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Bankruptcy resolution: Direct costs and violation of priority of claims

Within the various classes of unsecured creditors (e.g., senior and subordinated debentures), strict priority of claims rarely holds. For example, in the White Motor reorganization plan, the senior unsecured bondholders received 61 percent of their claims; the senior unsecured creditors, 55 percent; the general unsecured creditors, 51 percent; and the subordinated unsecured bondholders, 14 percent. The lawyers interviewed either did not know or were unwilling to provide any insight into why the senior unsecured creditors were not fully repaid before the junior unsecured creditors received anything. The lawyers agreed that priority was largely ignored within the group of unsecured creditors but insisted the consensual settlements made everyone better off.

Priority of claims for the secured creditors is maintained in 92 percent (thirty-four/thirty-seven) of the cases in my sample. The three cases of violation are Crompton, Evans Products, and Stevcoknit. Crompton, a textile mill that produced corduroy and velveteen products, filed for bankruptcy in New York on October 23, 1984; its reorganization plan was confirmed 1,423 days later, on September 15, 1988. Priority broke down because of litigation by the unsecured creditors against the secured creditors. The unsecured creditors argued that the secured creditors were not entitled to payment from the surplus in Crompton's pension plan and Crompton's holdings of export-re- lated commercial paper. After prolonged negotiations, a settlement was reached whereby the secured creditors received 85 percent of their claims, the unsecured creditors received 20 percent of their claims, and the equity holders received nothing.

Evans Products, a supplier of building materials and home mortgages, was the first major case in which a creditor initiated reorganization plan was confirmed by the court. Evans Products filed for bankruptcy in Florida on March 11, 1985, and its reorganization plan was confirmed 478 days later, on July 2, 1986. Lawyers involved with the case assert that secured creditors decided to go forward with the effort and expense of a creditor plan when they were unable to reach a settlement with Victor Posner, a Miami-based reclusive acquirer and buyout specialist, who held a controlling interest in the company's stock. The plan froze out the equity holders, but to ensure its success, the secured creditors offered the unsecured creditors a sweetened deal. Unsecured creditors actually received a higher percentage of their claims (87 percent) than secured creditors (76 percent); their total claims, however, amounted to less than one-fourth of the secured creditors' claims. Many of the lawyers involved now believe that the secured creditors gave the unsecured creditors substantially more than was necessary to get the deal done.

Stevcoknit, a producer of knitted fabrics for sportswear, filed for bankruptcy in New York on November 16, 1981, and had its reorganization plan confirmed 424 days later, on January 18, 1983. According to lawyers involved in

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the case, the secured creditors accepted 57 percent of their claims because the market value of their collateral had fallen far below the value of their claims. Unsecured creditors received 33 percent of their claims, and equity holders were given an 11 percent share of the reorganized firm.

D. How priority of claims is violated

Discussions with lawyers indicate that two factors, firm size and location of bankruptcy, are important in predicting whether priority of claims will be violated. According to the lawyers, the larger, more complicated bankruptcies present more opportunities for equity holders and small groups of unsecured creditors to extract concessions from other creditors. Anecdotal evidence supports the lawyers' claim that different jurisdictions treat debtors differently, and debtors respond by filing in the district they think will be most favorable to them. A February 6, 1989, Miami Review article describes how the Southern District of Florida's chief bankruptcy judge is much tougher on debtors than judges in some other districts.

Bankruptcy falls under federal law and, except for certain state-law issues, should be uniform across the United States. To receive bankruptcy protection, a firm must file with the bankruptcy clerk in the United States court district where the firm had its principal place of business for the preceding 180 days, or where most of the firm's assets are located, or in a district that facilitates negotiations with creditors. Corporations with assets and operations in several jurisdictions have some latitude in deciding where to file.

Figures 16.1 and 16.2 illustrate, by firm size and location of bankruptcy filing, violation of priority of claims in the sample of bankruptcy resolutions. The larger firms and firms filing in New York are more likely to violate strict priority of claims. Strict priority is violated for all twenty firms having total assets over $100 million, fourteen of which filed in New York. For firms with less than $100 million in assets, strict priority holds in eight of seventeen cases, only one of which filed in New York. There appears to be a strong link between firm size and priority of claims.

The results on the treatment of creditors in different locations are less clear. Lawyers in both Florida and Illinois assert that judges and lawyers in their jurisdictions are more willing to freeze out equity holders than are judges and lawyers in New York. One lawyer interviewed about the Evans Products case stressed how New York lawyers involved in the case were willing to give the equity holders a sizeable piece of the reorganized company. Only after the New York lawyers became frustrated by Victor Posner's demands were the Florida lawyers able to persuade their New York colleagues to propose a creditor plan and freeze out the shareholders. Priority of claims held for only one

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25

20

20 h

15

10

Figure 16.1. Priority of claims by firm size: 37 firms filing between 1980 and 1986; TA= BV at fiscal year-end prior to filing.

