1

A Cost Sharing Approach in the Bankruptcy Mechanism

Nicolae STEF*

Abstract: We develop a simple theoretical model that analyzes the relationship
between the forgiveness degree of creditors and the choice of triggering a liquidation
procedure. Debtors will have the incentives to propose suboptimal programs. Such
reorganization plans are equivalent to a win-win situation compared to an alternative
liquidation procedure. They provide a rent for the debtor and an expected gain for the
claimants which is higher than the liquidation value but lower than the value incurred by the
plan with an optimal forgiveness degree attached. Nevertheless, when the suboptimal level
increases too much the financial burden of the creditors, the liquidation may be preferred. The
result holds independently of the law orientation i.e. pro-creditor or pro-debtor.

JEL classification: G33; D86; D21;
Keywords: Bankruptcy, Forgiveness Degree, Suboptimal Plan


* Ph.D Student,
LaRGE, University of Strasbourg,
47 Avenue de la Fret Noire,
67000, Strasbourg, France,
nstef@unistra.fr
(00)33667886041





2
1. Introduction

In the corporate finance literature, the arbitration between liquidation and
reorganization was analyzed through different theoretical approaches. It allowed to bring to
the fore some sources that can influence the decision in favor of a certain legal procedure. For
instance, Brown (1989) noticed that the implementation of a reorganization procedure is more
difficult in the presence of conflicting incentives when each claimant wants to trigger the
liquidation in order to be paid first. Moreover, the asymmetric information and the divergent
interests can encourage the occurrence of costly bankruptcy (Webb, 1987) and induce the
equity holder to accept inefficient firms to continue their activity instead of those which are
economically viable (Mooradian, 1994). However, White (1989) argues that under different
bankruptcy priority rules, the survival of the firm is accepted only when it provides a higher
gain for the debt holders.
Although the reorganization decision can be affected by the level of monitoring
incurred by the senior and the junior creditors (Cornelli and Felli, 1997), the structure of the
debt can also play a significant role. According to the theoretical approach of Berkovitch and
Israel (1998), a short maturity of the total debt may help the firms reorganize more easily.
Nevertheless, free riders creditors can impede the choice of the best restructuration project
(Blazy and Chopard, 2004). The distribution of the voting power among the claimants may
produce some deviations from the efficient solution when there is a lack of coordination
among them. The bankruptcy timing or the default moment chosen by the debtor may also
affect the legal outcome (Bruche and Naqvi, 2010). Another factor that may influence the
arbitration is represented by the judges behavior. As a result, the decision to restructure the
company may be made using an informational signal transmitted by the court. Thus, the fact
that the lenient judges act differently than the strict judges can enhance the reorganization
probability of the firm (Frout, 2007).
Given these multiple theoretical sources, we should not overlook the heterogeneity of
the judicial systems. The legal background provides different rights and obligations to the
parties involved in the procedure (Beck, Demirg-Kunt and Levine, 2003). Hence, the
importance of such legal provisions will also have an impact on the arbitration such as the
possibility of replacing the incumbent management or imposing an automatic stay on the debt
interests (La Porta et al., 1998). However, the arbitration can also be influenced by the
presence of a grace period during which creditors offer to the debtors a certain time to
improve the firms financial situation before the liquidation is triggered (Broadie, Chernov
3
and Sundaresan, 2007). In certain national legislations, some reorganization plans may be
accepted by the court as long as they respect the creditors interest and provide a clear
monetary advantage compared to the liquidation outcome even tough such plans were firstly
rejected by the claimants.
1

In this diverse background, we would like to focus on the level of debt forgiveness
which can influence the outcome of a bankruptcy procedure. In respect to this source, we
consider a reorganization plan submitted to the court as a future contract that demands to each
party a certain degree of involvement sine qua non the plan cannot be implemented. The
concept of implication or involvement represents all the tasks and concessions that a party
must perform according to the contract. In our theoretical approach, we will imply the debt
forgiveness as a measure of the creditors involvement. It will also represent the type of
obligation that a contract plan demands to the creditors in order to set up its implementation.
2

Moreover, the debtors contribution in a reorganization project will be associated to the total
concessions that she is willing to accept for the firms continuation such as the decreasing of
the operating costs, the wages reduction, the modification of the work schedule, the
accomplishment of a particular number of layoffs or the infusion of new capital. In addition,
every reorganization plan requires efficiency measures designed to increase the profitability.
The both parties can propose such actions e.g. the improvement of the product or the
management competence, the diversification of firms activity, finding new markets or
innovative advertising to attract more customers, renegotiation of unfavorable contracts etc.
From such a perspective, each reorganization plan includes a set of obligations or
commitments. Thus, the contract plan makes a division of the obligations between the
creditors and the debtor. The sharing is important for two main reasons. On the one hand, the
sharing approach will have an immediate effect on the returns of each party. Knowing that the
plan modifies the firm value, its payment scheme must cover at least the initial investment of
both side. If the sharing is unbalanced which means that the monetary obligation of one party
is very high, its expected earnings from the plan could be lower than the returns related to a
liquidation outcome. On the other hand, unbalanced distribution enhances the chances of
voting the firm dissolution. If we take the liquidation value of the firm as a benchmark, the

1
The cram-down procedure of the U.S. bankruptcy code may enforce some reorganization plans to be
implemented even though they have not been voted by the creditors (Franks and Torous, 1989).
2
Given the complexity of our concept, the debt forgiveness matches with the analysis of our model. Future
research may address other types of involvement such as the payment rescheduling, granting a new loan or
providing a specialized assistance to the debtor.
4
creditors incentive to refuse plans that offer recovery values lower than the benchmark will
increase.
Our paper argues that the sharing of the financial obligations between creditors and
debtor has a direct impact on the decision to accept the project. Hence, reorganization
programs with unbalanced distribution may not be voted nor accepted given that they compel
a too high level of involvement from the other party thus making the liquidation procedure to
be preferred. Some plans with inefficient distribution may be accepted when they provide to
the creditors an expected gain higher than the liquidation value. Consequently, the way in
which the obligations of the plan are shared influence directly the creditors decision.
The relevance of studying the involvement sharing relies on three major reasons.
Firstly, analyzing the task repartition of a reorganization contract can help understand why the
continuation of the firm may not be approved. When the plans configuration implies that the
expected gain of one party is less than the potential value that she could receive in the case of
firms liquidation, it is unlikely that the project would be implemented. If the plan could be
subject to some modifications so to correct this inefficiency, the firm could be saved.
Secondly, the research topic also allows comprehend in what conditions a reorganization
program that does not detain an optimal sharing can be voted. The features of the national
bankruptcy law, the asymmetric information or the time decision process associated to the
bankruptcy procedure may induct creditors to accept suboptimal plans. Such plans provide
them an expected gain compared to the liquidation value but which is lower than the earnings
related to the case of an optimal distribution of the tasks. Thirdly, the partition may be
improved to avoid the liquidation procedure. Performing an appraisal or using the services of
an audit company in order to increase the information amount of creditors may be used to
balance the involvement in such a way that the reorganization could be attainable.
The article is organized as follows. Section 2 presents our simple theoretical model. Its
analysis is developed on two legal backgrounds. The first one concerns the existence of a
friendly creditor bankruptcy system which provides a strong bargaining power to the creditors
whereas the second one considers a pro-debtor judicial environment. The results of the model
allow to establish the relevance of the cost sharing between creditors and debtor. Section 3
assesses the conditions and the elements that favor the acceptance of reorganization plans
with suboptimal sharing. Some measures of avoiding and minimizing the effects of such plans
are proposed in section 4. Section 5 describes a certain extension of the model in which the
monitoring efficiency is taken into account whereas section 6 treats the relationship between
5
plans with suboptimal sharing and the violation of the absolute priority rule. The last section
summarizes and concludes.

