Chapter 28 Financial distress, bankruptcy and reorganization

R. Jarrow et al., Eds., Handbooks in OR & MS, VoL 9 © 1995 Elsevier Science B.V. All rights reserved

Chapter 28

Financial Distress, Bankruptcy and Reorganization L e m m a W. Senbet College of Business and Management, University of Maryland, University Park, MD 20742, US.A.

James K. Seward Amos Tuck School of Business Administration, Dartmouth University, Hanover, Nit 03755, US.A.

1. Introduction and overview

The decade of the 1980s saw some dramatic events in corporate finance, leading to wide attention to the role of corporate debt in public policy debates. Among these events are: (a) the increased reliance on the use of debt financing in corporate takeovers, restructurings and reorganizations; (b) the popularity (and subsequent collapse) of the 'junk' bond or original issue high yield bond market; and (c) the savings and loan crisis. These debates have been recently fueled by the arrival and severity of an economic recession, raising public concerns about the possibility of massive bankruptcies and their adverse consequences on the overall performance of the economy. 1 Correspondingly, the subject matter of financial distress and workouts has received a great deal of attention in the academic literature by finance and legal scholars. The purpose of this survey article is to synthesize the recent developments in the topics of financial distress, bankruptcy and reorganization. We focus primarily on developments in the corporate finance literature, although we summarize some important contributions by legal scholars that bear on the issue. Where appropriate, we also suggest research avenues of high promise. The subject matter is quite extensive with many important features that cannot be instructively included in a single, general model. Consequently, we refrain from attempting to work through a single structure that would have yielded no clear insights. Rather we organize the contributions around some unifying theoretical themes, and where available, we provide corresponding empirical evidence. 2 I Recent experience indicates that the number of corporations undergoing distress has increased substantially. For example, White [1990] reports that 86,000 businesses, with aggregate liabilities of $36 billion, filed for bankruptcy in 1987. 2 This approach is similar to the organization of the survey on capital structure by Harris & Raviv [1991]. 921

922

L.W. Senbet, J.K. Seward

We begin by setting forth the legal and economic ramifications of the U.S. Bankruptcy Code, focusing on the Bankruptcy Reform Act of 1978. It is important to have a deep appreciation of the main provisions of the Code in studying the economic implications of financial distress and formal bankruptcy procedures. Formal bankruptcy proceedings entail a liquidation process (Chapter 7) and a reorganization process (Chapter 11). Under Chapter 7, the firm is shut down by a court-appointed trustee, the firm's assets are sold, and the liquidation proceeds are distributed in accordance with the absolute priority rule (APR). Absolute priority establishes a strict hierarchy of distribution according to the seniority of claims held against the firm. While the procedure seems rather straightforward, it begs important issues of conflicts among claimholder groups with diverse interests, valuation of assets under asymmetrically informed parties, and related inefficiencies. Chapter 11 is intended primarily for a rehabilitation of a financially distressed firm, and the incumbent management team plays a crucial role in the reorganization process. We describe the economic implications of the main reorganization provisions, such as the automatic stay provision, the exclusivity privilege of management in filing a reorganization plan, and new financing by a 'debtor-in-possession'. In evaluating the legal ramifications, we also underscore the impact of the bankruptcy provisions on the behavior of corporate stakeholders outside of the formal bankruptcy process. Our next item on the survey agenda is a theoretical examination of the relationship between financial distress and economic distress. We do so by way of synthesizing the literature on bankruptcy and corporate financial policy. An important corollary of the Modigliani-Miller [1958] theorem, as generalized by Stiglitz [1974], is that corporate bankruptcy is immaterial to firm value. This important insight is often missed in discussions relating to the economic consequences of corporate bankruptcy, which often casually link economic distress with financial distress. As a related mater, it is also important to gain a clear appreciation of the dichotomy between bankruptcy and liquidation (the process of dismantling the firm's assets and selling them - - either piecemeal or in their entirety); otherwise liquidation costs may be mistakenly attributable to bankruptcy costs. Indeed, at the heart of the contemporary literature on financial distress is the determination of costs relevant to bankruptcy. These costs depend on the efficiency of resolution of financial distress. Thus, an important component of this survey is a synthesis of the theoretical and empirical evidence on private and formal resolutions of financial distress. At the outset, we recognize that these alternative methods for resolving financial distress are related in the sense that the incentives which various claimant groups have to reorganize a financially distressed firm depend on the relative costs and benefits conferred by each method. We discuss various private methods of resolving financial distress through debt restructurings, workouts, and informal reorganizations in the capital and real asset markets. There are, however, potential impediments to the privatization of financial distress. Foremost among these frictions are (a) the free rider problem, (b) informational asymmetry, and (c) inter- and intra-group conflicts of interest.

Ch. 28. Financial Distress, Bankruptcy and Reorganization

923

We believe that it is important to recognize that these potential impediments do not necessarily engender significant bankruptcy costs. Consequently, apart from examining these potential impediments in detail, the survey emphasizes innovations in the design of corporate financial contracts and capital structures which endogenize these impediments in the contracting process. We provide examples of bond indenture (and corporate charter) provisions and innovations in financial contracting designed to mitigate, or even eliminate, potential problems in the resolution of financial distress. We recognize, however, that other legal and regulatory restrictions might preclude full utilization of certain private contracting mechanisms. There is now a gradual accumulation of empirical literature which provides evidence on the determinants of relative utilization of private debt restructurings and formal bankruptcy proceedings. In our survey of this literature, we have found that the nature and degree of the complexity of corporate financial structures is a crucial determinant between informal and formal restructurings. Continuing with our survey, we discuss court-supervised methods of financial distress (or formal reorganizations), focusing on the efficiency characteristics of such methods of resolving bankruptcy disputes (and the available evidence) as well as the role of market mechanisms in formal reorganizations. While these methods of bankruptcy resolution serve as an alternative when private workouts fail, we also recognize that innovations in the legislative reform of the bankruptcy processes can facilitate or discourage private resolution methods. As an example, the nonunanimity requirement and automatic stay provisions of Chapter 11 reorganization serve as a threat against the free rider problem in private workouts. Thus, the formal bankruptcy process, as it is structured under the 1978 Bankruptcy Code, may entail benefits as well as costs. The inefficiency issues discussed stem mainly from bargaining and coordinating problems among claimant groups and from judicial discretion in the firm valuation and claimholder wealth allocation problems. We review the available empirical evidence on court-supervised methods of resolution, focusing on deviations from absolute priority rule, and the direct and indirect costs of formal bankruptcy proceedings. There is consistent evidence suggesting that direct bankruptcy costs, such as fees to bankruptcy lawyers, tax accountant, and trustees, are unlikely to be significant determinants of the firm's capital structure when the debt was originally issued. The evidence on the indirect costs of bankruptcy is inconclusive. These costs are difficult to conceptualize, let alone measure empirically. They are presumed to arise in the form of opportunity costs, resulting from suboptimal actions by corporate stakeholders, including customers, suppliers, and employees, in response to financial distress. The fundamental difficulty in empiricism arises from an inability to distinguish these costs form those that would have arisen form pure business dislocation and distress. We believe that none of the papers reviewed here has met this test satisfactorily, and hence this problem represents a challenging avenue for future research. Nonetheless, there is an important groundwork established, which we review in this survey. There is now an increasing utilization of capital market data in empirical investigations of formal bankruptcies through share price reactions surrounding

924

L.W. Senbet, J.K. Seward

bankruptcy processes and announcements. These studies have expanded to include the effects of bankruptcy on competing firms to see if there are industry effects of bankruptcy announcements. 3 The use of capital market data has also helped to d e m o n s t r a t e efficient securities pricing of deviations from the absolute priority rule. R e c e n t empirical evidence suggests that the A P R is frequently violated in Chapter 11 reorganizations, but that the equity markets generally anticipate and price these deviations, as documented by the relationship between share price reactions and subsequent A P R violations. O u r survey turns attention to the role of asset and financial market mechanisms in resolving financial distress under court-supervised reorganizations and liquidations. A market approach to formal bankruptcy proceedings has received little attention in corporate finance, but it is an exciting subject matter of debate in the legal literature. At the heart of debate is the relative efficiency of market valuations and judicial valuations in the appraisal of the firm and allocation of claims u n d e r formal bankruptcy. 4 There are some imaginative suggestions of the design of new financial instruments to minimize conflicts of interest under asymmetric information. A theme that runs through the available proposals is that market mechanisms and innovations can be employed to improve the efficiency, and fairness of formal bankruptcy proceedings. We present the perspectives of legal scholars in this survey, and hope that the debate on the market approach to formal bankruptcy proceedings will also interface with the domain of finance scholars. This survey has a limited purpose and cannot incorporate all the facets of the subject matter - - financial distress, bankruptcy and reorganization. As an example of the richness of the facets, we conclude the survey with a discussion of the impact of financial distress on the behavior of top corporate management, governance structures, and the firm's dividend policy. The literature here is sparse and primarily empirical. It faces the same challenges as the literature on the measurem e n t of indirect costs of bankruptcy in the sense of not clearly disentangling real financial costs from those that would have b e e n attributable to pure operational inefficiencies. However, this is also an example of a challenging avenue for further research. In closing, we wish to emphasize some general areas of research that are underdeveloped: the dichotomy between e c o n o m i c distress and financial distress; the increasing use of capital market data in evaluating the relative efficacy of C h a p t e r 11 and private workouts; interface between legal and financial research, particularly on the use of market mechanisms under formal, court-supervised bankruptcy proceedings; the design of innovative financial contracts and capital structures in enhancing efficiency in private workouts and formal reorganizations. 3 As an example, there is now considerable debate within the airline industry and the retail industry about how bankruptcy court protection can be strategically utilized to alter a financially distressed firm's cost structure. Healthy firms in the industry argue that this process, in turn, weakens their own financial condition as they seek to remain competitive with the court-protected bankrupt firms. 4 There is also a continuing debate on the efficiency of Chapter 11 in the legal literature. Moreover, our survey gives some attention to 'pre-packaged' bankruptcies which, we think, can be viewed as a 'convex combination' of Chapter 11 and private workouts.

Ch. 28. Financial Distresa; Bankruptcy and Reorganization

925

It is our h o p e that this survey facilitates an u n d e r s t a n d i n g of the principal issues and stimulates f u r t h e r r e s e a r c h on this topic.

2. Legal and economic ramifications of the U.S. Bankruptcy Code T h e process of resolving the disputes that arise in formal c o r p o r a t e b a n k r u p t c y is currently g o v e r n e d by the B a n k r u p t c y R e f o r m A c t of 1978 (hereinafter, the ~Code'). 5 T h e role of a f o r m a l b a n k r u p t c y p r o c e e d i n g is to p r o v i d e a collective p r o c e d u r e for the r e s o l u t i o n of i m p a i r e d c o n t r a c t u a l claims held against the firm. A b a n k r u p t c y filing may b e voluntary or involuntary, d e p e n d i n g o n w h e t h e r the p r o c e d u r e is initiated by the i n c u m b e n t m a n a g e m e n t . o r by the firm's creditors. T h e m a j o r i t y of b a n k r u p t c y filings by U.S. c o r p o r a t i o n s a r e voluntary. T h e C o d e alters the powers, duties and responsibilities of the firm's c o n t r a c t u a l claimants relative to the n o r m a l o p e r a t i o n of a solvent, ongoing entity u n d e r current c o m m e r c i a l and tax law. Since b a n k r u p t c y law s u p e r c e d e s the c o m m e r c i a l code, it seems likely that the incentives and b e h a v i o r of the claimants m a y be affected by the o p p o r t u n i t y to e n t e r formal bankruptcy. Consequently, an u n d e r s t a n d i n g of the m a i n provisions of the C o d e is necessary in o r d e r to d e t e r m i n e the e c o n o m i c implications of financial distress and formal b a n k r u p t c y p r o c e d u r e s . F o r the majority of the c o r p o r a t i o n s that e n t e r formal b a n k r u p t c y proceedings, the 1978 C o d e provides a liquidation process (Chapter 7) and a r e o r g a n i z a t i o n process (Chapter 11). C h a p t e r 7 liquidations are relatively straightforward p r o c e dures. T h e court a p p o i n t s a trustee who then shuts down the firm. T h e trustee sells or a b a n d o n s t h e firm's assets, and the p r o c e e d s are t h e n t u r n e d over to the court for d i s t r i b u t i o n to the firm's claimants. T h e seniority of p a y m e n t distribution is well-defined according to the absolute priority rule (APR). A c c o r d i n g to this rule, once the court establishes the hierarchy of claimants, a j u n i o r claim can receive no p a y m e n t until all senior claims are fully paid. Thus, payoffs to the firm's claimants d e p e n d directly on the values which the trustee obtains by liquidating all of the firm's assets, as well as t h e assigned seniority of the claim. In principle, the design o f an equitable and efficient b a n k r u p t c y law is relatively straightforward. Ideally, t h e C o d e would be s t r u c t u r e d so t h a t efficient firms (i.e., asset values are highest in their c u r r e n t use, a n d going c o n c e r n value exceeds l i q u i d a t i o n value) w o u l d be r e o r g a n i z e d and continue to survive, while only 5 Bankruptcy laws date back centuries in other advanced countries. A quotation from the

Economist [February 24, 1990] provides a glimpse of an historical perspective on bankruptcy laws: 'The word bankruptcy comes from banca rotta, Italian for broken bench. The custonr was that when a medieval trader failed to pay his creditors his trading bench was broken. Since bankruptcy was taken off the streets and put into the statute book it has become rather complicated... England's first bankruptcy law, signed by Henry VIII in 1542, was an "Act against such persons as do make bankrupt". For centuries British bankrupts went to debtor's prison: Charles Lamb, an essayist, thought they should be hanged... In contrast, one of America's attractions to immigrants was its very lack of a debtor's prison. Bankruptcy is still viewed in America as a side-effect of entrepreneurship.'

