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companies, headed by the Japanese company, Mitsui & Co., to build the power station, while the British company, National Power, became responsible for managing and running it. Hubco agreed to buy the fuel from the Pakistan State Oil Company and to sell the power station’s output to another government body, the Water and Power Development Authority (WAPDA).

Hubco’s lawyers drew up a complex series of contracts to make sure that each of these parties came up to scratch. For example, the contractors guaranteed to deliver the plant on time and to ensure that it would operate to specifications. National Power, the plant manager, agreed to maintain the plant and operate it efficiently. Pakistan State Oil Company entered into a long-term contract to supply oil to Hubco and WAPDA agreed to buy Hubco’s output for the next 30 years.36 Since WAPDA would pay for the electricity with rupees, Hubco was concerned about the possibility of a fall in the value of the rupee. The State Bank of Pakistan, therefore, arranged to provide Hubco with foreign exchange at guaranteed exchange rates.

The effect of these contracts was to ensure that each risk was borne by the party that was best able to measure and control it. For example, the contractors were best placed to ensure that the plant was completed on time, so it made sense to ask them to bear the risk of construction delays. Similarly, the plant operator was best placed to operate the plant efficiently and would be penalized if it failed to do so. The contractors and the plant manager were prepared to take on these risks because the project involved an established technology and there was relatively little chance of unpleasant surprises.

While these contracts sought to be as precise as possible about each party’s responsibilities, they could not cover every eventuality; inevitably the contracts were incomplete. Therefore, to buttress the formal legal agreements, the contractors and the plant manager became major shareholders in Hubco. This meant that if they cut corners in building and running the plant, they would share in the losses.

The equity in Hubco was highly levered. Over 75 percent of the $1.8 billion investment in the project was financed by debt. Some of this was junior debt provided by a fund that was set up by the World Bank and western and Japanese government aid agencies. The bulk of the debt was senior debt provided by a group of major international banks.37 The banks were encouraged to invest because they knew that the World Bank and several governments were in the frontline and would take a hit if the project were to fail. But they were still concerned that the government of Pakistan might prevent Hubco from paying out foreign currency or it might impose a special tax or prevent the company bringing in the specialist staff it needed. Therefore, to protect Hubco against these political risks, the government promised to pay compensation if it interfered in such ways with the operation of the project. Of course, the government could not be prevented from tearing up that agreement, but, if it did, Hubco was able to call on a $360 million guarantee by the

36WAPDA entered into a take-or-pay agreement with Hubco; if it did not take the electricity, it still had to pay for it. In the case of pipeline projects the contract with the customer is often in the form of a throughput agreement, whereby the customer agrees to make a minimum use of the pipeline. Another arrangement for transferring revenue risk to a customer is the tolling contract, whereby the customer agrees to deliver to the project company materials that it is to process and to return to the customer. One purpose of transferring revenue risk to customers is to encourage them to estimate their demand for the project’s output thoroughly.

37Notice that the project was not financed by a public bond issue. The concentrated ownership of bank debt induces the lenders to evaluate the project carefully and to monitor its subsequent progress. It also facilitates the renegotiation of the debt if the project company runs into difficulties.

World Bank and the Export–Import Bank of Japan. This was supposed to keep the Pakistan government honest once the plant was built and operating. Governments can be surprisingly relaxed in the face of the wrath of a private corporation but are usually reluctant to break an agreement that lands the World Bank with a large bill.

The arrangements for the Hubco project were complex, costly, and time-consuming. Not everything was plain sailing. The project was suspended for over a year by the Gulf War and it looked at one time as if it would be spiked by a Pakistani court ruling that the interest on the loans contravened Islamic law. Ten years after the start of discussions the final agreement on financing the project was signed and within a short time Hubco was producing a fifth of all Pakistan’s electricity.

However, that was not the end of the Hubco story. After the fall of Benazir Bhutto’s government in Pakistan, the new government terminated the contract with Hubco and announced a 30 percent cut in electricity tariffs. This inevitably led to a dispute with the World Bank, which spelled out that, until the dispute could be resolved, nothing could move on new loans.38

Project Finance—Some Common Features

No two project financings are alike, but they have some common features:

•The project is established as a separate company.

•The contractors and the plant manager become major shareholders in the project and thus share in the risk of the project’s failure.

•The project company enters into a complex series of contracts that distributes risk among the contractors, the plant manager, the suppliers, and the customers.

•The government may guarantee that it will provide the necessary permits, allow the purchase of foreign exchange, and so on.

•The detailed contractual arrangements and government guarantees allow a large part of the capital for the project to be provided in the form of bank debt or other privately placed borrowing.