2. Theoretical model

In some circumstances, a reorganization project may be rejected even when the
enterprise is characterized by a good history path at the moment of default. The type II error
may appear when the cost sharing attached to the investment project is made at the expense of
the other partner. For instance, a reorganization plan proposed by the equity holder can be
rejected if it requires a higher forgiveness degree from the claimants. The proposed level of
forgiveness can make the reorganization procedure too costly. In order to analyze the impact
of the financial sharing on the choice of triggering a liquidation procedure, we also need to
include other determinants that may have an influence on the forgiveness degree. We refer
here to the history path of the enterprise, the quality or the expected profitability of the
program and the share that each party
3
can receive from the final outcome. The variables
relates to the most important elements that are normally included in the configuration of a
restructuration plan. Nevertheless, the different levels of forgiveness may influence the
decision to liquidate or not.
The first element is associated to the internal and external background which
generated the default situation. For example, the existence of a faulty management, a reduced
level of assets or a bad macroeconomic context can shape the history path. We will assess the
path using A > 0 which represents the total value of assets at the moment of default. Having a
high value of A can signify a good economic situation of the firm when the bankruptcy
petition is filled. It will also imply ipso facto a potentially higher recovered value for the
creditors. We exclude the null value of A that can be related to a firm with no historical path
or simply a fictitious company. Such firms are predestined to be dissolved. In the absence of
any assets, even the liquidation procedure cannot be enforced because the liquidation costs
will not be recovered.
4
Thus, we will focus our analysis on firms that detain assets with
positive value.
In general, a reorganization program is characterized by a certain design quality which
has a direct impact on the firms value. From a practical perspective, the influence will be

3
We consider the reorganization plan as a future contract. The debtor and the creditors will be treated as the
parties of the contract.
4
We can encounter this legal approach in the bankruptcy systems of Belgium, Hungary, Poland or Romania.
6
found in the estimates of the turnover and of the net income which are usually made for each
year of the reorganization plan. These estimates may enable creditors to evaluate how the plan
can improve the financial situation of the company. In addition, we will assess the program
efficiency in expected monetary terms. The implementation of a higher quality program
provides a better expected improvement of the status quo. Furthermore, the expected impact
of a project will be assessed by > 0.
The plans payment is established through negotiations between the creditors and the
debtors. The negotiations are guided by the amount of rights granted by the judicial system.
Similarly, Gertner and Scharfstein (1991) consider that the way in which the legal rights are
used can influence the debtors bargaining power. The exclusive rights to propose a project
and/or to delay it are useful tools that the equity can use in order to achieve some personal
goals. According to Bebchuk and Chang (1992), the equity power increases when the
liquidation is subject to a loss value and when the delay right is associated to some financial
distress costs. The debtors bargaining position also becomes stronger when an equity
committee is put into operation for the shareholders interests or when the financial condition
of the firm is relatively good (Betker, 1995). However, the creditors are not just a devoid
category of rights or threat tools. When they have strong coordination incentives (Weiss,
1990) or the possibility to control or to replace the incumbent management (Betker, 1995), the
power to impose their own interests becomes stronger. Thus, the bankruptcy literature signals
that the relationship between creditors and debtors is performed most often on unequal
positions depending on the law orientation.
As in Acharya and Subramanian (2009), we will consider that the amount of rights
granted to one party of the contract plan helps establishing the orientation of the bankruptcy
code. We split the model into two analytical perspectives. The first one is based on a pro-
creditor environment in which the law grants the creditors with more rights during the
bankruptcy procedure. We will translate this in our model by the fact that the creditors
payment is not limited to a certain level. For the second case of a pro-debtor system, their
payment cannot exceed a maximum amount fixed in the contract plan given that the debtor
has more bankruptcy rights. In these perspectives, we will assess the influence of the sharing
on the decision to liquidate the firm.




7
2.1 Stages of the decision making process

We will consider that the firm is in default and that a bankruptcy petition is filled at
the court. Hence, the creditors are notified about the firms situation and they start declaring
their debts. In order to increase the recovered amount and so to diminish the potential
financial loss in case of liquidation, the equity holder configures a reorganization plan
5
with a
certain level of debt forgiveness. The project is submitted to the creditors for voting. In the
following stage, the claimants assess the expected value that they can withdraw at the end of
the plan when the forgiveness level is optimal. They make a decision by comparing that value
with the value related to the debtors plan and taking into account the amount recovered from
the liquidation procedure. When the benchmark liquidation value is higher than the other two
values, the plan may be rejected.
If the judge agrees, the firm can reconfigure the project with another distribution of the
obligations and submit again the new plan to the creditors vote. However, she will make such
a modification if it still provides a gain compared to the liquidation outcome. Nevertheless, a
reorganization plan cannot be implemented nor voted without the consent of one party. A
project can be approved only when both parties agree with the terms of their monetary
contribution allocated in the plan. The process is illustrated in the following figure.

