Учебный год 2023 / Bhandari_J__Weiss_L_Corporate_Bankruptcy_Economic_and_Legal_Perspectives_1996

Managing default

Table 19.1. Direct costs of exchange offers for troubledjunk bondsa

a Sample consists of eighteen exchange offers undertaken during 1981-1988 for which data were available. Costs consist of cash compensation paid to the exchange and information agent, legal, accounting, brokerage, and investment banking fees and the value of any common stock warrants issued to the firm's investment bank advisor (as estimated in the exchange offer prospectus).

currency, thus giving them an interest in preserving the value of the surviving firm and an incentive to get out of chapter 11 quickly.6 An interesting alternative approach was recently taken by Ames Department Stores, which filed for chapter 11 in April 1990. Ames established a special bonus plan for its CEO, Stephen Pistner, which would pay him $3.5 million if Ames was successfully reorganized within eighteen months of its chapter 11 filing, and successively smaller amounts if the reorganization took longer; no bonus would be paid if Ames was still in chapter 11 after thirty-nine months. Such innovative compensation schemes, however, are all too rare.7

A direct comparison of legal and professional fees for chapter 11 and private restructuring is difficult because firms are not required to report these costs outside of chapter 11. Nevertheless, firms that privately restructure their bonds through exchange offers are required to disclose an estimate of all offer-related costs in the exchange offer circular distributed to bondholders. As a result, I was able to obtain reliable cost data for a sample of 18 exchange offers undertaken by New York and American Stock Exchange-listed companies.8

As summarized in Table 19.1, these costs amounted on average to only .65 percent of the book value of assets (measured just prior to the exchange offer); the corresponding median percentage was only .32 percent. By contrast, academic studies have found that average legal and professional fees reported by

6 See proposals by Michael Price and Wilbur Ross in the Roundtable discussion in the Summer 1991 issue of the Journal ofApplied Corporate Finance.

7For evidence on how distressed firms pay their senior managers, see Stuart Gilson and Michael Vetsuypens, "CEO Compensation in Financially Distressed Firms," Journal of Finance (1991).

8This table is taken from Gilson, John, and Lang, cited in note 3. Exchange offer costs include cash compensation paid to the exchange and information agent, legal, accounting, brokerage and investment banking fees, and the value of any common stock warrants issued to the firm's investment bank as estimated in the offer circular.

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chapter 11 companies range from 2.8 percent to 7.5 percent of total assets (generally measured within one year of the filing).9 Although comparisons across studies are made difficult by differences in the samples and the definitions of costs, these results clearly suggest that private restructuring through exchange offers is much less costly than formal reorganization in chapter 11, perhaps by as much as a factor of ten.

B. Management by bankruptcy judges

Greater waste of corporate assets is also possible in chapter 11 because the Bankruptcy Code effectively requires judges to set corporate operating policies. Of course, judges also have the potential to add value by arbitrating disputes among the firm's claimholders, thus reducing the length of time required to restructure the debt.

In their traditional role, judges are supposed to interpret and administer the law. In chapter 11, however, because they must approve all major business decisions, bankruptcy judges have broad powers to influence how the firm's assets are managed. A company's future profitability may depend critically on how the bankruptcy judge rules on proposed corporate actions such as major asset divestitures and capital expenditures.

Moreover, the Bankruptcy Code does not require judges to base their decisions on whether corporate assets will be put to uses that produce the highest rate of return to all investors. For a company's plan of reorganization to be "confirmed" in bankruptcy court (the last legal hurdle to be crossed before exiting from chapter 11), the judge is required by law to ensure only that two conditions are met:

1.each claimholder must receive at least what he or she would have been paid if the firm were liquidated;10 and

2.the company must not appear to be in danger of going bankrupt again in the near future.

9 See Jerold Warner, "Bankruptcy Costs: Some Evidence," 32 Journal of Finance (1977); James Ang, Jess Chua, and John McConnell, "The Administrative Costs of Corporate Bankruptcy: ANote," 37 Journal of Finance (1982); and Lawrence A. Weiss, "Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims," 26 Journal of Financial Economics (1990) [reprinted in this volume as Chapter 16]. These studies calculate average costs using different definitions of the firm's assets, including the assets market value (Warner, Weiss), liquidation value (Ang, et al) and book value (Weiss).

This is referred to as the "best interests of creditors" test in Section 1129(a)(7) of the Bankruptcy Code. Strictly speaking, this standard only applies if all impaired classes of claimholders assent to the proposed plan (which generally happens). If one or more classes votes against the plan, then the relevant standard is the "fair and equitable" test in Section 1129 (b)(2), which basically requires that each impaired class receives the present value of its allowed claims under the plan (or whatever is available after all senior classes have been paid in full, provided more junior classes receive nothing). If a plan is fair and equitable, then dissenting classes can be forced to accept its terms under a court-imposed "cram-down."

