Bankruptcy Reforms When Workers Extract Rents

Abstract

Firms file for bankruptcy reorganization (Chapter 11) not only to restructure debt but also to restructure labor contracts. Starting from this observation, I build a theory where shareholders weigh the cost of restructuring labor contracts against their claims on the going-concern value of the firm. In this environment, pro-creditor bankruptcy reforms face a trade-off. Upon successful reorganization, creditors recover more at the expenses of the other stake-holders: shareholders get a smaller share of the firm’s value, have less incentives to restructure labor contracts, making more likely that reorganizations fail and firms get inefficiently liquidated. As a result, expected recovery values can actually fall, increasing the cost of debt. I characterize this trade-off in a static model and show analytically that the optimal level of creditor rights decreases with the bargaining power of the workers. I test the positive implications of the theory in the U.S. data by exploiting a shift towards a more creditor-friendly Chapter 11 in 2001 and heterogeneity in right-to-work (RTW) labor laws. I estimate a firm dynamic model to the pre-2001 period, and gauge a significant asymmetric effect of the shift in the creditor rights on RTW vis-a-vis non-RTW region.