Bankruptcy Law Design for Entrepreneurial Firms

JLEO, V23 N1 161
Bankruptcy and Entrepreneurship: The Value

of a Fresh Start
Kenneth Ayotte
Columbia Business School
This article considers bankruptcy law design in a setting that is appropriate for
entrepreneurial firms. These firms are characterized by a dependence on an
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owner-manager who is essential to the firm and must be given incentive through
an ownership stake to maximize the value of the project. In a relationship-lending
environment, the banks that fund entrepreneurs cannot capture the gains from
providing the entrepreneur with this stake, and this leaves the entrepreneur
emerging from bankruptcy with a larger debt burden than is socially efficient.
In this setting, a ‘‘fresh-start’’ bankruptcy policy provides greater debt relief than
the bank would approve voluntarily, and this generates greater social surplus.
The results suggest the value of separate procedures for small business bank-
ruptcies that allow some mandatory debt relief to preserve ex post incentives.
1. Introduction
A key principle underlying corporate bankruptcy scholarship is that contrac-
tually established seniority rules should be respected in bankruptcy whenever
possible. In practice, this principle is embodied in the absolute priority rule
(APR), which frames the bargaining process in Chapter 11. APR gives senior
creditors the right to insist on full repayment before junior creditors and equity
holders can retain value. Prior theoretical research on optimal bankruptcy laws
has identified several ex ante (prebankruptcy) benefits arising from the creditor
protection APR provides, including greater access to credit (since creditor
recoveries are higher) and greater incentive for managers to succeed (since
bankruptcy is less forgiving to managers who hold equity). For these reasons,
scholars have suggested reform proposals that would result in strict adherence
to priority in bankruptcy.1
This article suggests that existing analysis of corporate bankruptcy is incom-
plete, in that it leaves out a cost of APR that is particularly relevant for owner-
managed, entrepreneurial firms. While APR may have beneficial incentive
effects before bankruptcy, preserving the value of creditors’ claims may also
I would like to thank Barry Adler, Antoine Faure-Grimaud, Alejandro Justiniano, Jeffrey Kling,
Gad Levanon, Burton Malkiel, Ed Morrison, Howard Rosenthal, David Skeel, and David Skeie for
helpful comments, discussions, and suggestions. Special thanks to Patrick Bolton for numerous
valuable insights and guidance on this project.
1. See, for example, Bebchuk (1988) and Aghion et al. (1992).
The Journal of Law, Economics, & Organization, Vol. 23, No. 1,

doi:10.1093/jleo/ewm007
Advance Access publication August 23, 2006
The Author 2006. Published by Oxford University Press on behalf of Yale University.
All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org
162 The Journal of Law, Economics, & Organization, V23 N1
weaken the prospects of a reorganized firm by reducing an owner-manager’s

incentive to succeed after bankruptcy. While this postbankruptcy incentive
effect of debt is not often recognized in business bankruptcy contexts, it figures
prominently in the justification for the ‘‘fresh-start’’ emphasis in personal
bankruptcy law, which allows debtors to obtain relief from debt despite
less-than-full creditor repayment. The U.S. Supreme Court expressed this
motivation for bankruptcy law in the well-known Local Loan v. Hunt case,
292 U.S. 234, 244 (1934):
‘‘[The bankruptcy law] gives to the honest but unfortunate debtor . . .

a new opportunity in life and a clear field for future effort, unhampered

by the pressure and discouragement of preexisting debt.’’
When such incentives are important, a natural trade-off exists between the
postbankruptcy benefits (greater effort) and the prebankruptcy costs (credit
rationing, greater likelihood of failure) of debt relief, which has not yet been
analyzed formally. In this article, I consider the effects of bankruptcy laws in
an environment that is specific to entrepreneurial firms. These firms are defined
by an ongoing dependence on a liquidity-constrained owner-manager, whose
effort is essential to the firm’s value. The entrepreneur’s effort choice, in turn,
depends on his/her stake in the firm’s future output.
Under realistic and fairly general conditions characterizing entrepreneurs
and their lenders, I find that entrepreneurial firms may be ill-suited for a bank-
ruptcy law that contains APR. While lenders might provide some debt relief
voluntarily, the model suggests that bankruptcy bargaining backed by APR
produces less debt relief than is socially efficient. Instead, the results of the
model confirm the benefits of a policy that provides entrepreneurs with a fresh
start, defined as a lower level of debt (and, hence, a greater stake for the en-
trepreneur in his/her future output) than banks would voluntarily accept in
bankruptcy negotiations. Moreover, entrepreneurs and banks would not reach
this outcome through private contracting alone. This implies that the law must
be mandatory to be effective.
I consider a three-period principal-agent model, in which bankruptcy
becomes a factor in the second period if the firm’s project fails initially. At
the start of period 0, wealthless entrepreneurs of varying quality will seek fi-
nancing from an ex ante competitive banking sector. In contrast to the standard
competitive model normally assumed in the bankruptcy literature, however,
the bank chosen at time zero will acquire private information about the entre-
preneur’s quality due to its ongoing relationship, as in Sharpe (1990) and Rajan
(1992). This informational advantage will give the relationship lender market
power over the course of the lending relationship. The importance of relation-
ships in small business lending, which has received considerable empirical
support (Petersen and Rajan 1994; Berger and Udell 1995), will have impor-
tant implications for bankruptcy law design. Although a relationship bank may
be willing to offer a contract that includes a fresh start for the entrepreneur as of
period 0, it cannot commit to avoid exploiting its interim market power by
Bankruptcy and Entrepreneurship 163
denying the fresh start when it recontracts with the entrepreneur at the start of
period 1. Bankruptcy plays a role in helping the parties commit to a more ef-
ficient contract.
The law may intervene in period 2 by allowing the entrepreneur to trigger
bankruptcy after a failure rather than renegotiating privately. The role of bank-
ruptcy in the model is twofold. First, the law provides protection to lenders.
The court guarantees the entire liquidation proceeds to the lender and ensures
that the lender receives at least this much even if the project continues. Second,
bankruptcy allows for partial debt forgiveness that grants the viable but un-
lucky entrepreneur a sufficient stake in his/her future output. The court
achieves this by mandating the entrepreneur’s repayment obligation to the

bank in period 2 if the firm continues operating. This characterization of bank-
ruptcy closely resembles the existing Chapter 13, in that the entrepreneur’s
obligations to the bank are capped by the law rather than the result of nego-
tiations backed by APR.
Because the fresh-start policy is more forgiving to an entrepreneur who fails,
I show that ex ante efficiency losses will occur due to lower period 1 effort.
These losses, however, are smaller than the gains from greater effort ex post,
stemming from the additional debt forgiveness. In a world with heterogeneous
entrepreneur types, I consider the possibility that enforcing greater debt for-
giveness for the entrepreneur will cause the bank to screen projects more care-
fully, setting a higher standard for entrepreneur quality before extending
credit. This might adversely affect lower quality entrepreneurs’ access to
startup funds in period 1 and/or the lender’s desire to liquidate in period 2.
I find that both these potential problems are mitigated by the protection
afforded to creditors and the parties’ ability to renegotiate in the shadow of
bankruptcy. Under the assumptions in the model, a standard ‘‘best interests
of creditors’’ (BIC) test (guaranteeing creditors at least the liquidation value
of the assets) is sufficient to prevent the fresh-start policy from doing damage to
the lending market at the startup stage. If the marginal entrepreneur type that
receives startup funds is one that will be liquidated in bankruptcy in any case,
then the fresh-start policy has no effect on the bank’s payoff for this marginal
type: the bank will continue to liquidate and receive all the proceeds. Greater
debt relief, which only applies to high-quality entrepreneurs who continue,
reduces the bank’s interim profit on only the most profitable entrepreneur types.
With respect to the decision to liquidate or continue the firm in bankruptcy,
a court-imposed debt level that is too low may indeed distort the bank’s pref-
erence toward liquidation. It is in this environment that private workouts will
provide a critical complementary role to a fresh-start policy. Lower quality
entrepreneurs who would be otherwise liquidated because of excessive debt
forgiveness have an incentive to negotiate with the bank prior to filing for
bankruptcy. These entrepreneurs will allow the bank to take a larger debt claim
in a workout because it gives them a chance to continue the project when bank-
ruptcy would result in a shutdown.
This article contributes to existing theoretical research on bankruptcy in
considering the postbankruptcy incentives that laws affect, which has been
overlooked in the literature. In my model, the optimal bankruptcy policy will