Figure 16.2. Priority of claims by location: 37 firms filing between 1980 and 1986.

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of the 18 cases filed in New York, and in that case the firm's fortunes turned around during the bankruptcy so there were sufficient funds to repay all creditors in full. Priority of claims held for seven of the nineteen cases filed outside of New York.

Lawyers in New York acknowledge the high number of filings there and the favorable treatment of debtors. They say there is less fighting among parties in New York because of the greater sophistication of the creditors, the professional actions of the bankruptcy lawyers, and a willingness by creditors to compromise priority to settle the case quickly. No evidence, however, supports the lawyers' assertion that New York cases are resolved faster than cases filed in other parts of the country. The average time needed to resolve the New York cases is 974 days, compared with 850 days for the cases outside New York. The New York cases take longer than non-New York cases whether the cases examined are large or small (total assets of more or less than $100 million before the bankruptcy filing).4

The process of assigning judges to New York cases does not appear to be random as claimed by the court. As of August 1990, five bankruptcy judges (Abram, Buschman, Blackshear, Brozman, and Lifland) preside over all bankruptcy cases in the Southern District of New York. Of the eighteen New York cases examined, six (33 percent) were handled by the Honorable Burtan R. Lifland; the Honorable Prudence Abram and the Honorable Edward J. Ryan each handled three cases (17 percent each); the Honorable Howard C. Buschman III and the Honorable John J. Galgay each handled two cases (11 percent each); and the Honorable Cornelius Blackshear and the Honorable Joel Lewittes each handled one case. Too few cases were examined in each of the other districts for me to determine whether any particular judge dominated the larger cases filed there.

All the non-New York cases were filed in the jurisdiction where the firm's headquarters or principal place of business was located. Six of the eighteen firms filing in New York (Beker, HRT, KDT, Manville, Tacoma Boatbuilding, and Towle) did not have their headquarters or principal place of business in New York. The available evidence is insufficient to show why New York attracts a disproportionate share of the bankruptcy filings. New York may have more lawyers and judges with the expertise to work on large cases; it may be a convenient location for the firm and its creditors; it may happen to be the lo-

4 The larger New York cases (average total assets of $457 million) spend an average of 988 days from the filing of the bankruptcy petition to the court's confirmation of a reorganization plan, compared with 873 days for non-New York cases (average total assets of $691 million). The smaller New York cases (average total assets of $61 million) average 925 days in bankruptcy, compared with 818 days for non-New York cases (average total assets of $34 million).

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cation of the firm's headquarters and/or principal place of business; or New York judges may have different biases than judges in other districts. Whatever the reason, equity holders appear to receive better treatment in New York.

V. Conclusion

Bankruptcy represents a legal framework for recontracting when various interested parties cannot reach an accord following a firm's default on a debt contract. If either the direct costs of resolving a bankruptcy are high or creditors cannot be confident that priority of claims will be honored, creditors will require somewhat higher interest rates, raising the cost of corporate borrowing and altering the firm's capital structure. This chapter presents new evidence on the direct costs of bankruptcy and the degree to which priority of claims is violated in bankruptcy proceedings of NYSE and Amex firms.

I find lower direct costs of bankruptcy than previous researchers, a finding that may be explained by differences in the size and type of firms studied, the methods used to calculate firm size, the time periods considered, or changes in the bankruptcy law. On average, direct costs of bankruptcy are 3.1 percent of the book value of debt plus the market value of equity at the fiscal year end prior to the bankruptcy filing, with a range from 1 percent to 6.6 percent. These low direct costs, as demonstrated by Warner (1977a), will have little or no impact on the pricing of claims prior to bankruptcy.

Priority of claims is violated in twenty-nine of the thirty-seven cases examined. Unsecured creditors are frequently denied priority over both equity holders and lower-ranked unsecured creditors. Secured creditors receive their full claim in all but three of the thirty-seven cases. Creditors are likely to demand higher interest rates to compensate them for the violation of priority of claims that occurs in bankruptcy.

Equity holders of larger firms appear to fare better than their smaller-firm counterparts, probably because junior claimants are better able to delay the resolution in the larger, more complex cases, and to threaten the loss of taxloss carryforwards. The disproportionate number of cases in which equity holders in New York receive some compensation in violation of priority of claims, combined with the disproportionate number of cases filed there, seems to indicate that debtors may shop around for the best place to file - and correctly choose New York. Of all the cases where priority of claims held, only one was in New York. Because New York is the headquarters for a majority of the larger firms studied, however, it may simply be a proxy for firm size and complexity of capital structure.

