Учебный год 2023 / Bhandari_J__Weiss_L_Corporate_Bankruptcy_Economic_and_Legal_Perspectives_1996

The costs of conflict resolution and financial distress

funds four times; earnings and previous taxes were thus clearly inadequate to offset the losses immediately.14 At year-end 1987, the company reported $4.9 billion in losses and write-offs.

Second, the distinction in the tax law between ordinary income and capital gains could have lowered the tax liability of Pennzoil upon any receipt in 1986 or 1987. By purchasing assets from Texaco at a below-market price, Pennzoil could have avoided all but capital gains taxes on the step-up in basis of the assets. Since a settlement of this type was considered the most likely source of payment in that period, the implied tax liability may have been based on the capital gains rate.

Third, Federal law stipulates that in cases of "involuntary conversion" of property into similar property or cash used to purchase similar property within two years, the recipient of the resulting capital gain is not liable for tax on the gain.15 It is possible that Texaco's payments to Pennzoil would qualify as an involuntary conversion x>f Getty assets and so would be untaxed. Pennzoil has stated that it intends to file such a claim. It is not clear whether an involuntary conversion claim would be accepted by the IRS, however.

The tax consequences of a settlement are thus uncertain, both for the liability upon receipt and for the deduction upon payment. A consideration of debt and taxes together, however, makes it clear that the claims of these creditors do not counter the large initial loss in value or the subsequent increase. Even if the market had anticipated that Texaco could not use any tax deductions, that the payment to Pennzoil would have been taxed at a 28 percent capital gains tax rate, and that the payment from Texaco to Pennzoil would have equalled Texaco's loss in value, not Pennzoil's gain in value, the tax liability in the presettlement stock prices would have come to only $950 million, which is less than the $1.5 billion loss suffered by Texaco's bondholders.16 Further, the settlement substantially increased debt value, although the agreement on a cash transfer might have implied a higher overall tax payment.17 We thus conclude that the effects on nonequity claimants cannot explain the equity losses, and that the fluctuations in equity value did not reflect transfers among claimants.

14Texaco's financial statements do not report the amount of tax-loss carryforwards the company has accumulated, but did indicate that Texaco had some loss carryforwards.

5An involuntary conversion is defined as: "(1) destruction of property in whole or in part; or

(2)theft; or (3) actual seizure; or (4) requisition or condemnation or threat or imminence of requisition or condemnation."

16Indeed, even if the loss in value were the result of expected taxes or payments to the litiga-

tion participants, it is still a puzzle why the companies did not regain this value by negotiating an agreement sooner.

17 If the market was expecting a 28 percent rate before the settlement, a $3 billion payment taxed at the 34 percent rate would be an increase in expected tax payments of $180 million.

291

BEYOND THE CREDITORS' BARGAIN

V. Where Did the Value Go?

One explanation for the large swings in value is that the money would have been paid to the bankruptcy lawyers, trustees, and other litigation participants that both companies hired, and that these costs were saved by the settlement. Certainly, lawyers on both sides were numerous, and legal fees were large.

It is difficult to believe that the market had expected future fees for the case to be as large as $2 billion, however. On August 27, 1987, Texaco announced that its legal fees since the original jury decision had been $55 million. Texaco also had to pay an estimated $3.5 million each month for the bankruptcy expenses of the company and of the creditor committees. Over a five-year period the present value of a continuation of these payments is about $250 million. Since legal fees are deductible from taxable income, the after-tax cost would have been only $165 million.

It is unclear how much the market had expected Pennzoil to pay in total legal fees. Pennzoil's lead attorney, Joe Jamail, handled most cases on a con- tingency-fee basis. When asked about his fees, he was known to joke that the only math he knew was how to "divide by thirds" (Petzinger, p. 20). Jamail, however, insisted that he had no set fee for the case, and claimed that he took the case to help his friends at Pennzoil. Estimates of fees could thus have varied widely.18

Future market reactions, however, suggest that Pennzoil's expected legal fees were not large relative to the loss. After the settlement Pennzoil announced on December 29, 1987, that its costs for the case were $400 million, $200 to $300 million of which was estimated to go to Jamail. The abnormal return for Pennzoil on that day was -$113.4 million, which suggests an expected fee of at most $200 million. Thus, even if Pennzoil had additional future and past fees equal to Texaco's, the after-tax legal payment for both companies would be only $525 million, or 15 percent of the loss in joint value. Further, the reduction in fees from the settlement would explain only 14 percent of the resulting increase in value.