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However honorable their intentions, judges have no financial interest in the outcome of reorganizations, and generally lack relevant management experience. It is thus hardly surprising that corporate assets end up being worth less when judges set corporate policies.

C. Lost investment opportunities

To the extent dealing with creditors (and, in bankruptcy, the judge) diverts management's attention from operating the business, then the firm may forgo profitable investment opportunities. Value lost by not capitalizing on such opportunities is no less real a cost of financial distress than lawyers' fees, and should also be considered in the context of the workout-bankruptcy decision. Although these costs cannot be directly measured, it is reasonable to assume that the extent of any damage will be greater the longer it takes to renegotiate the firm's debts. Hence the "opportunity costs" of financial trouble are likely to be greater in chapter 11 than in private workouts.

Chapter 11 creates additional delays and distractions due to various procedural demands placed on managers. Before making any decision not in the ordinary course of the firm's business (such as hiring an investment bank to provide advice on asset sales), management must file an application with the court. They may file such an application, moreover, only after first notifying creditors in writing and allowing them sufficient time to file objections. Because the firm can act only after the judge approves the application, otherwise routine decisions can take months to complete. After Public Service Company of New Hampshire filed for bankruptcy in 1988, D.P.G. Cameron, the firm's vice-president and general counsel, commented that "the proceedings ... left us breathless."11

One proxy, admittedly crude, for the extent of a company's investment opportunities is the difference between its value as an ongoing concern and its liquidation value - what I refer to as excess going-concern value.12 To the extent investment opportunities are more likely to be lost in chapter 11 than in private workouts, troubled companies have incentives to avoid bankruptcy and restructure their debt privately. In the extreme, if chapter 11 leads to liquidation, creditors and shareholders effectively forfeit all of the firm's excess going-concern value by not settling privately.13

The importance of preserving going-concern value in these situations is well demonstrated by the case of Tiger International, a cargo shipper and

11See Stein, cited in note 4.

12Of course, excess going concern value will also reflect other sources of value such as monopoly power and goodwill.

13Of the chapter 11 companies I examined (all of them New York and American Stock Exchange companies) only 5 percent were completely liquidated through a conversion to chapter 7. For smaller, private companies the rate is generally higher.

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lessor of transportation equipment. In early 1983, the company initiated what turned out to be a successful workout. As reported at the time in The Wall Street Journal (February 16, 1983),

Wayne M. Hoffman, Tiger chairman, said the company was getting "excellent cooperation" in the early meetings with lenders. He said that he expects sessions to continue "for some weeks," but that he was confident a rescheduling of debt would be the result. "It's in the lenders' interests to do this. All of them agree that the going concern is the important thing."

Consistent with the outcome of this case, the Gilson-John-Lang study found that troubled companies are more likely to reorganize privately when they have greater excess going-concern value. For companies that successfully restructured their debt out of court, the average ratio of excess going concern value to liquidation value prior to restructuring was .83; for firms that filed for chapter 11 that average ratio was only .61.

III. How Do Shareholders Fare?

To the extent private workouts are less costly than chapter 11, both shareholders and creditors should be made better off when attempts to restructure debt privately succeed.1 My own research suggests shareholders have generally done better in workouts than in chapter II.15 The Gilson-John-Lang study found that shareholders of companies that successfully restructured their debt out of court realized an average 41 percent increase in the value of their common stockholdings over the period of restructuring (beginning with announcement of the default and net of general market movements). By contrast, for companies that tried to restructure privately but failed, average cumulative returns to shareholders were negative 40 percent over the period of restructuring that ended with a chapter 11 filing. At least part of the 80 percent difference in these returns can be viewed as the market's estimate of the shareholder portion of the total cost savings from avoiding chapter 11 and restructuring privately. (Some part of this 80 percent, of course, may also reflect the possibility that firms ultimately filing chapter 11 were systematically less profitable

14If only a subset of the firm's debt is restructured, a private restructuring plan could in principle harm nonparticipating creditors (for example, participating creditors claims could be given more security or made more senior). However, such harm will be limited by the right of nonparticipating creditors to sue the firm (and other creditors) by covenants that restrict the issuance of more senior debt, and by cross-default covenants that restrict the firm's ability to exclude certain creditors from participating in the restructuring.

