chomsisengphet & Elul Thus the reform was predicted to cause de- (2006) found that wealth exemptions had no fault rates on mortgages to rise. Li et al. effect on mortgage markets when they also (2010) tested this prediction and found that controlled for borrowers’ credit scores in their default rates on mortgages increased after regression models. They argue that credit bankruptcy reform, particularly for homeown- scores are correlated with wealth exemptions, ers with high incomes. Morgan et al. (2011) so that the effect of exemptions is biased found that foreclosure rates also increased af- upward when credit scores are omitted. ter the reform. Thus the 2005 bankruptcy re- Bankruptcy also affects debtors’ access to form caused mortgage default and foreclosure credit after filing because U.S. law allows fil- to rise even before the start of the financial ings to remain on debtors’ credit records for up crisis. to 10 years. Han & Li (2011) examine how filing for bankruptcy affects postbankruptcy access to Why have U.S. bankruptcy filings increased credit. They find that debtors borrow less and so sharply since 1980? The number of pay more for loans following bankruptcy and bankruptcy filings in the United States in- that the effect persists for the entire 10-year creased fivefold between 1980 and 2004. Al- period. This suggests that allowing bankruptcy though the various models discussed above pro- filings to remain on debtors’ credit records vide a number of explanations for why debtors for 10 years is a nontrivial punishment for file for bankruptcy, none can explain the large bankruptcy. increase in the number of filings over time. Wealth exemptions in bankruptcy also affect More adverse events cannot explain the increase

by University of California - San Diego on 09/05/12. For personal use only. the composition of debtors’ portfolios. When because the unemployment rate, the divorce exemptions are higher, households have an in- rate, and the fraction of households lacking Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org centive both to hold more assets and to hold health insurance did not increase over the pe- more debt. They prefer to hold both assets and riod. Higher financial benefit from filing sim- debt rather than using the assets to repay the ilarly cannot explain the increase because the debt because debt is discharged in bankruptcy fraction of households that would benefit from if it is unsecured, but households are allowed filing for bankruptcy did not increase over the to keep assets in bankruptcy as long as they are period. The most likely explanation for the in- exempt. Lehnert & Maki (2002) test whether crease in filings was the increase in the aver- households in states with higher wealth exemp- age level of unsecured debt held by households, tions simultaneously hold more debt and more which also rose fivefold over the period. The assets—a behavior that they call borrowing to increase in debt levels resulted largely from save. They find evidence that more households higher credit supply, which in turn was due to a

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combination of technological advances in lend- managers’ incentives to work hard, invest, and ing, abolition of limits on interest rates, and take risks; and whether financially distressed changes in the regulation of the banking indus- firms shut down versus continue to operate. try (see Mann 2006, White 2007, and Dick & Bankruptcy law not only affects financially Lehnert 2010 for discussion). distressed corporations and their creditors but also their workers and competitors and— during periods of financial crisis—the entire CONCLUSION economy. Personal bankruptcy law was shown This review started by discussing the three to affect individual debtors’ incentives to work most important components of bankruptcy— hard before and after bankruptcy, become collection resolution of all the bankrupt entity’s and remain entrepreneurs, take risks, become debts, rules for determining how much of the and remain homeowners, borrow and default bankrupt entity’s assets and income must be on debt, obtain health insurance, and get di- used to repay debts and how payments are vorced. Bankruptcy law also affects the welfare divided among creditors, and punishments of debtors’ families and neighbors. Because for default and bankruptcy. It then examined bankruptcy law affects behavior in so many how bankruptcy law affects the behavior of ways, its effects are often complicated and go both corporations and individuals and how both ways—for example, raising exemption it affects economic efficiency. Corporate levels in bankruptcy encourages individuals bankruptcy law was shown to affect the supply to go into business, but also harms small and demand for business credit; corporate businesses by reducing their access to capital.

DISCLOSURE STATEMENT The author is not aware of any afﬁliations, memberships, funding, or ﬁnancial holdings that might be perceived as affecting the objectivity of this review.

ACKNOWLEDGMENTS The author is grateful for support and hospitality from Cheung Kong Graduate School of Business, Beijing, where she wrote much of this article.

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Annual Review of Law and Social Science Contents Volume 7, 2011

The Legislative Dismantling of a Colonial and an Apartheid State Sally Falk Moore ppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp1 Credible Causal Inference for Empirical Legal Studies Daniel E. Ho and Donald B. Rubin ppppppppppppppppppppppppppppppppppppppppppppppppppppppppp17 Race and Inequality in the War on Drugs Doris Marie Provine pppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp41 Assessing Drug Prohibition and Its Alternatives: A Guide for Agnostics Robert J. MacCoun and Peter Reuter ppppppppppppppppppppppppppppppppppppppppppppppppppppppp61 The Triumph and Tragedy of Tobacco Control: A Tale of Nine Nations Eric A. Feldman and Ronald Bayer pppppppppppppppppppppppppppppppppppppppppppppppppppppppppp79 Privatization and Accountability Laura A. Dickinson ppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp101 The Conundrum of Financial Regulation: Origins, Controversies, and Prospects Laureen Snider ppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp121 Corporate and Personal Bankruptcy Law Michelle J. White ppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp139

by University of California - San Diego on 09/05/12. For personal use only. Durkheim and Law: Divided Readings over Division of Labor Carol J. Greenhouse pppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp165 Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org Law and American Political Development Pamela Brandwein pppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp187 The Legal Complex Lucien Karpik and Terence C. Halliday ppppppppppppppppppppppppppppppppppppppppppppppppppp217 U.S. War and Emergency Powers: The Virtues of Constitutional Ambiguity Gordon Silverstein pppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp237 The Political Science of Federalism Jenna Bednar ppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp269

v LS07-Frontmatter ARI 26 September 2011 12:41

The Rights of Noncitizens in the United States Susan Bibler Coutin pppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp289 Innovations in Policing: Meanings, Structures, and Processes James J. Willis and Stephen D. Mastrofski ppppppppppppppppppppppppppppppppppppppppppppppp309 Elaborating the Individual Difference Component in Deterrence Theory Alex R. Piquero, Raymond Paternoster, Greg Pogarsky, and Thomas Loughran ppppppp335 Why Pirates Are Back Shannon Lee Dawdy pppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp361 The Evolving International Judiciary Karen J. Alter ppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppppp387 The Social Construction of Law: The European Court of Justice and Its Legal Revolution Revisited Antonin Cohen and Antoine Vauchez ppppppppppppppppppppppppppppppppppppppppppppppppppppp417

Indexes

Cumulative Index of Contributing Authors, Volumes 1–7 pppppppppppppppppppppppppppppp433 Cumulative Index of Chapter Titles, Volumes 1–7 pppppppppppppppppppppppppppppppppppppp436

Errata

An online log of corrections to Annual Review of Law and Social Science articles may be found at http://lawsocsci.annualreviews.org by University of California - San Diego on 09/05/12. For personal use only. Annu. Rev. Law. Soc. Sci. 2011.7:139-164. Downloaded from www.annualreviews.org

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