weigh the postbankruptcy benefits of debt relief against the potential prebank-
ruptcy costs of credit rationing at the startup stage (Longhofer 1997) and lower
effort to avoid failure (Adler et al. 2000; Bebchuk 2002), along with the within-
bankruptcy costs of distorted liquidation/reorganization decisions (White
1989; Gertner and Scharfstein 1991; Berkovitch and Israel 1999), all of which
have been analyzed before in isolation. Adding the postbankruptcy benefit of
debt relief, combined with a relationship-lending environment, challenges pro-
APR results in models that restrict attention to prebankruptcy incentives and
perfectly competitive capital markets.
Of existing approaches to bankruptcy law design, the most similar to this ar-

ticle is Povel (1999), which explores the trade-off between the prebankruptcy
moral hazard benefits of a ‘‘tough’’ procreditor law and the within-bankruptcy
benefits of a ‘‘soft’’ prodebtor law, which encourages managers to reveal neg-
ative information at an earlier date. As with most theoretical models of bank-
ruptcy, optimal laws in Povel (1999) are default rules: policies that the creditor
and debtor would write into the contract themselves ex ante. A second impor-
tant contribution of this model is to demonstrate that optimal bankruptcy out-
comes need not arise from pure private contracting. In my model, the overall
efficiency gain from debt relief entails an interim wealth transfer from lender
to entrepreneur, which the lender cannot commit to provide. This means bank-
ruptcy must be a mandatory attachment to debt contracts to be effective, pro-
viding justification for this real-world feature of bankruptcy law which is often
questioned on theoretical grounds (Schwartz 1997, 1998).2
The rest of the article will proceed as follows. Section 2 introduces the setup
and timing of the model, the participants, and the main assumptions. To gen-
erate intuition, Section 3 considers a simplified version of the model with a
single entrepreneur type. I then allow for heterogeneous entrepreneurs in Sec-
tion 4, which introduces workouts and the screening activity of lenders. In Sec-
tion 5, I consider a robustness check on the analysis, allowing for perfectly
competitive lending markets throughout. When banks face perfect competition
ex interim and ex post, I find that the fresh-start policy has no impact on social
surplus, positive or negative: since the bank has no interim market, power it
will voluntarily provide the optimal amount of ex post debt forgiveness, mak-
ing the bankruptcy policy redundant. Section 6 concludes with analysis and
policy implications.
2. Model Setup
To make the setup of the model clear, I begin by introducing in turn the avail-
able projects, followed by the three groups of players in the game: entrepre-
neurs, banks, and the bankruptcy court.
2. Mine is not the only article to provide an explanation for mandatory rules in bankruptcy.
Alternative mechanisms are provided in Berkovitch et al. (1998), in which the bankruptcy court is
necessary to influence bargaining power, and Aghion and Hermalin (1990), in which mandatory
rules eliminate socially wasteful signaling.
2.1 Investment Projects

Entrepreneurial investment projects can last for at most three periods. In period
0, entrepreneurs choose a bank to create a lending relationship; in this period
no action is taken and no monetary investments are made, but the entrepreneur
and the chosen bank learn about the entrepreneur’s ability by the end of the
period.3 In period 1, an investment project requires startup financing I1 > 0 in
order to proceed; unworthy projects can be shut down. After the project is
financed and the entrepreneur chooses his/her action, the project will be re-
vealed as a success or a failure. Success in period 1 yields cash flow X ¼ R1.
If success occurs in period 1, the game ends at that point. If the project fails
in period 1, X ¼ 0 and the game continues to period 2. At this stage, the pro-

ject can be continued with no further investment required,4 or it can be liqui-
dated for a known value L: this can be considered the best alternative use of
the assets that does not require the participation of the entrepreneur. I limit
consideration to risky projects only, so that L < I1. If the project is continued,
the entrepreneur chooses his/her action again, leading to failure (yielding 0)
or success (yielding R2). To reflect the fact that the projects prospects can only
be weakened by an initial failure, R1 R2. For simplicity, all agents in the
economy have a discount factor of zero.
2.2 Entrepreneurs
There are a large number of risk-neutral, wealthless entrepreneurs seeking
funds in period 0. All entrepreneurs have an outside option of zero but differ
in their abilities. The ability of the agent is summarized by the parameter p,
which can be interpreted as the marginal product of effort: if the agent takes
hidden effort et in period t ¼ f1, 2g, the project succeeds with probability pet.
The effort et imposes a quadratic utility cost on the agent, Cðet Þ ¼ 12ce2t ; c > 0.
To ensure that the first-best effort level is always less than one, I take c > Rt.
At the beginning of the game, the entrepreneur will draw his/her permanent
talent level from a distribution with density g(p), p 2 ½0, 1. The entrepreneur
observes his/her talent level only at the beginning of period 1. I assume that
the average talent level is low enough such that funding all entrepreneurs in
period 1 would yield a negative return to an investor. This will imply that
investors who finance startup projects must screen projects in order to earn
a profit, since entrepreneurs will always prefer to be financed.
2.3 Banks
Lenders in the economy will consist of relationship banks that are competitive
and uninformed about entrepreneur types as of period 0. A bank that develops
a relationship with an entrepreneur at period 0 will acquire an informational
3. The bank could lend some amount I0 that is fully or partially recoverable if the project is
not funded; this is omitted for simplicity.
4. In an earlier version of this article I allow for a follow-on investment; this does not affect
any of the results.
advantage about his/her quality. I assume the relationship bank receives per-
fect knowledge of the entrepreneur’s type before the project begins to operate
in period 1 and shuts down all unprofitable projects. For most of the article,
I will focus on the case in which outside banks do not observe the entrepre-
neur’s type and the informational disadvantage eliminates interim competi-
tion by outside banks. (Section 5 will consider perfectly competitive banking,
in which outside banks also observe the entrepreneur’s type at period 1.)
The relationship bank will then offer a one-period contract F1 to those entre-
preneurs who will yield a nonnegative expected profit.
Since the bank faces no interim competition, the offer will maximize its
profit, given the optimal effort decision of the entrepreneur and the expected

outcome in period 2 that will depend on the bankruptcy policy.5 If the project
fails in period 1 and bankruptcy does not alter private contracts, the bank will
replace the existing debt obligation with a new debt offer that maximizes its
profit, denoted F2p , if it is profitable to continue the project. Alternatively, the
bank can liquidate the project, receiving the proceeds L. As we will see, this
solution is equivalent to a bankruptcy policy that enforces the APR.
If the government fresh-start bankruptcy policy is in effect, which will alter
debt contracts, then the bank will have an opportunity to avoid bankruptcy by
making a workout offer F2w if it desires to continue the project. I assume the
bank’s bargaining power in the workout stage is the same as in the startup
stage, which depends on the available competition in the lending market. If
the offer is refused, the entrepreneur can commence the bankruptcy procedure.
Once in bankruptcy, the bank has no control over the debt contract conditional
on continuation, which will be denoted F2g :
2.4 The Government/Bankruptcy Court