A second explanation for the fluctuations in value is that Pennzoil would not use any funds it received from Texaco so efficiently as Texaco would. Such explanations are consistent with the findings of Jensen (1986) that free cash flow may be invested at below the market return, thus lowering the value of the

18 Most discussions of Jamail's fees indicated that Pennzoil and Jamail had yet to agree on a dollar amount, although it was certain to be less than Jamail's usual award. There was occasional speculation that his fees would be rather large. The Wall Street Journal reported that "[s]ome wellplaced Wall Street sources say they understood Mr. Jamail stands to collect 20 percent of the jury's award, which, if upheld, would result in a mind-boggling $2.4 billion for him" (November 21, 1985, sec. I, p. 2, col. 3). This was the only estimate this large, however, and the amount was never repeated. Given the future stock market reaction, it seems reasonable to conclude that this figure was an overestimate of market expectations.

292

The costs of conflict resolution andfinancial distress

company. We find it difficult to believe that this explanation can account for the large value fluctuations, however. Throughout the litigation the most commonly discussed settlement was a transfer of oil and gas properties. There would thus be no cash for Pennzoil to misuse. Further, Texaco has historically had among the highest finding costs in the oil industry, and has certainly been much less efficient than Pennzoil. Finally, the settlement between the companies called for a payment in cash, not property. If the loss were due to potential wastefulness on the part of Pennzoil, the settlement should have been associated with a further reduction in joint value.

A third explanation for the large loss is the secondary costs of the dispute on Texaco's profitability. By creating uncertainty about Texaco's long-term viability, making it difficult for Texaco to obtain credit, and distracting Texaco's management, the litigation may have reduced Texaco's value by more than the expected value of the transfers it would have to make to Pennzoil. Effects of this kind have been stressed in discussions of credit constraints (Greenwald and Stiglitz, 1987) and of the burdens associated with LDC debt obligations (Sachs and Huizinga, 1987).

The most important evidence for the adverse effects of the dispute is an affidavit Texaco submitted with its bankruptcy filing that described the effect of the week-old Supreme Court decision on its operations. The affidavit asserted that some suppliers had demanded cash payments before performance or insisted on secured forms of repayment. Others halted crude shipments temporarily or cancelled them entirely. A number of banks had also refused to enter into, or placed restrictions on, Texaco's use of exchange-rate futures contracts.

This sentiment was echoed by journalistic accounts of Texaco's actions. Some analysts even attributed the stock market reaction to these costs.

Unfortunately, no direct evidence exists on whether these operational problems were really of major importance. Indeed, the day after the affidavit was filed, some of the suppliers mentioned specifically disputed Texaco's assertions. The principal evidence of their importance is the observation that most reasonable measures of conventional litigation costs are far below the observed fluctuations in joint value.

A fourth explanation for the large fluctuations in value is that the market response reflected changing probabilities of a takeover of either Texaco or Pennzoil. If the market associated favorable litigation announcements with increased takeover probabilities and adverse litigation announcements with less likely probabilities, the resulting fluctuations in takeover premiums would mirror the observed changes in joint value.

Changing takeover probabilities seem implausible as an explanation of the reduction in combined value during the litigation period. After the initial litigation decisions, it was widely commented that the losses increased, rather than decreased, the likelihood that Texaco would be taken over. The New York

293

BEYOND THE CREDITORS' BARGAIN

Times noted that "analysts said the ruling could send Texaco's stock price down further and perhaps attract a hostile bid from a company hoping to buy Texaco at a bargain price" (December 11, 1985, sec. IV, p. 4, col. 4).

It is much more likely, however, that a takeover premium was responsible for a large part of the increase in value at the conclusion of the dispute. The news media widely noted Carl Icahn's history of acquiring companies in hostile takeovers. Indeed, on the day that Icahn's first purchases of Texaco's shares were announced, the abnormal returns were $556 million for Texaco's equity and $182 million for Pennzoil's. After the settlement was announced the following month, the New York Times indicated that many takeover specialists saw Texaco as undervalued and were thinking about investing in it.

