The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in the United States and model bankruptcy as a strategic decision. We analyze a firm's choice between liquidation under Chapter 7, renegotiation of the debt contract in a workout, and reorganization under Chapter 11 of the bankruptcy code. Our premise is that a financially distressed firm chooses its action in order to minimize the loss in value caused by the well-known over- and under-investment problems. We show that the firm initiates a workout when it faces under-investment, and commences Chapter 11 when it faces over-investment. Some of the results are: (i) in default, total firm value and equity value increase upon the announcement of a workout and decrease upon the announcement of Chapter 11; (ii) firms with shorter maturity of debt are more likely to reorganize in a workout; (iii) among the firms that renegotiate their debt contract, the proportion of firms entering Chapter 11 is higher for firms in mature industries than for firms in growth industries.     

The Bankruptcy System's Chapter 22 Recidivism Problem: How Serious is It?

This paper is adapted from the keynote address from the Eastern Finance Association's 2014 meeting in Pittsburg, Pennsylvania. We highlight a recidivism problem: about 15% of debtors who emerge as continuing entities under Chapter 11, or are acquired as part of the bankruptcy process, ultimately file for bankruptcy protection again (18.25% when considering only those firms which emerge as a continuing, independent entity). We argue that the “Chapter 22” issue should not be dismissed by the bankruptcy community just because no interested party objects during the confirmation hearing. Applying the Z”‐Score model to a large sample of Chapter 11 cases reveals highly different and significant expected survival profiles at emergence. Credible distress prediction techniques can effectively predict the future success of firms emerging from bankruptcy and be used by the bankruptcy court to assess the feasibility of the reorganization plan, a requirement mandated by the Bankruptcy Code. Branch reviews, discusses, and critiques in this follow‐up article to Altman's original thesis.     

Asset Efficiency and Reallocation Decisions of Bankrupt Firms

This paper investigates whether Chapter 11 bankruptcy provides a mechanism by which insolvent firms are efficiently reorganized and the assets of unproductive firms are effectively redeployed. We argue that incentives to reorganize depend on the level of demand and industry conditions. Using plant-level data, we find that Chapter 11 status is much less important than industry conditions in explaining the productivity, asset sales, and closure conditions of Chapter 11 bankrupt firms. This suggests that firms that elect to enter into Chapter 11 incur few real economic costs.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in theUnited States and model bankruptcy as a strategic decision.We analyze a firm's choice between liquidation under Chapter7, renegotiation of the debt contract in a workout, and reorganizationunder Chapter 11 of the bankruptcy code. Our premise is thata financially distressed firm chooses its action in order tominimize the loss in value caused by the well-known over- andunder-investment problems. We show that the firm initiates aworkout when it faces under-investment, and commences Chapter11 when it faces over-investment. Some of the results are: (i)in default, total firm value and equity value increase uponthe announcement of a workout and decrease upon the announcementof Chapter 11; (ii) firms with shorter maturity of debt aremore likely to reorganize in a workout; (iii) among the firmsthat renegotiate their debt contract, the proportion of firmsentering Chapter 11 is higher for firms in mature industriesthan for firms in growth industries.     

Financial Restructuring in Fresh‐Start Chapter 11 Reorganizations

We find that firms substantially reduce their debt burden in “fresh‐start” Chapter 11 reorganizations, yet they emerge with higher debt ratios than what is typical in their respective industries. While cross‐sectional regressions reveal that post‐reorganization debt ratios are more in line with the predictions of the static trade‐off theory, they also reveal that pre‐reorganization debt ratios affect post‐reorganization debt ratios. Collectively, these results suggest that impediments in Chapter 11 prevent firms from completely resetting their capital structures. We also find that firms that reported positive operating income leading up to Chapter 11 emerge faster, suggesting that it is quicker to remedy strictly financial distress than economic distress.     

Post-Chapter 11 Bankruptcy Performance: Avoiding Chapter 22

Despite the long experience in the U.S. with restructuring companies in bankruptcy, there remains a persistent tendency for companies to emerge from Chapter 11 with too much debt and too little profitability. In this article, the author uses a variant of his well-known "Z-Score" bankruptcy prediction model to assess the future viability of companies when emerging from bankruptcy, including the likelihood that they will file again—a surprisingly common phenomenon that is now referred to as "Chapter 22."
The author reports that those companies that filed second bankruptcy petitions were both significantly less profitable and more highly leveraged than those that emerged and continued as going concerns. Indeed, the average financial profile and bond rating equivalent for the "Chapter 22" companies on emerging from their first bankruptcies were not much better than those of companies in default.
The authors findings also suggest that a credible corporate distress prediction model could be used as an independent, unbiased method for assessing the future viability of proposed reorganization plans. Another potential application of the model is by the creditors of the "old" company when assessing the investment value of the new package of securities, including new equity, offered in the plan.     