The key component of the bankruptcy law is a choice of the face value of debt
F2g that determines the entrepreneur’s required repayment to the bank when the
bank chooses to continue the project rather than liquidate it. This value will be
chosen to maximize the overall surplus generated in the economy. The court
will commit to F2g at the beginning of the game, and it will be common knowl-
edge to all participants. I assume no specific knowledge by the bankruptcy
court; in particular, the court cannot observe entrepreneur types, and thus,
F2g is a constant independent of p.
It is important to emphasize that the right to trigger bankruptcy is always
available to the entrepreneur when a project is debt financed and fails in
5. Since the lending decision at period 1 is made based on the entrepreneur’s nonverifiable type
and low types will be liquidated, the bank and the entrepreneur cannot commit to a fresh start
conditional on lending taking place. The bank can always claim the entrepreneur is a low type,
making such a contract unenforceable. The relationship would then return to a bargaining game.
The interim profit made by the bank from period 1 onward will be anticipated and returned
to entrepreneurs in period 0 through a cash payment that is independent of type (or a ‘‘teaser’’
rate of interest on period 0 lending). As the mass of low entrepreneur types increases, the cash pay-
ment per entrepreneur approaches zero. For further discussion on this assumption in a relationship-
banking model, see footnote 8 in Rajan (1992).
period 1. In other words, as in current law, bankruptcy is a mandatory compo-

nent of debt contracts, in the sense that the option for firms to write their
own bankruptcy policy as part of a debt contract is forbidden.
Having introduced the players and the technology, I describe two main
assumptions that will be referenced throughout the article.
Assumption A1 (BIC test). In any bankruptcy outcome, the lender must
receive at least L, the liquidation value of the assets.
This assumption is used in practice in both Chapter 11 and Chapter 13 cases.
In essence, this assumption restricts consideration to bankruptcy policies that

provide a minimum standard of protection for the lender.
Before introducing the next assumption,
qffiffiffiffiffi I introduce some notation concern-
ing entrepreneur types. Let pl ¼ 4cl R22 denote the lowest type whose project
would be continued through the second period in a world without bankruptcy.
In other words, in the private contracting solution, projects will be liquidated if
and only if p < pl.
Assumption A2.
2
pl R1 p2l R22
I1 :
c 2 16c
In the private contracting solution, the bank strictly prefers to provide

startup funding in period 1 to all entrepreneur types p 2 ½pl, 1, with pl < 1.
This assumption serves two purposes. First, it simplifies the analysis with
respect to the initial lending decision of the bank. Given Assumptions A1 and
A2, there exists a pmin < pl such that an entrepreneur receives funding if and
only if p pmin. The value will depend on the bankruptcy policy, allowing for
effects of fresh-start policy on lending, but there will not be jumps in the lend-
ing decision, whereby some type p receives funds and a higher type p# does
not. More importantly, the assumption is sufficient to ensure the existence of
a range of types ½pmin, pl that receive startup funding in period 1 but will be
liquidated if they fail. This will become important when we examine the
ex ante lending effects of the fresh-start bankruptcy policy.
To further summarize, the game will proceed as follows when bankruptcy
law affects contracting:
Period 0:
Entrepreneurs start a lending relationship with a bank.
Period 1:
(a) Information about the entrepreneur’s type (p) is revealed to the entre-
preneur and the relationship bank.
(b) Given p and F2g , the relationship bank lends I1 to an entrepreneur if it
expects nonnegative expected profit. The bank offers a one-period debt
contract F1. The entrepreneur will accept any F1 R1.
Relationships Type
{R1-F1, F1}
formed revealed Bank pe1
lends I1 Bankruptcy/ {R2-F2, F2}
workout pe2
T=0 T=1
Not Continue
funded 1-pe1
T=2
Liquidate 1-pe2
{0,0}
{0,0}
{0,L}
Figure 1. Model Timeline.
(c) The entrepreneur chooses effort e1, given the contract in place.

(d) Output is revealed; if success occurs (with probability pe1), the entre-
preneur pays the investor F1 and keeps R1 F1, ending the game. If
failure occurs (with probability (1 pe1)), the entrepreneur defaults
and the game proceeds to the second period.
Period 2 (following failure):
(a) The bank can make a take-it-or-leave-it workout offer F2w to the entre-
preneur to avoid bankruptcy. If the entrepreneur accepts, this becomes
the new debt contract. The entrepreneur can instead reject and file for
bankruptcy.
(b) If bankruptcy occurs, bank and entrepreneur announce whether they
prefer to continue or liquidate. If both prefer to continue, the firm
remains in operation with the bank taking a debt claim with face value
F2g : If either chooses to liquidate, the firm ceases operations and the
bank receives L.
(c) If the project is continued, the entrepreneur chooses a hidden level of
effort e2.
(d) Success occurs, yielding R2, or failure occurs, yielding zero, payments
are made according to the contract in place, and the game ends.
Figure 1 summarizes the timeline of the model, with the payoffs to the
entrepreneur and bank, respectively, in brackets.
Having introduced the general model, I will take a step backward and con-
sider a simple world with one entrepreneur type p ¼ 1 and a single bank that
acquires interim market power. This will allow us to focus on the moral hazard
part of the problem and to understand the trade-off between ex ante and
ex post effort that is created by a government-induced fresh-start policy. I
will then add unobservable types, which will allow us to analyze whether a
fresh-start policy damages the bank’s incentive to lend at the startup and bank-
ruptcy stages.
3. Homogeneous Entrepreneurs
To make the exposition cleaner, the functions U2(p, F2), V2(p, F2), and
S2(p, F2) will denote second-period expected utilities for the entrepreneur,
bank, and society, respectively, conditional on bankruptcy occurring and the
project being continued. Since second-period effort e2 will always maximize
pe2 ðR2 F2 Þ 12ce22 ; his/her ex post utility, the solution e*2 ðp; F2 Þ ¼ pðR2cF2 Þ is
substituted into the equations, resulting in functions that depend solely on the
second-period debt obligation F2.
1 p2 ðR2 F2 Þ2
U2 ðp; F2 Þ [ pe2 ðR2 F2 Þ ce22 ¼ ; ð1Þ
2 2c
p2 F2 ðR2 F2 Þ
V2 ðp; F2 Þ [ pe2 F2 ¼ ; ð2Þ
c
1 p2 ðR22 F22 Þ
S2 ðp; F2 Þ [ pe2 R2 ce22 ¼ : ð3Þ

2 2c
Since there are no externalities, it will always be the case that S2(p, F2) ¼
U2(p, F2) þ V2(p, F2). By examining the ex post surplus in bankruptcy,
S2(p, F2), which is strictly decreasing in F2 for nonnegative F2, we can see
clearly the ex post benefit of the fresh start. The greater the debt promise
incurred by the entrepreneur, the lower his/her effort will be in equilibrium.
Thus, the firm will have a lower chance of success after bankruptcy than is
socially efficient. As we will see, however, this benefit is attenuated by an
ex ante efficiency loss from lower period 1 effort.
3.1 First-Best Solution

If the government could act as a social planner and choose effort optimally in
both periods, it would solve the following program when all entrepreneurs are
of type p ¼ 1:
max S1 [ PrðX ¼ R1 ÞR1 Cðe1 Þ I1 þ PrðX ¼ 0ÞS2 ð1; R2 Þ; ð4Þ
e1 ;e2

1 2 1 2
[ e1 R1 ce1 I1 þ ð1 e1 Þ e2 R2 ce2 : ð5Þ
2 2
The first-best effort choices would be as follows:
R1 R22 R1 S2 ð1; 0Þ R2
eFB
1 ¼ 2¼ ; eFB
2 ¼ : ð6Þ
c 2c c c
Note that the first best would be attained if entrepreneurs could self-finance
their projects. The result is intuitive: second-period effort responds positively
to the reward from a success, R2, and negatively to c, the multiplier on the cost
of effort. In the first period, effort responds to these two factors and negatively
to the expected surplus available in period 2 following a failure. In other words,
it is optimal to reduce effort in period 1 if the consequences of the failure are
less severe.
3.2 Private Contracting Solution and Absolute Priority

Since I consider only the highest possible p, Assumption A2 guarantees that
the bank will prefer to fund the project and to continue it following failure
(otherwise, no projects would be funded). I will now consider the costs of ex-
ternal finance on ex ante and ex post efficiency of effort. The game is solved
backward, starting from the bank’s period 2 problem6:
R 2 F2
max e2 F2 subject to e2 ¼ : ð7Þ
F2 c
The second-period debt contract and effort levels are
R2 R2
F2p ¼ ; ep2 ¼ : ð8Þ
2 2c

Given this solution, the bank solves the following first period problem:
max e1 F1 I1 þ ð1 e1 ÞV2 ð1; F2p Þ; ð9Þ

