16.3How Chapter11 Bankruptcy Mitigates Debt Holder–Equity HolderIncentive Problems

This section discusses how some of the problems that arise because of the debt

holder–equity holder conflict can be mitigated in a Chapter 11 bankruptcy. Consider

again Lily Pharmaceuticals, described in Exhibit 16.1, which passed up a positive NPV

investment because of the debt overhang problem. Recall that firms suffer from debt

overhang when they have a substantial amount of existing debt with protective covenants

that prevent them from issuing additional debt that is senior to the existing debt.

By declaring Chapter 11 bankruptcy, a firm like Lily may be able to obtain addi-

tional financing that is senior to existing debt. The new debt obtained under Chapter11

is called debtor-in-possession (DIP) financing. DIPfinancing allows bankrupt corpo-

rations to raise the money necessary to fund investments that are required for its con-

tinued operation. In other words, Chapter 11 allows a bankrupt firm to obtain permis-

sion to violate the debt covenant that otherwise would keep the firm from obtaining

additional funds.

The Lily example provides some insights into why the federal bankruptcy code allows

for Chapter 11 bankruptcies. The original lenders to Lily are actually better off because

the weakening of their seniority allows the firm to make a good investment. Of course,

the firm could have avoided the Chapter 11 filing if its original debt was unprotected.

However, debt holders would not want to grant the firm an unrestricted ability to issue

new senior debt. By allowing the firm to issue senior claims only under extreme situa-

tions, Chapter 11 bankruptcies can create some of the advantages of unprotected debt while

avoiding some of the disadvantages. Of course, these advantages have to be weighed

against the efficiency losses and legal costs of going through the bankruptcy process.

Some of the efficiency losses in bankruptcy arise because the provision to obtain

DIPfinancing can allow a firm to continue operating when it would be better off liq-

uidating. As the last section showed, junior creditors have an incentive to keep a dis-

tressed firm operating if they stand to receive little from the firm’s liquidation. If the

senior debt has covenants that keep the firm from borrowing an additional amount, the

distressed firm is likely to be forced into bankruptcy. However, once the firm has

declared Chapter 11 bankruptcy, it can obtain DIPfinancing which allows the firm to

continue operating. This buys time and benefits the more junior claimants, but it may

keep a dying firm alive that would be worth more if it were liquidated.

Result 16.11

In Chapter 11 bankruptcy, firms are able to obtain debtor-in-possession (DIP) financing. Tosome extent, this provision of the bankruptcy code mitigates the debt overhang/underin-vestment problem. However, the provision also may allow some firms to continue operat-ing when they would be better off liquidating.