The Impact of Receiving Debtor-in-Possession Financing on the Probability of Successful Emergence and Time Spent Under Chapter 11 Bankruptcy

The ability to obtain financing is a critical element in attempting to successfully reorganise a firm which has declared Chapter 11 bankruptcy. Debtor-in-possession (DIP) financing has become an increasingly popular method in recent years. This paper examines whether receiving DIP financing is related to successful reorganisations and a shortened duration under Chapter 11 bankruptcy proceedings. This study finds that there is an increase in realised returns to equity at the announcement of DIP loan agreements which is positive and statistically significant. It is also found that DIP-financed firms have a reduced probability of liquidation, and shorter time spent under bankruptcy proceedings.     

Emerging from Chapter 11 Bankruptcy: Is It Good News or Bad News for Industry Competitors?

A firm under Chapter 11 bankruptcy protection may emerge from bankruptcy in a more advantageous competitive position within its industry to the detriment of their industry rivals. Using a sample of 264 firms that emerged from Chapter 11 bankruptcy during the period 1999-2006, I find that its industry competitors demonstrate negative postemergence long-term equity returns and deteriorating financial performance. Additional tests indicate that this outcome is less likely due to overall industry distress. Competitors tend to be more adversely affected if they are in more concentrated industries, if they have lower credit quality, when a more efficient firm emerges, and when the duration of bankruptcy is longer. This study suggests a need to reconsider Chapter 11's role in promoting competition and allocation of resources given its negative externalities on industry competitors.     

A Monitoring Role for Deviations from Absolute Priority in Bankruptcy Resolution

Firms that have successfully reorganized under Chapter 11 of the bankruptcy laws of the United States frequently award shares of common stock in the reorganized firm to pre‐bankruptcy shareholders, even though pre‐bankruptcy creditors' claims are not fully satisfied. Using a sample of large publicly traded firms, these deviations from absolute priority (DAPR) are found to be positively related to the severity of agency costs within a financially distressed firm. US bankruptcy laws may exacerbate these agency costs by granting exclusivity to management during the reorganization period. Firms in which outside shareholders are more concentrated have a lower occurrence of DAPR indicating that blockholders provide an effective monitoring mechanism for controlling managerial behavior during reorganization. On the other hand, firms without this monitoring mechanism have a higher probability of DAPR indicating that creditors attempt to control managerial behavior by providing them with some sort of financial compensation via their equity holding in the firm. Finally, the evidence indicates that DAPR can be used to mitigate the hold‐up problem resulting from voting rights granted to both junior and senior claimants of the firm by US bankruptcy laws.     

An Empirical Investigation of U.S. Firms in Reorganization

The purpose of this paper is to understand the institutional features of Chapter 11 from an empirical examination of thirty firms that have emerged from reorganization. We find the recontracting framework of Chapter 11 to be complex, lengthy, and costly. Violations of absolute priority in favor of stockholders are frequently encountered. These deviations may result from the bargaining process of Chapter 11 or from a recontracting process between creditors and stockholders which recognizes the ability of stockholder-oriented management to preserve firm value. An example of such recontracting addresses Myers' underinvestment problem. An investigation of the effects of Chapter 11 on the pricing of risky debt is also provided.     

Strategic Default and Equity Risk Across Countries

We show that the prospect of a debt renegotiation favorable to shareholders reduces the firm's equity risk. Equity beta and return volatility are lower in countries where the bankruptcy code favors debt renegotiations and for firms with more shareholder bargaining power relative to debt holders. These relations weaken as the country's insolvency procedure favors liquidations over renegotiations. In the limit, when debt contracts cannot be renegotiated, equity risk is independent of shareholders' incentives to default strategically. We argue that these findings support the hypothesis that the threat of strategic default can reduce the firm's equity risk.     

Does pre‐packed bankruptcy create value? An empirical study of postbankruptcy employment retention in The Netherlands

In recent years, there has been growing interest in whether pre‐packed bankruptcy can be a mechanism through which firms facing imminent insolvency can preserve value. Although an extensive body of literature exists on “pre‐packs,” whether such techniques really preserve value remains ambiguous. By analysing bankruptcy proceedings filed with Dutch courts in the period 2012–2018 through the lenses of real options and debt overhang theory, we examined employment retention postbankruptcy as a consequence of the type of bankruptcy proceeding (pre‐packed bankruptcy and conventional bankruptcy) and the severity of prebankruptcy financial distress. The results show that in the Netherlands, a pre‐packed bankruptcy, when compared with a conventional bankruptcy proceeding, positively impacts employment retention rates after bankruptcy. The severity of financial distress before bankruptcy does not affect employment retention rates postbankruptcy. This implies that despite the amount of resource slack, the preservation of employee value is better served under a pre‐packed bankruptcy than a conventional bankruptcy proceeding. This finding is important for insolvency practice, as up to 22 June 2017, employee rights in the Netherlands (including redundancy) were not considered to be automatically transferred to the firm acquiring the bankrupt debtor's assets when a pre‐packed bankruptcy was applied. Implications for insolvency regulation and practice are discussed.     