F1
1
subject to e1 ¼ arg max e1 ðR1 F1 Þ ce21 þ ð1 e1 ÞU2 ð1; F2p Þ:
e1 2
The first period debt contract and effort levels are given by
R1 R22 R1 U2 ð1; F2p Þ þ V2 ð1; F2p Þ

F1p ¼ þ ¼ ; ð10Þ
2 16c 2
R1 3R22 R1 S2 ð1; F2p Þ
ep1 ¼ ¼ : ð11Þ
2c 16c2 2c
The bank, when deciding on the debt contract, trades off the greater incen-
tives for effort that lower debt provides with the lower payoff when the project
succeeds. The solution becomes easier to interpret when the notation for the
second-period utilities of the entrepreneur and bank, respectively, U2 and
V2, are included. Looking at F1p , we can see that the bank, all else equal, sets
a higher debt level when its own second-period utility V2 is higher because the
consequences of failure are less severe. This means the bank is more willing to
risk failure to attain a higher payoff in period 1 if the project succeeds. Con-
versely, the bank sets a lower debt level when the entrepreneur’s second-period
utility is higher. All else equal, this will reduce entrepreneurial effort in period 1.
This in turn reduces the entrepreneur’s marginal cost of effort, strengthening
the incentive effect of lower debt.
In order to determine where the social planner’s interests lie, we can see how
the private contracting solution compares with the first best, in the following
lemma (all proofs not contained in the text are in the Appendix).
Lemma 1. In the private contracting solution, 2effort in each period is less

3R2 R2
than the first best: ep1 ¼ R2c1 16c22 < eFB R1 p R2 FB
1 ¼ c 2c2 and e2 ¼ 2c < e2 ¼ 2 :
R2
6. It will never be optimal to pay the entrepreneur other than with a share of the project’s
returns; this is implicitly incorporated in the maximization problem.
In other words, the need to repay the investor reduces the incentive of the
entrepreneur to succeed in both periods. The fact that second-period effort is
lower than the first best follows from the agent’s wealth constraint. The first
best would only be attainable if the entire project were sold to the entrepreneur;
because of his/her limited wealth, he/she cannot purchase a greater share than
the bank will allocate her, being motivated only by its own payoff rather than
overall surplus. Thus, he/she is underincentivized in the optimal contract.
When we look backward to the first period, the result is less obvious. The bank
and entrepreneur anticipate the second-period outcome, in which the total sur-
plus created, S2 ð1; F2p Þ; is less than the first best S2(1, 0) which would occur if
the entrepreneur had no debt obligation to repay. This implies that, collec-

tively, the bank and entrepreneur are more eager to avoid failure than if
the first-best surplus were available in period 2. This effect, which tends to
make first period effort greater in the private contracting solution, is over-
whelmed by the same incentive-reducing effect of the debt obligation F1 in
period 1.
It is important to note that the private contracting solution corresponds to the
outcome that would occur in bankruptcy if the APR is enforced. Absolute pri-
ority states that junior claimants (here, the entrepreneur) cannot receive any
stake in the reorganized firm unless senior claimants (here, the bank) are com-
pensated in full. In the present setup, the bank could never receive a claim
worth F1.7 If the bank liquidates the firm, it receives the entire liquidation value
while the entrepreneur receives nothing. If the bank prefers to refinance and
continue the project, it can do no better than taking the debt claim F2p : Thus, we
would expect this ex post profit-maximizing contract to emerge in bankruptcy
when courts enforce absolute priority.
It is also worthwhile to emphasize that because the bank can never extract
the value F1 from the project after it fails in period 1, the private contracting
solution always involves some debt forgiveness by the bank. Thus, I define
a fresh-start policy in bankruptcy as a policy involving greater debt relief than
the bank would approve voluntarily for entrepreneurs who are refinanced and
continued, that is, F2g < F2p : In other words, the fresh-start policy necessarily
implies the absence of the APR. I now consider policies of this type.
3.3 Court Intervention and Fresh-Start Policy

In what follows, the law will mandate a lower face value of debt in the second
period than F2p : I will analyze the best response of the bank that will set F1 to
maximize profit given this government policy. We already know, based on the
discussion of equation (3), that lower F2 will produce greater ex post effi-
ciency. It is not clear, however, what effect this will have on overall efficiency;
the effect of weaker ex ante incentives caused by the softer policy could dom-
inate the ex post benefit from better incentives inside bankruptcy. The follow-
ing lemma helps establish some intuition.
7. If this were possible, the bank would be indifferent between success and failure of the
project, and it would be optimal for it to raise F1 to a higher level.
Lemma 2. @F1
@F2g
> 0 " F2g < F2p ; when the government employs a softer
bankruptcy policy (lower F2g ), the bank responds by lowering F1 ¼
R1 U2 ð1;F2g ÞþV2 ð1;F2g Þ
2 :
It is easily verifiable from equations (1) and (2) that entrepreneur ex post util-
ity is strictly decreasing in F2 and bank utility is strictly increasing in F2 for
F2 F2p : Based on the discussion in the last subsection concerning the optimal
response of F1 to U2 and V2, we conclude that the softer policy, which decreases
ex post bank utility and increases ex post entrepreneur utility, will cause the
bank to request a smaller debt claim from the entrepreneur in period 1.

This lemma captures an interaction effect that is different from existing the-
oretical work on bankruptcy, due to the assumption of a relationship-lending
environment rather than one of perfect information and perfect competition.
When bankruptcy law allows deviations from absolute priority in favor of eq-
uity, entrepreneurs will choose actions that make bankruptcy more likely, hold-
ing the lender’s behavior fixed. In a perfectly competitive lending market, as
assumed in Adler et al. (2000) and Bebchuk (2002), for example, lenders respond
in equilibrium with higher interest rates to cover the expected losses from these
increased agency costs. This, in turn, exacerbates the ex ante agency problem.
In a relationship-lending context, even though zero-profit constraints bind as
of period 0, they need not bind at the interim period when F1 is chosen, due to
the lender’s acquired information advantage. As a result, interest rates are set
so as to maximize the bank’s profit given the bankruptcy policy in place. The
bank understands the added desire to slack on the part of the entrepreneur due
to the prodebtor policy and also recognizes that failure will be more costly to
its profits than before. The bank will respond by incentivizing the entrepreneur
more strongly with a lower debt burden, which is desirable from an efficiency
standpoint. To look at the issue another way, if we take the interest rate on the
debt in period 1 as r1 ¼ F1II1
1
; the conventional wisdom that prodebtor bank-
ruptcy policy will lead to higher interest rates for borrowers in equilibrium
does not hold true here since r1 is increasing in F1.8
This might lead us to believe that proentrepreneur policy can produce both ex
post and ex ante benefits from effort choices closer to the first best. Nevertheless,
in this model, the standard intuition will still hold: although the bank chooses to
counteract the softening by accepting a smaller debt claim, this is not enough to
completely neutralize the bankruptcy policy’s negative ex ante effect:
@e1 Fg
Lemma 3. @F g ¼
2c2 > 0; in equilibrium, a softer bankruptcy policy (a smaller
2
g 2
F2 ) results in less effort in period 1.
So in order to determine whether softer policy is optimal or not, we must

weigh the period 2 gains against the period 1 losses. Proposition 4 says that
8. Interestingly, Berkowitz and White (2004) find that greater personal bankruptcy exemptions
has no significant effect on interest rates offered to unincorporated borrowers, though it does result
in tighter credit provision.
fresh-start policy increases overall efficiency, after taking the lower ex ante
effort into account.
@S1
Proposition 4. If entrepreneurs are homogeneous, @F g < 0; fresh-start bank-
2
ruptcy policy will increase total surplus in the absence of lending effects.
The proposition is useful because it tells us that ex ante managerial slack-

ening effects alone are not enough to outweigh the efficiency benefits of a fresh
start for the entrepreneur. Part of this result is due to the relationship-lending
environment: in this setting, the bank anticipates the desire of the manager to
slack off and thus provides him/her more incentive to succeed through lower

