Dynamic Risk-Shifting, APR-violations, and Chapter 11: The Role of "Soft” versus "Tough” Bankruptcy Code Design

We show that there are two separate incentive effects of soft law working in opposite directions, the “NoAPR- effect” and the “Chapter 11-effect”, respectively. For firms living for a finite number of periods, the NoAPR-effect mitigates risk-shifting, while the Chapter 11-effect works the other way round. In a “going-concern” world with an infinite number of periods, APR-violation and soft law provide a unanimous positive impact on the firm’s incentive to risk-shift. These results suggest that, in a classical financial contracting framework, soft bankruptcy law should be regarded as superior when compared to tough law. Our results, however, further suggest that, in a Rational Expectations Equilibrium (REE) with rational creditors, the superiority of soft codes and APR-violation is not as clearcut. Instead, it may also happen that the regulator is better off with a “very tough” code, i.e. if the shareholders of insolvent firms are obliged for additional payments to the creditors by means of pledging private collateral.