926

L.W. Senbet, J.K. Seward

inefficient firms would be liquidated. White [1989], however, argues that it may not be possible to construct a bankruptcy law which provides this outcome. The difficulty is that conflicts of interest between claimant classes lead to diverse preferences for the resolution of financial distress. In general, senior claimants favor premature shutdown and the loss of going concern value in order to preserve the value of their claims. The residual nature of junior claims, such as common equity, implies that its value is increased by maintenance of the firm as an ongoing entity. As a consequence, formal bankruptcy law leads to one of two undesirable outcomes: either the Code allows inefficient firms to reorganize and survive, or the Code leads to inefficient liquidation of viable firms. The provisions of the 1978 Act effectively lead to the former outcome. The inefficiencies created by the transfers of wealth among the firm's distinct claimant classes are further complicated by the problem of asymmetric information. The presence of asymmetric information induces disagreement over the aggregate value of the assets to be distributed among the firm's claimant classes. Furthermore, since bankruptcy law encourages the resolution of impaired claims through a bargaining process, claimant groups may intentionally misrepresent their opinion of aggregate firm value. For example, if firm value is small, senior claimant entitlements will generally ensure that they are allocated a larger proportion of the corporation's assets. Conversely, junior claimants have an incentive to present inflated estimates of firm value. The primary purpose of Chapter 11 is rehabilitation of a financially distressed firm. Once the firm enters Chapter 11, the incumbent management prepares a reorganization plan which proposes an allocation of firm value among the existing claimants. Although formal reorganization procedures are somewhat complicated, we can describe the economic implications of the major provisions of Chapter 11. (A summary of these features appears in Table 1.) First, an automatic stay provision stops all principal and interest payments due to creditors, In addition, interest ceases to accrue on all outstanding unsecured debt. This effectively extends the maturity of the firm's debt obligations and reduces the market value of the debtholders' claim on the firm's assets. The provision also prevents secured creditors from seizing their collateral. Finally, the automatic stay precludes creditors from cancelling contracts and halts lawsuits against the firm. Relatedly, the court may void certain transfers and contracts that occurred prior to the bankruptcy filing. Thus, for example, Chapter 11 may allow the firm to eliminate costly labor or lease contracts. The f978 Act also mandated that the incumbent management team remain in control of the firm's assets, except in extreme cases such as fraud. Interestingly, mere incompetence is not a sufficient motive to remove incumbent management under Chapter 11. Beyond simple entrenchment, Chapter 11 also conveys important additional advantages to management. First, for the initial 120 day period after filing, incumbent management retains the exclusive right to file a reorganization plan. Since this plan often forms the basis for subsequent bargaining among the diverse claimant groups, this exclusivity represents a valuable power. Extensions of the exclusivity period beyond the initial 120 day period are quite

Ch. 28. Financial Distress, Bankruptcy and Reorganization

927

Table 1 Basic Chapter 11 reorganization features

1. The automatic stay • Stops principal and interest payments to unsecured creditors. • Secured creditors lose the right to take possession of collateral, but may receive 'adequate protection' payments; • Executory contracts can be assumed or rejected. If rejected, these claims then become unsecured creditors. 2. The debtor-in-possession • Typicallythe current management and board of directors retain control. • Management initially maintains exclusiveright to file a plan of reorganization and solicit acceptances by the committees. Exclusivityperiod extends for 120 days to file the plan and an additional 60 days to seek approval. Extensions are common. • Debtor-in-possession financing effectively allows the court to strip seniority covenants and collateral from existing debt. Allows incremental senior borrowing. 3. Reorganization • Plan must be approved by all classes of creditors and the court. Exception is the cramdown procedure. • Threat of delay of reorganization plan by management. Transfers wealth from some creditor classes to equity. • Bargaining powers favor debtors, but creditors can (i) propose an alternative cramdown; (ii) ask for a lift of the automatic stay; (iii) request conversion to Chapter 7 liquidation; (iv) refuse to lend new funds; (v) block asset sales.

c o m m o n , especially in the case of large, complex bankruptcies. In addition, once the firm has filed for bankruptcy, the debtor-in-possession can obtain new debt financing and those creditors will be provided senior status. This provision is i n t e n d e d to e n c o u r a g e new lending and protect the integrity of any new loans as the firm reorganizes. As we shall discuss in detail later, in the absence of such a provision, new funds may n o t be forthcoming, thereby diminishing the likelihood that the firm can e m e r g e from b a n k r u p t c y as a viable entity. Finally, the voting process for the approval of a reorganization plan may be adv a n t a g e o u s to the i n c u m b e n t m a n a g e m e n t and the shareholders. Restructuring of public debt outside of the b a n k r u p t c y process (i.e., informal or private workouts) is g o v e r n e d by the Trust Indenture A c t o f 1939. T h e Act m a n d a t e s that any changes to a n o u t s t a n d i n g public b o n d ' s interest, principal, or maturity can be m a d e only if approved by 100% of the issue's holders. I n practice, this virtually precludes any change in these terms directly. Consequently, informal restructuring of public debt generally takes the form of an exchange @ r . I n bankruptcy, however, the voting process for approval of a debt restructuring plan is different. First, approval of a r e o r g a n i z a t i o n plan requires an affirmative vote by two-thirds in face value and one-half of the n u m b e r of holders in each class. Thus, C h a p t e r 11 would be especially a d v a n t a g e o u s to firms with complex capital structures or a small group of obstinate holdouts. Moreover, the bankruptcy court has the power to bind dissent-

928

L.W. Senbet, J.K. Seward

ing parties to a reorganization through the cramdown procedure. This procedure allows the court to confirm a reorganization plan that has been vetoed by one of the claimant classes. Although the voting process for the approval of a reorganization plan favors a Chapter 11 filing, one important disadvantage of the bankruptcy process is that it is a collective procedure. This effectively accelerates the due date for all of the firm's liabilities. Thus, relative to the case of a private restructuring with a single class of creditors, formal bankruptcy substantially increases the number of diverse claimant classes involved in the plan of reorganization. Related to the voting process is the provision in the Code that encourages the parties to bargain during the reorganization process. This, in conjunction with the other powers bestowed upon management, allows equity claimants to retain some fractional ownership in many reorganized firms, despite the fact that senior claimants do not receive their full entitlement (i.e., absolute priority is violated). Because the incumbent management remains in control of the firm, the ability to extract economic concessions from senior claimants can be viewed as compensation for extinguishing the option to delay the process and to invest funds in excessively risky projects. Thus, the Bankruptcy Code impacts the balance of power among managers, equityholders, and the firm's remaining stakeholders in economically important and identifiable ways. Since the Code specifies the set of rules under which claimants bargain for their entitlements, it also influences the behavior of the various stakeholders outside of the formal bankruptcy process. This point is important because it suggests that any reform of the Code must also consider its impact on the behavior of corporate stakeholders outside of the formal bankruptcy process. Next, we consider the linkage between a firm's capital structure policies and the firm's decision to enter formal bankruptcy. As we shall see, the importance of this link to the theory of capital structure depends upon the costliness of bankruptcy. An understanding of this relationship is crucial in distinguishing between economic distress and financial distress.

3. Bankruptcy and corporate financial policy The origin of the early literature on the relationship between bankruptcy and corporate capital structure decisions can be found in the seminal work of Modigliani & Miller [1958, 1963]. Their initial analysis establishes that, in perfect and frictionless capital markets, firm value is unaffected by financial policy. The original proof of the celebrated Modigliani-Miller theorem is predicated on the assumption of riskless debt. The theorem was later generalized by Stiglitz [1974] and others who argued that, in perfect and frictionless markets, the irrelevance of corporate financial policy extends beyond the issuance of riskless debt and equity securities to other forms of securities, including risky debt, preferred stock, and all kinds of hybrid securities. The theorem holds both in a single period and multiperiod framework so that firm value is also independent of debt maturity structure decisions.

Ch. 28. Financial Distress, Bankruptcy and Reorganization

929

Equity

q~ o

SenioDebt r __~

o=

.//.." .....................................................

CO

oiorO _f

/i

o n

...........

//'/ '

' '

~66

/// ' ' 1'ob6'

' labb'

RrmValue ' ~iob6'

' ~,do6'

' do'or)'

' ~ob'

'4d(

Fig. l.

The corollary of the M M theorem is that corporate bankruptcy is inconsequential to firm value, since the operating or investment decisions are completely separable from the financing decisions. Figure 1 provides an intuitive illustration of this result. Consider the allocation of the firm's aggregate cash flows between the equity claimants and bondholders on the maturity date of the firm's debt securities. In the Modigliani-Miller framework, the amount of corporate indebtedness has no effect on the value of the firm's assets nor on the riskiness of the total cash flow stream generated by the firm's assets. Debt financing simply partitions the cash flows so that greater financial leverage alters the amount of risk borne by the bondholders. While obvious, this important insight is often missed in discussions relating to the economic consequences of corporate bankruptcy. There is no necessary linkage between bankruptcy and the firm's operating performance; bankruptcy does not cause economic distress or poor performance. We will consider the distinction between financial distress and economic distress later in this chapter, but wish to emphasize here that a clear appreciation of this dichotomy greatly enhances an appreciation of the voluminous debate surrounding the consequences of corporate bankruptcy. For instance, it is tempting to point to news stories of distressed firms as evidence of a ,causal relationship between impending bankruptcy and a deterioration in profitability or a decrease in product demand. The crucial consideration is whether an identical but otherwise nondistressed firm (due to low financial leverage) would face a similar deterioration in its operating performance. Moreover, liquidation and bankruptcy are often discussed in the literature as though they are related. Liquidation is the process of dismantling the firm's assets and selling them (either piecemeal or in their entirety) to new management teams. Liquidation is optimal when the value of the firm's existing resources is higher in alternative uses. Hence liquidation should be viewed as a capital budgeting decision which is independent of the way in which the firm is financed. Liquidation and bankruptcy are separate, independent events. (See Haugen &

930

L.W. Senbet, J.K. Seward

Senbet [1978] for further discussion on this issue.) A highly profitable firm with high leverage may remain viable as a going concern, irrespective of bankruptcy, while an unprofitable firm may be liquidated even if it has no debt in its capital structure. It is important to resist the temptation of confounding bankruptcy and liquidation, because liquidation costs may be mistakenly characterized as bankruptcy costs. The latter, if significant, are determinants of the firm's capital Structure, but liquidation costs are inconsequential to corporate financial policies or debt decisions. In the event that bankruptcy is costly, it fills an important void between the corner result of the Modigliani-Miller tax adjusted model and the observed limitations on the amount of debt financing employed in practice. Although the costliness of bankruptcy and financial distress is not the primary subject of this paper, it is appropriate to highlight what has come to be known as the 'trade-off theory'. Modigliani & Miller [1963] argue that the tax code favors debt over equity financing by allowing the firm's interest expense to be deducted from gross income for corporate tax purposes. Since an additional dollar of debt generates the marginal benefit of a tax deduction without any offsetting cost in this framework, firm value is maximized by utilizing as much debt as possible to finance corporate investment decisions. Other financial economists, such as Kraus & Litzenberger [1973], Scott [1976], and Kim [1978], suggest that the costs of bankruptcy might provide a reconciliation between the observed limits on the usage of debt and the predictions of the tax-adjusted Modigliani-Miller analysis of financial policy. The intuition provided for the existence of finite, optimal capital structures is straightforward. Debt capacity is limited, because corporations trade-off the tax savings generated by the deductibility of interest payments against the expected value of the costs incurred in the event of bankruptcy. Unfortunately, these early models failed to provide any rigorous economic justification for the existence of these bankruptcy costs. Thus, at the heart of the contemporary literature on the relationship between corporate financing decisions and financial distress is the issue of whether bankruptcy is costly. Bankruptcy costs may potentially emerge directly in the form of court fees involving third party advisors to the firm, such as lawyers, tax accountants, trustees, etc., or indirectly in the form of costly disruptions in the relationship of the firm with customers, suppliers, and employees. If market mechanisms exist, such as those described in Haugen & Senbet [1988], which allow firms to escape the deadweight costs of bankruptcy, then bankruptcy has no impac(on corporate capital structure decisions. If, however, bankruptcy costs are not always avoidable, then virtually all dimensions of the firm's financial contracting decision are impacted. This latter result follows because the characteristics of the firm's financial contracts influence the likelihood of bankruptcy as well as the magnitude of the costs incurred. Consequently, for example, financial contract characteristics such as maturity, seniority, complexity, collateral, covenants, and public vs. private are likely to influence the firm's bankruptcy decision. The next two Sections consider the theoretical and empirical evidence on private and formal resolutions of financial distress. It is useful to recognize that

Ch. 28. Financial Distress, Bankruptcy and Reorganization

931

these alternative methods for resolving distress are related, so that the incentives which various claimant groups have to reorganize the firm depend on the relative costs and benefits conferred by each method. The costliness of financial distress depends on the design of resolution procedures which facilitate maintenance of maximum firm value. We shall argue that, currently, a number of factors exist which potentially impede costless formal or informal reorganization of financially distressed firms. We also suggest a number of market mechanisms which might be utilized to enhance the efficiency of formal and informal resolution procedures.

4. Private methods of resolving financial distress

In this section, we examine various methods of resolving financial distress outside the bankruptcy court system. Our discussion focuses on three alternatives which are available to corporate managers for dealing with financial distress° In particular, we consider the following: (1) financial restructurings; (2) asset sales; (3) infusions of new capital from outside sources. The academic literature focuses principally on the restructuring of the firm's financial claims which, for reasons we discuss below, are typically implemented through an exchange offer. Generally, these informal, or private, reorganization mechanisms are designed to mitigate, or possibly even eliminate, the costs of bankruptcy. We also discuss conditions under which these informal reorganization methods may be impeded, possibly giving rise to significant costs of financial distress. We then generalize our discussion to consider additional market mechanisms and innovations that may reduce, or eliminate, the potential impediments to the informal resolution of financial distress.