debt at the initial stage. The proposition also holds for any p for which funding
occurs ex ante and ex post, which will apply in the next section.
I should be careful to point out that while this strong result holds for the
standard effort cost function Cðet Þ ¼ 12ce2t ; it may not be true for every possible
cost function. A conservative interpretation of Proposition 4 is that earlier the-
oretical work is missing an economically important effect by focusing only on
ex ante moral hazard problems. For any realistic cost function, the qualitative
trade-off should exist between ex post benefits and ex ante costs of the fresh-
start policy. Using a standard setup, the ex post efficiency gains strictly dom-
inate the ex ante losses.
4. Heterogeneous Entrepreneurs
After establishing some intuition in the homogeneous case by focusing solely
on effort provision, the model will be broadened to include heterogeneous en-
trepreneur types. This will introduce considerations of bank screening which
generates new potential costs and benefits of proentrepreneur policy. Neverthe-
less, using the available policy instruments, we will see that it is always possible
to improve upon the private contracting solution through a policy that involves
greater debt forgiveness ex post. First, we should define the new government
objective of social surplus, which will depend on the entrepreneurs who receive
funds and the effort decisions of these entrepreneurs both ex ante and ex post:
ð pl
1
Stot ¼ pe1 R1 ce21 I1 þ ð1 pe1 ÞL gðpÞdp
pmin 2
ð 1
1 2 1 2
þ pe1 R1 ce1 I1 þ ð1 pe1 Þ pe2 R2 ce2 gðpÞdp: ð12Þ
pl 2 2
Of course, the effort term e1, the ex ante lending choice pmin, and the realized
second-period surplus will depend on the optimal contract offered by the bank
in period 1, which in turn depends on the bankruptcy policy. In the analysis
p
that follows, the function Stot ðF2g Þ will be used to write total social surplus in
reduced form as a function of the bankruptcy policy, given that the other com-
ponents in the model are determined by profit maximization by the bank and
utility maximization by the entrepreneur.
As a starting point for this section, we will examine the new sources of
inefficiency that arise when the bank may choose whether or not to extend fi-
nancing to the entrepreneur. Earlier, we saw that the solution to the principal-
agent problem with a wealth-constrained entrepreneur involves the bank and
entrepreneur splitting the proceeds from success, which leads to subopti-
mal effort due to the share allocated to the bank. The second part of the prob-
lem is the converse: the share allocated to the entrepreneur causes the bank
to make suboptimal lending decisions. This is summarized in the following
proposition.
Proposition 5. In the private contracting solution, fewer entrepreneur types

receive funding ex ante, and more entrepreneur types are liquidated than in the
first-best solution.
Since the bank must supply the entire cost of funding the project (or the
continuation) but can only claim part of the benefit, the underinvesting, over-
liquidating result is not surprising, but it brings to light the critical difference
between entrepreneurial and nonentrepreneurial firms. This difference lies in
the necessity of maintaining the entrepreneur’s claim (due to moral hazard)
and his/her limited wealth. If moral hazard is not a consideration and contin-
uation is efficient, the bank could offer the entrepreneur a fixed wage between
0 and S2 L for his/her participation in the continuation of the firm, and both
parties would be better off than under a liquidation. Similarly, if the entrepre-
neur had enough wealth, he/she could pay a price between L and S2(p, 0) for
firms that would otherwise be liquidated, take control of all the equity, and
make the first-best effort decision.
In order to consider the potential cost of softer policy, suppose for the mo-
ment that bankruptcy is the only available option, implying that the entrepre-
neur must reorganize using the government-imposed debt contract F2g < F2p :
Recall that by Assumption A2 there exists a lowest type pmin for which entre-
preneurs receive startup funding from the bank if and only if p pmin. Entre-
preneurs of this type will be liquidated if they fail in period 1. Since F2g only
applies to firms that continue in period 2, it does not affect the bank’s profit on
the marginal types and, thus, does not change the startup lending decision for
any entrepreneur type.
The fact that a transfer of surplus from the bank to the entrepreneur does not
affect the lending decision may seem surprising at first, but this follows from
two factors. First, it is essential that there exist a large enough set of types that
will be optimally liquidated following failure, as embodied by Assumption A2.
Second, the startup lending result is guaranteed by the creditor protection pro-
vided by law, the BIC test. On the least able entrepreneur who receives funds
(type pmin), the bank receives the entire liquidation value after a period 1 fail-
ure. The BIC test guarantees that the bank will receive at least this much ex post
on all other entrepreneur types which are better than this marginal type. The
market power of the bank guarantees that it will be able to appropriate at least
part of the surplus that comes from funding these better entrepreneurs. Thus,
the ex post transfer from bank to entrepreneur, that occurs only for types that
are high enough to be refinanced, does not change the lending decision ex ante.9
In period 2, however, the liquidation/continuation decision will be affected.
Since F2g < F2p ; there will exist a group of entrepreneur types such that
V2 ðp; F2g Þ < L < V2 ðp; F2p Þ: The types that satisfy this condition would be con-
tinued under private contracting, but since the parties are limited to the bank-
ruptcy debt contract that would give the bank less profit than a liquidation, the
bank would choose to liquidate. Thus, if the bank and entrepreneur are con-
strained by the inflexible government policy, the overliquidation problem
would be more severe.
With this potential problem in hand, I now consider the availability of pre-

bankruptcy workouts, which will allow the players the flexibility to circumvent
a policy that makes them both worse off. We will see that the existence of
workouts has a beneficial effect: it allows the most able entrepreneurs to take
advantage of the fresh start, while allowing the bank and entrepreneur to pre-
vent inefficient liquidations of lower ability entrepreneurs.
4.1 The Role of Private Workouts

Recall that after a first period failure, the bank will be able to make a take-it-or-
leave-it workout offer to the entrepreneur. Naturally, this option is trivial if the
bankruptcy policy enforces absolute priority, in which case the outcome
matches private contracting. If the bankruptcy policy involves a lower F2g than
the bank would offer, however, the bank would like to avoid this outcome and
will attempt to negotiate with the entrepreneur. The entrepreneur will not ac-
cept unless the bank’s offer gives him/her higher utility than he/she would
receive by declaring bankruptcy. Once bankruptcy occurs, the parties have
only two choices: continue the project and accept the debt claim F2g or liqui-
date. If the entrepreneur anticipates continuation in bankruptcy, he/she will
reject any debt offer with face value higher than F2g ; making the workout at-
tempt futile. On the other hand, if he/she anticipates liquidation, he/she will
accept any workout offer, and the bank will offer the profit-maximizing con-
tract; thus, F2w ¼ F2p whenever a workout is successful. This implies that work-
outs will occur for entrepreneur types such that V2 ðp; F2g Þ < L < V2 ðp; F2p Þ: As
suggested before, these are the types that would be continued under private
contracting but liquidated if bankruptcy was the only alternative.
It is interesting to note the way workouts are influenced by the expected
outcome in bankruptcy. The bankruptcy policy is designed to provide a fresh
start to the best entrepreneurs that merit a second chance, while protecting the
lender on lower quality entrepreneurs to ensure that they receive startup fund-
ing. Such goals are still possible even though the parties have a chance to avoid
9. The only caveat is that ex ante effort can jump downward discontinuously when a small
improvement in entrepreneur talent leads the entrepreneur to expect continuation instead of liq-
uidation in period 2; in such a case, the entrepreneur’s ex post utility would jump from zero to
U2 ðp; F2g Þ: The resulting lower ex ante effort would provide a discontinuous jump downward in
bank profit. Assumption A2 is sufficient to guarantee that such considerations will not affect startup
lending decisions in this environment.
bankruptcy because the availability of bankruptcy sets the bargaining terms of

the workout. The best entrepreneurs, who expect refinancing in bankruptcy,
insist on a low debt level to complete a workout because they know they will
receive a fresh start if they declare bankruptcy. The low-quality entrepreneurs
expect that they will be liquidated in bankruptcy, and this gives the bank the
bargaining power in the workout. This is critical because the bank must be able
to impose a larger debt claim on the least able entrepreneurs in order to be
willing to provide funds.
I now return to the potential gains from fresh-start policy in a world with
heterogeneous types and private workouts.