Figure 1. Decision making process of the model
0 1 2 4






2.2 Assumptions

The model makes three main assumptions which are presented bellow.
A1: We assume that the firm is in default. The amount of debt prior to the arbitration
between restructuration and liquidation will be denoted by D with D > 0 while the total value

5
We will consider that the firm has the legal right to request the reorganization procedure. Otherwise, the firm
must be dissoluted.
A bankruptcy
petition is filled.
The debtor proposes a
reorganization plan with
a certain degree of
forgiveness.
The claimants decide
by assessing their
gain associated to
the optimal level of
forgiveness.
The debtor
reconfigures or
not the plan
according to
the creditors
decision.
8
of the firms assets is given by A with A > 0.
6
If the liquidation is triggered, the creditors will
receive A c where c represents the liquidation costs and/or costs related to the under pricing
of the assets (Shleifer and Vishny, 1992) and/or any other administrative and legal costs or
loss of tax credits (Ang, Chua and McConnell, 1982). Furthermore, the value that the
creditors can recover from the liquidation procedure depends on the history path or the
financial situation of the enterprise at the moment of default (D > A c). We can notice that
the presence of a better economic situation can provide a higher recovery of the debt while a
less good history path provides a costly liquidation.
A2: A certain level of monitoring (m > 0) can be attached to the reorganization
program in order to control the potential personal deviations of the debtor from the project
objectives or any other moral hazard issue. We assume that the implementation cost of the
project is given by mI > 0 where I represents the standard cost of the reorganization program
when the debtor's interests fully coincide with those of creditors and no personal deviations
are incurred.
7
The implementation of such a project will generate an expected multiplication
of the total assets value denoted by . However, the monitoring act produces a certain impact
on the final outcome which is assessed through m.
A3: The firm reorganization is costly. Thus, a sharing of the implementation cost is
suitable. In our model, the cost of saving the firm is too high to be burdened only by one
party. This analytical approach will motivate the sharing act. The plan cost cannot be borne
only by the firm knowing that certain expenditures have already been incurred for its design.
The absence of their participation could also enhance a moral hazard problem which could
affect the outcome of the project. Nevertheless, if the investment is made only by the
creditors, it will reduce more their final gain than in a sharing cost case and it will affect the
efficient work incentives of the debtors. From this context, the proposal of a program could be
feasible.
Consequently, the implementation cost includes all the obligations that the parties
must meet in order to put through the plan. We suppose that the total cost will be shared by
the claimants with the debtors in a certain proportion called p. The creditors contributions
will be represented by the forgiveness of a certain part of the debt i.e. p mI. Furthermore, we
will treat p as the forgiveness degree of the creditors. The debtors contribution will be

6
For D = 0, it will not be the case of a cost sharing given that the contract plan will be unilateral. If the debtor
has sufficient funds to put forward the firm restructuration, the court presence will not be needed. If there is a
lack of ressources, a contract debt may be signed with a certain financial institution. Nonetheless, if the firm
demand will be rejected, our analysis will correspond to a voluntary liquidation which will imply that the
liquidation outcome will get in the debtors pocket.
7
We will analyze the importance of the monitoring efficiency in section 5.
9
associated to actions whose purposes will be to increase the firms efficiency such as a wage
reduction, a redefinition of the work time or any other costs related to other beneficial
measures.
The participation of the debtor in the contract plan must also be paid. In general, the
reorganization plan admits a certain payment to the debtor that is well represented by the
wage and the cost production needed for the firms continuation. However, the debtor may
obtain some benefits when she exploits the rights provided by the court (Ayotte and Morrison,
2009). When she detains a certain voting power, its payment is necessary to allow the plans
implementation (White, 2011). However, the sum recovered by creditors depends on how the
bargaining power is distributed (Baird and Picker, 1991). In our theoretical framework, the
expected outcome of the plan will be divided and used to pay off the parties. At the end of the
program, the creditors will retain a certain part from the outcome denoted by d > 0. In
addition, the monitor act also prevents that the debtor increases unfairly and secretly its share
of pie i.e. 1 d. Senbet and Seward (1995) noticed that the design of a reorganization plan
concerns two major issues: the way in which the plan will affect the firms assets and the
distribution of the reorganized firm value among the claimants. The first issue is counted
through whereas the assets distribution is related to d.

2.3 Model

The claimants will maximize their potential gain with respect to the monitoring level
and the forgiveness degree:


p m,
max dmA pmI (1)

The first term represents the final expected sum withdrawn by the creditors when the
project is completed while the second term is their part of investment which is equivalent to
the amount of debt which is forgiven. Furthermore, the maximization will be subject to the
following constraint:
(1 p)mI < (1 d)mA, (2)
The participation constraint of the debtor implies that the expected amount that will
remain after the payments of the partners will cover at least their initial effort. The constraint
will be binding at the optimal solution. For our model, we assumed that the cost sharing
10
process cannot be incurred by a single side. Given that m > 0, the participation constraint can
be rewritten such as:
(1 p)mI < (1 d)A (3)
In order to capture the importance of the legal environment, two cases will be
considered. The first one is based on a pro-creditor environment in which the maximum
amount that the creditors can withdraw at the end of the reorganization program is not limited
to a certain level, but it depends in a percentage way only on d. From a different perspective,
the pro-debtor case considers that the maximum amount that the debt holders can withdraw
cannot exceed D with D > 0.

2.3.1. Pro-creditor environment

The Lagrangian function can be written using (1) and (3)
8
.
L = dmA pm I +
1
[(1 d)A (1 p)mI] (4)
The first order conditions are obtained through the maximization of L with respect to
m and p
9
.

m
L

= dA p2m I
1
(1 p) I = 0 (5)

p
L

= mI +
1
m I = 0 (6)
The relationship (6) provides:
m =
1
(7)
Given that the participation constraint is binding at the optimal solution and the result
of condition (7), m* and p* will be the solution of the equations system consisting of:
10

dA p*m*I m*I = 0 (8)
(1 d)A (1 p*)m* I = 0 (9).
Solving the above system, we obtain the optimal values of the forgiveness degree and
the monitoring level associated to the project.

8
The constraint qualification of the Kuhn and Tucker theorem is verified given that the rank of the Jacobian
matrix associated to the participation constraint is one.
9
The second order conditions are given by
m
L
2
2

= 2pI > 0 and

p
L
2
2

= 0. The objective function is also

concave.
10
The condition (8) is the simplified form of (5) using (7) whereas the condition (9) is the binding participation
constraint of the equity holder.
11
m*=
I
A
2

(10)

*
S
p = 2d 1 (11)
The optimal monitoring is increasing with the quality of the program and the initial
value of the assets at the moment of default. Nevertheless, the optimal forgiveness level
depends directly on the percentage retained from the final outcome which can be set in the
plan. According to our theoretical approach, d must be strictly higher than 0.5 in order to have
a positive
*
S
p . Such limitation concerns the pro-creditor environment which grants the
claimants with more rights. Logically, they will want to obtain at least half of the
reorganization pie given that the liquidation procedure doesnt cover fully the value of their
facial debt and the law supports their interest. However, the purpose of our model is to
highlight how the sharing can influence the creditors decision.
In the presence of rationality, the creditors choice will not be based only on their
degree of forgiveness. Thus, the amount that can be received in a triggered liquidation
procedure can be used as a benchmark (Bullow and Shoven, 1978). We will denote by V
S
the
maximum expected gain given the optimal financial configuration of a project with
*
S
p and
m*.
V
S
= dm*A
*
S
p m*I (12)
Using (10) and (11), we can redefine V
S
such as:
V
S
=
I
A
4
) (
2