4.1. Debt restructurings and private workouts An actual or impending default on the firm's existing debt obligations is typically the event that initiates the process of resolving financial distress. This does not imply that default causes financial distress, but rather that it provides creditors with the contractual right to renegotiate certain aspects of their claim against the firm. A default can occur either because the firm fails to make a scheduled payment to the creditors, or because the firm violates one or more of the restrictive provisions contained in the indenture. In the following discussion, we do not distinguish between the causes of a default, but rather focus on its consequences. There is an abundance of attention in both the academic literature and the popular press about informal reorganization of corporate financial structures through debt restructurings and private workouts. We define a debt restructuring as an agreement by the firm's creditors to modify any term(s) of an outstanding financial claim currently held against the firm. We view the term broadly so as to encompass both public and private loan agreements. We note, however, that publicly-held credit arrangements are subject to different disclosure and regulatory constraints than private debt. As a result, the set of feasible debt

932

L.W. Senbet, J.K. Seward

restructuring techniques outside of formal bankruptcy proceedings will depend on who holds the firm's credit obligations. Common restructuring techniques include exchange offers, tender offers, covenant modification, and (in the case of private debt) maturity extension or interest rate adjustments. Haugen & Senbet [1978] provide an early theoretical analysis of the linkage between informal debt restructurings and bankruptcy costs, and the firm's financial policy decisions. They utilize the spirit of the Modigliani and Miller no-arbitrage approach to argue that the costs of financial distress are insignificant to the theory of capital structure. To understand their argument, consider a firm that encounters financial distress and must restructure its financial contracts. Haugen and Senbet note that the firm can elect to resolve financial distress through (1) a formal reorganization involving the court system, or (2) informal reorganization through the financial markets. Hence, the costs of resolving financial distress must be bounded by the least costly of these two alternative resolution mechanisms. In addition, they argue that, in general, the present value of the transaction costs of informal reorganization are likely to be small, or even insignificant, at the time of the firm's initial capital structure decisions. Hence, all rational claimholders will agree to restructure in this manner. Since capital market participants recognize that it is in the interests of all claimholders to support the more efficient method of restructuring, bankruptcy costs should not be sufficiently large to offset the tax subsidy generated by debt financing. Hence, they argue, bankruptcy costs do not explain the corporate decision to limit the amount of debt financing utilized to fund real investments decisions. The intuition for this result is to recognize that informal restructurings represent an alternative to formal bankruptcy proceedings and it pays claimants to 'privatize' bankruptcy away from the court system, if the informal route of resolving financial distress is cost-efficient. Jensen [1989, 1991] provides a similar argument in support of the privatization of bankruptcy. Similar viewpoints were also expressed forcefully in the legal literature by Roe [1983]. The preceding discussion focuses on the incentives and opportunities for corporate insiders to restructure a distressed firm's financial claims through the capital markets. However, the privatization of the bankruptcy process can also be initiated by outside arbitrageurs. To see this, suppose that the market values of a distressed firm's publicly-traded securities reflect the expectation that significant bankruptcy costs would be incurred as a result of the claimants' failure to successfully implement an informal reorganization. Outside arbitrageurs can buy up the outstanding securities at prevailing market values to prevent the costly alternative of a formal reorganization. The potential arbitrage profit would be the bankruptcy costs, net of the transactions costs, of informal reorganization. Once the old debt is eliminated in its entirety so as to prevent any windfall gain to the remaining bondholders, new debt can be issued to take optimal advantage of the corporate tax subsidy. The expedient of outside takeover, as an alternative to private workout and recapitalization by the original claimants, is also discussed in Haugen & Senbet [1978]. The main implication of this analysis is that the capital markets provide a more efficient forum for the resolution of financial distress, and hence one would not expect to observe a substantial amount of court-supervised

Ch. 28. Financial Distress, Bankruptcy and Reorganization

933

reorganization activity. However, it seems clear that a large and growing number of corporations elect to forgo the alternative of a private workout. As Haugen & Senbet [1978] recognize, failure to utilize cost-effective private mechanisms for resolving financial distress must be predicated upon: (1) outright irrationality by the firm's financial claimants or market participants, or (2) impediments to the arbitrage or private workout processes. Much of the subsequent literature on informal debt restructurings focuses on attempts to identify the potential impediments to informal reorganizations 6 The next two sections examine the theoretical and empirical evidence which focuses on the implications of these impediments.

4.2. Potential impediments' to privatization of financial distress In this section, we examine the impact of the following impediments to the resolution of financial distress through private reorganization mechanisms: (1) free rider problem; (2) asymmetric information; (3) inter- and intra-group conflicts of interest. Although we discuss these impediments in detail, it is important to note that their existence does not necessarily render bankruptcy costs significant to the theory of optimal capital structure. We describe how these impediments, particularly the free rider problem, can be eliminated by inclusion of simple provisions into corporate charters and bond indentures. More generally, we would expect to observe innovations in the design of corporate financial contracts and capital structures which endogenize the potential impediments in the contracting process. We suggest that corporate decision-makers should recognize the benefits of adopting financing arrangements that mitigate, or even eliminate, potential problems in the resolution of financial distress in the bankruptcy process. A case in point is an increased usage of the strip financing technique which allows the financial claimants to hold both the debt and the equity claims issued by the firm. We recognize, however, that other legal and regulatory restrictions might preclude full realization of certain solutions. For example, current limitations on the ability of U.S. banks to hold long-term corporate equity stakes may inhibit the range of feasible resolution mechanisms. We discuss the implications of some of these restrictions in more detail below.

4.2.1. The free rider problem A financial restructuring of the firm's existing debt obligations is typically intended to relax the firm's cash flow problems by: (1) reducing interest payment obligations, or (2) extending the maturity date. Informal renegotiation of creditor claims depends on whether the debt obligation is public or private. The restructuring of public debt is governed primarily by the Trust Indenture Act of 1939. This Act requires unanimous consent by the holders of a particular class of debt secu6 Senbet & Seward [1991] propose an indifference proposition for the equivalence of three private workout mechanisms - - informal reorganization initiated by corporate insiders (equityholders), informal reorganization initiated by bondholders, and informal reorganization initiated by outside arbitrageurs - - in well-functioning markets. They examine the relative efficacy of these reorganization procedures in more general settings characterized by frictions.

934

L.W. Senbet, J.K. Seward

rities in order to change the debt obligation's maturity, principal, or coupon rate of interest. These stringent voting rules effectively preclude a debt restructuring in which the holders of any outstanding public bonds agree to alter these terms. As a result, virtually all informal public debt restructurings are accomplished through an exchange offer. In a typical exchange offer, the firm allows the holders of a particular class of the firm's debt securities the right to exchange their existing claims for a new class of securities. A successful exchange offer generally enhances the firm's credit quality, thereby enhancing the value of the remaining bonds which are not tendered. Since exchange offers grant holders the right (but not the obligation) to participate, some bondholders may elect to 'hold-out' in the expectation that the postexchange offer value of their existing claim will exceed the value of participation in the exchange. Since all bondholders have similar incentives, the exchange offer is likely to fail. This problem could be solved if the issuer induces the required level of participation by sufficiently increasing the value of the claims offered in the exchange. Unfortunately, the firm may find that the costs of resolving the free rider problem in this way can be sufficiently large so as to eliminate all of the economic benefit created by a successful debt restructuring. Green & Juster [1992] study the structure and timing of debt restructuring decisions by financially distressed firms. They show that the firm's decision to exchange or repurchase outstanding debt is a separable, two-part decision. First, the firm must decide on the amount of debt to repurchase. Then, the firm can determine the price to offer in the exchange. They also show that it is oftentimes optimal for the firm to delay the exchange or repurchase in order to efficiently reduce the role of free riders in the restructuring process. At least two other approaches towards mitigating the hold-out problem should be mentioned: (1) endogenize the impediment at the time of the firm's initial capital structure decision; (2) coercive participation. The first approach is analyzed by Haugen & Senbet [1988]. They suggest that the bondholder free rider problem can be eliminated through simple, innovative bond indenture provisions, such as (a) granting the bond trustee the right to accept or reject tender and exchange offers on behalf of all bondholders; (b) by making tender offers binding on all holders within the class, once a majority of bondholders have tendered their holdings; (c) including a 'continuous' call provision, which allows the firm to call the bonds at the price registered in the most recent trade. These suggestions highlight the fact that the potential impediments to a successful financial restructuring often assume that the form of the firm's debt finance is exogenously specified. Here, we argue that security design and corporate capital structure decisions should be endogenized in order to redress the problems that may arise in the bankruptcy process. In practice, corporations have relied upon coercive techniques in order to successfully implement exchange offers. Although the Trust Indenture Act requires unanimous approval by all holders within a particular class of public debt in order to change the maturity, interest, or principal features of the security, covenants can be changed or waived by a simple majority or super-majority vote. The

Ch. 28. Financial Distress, Bankruptcy and Reorganization

935

modification of bond covenants is typically accomplished through a technique known as consent solicitations or exit consents. The combination of exit consents and exchange, or tender, offers works as follows. A distressed firm announces an exchange offer, but conditions the offer on a bondholder vote to change or eliminate the issue's covenant(s). The issuer also conditions its acceptance of the exchanged debt on approval of the consent solicitation by the requisite majority. The loss in value for those bondholders who elect to retain their original, stripped debt claim generally outweighs the benefits of electing to not participate. As a result, financially distressed firms can design financial restructuring programs which simultaneously strip the protection of existing bond indentures and coerce participation in tender or exchange offers. Coffee & Klein [1991] argue that participation in the exchange offer should be separate from, not conditional on, the vote to strip covenants. This separation of the vote and the exchange decision would mitigate the coercive element of this technique. Gertner & Scharfstein [1991], building upon an earlier work which analyzes the investment distortions created by risk shifting [Jensen & Meckling, 1976] and underinvestment [Myers, 1977], show how: (1) the possibility of debt restructurings affects the investment decisions of financially distressed firms and (2) the use of consent solicitations alters investment decisions. One of their principal findings is that informal d e b t restructurings typically do not restore efficient investment incentives. Rather, exchange offers may serve to reduce the burden of debt obligations by simply extracting wealth from the participating creditors. The impact of exchange offers on investment incentives depends on the presence or absence of seniority covenants. A seniority covenant is a provision in debt contracts, which precludes the firm from issuing new securities with a more senior claim. This provision is intended to protect the seniority position of a firm's outstanding securities against the dilutive effects of subsequent financing decisions. The use of a consent solicitation allows the firm to strip the seniority covenant, thereby allowing the firm to offer a more senior security in the exchange. Gertner and Scharfstein find that a separation of the vote to strip covenants and the decision to participate in an exchange offer does enhance the efficiency of corporate investment decisions. More generally, these findings offer some new evidence on the ability of bond covenants to protect creditors against expropriative behavior by managers and stockholders. Divergent views on this issue are offered by Smith & Warner [1979] & McDaniel [1986]. The use of consent solicitations to strip covenant protection in distressed exchange offers is more consistent with the view advocated by McDaniel. H e argues that bond covenants provide the least protection at precisely the time when they are most needed. The use of exit consents by distressed firms in order to implement coercive exchange offers suggests that even well-thought-out covenants can be circumvented under certain conditions, thereby reducing their value as an integral limitation on the opportunistic behavior of equityholders. These findings suggest that additional research on the role of bond covenants in controlling agency problems between bondholders and stockholders is necessary.

936

L.W. Senbet, J.K. Seward

4.2.2. Information aayrnrnetry The problem of designing and completing an informal debt restructuring is exacerbated in the case of financially distressed firms by information asymmetries. Asymmetric information exists in any transaction where one party knows more about true value than another party. In order to understand the role of asymmetric information in different financial transactions, corporate managers are typically assumed to possess private information about the true economic value of the firm. For example, a substantial number of models in the capital structure literature assume that insiders have private information about the firm's cash flow stream or its future investment opportunities. The existence of asymmetric information in the case of financially distressed firms emanates from two possible sources. First, corporate insiders and outside investors may, based upon their differential information, simply disagree about the value of the firm. Second, when the firm is financially distressed, insiders may have an incentive to intentionally misrepresent value in order to convince bondholders to agree to exchange their existing claims for lower valued securities. In this connection, even the state of financial distress can be misrepresented by a privately informed entrepreneur, depending on the nature of the debt contract, as recently demonstrated by Heinkel & Zechner [1993]. They show that informational asymmetry may prevent contract renegotiation prior to maturity if the debt outstanding is a pure discount bond. The insiders of a firm with poor prospects may hide the default state and hence their worthless position, and those with good prospects may declare default with the expectation of favorable debt renegotiation. The inefficiencies resulting from not declaring default prior to maturity may be mitigated by an alternative design of debt contract with risky intermediate payments, such as a coupon or sinking fund payments and bankruptcy institutional arrangements permitting deviations from absolute priority rules (APRs). (We will have more to say about APRs in the next section.) The asymmetric information effect of financial distress suggests that a greater proportion of the securities offered in a distressed exchange offer should contain contingent payment features. The reason why contingent payment securities are useful is that their future values will adjust more readily to the revelation of information about the true value of the f i r m ] There are, of course, different types and classes of financial securities with different degrees and forms of payment contingencies - - common equity, warrants, contingent value rights, and call provisions, to name just a few. Franks & Torous [1989] indicate that a few financially distressed firms, in fact, issued debt with warrants or convertible securities in exchange for defaulted debt. Ultimately, then, the resolution of this issue involves a security design problem. ~ There are, however, various legal, regulatory and institutional restrictions that limit the types of securities that debtholders may be able or willing to accept in exchange for their claims..These restrictions may impede the completion of an ex7 A more complete discussion of this issue is contained in Senbet & Seward [1991]. Heinkel & Zechner [1993]

