This paper studies optimal financial contracts in a framework with asymmetric information. The key idea is that financial distress of a firm is not observed by its lenders for quite a while. As early rescues are much cheaper than late rescues, it may pay for the creditors to be 'forgiving' in bankruptcy, thereby inducing the revelation of difficulties as early as possible. Either 'tough' and 'soft' bankruptcy laws can emerge as a part of equilibrium contracts. Implications for the design of bankruptcy laws are derived. "Tough' Reorganisation procedures are found to be redundant, and possibly harmful. 'Absolute Priority Rules' may be helpful as a part of pure liquidation procedures, but their introduction is inconsistent with the design of 'soft' procedures like Chapter 11. The paper also reviews evidence on the performance of Chapter 11, questioning many negative results.
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