(13)
The reorganization procedure will be preferred when:
V
S
> A c (14)

S
(
*
S
p ) = V
S
A + c (15)
When the decision criterion (14) is valid, the implementation of the optimal
forgiveness level is crucial for the continuation of firms activity. Nevertheless, suboptimal
values can produce some distortions in such a way that the liquidation value could be
preferred. These values may be proposed to the other party if there is a rent-seeking behavior.
When the reorganization project has attached only the optimal monitoring, the legal
environment could lead to a lower forgiveness. Thus, the equitys financial burden will
increase but also the creditors real earnings compared to the liquidation value. However, such
plan may fail due to a lack of financial resources. The participation constraint could be
12
reversed transforming the debtors participation in a sunk cost which can imply a greater
preference for liquidation assuming it is unlikely that she accept and get involved in an
unprofitable plan.
In certain conditions, the project can be voted even if the cost sharing is not optimal.
This may occur when the modification incurred in the plan still offers a surplus for the
claimants. When
S
(
*
S
p ) > 0 and the design of the program detains an optimal monitoring
level, we can determine the suboptimal threshold up to which such changes are possible e.g.
the value of the forgiveness degree that provides indifference between reorganization and
liquidation. The threshold
s
p will be the solution of the following equation:
dm*A
s
p m*I = A c (16)

s
p =
2
2
) (
) 2 ( 2 4

A
I dA A ce +
(17)
For any p [
*
S
p ,
s
p ], the cost sharing of the plan resumes a win-win situation.
Firstly, the debt holders will have an estimated gain higher than the liquidation outcome even
if it is not the highest one possible. Secondly, the participation constraint will be slack leaving
a positive rent for the debtors. Hence, programs with suboptimal forgiveness degree may be
accepted
11
.

2.3.2. Pro-debtor environment

The pro-debtor environment corresponds to a friendly debtor bankruptcy system which
provides a weak negotiation power to the creditors. Such a position limits their expected
payments. Hence, their payment is limited to a certain value D. In order to control for this
aspect, we will introduce a new constraint which will be binding at the optimal solution.
dmA < D (18)
We can notice that the constraint can provide the choice of the monitoring level
associated with the withdrawal of the maximum amount authorized by the plan.
m*=
A d
D

'
. (19)
A high value of D supposes more monitoring while the optimal level is decreasing
when the history path is good and when the expected profitability of the project is higher. We

11
A numerical approach is provided in the Appendix A.
13
can replace m* in the binding participation constraint of equity holder (3). We can obtain the
optimal forgiveness degree related to a friendly debtor judicial system.
12


*
w
p =
I D
A d d I D
'
) )( 1 ( '
2

(20)
We can notice that the optimal share that should be proposed to the debt holders is
depending on the history path of the firm. The first derivate of
*
w
p with respect to A is strictly
negative. Having a good history path at the moment of default can be a guarantee of the
competence and the creditworthy character of the debtors. It supposes that the firm has a
satisfactory financial situation that doesnt imply such a higher degree of forgiveness from the
creditors compared to the situation when the firm has a poor history. In the latter case, the
debtors incentives to engage in the rescue of the firm are weaker. Firms with negative history
issues need a higher support from the creditors. When the reorganization program is too
costly, most probably the liquidation will be voted. However, we can notice that the
participation constraint will be binding when m* and
*
w
p are attached to the plan. The plan
with an optimal design leaves no rent for the debtor when the legal environment is pro-debtor.

Table 1. Impact of history path
History path (A) Cost Share of
Debtors (1
*
w
p )
Cost Share of
Creditors (
*
w
p )
High value Positive Negative
Low value Negative Positive

Furthermore, we can redefine V
W
using (19) and (20) such as:
V
W
= D )
) (
) 1 ( '
1 (
2
A d
A d d I D

(21)
The reorganization procedure could be preferred when:
V
W
> A c (22)

W
(
*
w
p ) = V
W
A + c (23)
Even in the case of a pro-debtor environment, suboptimal forgiveness values can be
proposed by the equity holder. In order to ease their burden and to obtain a certain rent, their
incentives to promote a project with a higher p can increase. Such a decision may affect

12
The constraint qualification is also verified. The Jacobian matrix associated to the participation constraint and
the creditors gain constraint has the rank two.
14
negatively the expected value recovered by the creditors from the plan (V
W
). If the design
implies a suboptimal forgiveness degree that makes
W
(p) negative, the debt holders can
reject it. Nevertheless, if the modification of the sharing still leaves a lower rent compared to
the liquidation value, claimants could be induced to accept the proposal. Given that
W
(
*
w
p )
> 0 and the optimal monitoring degree is attached to the plan, the threshold
w
p is determined
using:
dm*A
w
p m*I = A c (24)

w
p =
I D
A d c A D
2
2
'
) )( ' ( +
(25)
The reorganization can be voted even when the sharing of the implementation cost is
not optimal. If
*
w
p < p <
w
p and the condition (22) is true, the equity holder can obtain a
certain gain reducing their cost share.
w
p is the maximum forgiveness level that can be
demanded to the claimants which ensure that their expected earnings from the plan exceed the
liquidation value. The debtor with a certain legal power may propose a project with such a
design. If the debt holders agree the terms of the suboptimal sharing, the continuation of the
firms activity can occur.
13


2.4 Importance of the forgiveness degree

The objectif of our model is to analyze wheter a reorganization plan is accepted or not.
For the moment, we are not interested in the realized ex post outcome of the plan.
Furthermore, the mechanism of choosing and proposing a certain level of forgiveness to the
creditors can establish when a liquidation procedure may be chosen. In addition, the following
table presents the importance of the forgiveness level when the optimal monitoring level is
attached to the design of the plan and
W S,
(
*
,W S
p ) > 0. The last condition renders the
possibility that a reorganization plan with optimal or suboptimal sharing can be implemented.
Otherwise, the creditors liquidation recovery will be higher than the maximum expected
returns from a plan with optimal distribution and the liquidation procedure would be then
preferred.



