Secured Creditor Control in Bankruptcy: Costs and Conflict

The secured creditor control in the resolution of distress in small businesses can have two effects: it can reduce the ex-post cost of financial distress but, on the other hand, secured creditors and business owners may collude to divert value from junior creditors. This concern has been particularly expressed in the US for state procedures under which a large percentage of small businesses are restructured. In the UK the secured creditors have introduced the highly contested practice of pre-packs which vividly highlights this trade-off. In a pre-pack, an insolvency practitioner, appointed by the secured creditor, can privately sell the company without involving the courts or consulting with junior creditors and in 50% of the cases the company is sold back to the original owner. Contrary to widespread criticism that this procedure leads to collusion, we find no evidence of exploitation of conflict of interests and we find that it preserves the value of the business and maximises recovery in circumstances in which a public announcement of bankruptcy would destroy value. In small businesses where secured creditors are concentrated, the benefits of their control seem to outweigh the costs. This evidence contradicts the view that court supervision, instead of freedom of contracting, is always needed to avoid expropriation. Moreover, the findings of the paper have important implications for debates about auction designs of bankruptcies and for the social implications of using floating charge as a debt resolution mechanism.