Ch. 28. Financial Distress, Bankruptcy and Reorganization

937

change offer if the optimal security does not conform to these requirements. This suggests one of two outcomes: (1) holding the restrictions constant, the firm will be able to complete the debt restructuring only if the existing claimants accept a new security which is suboptimal; or (2) in order to distribute the appropriate security, the applicable restrictions must somehow be loosened. Unfortunately, while the latter outcome would seem more desirable, the former is more likely to happen. Giammarino [1988], however, shows how the structure of a normal bankruptcy procedure may, in the presence of asymmetric information, induce financial claimants to forgo an informal debt restructuring. Thus, his analysis provides an explanation for the 'rational' decision by claimholders to incur significant bankruptcy costs by entering the formal reorganization process in order to resolve financial distress. Successful formal reorganization in Chapter 11 involves a substantial amount of judicial discretion and latitude. The presence of asymmetric information may cause debtholders to prefer the uncertain allocation outcome of a formal bankruptcy procedure rather than to trust the claims of equityholders/ management in an informal reorganization. Hence, Giammarino's analysis suggests that there are conditions under which a formal reorganization may be preferred even when the process involves deadweight costs. 9 Future analyses of the role of security design in mitigating asymmetric information problems in an informal debt restructuring should explicitly consider the alternative outcome(s) offered by a formal bankruptcy proceeding. Although the outcome of financial distress depends on imperfect information and, as we discuss in the following section, conflicts of interest among claimants, this does not necessarily imply that the use of debt financing should be minimized to avoid such problems. Wruck [1990] suggests that debt may serve as an important and valuable catalyst for operational and organizational change, and that reducing leverage may obviate this service. For example, she argues that financial distress may entail benefits such as precipitating changes in management, corporate governance, and organization strategy and structure. Evidence which supports this view is contained in Warner, Watts & Wruck [1988] and Gilson [1989], who show that poor stock performance p e r se is generally not sufficient to motivate the replacement of the incumbent management. Hence, although lower financial leverage may reduce the costs of financial distress due purely to asymmetric information problems, important benefits are foregone by the suboptimal use of debt financing. Indeed, a recent literature on optimal security design [e.g. Aghion & Bolton, 1988; Zender, 1991; Dewatripont & Tirole, 1992; Harris & Raviv, 1993] empha9 A similar argument is made by Webb [1987] who proposes two different informational scenarios under which bankruptcy costs may be incurred, namely (a) uncertainty about court valuation of bankruptcy settlement, and (b) heterogeneous beliefs of bondholders and equityholders about firm value. The court settlement uncertainty problem, though, may be resolved by avoiding the court system to begin with via informal reorganization. The second informational issue assumes that information can be segmented on the basis of security ownership types. At any rate, arguments based on asymmetric information confound bankruptcy and informational problems, because the latter exist even under all-equity financing.

938

L.W. Senbet, J.K. Seward

sizes the efficiency gains from debt financing attributable to transfer of control rights in bankruptcy. Financial contracts are mechanisms that distribute the firm's cash flows and control rights. In Zender [1991], an optimal security design that implements efficient investment decisions results in debt-like and equity contracts through joint distribution of cash flows and control rights. Bankruptcy implements a state-contingent transfer of control and mitigates opportunistic behavior by the controlling investor, since the marginal return from investment is realized by these investors. Likewise, control is vested in the hands of shareholders in those states where the payments to debtholders are fixed. In either case, the return to passive (or noncontrolling) investors is insensitive to performance. Thus, Zender's analysis endogenizes the beneficial role of bankruptcy as a mechanism for state-contingent transfer of control, with the resultant efficiency gain. Likewise, Aghion & Boltou [1988] argue that, bankruptcy as a state-contingent transfer of control, facilitates contract renegotiation based on information revealed concerning the prospects of the firm. Dewatripont & Tirole [1992] show how to generalize the notion of control transfer into efficient design of managerial contracts, along with the design of capital structure. An optimal financial structure exists by virtue of trading off excessive interference of debtholders in managerial decisions and passivity of equityholders.

4.2.3. Conflicts of interest and coalition formation Different reorganization plans, whether formal or informal, allocate wealth across management, creditors and shareholders differently. Hence, at least two concerns will govern the design and advocacy of any reorganization plan: (1) how does the plan affect the aggregate value of the firm's assets; (2) how is the value of the firm under alternative reorganization plans distributed among the different claimants. Since the latter consideration is largely a problem in bargaining, several studies examine the linkage between conflicts of interest, coalition formation and the resolution of financial distress. Not surprisingly, conflicts of interest can reduce overall economic efficiency because coalitions of claimants can be formed to extract concessions (i.e., wealth transfers) from other nonaligned claimants. For example, Bulow & Shoven [1978] and White [1989] investigated the impact of coalition formation on the firm's liquidation vs. continuation decision. In both cases, private gains from the restructuring process interfere with the efficient resolution of financial distress. Brown [1989] examines the way in which conflicts of interest among claimholders can inhibit the resolution of financial distress through an informal reorganization. These conflicts may either be inter- or intra-claimant class. Intergroup conflicts arise because allocations under any given reorganization plan can always be increased at the expense of a separate claimant class. Intragroup conflicts can emerge when a restructuring allows members of a particular reorganization plan to decide whether to participate or not. This creates the incentive to holdout, or free ride, if successful reorganization would enhance the value of the old claims. Brown [1989] demonstrates that the structure provided by the Bankruptcy Code pares down the feasible set of outcomes otherwise available in a voluntary,

Ch. 28. Financial Distress, Bankruptcy and Reorganization

939

informal workout. This distinction arises because the set of rules and procedures which govern informal reorganizations (such as the Trust Indenture Act) differ from those which apply in a formal reorganization. Effectively, the relative bargaining strengths of the various claimant classes are altered once a firm enters the bankruptcy process.

4.3. Empirical evidence on debt restructurings An empirical study by Gilson, John & Lang [1990] provides extensive evidence on the incentives of financially distressed firms to choose between private debt restructurings and formal bankruptcy proceedings. Their findings suggest that asset and financial characteristics jointly affect the firm's choice between these alternative reorganization mechanisms. In particular, the firms in their sample are more likely to resolve financial distress through private workouts under the following conditions: (1) a greater proportion of the firm's assets are intangible; (2) the firm has fewer distinct classes of debt outstanding; (3) the firm relies more heavily on bank debt than public debt. The economic intuition which explains these findings is consistent with the theories discussed earlier. In essence, these asset and financial characteristics make the privatization of financial distress more cost-effective and/or minimize the role of costly impediments in the informal resolution process. Intangible assets proxy for the likelihood that the failure to renegotiate the firm's impaired credit obligations will result in the destruction of going concern firm value. The aggregate value of firms which have a larger proportion of intangible assets will be higher if the firm maintains operating continuity through private resolution mechanisms. Presumably, then, the private renegotiation process ensures that the creditors' impaired share of the larger going concern value exceeds what they would receive by forcing the firm into formal bankruptcy reorganization or liquidation. Capital structure characteristics (i.e., role of bank lenders, number and complexity of firm's financial contracts) matter, because they impact the efficiency of the bargaining process in a private renegotiation. Smaller numbers of distinct creditor classes, with fewer claimants in each, facilitate informal restructurings by reducing the potential problems created by asymmetric information and conflicts of interest. Gilson, John & Lang also provide evidence of the relative indirect costs of financial distress for formal and informal reorganizations. They examine stock market price reactions around the time that investors become aware that the firm is experiencing financial distress, and find that: (1) the market is capable of predicting whether a private workout will be successful or not; (2) private workouts are a more efficient form of reorganization than Chapter 11. Indeed, they find that the costs of private restructuring are only a fraction of the cost of a bankruptcy court-supervised workout. 1° H)Of course, this is not to suggest that the firms that ended up in Chapter 11 would have been better off under private workouts. It may well be that such firms found it more cost-efficient to enter formal bankruptcy (under court supervision) due to their complex financial structures.

940

L.W. Senbe~ ZK. Seward

A subsequent study by Asquith, Gertner & Scharfstein [1991] sheds further light on the costs of financial distress. They examine the restructuring activities of 102 companies which issued high yield debt and then subsequently encountered financial distress. In particular, they find that: (1) banks rarely forgive principal on outstanding loans or provide new financing in an informal restructuring; (2) public debt restructurings through exchange offers are a crucial determinant of the success of an informal reorganization; (3) the complexity of a firm's contractual claims is a key determinant of whether a firm will enter formal bankruptcy; (4) there is no evidence that firms with better operating performance deal more successfully with financial distress; (5) asset sales and capital expenditure reductions are commonly utilized by financially distressed firms. These findings conflict somewhat with the evidence and conclusions described in Gilson, John & Lang [1990]. In particular, Asquith, Gertner & Scharfstein conclude that 'banks do not play much of a role in resolving financial distress'. They attribute this to the presence of subordinated public debt in the capital structures of many of the firms in their sample. Thus, although much of the literature emphasizes the unique role of bank debt in the resolution of financial distress, these findings suggest that this issue requires further study. An alternative avenue of future research which promises to shed light on these issues is to examine the structure of bankruptcy laws and financial systems in other economies. Hoshi, Kashyap & Scharfstein [1990] provide empirical evidence on the relationship between financial distress and firm performance for a sample of Japanese industrial firms. They discuss how several unique features of the Japanese product and financial markets - - i.e., the keiretsu and the main bank system - - are structured to economize on the costs of financial distress. Their findings demonstrate how those firms with close ties to a main bank are able to invest more and increase sales, following the onset of financial distress. Hoshi, Kashyap & Scharfstein interpret their results as evidence that certain financial structures and creditor relationships reduce the costs of financial distress and facilitate better firm performance. Problems of free ridership and asymmetric information are internalized by the close main bank relationships, concentration of financial claims among financial institutions, and by the strengthening of product market ties through cross-holding equity relationships. 4.4. The interfirm asset sale market

As an alternative to the informal restructurings of its debt obligations, the firm may attempt to sell assets in an attempt to relieve its financial distress. A partial sell-off of the firm's existing assets generates cash which can be used to reduce outstanding debt or to undertake new investment opportunities. There are several reasons why asset sales by financially distressed firms may differ from asset sales by healthy firms, and hence may be difficult to implement on a favorable basis. Shleifer & Vishny [1992] suggest that the secondary market for interfirm asset sales may be subject to adverse liquidity problems. They argue that there are several factors which determine market liquidity in the case of interfirm asset sales, such as

Ch. 28. Financial Distress; Bankruptcy and Reorganization

941

fungibility (i.e., the number of uses and users for a particular asset), participation restrictions (e.g., regulations on foreign acquisitions or antitrust considerations), and credit constraints. If such liquidity problems occur, then the price which the seller is likely to receive in a distress sale will be adversely affected. Hence, the main consequence of an illiquid secondary market for interfirm asset sales is that it increases the costs of dealing with financial distress through this mechanism. A second distinguishing characteristic of this market is that purchasers of assets from distressed firms face some unique risks when assets are acquired outside of formal bankruptcy proceedings. First, the transaction must be structured to ensure that the acquiror does not subsequently become unintentionally liable for the debts and obligations of the seller. In addition, if the selling firm subsequently files for bankruptcy, the court may void the sale as a fraudulent transfer or a voidable preference. Typically, this would occur if the price received by the seller is deemed insufficient consideration for the value of the assets sold. In such a case, the acquiror risks the possibility of subsequently having to return the assets to the seller. Finally, the sale of assets can limit, or even eliminate, the use of net operating losses (NOLs) to shield future income from taxation. To the extent that these loss carry forwards represent a valuable firm asset, financially distressed firms musl/ensure that the sale of assets is structured to preserve their tax benefits. The price obtained by the seller in an asset sale is ultimately determined by the outcome of a bargaining negotiation between the acquiror and the seller. The poor financial condition of the seller may weaken the firm's bargaining position, thereby reducing the price it receives for'the assets. Furthermore, if the sale is conducted under duress from the firm's creditors, the outcome may be that the price received is less than the value of the asset under continued ownership and operation by the distressed firm. Creditors may favor the asset sale, however, because it effectively accelerates receipt of the future cash flow stream that would otherwise be generated by continued ownership. Hence, the net result of the transaction could entail a wealth transfer from stockholders to bondholders as well as a reduction in aggregate firm value. Brown, James & Mooradian [1992b] provide empirical evidence on this issue in their study of asset sales by financially distressed firms. They find that asset sales are frequently conducted by the financially distressed firms in their sample, and that the distinguishing characteristic of the firms which sell assets is that they operate multiple divisions or subsidiaries. Conversely, most of the sample firms that don't sell assets operate only a single division. Thus, to the extent that asset sales help reduce the firm's expected costs of bankruptcy, corporate diversification may provide important economic benefits. They find that, on average, shareholder abnormal wealth effects are insignificant on the announcement date of the asset sale. However, further partitioning of the sample suggests that stockholder returns are positive if the firm subsequently avoids bankruptcy. This finding also suggests that, at least in some cases, asset sales are implemented to the benefit of creditors and the detriment of shareholders. Thus, although asset sales do provide an alternative mechanism to deal with financial distress, the impediments described above may inhibit the flow of benefits to shareholders.