The Role of Project Finance

Project finance is widely used in developing countries to fund power, telecommunication, and transportation projects, but it is also used in the major industrialized countries. In the United States project finance is most commonly used to fund power plants. For example, an electric utility company may get together with an industrial company to construct a cogeneration plant that provides electricity to the utility and waste heat to a nearby industrial plant. The utility stands behind the cogeneration project and guarantees its revenue stream. Banks are happy to lend as much as 90 percent of the cost of the project because they know that, once the project is up and running, the cash flow is insulated from most of the risks facing normal businesses.39

There are some interesting regulatory implications, however. When a utility builds a power plant, it is entitled to a fair return on its investment: Regulators are

38The confrontation between Hubco and the government of Pakistan is described in C. Hill, “Power Failure,” Institutional Investor (November 1999), pp. 109–119.

39Such extremely high debt ratios must rest on the utility’s creditworthiness. In a sense, the utility has borrowed money “off balance sheet.”

you had invested an equal amount in each tranche, the average interest rate on your two holdings would have been 6.4 percent.

That was not the end of tranche B’s complications, since the principal payment was not fixed at 100 percent. Instead it declined if the Japanese stock market fell. If the index fell by about 50 percent, the bondholder did not receive any principal payment at all. Thus, investing in tranche B was like buying an unusual floatingrate note and also selling a put option on the Japanese stock market. To compensate for the possible capital loss, the bonds offered a relatively high rate of interest.

For several years the majority of international issues of yen bonds involved similar options. Why? One reason is that life insurance companies in Japan cannot distribute capital gains to policyholders and therefore had a powerful appetite for high-yielding bonds even if such investments involved the risk of a capital loss. Christiania Bank paid a high rate of interest on the package, but it obtained a put option in exchange. If it did not want to hold onto this put option, it could easily sell it to foreign investors who were worried that the Japanese equity market was overpriced and wanted protection against a fall in that market.

Our second example is a pay-in-kind bond (or PIK) issued by RJR Nabisco. The bond carried an attractive coupon of 15 percent, but for the first few years of the bond’s life, RJR could choose to pay interest either in the form of cash or of bonds with an equivalent face value. This gave the company a valuable option. If RJR fell on hard times and bond prices dropped, it could hand over low-priced bonds instead of hard cash. RJR also had the right to call the bonds. That provided another valuable option: If interest rates fell and bond prices rose, the company could buy back the bond for the call price.

It is often difficult to foresee which new securities will become popular and which will never get off the ground. Sometimes new financial instruments succeed because they widen investor choice. Economists refer to such securities as helping to “complete the market.” For example, the unusual weather in 1997–1998 resulting from El Niño encouraged a number of firms to market financial contracts that would pay off in unfavorable weather conditions. These firms hoped that weather derivatives would prove popular with the newly deregulated energy companies, the agricultural community, and many other businesses that might wish to protect themselves against the vagaries of the weather.

Governments may unwittingly play a major role in stimulating financial innovation, for new types of security are often designed to circumvent government regulations. For instance, we have already seen how one unusual bond, the equitylinked yen bond, was a consequence of Japanese insurance regulation. Unforeseen changes in the bond market can also result from changes in the tax rules. One of the most striking examples was the U.S. government’s imposition of a tax on purchases of foreign securities, which brought about the development of the eurobond market in the 1960s.

The indenture states whether the bonds are senior or subordinated and whether they are secured or unsecured. Most bonds are unsecured debentures or notes. This means that they are general claims on the corporation. The principal exceptions are utility mortgage bonds, collateral trust bonds, and equipment trust certificates. In the event of a default, the trustee to these issues can repossess the company’s assets in order to pay off the debt.

Most long-term bond issues have a sinking fund. This means that the company must set aside enough money each year to retire a specified number of bonds. A sinking fund reduces the average life of the bond, and it provides a yearly test of the company’s ability to service its debt. It therefore protects the bondholders against the risk of default.

Long-dated bonds may be callable before maturity. The company usually has to pay a call premium, which is initially equal to the coupon and which declines progressively to zero. The option to call the bond may be very valuable: If interest rates decline and bond values rise, you may be able to call a bond that would be worth substantially more than the call price. Of course, if investors know that you may call the bond, the call price will act as a ceiling on the market price. Your best strategy, therefore, is to call the bond as soon as the market price hits the call price. You are unlikely to do better than that.

The bond indenture also imposes certain conditions on the borrower. Here are some examples of covenants:

1.Issues of senior bonds prohibit the company from issuing further senior debt if the ratio of senior debt to net tangible assets is too high.