15Assessing the relative returns to creditors is more difficult because their claims trade much less frequently and market price data are either unreliable or nonexistent. There is nonetheless some evidence that creditors take bigger writedowns of their claims in chapter 11 than in workouts. See Julian Franks and Walter Torous, "How Firms Fare in Workouts and Chapter 11 Reorganization," London Business School and UCLA, working paper (1991).

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after negotiations with creditors began - or that operating problems were far worse than investors initially suspected at the time of default - than firms that did not end up filing.)

Shareholders are also typically allowed to retain a significantly higher percentage of the equity in workouts than in bankruptcy. As I found in a recent study, creditors on average receive 20 percent of the common stock in workouts, as compared to 67 percent of the outstanding stock in chapter II.16 Shareholders will be harmed by dilution of their equity to the extent creditors effectively purchase the new shares at a below-market price, or if the value of control conferred by large blocks is dissipated by the issuance of new shares. In some chapter 11s, of course, shareholders are completely wiped out, as happened recently in the bankruptcy of Sharon Steel (which emerged from chapter 11 late last year). In workouts, obviously, shareholders never voluntarily consent to such a plan.

IV. Advantages of Chapter 11

Although evidence from the 1980s suggests that chapter 11 is more costly than private restructuring in the average case, bankruptcy also provides certain benefits that offset at least part of this cost difference and cause some companies to file for chapter 11 directly. There are four principal advantages to filing.

First, the Bankruptcy Code allows firms to issue new debt that ranks senior to all debt incurred prior to filing (prepetition debt). Such debtor-in-possession (DIP) financing is valuable because the firm can borrow on cheaper terms and thus conserve on scarce cash.17 Over the last few years, increasing sophistication of DIP lenders and growth of the market for tradable bank debt have resulted in more firms entering chapter 11 with a DIP facility already in place (two recent examples are Ames Department Stores and Pan Am).

Second, interest on prepetition unsecured debt stops accruing while the firm is in bankruptcy, again freeing up cash.18

Third, the Bankruptcy Code's automatic stay provision protects the firm from creditor harassment while it reorganizes, thus allowing the business to function with fewer disruptions.

Fourth, it is easier to get a reorganization plan accepted in chapter 11 because the voting rules are less restrictive. Acceptance of the plan requires an

16See Stuart Gilson, "Bankruptcy, Boards, Banks and Blockholders," 26 Journal of Financial Economics (1990). Such percentages assume that none of the warrants or convertible debt and preferred stock received by creditors are converted eventually. Assuming such securities are fully converted the average creditor holdings increase to approximately 40 percent and 80 percent, respectively.

17For an excellent description of current DIP lending practices, see Mark Rohman and Michael Policiano, "Financing Chapter 11 Companies in the 1990s," Journal of Applied Corporate Finance (Summer 1990).

18Interest on secured debt continues to accrue up to the excess, if any, of the security's assessed value over the debt's face value.

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affirmative vote by only a majority (one-half in number, but representing twothirds in value) of the claimholders in each class whose claims are impaired. By contrast, a workout cannot pass without the consent of all who participate, thus increasing the incidence of creditor holdouts.

V. The Holdout Problem

Whether the cost savings from private restructuring are realized will depend on whether creditors unanimously agree to the terms of the restructuring. Any factors that increase the likelihood of creditor holdouts thus make attempts at private workouts less likely to succeed. Of course, many of these factors are either difficult or impossible to quantify - such as creditors' relative bargaining strength or the amount of antipathy that creditors feel towards shareholders and management. Nonetheless, some academic work has succeeded identifying factors that can be used to predict the likelihood of holdouts.

The extent of the holdout problem depends partly on what type of debt is restructured. As noted previously, publicly traded bonds traditionally have been restructured through voluntary exchange offers. The holdout problem in these offers can be quite severe. Provided enough bonds are tendered that the firm stays out of bankruptcy, the bondholders who do not tender (and thus, typically, do not agree to a reduction in the value of their claims) benefit at the expense of those who do. The alternative to an exchange offer - namely, modifying the interest rate, principal amount, or maturity of the outstanding bonds by a vote of bondholders - is made virtually impossible by the Trust Indenture Act of 1939, which requires every bondholder to agree to such changes. (Modification of all other, "noncore" covenants of the bond indenture usually requires only a simple or two-thirds majority.)

To address this problem, exchange offers are structured to penalize holdouts. New bonds offered in these exchanges, in addition to having a lower coupon rate or principal amount, are also typically more senior and of shorter maturity, than the outstanding bonds they will replace.19 Holders are also sometimes asked jointly to tender their bonds and vote for the elimination of noncore protective covenants in the old bonds (called an exit consent solicitation). By so doing, bondholders who tendered will be in a better position than those who don't if the firm later files for bankruptcy.

