Учебный год 2023 / Bhandari_J__Weiss_L_Corporate_Bankruptcy_Economic_and_Legal_Perspectives_1996

Is corporate bankruptcy efficient?

losers will be not the unsecured creditors but the superior firms (and their investors), which must pay the higher price of capital. Investors in these firms including both secured and unsecured creditors would be better off if the legal rule were more efficient.

So, too, if existing rules fall harshly on secured creditors by disregarding the absolute priority rule and by indulging optimistic judicial valuations that allow unsecured creditors and equity investors to obtain more than their contractual shares. Again prices adjust, and the anticipation of redistribution ex post means that there is none ex ante.

It is unrealistic to suppose that suppliers of capital fall naturally into groups such as secured lenders, unsecured lenders, and equity investors. People have portfolios of investments, and even though some institutions (such as banks) cannot purchase some instruments (such as stock), financial intermediaries are not themselves winners and losers. Real persons supply the capital, and their portfolios are or readily can be diversified across kinds of investment. If an inefficient rule raises the price of unsecured debt, both prices and portfolios will adjust. No one gains ex ante, and all creditors (potentially) lose.

The remaining interest group is lawyers. Bankruptcy laws were drafted not by the creditors but by their lawyers. Agency problems are everywhere; maybe the bar figured out how to feather its own nest through extended proceedings at the expense of all creditors' interests. Such an explanation works, however, only if the bankruptcy bar is closed; free entry would dissipate any rents. Entry is not hard. Lawyers may take up bankruptcy practice freely, and many have done so. Large law firms have greatly expanded their bankruptcy departments in recent years, while other departments, such as antitrust, have melted away. Because entry is possible, and large financial intermediaries have their own teams of lawyers to monitor the work of legislative drafters, rent-seeking is not a plausible explanation of the failure of bankruptcy law to auction off corporate debtors. This leaves efficiency as the likely explanation.

Many people find it hard to believe that the judicial system ever operates with lower transactions costs than markets. Baird (1986) expresses justified skepticism on this score. Yet consider that Weiss's (1990) measurements of the cost of corporate bankruptcy, the best now available, show costs significantly less than those entailed in taking a corporation public. Ritter (1987) finds that the costs of a firm-commitment offering average 14 percent of the gross proceeds with a range of 9.3 percent for placements exceeding $10 million to 19.5 percent for those of less than $2 million.

Private debt placements are less costly, but a bankruptcy auction is more like the sale of equity - because the debtholders in bankruptcy have the residual claims and the failure of the firm to pay its debts implies substantial risk concerning the success of its future operations. High variability means high

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costs of sale, because potential buyers rationally spend more evaluating the firm's prospects and examining whether changes can improve them. Variability is especially high when the value of a firm is linked closely to its managers human capital.

Managers of firms going public or involved in LBOs usually promise to stay and often are tied by golden handcuffs - stock, often subject to formulaic buysell agreements (the departing manager gets only book value for the stock); if the manager is allowed to sell the stock, any diminution in value attributable to the manager's departure will be reflected in the lower price realized. Managers of firms in bankruptcy are not tied to the firm in this fashion (their stock probably is worthless) and as Gilson (1990) shows, are likely to depart.

Auctions of bankrupt firms may well be more costly than IPOs. Although as Baird (1986, pp. 137-8) observes flourishing and failed firms may hire the same investment banks to sell the assets, different people set the reservation price and decide when to sell. The residual claimants who bear the costs of the auction and collect the marginal dollar of receipts have the right incentives to make decisions about timing and minimum price. When a firm is sound, the equity investors hold the residual claims and make the decisions through the managers. The fabled conflict between debt and equity claimants is a last-pe- riod problem. See Easterbrook (1991).

When the firm is in default, the managers may still be in control, but the equity claimants they represent no longer hold the residual claims. If the firm's prospects are volatile, shareholders will want the managers to delay, in the hope of selling when the price is high. On average, however, delay will be costly. Equity claimants have reason to wait too long and to set unrealistic reservation prices, for their claims are worthless unless something unexpectedly good happens. Immediate sale at a realistic price wipes them out; debt claimants bear any erosion of value during a delay, yet have fixed claims and so do not realize the full gain if things turn out well. This is the standard conflict between debt and equity claims, and as usual is substantially aggravated during times of financial distress, when the equity claim is worth little.

