Your Latest Trick? Timely Identification and Response to Business Distress in Light of Bounded Rationality

Abstract

Insolvency law has traditionally relied on the assumptions of the neoclassical economic model, which treat economic agents as rational, opportunistic actors who consistently act in their self-interest. These assumptions have shaped the legal frameworks governing insolvency, particularly in terms of how debtors and company directors are expected to respond to distress. However, this model fails to account for the cognitive limitations and biases that systematically impair decision-making during business distress. By systematizing the insights from behavioral economics, this paper challenges the neoclassical approach, offering a different interpretation of the actions of directors and shareholders, based on the cumulative effects of loss aversion, overconfidence, and hyperbolic discounting on their decision-making process. These biases can cause delays in recognizing and addressing the distress situation, worsen outcomes for creditors and reduce the likelihood of business recovery. The concept of "cognitive hazard" is introduced as an alternative to the traditional moral hazard explanation, focusing on how these biases — rather than purely opportunistic behavior — distort decision-making. The paper advocates for a recalibration of insolvency law incentives, suggesting that more immediate sanctions and rewards, along with organizational changes like decision-support systems, could help mitigate the effects of these cognitive distortions. This recalibration would align legal frameworks more closely with the real-world behaviour of economic agents, ultimately promoting a more effective and timely response to distress.