Bankruptcy has been a fertile ground for the economic analysis of law. A significant portion of bankruptcy scholarship during the past fifteen years applies the basic assumptions of standard economic theory to the problems caused by financial distress. This scholarship begins with the premise that people make choices in a rational manner in order to maximize their individual utility. It applies this axiom to questions ranging from when do individuals file for bankruptcy to how bankruptcy laws affect firms' investment decisions. As it has in most other areas of law (especially private law), law and economics has both reshaped our understanding of extant bankruptcy law and generated numerous proposals for reform.
As illustrated by this symposium, scholars studying the way people make decisions have demonstrated that decision making routinely departs from the ideal posited by standard economic analysis. In various and systematic ways, people make choices which depart from the rational actor model that is the basis of much economic analysis of law. They dislike losses more than they like gains of the same amount, prefer the status quo, do not update beliefs in a rational manner, and otherwise fail to fit the model of Homo economus.
These insights could be used to enrich the study of bankruptcy law in various ways. One such way would be to examine the workings of current law. For example, the extant reorganization process of Chapter 11 is predicated on bargaining among the affected parties, and the literature on behavioral economics suggests that people at times bargain in ways that are more "fair" than they are rational.l Similarly, Congress is currently considering major reform to bankruptcy law as it applies to individuals, based largely on a perception that some individuals use these laws opportunistically. In this Essay, however, I begin the project of re-examining the strand of bankruptcy scholarship that attempts to specify optimal bankruptcy rules for firms in financial distress.
This Essay first identifies the ways in which the normative prescriptions of the economic analysis of bankruptcy law rely on assumptions of individual rationality, and then examines one of these assumptions-namely, the assumption that creditors pass on the cost of an inefficient bankruptcy regime to the debtors to whom they extend credit. This is not to say that the other ways in which the economic analysis of bankruptcy law is driven by the rational actor model are uninteresting or unimportant. Rather, I only hope to show that behavioral economics can enrich the economic analysis of bankruptcy law.
II. THE RATIONAL ACTOR IN BANKRUPTCY THEORY
Thomas Jackson and Douglas Baird articulated the first law and economics model of corporate bankruptcy law.2 They argued that bankruptcy law responds to a common pool problem that individual creditors would face under state debt collection law.8 Outside of bankruptcy, general unsecured creditors of a debtor are in a race amongst themselves for the debtor's unencumbered assets. Each creditor will be paid only when it can induce the debtor to voluntarily pay, or when it litigates its claim to judgment, and thus can call on the aid of the state in obtaining the debtor's assets. This system works well when a firm has sufficient assets to pay off all of its creditors. Creditors are able to watch after their own interests, and take appropriate action to ensure that they are paid. Debtors, on the other hand, have various incentives to voluntarily pay all legitimate claims. Debtors who do not pay legitimate debts face not only the threat of lawsuits, but also the possibility that they will not be able to find credit in the future.
Problems arise, however, when the firm's debts exceed its assets. In this situation, Baird and Jackson argued that unsecured creditors face a common pool problem. There are simply not enough assets to pay all creditors in full. …