A bankruptcy judge could cure the problem by assigning to the residual claimant not only the right to run the auction but also the obligation to do so within a short time. But this is not possible until the bankruptcy process begins and managers, knowing that court means a prompt end to their powers, may delay inefficiently before commencing the case [White (1989, pp. 14950)]. What's more, how does a judge identify the residual claimant when there are several layers of debt? To do this the judge must know the firm's value yet the superiority of market over judicial processes in pricing the firm's assets is the impetus for holding an auction.

It is not particularly useful to have both a judicial and a market valuation process for the same corporation. This means that the court should not itself

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try to run an auction; how is a judge to set a reservation price intelligently? Not by hiring an investment bank to determine a "fair price" for the assets. Small changes in assumptions about the discount rate and the income stream produce spectacular differences in bankers' estimates of value [Bebchuk and Kahan (1989)], and the judge has no way to evaluate the wisdom of the bankers' assumptions. If instead of trying to value the assets the judge invites one group of investors to buy the entitlement to resell the firm as a unit, this is an auction by another name, and it does not solve the question who is to determine timing and reservation price.

In comparing the costs of market and judicial valuation, it is important to understand that bankruptcy values the claims as well as the assets. A substantial portion of the measured costs of bankruptcy would exist even if the assets were sold immediately, and the judge dealt only with a pot of cash.

Proceedings such as the Manville and Robins bankruptcies were devoted principally to determining the value of contingent claims held by persons injured by the firm's products. Other cases require valuation of the costs by cleaning up toxic wastes, or of contentions that the debtor committed fraud. Whether the debtor can recover payments made to creditors before bankruptcy (preferences), whether a given debt arises out of a valid contract, and so on, are questions that must be answered by a court even if all assets turn to cash on day one. It is beneficial to resolve in a single forum the extent and priority of all claims to the firm's wealth. Here lie the principal costs of the process, making the comparison between bankruptcy and IPOs unduly favorable to IPOs. If bankruptcy does well even in such a comparison, it is understandable why there has not been an outcry for a better way.

Bankruptcy is a backup. When auctions are superior, creditors will arrange for them in or out of bankruptcy; when they are more expensive, the legal system supplies the method of writing down investments. All investors gain from an agreement to use the more efficient method. Holdouts may prevent the realization of gains from choosing the superior method, and because there are many creditors, holdouts could be a serious problem. Yet the 1978 Code makes it hard for a small number of creditors to hold out. The Code allows a class to compromise its claims by majority vote (two-thirds by value). That rule influences the bargains that can be struck outside of bankruptcy. Solitary holdouts no longer may play the role of spoilers, so it is more likely that creditors as a group will be able to take advantage of superior nonbankruptcy alternatives. When we see creditors resort to bankruptcy, they are telling us that the legal process is superior to market methods available to them.

Consider another possibility: The absence of auctions in bankruptcy may be attributable not to any comparative advantage of the legal process but to the infrequent bankruptcy of public corporations. Current legal processes may be adequate for closely held firms but inferior for larger entities. Now that bank-

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ruptcy of well-known firms (Texaco, Eastern Airlines, and Federated Stores) is more common, creditors may demand a change in the statute. A competing explanation is that bankruptcy of large firms is more common because, with the 1978 Code, bankruptcy became more attractive in comparison with other devices for dealing with financial distress: workouts, mergers, and so on. I am not so sure that bankruptcy of public corporations is more common; railroad bankruptcies, in particular, have hogged judicial time for more than 100 years. But if it is, an efficiency explanation is at least as attractive as an oversight explanation. Survival will distinguish the two, and it will be interesting to see whether in the coming decades the law moves toward a preference for market over judicial valuation of corporate assets.

References

Baird, Douglas G., "The uneasy case for corporate reorganization," 15 Journal of Legal Studies 127-47 (1986) [reprinted in the volume as Chapter 22].

Bebchuk, Lucian Arye, "Anew approach to corporate reorganizations," 101 Harvard Law Review 775-804 (1988) [reprinted in the volume as Chapter 24].

Bebchuk, Lucian Arye and Kahan, Marcel, "Fairness opinions: How fair are they and what can be done about it?," Duke Law Journal 27-53 (1989).

Easterbrook, Frank H., "High-yield debt as an incentive device," 2 International Review of Law and Economics 183 (1991).

Gilson, Stuart C, "Bankruptcy, boards, banks, and blockholders," 27 Journal of Financial Economics (1990).

Gilson, Stuart C, John, Kose, and Lang, Larry H.P., "Troubled debt restructurings: An empirical study of private reorganizations of firms in default," 27 Journal of Financial Economics (1990).

