Bankruptcy Regimes and Gambling on Resurrection

This paper analyzes debt contracting in the presence of gambling on resurrection under different bankruptcy regimes. Ex-ante effects on investment levels, interest rates and profit, and ex-post effects on debtor's strategy choices are examined. A model of a debtor-creditor relationship is presented which shows that violation of the Absolute Priority Rule in bankruptcy (soft bankruptcy law) may partially eliminate excessive managerial risk-taking. But under law that is insufficiently soft, this moral hazard problem may be even stronger than under completely tough law. The gambling on resurrection argument for soft law is further weakened if the possibility of verifying the firm's situation by creditors is introduced.