Financial Restructuring in Chapter 11

Abstract

In this study, we investigate a large sample of firms that emerged from Chapter 11 reorganizations, with the primary aim of improving our understanding of how these reorganizations affect capital structure. Even though Chapter 11 reorganizations wipe out the majority of short-term debt, we find, like Gilson (1997), that total debt ratios remain significantly higher than those of industry peers immediately after emergence. Further, cross-sectional regressions of debt ratios suggest that observed post-emergence capital are only partially consistent with the predictions of the static-trade-off capital structure theory. Moreover, unlike Gilson, we find that the post-reorganization debt ratios are positively related to pre-reorganization debt ratios, suggesting that the debt is sticky. We interpret our collective results as evidence that the Chapter 11 process assists firms in moving toward their theoretically optimal capital structures, but not all the way. This is consistent with the argument put forth by Roe (1983) and Bebchuk (1988) that the Chapter 11 process does not permit firms to remove as much debt as would be optimal, but at odds with Gilson's conclusion that repeat bankruptcy filings or restructurings by these firms should not be taken as evidence that Chapter 11 produces economically inefficient capital structures (p. 190). While our evidence suggests that reorganizations partially alleviate financial distress, they presumably also alleviate economic distress via asset restructurings and sales. Despite apparent impediments to adjusting capital structure, we conjecture that the latter takes more time. Because firms with high debt ratios, especially short-term debt ratios, are most likely financially (but not necessarily economically) distressed, we therefore predict that firms with high debt ratios spend less time in Chapter 11. Regressions of the time spend in Chapter 11 support our predictions. Overall, our results suggest that while the Chapter 11 process might not completely resolve financial distress issues, it does so much faster than it resolves more fundamental operational problems.