2.Issues of subordinated bonds may also prohibit the company from issuing further senior or junior debt if the ratio of all debt to net tangible assets is too high.

3.Unsecured bonds incorporate a negative pledge clause, which prohibits the company from securing additional debt without giving equal treatment to the existing unsecured bonds.

4.Many bonds place a limit on the company’s dividend payments.

Private placements are less standardized than public issues, and they impose more stringent covenants. Otherwise, they are generally close counterparts of publicly issued bonds. Sometimes private debt takes the form of project finance. In this case the loan is tied to the fortunes of a particular project.

There is an enormous variety of bond issues, and new forms of bonds are spawned almost daily. By a principle of natural selection, some of these new instruments become popular and may even replace existing species. Others are ephemeral curiosities. Some innovations succeed because they widen investor choice and allow investors to manage their risks better. Others owe their origin to tax rules and government regulation.

What do Pacific Gas and Electric, Global Crossing, Enron, Fruit of the Loom, and Kmart have in common? Answer: They have all filed for bankruptcy. In this appendix we will explain what this involves and we will look at some of the pros and cons of the U.S. bankruptcy laws.

Occasionally bankruptcy proceedings in the United States are initiated by the creditors, but usually it is the firm itself that decides to file. It can choose one of two procedures, which are set out in Chapters 7 and 11 of the 1978 Bankruptcy Reform Act. The purpose of Chapter 7 is to oversee the firm’s death and dismemberment, while Chapter 11 seeks to nurse the firm back to health.

Most small firms make use of Chapter 7.41 In this case the bankruptcy judge appoints a trustee, who then closes the firm down and auctions off the assets. The proceeds from the auction are used to pay off the creditors. There is a pecking order of unsecured creditors. The U.S. Treasury, court officers, and the trustee have first peck. Wages come next, followed by taxes and debts to some government agencies such as the Pension Benefit Guarantee Corporation. Frequently the trustee will need to prevent some creditors from trying to jump the gun and collect on their debts, and sometimes the trustee will retrieve property that a creditor has recently seized. Managers of small firms that are in trouble know that Chapter 7 bankruptcy means the end of the road and, therefore, will try to put off filing as long as possible. As a result, when the assets are eventually liquidated, the unsecured creditors usually receive only a few crumbs.42

Instead of agreeing to a liquidation, large public companies generally attempt to rehabilitate the business. This is in the shareholders’ interests; they have nothing to lose if things deteriorate further and everything to gain if the firm recovers. The procedures for rehabilitation are set out in Chapter 11 of the 1978 act. Their purpose is to keep the firm alive and operating and to protect the value of its assets43 while a plan of reorganization is worked out. During this period, other proceedings against the firm are halted, and the company usually continues to be run by its existing management.44 The responsibility for developing the plan falls on the debtor firm but, if it cannot devise an acceptable plan, the court may invite anyone to do so—for example, a committee of creditors.

The plan goes into effect if it is accepted by the creditors and confirmed by the court. Acceptance requires approval by at least one-half of the creditors voting, and the creditors voting “aye” must represent two-thirds of the value of the creditors’ aggregate claim against the firm. The plan also needs to be approved by two-thirds of the shareholders. Once the creditors and shareholders have accepted the plan, the court normally approves it, provided that each class of creditors is in favor and that the creditors will be no worse off under the plan than they would be if the firm’s assets were liquidated and distributed. Under certain conditions the court may confirm a plan even if one or more classes of creditors votes against it,45 but the rules for a “cram-down” are complicated and we will not attempt to cover them here.

The reorganization plan is basically a statement of who gets what; each class of creditors gives up its claim in exchange for new securities or a mixture of securities and cash. The problem is to design a new capital structure for the firm that will

41Sometimes small firms file under Chapter 11, but attempts to rehabilitate the firm are rarely successful and the assets eventually have to be liquidated.

42See M. J. White, “Survey Evidence on Business Bankruptcy,” in J. S. Bhandari and L. A. Weiss (eds.), Corporate Bankruptcy, Cambridge University Press, Cambridge, 1996.

43To keep the firm alive, it may be necessary to continue to use assets that were offered as collateral, but this denies secured creditors access to their collateral. To resolve this problem, the Bankruptcy Reform Act makes it possible for firms operating under Chapter 11 to keep such assets as long as the creditors who have a claim on those assets are compensated for any decline in their value. Thus, the firm might make cash payments to the secured creditors to cover economic depreciation of the assets.

44Occasionally the court will appoint a trustee to manage the firm.

45But at least one class of creditors must vote for the plan; otherwise the court cannot approve it.

