Governors may benefit from their influence on courts in different ways. They may extract rents from the managers of insolvent firms in exchange for protection from losing control in bankruptcy. They may also receive benefits from the managers of profitable enterprises who fake insolvency, using bankruptcy procedures to avoid federal taxes and debt repayment to creditors outside the region. Governors may also use their influence to prevent the bankruptcy of large enterprises for political reasons.

In this article we focus on the first two cases. Based on evidence and a theoretical model, we conclude that the capture of arbitrage courts results in a failure of the bankruptcy institution to protect creditor rights and put pressure on managers to restructure.

The Russian Federation has had bankruptcy legislation since November 1992. The first bankruptcy law was completely ineffective. Its failure motivated the adoption of a new law in March 1998, drafted according to Western standards. The new law makes the initiation of bankruptcy proceedings very easy: a creditor can file a bankruptcy petition against a firm that has a debt of as little as $5,000 that is overdue by at least three months.

The law was expected to vastly improve managerial incentives because it is harsh on the incumbent management: under the law, the manager loses control in bankruptcy. It was drafted, however, to avoid inefficient liquidations: judges are given the discretion to refuse liquidation suggested by creditors. We show that the discretionary powers granted to the judge are abused and the law has not achieved its goals.

Experts had predicted that the law would cause a flood of bankruptcies. Before 1998 most Russian firms accumulated large arrears to the government and private creditors. The number of bankruptcies has, indeed, increased since the law was adopted—a fact that many economists interpreted as evidence of hardening managers’ budget constraints. Aggregate figures, however, are insufficient to reach such a strong conclusion. By looking at which companies went bankrupt and what happened to these companies in bankruptcy, we provide evidence in favor of the opposite conclusion: bankruptcy has softened managers’ budget constraints. To explain this, we build a simple theoretical model of capture in bankruptcy and show that empirical evidence is consistent with the model.

The model investigates how bankruptcy capture affects managerial incentives, the financial positions of firms, and the protection of creditor rights by considering a firm with a manager and two creditors. The firm is insolvent in terms of verifiable cash flows but has high private benefits that accrue to the manager. One of the creditors is the governor, who can influence the decisions of the bankruptcy judge. An important assumption of the model is that the governor values bribes from the manager in addition to tax debt repayments. The model shows what happens when the judge is under the governor’s influence: debts are not repaid, the firm does not restructure, and the manager pays bribes to the governor in exchange for protection from losing control in bankruptcy. As a result, the outside creditor is expropriated by a coalition forged by the incumbent manager and the governor. The bankruptcy law fails to create additional incentives for restructuring and may even prevent restructuring when such incentives exist. The implication is the following. When official taxes are small, the governor may stop restructuring because he or she can extract bribes only from insolvent firms. When the governor values official taxes a lot, restructuring still may not happen because the governor cannot commit to liquidate. Instead, he or she prefers to accept a bribe from the manager. The model provides a classic example of state capture: the manager captures the bankruptcy procedure through the governor when the governor places a high value on tax income or is weak (unable to influence judge on his own).

We apply this model to the Russian economy by noting that the federal government, with its tax arrears claim on the regional enterprises, plays the same role as any outside creditor. We formulate hypotheses of the capture model and test them using the data on Russian industrial enterprises. We find that the data are consistent with our story.

The probability that an external management procedure is initiated against a particular firm increases with the strength of the governor in the region, tensions between the governor and the federal center, federal tax arrears in the region, and opacity in the system of regional tax collection. The probability of external management is higher for very large firms in efficient and profitable industries. In contrast, the probability of a liquidation procedure decreases with the strength of the regional governor, tensions between the governor and the center, and federal tax arrears in the region. The probability of liquidation is higher for smaller firms operating in loss-making industries. In addition, we find no evidence that the initiation of external management procedure (imposed by the judge) changes the performance characteristics of firms.

Our results suggest that the managers of large enterprises and regional governors collude to expropriate the federal government and investors from outside the region. Large insolvent firms are not restructured. And incumbent managers stay in control even under the external management procedure, possibly because they are protected by regional governors.

The dependence of arbitrage courts on regional governments has important implications for the Russian economy. First, there is no pressure on managers of industrial enterprises to restructure. Second, it is difficult to obtain financing from outside investors even for very profitable projects because the bankruptcy law does not secure investors’ property rights. Third, regional protection of firms against federal tax authorities seriously undermines federal attempts to improve tax collection.