It is unclear how much of the settlement revaluation should be attributed to takeover premiums, however. Although Icahn's initial purchases of Texaco's stock resulted in large increases in value, his subsequent actions had little effect on market values. When Icahn filed a notice with the SEC stating his intentions to increase his shares in the company, for example, Texaco's value rose by only $38.5 million. Two weeks later, when Icahn first threatened to file his own reorganization plan, Texaco's value fell by $18.5 million. These small revaluations suggest that, at least as of the time of the settlement, the involvement of Icahn in the dispute may have signalled only that a resolution of the dispute was forthcoming.

A final explanation for the large fluctuations is that the market inefficiently valued the claims of the two companies, perhaps because many investors were unwilling to hold stock in a potentially or actually bankrupt company like Texaco, and other investors did not step in to fill the gap.19 Consistent with this view, there is evidence that news provided by the companies resulted in asymmetric returns to the two stocks. On October 8, 1987, for example, Pennzoil's value rose by $170.2 million and Texaco's fell by $42 million because "the company impressed industry analysts in New York with a presentation explaining its position in its protracted legal dispute with Texaco" (the New York Times, October 9, 1987, sec. IV, p. 3, col. 1).

The hypothesis of market error in valuing Texaco and Pennzoil is attractive, given our inability to locate large costs of the ongoing struggle. If Texaco and Pennzoil were valued inefficiently, however, there must be strong general grounds for doubting the rationality of market valuations. Unlike many important events the principal uncertainty in the Texaco-Pennzoil case involved matters of public record. Further, both Texaco and Pennzoil were widely followed and actively traded throughout the period. Finally, the valuation pattern persisted over two years, and was noted on several occasions in the financial press.

19 The argument that the combined value of the two companies was depressed because of risk aversion founders on the observation that investors could purchase shares of both companies and thus profit from the settlement revaluation.

294

The costs of conflict resolution and financial distress

VI. Conclusions and Implications

Our results suggest that the Texaco-Pennzoil dispute reduced the combined wealth of the claimants on the two companies by about $2 billion. These costs seem much larger than reasonable estimates of the transfers the case was likely to generate. Given these large costs, it is natural to wonder why a bargain was not struck sooner. Theories of bargaining under complete information such as Rubinstein's (1982) work usually imply that if both parties are fully informed, bargains should be struck immediately and bargaining costs should not be incurred. Settlement did not take place in the Texaco-Pennzoil conflict, however, until four years after the dispute arose.

The most commonly advanced explanations for failure to come to immediate agreement are differing expectations about the ultimate outcome, delaying settlement as a means of signalling private information, and committing to an inefficient outcome to influence the range of potential solutions (Crawford, 1982; Farber and Bazerman, 1987). These arguments seem like weak reeds in the Texaco-Pennzoil case. The principal uncertainties revolved around likely legal judgments that both parties had equivalent capacities to predict. Further, we have seen no indication that the parties had private information about their own financial condition. Finally, commitment does not seem credible when the case will be decided by a third party.

Journalistic accounts typically explain why no bargain was struck by pointing to the mutual antipathy between the executives of the two companies. Two billion dollars, however, seem like a lot to pay to engage in pique. In the end it seems that something other than asymmetric expectations or information lay behind the inability of Texaco and Pennzoil to settle the case, or alternatively, that if the amount of asymmetry in this case is enough to explain why almost $2 billion were nearly sacrificed in bargaining costs, that asymmetry must be present in almost every bargaining situation.20

The costs of Texaco's financial distress also shed light on several aspects of corporate financing and macroeconomic policy. American firms rely heavily on equity despite the substantial incentive to debt finance provided by the deductibility of interest but not dividends. This is often attributed to bankruptcy costs, or more generally to the costs of financial distress (Gordon and Malkiel, 1981). Yet empirical evidence demonstrating that bankruptcy expenses are substantial has been lacking (Warner, 1977; White, 1983; Jensen and Meekling, 1976). The Texaco-Pennzoil case indicates that legal disputes can impose

20 One possible resolution of the failure of bargaining is the agency problem associated with shareholder lawsuits. Since Texaco's managers may be personally liable for damages the company pays, they might not have an interest in specifying a damage amount (Mnookin, 1987). The proposed settlement, however, indemnified Texaco's directors from any personal liability, and it is not clear why such an indemnification could not have been proposed earlier.

295

BEYOND THE CREDITORS' BARGAIN

large costs on a firm, and that the indirect effects of conflict on profitability can be substantially greater than the direct expenses of the litigation (Altman, 1984). We suspect that if market valuations of the participants in other large disputes, such as the asbestos claimants and companies, could be found, they would show similar losses in joint value. The evidence suggests that this is almost certainly the case for intercorporate disputes (Engelmann and Cornell, 1988; Bhagat, Brickley, and Coles, 1988; Baldwin and Mason, 1983).

