Chapter 11 bankruptcy is a dizzyingly complex and inefficient process. Voting on potential reorganization plans take place by class, rules are based on achieving majorities and super-majorities by different standards, and a judge must evaluate the plan to ensure it respects pre-bankruptcy entitlements appropriately. Plan proponents can gerrymander plans in order to isolate creditors; hedge funds can buy positions that pay off if plans fail while allowing them to exert influence over the negotiation process; and judges are often unable to stop such gaming. To cut through this morass, lawyers and economists have proposed reforms, such as holding an auction for the firm or offering options to junior creditors that enable them to buy out senior creditors.
While these reforms could make important steps towards improving Chapter 11, they neglect a crucial problem the current system is designed to address: that of collective action. The current owners of various claims on the firm are usually well-suited to play the particular roles they are playing within the capital structure. Because of sunk investments in learning about the firm or their risk-preferences they are the most valuable investors to hold the assets they hold. A reorganized firm that does not have their appropriate participation may not be nearly as valuable as one that does. In fact, it may be better to liquidate the firm, even if reorganization could be efficient, than to reorganize it with the wrong owners.