Auctions allocate resources to their highest-valued uses. Yet bankruptcy does not use auctions. Instead judges determine a value and parcel out interests on the assumption that this valuation is correct. Errors inevitable in this process lead many persons to conclude that bankruptcy is inefficient. This essay argues that the conclusion does not follow. The costs of error in valuation may be less than the cost of conducting an auction. Legal rules endure because they are efficient or because they transfer wealth. Transfers are an implausible explanation of the current bankruptcy regime, leaving efficiency as the prevailing explanation.

This study investigates the incentives of financially distressed firms to restructure their debt privately rather than through formal bankruptcy. In a sample of 169 financially distressed companies, about half successfully restructure their debt outside of Chapter 11. Firms more likely to restructure their debt privately have more intangible assets, owe more of their debt to banks, and owe fewer lenders. Analysis of stock returns suggests that the market is also able to discriminate ex ante between the two sets of firms, and that stockholders are systematically better off when debt is restructured privately.