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Enforcement and Firm Finance

Anne Villamil, Stefan Krasa and Tridib Sharma ()

No 868, 2004 Meeting Papers from Society for Economic Dynamics

Abstract: The power to enforce rights and obligations in a society is essential. For simplicity, economists have focused on two extreme forms of enforcement: perfect ex-post enforcement of contracts by an exogenous un-modeled authority (a ``court'') or contracts that are ``self-enforcing.'' Models that assume perfect ex-post enforcement have focused on ability to pay -- a borrower fails to repay only when assets are below the promised amount. Otherwise, the borrower honors the promise. In contrast, when judicial enforcement is not possible the problem of willingness to pay arises. We consider the intermediate case where enforcement is possible, but not all assets can be seized. In this case the twin problems of ability and willingness to pay arise. We model enforcement as a technology with two key parameters. (i) The efficiency of enforcement is the cost paid to secure rights in court. This cost varies across countries due to different institutions (e.g., legal and accounting systems and corruption). (ii)Creditor protection is the percentage of total assets that a court can seize; debtor protection is the remainder. The amount of protection is determined by factors such as the level of exemptions permitted by the bankruptcy code, inflation, the length of bankruptcy proceedings, and the debtor's ability to ``hide'' assets. The paper provides a complete characterization of the effect of these enforcement parameters on the contract interest rate and the bankruptcy probability. The most striking result is that the enforcement parameters have a highly non-linear influence on firm finance. The theoretical characterization and quantitative analysis show that for some parameter values finance is not sensitive to the legal structure. For other values, after a critical threshold is reached, finance is severely compromised. The paper provides a (positive) theory with quantitative implications that can explain the observed relationship between legal systems and firm finance. We take the legal system as given and consider the opportunity to relieve firm distress by both liquidation and renegotiation. In the U.S. there are five types of bankruptcy. We focus on Chapter 7, often called liquidation. When bankruptcy occurs under Chapter~7, the debtor gives up all non-exempt property owned at the time the bankruptcy petition is filed. If the court grants a discharge, the debtor is not liable for any other pre-bankruptcy debts and no claims can be made against future earnings. Thus, Chapter 7 simultaneously liquidates all non-exempt assets for the benefit of creditors and protects the insolvent debtor. We model this protection via parameter eta and the cost of enforcement by c. Underlying the computable contract problem is a dynamic game with incomplete information and our stylized description of the enforcement technology. In the initial period the entrepreneur and lender share common beliefs about the possible returns from a risky investment project. The realization is the entrepreneur's private information unless costly bankruptcy occurs. We explicitly model agents' sequential decisions. First, agents write a contract. Next, the entrepreneur has the opportunity to default or to voluntarily make a contract payment. The lender then optimally chooses whether to request enforcement, given the information revealed by the entrepreneur's default decision. Finally, agents have rational expectations in the sense that all decisions are time consistent. Limited commitment is an essential feature of the model because the lender can revise the enforcement strategy after information is revealed by the entrepreneur's default decision. This leads to a sharp non-linearity in firm finance with respect to enforcement costs. The model also distinguishes between default and bankruptcy. Default means that the borrower (optimally) chooses not to make a payment. If default occurs, the lender then (optimally) chooses whether to invoke bankruptcy proceedings to liquidate the firm. We show how the legal code affects agents' incentives to default and pursue bankruptcy

Keywords: enforcement (search for similar items in EconPapers)
JEL-codes: G31 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn and nep-reg
Date: 2004
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