13
We illustrate these conclusions using a numerical example in the Appendix A.
15
Table 2. Importance of the financial sharing between creditors and debtor
14

Value of p
proposed to
creditors
Sign of the
Debtors expected
returns
Sign of

W S,
(p)
Outcome of the
legal procedure
w s
p
,
< p
Positive Negative Liquidation
*
,W S
p < p <
w s
p
,

Positive Positive Reorganization
p <
*
,W S
p
Negative Positive Liquidation

Proposing a forgiveness level above the threshold value (
w s
p
,
) provides an expected
rent for the debtor. In this case, the participation constraint (3) will be slack and the debtors
earnings wil be given by:
G = (1 d)m*A (1 p)m*I (26)
However, such a value will make the expected returns from the reorganization to be
lower than the liquidation value i.e.
W S,
(p) < 0. The creditors will be tented to vote against
the reorganization because the amount of debt that they have to forgive makes the liquidation
value to be superior. Such contract plans with a higher burden for the claimants are the most
beneficial plans for the debtor. She is the only player who can make a win. Given that the debt
holders will not accept to get involved in such plans, its implementation is conditioned by the
presence of a lenient judge
15
or a friendly debtor bankruptcy system that can enforce it by
seeking social purposes e.g. the preservation of jobs. However, if the loss of creditors is high
compared to the liquidation value and the amount of forgiveness that they have to accept is
also important, it is unlikely that even a lenient judge will admit a pro debtor plan.
When the forgiveness level proposed is located between the optimal value and the
threshold value, the reorganization plan can be accepted because it provides an expected
surplus for the creditors compared to the liquidation value, but also a nonnegative gain, G, for
the debtor. If the forgiveness degree coincide with the optimal value
w s
p
,
, the claimants will
extract the entire surplus value of the plan leaving the debtor with no gain i.e. G = 0.
Moreover, we can notice that second best projects may also be accepted. Such suboptimal
plans supposes that
*
,W S
p < p <
w s
p
,
and G > 0. They can provide positive expected returns for
both parties. Although the creditors do not achieve the maximum expected gain, they may

14
The results hold as long as the parties of the contract are rational agents. The rationality will imply that one
party will always choose the procedure that provides a higher gain.
15
More about the behavior of strict and lenient judges can be found in Frout (2007).
16
approve the implementation of a suboptimal plan. It will imply that their expected returns will
be superior to the liquidation benchmark and the debtor will obtain a positive expected value.
In certain conditions, the debtor may acquire a gain by reducing the total expected earnings of
the creditors. Those conditions will be analyzed in the following section.
Finally, a project with a lower forgiveness degree renders G negative. It would be the
most desirable situation for the claimants when they can increase their recoveries at the
expense of the equity holder. But the debtor will have no incentive to propose or accept plans
that dont provide him at least his returns from a liquidation procedure. The dissolution of the
firm will be the probably outcome due to a lack of resources and a refusal of the contract
terms. According to our theoretical model, even if the plan is proposed by the claimants, the
sharing cost is required in order to reduce their burden and to use the information knowledge
in the benefit of the program. If the debtor refuses to take part, the plans implementation may
be hampered. However, if the judge is strict and the debtors behavior is the primarily cause
for the firms financial distress, such plans could be implemented. In this case, the judge
could treat the debtors loss as a penalty for his irresponsible behavior. If the law forbids such
a court order, an increase of the forgiveness level may be appropriate to save the firm.

3. Why accept projects with suboptimal forgiveness ?

The main finding of our theoretical approach argues that the equity holder may have
the incentives to propose reorganization plans with suboptimal forgiveness level for claimants
when the modifications of the plans ensure the ex post efficiency. Such plans are equivalent to
second best projects. They characterizes a win-win situation in which the creditors and the
debtor obtain a higher expected return compared to an alternative dissolution procedure.
Although these projects do not provide the maximum expected gain for the debt holders, they
may be accepted in certain situations. We will present furthermore some situations or
elements that can induce the creditors to accept them.
The character of the national bankruptcy law can play an important role in the
implementation of such plans. A soft law that takes into account the potentialy social loss of a
winding-up procedure may increase the judges incentives to accept the continuation of the
firms activity through a reorganization. Soft judicial systems can be encountered in the U.S.
or France which are mainly view as debtor friendly systems. They are quite different from
those of U.K. and Germany which have a certain predilection for the enforcement of the
contracts (Biais and Recasens, 2001). However, the law may strengthen the debtors
17
bargaining position. For instance, the Chapter 11 of the U.S. Bankruptcy Code offers them the
first right to propose a project for a period of 120 days which can also be extended by the
judge. Nevertheless, the approval of suboptimal plans may be favored when the law doesnt
require a consent from the creditors like in the case of Spain, the U.S. or France (La Porta et
al., 1998).
Even in the case of a friendly creditor law, the acceptance of such reorganization
proposals may be due to the the lack of information required for the setting up of a better plan.
Senbet and Seward (1995) noticed that the asymmetric information may produce some
divergences between the insiders and the claimants concerning the true value of the firm. In
the context of a distorted information, the debt holders possibility to design a more favorable
project is limited. If the appraisal cost is too important and the firms suboptimal project
respect the fairness criterion
16
, it is unlikely that the judge would reject it.
According to Mella-Barral (1999), the timing decision process in a bankruptcy
procedure can influence the creditors behavior. They may accept some compromises when a
costly liquidation may be induced by an early triggering. The equity holder may use delay
tactics to obviate the liquidation (Jackson and Scott, 1989). If the delay costs
17
incurred by the
reject of a plan with suboptimal forgiveness produce a certain loss k that provides
W S,
k <
0, the claimants may be forced to vote the plan. Otherwise, the liquidation will be engaged.
Furthermore, benevolent creditors with a solid long term relationship with the firm
may accept suboptimal proposals knowing that a successful reorganization may imply other
loan or financial contracts. Such creditors may act by assessing the history path rather than the
liquidation benchmark value. They will simply use the reasoning presented in Table 1. In
effect, leaving a rent to the debtor can be equivalent with an absolute priority rule violation.
The fact that the creditors grant the debtor with a certain gain may represent a sign of
confidence that should motivate him more in order to achieve the goals included in the
contract plan. The deviations can also encourage the entrepreneur to take beneficial financial
decisions for the firm (Longhofer and Carlstrom, 1995). Hence, the debt holders may find a
reason to become benevolent. However, some claimants may refuse to have a kindly attitude
simply because they are seeking their own interests. They will want to apply some helpful
solutions designed to increase their expected recovery and limit the debtor gain, G. Improving
the sharing of the implementation cost increases the creditorss payment. Such solutions will

16
The fairness criterion implies that both parties are better off in the case of setting up the reorganization plan
than in the case of firms liquidation.
17
The delay costs can be associated to the depreciation of assets, time loss or missed financial opportunities.
18
aim to fulfill this objective. In the following section, we propose some measures that help
minimize the effects of suboptimal plans.