(1) satisfy the creditors and (2) allow the firm to solve the business problems that got the firm into trouble in the first place.46 Sometimes satisfying these two conditions requires a plan of baroque complexity, involving the creation of a dozen or more new securities.

The Securities and Exchange Commission (SEC) plays a role in many reorganizations, particularly for large, public companies. Its interest is to ensure that all relevant and material information is disclosed to the creditors before they vote on a proposed plan of reorganization. The SEC may take part in a hearing before court approval of a plan, for example.

Chapter 11 proceedings are often successful, and the patient emerges fit and healthy. But in other cases rehabilitation proves impossible, and the assets are liquidated. Sometimes the firm may emerge from Chapter 11 for a brief period before it is once again submerged by disaster and back in the bankruptcy court. For example, TWA came out of Chapter 11 bankruptcy at the end of 1993, was back again less than two years later, and then for a third time in 1998, prompting jokes about “Chapter 22” and “Chapter 33.”47

Is Chapter 11 Efficient?

Here is a simple view of the bankruptcy decision: Whenever a payment is due to creditors, management checks the value of the equity. If the value is positive, the firm pays the creditors (if necessary, raising the cash by an issue of shares). If the equity is valueless, the firm defaults on its debt and petitions for bankruptcy. If the assets of the bankrupt firm can be put to better use elsewhere, the firm is liquidated and the proceeds are used to pay off the creditors; otherwise the creditors simply become the new owners, and the firm continues to operate.48

In practice, matters are rarely so simple. For example, we observe that firms often petition for bankruptcy even when the equity has a positive value. And firms often continue to operate even when the assets could be used more efficiently elsewhere. The problems in Chapter 11 usually arise because the goal of paying off the creditors conflicts with the goal of maintaining the business as a going concern. We described in Chapter 18 how the assets of Eastern Airlines seeped away as the court attempted to keep the airline flying. When the company filed for bankruptcy, its assets were more than sufficient to repay in full its liabilities of $3.7 billion. But the bankruptcy judge was determined to keep Eastern flying. When it finally became clear that the airline was a terminal case, the assets were sold off and the creditors received less than $.9 billion. The creditors would clearly have been better off if Eastern had been liquidated immediately; the unsuccessful attempt at resuscitation cost the creditors $2.8 billion.49

46Although Chapter 11 is designed to keep the firm in business, the reorganization plan often involves the sale or closure of large parts of the business.

47One study found that after emerging from Chapter 11, about one in three firms reentered bankruptcy or privately restructured their debt. See E. S. Hotchkiss, “Postbankruptcy Reform and Management Turnover,” Journal of Finance 50 (March 1995), pp. 3–21.

48If there are several classes of creditors, the junior creditors initially become the owners of the company and are responsible for paying off the senior debt. They now face exactly the same decision as the original owners. If their equity is valueless, they will also default and turn over ownership of the company to the next class of creditors.

49These estimates of creditor losses are taken from L. A. Weiss and K. H. Wruck, “Information Problems, Conflicts of Interest, and Asset Stripping: Chapter 11’s Failure in the Case of Eastern Airlines,” Journal of Financial Economics 48 (1998), pp. 55–97.

Here are some reasons that Chapter 11 proceedings do not always achieve an efficient solution:

1.Although the reorganized firm is legally a new entity, it is entitled to the tax-loss carryforwards belonging to the old firm. If the firm is liquidated rather than reorganized, the tax-loss carryforwards disappear. Thus there is a tax incentive to continue operating the firm even when its assets could be sold and put to better use elsewhere.

2.If the firm’s assets are sold off, it is easy to determine what is available to pay the creditors. However, when the company is reorganized, it needs to conserve cash. Therefore, claimants are generally paid in a mixture of cash and securities. This makes it less easy to judge whether they receive a fair shake. For example, each bondholder may be offered $300 in cash and $700 in a new bond that pays no interest for the first two years and a low rate of interest thereafter. A bond of this kind in a company that is struggling to survive may not be worth much, but the bankruptcy court usually looks at the face value of the new bonds and may therefore regard the bondholders as paid off in full.

3.Senior creditors who know they are likely to get a raw deal in a reorganization are likely to press for a liquidation. Shareholders and junior creditors prefer a reorganization. They hope that the court will not interpret the pecking order too strictly and that they will receive some crumbs when the firm’s remaining value is sliced up. In the majority of cases their hopes are realized; often they

receive a substantial portion of the equity of the reorganized company even though the senior creditors receive less than they are owed.50

4.Although shareholders and junior creditors are at the bottom of the pecking order, they have a secret weapon—they can play for time. On average it takes two to three years before a plan is presented to the court and agreed to by each class of creditor. When they use delaying tactics, the junior claimants are betting on a stroke of luck that will rescue their investment. On the other hand, the senior claimants know that time is working against them, so they may be prepared to accept a smaller payoff as part of the price for getting a plan accepted. Also, prolonged bankruptcy cases are costly (the bankruptcy

proceedings of Wickes Corporation involved about $250 million in legal and administrative costs).51 Senior claimants may see their money seeping into lawyers’ pockets and therefore decide to settle quickly.

