A Theory of Workouts and the Effects of Reorganization Law




  • This is a greatly revised version of “The Effects of Reorganization Law on Investment Efficiency.” Gertner is with the Graduate School of Business and the Law School, University of Chicago; Scharfstein is with the Sloan School of Management, Massachusetts Institute of Technology, and with the National Bureau of Economic Research. We thank Ian Ayres, Doug Baird, Walter Blum, Keith Cohon, Doug Diamond, Ken Froot, Bob Gibbons, Steve Kaplan, Ron Masulis, Kevin Murphy, Randy Picker, Mark Roe, Jeremy Stein, René Stulz, Robert Sydow, Rob Vishny, an anonymous referee, and seminar participants at the NBER, University of Chicago, the Federal Reserve Bank of Richmond, Ohio State, University of Michigan, Boston University, and Princeton for helpful comments. We especially thank Paul Asquith for comments and providing the data for some of the summary statistics. Gertner is grateful to the John M. Olin Foundation Fellowship in Law and Economics at The University of Chicago Law School, the NSF, Grant SES-8911334, and the IBM Faculty Research Fund at the Graduate School of Business, University of Chicago for financial support. Scharfstein is grateful for fellowships from the Olin Foundation and Batterymarch Financial Management and for financial support from the International Financial Services Research Center at MIT.


We present a model of a financially distressed firm with outstanding bank debt and public debt. Coordination problems among public debtholders introduce investment inefficiencies in the workout process. In most cases, these inefficiencies are not mitigated by the ability of firms to buy back their public debt with cash and other securities-the only feasible way that firms can restructure their public debt. We show that Chapter 11 reorganization law increases investment, and we characterize the types of corporate financial structures for which this increased investment enhances efficiency.