4. How to avoid or minimize the effects of suboptimal projects?

A low knowledge about the enterprise renders difficult the creation of an appropriate
reorganization plan. In order to enhance the information level and to adjust the forgiveness
degree, the creditors may demand the judge for a bankruptcy appraisal or just buy the
information from an audit company. If the cost of the operation is less than the rent retained
by the debtor in her suboptimal project, it would be reasonable to impose an assessment
ceteris paribus. However, ex ante contracts which continually provide information about the
evolution of the company may be a solution to avoid the appraisal cost. Such covenants allow
to balance the information level between the parties and to increase the creditors chances to
put up a saving plan on their own. If the information problem persists and the appraisal cost is
proved to be important, Jensen (1991) proposes the selling of the firm through an auction as a
solution to cope with these issues. It will avoid the firms assessing and also protect its assets
from certain disagreements between the creditors and the debtor. The auction outcome will be
divided according to the absolute priority rule (APR). Such a solution can also be useful when
the debtor continuously submits unbalanced plans knowing that the extension of bankruptcy
has a destructive effect on the firm value.
Some bankruptcy law offers the possibility to replace the incumbent management
during the resolution of the reorganization like in the case of U.K. or Japan (La Porta et al.,
1998). Changing the management staff knowing that she will accept their participation degree
which can be associated to low salaries and/or more working hours and/or other employment
commitments may favor the plan implementation. This solution can be suitable when the new
management doesnt need an important periode for accomodation and when it will not
produce negative effects on the expected outcome of the plan.
In the absence of delay costs, creditors with a signal about the possibility of setting up
a better project can continue to reject the debtors proposals. The informational signal can be
provided by a financial expert or an accountant who had a formal contact with the firm before
the advent of the default. However, the market concentration, the experience degree of the
firm, the economic situation of the market, the deterioration level of the assets and the
purchasing power of local customers can be used as tools to assess the program feasibility.
Moreover, the refusal can induce the entrepreneur to reconfigure the sharing in the benefit of
19
the other party. They can also use the signal to convince the judge that other ex post efficient
projects exist.
However, the insertion of bankruptcy clauses in debt contracts that yield the parties to
use an alternative procedure to the one provided by the law may help avoid the proposing
process of the debtors plan. They are equivalent to renegotiation contracts that enhances the
debtor incentives to choose efficiently between continuation and liquidation. When the
mandatory feature of the bankruptcy law prohibits such clauses and when the alternative
procedures violate the absolute priority principle, the use of the solution may be hampered
(Schwartz, 1997). If the bankruptcy contract is not in contradiction with the softness or the
toughness of the national law, it would be useful to write it (Povel, 1999). A preventive
measure precludes the legal increase of the bargaining power that the debtor enjoys when
filling for bankruptcy.
When the debtor probity is questioned, the creditors can ask the judge to appoint a
trustee to be in charge of the programs design. The objectivity of a third party can overcome
the confidence problem even if such an arbitrator is costly (Giammarino, 1989).
Consequently, the trustee may implement technical solutions to save the firm in accordance
with the principle of prudent investment (LoPucki and Whitford, 1993). Thus, the trustee can
gather information about the firm making a plan with a more equitable distribution of the
involvement. Such a solution is also advised in the case of a cheater debtor whose purpose
would be to lie to the creditors on the effectiveness of the project in order to increase her gain,
G. We shall analyze the cheater behavior bellow.

4.1. Cheater Debtor

One way to impress and motivate lenders to accept a plan is to attach a false return
rate. Even if the success of such a project is very difficult to obtain, the debtors justification
is to avoid the liquidation making a gain at the expense of the creditors. If such a behavior is
detected, there are two major solutions that can be used for the protection of the claimants
interest. The first one is an ex ante solution which concerns the appointing of a trustee or an
auditor who can assess the financial situation of the firm at the default moment and offer
information about the real possibilities of saving the firm. However, attaching a penalty clause
to the plan can be an ex post solution to prevent faulty behavior. In addition, the penalty
amount can play a significant role in this situation.
20
Let us considering

the false value of the expected impact of the plan on the firm
value. The debtor knows the true realization value of

. For the simplicity of the analysis,

we will assume that there is a large gap between those values. Thus, given that

> , she will

have the incentives to lie about the efficiency in order to convince the creditors to vote such a
plan. The relationship that we just described is presented by the condition (27).
dm

A pm I > L > dmA pm I (27)

The left hand term represents the expected gain promised to the creditor whereas the
realized value recovered at the end of the program is included in the right hand term. L
represents the liquidation value of the firm which is equal to A c. According to the above
relationship, we can determine the sanction level for the cheater debtor.
Penalty = min { dm(

) A, G } (28)
When the gain extracted by the debtor, G, is sufficiently high, the debtor has the right
to obtain at least the promised earnings of the plan i.e. the difference between the left term
and the right term of relationship (27). The penalty is indicated when the cheated behavior is
proved and not when the realization of

is related to the economic evolution of the market.

A penalty clause attached to the plan may represent a guarantee against such a behavior. It can
improve the debt holders protection by reducing the equity holders incentives to propose
reorganization plans with false expected returns. However, the inclusion of a penalty clause
must also be accepted by the judge. If the court considers that such a clause is an element of
pressure on the business activity, it is unlikely that the penalty could remain attached to the
contract plan. Nevertheless, the creditors should detain the appropriate tools to detect such
behavior. In this matter, the efficiency of the monitory act can play a key role.

5. How to monitor the debtor ?

In our theoretical approach, we didnt make a distinction of the monitoring type that
can be attached to the plan design. The quadratic form of the creditors potential gain included
in the relationship (1) provides a certain freedom to decide the monitoring efficiency. Thus,
we will consider that the monitoring action is efficient when m (0,1] given that its impact on
the reorganized firm value is higher than its influence on the implementation cost i.e. m > m.
Conversely, the monitoring act will be treated as inefficient for m > 1. However, the presence
21
of the cost sharing allows an arbitration between the two types of monitoring. We will address
this issue according to the law orientation.
In the case of a friendly creditor law, we can rewrite the relationship (13) using (10)
such as:
V
S
(m*,
*
S
p ( m*)) =
I
A
4
) (
2

=m*I (29)
We can notice that a higher value of the optimal monitoring increases the maximum
expected gain that can be withdrawn by the creditors when the plan has an optimal
configuration. If the claimants would have the possibility to decide the monitoring type, their
expected gain with an inefficient monitoring would be superior or at least equal to the gain
related to an efficient monitoring.
V
S
(m* < 1,
*
S
p ( m*<1)) < V
S
(m* > 1,
*
S
p ( m* > 1)) (30)
Under a pro-creditor judicial system, the creditors incentive to choose an inefficient
monitoring would be higher. In fact, the deficiencies of such a monitoring are offset by the
amount of rights that the law grants to the creditors. An imperfect monitoring can be incurred
especially when there is a high informational gap between the parties of the contract plan. If
the creditors dont detain the experience and the appropriate monitoring tools, an inefficient
monitoring is more likely to be attached to the plan. In this context, a friendly creditor law
will work in the claimants interest. However, the result holds when the plan has an optimal
design and the creditors can decide the monitoring type.
Based on the same reasoning, we assess the pro-debtor system case. Thus, we can
rewrite (21) using (19) such as:
V
W
(m*,
*
W
p (m*)) = m*A m*I (31)
Solving the quadratic equation, we obtain the following results presented in table 3.