942

L.W. Senbet, J.K. Seward

4.5. Infusions of new capital Assuming that the firm in financial distress still has positive net present value projects available, one alternative for enhancing firm value is to attract new investment capital. In the event of financial distress, however, additional funding may be difficult to obtain due to problems described in Myers [1977]. Essentially, this 'underinvestment' problem arises because a disproportionate amount of the economic gain from the incremental investment accrues to the pre-existing (especially senior) financial claimants. This problem is likely to be greater the more junior the incremental source of funding. These observations suggest two general approaches to the problem of attracting new investment capital. First, the firm should try to make the new claim as senior as possible. Oftentimes, however, covenants in the firm's outstanding debt securities explicitly preclude this form of financing. One alternative to circumvent this problem is to utilize asset-based and secured debt financings [see, e.g., Stulz & Johnson, 1985]. In general, the feasibility of this form of financing depends upon the availability of collateral to pledge, as well as an understanding of the additional encumbrances imposed by the new creditors. We are unaware of any empirical study of this issue. The second alternative is to combine junior financing with a certain amount of senior debt restructuring. For example, the Southland Corporation was privately reorganized in 1990 by arranging an equity infusion by Ito-Yokado Co. and SevenEleven Japan. The equity investment was made contingent upon the successful completion of a conditional exchange offer. Although we are unaware of any empirical study of this issue, our impression is that new equity infusions are not frequently utilized to resolve distress. Apparently, the problems which discourage new investment described by Myers [1977] and Gertner & Scharfstein [1991] make this form of distress resolution unattractive. Relatedly, perhaps, the availability of debtor-in-possession financing in Chapter 11 may limit the amount of control which equity claimants are willing to forgo in a private restructuring.

5. Court-supervised methods of resolving financial distress or formal reorganizations

Court-supervised methods of bankruptcy resolution serve as an alternative when private workouts fail. However, we take a view here that the innovations in the legislative reform of the bankruptcy processes can facilitate or discourage private resolution methods. For instance, the nonunanimity requirement and Automatic Stay provisions of Chapter 11 reorganization serve as a threat against the free rider problem discussed earlier, and hence facilitate private workouts. On the negative side, we already saw how the Trust Indenture Act of 1939 could inhibit private informal reorganization. In this section we shall examine the efficiency characteristics of court-supervised methods of resolving bankruptcy disputes and the available evidence.

Ch. 28. Financial Distress, Bankruptcy and Reorganization

943

5.1. The efficiency characteristics Of the Bankruptcy Code T h e formal bankruptcy process, as it is currently structured under the 1978 Bankruptcy Code, may entail benefits" as well as costs. Recent studies by Gertner & Scharfstein [1991] and Wruck [1990] provide evidence on these benefits. G e r t n e r and Scharfstein adopt a coalition view of financial distress, and argue that coordination problems a m o n g public debtholders create investment inefficiencies which may not be mitigated by private restructurings. They show how three particular features of existing reorganization law (the automatic stay, voting rules for the reorganization plan, and the retention of equity value) affect investment decisions by financially distressed firms. In particular, these provisions increase the level of investment both inside and outside of Chapter 11. However, while these provisions increase investment incentives, economic efficiency may not necessarily be enhanced. Gertner & Scharfstein show that the net benefit of the increased investment depends on the incentives generated by various characteristics of the firm's financial contracts, such as maturity structure, covenants, and the priority of private vs. public debt. They conclude that Chapter 11 has ambiguous effects on efficiency, but will provide the greatest economic benefit when underinvestment is a problem. All else equal, this is most likely to h a p p e n w h e n the firm has shorter-term public debt, senior bank debt, and the public debt has seniority covenants. T h e additional inefficiencies may arise from bankruptcy judges overstepping their legal jurisdiction and interfering with rational wealth allocation a m o n g the conflicting parties in the bankrupt firm. Weiss [1991] cites several such incidents: a refusal of the judge to liquidate Eastern Airlines when it appeared optimal to do so in the j u d g m e n t of the creditors and other outside observers, and an interference of the judge with. private restructuring of the L T V and hence forcing a costly negotiation under court supervision. Weiss also observes lack of uniformity in extensions of the exclusivity period of 120 days, since judges have considerable latitude in deciding to extend the period. For instance, Florida judges rarely extend while judges in the Southern District of New York often extend the period for years. This creates an incentive for migration of bankruptcy cases from Florida to New York, since bankruptcy falls under federal law (e.g., the filing of Eastern in New York rather than Miami, its principal place of business). Shopping for the right bankruptcy court judge presumably favors m a n a g e m e n t and engenders cost to society, apart f r o m the direct cost of case overloads. I1 Wruck [1990] suggests that Chapter 11 provides gross benefits for certain firms. 11There is also a problem relating to arbitrariness in appraisals by judges. Consider a question from Fortgang & Mayer [1985] regarding Judge Winner in Canadian Arctic: 'With all of these things, to say that you can appraise the values of Canadian Arctic is to say you can attend the county fair with your crystal ball, because that is the only possible way you can come up with a result ... my final conclusion ... is that it is worth somewhere between $90 million and $100 million as a going concern and to satisfy the people who want precision on value, 1 will fix ... $96,856,850, which, of course, is a total absurdity that anybody would fix a value with that degree of precision, but for the lawyers who want to make that fool estimate, I have just made it.'

944

L.W. Senbet, J.K. Seward

She identifies the ability to deal with diffuse creditors as a single class, the ability to renegotiate or void burdensome lease or labor contracts, and debtor-in-possession financing as valuable rights contained in Chapter 11. Also, Chapter 11 protects against a race to the assets of the firm by diverse creditors [Easterbrook, 1990]. Berkovitch & Israel [1992] analyze a strategic choice of a financially distressed firm between a private workout and bankruptcy declaration under Chapter 11. The firm's choice is dictated by the two standard incentive problems arising from bondholder-stockholder conflict, namely the underinvestment problem associated with valuable growth opportunities and the risk-shifting problem. The optimal choice is one which minimizes the loss in value due to the investment distortions resulting from the incentive problems. It is argued that a private workout can eliminate the underinvestment distortion by creating an incentive for debtholders to accept a renegotiated contract that compensates shareholders for undertaking value-increasing projects. However, the converse is argued for the problem of overinvesting in risk. Since the risk-shifting incentive decreases debt value and debtholders would seek to block such investments if they are disclosed, shareholders may lose incentive to engage in private methods of resolving financial distress. It is argued that the 'automatic stay' provision of Chapter 11 extinguishes the blocking power of debtholders and leads to renegotiation. 5.2. Empirical evidence

In this section, we review the available evidence on the direct and indirect costs of formal bankruptcy proceedings. In principle, bankruptcy costs matter because they impose dead weight costs on the firm which are borne by the shareholders through an ex ante compensation to the creditors for the possibility of incurring these costs ex post. In addition, bankruptcy may impose costs on stakeholders other than the firm's capital contributor. For example, Titman [1984] examines the financing implications of bankruptcy-related costs borne by employees, supplies, and/or customers. To the extent that the bankruptcy process itself is costly, and if these costs are not avoidable, then capital structure decisions will be affected. 5.2.1. Direct costs

A study of railroad bankruptcies by Warner [1977] provides evidence of the magnitude of direct bankruptcy costs. Direct bankruptcy costs are the legal, administrative and advisory fees that the firm bears as a direct result of entering the formal bankruptcy process. Warner finds that these direct costs average about four percent of the firm's aggregate market value measured just prior to declaring bankruptcy. Warner notes that costs of this magnitude are unlikely to affect the pricing of debt claims and optimality of capital structure at the time of debt issuance. The reason is that it is thepresent value of bankruptcy costs that matter at the time of capital structure decisions. The ex-ante costs of bankruptcy in Warner's study are insignificant when adjusted for the ex-ante probability of bankruptcy. The time period for Warner's study [1933-1955] predates the adoption of the current Bankruptcy Code, and hence may not be applicable under existing

Ch. 28. Financial Distress, Bankruptcy and Reorganization

945

practice. Weiss [1990] provides evidence on the direct costs of bankruptcy in the period 1980-1986. His results are comparable, but somewhat lower, than the estimate provided by Warner. 12 This, again, suggests that direct bankruptcy costs are unlikely to represent a significant determinant of security pricing prior to the entry into formal bankruptcy and of the capital structure decision when debt was originally issued.

5.2.2. Indirect costs Potentially more significant and substantial are the indirect costs of bankruptcy. These costs can be viewed as opportunity costs, in that they collectively represent the outcome of suboptimal actions by corporate stakeholders. Thus, costs that arise because of inter- or intra-group conflicts of interest, asymmetric information, tree-rider problems, lost sales and competitive position, higher operating costs, and ineffective use of management's time all potentially represent the indirect costs of bankruptcy. A common sentiment seems to be that the indirect costs are substantially larger than the direct costs, but they may also be confounded with costs that would have arisen with pure business dislocation and distress. Moreover, these costs are difficult to observe and measure. As a result, the empirical evidence on the magnitude of the indirect costs of bankruptcy is derived primarily from specific cases. Altman [1984] measures the indirect costs of bankruptcy as the difference between the earnings realized in each of the three years prior to the firm's bankruptcy and the earnings that could have been expected at the beginning of each of those years. In essence, this procedure measures the deviation of actual profits from their expected counterparts and attributes it indirect bankruptcy costs. A second test examines deviations from what security analysts were predicting for up to two years. The immediate danger is that the deviations are not distinguishable from a mere forecasting error in the event that the market or security analysis makes rational and unbiased forecasts about earnings. The more fundamental issue, though, is that the procedure confounds the costs of liquidation with the indirect costs associated with bankruptcy. To see this, consider the example in Haugen & Senbet [1988] whereby the firm is confronted with the introduction of a dominant product by a competing firm. This event has an adverse impact on the economic viability of the firm as a going concern with the consequent impact on the realized earnings through reductions in sales and increases in costs. The unanticipated event is not reflected in the expected profits at the beginning of the year, leading to negative surprises at the end of the year. Altman's procedure measures such negative deviations as part of indirect bankruptcy costs, but they are unrelated to the way the firm is financed. The above problem cannot be alleviated by splitting the sample into those firms that are reorganized and those that are liquidated. Liquidation costs can be incurred even when the firm is not liquidated ex post. In the above example the increased 12See also Altman [1984], Morse & Shaw [1988], Macmillan, Nachtman & Phillips-Patrick [1990] for similar results.

946

L.W. Senbet, J.K. Seward

probability of liquidation stemming from the firm's strategic disadvantage in its product market triggers adverse reactions from its suppliers, customers, and employees. Thus, indirect costs of liquidation could have been incurred by firms that were reorganized. These issues are once again illustrations of how difficult it is to empirically measure indirect costs of bankruptcy without confounding economic and financial distress. Lang & Stulz [1992] study the intra-industry effects of bankruptcy announcements by investigating the reactions of share prices of competing firms. The study is based on the notion that bankruptcy announcements convey information about the cash flow characteristics of similar firms in the industry and their competitive position. They find evidence that the equity value of competing firms in the industry of the bankrupt firm decreased, on the average, by 1% at the time of the bankruptcy announcement. However, for competing firms in highly concentrated industries and low leverage, the stock price reaction was positive with an increase in the equity value of 2.2%. The positive competitive effect is attributable to the possibility that the competitive position of the nonbankrupt firms is enhanced by the misfortunes of the bankrupt firm. If these industry effects are merely informational, they cannot be used as evidence of bankruptcy leading to investment inefficiency and indirect bankruptcy costs. It is interesting, though, that such magnitudes of industry effects of bankruptcy announcements are detected for concentrated industries. 13 Cutler & Summers [1988] study abnormal share price reactions surrounding various events in the Texaco-Pennzoil litigation. They argue that the amount of the award represents a pure wealth transfer, so that fluctuations in the joint value of the firms would likely represent the direct and indirect costs of the litigation process. Their estimates indicate that, upon settlement of the litigation, shareholder wealth had declined by approximately one billion dollars. They note that this amount significantly exceeds most estimates of direct bankruptcy costs, and hence may reflect the economic value lost due to the disruptive effects of the formal proceedings. Here there is an asymmetry between price reaction of Texaco and Pennzoil shares. However, this analysis fails to deal with an ever-present thorny issue of separating economic distress from financial distress. It is very likely that the impact is related to the adverse effects of lost reputation with the stakeholders resulting from information release surrounding the award. This is reflected in the asymmetric stock price reaction of Texaco and Pennzoil. J3 There are other studies dealing with announcement effects of bankruptcy, but they don't investigate intra-industry effects directly. Clark & Weinstein [1983] document a significant informational content of bankruptcy filings; so do Eberhart, Moore & Roenfeldt [1990]. Aharony & Swary [1983] provide evidence for bankruptcy announcements where the industry effect is negligible due to the bankruptcy filings being made for idiosyncraticpurposes. Bankruptcy announcement effects of risk measures have been investigated by Baldwin & Mason [1983], Johnson [1989], Aharony & Swary [1983], and Morse & Shaw [1988]. In general, the authors report negligible announcement effects of systematic or beta risk but significantly positive effects of the unsystematic risk component. However, Baldwin & Mason [1983] show a decrease in beta as the firm approached bankruptcy, and they suggest an expected violation in APR as a possible explanation.