Ritter, Jay R., "The costs of going public," 19 Journal of Financial Economics 269-81 (1987).

Roe, Mark J., "Bankruptcy and debt: Anew model for corporate reorganizations," 83 Columbia Law Review 527-602 (1983) [reprinted in the volume as Chapter 23].

Weiss, Lawrence A., "Bankruptcy resolution: Direct costs and violation of priority of claims," 27 Journal of Financial Economics 285 (1990).

White, Michelle J., "The corporate bankruptcy decision," 3 Journal of Economic Perspectives 129-51 (1989) [reprinted in the volume as Chapter 14].

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CHAPTER 27

The voting prohibition in bond workouts*

MARK J. ROE**

Fifty years ago, Congress prohibited all binding bondholder votes that would modify any core term - principal amount, interest rate, and maturity date - of a bond indenture. As a result, firms in financial distress may now successfully recapitalize their outstanding bond obligations outside of bankruptcy only if enough bondholders individually consent.

The 1980s explosive use of junk bonds makes timely a reexamination of this longstanding congressional prohibition. In a future economic recession, some issuers of junk bonds will be forced to seek financial reorganization; similarly, some issuers of investment grade bonds will experience severe reverses and also seek reorganization. A workout, in which the unserviceable debt is exchanged for stock or in which payments are stretched out, would then be necessary. If a workout fails, bankruptcy may ensue.

Against this backdrop, I examine in this chapter whether and how current bond regulation of workouts could be reformed to reduce the costs of financial collapse. In Section I, we see how financial stress creates problems that current bond regulation exacerbates. Creditors that refuse to participate in the workout will benefit, because the firm more easily can pay residual creditors in full after (and if) the recapitalization succeeds.

In Section II, I critically examine the Trust Indenture Act's prohibition of a bondholder vote in a workout. By prohibiting a binding vote among bondholders, the Trust Indenture Act makes a deal and recapitalization more likely to fail than it would otherwise be.

In Section III, I examine alternative methods of indenture regulation and bondholder protection. While simple repeal of the prohibition on majority votes would give rise to complex problems of information, protective renegotiation, signalling effects, and serious tax problems, these difficulties are not all intractable. Better ways - regulation by SEC rulemaking instead of a flat ban - can be found to accomplish the little that the prohibition now achieves. The alternatives I propose here can better serve both issuers and bondholders than the current prohibition.

*This chapter is an edited version of the article that originally appeared in 97 The Yale Law Journal 232-79 (1987). Permission to publish excerpts in this book is gratefully acknowledged.

**Professor, Columbia University Law School.

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I.Why Workouts Collapse

A. Why are there bankruptcies?

Bankruptcies are thought to be expensive. The fundamental operational decline reduces sales and profits, but the financial stress of bankruptcy deepens these losses, although the size of these bankruptcy costs is still an open matter. Financial distress, short of bankruptcy, also will produce most of these costs until the stress is eliminated. A typical bond recapitalization, if successful, can take three months, while a bankruptcy reorganization typically takes two or three years.

Why don't the owners and creditors of the firm negotiate a deal to avoid bankruptcy? Ronald Coase's famous theorem suggests that, in the absence of transaction costs, the incentives of those financially interested in the nearly bankrupt firm would be to contract to the efficient solution.1 Creditors could take a large stock position or reduce required current cash payments in return for a greater deferred return. In the workout, they could then split among themselves (and perhaps with stockholders) the savings in bankruptcy costs. Creditors and stockholders frequently make that attempt, sometimes succeeding, but often failing. The failures that will concern us are those caused by a buoying-up effect, which we examine next.

1. Holdouts and the buoying-up effect

In a workout affecting bondholders, the company asks the bondholders to exchange their bonds for stock or for bonds with different terms. In a basic exchange offer, bondholders that do not exchange will be enriched at the expense of those that do: The exchange will leave the company able to pay the diminished fixed debt to the holdout bondholders in full. Indeed, the exchanging bondholders might be made worse off, since they help assure payment to the holdouts. If the subsidy to the nonexchanging bondholders is greater than their savings in avoided bankruptcy costs, each bondholder is better off refusing to exchange. If enough bondholders refuse, they will frustrate the workout.

These effects are neatly captured in lawyers' admonition to creditors against "losing your priority" in a recapitalization and that the "principle of equality of sacrifice" ought to govern a workout. Creditor self-protection induces creditors not to give up their priority unless there is equality of sacrifice among creditors. However, when creditors follow these maxims, they will place the distressed firm in a bind: Without near unanimity, a workout will fail.

