Can bankruptcy law discriminate between heterogeneous firms when information is incomplete ? The case of legal sanctions

We study conditions under which legal sanctions may lead to an efficient selection of heterogeneous investment projects. The bankruptcy code is a "primitive creditor system" and financial distress leads to an arbitration between private agreement and costly formal bankruptcy. We consider a standard debt contract between a bank and a small firm, both risk-neutral. There are two types of leveraged firms in the economy: profitable firms and non-profitable ones. Before the debt repayment time, firms arbitrate between continuation and voluntary liquidation (considered strategies may be pure or mixed). Non-profitable firms may be incited to pursue business because of limited liability. The legislator computes a collectively optimal level of legal sanctions that incites good firms to continue and bad ones to liquidate. For any level of legal sanctions, we show that costly formal bankruptcies may occur at equilibrium and the internalization of bankruptcy costs is impossible. Besides, when bankruptcy costs are not too high, an infinite level of legal sanctions may allow such a selection among heterogeneous firms. Nevertheless, because legal sanctions are bound to the level of the assets shortage, the legislator's action only leads to a second best optimum.