Comments

Ronald Fischer:

This paper touches on a subject usually ignored by Latin American economists, despite its importance. As Araujo and Funchal make clear, bankruptcy law is an essential ingredient of a well-designed economic system. The difference between the recoveries of Mexico and Chile after their respective crises in the early 1980s has been ascribed to changes in the Chilean bankruptcy law following the crisis.¹ A good bankruptcy law speeds the recovery after a crisis by freeing resources tied down in inefficient firms. It also lowers the cost of capital by ensuring that a large fraction of the assets in bankrupt firms is recovered, such that not all of the value of a loan is lost even in bad scenarios.

Bankruptcy legislation intervenes not only when debt contracts are not being serviced, but also when this is expected to occur in the near future, in which case reorganization is appropriate. Bankruptcy law tries to achieve several goals by making reasonable compromises among them. The first goal is to provide proper incentives to management. Management should ask for bankruptcy protection or for a period of protection in which to negotiate its obligations with creditors, in case the firm faces liquidity problems. Protection should not be used to protect inefficient management, however, which might use the breathing space to improve its bargaining position. The punishment to managers and owners cannot be so large that they decide to bet the firm in hopes of its survival, thus increasing the risk to creditors. Moreover, large punishments discourage entrepreneurship for fear of the consequences of failure.

As mentioned, another object of bankruptcy legislation is to improve the functioning of credit markets, by ensuring that lenders know they will receive as much as possible in case of liquidity problems in the firm. The absolute priority rule (APR) must also be respected, so lenders know what to expect when they sign a contract. In particular, collateral for loans (mortgages and other liens) should not be included among the firm's assets at bankruptcy. Araujo and Funchal clearly make all these points in the paper, which presents a simple but extremely effective model to illustrate these various effects; this is probably the best feature of the paper.

The paper mentions the issue of fraud associated with bankruptcy, but it is not given the importance it merits in the Latin American context. The inefficient civil procedures in our countries restrict the design of bankruptcy legislation, since the weakness of civil law means that rules that create incentives for fair negotiation can easily be co-opted.² For example, it appears that the original spirit of the concordata procedure in Brazil is similar to that of Chapter 11 in the U.S. bankruptcy code: namely, to provide an opportunity for a viable firm with liquidity problems to reorganize itself and avoid liquidation. The results were very different, however: while Chapter 11, despite its many flaws, is useful in reorganizing bankrupt firms, the concordata procedure appears to be used as a mechanism to stop the payment of loans through its excessive protection of managers and owners. The effect is to restrict the flow of credit.

In this area of law, small legislative changes can make a law inoperative or, alternatively, turn a law that does not work into one that is efficient. An example of this is the minor change in Chilean bankruptcy law in 1982 that introduced court-appointed private managers to direct, supervise, and manage the liquidation process. These officials had no more performance incentives than the previous judicial branch appointees, but the difference between private versus public administrators was significant.

Several Latin American countries have responded to dissatisfaction with the results of bankruptcy legislation and reformed their bankruptcy codes, as described in the paper. It is too early to determine which of the reforms have been successful, since the effects of this type of legislation affect fundamental economic relations that may affect performance in the long run. To proceed with my comments, I provide some details about Chile.

Until the recent legislative changes, Chilean bankruptcy procedures had as their sole object the repayment of loans—not, as...