Ch. 28. Financial Distress, Bankruptcy and Reorganization

947

5.3. Deviations from absoIute priority rule (APR) Traditionally, financial economists have assumed that the value of a bankrupt firm is allocated among its claimants by strict adherence to the absolute priority rule (APR). APR is an allocation rule based upon the relative seniority of the contractual entitlements held by all of the firm's claimants. According to the APR, the value of a bankrupt firm is distributed so that senior claimants receive their full contractual entitlement before any class with a more junior claim receives anything. In a Chapter 7 liquidation, the trustee sells the assets of the firm, and distributions of the proceeds are made according to the APR. Recent empirical evidence contained in studies by Franks & Torous [1989], Eberhart, Moore & Roenfeldt [1990], and Weiss [1990] suggests that the APR is frequently violated in a Chapter 11 reorganization. Deviations from APR in formal reorganization are primarily attributable to various features and provisions of the Bankruptcy Code, which effectively provide the debtor with substantial protection and bargaining powers against creditors. Relatedly, sanctions of APR violations by the courts in formal reorganization procedures increase the likelihood of similar violations in informal debt restructurings. This is because formal reorganization c a n be viewed as an alternative to informal workouts, and hence forms the basis for negotiations with creditors outside of the protection of formal bankruptcy. Franks & Torous [1989] suggest that the institutional features of Chapter 11, which grant the debtor-in-possession valuable rights, effectively provide management with a valuable option. This option provides management the opportunity to adopt investment and financing decisions which can diminish the value of the claims held by the firm's creditors. For example, Chapter 11 allows management to obtain new senior financing and to exclusively propose a plan of reorganization for the first 120 days. These rights can be used to diminish the value of the pre-existing creditors' claims by effectively decreasing the exercise price and extending the maturity of the firm's pre-bankruptcy liabilities. As a result, deviations from the APR can be viewed as compensation by senior claimants to the junior claimants in order to extinguish this option. The documentation of frequent and economically significant deviations from the APR raises a number of related issues. First, if market participants are rational and anticipate the frequency and magnitude of deviations from the APR, then security prices should reflect these violations. Eberhart, Moore & Roenfeldt [1990] examine the relationship between share price reactions and subsequent APR violations, and find that the equity markets generally anticipate and price these deviations. Frank & Torous [1989] provide numerical examples to show how deviations from the APR affect risk premiums on corporate bonds. They adjust Merton's [1974] model for valuing risky debt for APR violations, and then show how their results are closer to observed spreads between risky and default-free interest rates. Thus, ex-ante deviations from the APR raise the interest cost of debt financing for corporations as might be expected in an efficient market. Weiss [1990] shows that it is primarily unsecured creditors who bear a disproportionate amount of

948

L.W. Senbet, J.K. Seward

this transfer, so that the pricing of junior level debt should reflect a high premium for A P R violations. Note that if bonds are priced correctly and efficiently in the manner discussed above, there is no wealth transfer among bondholders and equityholders as A P R violations are fully internalized. In addition, Eberhart & Senbet [1992] argue that A P R violations have the potential to mitigate the risk shifting agency costs of debt financing. The incentives of corporate insiders to engage in excessive risk taking are typically magnified by the increased probability of bankruptcy which cannot be readily controlled by traditional incentive compatible contracts, such as convertible debt. Eberhardt & Senbet show how A P R violations serve as an implicit contract to control the risk incentives in the vicinity of bankruptcy. In a related context, Berkovitch & Israel [1992] rationalize APR violations as part of a strategic debt renegotiation both under private workout as motivated by a desire to eliminate the underinvestment problem and under Chapter 11 as motivated by a desire to reduce the investment distortion resulting from riskshifting incentives. Note we have earlier provided a more detailed discussion of Berkovitch and Israel under Section IV(B). A m o n g a growing literature on efficiency rationale for deviations from absolute priority rule is an interesting paper by Harris & Raviv [1993], which proposes an optimal design of Chapter 7 - - like bankruptcy procedure. Harris & Raviv consider an environment with suboptimal liquidation under financial distress and with noncontractible project returns. The entrepreneur has an incentive to make payments to outside capital contributors only to avoid costly liquidation; otherwise he can appropriate funds not paid out. This environment is akin to Hart & Moore [1989]. Moreover, private workouts and privatization of bankruptcy through informal reorganization and takeover markets are precluded. It is interesting that this environment then rationalizes a debt-like contract with a bankruptcy court. The role of the court is to impose limits on the extent of liquidation via involuntary debt forgiveness in states with high costs of liquidation. In this sense, deviations from absolute priority rule are endogenous to an optimal design of bankruptcy procedure, since the court's role is precisely to enforce these deviations.

5.4. The role of market mechanisms in formal reorganizations The resolution of financial distress through a formal court proceeding is typically accomplished via a process of bargaining among the claimants and the application of judicial discretion by the presiding bankruptcy judge. As a result, formal bankruptcy proceedings currently forgo the opportunity to utilize asset and financial market mechanisms to resolve financial distress. In this section, we examine various proposals which have been advanced to enhance the role of market forces in efficiently resolving financial distress in formal bankruptcy proceedings. Although financial economists have not yet studied this issue in detail, legal scholars have provided some important insights into the question of whether market valuations or discretionary judicial valuations provide more efficient estimates of aggregate firm value in formal bankruptcy proceedings. Baird [1986], for example, views the two forms of bankruptcy (i.e., reorganization and liquidation) as the sale

Ch. 28. Financial Distress, Bankruptcy and Reorganization

949

of a firm's assets and the distribution of proceeds among the existing claimants. He suggests, however, that Chapter 7 involves the actual sale of assets while Chapter 11 is a ~hypothetical' sale, where judicial discretion establishes a 'fictitious' value for the firm. Baird argues that claimants collectively would benefit from elimination of the formal reorganization option since it is a costlier procedure than the actual sale of assets. Thus, the market mechanism supported by Baird is to utilize only the market for asset sales. As an alternative to the forced liquidation of all firms that file formal bankruptcy, Roe [1983] and Bebchuck [1988] suggest that the innovative design of new financial instruments might mitigate the valuation problems in the existing formal bankruptcy process. Essentially, their argument is that, by designing and distributing claims whose structure minimizes conflicts of interest and whose value is not particularly sensitive to asymmetric information, firm value can be efficiently allocated to claimants in accordance with their contractual entitlements. Roe, for example, criticizes tile existing Chapter 11 reorganization process because the current practice reconstitutes the firm's capital structure as the outcome of an interclass bargaining process and the determination of firm value by judicial discretion. Thus, the capital structures confirmed in reorganization plans are quite disparate, and unlikely to represent a decision which maximizes the value of the firm. The solution proposed by Roe is to require that the bankruptcy courts approve only those reorganizations with all-equity capital structures. The allocation of firm value among the claimant classes would then be determined by the initial sale of a small amount of equity (Roe mentions 10%) in the capital markets, the use of this sale to infer the aggregate value of the firm, and then the distribution of the equity claims according to the absolute priority rule. The role of the initial sale of equity in Roe's proposal is that it is necessary to establish the aggregate value of the reorganized firm in order to then distribute claims according to each participants contractual entitlements. Bebchuck [1988] argues that Roe's proposal is predicated on the correct market pricing of the initial equity sale. The role of the equity sale in Roe's proposal is that it is necessary to infer the aggregate value of the reorganized firm in order to then allocate claims according to contractual entitlements. Bebchuck proposes a modification of the Chapter 11 process which utilizes claims whose value does not depend on knowing the true value of the firm. He suggests that the distribution of rights, or warrants, whose exercise prices and seniority are based upon the seniority and contractual entitlements of the firm's existing claimants. He shows how these rights can be designed and distributed to provide claim holders with values that are consistent with their contractual entitlements. One later addition to the stock of bankruptcy reform proposals is an antiChapter 11 extension of Bebchuck by Aghion, Hart, & Moore [1992]. The proposal adopts Bebchuck's allocation mechanism for claims in bankruptcy under Chapter 7, but it curtails the role of management in the bankruptcy process. A judge (or a reorganizer) is appointed to solicit cash and noncash bids for the bankrupt firm, and distributions are made under a strict APR rule. Aghion, Hart & Moore view management as pro-Chapter 11, and their proposal is intended

950

L.W. Senbet, J.K. Seward

to eliminate all the inefficiencies associated with managerial handling of the bankruptcy process. The paper sidesteps the issue of correctly identifying the priority and the size of individual entitlements and the judge has considerable discretion in deciding who gets what (or who gets which options). In order to be successful, the allocation of the bidding process has to be done in a short period of time; Aghion, Hart & M o o r e propose a three-month period. Longer periods would engender managerial intention problems. 14,15 A c o m m o n theme in each of these proposals is that market mechanisms, either asset or financial, can be employed or developed to improve the efficiency and fairness of formal corporate bankruptcy proceedings. A countervailing viewpoint is provided in Easterbrook [1990], who suggests that the costs of judicial valuation errors may be less than the .costs of market mechanisms (in particular, the costs of conducting an auction for the firm). Thus, he argues that the judicial system may operate with lower transactions costs than markets. The question of whether m a r k e t mechanisms can enhance the resolution of financial distress in formal bankruptcy proceedings remains important but largely unanswered. A related matter is the extent to which the rules and structure of the formal bankruptcy process influences the efficiency of informal reorganizations and private workouts. As reported earlier, there is strong evidence that the costs of informal reorganizations are much less than the costs of formal bankruptcy. Consequently, an important role of any reform of the formal bankruptcy process should be to introduce innovations that facilitate the role of markets and informal reorganizations in privatizing bankruptcy outside the court system. As an example of the beneficial effect of the 1978 reform, the nonunanimity requirement and automatic stay provisions of Chapter 11 should serve as an important threat against the free rider problem in private reorganization. O n the other hand, the detrimental effect of the legislative rules is reflected in the Trust Indenture Act of 1939, which inhibits private workouts.

5.5. Pre-packaged bankruptcies Section 1126(b) of the Bankruptcy Code allows a financially distressed firm to simultaneously file a bankruptcy petition and a plan of reorganization. A J4 There is a continuing debate on the efficiency of Chapter 11 in the legal literature. For instance, Eisenberg [1992] challenges reformer proposals that call for the abolition of Chapter 11 on the ground that its costs are overstated ad confounded with the costs of reorganization that would have been incurred even in the absence of Chapter 11. He points out that the real costs of Chapter 11 are unknown. From historical perspective, Eisenberg argues that Chapter 11 reorganization proceedings took roughly the same length of time, on average, as the traditional receivership reorganizations and pre-Chapter 11 proceedings. In addition, even deviations from the APR are not inherent in Chapter ]1, since they too occurred in receivership reorganizations that preceded Chapter 11. 15A provocative article by Bradley & Rosenzweig [1992] proposes a complete repeal of the current Chapter 11 process. They provide empirical evidence to support their contention that stakeholder welfare is reduced under the existing bankruptcy procedure. Altman [1993], however, questions some of their findings.

Ch. 28. Financial Distress, Bankruptcy and Reorganization

951

pre-negotiated bankruptcy reorganization allows the firm to combine the cost efficiency of an informal debt restructuring with certain benefits afforded by a formal bankruptcy proceeding. In particular, the less stringent voting requirements in Chapter 11 can be utilized to bind all creditors to a reorganization plan. Thus, a pre-packaged bankruptcy effectively circumvents the holdout problem by allowing the court to force dissenting creditors to accept the proposed reorganization plan. Two other considerations also enhance the relative benefits of a pre-packaged bankruptcy. The first arises from a January 1990 ruling by a bankruptcy judge in the LTV bankruptcy case. The judge ruled that creditors who participate in an informal debt restructuring are, if the firm subsequently files for bankruptcy, entitled to a claim equal to the value of the securities received in the exchange offer. Since exchange offers typically involve some amount of debt relief, this ruling further discourages participation by creditors in a private restructuring of the firm's liabilities. This, in turn, is likely to enhance the attractiveness of a pre-packaged bankruptcy. The other factor to consider is the tax consequences that arise from the cancellation of indebtedness. For a firm which reorganizes outside of bankruptcy, the taxability of the 'income' generated by debt forgiveness depends upon whether the firm is deemed to be solvent or insolvent. To the extent that the firm is made solvent by the cancellation of debt through an informal exchange offer, the income is taxable. However, if the firm reorganizes within a formal bankruptcy proceeding, the debt discharge is exempt from corporate income taxation. Thus, all else equal, certain tax benefits may be available to the firm if it reorganizes within a formal bankruptcy proceeding that would otherwise not be allowed. Moreover, the maintenance of net operating loss carry-forwards depends upon the retention of at least a 50% ownership position by the pre-existing equity claimants. There are, however, special rules that may apply in a bankruptcy case that preserve these valuable tax shields even if a substantial change in ownership occurs. Thus, asymmetric tax treatment in formal and informal debt restructurings will likely encourage more frequent use of pre-packaged bankruptcies in the future.

6. An a s s e s s m e n t of the impact of financial distress on the behavior of corporate m a n a g e r s

6.1. Top management turnover and corporate governance structures" Managerial ability and decision-making are important determinants of the value of the firm. The managerial labor market can be viewed as an arena where corporations compete to acquire and retain the services of top management. Fama [1980] argues that a competitive managerial labor market is an important mechanism to control the behavior of opportunistic professional corporate managers. In effect, a well-functioning managerial labor market disciplines the behavior of corporate executives in two ways. First, compensation schemes are structured to reward decisions that enhance shareholder wealth, and penalize outcomes that

952

L.W. Senbet, J.K. Seward

diminish shareholder wealth. Second, shareholders, through their representatives elected to the Board of Directors, hire and fire top managers. T h e behavior and decision-making of top corporate managers are likely to be influenced by financial distress for a n u m b e r of reasons. First, the wealth of top managers is usually affected directly by stock price performance through equity ownership positions in their firms. To the extent that shareholders bear any costs of financial distress, managerial welfare is likely to be affected as well. Secondly, financial distress may also impose costs directly on top management. For example, Gilson [1989] notes that financial distress may entail significant personal costs to corporate managers through: (1) loss of future income; (2) loss of firm-specific h u m a n capital; (3) loss of power, prestige, or other nonpecuniary benefits; (4) adverse reputation effects. Since top managers make major corporate policy decisions that can influence firm value, these costs can directly influence firm p e r f o r m a n c e and efficiency. 16 In assessing the significance of m a n a g e m e n t - b o r n e costs, it is important again to distinguish between economic distress and financial distress. Thus, m a n a g e m e n t b o r n e costs are associated with the increased probability of the firm going out of business or being liquidated rather than financial distress or the way that the assets are financed. Of course, the economic viability of the firm is affected by managerial performance and competence so that m a n a g e m e n t - b o r n e costs, such as the loss of future income, may be appropriately attributable to managerial efficiency b o t h in the reorganized firm and alternative employment opportunities. Is the performance and decision-making of top m a n a g e m e n t responsible for the onset of financial distress, or is deterioration due to systematic economic or industry factors? This distinction, while difficult to make in practice, is crucial to understand in order to enhance the likelihood that a distressed firm will remain viable in the future. If m a n a g e m e n t is inefficient or incompetent, then a wellfunctioning managerial labor market would simply replace the incumbent with a new, qualified manager. The problem is that managerial ability is difficult t o observe, and that performance proxies (such as stock price returns) are, at best, noisy indicators of the manager's ability. In general, it is the responsibility of the Board of Directors to monitor top m a n a g e m e n t , design and implement compensation packages, and make hiring and firing decisions. However, as financial distress approaches, the membership of the B o a r d experiences higher turnover [see, e.g., Gilson, 1990]. Thus, the legal appara~6There is considerable interest in the legal literature on the impact of financial distress on the firm's stakeholders beyond financial claimholders. For instance, Triantis [1992] suggests that bankruptcy may lead to a debtor's unilateral abrogation of contracts involving various stakeholders. The argument is based on the notion that, unlike the nondebt party, a debtor may not be disciplined by social norms and reputational considerations. In addition, the debtor enjoys moral legitimacy for the rehabilitation of the firm through an abrogation of bnrdensome contracts. This opportunistic behavior may not be fully internalized at the time of debt issuance due to an incomplete contracting environment. However, the inefficiency suggested by Triantis is more relevant for the bankruptcy case with an endgame (or liquidation) because a bankrupt, but economically viable firm, would be concerned about market sanction and reputation.