Earnings Management in Chapter 11 Bankruptcy

We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11. Using data on public US firms, we construct three measures of earnings management: a real activities manipulation measure (abnormal operating cash flows) and two accounting manipulation measures (discretionary accruals and abnormal working capital accruals). We find that, controlling for the impact of factors known to influence earnings management and firm survival in bankruptcy, earnings management prior to bankruptcy significantly reduces the likelihood of Chapter 11 plan confirmation and emergence from Chapter 11. The results are driven primarily by extreme values of earnings management, characterized by one or two standard deviations above or below the mean. The findings are consistent with creditors reacting positively to unduly conservative earnings reports and negatively to overly optimistic earnings reports. We also find that the presence of a Big 4 auditor is associated with a higher incidence of confirmation and switching to a Big 4 auditor before filing increases the incidence of emergence.     

Strategic Bankruptcies and Price Reactions to Bankruptcy Filings

This study investigates whether the stock market differentiates between firms that file bankruptcy petitions for strategic reasons and firms that file bankruptcy petitions for financial reasons. We perform both univariate and regression tests on a sample of 245 firms that filed Chapter 11 bankruptcy petitions between 1981 and 1996. After controlling for bankruptcy outcome, probability of bankruptcy, firm financial condition, and firm size, we find that, in the period around bankruptcy filing, firms that file bankruptcy petitions for financial reasons have significantly larger stock price declines than firms that file bankruptcy petitions for strategic reasons.     

Bankruptcy risk,costs and corporate diversification

This paper studies the impact of diversification on firms that file for Chapter 11 bankruptcy. Prior research suggests that diversification affects both the probability and costs of distress. Treating bankruptcy as a special case of distress, we find that diversification reduces the likelihood of bankruptcy and liquidation in Chapter 11, which is consistent with the coinsurance hypothesis. However, we observe higher bankruptcy costs as measured by time spent in Chapter 11 and inefficient segment investment for diversified firms. Our evidence is consistent with the idea that diversification provides benefits to managers in terms of job security rather than to firms. Our findings may help firms to make diversification decisions and creditors determine lending policies toward different forms of organizations.     

The effect of discretionary actions on small firms' ability to survive Chapter 11 bankruptcy

This paper analyzes whether judges' actions within Chapter 11 bankruptcy affect debtor firms' ability to reorganize (e.g., debt restructurings and mergers) as opposed to being liquidated in Chapter 7 bankruptcy. Our main finding is that debtor firms' control of the process, e.g., the exclusivity period, affects their ability to restructure debt. A reduction in the exclusivity period decreases the likelihood of reorganization, but increases the likelihood of deviation from absolute priority when plans of reorganization are agreed upon. An extension of the exclusivity period, however, does not increase the likelihood of either reorganization or deviation from absolute priority.     

ROUNDTABLE ON PRESERVING VALUE IN CHAPTER 11

In an article published in this journal in 1991, Michael Jensen describedthe U.S. bankruptcy system as "fundamentally flawed." As Jensen went on to say, "It is expensive, it exacerbates conflicts among different classes of creditors, and it often takes years to resolve individual cases. As a result of such delays, much of the operating value of viable businesses is destroyed and the value of creditors' claims is often dissipated in providing life support for terminal cases." Lending support for Jensen's claim, academic studies of financial reorganization in the 1980s reported that the cost of reorganizing companies in Chapter 11 tends to run as much as ten times the cost of out-of-court workouts.
In this roundtable, bankruptcy authority Thomas Jackson discusses the current state of Chapter 11 with a financial economist, a practicing bankruptcy attorney, and a corporate executive who recently helped lead his firm (Global Crossing) through a reorganization. According to Jackson, academic research has helped bring about notable improvements in the court-supervised reorganization process. The most important source of such improvements is the growing tendency to limit "exclusivity periods" and use auctions to solve information and incentive problems that plagued the traditional process. Though by no means a panacea, as the practitioners point out, the increased use of auctions is preserving value by effectively substituting the market's judgment for that of a bankruptcy court judge in both valuing the assets and determining who is most qualified to own and manage them.     

The Effect of Bankruptcy Protection on Investment: Chapter 11 as a Screening Device

Asymmetric information and conflicts of interest between equity and debt holders can force a distressed but efficient firm to liquidate and may enable a distressed inefficient firm to continue. In the extreme, if it is costless for an inefficient firm to mimic an efficient firm in a debt restructuring, efficient and inefficient firms are equally likely to continue or liquidate. This article shows that Chapter 11 procedures impose costs on inefficient firms that would otherwise mimic efficient firms. This separation induces voluntary filing for bankruptcy by inefficient firms and consequently enables efficient firms to continue when they would otherwise be liquidated.     

Is Chapter 11 Efficient?

The efficiency of the Chapter 11 bankruptcy process is examined by estimating the impact of Chapter 11 filings on the operating performance of bankrupt firms. We control for firm‐level heterogeneity in prefiling characteristics using matching methods to select benchmark firms comparable to filing firms. We compare bankrupt firms’ operating performances with those of matched nonbankrupt firms. Our results challenge the contention that Chapter 11 is an inefficient, debtor‐friendly mechanism that rehabilitates economically nonviable firms. We demonstrate that firms that file under Chapter 11 perform no worse and, if anything, better than comparable nonfiling firms.