The Bankruptcy Decision and Debt Contract Renegotiations *

Abstract

We consider the bankruptcy law and workout practices in the United States and model bankruptcy as a strategic decision. We analyze a firm's choice between liquidation under Chapter 7, renegotiation of the debt contract in a workout, and reorganization under Chapter 11 of the bank- ruptcy code. Our premise is that a financially distressed firm chooses its action in order to minimize the loss in value caused by the well-known over- and under-investment problems. We show that the firm initiates a workout when it faces under-investment, and commences Chapter 11 when it faces over-investment. Some of the results are: (i) in default, total firm value and equity value increase upon the announcement of a workout and decrease upon the announcement of Chapter 11; (ii) firms with shorter maturity of debt are more likely to reorganize in a workout; (iii) among the firms that renegotiate their debt contract, the proportion of firms entering Chapter 11 is higher for firms in mature industries than for firms in growth industries. Financial distress may cause traumatic events like default, bankruptcy, liquidation or reorganization, whose resolution has a great impact on a firm's financial and economic policies. Several actions are available to firms to alleviate the costs of these events, among which are commencing Chapter 11 or Chapter 7 of the bank- ruptcy code, out-of-court workout negotiations to change the debt contract, and open-market liquidation. In order to better understand the behavior of financially distressed firms, their choices over this entire set of actions must be considered. In this paper, we explore the determinants of the bankruptcy decision in the presence of the other options to resolve the conflict between debtors and creditors. Several puzzling issues arise when bankruptcy is viewed as a strategic decision. First, why do firms commence Chapter 11 instead of directly negotiating with