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Authors:

• Ronald M. GIAMMARINO
  University of British Columbia

• Ed NOSAL
  University of Waterloo

When a debtor defaults, creditors can use debt collection law to seize the assets of the firm. Bankruptcy law provides courts with the power to suspend a creditor's right to seize, maintain the debtor in possession of the assets, and require that creditors accept a reorganization that they would reject in the absence of bankruptcy law. The latitude given the court by bankruptcy law (judicial discretion) has been harshly criticized by a growing number of scholars. We examine alternative debt collection systems and establish conditions under which it is more efficient to allow judicial discretion than to require the court to strictly enforce contracts as written. The key to our result is recognition that bankruptcy law does not prevent agents from writing contracts that can avoid seizure and, hence, avoid judicial discretion. We show how this result in bankruptcy law being a contracting option. Furthermore, we demonstrate that there is no efficiency cost of the option. Since, as with any option, it is only exercised when it is more efficient than the alternative, bankruptcy law cannot reduce efficiency and in some cases can increase it.