Ch. 28. Financial Distress, Bankruptcy and Reorganization

953

tus which is designed to monitor top management performance may be ineffective at precisely the time that its fiduciary role is most important. This suggests that ineffectiveness on the part of the Board of Directors may also be a contributing factor to the onset or acceleration of financial distress. Walsh & Seward [1990] argue that poor decision-making by top management may not necessarily reflect managerial inability or incompetence. The economic foundation of agency models is that managerial actions can be directed and motivated by appropriately designed incentive mechanisms. But suppose that these incentives are inappropriately designed. Then poor firm performance may be due to poorly designed incentive mechanisms by the Board rather than poor management per se. In this case, management turnover is unlikely to resolve the firm's performance problem. In light of the ambiguity about the relationships between firm performance, top management, and board membership, consideration of the empirical evidence on the linkage between them is important. Gilson [1989] examines the incidence of senior management turnover in 381 unprofitable firms between 1979 and 1984. He separates the sample into distressed and nondistressed firms, and finds that the top management of financially distressed firms are ahnost three times as likely to experience turnover as those in nonfinancially distressed firms. Since the sampling procedure selects only poorly performing firms, this finding suggests that the onset of financial distress is itself an important determinant of management turnover. Interestingly, Gilson [1989] also finds that a larger fraction of managers keep their jobs when firms restructure privately rather than through the formal chapter 11 process. This finding is somewhat surprising because of the debtor-in-possession provisions that effectively entrench incumbent management under the Bankruptcy Code. Although Gilson provides no explanation for this result, it does suggest that other factors influence management turnover in financially distressed firms. In particular, financial distress may just be a signal for poor economic performance and managerial inefficiency or incompetence leading to managerial turnover. Since private restructuring is less costly, as documented empirically, it may be associated with more efficient management and hence lower turnover. Again, the available evidence is insufficient in documenting that financial distress, rather than economic misfortunes and the associated managerial inefficiency, that leads to management turnover. Gilson [1990] provides an extensive empirical analysis of changes in the corporate governance structures of 111 firms that defaulted on a creditors' claim between 1979 and 1985. He finds evidence of substantial changes in directors' roles and responsibilities when the firm restructures its liabilities. Turnover among the pre-default board members is high, and their monitoring role is largely replaced by two sources. First, creditor influence increases by obtaining stock ownership and board representation in exchange for the agreement to forgo their entitlements under their debt contracts. Relatedly, new credit agreements often contain explicit covenant restrictions on corporate investment and financing policies. These covenants enhance the creditors' ability to constrain managerial decision-making. The second source of monitoring in restructured firms is the substantial increase in large blockholdings that occurs when firms become finan-

954

L.W. Senbet, J.K. Seward

cially distressed. The greater degree of equity concentration among fewer holders improves the net benefits attainable from greater monitoring. Although these two studies provide extensive evidence on the impact of financial distress on top management turnover and corporate governance structures, the literature still lacks a unified study of these issues. That is, when firm performance is poor, and some change in the management, governance and control of the corporation is necessary, how do we know which should be changed? Is poor performance and financial distress due to the inability or incompetence of management, or is a quality manager simply led to poor decisions through an ineffective, inefficient or unqualified governance structure? Despite the difficulty in disentangling these separate effects, the distinction is crucial if we are to understand how public and private initiatives can improve the process of rehabilitating or liquidating distressed firms. 6.2. Dividend policy

Smith & Warner [1979], in their analysis of bond covenants, note that restrictions on dividend payments help to control the agency conflict between bondholders and stockholders. In the absence of such a restriction, shareholder wealth could be maximized by simply expropriating bondholders through the payment of as large a dividend as possible. This view, however, ignores the possibility that this policy may precipitate the onset of financial distress, which may in turn be personally costly for corporate managers. Since dividend policy is controlled by the latter, and managers may be more interested in job preservation than maximizing shareholder wealth, empirical evidence on the link between cash distributions to equity claimants and financial distress is necessary to understand these conflicting incentives. DeAngelo & DeAngelo [1990] investigate the link between dividend policy and financial distress in a sample of 80 financially distressed firms from 1980 through 1985. The authors find that dividend growth during the pre-distress period was high (approximately 11% per year for the ten year period prior to the onset of distress), but that managers substantially decreased dividends during the distress period. Moreover, they find that, on average, managers reduce dividends quite early in reaction to the onset of financial distress. Their findings suggest that binding debt covenants are an important motivation for the reduction of dividends. They also find, however, that many distressed firms which are not constrained by binding debt covenants, nonetheless, voluntarily reduce dividends. This finding suggests that other factors beyond restrictive covenants are likely to influence the dividend policy decision of distressed firms. DeAngelo & DeAngelo [1990] find evidence that the history of the firm's dividend record is important, and strategic motivations also matter. Examples of the latter are bargaining situations with organized labor or other stakeholder groups. This suggests that some managers may view dividend omissions as a credible signal of impending financial distress. Since dividend policy decisions represent observable events, it would be interesting to examine the relationship between dividends and management turnover.

Ch. 28. Financial Distress, Bankruptcy and Reorganization

955

Stated differently, do dividend policy decisions convey information to markel participants about the quality of management, and hence signal whether the incumbent team should be replaced? An investigation of the linkage between observable policy decisions, management turnover, and subsequent firm performance represents a fruitful area of future research.

Appendix A.1. Financial distress': theory AUTHORS a

MAIN FINDINGS

Modigliani & Miller [1958, corollary], Stiglitz [1974]

Bankruptcy is inconsequential to firm value under perfect and frictionless capital markets.

1. Bankruptcy and corporate financial policy

Kraus & Litzenberger [1973], The costs of bankruptcy serve as a countervailing force against tile Scott [1976], Kim [1978] corner solution of the Modigliani-Miller [1963] tax-adjusted model, giving rise to optimal capital structure and the observed limits on the usage of debt.

2. Liquidation and bankruptcy Haugen & Senbet [1978, 1988]

Titman [1984]

Liquidation, the process of dismantling the firm's assets and selling them (either piecemeal or in their entirety) to new management teams, is independent of the way the firm is financed, and hence bankruptcy and liquidation are independent events. A highly profitable firm with high leverage may remain viable as a going concern, irrespective of bankruptcy, while an unprofitable firm may be liquidated even if it has no debt in its capital structure. Because of costs imposed on customers when the firm liquidates, equityholders may promote a capital structure that results in a (binding) suboptimal liquidation policy.

White [1989]

Because of agency conflicts where claimants act in their own best interest, some profitable firms may get liquidated while some unprofitable firms may not get liquidated.

Haugen&Senbet [1978, 1988]

The costs of resolving financial distress must be bounded by the lower of (a) costs of formal reorganization involving the court system, or (b) transaction costs of informal reorganization through financial markets or private workouts. It is argued that the present value of transaction costs are insignificant at the time of capital structure decisions, and hence bankruptcy costs, that affect capital structure choices, are insignificant. Bankruptcy will be taken out of the courts and 'privatized', because large potential costs of formal reorganization provide incentives for the parties to accomplish informal reorganization more efficiently outside the courtroom.

3. Debt restructurings and private workouts

Jensen [1989, 1991]

a Not all authors are included. See the text for more writers on the subject matter.

956 Berkovitch & Israel [1992]

G r o s s m a n & Hart [1980]

L.W. Senbet, J.K. Seward The choice between a private workout and bankruptcy declaration under Chapter 11 is a strategic decision. The optimal choice minimizes the value loss due to investment distortions from underinvestment and risk-shifting problems.

4. Potential impediments to privatization of financial distress The free rider problem: Claimants may not be willing to tender their claims in an informal reorganization so as to capture the potential increase in value that would occur in an informal reorganization. This may preclude an exchange offer or market-based solution.

G r e c n & Juster [1992]

The firm's decision to exchange or repurchase outstanding debt is separable in terms of the a m o u n t of debt to repurchase, and the price to offer in the exchange. Also, delaying the timing of renegotiation can reduce the free rider problem.

Bulow & Shoven [1978], Brown [1989], White [1989]

Coalition formation: Conflicts of interest can reduce overall economic efficiency, because coalitions of claimants can be formed to extract concessions (e.g., wealth transfers) from other nonaligned claimants. For instance, coalition comprising equity/bank will have an incentive to reorganize, whereas senior claimants will have an incentive to force liquidation. This conflict may prevent private workouts.

G i a m m a r i n o [1989]

Information asymmetry: Because insiders know more about the true value of the company, outsiders (senior claimants) may find it in their best interest to use a court-imposed solution that results in deadweight costs even if private reorganization is costless.

Heinkel & Z e c h n e r [1993]

A firm's insiders may attempt to misrepresent the company's solvency position. This informational problem can be mitigated by debt features such as the repayment schedule, and institutional features such as deviations from APR.

G e r t n e r & Scharfstein [1991] Exchange oilers may not restore efficient investment incentives as a result of coordination problems between public debtholders. Underinvestment occurs with senior bank debt and short-term public debt protected by covenants. Formal bankruptcy helps to solve the coordination problem.

5. The role of markets and complex financial securities in the resolution of financial distress Roe [1983]

A sale of 10% of equity can be used to calculate aggregate value. A reorganized capital structure should be all-equity to overcome the problem of valuing reorganized claims.

Baird [1986]

Since reorganization is a hypothetical sale, while auctions are an actual sale, an auction of company assets is preferable in a formal reorganization.

Bebchuck [1988], Aghion, Hart & Moore [1992]

Option contracts can be issued to claimants in a company that enforces absolute priority rule and avoids strategic actions. It will also be insensitive to the valuation problem.

Easterbrook [1990]

Auctions or private reorganizations may be used when they are superior to a legal solution. Likewise, the converse is true as 'legal rules endure because they are efficient (or transfer wealth)'.

H a u g e n & Senbet [1988], Senbet & Seward [1991]

Simple (ex-ante) features in corporate charters and bond indentures can mitigate the free-rider problem. T h e provisions in the existing bankruptcy code may enhance or impede private workouts or market-based solutions.

Ch. 28. Financial Distress, Bankruptcy and Reorganization Z e n d e r [1991]

957

Bankruptcy is a means to transfer decision-making power from debtors to creditors. Such control right transfers can improve the efficiency of investment decisions.

Dewatripont & Tirole [1992] Generalize the concept of control transfer into the design of capital structure and managerial contracts. An optional financial structure exists by trading-off excessive interference of debtholders in managerial decisions against the passivity of equity claimants.

A. 2. F i n a n c i a l distress." empirical AUTHORS

MA1N FINDINGS

Gilson, John & Lang [1990]

T h e larger the proportion of assets that were intangible, of debt held by banks, and less the n u m b e r of classes of debtholders then the greater the chance that a private restructurings would be successful. Successful private restructuring were associated with an abnormal positive stock price performance relative to stock price reactions associated with formal restructurings.

Asquith, Gertner & Scharfstein [1991]

Examined the restructuring activities of companies which issued high yield bonds.

1. Debt restructurings

2. Direct costs of bankruptcy Warner [1977]

Direct costs of 5.3% (average) of market value a t a n n o u n c e m e n t of bankruptcy of firm for 11 large railway companies. Economies of scale in direct costs appears to exist.

Altman [1984]

Direct costs of 4% of market value of equity plus book value of debt at a n n o u n c e m e n t of bankruptcy for a retailing sample and 6% for an industrial sample.

Weiss [1990]

A sample of 31 firms from 1980-1986 reported a mean of 20.6% (range 2.0-63.6%) of equity value or 3.1% of the book value of debt plus equity value (range 1.0-6.6%). This was 2.9% of book value of assets. T h e direct costs of exchange olferings was found to be, on average, 0.65% of the book value of assets (median 0.32%) with a range of 0.01%-3.4%. Economies of scale appeared to exist for direct exchange costs. See the text for a comprehensive discussion.

Gilson, John & Lang [1990]

3. Indirect costs of financial distress Altman [1984]

By using unexpected losses as a proxy for indirect costs it was found that 11-17% of firm value as m e a s u r e d up to 3 years before bankruptcy was consumed as indirect costs.

Lang & Stulz [1992]

Intra-industry effects of bankruptcy a n n o u n c e m e n t s were studied by investigating the share price reactions of competing firms. The positive competitive effect was detected for concentrated industries.

