Coase's Theorem At Work

Coase's Theorem, attributed to Ronald Coase says, in a nutshell, that economic rights will end up in the control of the person who can use them most efficiently, regardless of who starts out using them, if property rights are well enough defined and transaction costs are low enough. It is well illustrated by the case of Colorado general aviation aircraft manufacturer Adam Aircraft.

Adam Aircraft filed for a Chapter 7 liquidation bankruptcy in February.

Businesses can file for bankruptcy under either Chapter 7 or Chapter 11 (ignoring for the moment Chapter 12 applicable to farms only, and Chapter 13 which applies not only to wage earners but to certain proprietorships).

When one files under Chapter 11, one is implicitly arguing that, but for the company's burden of past debts that it is a viable business which can shed some or all of the debt and return to non-bankruptcy operations if creditor's rights can be suspended temporarily and some or all debts can be discharged.

The statement a firm makes when it elects to file for bankruptcy under Chapter 7, in contrast, is that even with no debt, the firm is not profitable enough to continue operating. As a result, a firm that files for bankruptcy under Chapter 7 seeks merely to liquidate its assets piecemeal and turn the proceeds over to creditors on an equitable basis. This is the legal declaration that Adam Aircraft made when it filed for bankruptcy.

But, the market begged to differ. Multiple bidders seeking to buy all of Adam Aircraft's assets have come forward. Thus, there must be multiple parties in the market who believe that Adam Aircraft is a viable business if properly financed (which, in fairness, it not the same thing as saying that it is a viable business if it has no debt). As a result, today, the business as a whole is being auctioned to the highest bidder. If the result is rich enough, the result will be similar to a reorganization despite the manner in which Adam Aircraft filed for bankruptcy.