Table 3. Monitoring decision when the law is pro-debtor
Condition Result Restriction
A < I
V
W
(m* > 1) < V
W
(m* < 1)
None
2

< I < A
V
W
(m* > 1) < V
W
(m* < 1)
m ] 1 , 1
I
(


I <
2


V
W
(m* > 1) > V
W
(m* < 1)
m ) 1
I
, 1 (




22
The creditors incentives to choose an efficient monitoring increase when the contract
plan requires a higher amount of investment in order to save the firm. A higher I implies a
higher implementation cost of the plan i.e. a higher degree of forgiveness. Given that the
judicial system protects more the debtors interests, the creditors will have to offset the lack of
rights using a different alternative. In a pro-debtor environment, the decision to monitor
efficient would be most probable for firms that necessitates costly reorganization. However,
the result may also be explained by the riskiness of the contract that can be included in . We
treated the importance of the risk in the Appendix B.

6. Suboptimal plans and violation of the absolute priority rule

According to our theoretical approach, a violation of the absolute priority rule (APR)
represents the situation when the debtor acting as residual claimant will receive a return
before the creditors will be paid in full
18
. The violation may be used to provide to the debtor
the incentives to undertake the right investment decision (Berkovitch and Israel, 1998).
Moreover, the violations represent payoffs from the debt holders to the firm (Longhofer and
Carlstrom, 1995). An accepted plan with a suboptimal sharing can imply a violation of the
APR given that it will provide a certain gain to the debtor compared to the liquidation
procedure and a partial payment of the initial debt, D. Nevertheless, not all the suboptimal
plans can be treated as plan that violates the APR of a reorganization procedure. Some plans
may provide the expected full payment of the facial debt and also a residual return for the
equity holder especially when the realized value of is higher and when the debt holders are
granted with more rights. Hence, a plan that imposes a violation of the APR represents a
particular case of a suboptimal plan.
The model assesses the creditors decision to accept the reorganization plan. It does
not treat the realized outcome of the bankruptcy. Hence, a potential existence of an APR
violation depends on the ex post results that are obtained during or at the end of the plan and
on the bargaining power of debt holders. Our model allows establishing a relationship
between the plans design and the creditors decision. Nonetheless, if we perceive the
suboptimal plans as plans that violates directly the APR, the literature signals some benefits of
such a regime. For instance, it decreases the incentives of equity holder to chose only projects

18
We adopted a homogeneous approach of the creditors. If there was a separation between junior and senior
claimants, the violation of APR would represent a situation in which the junior creditors would recover a part of
their debts before the senior creditors would be repaid in full.
23
that match with their unique skills even though such projects doesnt increase so much the
firm value like the general ones (Bebchuk and Picker, 1993). The APR violation can also
increase the entrepreneurs incentives to protect some sunk investments (Berkovitch, Israel
and Zender, 1998). However, the motivations to accept such plans which are presented in
Section 3 will hold.

7. Conclusions

In this paper, we set up a static theoretical model that analyzes the impact of the
forgiveness degree on the legal outcome of the bankruptcy mechanism. Furthermore, we
provide an original approach of the reorganization plan which we treated as a future contract
that demands to each party a certain degree of involvement. The concept of involvement
describes all the necessary tasks and concessions that a party must perform according to the
contract plan. The idea behind our approach argues that the level of contribution in the
implementation cost of the plan will influence the creditors decision. However, each
reorganization program implies a certain sharing of its cost implementation. We considered
that the creditors participate at the finance of the program with a certain forgiveness of the
debt.
Furthermore, we develop our model on two perspectives. The first one is based on a
pro-debtor environment in which the claimants recovery is not limited to a certain fixed
value written in the contract plan. Conversely, we treated the case of a friendly debtor system
which limits the creditors expected payment. Our model predicts that reorganization plans
with suboptimal sharing are the most likely plans to be voted by creditors and/or accepted by
the court. Suboptimal projects or plans with a second best sharing are characterized by two
main features: 1) they provide to the debtor an expected gain which is at least equal to the
earnings of the liquidation outcome and 2) the expected returns of debt holders are higher than
the liquidation value of the firm but lower than the recovered value of the plan with an
optimal distribution. Nevertheless, if the proposed level of forgiveness increases too much the
burden of the creditors, the liquidation may be preferred. However, a plan with an optimal
sharing doesnt provide any gain for the debtor irrespective of the law orientation.
We also identify some elements that favor the approval of such plans. Having a soft
judicial system increases the debtor incentives to submitt a suboptimal project especially
when she has the first right to propose a reorganization plan and she can act as a debtor in
possession like in the U.S. or the Belgium bankruptcy system. The existence of assymmetric
24
information or the benevolent character of creditors can also determine its implementation.
However, some measures that can minimize or avoid the effects of a suboptimal sharing are
available. The signing of ex ante covenants that balance the information level between
partners, the legal replacement of the incumbent management, the setting up of a bankruptcy
appraisal or the appointement of a trustee charged with the plans design are some efficient
measures that can be employed in order to improve the creditors recovery.
Under a pro-creditor environment, we noticed that the creditors incentives to opt for
an inefficient monitoring are higher. However, an efficient monitoring will be preffered when
the law is more debtor friendly and the firm restructuration is costly. Thus, the law might
influence the creditors behavior but these statements are subject to an empirical validation.
Altough we develop a simple model, more extended works can be done in order to
better understand the relevance of the involvement concept in the design of a contract plan.
For instance, assessing the involvement by a parameter is not an exhaustive approach. The
concessions that the creditors have to accept are various. The debt forgiveness does not imply
the same degree of involvement as the debt rescheduling. In some circumstances, it may
provide a fresh start when the creditors are willing to forgive a part of their debt (Ayotte,
2002). The debt forgiveness also allows to avoid the bankruptcy costs when they are high
(Hege and Mella-Barral, 2000). The model should be developed by considering the different
type of involvement that a party must perform. Moreover, the heterogeneity of creditors is an
assumption that should be integrated in a further analysis (Cornelli and Felli, 1997). Given the
priority in payment, it is likely that the involvement of senior creditors is not equivalent with
the one of junior claimants. Furthermore, a dynamic approach may allow the integration of
the delay costs especially in the presence of perishable assets.