Proposition 6. The following conditions characterize an optimal bank-
ruptcy policy.
(a) There exists F2g < F2p such that Stot

p
ðF2g Þ > Stot
p
ðF2p Þ and
p g p p g p
(b) Stot ðF2 Þ Stot ðF2 Þ " F2 < F2 :
There always exists a fresh-start policy that generates greater social surplus.
Moreover, any fresh-start policy will generate at least as much social surplus as
a bankruptcy policy that enforces absolute priority.
The intuition behind the proposition is straightforward. For entrepreneur

types who are refused startup financing, financed and liquidated in bank-
ruptcy, or financed and undertake a private workout before bankruptcy, the
outcome is exactly the same as in the private contracting solution both
ex ante and ex post. Thus, the overall surplus generated by these entrepre-
neurs does not change. The only remaining entrepreneur types are those
who are continued under the fresh-start policy instead of the profit-maximizing
contract. Assumption A2 guarantees that the lending decision with respect
to these firms does not change, and Proposition 4 proves that, including
ex ante and ex post considerations, these projects will generate greater over-
all surplus.
Part (b) of the proposition is important because it tells us that the bankruptcy
law, in addition to being uninformed, need not even be precise to increase
surplus, since it always does at least as well as a no-bankruptcy world. This
result reveals the true value of the private workout as a complement to a man-
datory bankruptcy policy: it provides a minimum floor for social surplus,
which is the surplus generated in the private contracting solution.
Thus, the optimal choice of F2g is a trade-off between providing a greater
discharge to entrepreneurs that are continued in bankruptcy and preventing too
many projects from escaping bankruptcy protection through workouts. If the
policy is very aggressive (F2g is set very low), very few entrepreneurs will enter
bankruptcy because liquidation would result. More entrepreneurs will choose
workouts, which mimics a private contracting solution. To see the extreme
case, suppose bankruptcy provided a complete discharge: F2g ¼ 0: Then the
bank would never prefer to sacrifice the liquidation value L to continue the
project, and thus, no projects would be continued in bankruptcy; all firms that
continue would be under contracts negotiated in private workouts, which

would return us to the private contracting solution.
If the policy is very conservative, on the other hand (F2g is very close to F2p ),
then more entrepreneur types will use bankruptcy to reorganize rather than
workouts. Surplus will increase for a greater fraction of entrepreneur types,
but the increase in surplus per entrepreneur will be small. In general, the op-
timal F2g should depend on the distribution of types, g(p). If the mean of this
distribution is higher (entrepreneurs are on average more talented), then
a smaller F2g will be preferred. To see this formally, note that the optimal
ex post repayment level is type specific and corresponds
qffiffiffiffiffiffiffiffiffiffiffiffiffito the repayment that
R2

gives the bank its liquidation payoff, F2c ¼ R22 42 Lc p2 ; which is decreasing
in p. The court may prefer to implement a very forgiving policy to get the most
surplus out of the higher types when they are abundant. When these types are
scarce, it must be more cautious given that the court creates no surplus on all
types that satisfy V2 ðp; F2g Þ < L < V2 ðp; F2p Þ; which grows as F2g falls.
5. Fresh-Start and Interim Competition

To this point, I have focused on the case in which the bank acquires an interim
monopoly by virtue of its informational advantage. When the lender acquires
this interim market power, the fresh-start policy prevents the lender from
exploiting it fully, and social surplus is gained. Because the model assumes
ex ante competition as of period 0, the gains from the fresh start accrue com-
pletely to entrepreneurs. Although interim market power is a standard assump-
tion in the banking literature following Rajan (1992), it will certainly not hold in
all circumstances, particularly when information about borrowers is easily
attained. Given the inherent difficulty in conditioning bankruptcy on the struc-
ture of lending markets, it is important to analyze the case of interim competition
to decide whether a fresh-start policy could be welfare improving on balance. In
this section I analyze the effect of bankruptcy policy when banking markets are
perfectly competitive as a robustness check on the previous analysis.
5.1 Private Contracting Solution

In contrast to the previous sections, suppose that the entrepreneur’s type is pub-
licly observable to the entrepreneur and all banks at the beginning of period 1.
This implies that the relationship bank must offer a contract to the entrepreneur
that maximizes his/her utility subject to the bank’s participation constraint. The
entrepreneur’s period 1 problem for a given type p is as follows10:
1
max pe1 ðR1 F1c Þ þ ð1 pe1 ÞU2 ðp; F2c Þ ce21 ; ð13Þ
F1c ;F2c 2
1
subject to e1 ¼ arg max pe1 ðR1 F1c Þ þ ð1 pe1 ÞU2 ðp; F2c Þ ce21 ;
e1 2
10. I restrict attention to one-period debt contracts here to consider cases in which bankruptcy
may matter. Naturally, if the bank offers a long-term contract, then bankruptcy is not a factor apart
from liquidation and any fresh-start policy has no effect on outcomes.
pe1 F1c þ ð1 pe1 ÞV2 ðp; F2c Þ I1 ¼ 0; ð14Þ
V2 ðp; F2c Þ ¼ L: ð15Þ

Equation (15) follows from the fact that the bank cannot require the entrepre-
neur to work under any contract that does not maximize his/her utility ex post.
As long as the firm’s assets are not specific and can be purchased on the open
market at a price L, an outside bank could purchase these assets and hire the
entrepreneur, taking a debt claim on the firm such that V2 ðp; F2c Þ ¼ L:
Working backward, the entrepreneur’s period 2 problem and solution is as
follows:

1
max pe2 ðR2 F2c Þ ce22 ; ð16Þ
F2c 2
R 2 F2
subject to e2 ¼ ; ð17Þ
c
V2 ðp; F2c Þ ¼ L: ð18Þ
The second-period solution is
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
R 2 R22 Lc
F2c ¼ 2;
2 4 p
pðR2 F2c Þ
ec2 ¼ :
c
The first period solution is
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
R 1 U 2 ðp; F c
Þ ðR1 U2 ðp; F2c ÞÞ2 I1 c
F1c ¼ 2
2;
2 4 p
pðR1 F1c U2 ðp; F2c ÞÞ

ec1 ¼ :
c
Note that in the interim competitive case, like the interim monopoly case, the
private contracting solution is equivalent to bankruptcy under the APR. As
before, the bank cannot fully recover F1c if the project fails. If the entrepreneur
is not talented enough to be refinanced, the bank liquidates and receives all the
proceeds. If the project is continued, the bank receives as much as it could
possibly receive given the contract reached in equilibrium. Unlike the monop-
oly case, however, the bank’s ex post profit is zero; on all types continued out
of bankruptcy, the bank receives exactly the liquidation value from continu-
ation and nothing more. In effect, absolute priority has no ‘‘bite’’ because the
competitive banking sector prevents the bank from taking a profit-maximizing
claim on the entrepreneur that would be permissible under the bankruptcy pol-
icy in effect.
5.2 Bankruptcy Policy Under Competitive Lending

The analysis of bankruptcy intervention under competition differs slightly
from the relationship-lending case because the second-period contract depends
on the entrepreneur’s type. In particular, higher types receive a smaller debt
obligation in period 2 because they have a greater probability of success. This
implies that, for a fixed F2g set by the court, the private contracting solution
may imply higher debt than the bankruptcy policy specifies for some types and
lower debt than the bankruptcy policy for other types. Thus, as I have defined
it, fresh start may be type specific: if F2c ðpÞ > F2g , then type p faces a fresh-start
policy in bankruptcy. Despite this minor complication, analysis of bankruptcy
policy is straightforward, as illustrated in the following proposition:

