In its reform of the US bankruptcy procedure, the American Bankruptcy Institute (ABI) is proposing to grant a redemption option to junior creditors and let them exit the bargaining process. A game-theoretic, continuous-time model of the leveraged firm is developed to assess the wealth transfers and welfare impacts of such an amendment. After fitting the model to the current outcomes of Chapter 11, numerical experiments show that the compensation to junior creditors is too high and that the redemption option replaces one type of Absolute Priority Rule violations with another. Experiments also show that, while the ABI reform reduces bankruptcy costs, it also increases the frequency of liquidation. We conclude that it may be advisable to revise the design of the redemption and to offer it on a case-by-case basis.
Published November 2018 , 21 pages