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In the post-financial crisis period, many corporate bankruptcies involve complicated, fragmented capital structures characterized by many layers of debt and complex legal entity structures with many subsidiaries. Why do capital structures evolve this way, given that they make distress more costly to resolve? I suggest an answer based on the notion that investors may disagree about the value of assets that back loans. When such disagreement exists, firms have the incentive to exploit it by issuing claims that are targeted to subsets of the assets that investors are more optimistic about. This capital structure fragmentation can minimize the borrower's cost of funds ex-ante by maximizing creditors' perceived recoveries, but it can be socially inefficient, because it creates costly valuation disputes in bankruptcy. I show that disagreement about collateral values can cause inefficient liquidations. I also find that reorganizations, in which pre-bankruptcy creditors receive securities in the ongoing firm, allows parties to continue "agreeing to disagree" about the value of their entitlements. This can promote settlement and reduce costly litigation over valuation, relative to selling the firm as a going concern for cash.

Subsidiary legal entities can be used to create a path around bankruptcy's automatic stay, giving a secured creditor a free right to withdraw collateral. In some cases, core assets of the firm are made separable from each other. To fully understand the desirability of subsidiaries as a path around the stay, I take a step backward and ask a fundamental question that has not been addressed formally: why do we need a mandatory stay of secured creditors in the first place? The model generates conditions under which a stay of secured creditors can be valuable. Three conditions are necessary: a) the collateral must be firm-specific, b) debt contracts are sequential and incomplete, and c) bargaining at bankruptcy is imperfect. Under these conditions, a debtor may grant withdrawal rights even when they are less efficient than a stay. I discuss ways that a stay might be made applicable to subsidiary creditors in a way that is targeted at the inefficiencies the model identifies.

Placing innovative assets in a separate subsidiary creates more autonomy for the unit manager of the innovation than a division, even when the subsidiary is wholly owned and controlled by the parent. The key driver is limited liability: unlike a division, the parent has the option to walk away from the subsidiary’s debt obligations. As a result, the parent invests less in developing internal uses for the innovation. This causes the unit manager to invest more in developing independent uses for the innovation: he must ”sink or swim” on his own effort, and his desired actions are less subject to overrule.

In this paper, we develop a theory that explains why firms are so commonly organized as legal entities that are formally distinct from their owners. A legal entity permits an owner to create a firm as a bundle of contracts that can be transferred to someone else, but only if they are transferred together. This bundled assignability allows for a balancing of several potentially conflicting interests. First, the owner who assembles the contracts wants liquidity – that is, the ability to transfer the contracts and cash out. Second, the firm's contractual counterparties want protection from opportunistic transfers that will reduce the value of the performance they have been promised. And third, the owner wants long-term commitments from the firm's counterparties to protect the value of her investments in the bundle. Because transfers of equity interests in a legal entity will generally not be considered assignments of the entity's contracts, entities reduce the contracting costs of creating bundled assignability. We find that owners will prefer bundled assignability when investments in the bundle are alienable from the owner; but when investments are specific to the owner, contracts that prohibit changes of control are optimal.

This paper focuses on a key property of asset-backed securities (ABS); namely, that ABS are designed to achieve "bankruptcy remoteness"of the securitized assets from the borrowing …rm. This provides lenders with maximal protection from dilution that is not available with other contracts, such as secured debt. ABS can have real eects in allowing …rms to commit to more e¢ cient investment decisions in bankruptcy. We show that securitization of replaceable assets (such as receivables) prevents ine¢ cient continuation in bankruptcy, but securitization of necessary assets can lead to ine¢ cient liquidations. In these circumstances, secured debt and/or leases can be preferred. Our model also predicts that greater legal risk of "bankruptcy remoteness"being undermined by courts leads to lower overall e¢ ciency and higher interest rates for ABS investors. We test this second prediction using a controversial decision in the Chap- ter 11 bankruptcy of LTV Steel, in which a securitization contract was unexpectedly treated as a secured loan. Using a dierence-in-dierences approach, we …nd that ABS spreads for securitizers eligible for Chapter 11 increased signi…cantly more than spreads for insured bank securitizers, who are not Chapter 11-eligible, in the period fol- lowing the LTV …ling. The results demonstrate that the creditor protection provided by "bankruptcy remoteness"is indeed valuable and priced in …nancial markets.