5.While a reorganization plan is being drawn up, the company is likely to need additional working capital. It is therefore allowed to buy goods on credit and borrow money. The new creditors have priority over the old creditors, and their debt may even be secured by assets that are already mortgaged to existing debtholders. This also gives the old creditors an incentive to settle quickly, before their claims are diluted by the new debt.

6.While the firm is in Chapter 11, secured debt receives interest but unsecured debt does not. For unsecured debtholders that is another reason for a fast settlement.

50Franks and Torous found that stockholders received some payoff—usually securities—in two-thirds of Chapter 11 reorganizations. See J. R. Franks and W. N. Torous, “An Empirical Investigation of U.S. Firms in Reorganization,” Journal of Finance 44 (July 1989), pp. 747–770. A similar study concluded that in a third of the cases shareholders received more than 25 percent of the equity in the new firm. See L. A. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics 27 (October 1990), pp. 285–314.

51We reviewed these costs in Section 18.3.

7.Sometimes profitable companies have filed for Chapter 11 bankruptcy to protect themselves against burdensome suits.52 For example, Continental

Airlines, which was bedeviled by a costly labor contract, filed for Chapter 11 in 1982 and immediately cut pay by up to 50 percent.53 In 1995 Dow Corning was threatened with costly litigation for damage allegedly caused by its silicone-gel breast implants. Dow filed for bankruptcy under Chapter 11, and the bankruptcy judge agreed to stay the damage suits. Needless to say, lawyers and legislators worry that these actions were contrary to the original intent of the bankruptcy acts.

Workouts

If Chapter 11 reorganizations are not efficient, why don’t firms bypass the bankruptcy courts and get together with their creditors to work out a solution?

Many firms that are in distress do first seek a negotiated settlement. For example, they can seek to delay repayment of the debt or negotiate an interest rate holiday. However, shareholders and junior creditors know that senior creditors are anxious to avoid formal bankruptcy proceedings. So they are likely to be tough negotiators, and senior creditors generally need to make concessions to reach agreement.54 The larger the firm, and the more complicated its capital structure, the less likely it is that everyone will agree to any proposal. For example, Wickes Corporation tried—and failed—to reach a negotiated settlement with its 250,000 creditors.

Sometimes the firm does agree to an informal workout with its creditors and then files under Chapter 11 to obtain the approval of the bankruptcy court.55 Such prepackaged bankruptcies reduce the likelihood of subsequent litigation and allow the firm to gain the special tax advantages of Chapter 11.

Alternative Bankruptcy Procedures

The United States bankruptcy system is often described as a debtor-oriented system: Its principal focus is on rescuing firms in distress. But this comes at a cost, for there are many instances in which the firm’s assets would be better redeployed in other uses. One critic of Chapter 11, Michael Jensen, has argued that “the U.S. bankruptcy system is fundamentally flawed. It is expensive, it exacerbates conflicts of interest among different classes of creditors, and it often takes years to resolve individual cases.”56 Jensen’s proposed solution is to require that any bankrupt company be put immediately on the auction block and the proceeds distributed to claimants in accordance with the priority of their claims.57

52See, for example, A. Cifelli, “Management by Bankruptcy,” Fortune, October 1983, pp. 69–73.

53The pay cut enabled Continental to reduce fares aggressively and improve its load factors, but it did not solve Continental’s problems. Shortly after emerging from bankruptcy, it was back in the bankruptcy court.

54Franks and Torous show that creditors make even greater concessions to junior claimholders in informal workouts than in Chapter 11 reorganizations. See J. R. Franks and W. N. Torous, “How Shareholders and Creditors Fare in Workouts and Chapter 11 Reorganizations,” Journal of Financial Economics 35 (May 1994), pp. 349–370.

55For example, when TWA reentered Chapter 11 in 1995, it had already agreed to a prepack with its creditors.

56 M. C. Jensen, “Corporate Control and the Politics of Finance,” Journal of Applied Corporate Finance 4 (Summer 1991), pp. 13–33.

57An ingenious alternative set of bankruptcy procedures is proposed in P. Aghion, O. Hart, and J. Moore, “The Economics of Bankruptcy Reform,” Journal of Law, Economics and Organization 8 (1992), pp. 523–546.