Proposition 7. Under interim perfect competition, any bankruptcy policy
F2g yields the same outcome as the private contracting solution. All entrepre-
neur types p that satisfy V2 ðp; F2p Þ 0 will complete workouts prior to bank-
ruptcy, with F2w ¼ F2c : All lower entrepreneur types will be liquidated.
The proof is simple. For types such that the bankruptcy policy offers a fresh
start, F2g < F2c ðpÞ, the bank prefers liquidation to refinancing the entrepreneur
under F2g , by the definition of F2c ðpÞ: If a bankruptcy filing occurs, the bank will
liquidate, but an outside bank would purchase the assets for L and rehire the
entrepreneur under the debt contract F2c ðpÞ: Anticipating this, the relationship
bank will offer F2c ðpÞ in a workout. For types such that F2g > F2c ðpÞ, the bank
may prefer to refinance under the ‘‘tougher’’ government debt contract (pro-
vided that V2 ðp; F2g Þ > V2 ðp; F2c Þ ¼ L). The bank anticipates, however, that
the entrepreneur will instead propose a liquidation to start again with a new
bank under the competitive debt contract. The bank will then offer F2c ðpÞ in
a workout.
In conclusion, under perfect competition, bankruptcy policy cannot affect
outcomes by mandating the terms of a contract because market forces will
work around it. The result thus reinforces that the fresh-start policy does at
least as well as absolute priority regardless of the information structure of lend-
ing markets. In cases where informational advantages exist, or lending markets
are not perfectly competitive, the policy does strictly better than absolute pri-
ority (or private contracting). In settings with no such advantages by relation-
ship lenders, fresh start and absolute priority are equivalent.
6. Analysis and Conclusions

This article suggests that the entrepreneurial firm, whose value depends on the
effort of a key individual, is better served by the bankruptcy principles that
were designed for the individual debtor rather than the corporate debtor. In
particular, social gains can be made from bankruptcy law that offers entre-
preneurs an opportunity for a fresh start—a second chance to succeed that
would otherwise be encumbered by debt obligations carried over from its pre-
vious failure. Much of the previous literature assumes an environment in which
bargaining between the relevant parties would reach efficient outcomes without
court intervention; prodebtor policy in this environment is merely a wealth
transfer that hurts ex ante incentives. In this article, I demonstrate that an en-
vironment that characterizes entrepreneurial activity (a wealth-constrained
owner-manager financed by a relationship bank) is an important exception,
in which ex post efficiency is not guaranteed by bargaining alone. In such
an environment, using bankruptcy to induce greater forgiveness of prebank-
ruptcy debts than a privately arranged outcome increases social surplus. Be-
cause the contracting parties cannot commit to such an outcome, however,
the policy must be mandatory: gains cannot be achieved when lenders and bor-
rowers are left free to write their own bankruptcy policy into an ex ante contract.

The model has several implications that are relevant to the existing debate
about bankruptcy law design. The first and most obvious is that a law that
results in strict adherence to absolute priority is not optimal for entrepreneurial
firms whose circumstances resemble those modeled here. This suggests special
rules for small business bankruptcies that balance debtor and creditor interests
differently than in large cases. Although there already exist special small busi-
ness provisions in the current Chapter 11, these likely make APR deviations
more difficult than in large cases. Stricter time limits are imposed on debtor
exclusivity periods and plan confirmation, which would likely reduce
a debtor’s bargaining power with creditors. Although these small business pro-
visions are intended to reduce deadweight losses from delay, the model empha-
sizes that the fresh-start gains from lower APR deviations (Proposition 6) will
be reduced.
Although the model is geared toward the reorganization of an existing busi-
ness under a corporate bankruptcy law, it can apply equally well to ‘‘serial
entrepreneurs’’ who start new businesses after filing for personal bankruptcy
(Baird and Morrison 2005). An increasing fraction of small business debtors
use Chapter 13 to resolve distress (Warren and Westbrook 1999), which bears
close resemblance to the bankruptcy law in the model. In a Chapter 13 plan, the
debtor repays his/her disposable income for a set number of years (a longer
time period corresponds to a larger F2g ) and receives a discharge when the plan
is completed. Similar to the assumptions in the model, the creditor is only guar-
anteed the amount he/she would receive in a Chapter 7 liquidation of the debt-
or’s assets. Second, the debtor’s required repayment is determined in advance
by law and need not be approved by creditors, in sharp contrast to Chapter 11.
Importantly, recent changes to U.S. bankruptcy law11 have increased pro-
tection of certain secured creditors in Chapter 13, preventing the debtor from
‘‘stripping down’’ the lien to the value of the collateral, as was allowable pre-
viously. Instead, debtors are now required to pay the secured creditor in full in
order to keep possession of the collateral. In the model, this amounts to replac-
ing the BIC test (Assumption A1), which protects a secured creditor up to the
liquidation value of the collateral, with protection resembling APR (since the
secured creditor has the right to insist on full repayment). The model suggests
11. The act is entitled The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
that, in some circumstances, the weaker BIC test is sufficient to protect lending
markets at the startup stage. Although this additional protection to secured
creditors reduces the ex post incentive benefits of the Chapter 13 fresh start,
it need not have offsetting benefits.
Implicitly, the model finds that a particular environment is required for
a fresh-start policy to have beneficial effects. In the case of the large corpo-
ration that usually files for Chapter 11, the policy described herein would not
be fitting for several reasons. First, empirical research indicates that the chief
executive officer of the large firm entering bankruptcy is far from essential to
the firm’s survival: Hotchkiss (1995) finds that dismissal of top executives is
quite common in the large Chapter 11. In addition, the benefits of fresh start

require that workouts are possible in the wake of bankruptcy. Although this is
likely to be true for the small debtor with a simple capital structure, it is less
valid for the large corporation with widely dispersed bondholders (Asquith
et al. 1994). Finally, the benefits of fresh start are tied to a market in which
the lender acquires market power, potentially at an interim stage. Thus, it fits
well in relationship-lending contexts where information acquisition is im-
portant or in markets where lenders are not perfectly competitive. Where
competition for funds is available from a competitive capital market and
informational asymmetries are negligible, the model suggests that a fresh-start
policy does no damage but has no benefit either.12
These facts reinforce that there are important differences between the
pure corporation (characterized by a significant separation of ownership and
control) and the owner-managed entrepreneurial firm that require different ap-
proaches to produce efficient outcomes. The fresh-start policy modeled here
should be available only for corporate debtors who fit the assumptions in the
model. In practice, this could be achieved through a requirement on the max-
imum number of shareholders (Skeel 1993) or through a requirement on own-
ership concentration in addition to restrictions based on size and amount of
debt, as currently exists in practice. The model suggests that the distinction
between the entrepreneurial firm and the pure corporation is valuable despite
the potential difficulties of identifying the difference in practice.
Appendix
Proof of Lemma 1. Comparing the period 2 effort levels is simple, since
ep2 ¼ 12eFB
2 :
For the first-best period 1 effort to be greater than the profit-maximizing

period 1 effort, the following condition must hold: 12 R1 > 16c
5 2
R2 ; but this is
1 1 5 5 2
always true, since 2R1 2R2 > 16R2 > 16cR2 :
12. One way to achieve the commitment benefits of a fresh-start bankruptcy law without the
problem of overinclusion is to allow for hands-tying contracts, which would prohibit renegotiation
away from a fresh start at an interim stage. Such contracts are not legally enforceable under current
law, however, and whether they are enforceable as a practical matter is also debatable. I am grateful
to Barry Adler for suggesting this alternative and for a helpful discussion on this point.
The first three inequalities are straightforward, whereas the last one follows
from the condition R2 < c that is required for the first-best probability of suc-
cess to be less than one.
Lemma 2. We can see this quickly from looking at the investor’s best
response function (its choice of F1) when the government sets F2.
R1 F2 ðR2 F2 Þ ðR2 F2 Þ2
F1* ¼ þ :
2 2c 4c
Differentiating with respect to F2 and comparing to zero reveals that the in-

vestor responds positively to a softening of bankruptcy policy if and only if the
@F *
following is true: @F12 > 0 if and only if F2 < 23R2 :
But this will always be true, since the investor will never propose to a
F2 > 12R2 :
Lemma 3. We can simply consider the entrepreneur’s equilibrium effort
function and differentiate with respect to F2:
2
R1 ðR2 F2 Þ F2 ðR2 F2 Þ
e*1 ðF1*; F2 Þ ¼ ;
2c 4c2 2c2
@e*1 ðF1*; F2 Þ 1
¼ 2 F2 :
@F2 2c
This expression is positive for all F2 > 0, which is true for any feasible
bankruptcy policy.
Proposition 4. First, we can rewrite the best response function of the inves-
tor and the optimal effort function from Lemma 2 in the abbreviated notation:
R1 U2 ð1; F2 Þ V2 ð1; F2 Þ
e*1 ¼ :
2c
We plug this expression into the total surplus function (the policy maker’s
objective):
1
S1 ð1; F2 Þ [ e1 R1 ce21 I1 þ ð1 e1 ÞS2 ð1; F2 Þ:
2
This yields the following expression:
3
S1 ð1; F2 Þ ¼ ðR1 S2 ð1; F2 ÞÞ2 þ S2 ð1; F2 Þ:
8
If we differentiate this with respect to S2 ð1; F2 Þ; second-period total surplus,
we get the following:

