Economic theory suggests that bankruptcy should serve as a screening process designed to eliminate only those firms that are economically inefficient and whose resources could be better used in some other activity. However, firms typically file for bankruptcy voluntarily. When they do, creditors are not all repaid in full and large redistributional effects occur. Managers of firms do not take creditors' losses fully into account in deciding either how to run the firm or whether and when to file for bankruptcy. This suggests that firms in bankruptcy might not always be economically inefficient and that inefficient firms might not always end up in bankruptcy. The paper is divided into separate sections on bankruptcy liquidation and reorganization. In examining each of those topics, it will consider the features of an economically efficient bankruptcy procedure and how such a procedure might differ from actual U.S. bankruptcy law. In a concluding section, I consider the costs of bankruptcy and some proposed reforms. I argue that some deadweight losses are the unavoidable consequence of having a bankruptcy procedure and cannot be eliminated by reforming it. These deadweight losses are the price of having limited liability for corporate equity holders.
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