Greenwald and Stiglitz (1987) have argued that monetary contractions have substantial supply-side effects. By raising the debt burdens of firms, they interfere with firms' ability to obtain working capital and so make them less profitable. This is quite distinct from any adverse effects that contractionary monetary policies and high interest rates may have on the demand for investment goods. The idea that contractionary monetary policies adversely affect productivity can explain why real wages often fall rather than rise during recessions, and why firms postpone production by liquidating inventories rather than building up stocks during recessions. The Texaco-Pennzoil evidence supports the contention that financial distress can interfere with firms' ability to produce efficiently.

References

Altman, E.I., "A Further Empirical Investigation of the Bankruptcy Cost Question," 39

Journal of Finance 1,067-89 (1984).

Baldwin, C.Y. and Mason, S.P., "The Resolution of Claims in Financial Distress: The Case of Massey Ferguson," 38 Journal of Finance 505-16 (1983).

Bhagat, S., Brickley, J.A., and Coles, J.L., "The Wealth Effects of Interfirm Lawsuits: An Empirical Investigation," Mimeo, University of Rochester (1988).

Coll, S., The Taking of Getty Oil, New York: Atheneum Press (1987).

Crawford, V.P., "A Theory of Disagreement in Bargaining," 50 Econometrica 607-37 (1982).

Engelmann, K. and Cornell, B., "Measuring the Cost of Corporate Litigation: Five Case Studies," 17 Journal of Legal Studies 377-99 (1988).

Fama, E.F., Fisher, L., Jensen, M., and Roll, R., "The Adjustment of Stock Prices to New Information," 10 International Economic Review 1-21 (1969).

Farber, H.S. and Bazerman, M.H., "Why Is There Disagreement in Bargaining?" 77

American Economic Review 347-51 (1987).

Gordon, R.H. and Malkiel, B.G., "Taxation and Corporate Finance" in H.J. Aaron and J.A. Pechman, eds., How Taxes Affect Economic Behavior, Washington, D.C.: The Brookings Institution (1981).

Greenwald, B. and Stiglitz, J.E., "Money, Imperfect Information, and Economic Fluctuations," NBER Working Paper No. 2188 (March 1987).

Jensen, M.C., "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," 76 American Economic Review 323-9 (1986) [reprinted in this volume as Chapter 2].

296

The costs of conflict resolution and financial distress

Jensen, M.C. and Meckling, W., "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," 7 Journal of Financial Economics 305-60 (1976).

Mnookin, R.H., "The Mystery of the Texaco Case," The Wall Street Journal (November 27, 1987).

Petzinger, T., Jr., Oil and Honor: The Texaco Pennzoil Wars, New York: Putnam Publishing Group (1987).

Rubinstein, A., "Perfect Equilibrium in a Bargaining Model," 50 Econometrica 99-110 (1982).

Schwert, G.W., "Using Financial Data to Measure the Effects of Regulation," 24 Journal of Law and Economics 121-59 (1981).

Warner, J.B., "Bankruptcy Costs: Some Evidence," 32 Journal of Finance 331-41 (1977).

White, M.J., "Bankruptcy Costs and the New Bankruptcy Code," 38 Journal of Finance 477-88 (1983).

297

CHAPTER 18

Survey evidence on business bankruptcy*

MICHELLE J. WHITE**

This chapter reviews the empirical evidence concerning how firms and their creditors and equity holders fare in bankruptcy. The data come from surveys of firms that have filed for bankruptcy since the adoption of the Bankruptcy Code.

There have been two basic types of surveys. The first involves examining the records of firms that file for bankruptcy under chapter 7 or chapter 11 in a particular bankruptcy court. Since most firms that file for bankruptcy are relatively small, these surveys provide evidence concerning the characteristics of small firms in bankruptcy. The other type of survey involves large firms with publicly traded debt or equity that filed for bankruptcy, almost always under chapter 11. A variety of data sources are used to obtain information concerning large firm bankruptcies, including bankruptcy court records, annual reports, 10K filings, trading data, information from articles in The Wall Street Journal and other financial publications, and interviews with lawyers and managers.