@S1 ð1; F2 Þ 3 R1 S2 ð1; F2 Þ
¼1 ;
@S2 ð1; F2 Þ 4 c
R1 S2 ð1;F2 Þ
which is always positive, since c < Rc1 < 1: Now it remains to show
R22 F22
that S2 ð1; F2 Þ ¼ 2c is decreasing in F2, which is evident from inspection.
Proposition 5. I present the result for the startup lending decision; the proof
for the second-period continuation decision follows similarly.
By the definition of the first-best levels of effort feFB FB
1 ; e2 g and Lemma 1 it
must be the case that for all p:
1 FB 2
S2 ðp; 0Þ þ peFB
1 ðR1 S2 ðp; 0ÞÞ I1 cðe1 Þ
2
1
> S2 ðp; F2 Þ þ pe1 ðR1 S2 ðp; F2 ÞÞ I1 cðep1 Þ2 :
p p p

2
The right-hand side of the inequality can be broken up into the entrepreneur’s
utility and the bank’s utility:

p p p p 1 p 2
¼ U2 ðp; F2 Þ þ pe1 ðR1 F1 U2 ðp; F2 ÞÞ cðe1 Þ
2
p p p
þ V2 ðp; F2 Þ þ pe1 ðF1 V2 ðp; F2 ÞÞ :
The entrepreneur’s utility is always weakly positive (the entrepreneur can

always choose et ¼ 0), so it must be true that
1 FB 2
S2 ðp; 0Þ þ peFB
1 ðR1 S2 ðp; 0ÞÞ I1 cðe1 Þ
2
> V2 ðp; F2p Þ þ pe1 ðF1p V2 ðp; F2p ÞÞ:
The social planner will lend to the entrepreneur if and only if the left-hand side
is greater than or equal to zero, whereas the bank will lend if and only if the
right-hand side is greater than or equal to zero. It then follows, since I1 > 0 and
g(p) > 0 for all p 2 ½0; 1; that all types that are funded by the bank in the
private contracting solution would be funded in the first best, and there exist
types that would be funded by the social planner and not by the bank.
Proposition 6. I will prove part (b) of the proposition first. Let S1 ðp; F2g Þ
denote the overall surplus generated by an entrepreneur type p when the gov-
ernment proposes the bankruptcy debt contract F2g (the entrepreneur need not
continue under F2g ). Let S1 ðp; F2p ; DÞ correspond to the overall surplus under
private contracting for type p. Since the entrepreneur and bank know the entre-
preneur’s type when the contract is signed in the first period, I will analyze
entrepreneurs type-by-type and show that for all F2g < F2p and for all p 2
½0; 1; S1 ðp; F2g ; DÞ S1 ðp; F2p ; DÞ; with strict inequality for some p* 2 ½0; 1;
implying that Stot ðF2g ; DÞ > Stot ðF2p ; DÞ for all F2g < F2p : There are three
cases to consider.
1. Let pl denote the type that satisfies V2 ðp; F2p Þ ¼ 0: For types p# < pl, for
which V2 ðp; F2p Þ < 0; the entrepreneur will be liquidated in bankruptcy
for any F2 F2p ; since V2(p, F2) is increasing in p and maximized at
F2 ¼ F2p : For these types, F2g is not relevant since the project does not
continue, thus S1 ðp#; F2g ; DÞ ¼ S1 ðp#; F2p ; DÞ:
2. For types p$ such that V2 ðp$; F2g Þ < 0 V2 ðp$; F2p Þ; the bank will make
a successful workout offer of F2p : For these types, the outcome is identical
to the private contracting solution, which again implies S1 ðp$; F2g ; DÞ ¼
S1 ðp$; F2p ; DÞ:
3. For types p% such that V2 ðp%; F2p Þ > V2 ðp%; F2g Þ 0; the project will
continue under the debt contract F2g : Proposition 4 guarantees that
S1 ðp%; F2g ; DÞ > S1 ðp%; F2p ; DÞ for F2g < F2p : Assumption A2 guarantees
that pmin < pl, so the funding decision will not change for types p > pl, for
which the policy F2g is relevant. Thus, for all p 2 ½0, 1, S1 ðp; F2g ; DÞ

S1 ðp; F2p ; DÞ which proves part (b).
By Assumption 2, pl < 1. Since V2(p, F2) is continuous and increasing in p,

there exists a p* 2 ðpl ; 1Þ such that V2 ðp*; F2p Þ > 0: Since V2(p, F2) is also
continuous and increasing in F2 for F2 < F2g and V2 ðp*; 0Þ ¼ 0; the interme-
diate value theorem guarantees the existence of an F2g* < F2p that satisfies
V2 ðp*; F2g* Þ ¼ 0: Thus, I have shown the existence of an F2g for which some
p* belongs to the third category above, for which V2 ðp; F2p Þ > V2 ðp; F2g Þ 0;
and S1 ðp*; F2g ; DÞ > S1 ðp; F2p ; DÞ: For this, F2g* ; Stot ðF2g* ; DÞ > Stot ðF2p ; DÞ;
proving part (a) of the proposition.
Proposition 7. The proof is given in text.
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Bankruptcy Law Design for Entrepreneurial Firms

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JLEO, V23 N1 161

Bankruptcy and Entrepreneurship: The Value

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The Journal of Law, Economics, & Organization, Vol. 23, No. 1,

weaken the prospects of a reorganized ﬁrm by reducing an owner-manager’s

‘‘[The bankruptcy law] gives to the honest but unfortunate debtor . . .

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overlooked in the literature. In my model, the optimal bankruptcy policy will

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2.1 Investment Projects

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2.4 The Government/Bankruptcy Court

period 1. In other words, as in current law, bankruptcy is a mandatory compo-

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In the private contracting solution, the bank strictly prefers to provide

Figure 1. Model Timeline.

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3.1 First-Best Solution

3.2 Private Contracting Solution and Absolute Priority

The second-period debt contract and effort levels are

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max e1 F1 I1 þ ð1 e1 ÞV2 ð1; F2p Þ; ð9Þ

R1 R22 R1 U2 ð1; F2p Þ þ V2 ð1; F2p Þ

Lemma 1. In the private contracting solution, 2effort in each period is less

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3.3 Court Intervention and Fresh-Start Policy

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So in order to determine whether softer policy is optimal or not, we must

The proposition is useful because it tells us that ex ante managerial slack-

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Proposition 5. In the private contracting solution, fewer entrepreneur types

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4.1 The Role of Private Workouts

bankruptcy because the availability of bankruptcy sets the bargaining terms of

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(a) There exists F2g < F2p such that Stot

The intuition behind the proposition is straightforward. For entrepreneur

continue would be under contracts negotiated in private workouts, which

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5. Fresh-Start and Interim Competition

5.1 Private Contracting Solution

pe1 F1c þ ð1 pe1 ÞV2 ðp; F2c Þ I1 ¼ 0; ð14Þ

V2 ðp; F2c Þ ¼ L: ð15Þ

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pðR1 F1c U2 ðp; F2c ÞÞ

5.2 Bankruptcy Policy Under Competitive Lending

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6. Analysis and Conclusions

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For the ﬁrst-best period 1 effort to be greater than the proﬁt-maximizing

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The entrepreneur’s utility is always weakly positive (the entrepreneur can

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By Assumption 2, pl < 1. Since V2(p, F2) is continuous and increasing in p,

Proposition 7. The proof is given in text.

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