1 R. Coase, "The Problem of Social Cost," 3 Journal of Law & Economics 1 (1960); J. Bulow and Shoven, "The Bankruptcy Decision," 9 Bell Journal of Economics 437, 438 (1978) (bankruptcy costs raise "primary question [of] why bankruptcy should ever occur").

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We can illustrate how the exchanging bondholders would "buoy up" a holdout by looking at a couple of balance sheets. Consider a company that issued $200 million of bonds when the company was worth considerably more than $200 million. The company thereafter declined in value, and now its operations are worth only $125 million. There are only five bondholders, each holding $40 million face value of bonds, each of whose bonds are worth no more than $25 million, since the firm itself is worth only $125 million.

Assets Liabilities

$ 125M $ 125M bonds ($200M face) 0 common stock

The bondholders view a recapitalization to common stock as valuable, because after the exchange the company, free from financial stress, would be worth a little more. Four of the five are initially willing to trade their bonds for an aliquot portion of the firm's new common stock. But even if the four were to share all of the firm's common stock, a bargaining problem would arise, induced by the single holdout. Why? Consider what the balance sheet would look like if four bondholders remained in place, owed $40 million by the firm. The new common stock would not be worth $100 million but less:

Assets Liabilities

$125 $40M bonds (formerly $25M in real value) $85M common stock

How could it be that the bondholders could turn in $100 million in bonds and would get only $85 million of stock, despite the fact that they would take all of the firm's stock? The recapitalization would relieve the firm's financial stress and thereby make the firm certain to pay off the fifth bondholder in full. The holdout fifth bondholder had bonds worth $25M before the exchange; it would have bonds worth $40M after the exchange. The exchanging bondholders would, however, have turned in $100 million worth of bonds and received only $85 million in stock, because of the fifth bondholder's continuing priority. Anticipating the decline in value of their holdings, the exchanging bondholders would condition their exchange to stock on the fifth bondholder joining them in the exchange.

2. Reasons for holdouts and bargaining failures

A multicreditor workout may fail for a number of reasons, some having little to do with the presence of multiple creditors. Even a firm's attempt to restructure with a single creditor can fail. Differences of opinion, mistrust and strategic action can thwart a deal. Parties may have different estimates of the firm's

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future revenues, or of the dispersion in those estimates; institutional creditors may have strong preferences for one means of compensation (cash or debt) over another (stock).

Multicreditor bargains present more pernicious problems because the buoy- ing-up effect worsens the basic bargaining failures. Even when a single creditor and the firm overcome these impediments, they cannot readily strike their own deal and ignore the other creditors, because value will flow from the consenting creditor to the holdout creditors.

This increased complexity usually affects all creditors. Bondholder holdouts stand to benefit at the expense not only of other bondholders but of all the company's creditors. Therefore, nonbondholder creditors will often be unwilling to agree to a recapitalization without substantial bondholder participation as well.

Finally, bondholders may seek to use the buoying-up effect offensively. By withholding consent to the recapitalization a bondholder may hope to gain from the buoying-up by seeing the economic value of her bonds increase if the recapitalization succeeds. But if many bondholders think the same way and act strategically, while hoping the other bondholders consent to the deal, then the deal will collapse. Furthermore, even if only a few act strategically, their holdout may induce others to act defensively to protect themselves from the buoy- ing-up effect. Again, the deal collapses.

3. Regulation and the necessity of near unanimity

Surely issuers, investment banks selling bonds, major bondholding institutions, and their respective legal counsel must have recognized the usefulness of bondholder collective action over the course of decades and billions of dollars in bond issues. A vote could allow bondholders to act as a single creditor, thereby eliminating a crucial source of multicreditor bargaining failure.

Although the Trust Indenture Act prohibition is sufficient to explain the lack of majority action, there may be other explanations. Creditors may want to have an individualized veto over a workout or bondbuyers may prefer bonds without a majority action clause. If bankruptcy costs are seen as low and the advantages of veto high, then majority action clauses might not arise even if permitted. However, economic and historical evidence indicates that the absence of the majority action clause in public bond indentures is not necessarily explained by either uselessness of the clause or creditor demand for an individualized veto. For example, preferred stock, which is roughly similar to the junk bond, typically uses binding votes for recapitalization. The clause was occasionally used before its prohibition in 1939, despite other regulatory problems.

2 15 U.S.C. sections 77aaa-77bbbb (1982).