Table 18.1 summarizes much of the information. The left column refers to characteristics of small firms that filed for bankruptcy liquidation under chapter 7, the middle column refers to characteristics of small firms that filed for bankruptcy reorganization under chapter 11, and the right column refers to characteristics of large firms that filed for bankruptcy reorganization under chapter 11. Since large firms virtually never file under chapter 7, there is no "large chapter 7" column. The reason for separating large versus small firms is that their experience in bankruptcy is generally quite different.

I. Small Firms in Bankruptcy

Much of the information concerning small firms in bankruptcy comes from surveys of firms that filed for bankruptcy in particular bankruptcy courts. White (1984) surveyed all the firms that filed for bankruptcy in the Bankruptcy Court for the Southern District of New York in Manhattan during the period 1980 to 1982. Her survey included filings under both chapter 7 and chapter 11. LoPucki (1983) surveyed forty-eight firms that filed for bankruptcy in

*This chapter is an edited version of the article that originally appeared in Handbook of Modern Finance, 3rd edition, Dennis E. Logue, editor (1994), published by Warren, Gorham & Lamont. Permission to publish excerpts in this book is gratefully acknowledged.

**Professor of Economics, University of Michigan.

298

Survey evidence on business bankruptcy

Table 18.1. Characteristics of firms in bankruptcy

Notes to table: (F/T) indicates Franks and Torous (1989), (L/W) indicates LoPucki and Whitford (1990) or (1993). (E/M/R) indicates Eberhard, Moore, and Roenfeldt (1990), (J-C) indicates Jensen-Cocklin (1992). Other references are given in the text. The first figure given for Hotchkiss is for her large sample and the second is for her small sample. See text for discussion.

299

BEYOND THE CREDITORS' BARGAIN

the Western District of Missouri (Kansas City), but included only firms that filed under chapter 11. A more recent survey by Jensen-Cocklin (1992) examined 260 firms that filed under chapter 11 in the Bankruptcy Court in Poughkeepsie, New York, of which forty-five adopted chapter 11 plans. Two other surveys cover a wider geographical area and examine larger samples, but contain less detail. The paper by Ames (1983) reports a survey by Abt Associates of 500 firms that filed for bankruptcy under chapter 7 and 500 that filed under chapter 11 in the early 1980s. The paper by Flynn (1989) reports on a study by Ernst & Young, Inc., of 2,400 confirmed chapter 11 plans in fifteen districts.1

Consider first the characteristics of small firms that file to liquidate in bankruptcy under chapter 7. At the time of the bankruptcy filing, these firms' ratio of liabilities to assets is well above one, providing support for the hypothesis that managers of small firms are able to delay filing for bankruptcy until well past the point where their firms are insolvent. The ratio of secured liabilities to assets is of interest since managers attempting to avoid filing for bankruptcy have an incentive to convert Unsecured claims to secured claims as a means of inducing creditors to renew their loans. If secured liabilities/assets equalled one, then all the firm's assets would be subject to some creditor's claim. Thus a ratio of secured liabilities/assets of one represents an outer limit for delay in filing for bankruptcy, although measurement of assets at book rather than market value distorts the comparison. It is nonetheless interesting that the Ames study finds a ratio of exactly one.

Given the delay in filing for bankruptcy, it is not surprising that unsecured and priority creditors receive little in bankruptcy liquidations. By the time firms file under chapter 7, most of their assets have either been claimed by secured creditors already or are subject to secured creditors' liens. There are few remaining assets available to unsecured creditors and these have a tendency to "grow legs and disappear" before the bankruptcy trustee can find them. Thus unsecured creditors receive very little. White finds an average payoff rate to unsecured creditors of 4 percent. This represents an average of many firms in which creditors received nothing and an occasional firm in which creditors received a substantial payoff.

Turn now to small firms that file under chapter 11. All the surveys suggest that firms filing under chapter 11 are larger than firms filing under chapter 7. This is not surprising, since reorganizing under chapter 11 involves high legal and professional fees, so that it is presumably not feasible for the smallest firms. Both the Ames and the White surveys also show that firms filing under chapter 11 are in better financial condition than firms filing under chapter 7, as measured by lower ratios of total liabilities to assets. (However, White's survey finds a higher ratio of secured liabilities to assets for firms filing under chapter

1 Dollar values in the table are not adjusted for inflation, so that depending on the particular study, they represent dollars of either the early or the late 1980s.

300