Olson (1965) declares that "unless the number of individuals in a group is quite small, or unless there is coercion or some other special device to make

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individuals act in their common interest, rational, self-interested individuals will not act to achieve their common or group interest." Bankruptcy is a social institution designed to deal with just such a collective-action problem by:

1.preserving the value of the firm and preventing premature liquidation after the firm has defaulted on its debt; and

2.enforcing creditors' rights.

Bankruptcy has always sought to prevent creditors from racing to grab assets; however, there is no reason it could not deliver the reorganized firm into the hands of the creditors and keep the stockholders in their place as residual claimants. A lack of belief in markets may be the underlying reason the law perceives it necessary to allow violation of priority of claims.

References

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Journal of Finance 1067-89 (1984).

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Ang, J.S., Chua, J.H., and McConnell, J.J., "The Administrative Costs of Corporate Bankruptcy: ANote," 37 Journal of Finance 219-26 (1982).

Baird, D. and Jackson, T., "Corporate Reorganizations and the Treatment of Diverse Ownership Interests: A Comment on Adequate Protection of Secured Creditors in Bankruptcy," 51 University of Chicago Law Review 97-130 (1984).

Baldwin, C. and Mason, S., "The Resolution of Claims in Financial Distress: The Case of Massey Ferguson," 38 Journal of Finance 505-23 (1983).

Barrickman, R., Business Failure: Causes, Remedies, and Cures, University Press of American, Washington, DC (1979).

Cohen, D., "Subordinated Claims: Their Classification and Voting Under Chapter 11 of the Bankruptcy Code," 56 American Bankruptcy Law Journal, 293-324 (1982).

Demsetz, H., "When Does the Rule of Liability Matter?" 1 Journal of Legal Studies, 13-28 (1972).

Dodd, P. and Leftwich, R., "The Market for Corporate Charters: Unhealthy Competition Versus Federal Regulation," 53 Journal of Business, 259-83 (1980).

Easterbrook, F. and Fischel, D., "Corporate Control Transactions," 91 Yale Law Journal, 698-737 (1982).

Eberhart, A., Moore, W, and Roenfeldt, R., Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings, Working paper (Georgetown University, Washington, DC and University of South Carolina, Columbia, South Carolina) (1990).

Franks, J. and Torous, W, "An Empirical Investigation of U. S. Firms in Reorganization," 44 Journal of Finance, 747-69 (1989).

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Jackson, T., "Of Liquidation, Continuation, and Delay: An Analysis of Bankruptcy Policy and Nonbankruptcy Rules," 60 American Bankruptcy Law Journal, 399-428 (1986).

Jackson, T., The Logic and Limits of Bankruptcy Law, Harvard University Press, Cambridge, Mass. (1987).

Jensen, M. and Meckling, W., "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," 3 Journal of Financial Economics, 305-60 (1976).

LoPucki, L., "The Debtor in Full Control - Systems Failure Under Chapter 11 of the Bankruptcy Code?" 57 American Bankruptcy Law Journal, 99-126, 247-73 (1983).

Meckling, W., "Financial Markets, Default, and Bankruptcy: The Role of the State," 41

Law and Contemporary Problems, 13-28 (1977).

Meckling, W., "Discussion - The Economics of Bankruptcy Reform," 41 Law and Contemporary Problems, 124-77(1977).

Miller, M., "The Wealth Transfer of Bankruptcy," 41 Law and Contemporary Problems, 39-46 (1977).

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Praeger, New York, NY (1981).

Nimmer, R., "Executory Contracts in Bankruptcy: Protecting the Fundamental Terms of the Bargain," 54 University of Colorado Law Review, 507-54 (1983).

Olson, M., The Logic of Collective Action, Harvard University Press, Cambridge, Mass. (1965).

Raiffa, H., The Art and Science of Negotiation, Harvard University Press, Cambridge, Mass. (1982).

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lumbia Law Review, 527-602 (1983).

Smith, C. and Warner, J., "On Financial Contracting - An Analysis of Bond Covenants," 7 Journal of Financial Economics, 117-61 (1979).

Stanley, D. and Girth, M., Bankruptcy: Problems, Process, Reform, Brookings Institution, Washington, DC (1971).

Warner, J., "Bankruptcy Costs: Some Evidence," 32 Journal of Financial Economics, 331-41 (1977a).