This situation changed dramatically, however, in January 1990 when Judge Burton Lifland ruled in LTV's bankruptcy that bondholders who tendered in a previous exchange offer were entitled to a claim in bankruptcy equal only to the market value of the bonds accepted under the offer: Bondholders who held onto their original bonds were allowed a claim equal to the bonds' full face

1 As pointed out to me by an investment banker acquaintance, the effect of the exchange is similar to offering passengers on the Titanic the chance to move up from steerage to first class.

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value. Since bonds of distressed companies usually sell at big discounts, the effect of this ruling was to reward LTV's holdouts. Although the LTV decision was reversed on appeal in April 1992, for over two years this ruling severely undermined companies' ability to restructure their publicly traded debt.20

With regard to private debt, my research suggests that holdouts are less common, and private restructurings thus more likely to succeed, when more of the firm's debt is owed to commercial banks - to a lesser extent, to insurance companies. The Gilson-John-Lang study found that, on average, bank debt amounted to 40 percent of total liabilities in firms that successfully restructured, but only 25 percent in firms that filed for chapter 11 (median debt ratios were 36 percent and 20 percent, respectively).

As one would expect, bank lenders tend to be more sophisticated and fewer in number than other kinds of creditors and are more likely to recognize the potential benefits of private restructuring. Trade creditors, by contrast, are generally less predisposed to settle. Bankruptcy professionals frequently characterize trade creditors as "unsophisticated" and "acrimonious." Consistent with this characterization, so-called vulture investors often buy out a firm's trade debt at the very start of their involvement with the company.

Our results also indicate that private restructuring succeeds more often when there are fewer distinct classes of long-term debt outstanding.21 The simplest way to interpret this evidence is that having more creditors increases the likelihood that any one creditor will hold out, and thus make disputes among creditors more likely. The number of debt classes also serves as a measure of the complexity of a firm's capital structure. Complex capital structures will be more difficult to restructure privately, especially if the claims are more difficult to value and there is greater disagreement among creditors over whether they are being treated "fairly" relative to other creditors or shareholders.

VI. Incentives of Managers and Directors

Although the workout-bankruptcy decision has a significant impact on a company's stock price, surprisingly few workout proposals are formally put to a shareholder vote. In only one out of every five workouts that I studied did

20 David Schulte, in the Roundtable discussion in the Summer 1991 issue of the Journal of Applied Corporate Finance, calls 1990 a "very bad year for exchange offers." And according to investment bankers with whom I have spoken privately, an additional consequence of the ruling has been that companies give up more easily (and file for chapter 11) when an exchange offer generates a low initial lender rate. During the 1980s, by contrast, it was not uncommon for companies to revise the terms of exchange offers up to half a dozen times until some desired tender rate was attained.

1 As identified in the notes to the firm's balance sheet in its annual 10K report. More precisely, we deflate this variable by the book value of long-term debt to provide a measure of the number of creditors per dollar of debt owed. The rationale for this adjustment is that smaller creditors have less of their wealth at risk if a private restructuring attempt fails, and therefore are more likely to hold out everything else unchanged.

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firms first solicit shareholders' approval, either to increase the number of authorized shares or to sell off assets. This raises the interesting question whether managers can personally gain by settling with creditors on overly generous terms and thus at shareholders' expense. One obvious reason why managers might strike a deal with creditors is to protect their jobs.

To investigate this possibility, I analyzed turnover among the senior managers (the CEO, chairman, and president) of 126 New York and American Stock Exchange-listed firms that defaulted on their debt during the early 1980s.22 As shown in Figure 19.1, management turnover was substantial regardless of which restructuring method was chosen. At the end of a fouryear period starting two years prior to the start of a workout or chapter 11 filing, only 40 percent of the original senior managers remained in firms that privately restructured, and only 30 percent were left in firms that filed for chapter 11. Turnover among directors of these firms was also high: Approximately half the board was replaced during a typical workout or bankruptcy.23

Executives' professional reputations also appear to suffer when they are replaced. Although the average age of departing managers in my study was only fifty-two years, not one of these managers later found work with another exchange-listed firm for at least three years after leaving. Similarly, departing directors subsequently sat on a third fewer boards of other companies three years after leaving, suggesting that their services as directors were valued less highly by other firms. (Of course, these individuals may also have been generally less inclined to serve with large public corporations as managers or directors after their experience with financial distress.)