Cutler & S u m m e r s [1988]

In the Texaco-Pennzoil litigation the shareholders wealth declined by $3 billion, significantly exceeding most estimates of direct costs and hence consistent with indirect costs.

4. Management, governance, and ownership Gilson [1989]

Selecting the bottom 5% of companies on the NYSE and A M E X (ranked by returns) as a sample of economically distressed firms,

958

DeAngelo & DeAngelo [1990] Gilson [1990]

Weiss [1990]

Franks & Torous [1989] Eberhart, Moore & Roenfeldt [1990]

Harris & Raviv [1993]

L.W. Senbet, J.K. Seward those that were also financially distressed experienced management (including directors) turnover of 52%. This was significantly greater than the nonfinancially distressed firms. Companies that restructured privately had lower turnover. 78.6% of 42 firms that were financially distressed cut dividends, even when covenants were nonbinding. Of II 1 financially distressed firms only 46% of incumbent directors and 44% of CEOs remained after 4 years. Other changes included more covenants and larger block shareholders (which included creditors).

5. Deviations from the absolute priority rule APR violations were reported in 29 out of 37 cases examined. The deviations were mainly at the expense of unsecured creditors for the benefit of equityholders and other junior security. APR deviations were worst in the case of large firms with complex capital structures. Of a sample of 39 firms in Chapter 11, 21 firms exhibited deviations from APR. In some cases the deviations were substantial. 23 APR deviations were reported for 30 cases examined. The mean violation was 7.5% (range 0-35.71%) of total awards to claimants. Evidence was presented for the equity markets anticipating subsequent deviations and pricing them efficiently. Demonstrate that the role of the court in an efficient bankruptcy procedure is to impose limits on the extent of liquidation via involuntary debt forgiveness in high liquidation cost states. Hence, deviations from APR are endogenous in their bankruptcy procedure recommendation.

Acknowledgements We t h a n k Philip O ' C o n n o r for research assistance. C o m m e n t s on an earlier v e r s i o n o f t h e p a p e r by E d w a r d A l t m a n , D a v i d T. B r o w n , S t u a r t G i l s o n , a n d R i c k Green are gratefully acknowledged.

References Aghion, E and R Bolton (1988). An 'incomplete contract' approach to bankruptcy and the financial structure of the firm, unpublished manuscript, MIT. Aghion, R, O. Hart, and J. Moore (1992). The economics of bankruptcy reform, unpublished manuscript, MIT Aharony, J., C. Jones, and I. Swary (1980). An analysis of risk and return characteristics of corporate bankruptcy using capital market data. J. Finance 35, 1001-1016. Aharony, J. and I. Swary (1983). contagion effects of bank failures: Evidence from capital markets. J. Bus. 56, 305-322. Airman, E. (1984). A further empirical investigation of the bankruptcy cost question. J. Finance 39, 1067-1089. Altman, E. (1993). Corporate Financial Distress. and Bankruptcy John Wiley and Sons, Inc., New York, NY.

Ch. 28. F i n a n c i a l Distress, B a n k r u p t c y a n d R e o r g a n i z a t i o n

959

Ang, J., J. Chua, J. McConnel (1982). The administrative costs of corporate bankruptcy: A note. jr. Finance 37, 219-226. Asquith, E, R. Gertner, and D. Scharfstein (1991). Anatomy of financial distress: An cxamination of junk-bond issuers, unpublished manuscript, MIT and University of Chicago. Baird, D. (1986). The uneasy case for corporate reorganizations. J. Legal Studies 15, 127-147. Baldwin, C. and S. Mason (1983). The resolution of claims in financial distress: The case of Massey Ferguson. Z Finance 38, 505-516. Bebchuck, L. (1988). A new approach to corporate reorganizations. Harvard L a w Rev. 101,775-804. Bergman, Y., and J. Callen (1991). Opportunistic underinvestment in debt renegotiation and capital structure. J. Financ. Econ. 29, 137-171. Berkovitch, E. and R. Israel (1992). The bankruptcy decision and debt contrat renegotiations, unpublished manuscript, University of Michigan. Betker, B. (1990). An analysis of the returns to stockholders and bondholders in a Chapter 11 reorganization, unpublished manuscript, UCLA. Bradley, M. and M. Rosenzweig (1992). The untenable case for Chapter 11. Yale L a w .L 101, 1043-1095. Brown, D. (t989). Claimholder incentive conflicts in reorganization: The role of bankruptcy law. Rev. Financ.Studies 2(1), 109-123. Brown, D., C. James and R. Mooradian (1992a). The information content of distressed restructurings involving public and private debt claims, unpublished manuscript, University of Florida. Brown, D., C. James and R. Mooradian (1992b). Asset sales by financially distressed firms, unpublished manuscript, University of Florida. Bulow, J. and J. Shoven (1978). The bankruptcy decision. Bell J. Econ. 9, 437-456. Clark, T. and M. Weinstein (1983). The behavior of the common stock of bankrupt firms. J. Finance 38, 489-504. Colfee, J. and W. Klein (1991). Bondholder coercion: The problem of constrained choice in debt tender offers and recapitalizations, unpublished manuscript, Columbia Law School and UCLA Law School. Cutler, D. and L. Summers (1988). The costs of conflict resolution and financial distress: Evidence from the Texaco-Pennzoil litigation. Rand J. Econ. 19, 157-172. DeAngelo, H. and L. DeAngelo (1990). Dividend policy and financial distress: An empirical investigation of troubled NYSE firms. J. Finance 45, 1415-1431. Dewatripont, M. and J. Tirole (1992). A theory of debt and equity: Diversity of securities and manager-shareholder congruence, unpublished manuscript, MIT. Easterbrook, E (1990). Is corporate bankruptcy efficient? J. Financ. Econ. 27, 4ll-417. Eberhart, A., W. Moore, and R. Roenfeldt (1990). Security pricing and deviations from the absolute priority rule in bankruptcy proceedings. J. Finance 45, 1457-1470. Eberhart, A., and L2 Senbet (1992). Absolute priority rule violations and risk incentives for financially distressed firms, unpublished manuscript, Georgetown University and University of Maryland. Eberhart, A., and R. Sweeney (1992). Bond prices as unbiased forecasts of bankruptcy settlements, J. Finance 47, 943-980. Eisenberg, T. (1992). Baseline problems in assessing Chapter 11, unpublished manuscript, Cornell University. Fama, E. (1980). Agency problems and the theory of the firm. J. Polit. Econ. 88, 288-307. Fortgang, C. and T.M. Mayer (1985). Valuation in bankrutpcy. UCLA L a w Rev. 32, 1061-1132. Franks, J. and W. Torous (1989). An empirical investigation of U.S. firms in reorganization. J. Finance 44, 747-770. Gertner, R. and D. Scharfstein (1991). A theory of workouts and the effects of reorganization law. J. Finance 46, 1189-1222. Giammarino, R. (1989). The resolution of financial distress. Rev. Financ. Studies 2(1), 25-47. Gilson, S. (1989). Management turnover and financial distress. J. Financ. Econ. 25, 241-262.

960

L.W. Senbet, J.K. S e w a r d

Gilson, S. (1990). Bankruptcy, boards, banks and blockholders: Evidence on changes in corporate ownership and control when firms default. J. Financ. Econ. 27, 355-388. Gilson, S., K. John, and L. Lang (1990). Troubled debt restructurings: An empirical study of private reorganization of firms in default. J. Financ. Econ. 27, 315-353. Gilson, S. and M. Vetsuypens (1993). CEO compensation in financially distressed firms: An empirical analysis. J.Finance 48, 425-458. Green, R. and A. Juster (1992). The structurc and timing of debt renegotiations by financially distressed firms, unpublished manuscript, Carnegie-Mellon University. Grossman, S. and O. Hart (1980). Takeover bids, the free-rider problem and the theory of the corporation. Bell J. Econ. 11, 42-64. Harris, M. and A. Raviv (1990). Capital structure and the informational role of debt..I. Finance 45, 321-349. Harris, M. and A. Raviv (1991). The theory of capital structure..1, tqnance 46, 297-356. Harris, M. and A. Raviv (1993). The design of bankruptcy procedures, unpublished manuscript, University of Chicago. Hart, O. and J. Moore (1989). Default and renegotiation: A dynamic model of debt, unpublished manuscript, MIT. Haugen, R. and L. Senbet (1978). The insignificance of bankruptcy costs to the theory of optimal capital structure. J. Finance 33, 383-392. Haugen, R. and L. Senbet (1988). Bankruptcy and agency costs: Their significance to the theory of optimal capital structure. J. Financ. Quant. Anal. 23, 27-38. Heinkel, R. and J. Zechner (1993). Financial distress and optimal capital structure adjustments, unpublished manuscript, University of British Columbia. Hoshi, T, A. Kashyap and D. Scharfstein (1990). The role of banks in reducing the costs of financial distress in Japan. J. Financ. Econ. 27, 67-88. Jensen, J. (1991). Corporate control and the politics of finance. J. Appl. Corp. Finance 4, 13-33. Jensen, M. (1989). Active investors, LBOs, and the privatization of bankruptcy. J. Appl. Corp. Finance 2, 35-44. Jensen, M. and W. Meckling (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure, .1. Financ. Econ. 3, 305-360. Johnson, D. (1989). The risk behavior of equity of firms approaching bankruptcy. J. Financ. Res. Nil(l), 33-50. Kim, E.H. (1978). A mean-variance theory of optimal capital structure and corporate debt capacity. J. Finance 33, 45-64. Kraus, A. and R. Litzenberger (1973). A state:preference model of optimal financial leverage. J. Finance 28, 911-922. Lang, L. and R. Stulz (1992). Contagion and competitive intra-industry effects of bankruptcy announcements: An empirical analysis, New York University and Ohio State University, unpublished manuscript. McDaniel, M. (1986). Bondholders and corporate governance. Bus. Lawyer 41, 413-460. McMillan, H., R. Nachtmann and F. Phillips-Patrick (1990). Costs of reorganizing under Chapter 11: Some evidence from the 1980% SEC working paper. Merton, R. (1974). Theory of rational option pricing, Bell Z Econ. Manage. Sci. 4, 141-183. Merton, R. (1990). The financial system and economic performance..1. Financ. Senz Res. 4, 263300. Miller, M. (1977). Debt and taxcs. Y. Finance 32, 261-275. Miller, M. (1991). Leverage. J. Finance 46, 479-488. Modigliani, F. and M. Miller (1958). The cost of capital, corporation finance, and the theory of investment. Am. Econ.Rev. 48, 261-297. Modigliani, E and M. Miller (1963). Corporate income taxes and the cost of capital. Am. Econ. Rev. 53, 433-443. Morse, D. and W. Shaw (1988). Investing in bankrupt firms. J. Finance 43, 1193-1206. Myers, S. (1977). Determinants of corporate borrowing. Z Financ. Econ. 5, 147-176.

Ch. 28. Financial Distress, Bankruptcy a n d Reorganization

961

Roe, M. (1983). Bankruptcy and debt: A new model for corporate reorganization. Columbia Law Rev. 83, 527-602. Roe, M. (1987). The voting prohibition in bond workouts. Yale Law J. 97, 232-279. Rohmau, M. and M. Policano (1990). Financing Chapter 11 companies in the 1990s. di Appl. Corp. Finance 5, 96-101. Schwartz, A. (1981). Security interests and bankruptcy priorities: A review of current theories. J. Legal Studies 10, 1-37. Scott, J. (1976). A theory of optimal capital structure. Bell J. Econ. 7, 33-54. Senbet, L. and J. Seward (1991). A market-based reform of the bankruptcy process, unpublished manuscript, University of Maryland and Dartmouth College. Shleifer, A. and R. Vishny (1992). Liquidation values and debt capacity: A market equilibrium approach. J. Finance 47, 1343-1366. Smith, C. and J. Warner (1979). On financial contracting: An analysis of bond covenants. J. Financ. Econ. 7, 117-161. Stigtitz, J. (1974). On the irrelevance of corporate financial policy. Am. Econ. Rev. 64, 851-866. Stulz, R. and H. Johnson (1985). An analysis of secured debt. J. Financ. Econ. 14, 501-521. Titman, S. (1984). The effect of capital structure on a firm's liquidation decision. J. Financ. Econ. 137-152. Triantis, G. (1992). Relational stakeholder contracts in bankruptcy, University of Toronto, unpublished manuscript. Walsh, J. and J. Seward (1990). On the efficiency of internal and external corporate control mechanisms. Acad. Manage. Rev. 15, 421-458. Warner, J. (1977). Bankruptcy, absolute priority, and the pricing of risky debt claims. J. Financ. Econ. 4, 239-276. Warner, J., R. Watts and K. Wruck (1988). Stock prices and top management changes. J. Financ. Econ. 20, 461-492. Webb, D. (1985). The importance of incomplete information in explaining the existence of costly bankruptcy, unpublished manuscript, London School of Economics. Webb, D. (1987). The importance of incomplete information in explaining the existence of costly bankruptcy. Economica 54, 279-288. Weiss, L. (1990). Bankruptcy resolution: Direct costs and violation of priority of claims. J. Financ. Econ. 27, 285-314. Weiss, L. (1991). Bankruptcy judges overstepping their bounds: Commentary, unpublished manuscript, Tulane University. White, M. (1989). The Corporate bankruptcy decision. J. Econ. Perspect. 3, 129-151. White, M. (1990). Bankruptcy liquidation and reorganization, in: D.E. Logue (ed.), Handbook of Modern Finance, Warren, Gorham & Lamont, New York. Wruck, K. (1990). Financial distress, reorganization, and organizational efficiency. J. Financ. Econ. 27, 419-444. Zender, J. (1991). Optimal financial instruments. J. Finance 46, pp. 1645-1663.