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White, M., "Bankruptcy Costs and the New Bankruptcy Code," 38 Journal of Finance, 477-504 (1983).

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CHAPTER 17

The costs of conflict resolution and financial distress: Evidence from

the Texaco-Pennzoil litigation*

DAVID M. CUTLER**

LAWRENCE H. SUMMERS***

I. Introduction

From 1984 to 1988 Texaco and Pennzoil were engaged in a legal battle over Texaco's usurpation of Pennzoil in the takeover of the Getty Oil Company. The stakes were huge: the original jury award called for a payment of more than $10 billion; the companies ultimately settled for $3 billion. The TexacoPennzoil case presents a unique experiment for studying debt burdens and bargaining costs. Market assessments of the prospects of both parties in a prolonged dispute are rarely as observable as they are in the Texaco-Pennzoil case. Further, unlike in most other litigation settings and in almost all bankruptcy cases, the burden imposed on Texaco did not have a collateral effect on future cash flows.

This article examines the abnormal returns earned by the shareholders of Texaco and Pennzoil over the course of the dispute.1 A clear pattern emerges. Events affecting the size of the transfer resulted in opposite but asymmetric returns to the two companies. When its obligation to Pennzoil was increased, Texaco's value fell by far more than Pennzoil's rose; the opposite reaction occurred for events reducing the expected transfer. These "leakages" in value were enormous: each dollar of value lost by Texaco's shareholders was matched by only about forty cents' gain to the owners of Pennzoil. The ongo-

*This chapter is an edited version of the article that originally appeared in 19 Rand Journal of Economics, 157 (1988). Permission to publish excerpts in this book is gratefully acknowledged.

**Massachusetts Institute of Technology.

***Harvard University and National Bureau of Economic Research.

1After circulating an early draft of this article, we became aware of work by Engelmann and Cornell (1988) on the wealth effects of several large corporate disputes, including the TexacoPennzoil case. They note the asymmetric returns as well, but concentrate on events at the beginning of the case. Bhagat, Brickley, and Coles (1987) examine stock price movements to news in a large number of corporate legal cases and obtain similar results. Mnookin (1987) discusses the reasons Texaco and Pennzoil failed to settle the litigation earlier. Baldwin and Mason (1983) in related work examine the market reaction to the Massey Ferguson bankruptcy case and find that the resolution of the bankruptcy resulted in a substantial increase in the value of the company.

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ing dispute reduced the combined equity value of the two companies by $3.4 billion, over 30 percent of the joint value of the two companies before the dispute arose. A large fraction of the losses in combined value was restored when the case was settled. The precise impact of the settlement is difficult to gauge, however, because of the coincidence between the case's settlement and takeover threats to Texaco.

After documenting these large fluctuations in joint value, we seek to identify their causes. One explanation is the fees that both companies paid to the many lawyers, investment bankers, and advisors that were retained. These costs seem too small to account for the large swings in joint value, however. A second explanation is that a settlement would have been wasted by Pennzoil and thus was discounted by the market. This explanation seems inconsistent with the large increase in value after the resolution of the dispute, however. It appears either that there were additional costs to Texaco's shareholders that were relieved by the settlement, or that the claims on the two companies were valued inefficiently during the litigation.

We conclude by discussing a number of implications for economic analysis. First, the large losses illustrate that efficient bargains will not always be struck, even when neither side possesses much relevant private information. Second, the losses suggest that financial conflict can have substantial effects on productivity. This has implications for bankruptcy-cost explanations of firms' debt-equity choices, macroeconomic theories that stress credit disruptions as an important element in business-cycle fluctuations, and arguments that debt relief for major debtor nations would make all parties to the LDC debt crisis better off.

II. The Texaco-Pennzoil Conflict

The Texaco-Pennzoil dispute arose from the bids both companies made to acquire Getty Oil.2 On January 2, 1984, Pennzoil reached what it felt was a binding agreement with the directors of Getty Oil to acquire three-sevenths of Getty. Within a week of the Pennzoil-Getty proposed sale, however, Texaco purchased all of the Getty stock at a higher price per share. As a condition of the sale, Texaco indemnified Getty and its largest shareholders against any possible litigation. Thus, when Pennzoil sued for breach of contract, Texaco became liable for damages.

The case ultimately was brought before the Texas State Court and was tried in mid-1985. Adecision was reached on November 19,1985 (event 1) in favor

2 The description of the dispute here is necessarily brief. Entertaining narrative histories of the Getty case may be found in Petzinger (1987) and Coll (1987). We have also drawn heavily on the ongoing reporting of The Wall Street Journal and the New York Times.

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