Many firms have filed for bankruptcy to manage mass tort liabilities, most notably asbestos producers. We model a bankruptcy procedure that optimally balances the liquidity needs of present claimants and an uncertain number of future claimants. We find that future claimants should receive greater awards in expectation than present claimants as compensation for bearing greater future claims risk. We also find that allocating more value to contractual creditors in bankruptcy makes an earlier filing more likely, which may increase overall welfare. Optimal risk-sharing implies that creditors should receive equity in a trust fund, with tort claimants receiving senior debtlike securities.

An influential theory in the management literature (Christensen, 1997) argues that incumbent firms have difficulty commercializing innovations that are not initially useful to its existing customers, and recommends creating separate, autonomous units for the innovation. This paper explains why subsidiary entities, even when wholly-owned and formally controlled by their corporate parent, can assist in this process. I show that placing the innovation in a subsidiary creates more autonomy for the unit manager of the innovation than if the same project were held as a division inside the parent entity. The key difference between subsidiaries and divisions in my model is limited liability: unlike a division, the parent has the option to walk away from the subsidiary's obligations. Because of this implicit "put option", the parent invests less in developing internal uses for the innovation. This causes the unit manager to invest more in developing independent uses for the innovation, for two reasons. First, less investment by the parent means the unit manager must "sink or swim" on the product of his own effort. Second, less parent involvement means that the unit manager's desired actions are less subject to overrule. This increases the unit manager's initiative, as in Aghion and Tirole (1987).

We analyze a sample of large privately and publicly held businesses that filed Chapter 11 bankruptcy petitions during 2001. We find pervasive creditor control. In contrast to traditional views of Chapter 11, equity holders and managers exercise little or no leverage during the reorganization process. 70 percent of CEOs are replaced in the two years before a bankruptcy filing, and few reorganization plans (at most 12 percent) deviate from the absolute priority rule to distribute value to equity holders. Senior lenders exercise significant control through stringent covenants, such as line-item budgets, in loans extended to firms in bankruptcy. Unsecured creditors gain leverage through objections and other court motions. We also find that bargaining between secured and unsecured creditors can distort the reorganization process. A Chapter 11 case is significantly more likely to result in a sale if secured lenders are oversecured, consistent with a secured creditor-driven fire-sale bias. A sale is much less likely when these lenders are undersecured or when the firm has no secured debt at all. Our results suggest that the advent of creditor control has not eliminated the fundamental inefficiency of the bankruptcy process: resource allocation questions (whether to sell or reorganize a firm) are ultimately confounded with distributional questions (how much each creditor will receive) due to conflict among creditor classes.

This article considers bankruptcy law design in a setting that is appropriate for entrepreneurial firms. These firms are characterized by a dependence on an 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 bankruptcies that allow some mandatory debt relief to preserve ex post incentives.

We analyze a sample of large Chapter 11 cases to determine which factors motivate the choice of filing in one court over another when a choice is available. We focus in particular on the Delaware court, which became the most popular venue for large corporations in the 1990s. We find no evidence to suggest that Delaware's popularity was driven by managers or equity holders seeking a procedure friendly to their interests. Instead, debt structure differences, specifically, the fraction of assets financed with secured debt, and court characteristics, particularly a court's level of experience, are the most important factors driving the choice of venue. While Delaware does not appear significantly different with respect to deviations from absolute priority in favor of equity or likelihood of producing reorganizations, it does differ along the dimension of speed. Controlling for other factors, we find that a Delaware reorganization is between 140 and 190 days faster than an equivalent case in another court. Given that speed benefits secured creditors most, we conclude that Delaware's popularity in the 1990s was unlikely to have resulted from a pro-debtor bias combined with a manager or equity holder preference for Delaware.

We study a model of optimal bankruptcy law in an environment where legal quality can vary along two dimensions: the ability of judges, and the quality of contract enforcement. We analyze a model in which a judicially-influenced bankruptcy process can enhance the efficiency of incomplete contracts by conditioning the allocation of control rights in bankruptcy on firm quality. We consider the optimal balance of debtor and creditor interests as a function of the legal environment, and show that the optimal degree of "creditor-friendliness" in the bankruptcy code increases as judicial ability to recognize firm quality falls and as the quality of contract enforcement deteriorates. Our model contributes to the existing bankruptcy law design literature in demonstrating that a "debtor-friendly" law that focuses on preserving going-concern value, such as U.S. Chapter 11, requires judicial expertise to be effective. Where such expertise is unavailable, a law that focuses more on creditor recovery is preferred. Our model is also able to explain cross-country patterns in the content and usage of bankruptcy laws around the world as reported in existing empirical research.