In short, my own research suggest that managers and other corporate insiders do not gain from systematically choosing a particular restructuring method. Moreover, it lends no support to the popular view, so often aired in the financial press, that chapter 11 offers a "safe harbor" for the firm's managers.24 To be sure, chapter 11 does give the filing firm the exclusive right to file the first reorganization plan for at least 120 days; and it's also true that bankruptcy judges usually grant extensions - sometimes for several years. But such extensions, however potentially costly for investors, represent, at most, a temporary reprieve for senior managers.

Indeed, in the ten largest bankruptcies in 1990, seven firms replaced their CEOs, generally within one month of filing. In the bankruptcy of Circle K, for example, Karl Eller resigned as chairman and CEO approximately one

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Years relative to start of workout or chapter 11

* Sample consists of 196 managers initially employed by 126 New York and American Stock Exchange listed companies (sixty-nine firms in chapter 11 and fifty-seven private workouts) that first defaulted on their debt during 1979-1984.

Figure 19.1. Percentage of original senior managers (CEO, chairman, and president) who remain with their firms throughout period of financial distress.

week before his firm filed (despite his ownership of over 7 percent of Circle K's common stock). Peter Hollis resigned as president and CEO of Ames Department Stores two days after it filed for chapter 11.

In addition to my finding that managers are routinely displaced when their firms file, I also found that one of every five top-level management changes was initiated at the behest of creditors - in particular, bank lenders. Creditors are thus far from powerless in these situations. In short, chapter ll's automatic stay protects the firm from creditor harassment, but not its managers.

VII. Policy Implications

Distressed firms can preserve more of their value by restructuring their debt privately, when possible, and thus avoiding chapter 11. My own research suggest that the professional fees incurred in exchange offers are about one-tenth those incurred in a typical chapter 11 case.

Unfortunately, two recent developments have turned more troubled companies towards the bankruptcy courts. First, as discussed previously, the LTV decision has undermined bondholders' incentives to tender in exchange offers for publicly traded junk debt. The second development has been a shift in the tax law toward less favorable treatment of firms that restructure their debt outside of chapter 11.

Following the Tax Reform Act of 1986, distressed firms have found it more difficult to preserve their net operating-loss carryforwards, and to avoid pay-

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ing taxes on forgiveness-of-debt income, when they operate outside of bankruptcy. Since late 1990, firms have been subject to a new tax on private exchange offers. Under the Revenue Reconciliation Act of 1990, whenever new bonds issued in an exchange offer sell at a discount below their stated face value (as is most often the case), the firm must book the difference as taxable income. Prior to the Act, such original issue discounts were tax exempt.25

Although it is still too early to assess the full impact of these developments on corporate reorganizations, some preliminary evidence suggests that troubled firms are more often choosing to deal with default in chapter 11.1 examined press reports for all firms that were identified in The Wall Street Journal as having filed for chapter 11 between January 1990 and February 1991.26 Almost 70 percent of these companies apparently made no attempt to restructure their debt privately before filing. During the 1980s, by contrast, only 30 percent of financially distressed firms sought chapter 11 protection as a first resort. Also, for those companies that did attempt to restructure privately in 1990, only three months elapsed, on average, before a chapter 11 filing. In the 1980s companies spent an average of eight months attempting to find a private solution before filing chapter 11.

Society loses when firms are forced to use the more expensive method for dealing with financial distress. The LTV decision made it less likely that bondholders would consent to private exchanges, even though the other cost benefits of private workouts relative to chapter 11 were largely unaltered. Although entering chapter 11 to preserve tax benefits helps the firm's security holders, these gains are essentially financed by other taxpayers; as such, they represent wealth transferred rather than wealth created.

Public policy should be directed toward breaking down these and other barriers to private contracting (or recontracting). For example, a strong case can be made for repealing the Trust Indenture Act to facilitate private restructuring of publicly held debt.27 Corporate default could also be made less costly

25 The tax on OIDs could be avoided in two ways. First, any OID was nontaxable if the new bonds had the same face value as the old bonds retired under the exchange offer, and both old and new bonds were considered "securities" for tax purposes (among other things, this effectively required both issues to have a term to maturity of at least five years). Second, firms could qualify for the "stock-for-debt" exception, under which the OID would be nontaxable if stock was also issued under the exchange (in sufficient amount to satisfy the IRS that the firm's principal motive for issuing stock was not simply to avoid paying taxes).

However, the 1990 Act reduces the effectiveness of the stock-for-debt exception by also imposing tougher standards with respect to the type and amount of stock that must be issued for an

27 See Mark Roe, "The Voting Prohibition in Bond Workouts," 97 Yale Law Review (1987), and Robert Gertner and David Scharfstein, "A Theory of Workouts and the Effects of Reorganization

Law," Journal of Finance (1991).

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