The relationship between entrepreneurs looking for funds to establish new firms and outside investors who provide the funds is fundamental to all economic systems. The need for outside financing creates two economic inefficiencies. First, with debt outstanding, the borrowing firm may continue to operate when it should be liquidated. This happens because in liquidation the creditor receives everything and the manager is removed and receives nothing, whereas if the firm continues, the manager can extract benefits from running the firm. The second source of inefficiency is in the financing stage, where some valuable projects are not financed because the inefficient liquidation policy described above is anticipated by the creditors.

A well-designed bankruptcy law should aim at minimizing the cost of these inefficiencies. As such, the bankruptcy law has to address the following issues:

To focus the discussion, we concentrate on the following three representative economic systems:

1. In a market-based system, most corporate financing is done through the capital market. Therefore, the relationship between creditors and firms is relatively distant; creditors obtain most of their information from the financial markets and their own independent investigations of the firm’s affairs. Managers cannot see and do not have control over the information processed by creditors. Therefore, managers do not have a strategic advantage relative to creditors. Moreover, the quality of the information that is available to creditors increases as capital markets become more efficient. (An example is the U.S. economy.)

2. In a bank-based system, most corporate financing is done through banks and other financial institutions. Banks take an active interest in firms, usually by having representatives on the board of directors and maintaining veto power over certain activities. Managers are likely to have a good idea of the information creditors are processing at any time. Thus, managers have a strategic advantage; they can preempt creditors by filing for bankruptcy first if they learn that the creditors have sufficient evidence to file for bankruptcy. On the other hand, managers can avoid bankruptcy if they learn that creditors don’t have sufficient evidence to file for it. (Germany and Japan are good examples of such an economic system.)

3. In an underdeveloped system, the financial markets, financial institutions, and accounting systems are not yet developed. There are no reliable information collection entities, such as rating agencies and financial analysts. As in a bank-based system, most corporate financing is done by banks and other financial institutions. But information transmission in the economy is poor, so creditors are unlikely to have access to information. Managers in such an economy do not have a strategic advantage and creditors are unlikely to collect sufficient evidence to file for bankruptcy.

Based on these considerations, our proposed optimal bankruptcy laws for various economic systems are as follows:

1. In developed countries with a market-based system like that in the United States, where information acquisition technologies are well developed and most financing is at arm’s length, bankruptcy law includes both a creditor chapter and a debtor chapter.

2. In developed countries with a bank-based system like that in Germany or Japan, where information acquisition technologies are well developed and most of the financing is done through banks, bankruptcy law includes only a creditor chapter. The rules governing this chapter are biased in favor of banks and other creditors and give no protection to the manager. In such economies bankruptcy law should protect debtors (without requiring a legal procedure similar to Chapter 11 of the U.S. bankruptcy law).

3. For countries with an underdeveloped system with poor information acquisition technologies and concentrated financing, such as the transition economies, an optimal bankruptcy law should include both a creditor chapter and a debtor chapter, but with a stronger bias toward the borrowing firm than in the case of a market-based system.