Efficiency and Distributional Fairness in a Bankruptcy Procedure: A Laboratory Experiment

What is it about?

We undertake a laboratory experiment to evaluate whether the corporate bankruptcy procedure employed under the current Indian law simultaneously achieves the dual objectives of efficiency and fairness. As the baseline scenario, we deploy the procedure used under the current Indian bankruptcy law. The law adopts a unique mandatory auction mechanism, which combines the claim distribution mechanism with the asset deployment process of the bankrupt firm. Results reveal that, under the existing mechanism, there exists a fairness-efficiency trade-off. If the outcome is efficient, i.e. if the value of the firm is maximized, then it is often distributionally unfair, i.e. the operational creditors do not get their fair share of claim recovery. In contrast, if the outcome is distributionally fair, then it may be inefficient. We introduced a mechanism that separates the deployment and distribution processes. Efficiency and fairness simultaneously improve under the modified mechanism.

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Why is it important?

As policymakers seek to continuously improve bankruptcy laws, this study makes a significant contribution by providing fresh insights into the fairness-efficiency trade-off in resolution procedures. The current mechanism employed in India, under IBC, is not only unfair to the operational creditors, but it might be inadequate to maximize claim recovery. In particular, this paper highlights the agency problem associated with the mechanism and has shown experimental evidence in support of the idea that a separation of the asset deployment and asset distribution mechanisms would improve the efficiency and distributional fairness of the bankruptcy resolution process.