25
Appendix A

In order to illustrate the importance of the forgiveness degree on the choice of
triggering the liquidation procedure, let us consider the following example of a firm
characterized by a history path of A = 50 with a facial debt of 80. The bankruptcy costs c are
equal to 5, thus the potentially liquidation gain is L = A c = 45. A reorganization project has
the following features: = 1.2, d = 0.8 and I = 18. Such values provide an expected gain to
the creditors superior to the liquidation value when the monitoring and the forgiveness level
are optimal. Otherwise, the liquidation would be preffered. We also use this example to prove
the possibility of having suboptimal projects. Let us now consider our two cases.

1. Pro-creditor environment

The optimal forgiveness degree will be p* = 0.6 while the optimal monitoring
associated to the project will be m* = 1.66. According to the condition (12) , the expected
gain of creditors V
S
will be equal to 50. Hence, a plan with this design offers strong
implementation incentives given that
S
= V
S
(A c) = 50 45 = 5. But if the project is
proposed by a debtor with a rent-seeking behavior, she may increase the financial burden of
their partners in such a way that the liquidation act would be suitable. Keeping the optimal
monitoring, if p = 0.75 than V = 42.5 with = 2.5 and G = 7.5.
We can also determine the threshold value that allows an expected positive rent
i.e.
s
p = 0.7. We can notice in Figure 1. that projects with p [0.6 , 0.7] may be accepted by
the claimants as long as they provide a surplus compared to L.
Figure 1.
0.2 0.4 0.6 0.8 1
p
20
40
60
80
Gain Value
H0.6 ,50L
H0.7 ,45L
L
V


26
2. Pro-debtor environment

We will assume that the maximum amount that can be withdrawn by the claimants,
D, is 70. We obtain the following optimal design: p* = 0.54 and m* = 1.45 which would
generate an expected gain V
W
= 49.21 and a maximum surplus
W
= 4.21. In this case, the
threshold value
w
p would be equal to 0.65. We can notice in Figure 2. that if the forgiveness
level proposed is higher than
w
p when keeping the optimal monitoring, the liquidation value
L is prefered.
Figure 2.
0.2 0.4 0.6 0.8 1
p
10
20
30
40
50
60
70
Gain Value
H0.54 ,49.21 L
H0.65 ,45L
L
V


The debtor may configure a second best design that may be accepted by the creditors.
For example, if the suboptimal level p is 0.6 than the claimants expected return V will be
equal to 47.03. Such a return provides a surplus compared to the liquidation value i.e. = V
L = 2.03 which is less than the case of an optimal sharing i.e. <
W
. In certain
circumstances, the creditors may accept a plan with such a design. Moreover, the equity
holder will obtain a rent G = 2.18. We will also consider the suboptimal plans as the projects
that integrate a forgiveness degree for creditors which respect the following condition: 0.54 <
p < 0.65. A plan will have more chances to be voted as long as the creditors participation is
located in that range given that such a sharing will generate a gain relative to the liquidation
outcome, L. Any other unbalanced distribution may force the plan rejection. If p < 0.54, the
debtor may refuse to propose projects that yield a negative G. If p > 0.65, the investment part
of the claimants transform the firms dissolution into a more rationale decision.


27
Appendix B - Integrating risk into the model

Until now, we didnt introduce a risk feature for the reorganization plan in the model.
The way in which the managers view the risk has an importance to their attitude to avoid the
firms ruin (Rose-Ackerman, 1991). In general, projects submitted to the court entail a certain
degree of riskiness of which creditors can be aware. Some of them can be successful whereas
some plans can have a higher probability of failure. We will introduce such a feature through
. For the simplicity of the analysis, we will consider as the expected successful impact of
the plan. Less risky projects are characterized by a high value of which is equivalent to a
higher expected efficiency of the plans implementation. We will consider this approach when
the cheater behavior is excluded.
Moreover, the voting of the reorganization project is favored by the existence of an
important difference between the threshold value,
w s
p
,
, and the optimal value of the
forgiveness,
*
,W S
p . When the difference between those values increases, the number of
suboptimal projects that can be proposed to the debt holders grows too. Thus, there are more
possibilities to reconfigure the sharing cost of the plan and there will be more chances that
one of those modifications to be accepted by the claimants. The following proposition
summarizes the results of table 2.

Proposition 1. A higher gap between the threshold implication value and the optimal
value increases the chances of voting the reorganization plan.

Analyzing
s
p and
w
p , we can observe that higher liquidation costs favor the increase
of the threshold values in both cases. Costly liquidations make reorganization a viable and
more desirable option. When such costs are high, creditors will have the incentives to avoid
them. In effect, a costly liquidation offers an incentive to propose suboptimal plans knowing
that at least one plan must be accepted in order to avoid the firm dissolution. When those
costs are important, the possibilities to deviate from the optimal forgiveness degree of
creditors increase i.e. [
*
S
p ,
s
p ] and [
*
w
p ,
w
p ] become larger. As a result, the probability of
voting the reorganization plan increases when the liquidation costs are higher. An opposite
effect is played by the standard effort required by the plan. A higher implementation cost will
have a negative impact on the creditors payment and also on the threshold values that permit
the adoption of second best projects.
28
0

,
>

c
p
w s
(32)
0

,
<

I
p
w s
(33)
We can ask how the riskiness of the project will influence the gap. Intuitively, having
a higher gap is tantamount to a higher number of suboptimal plans that can be proposed to the
creditors. Furthermore, we shall analyze the impact of on the gap according to the law
orientation.
Furthermore, we consider the first derivate of
s
p
*
S
p and
w
p
*
w
p subject to . We
obtain the followings:

3 2
*
) ( 8 ) (
A
c A I p p
S S

=

(34)

I D
D c A d dA p p
W W
3
2 *
'
) ' ) ( 2 [( ) (

(35)
In a friendly creditor environment, we can notice that the level of assets determines the
impact of on
s
p
*
S
p . On the one hand, when the assets at the moment of default allow
recover at least the liquidation costs, a higher success probability increases the incentives to
vote the reorganization plan. On the other hand, even if the success probability is higher, the
lack of assets represents a signal that a future contract plan will require more forgiveness and
more financial funds in order to save the firm. The signal may offer information about the
competence of the debtor and the demand of the activity sector. Given that the history path is
poor, the incentives to vote for a less risky plan may decrease. The result offers support for
the idea that the history path is relevant for the possibilities of saving the firm through a
reorganization procedure (Jensen, 1991). The results are similar for a friendly debtor law. A
relative higher liquidation value imposes a positive correlation between and the chances of
saving the firm through a reorganization plan. When the economic environment is less risky,
there are more possibilities of reconfiguring the sharing distribution and making the firm
saving a viable option through a suboptimal plan.





29
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