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B. Other costs of prohibition

The inability to recapitalize smoothly imposes costs beyond those incurred by deadlocked bondholders involved in a recapitalization process. Economic resources can be misallocated. If attempts at workouts are unsuccessful, capital may not be made available for worthwhile projects, including the salvaging of ongoing projects, and rapid consolidation of a declining industry may be prevented.

Even in fragmented, competitive industries, failed recapitalizations will impose costs. When industries decline, economic theory suggests that there often should be consolidation in the industry. The buoying-up effect will frustrate some worthwhile mergers.

Of course, when the buoying-up effect is small, or when previously negotiated covenants allow senior debt or a transactional alternative (such as separate incorporation for, or sale of, what is valuable in the firm) deals can be worked out. But eventually these separation techniques can be exhausted; often they are barred by preexisting contractual arrangements,3 creditor protection statutes,4 antitrust rules, or managerial self-interest.

Firms in financial distress clearly do not always have worthwhile new opportunities. These troubled firms usually should be shrinking instead of expanding. But, when these firms do have good, even if only salvage, opportunities that require new cash, a merger, or the sale of most of their assets, they often cannot take advantage of them. Financial gridlock upsets allocational efficiency. When the lawyers' separation techniques are exhausted, the only remaining alternatives are renegotiation with preexisting creditors in a workout or a bankruptcy.

C. Reorganization techniques that reduce the buoying-up effect: Altering holdouts'incentives with exit consents and the thin residual market

Even when the separation techniques are exhausted, a recapitalization plan might be structured to reduce the buoying-up effect. Such plans usually must be attempted early during an operational decline to succeed. Three related courses of action are treated in the following discussion: offering a security that is senior to (or more quickly maturing than) the target issue, requiring exchanging bondholders to vote to dilute indenture covenants on noncore terms

3For example, preexisting creditors often will have insisted upon a negative pledge clause, which prohibits the firm from granting new creditors security without equally and ratably securing the preexisting creditors. In the absence of the negative pledge, the firm could change the expected risk of the loan by borrowing on a low-risk, low-cost secured basis, making the preexisting unsecured creditors worse off.

4For example, under fraudulent conveyance statutes, a creditor of an insolvent firm can attack some transfers of assets. See Uniform Fraudulent Conveyance Act sections 4-8, 7 U.L.A. 474, 504, 507, 509, 576 (1985).

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just prior to the tender of their bonds, and noting the natural result of a thin trading market for the nonexchanging bondholders. While each of these plans may diminish the buoying-up effect, none is assured of doing so and some raise fairness questions that have made them the subject of litigation.

1. Senior securities

The firm can offer exchanging bondholders senior debt instead of common stock, thereby altering the target bondholders' calculus of value. The firm could also offer a mixture of stock and bonds, with the offered bonds maturing before the target bonds. The target bondholders would then have to assess the risk that cash will flow out of the firm to pay the more quickly maturing bonds and that the firm will later have difficulty repaying the remaining target bondholders.

How does seniority reduce the buoying-up effect? In the event of bankruptcy, the newly created senior debt will be entitled to payment before the old debt. This loss of priority will make the expected value in bankruptcy of a holdout's claim less after the exchange than before the exchange. A prospective holdout will have to consider the chance of bankruptcy and a devalued claim before withholding her consent.

Ordinarily, for this type of exchange to relieve the company of stress, the exchanging bondholders have to give up current interest payments in return for some stock, deferred payment of interest, or another feature. However, these alternatives may not alter the buoying-up effect enough: In the interim between recapitalization and potential default, cash would flow out of the firm in interest and sinking fund payments to the nonexchanging bondholders. That is, if the new senior bondholders give up interest until a certain date or exchange some of the principal of their bonds for stock, then some payments due to the nonexchanging bondholders will be better assured of payment, since the new seniors will have reduced some of the firm's competing cash requirements. A proposed exchange has pluses and minuses for all affected; it might not work.

Even if most of the bondholders exchange, an exchange for deferred senior debt often does not completely relieve the firm's financial stress. The firm still has a lot of debt to pay off; repayment has only been deferred. If the senior debt is risky, that riskiness may still impede raising new capital or merging, due to buoying-up of the senior debt. Some exchanges to deferred senior debt or to packages containing more quickly maturing debt may occur only because the best recapitalization to common stock cannot be readily implemented in the face of the voting prohibition.

In sum, these techniques assure neither a completed recapitalization nor a financially viable firm even if the exchange offer is completed. They are often no more than second-best solutions.

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