Distressed Debt Research Articles

Transplanting Absolute Priority in Indian Bankruptcy Law: Part II

In 2016, India revamped its bankruptcy legislation and introduced a new framework for resolution of financially distressed businesses. The Insolvency and Bankruptcy Code (IBC) was intended to usher in a new era of efficiency and galvanize India’s ailing bankruptcy regime. The results thus far have been mixed. One of the issues that has frequently arisen under the new regime is how to distribute the resolution proceeds amongst different classes of creditors. The doctrine evolved by courts and tribunals has been to leave any question on distribution to the discretion of the Committee of Creditors – an approach developed to insulate bankruptcy proceedings from excessive judicial interference. In this paper, which will be published across two volumes, I endeavour to show that this approach is flawed and contributes to the systemic problems afflicting the Indian bankruptcy regime. Drawing on doctrine developed in transnational bankruptcy law, I argue in favour of adopting the absolute priority rule as a fixed rule for distribution of resolution proceeds in India, which can augment value maximization and enable efficient resolution of distressed debt. In Part I of this paper, which was published in the previous volume, I traced the origins, evolution and migration of the absolute priority rule in transnational bankruptcy law. In Part II, I contextualize rules of priority in India and make the case for transplanting absolute priority in Indian bankruptcy law.

Measuring Going Concern Viability and the Effect of Interim Financing Under the Indian Insolvency and Bankruptcy Code, 2016

Abstract India’s insolvency framework mandates preserving viable firms as going concerns, but a critical gap remains – the lack of a standardised approach to assessing a firm’s viability during bankruptcy proceedings, resulting in inefficient allocation of interim finance to insolvent firms. This study sheds light on this issue by examining the performance of 21 firms during insolvency. We find that the absence of a clear viability assessment has led to suboptimal outcomes: viable firms being underfinanced and unviable firms being overfinanced. This has led to value deterioration, as many viable firms were ultimately pushed into liquidation due to insufficient interim financing. As a remedy, the authors propose a periodic viability assessment framework, for collecting and publishing information about the insolvent firm during insolvency proceedings. This would improve transparency and predictability for viable firms seeking interim finance, empowering lenders and investors to make better-informed decisions. By supporting viable distressed firms, this framework could foster a thriving market for distressed debt in India, rescuing valuable companies from the bankruptcy abyss.

Transplanting Absolute Priority in Indian Bankruptcy Law: Part I

In 2016, India revamped its bankruptcy legislation and introduced a new framework for resolution of financially distressed businesses. The Insolvency and Bankruptcy Code (IBC) was intended to usher in a new era of efficiency and galvanize India’s ailing bankruptcy regime. The results thus far have been mixed. One of the issues that has frequently arisen under the new regime is how to distribute the resolution proceeds amongst different classes of creditors. The doctrine evolved by courts and tribunals has been to leave any question on distribution to the discretion of the Committee of Creditors – an approach developed to insulate bankruptcy proceedings from excessive judicial interference. In this paper, which will be published across two volumes, I endeavour to show that this approach is flawed and contributes to the systemic problems afflicting the Indian bankruptcy regime. Drawing on doctrine developed in transnational bankruptcy law, I argue in favour of adopting the absolute priority rule as a fixed rule for distribution of resolution proceeds in India, which can augment value maximization and enable efficient resolution of distressed debt. Part I of this paper will trace the origins, evolution and migration of the absolute priority rule in transnational bankruptcy law. Part II, which will be published in the following volume, will make the case for transplanting absolute priority in Indian bankruptcy law.

The Changing Face of Chapter 11 Bankruptcy: Insights from Recent Trends and Research

Several recent trends have reshaped the nature of bargaining in Chapter 11. These include increasingly complex prebankruptcy capital structures, decreasing time in Chapter 11 due to prepacks and prenegotiated plans, growing use of restructuring support agreements (RSAs) and sales of substantially all assets, an increased number of defaulting private equity–owned firms, and an increase in activity of specialized distressed debt investors. These trends have changed the balance of power in favor of senior secured lenders, who further shape the course of out-of-court negotiations. We examine evidence of the impact of these changes on important stakeholders, including creditors and workers.

The “Debt Trap” or the “Benefit Pie” View of China’s Belt and Road Initiative on Host Countries: Evidence from Chinese Enterprises’ Outward Foreign Direct Investment

ABSTRACT The Belt and Road Initiative (BRI) attracts many Chinese multinational enterprises (MNEs) to invest abroad, but China’s intention behind this policy has raised heated disputes. Drawing on an institution-based view and theories of emerging market multinational enterprises (EMNEs), we analyze whether the initiative undermines host countries’ financial conditions through outward foreign direct investment (OFDI). Using the time-varying Difference-in-Differences model based on Chinese enterprises’ investment data from 2009 to 2020, we find the BRI facilitates Chinese OFDI to host countries but with no significant increase in distressed debt. Chinese OFDI eschews heavily indebted countries and shows little relevance to the growth of the BRI countries’ non-repayable debt, which contradicts the “debt-trap” argument.

Do Country-Level Creditor Protections Affect Firm-Level Debt Structure Concentration?

AbstractWe study the effects of country-level creditor protections on the firm-level choice of debt structure concentration. Using data from forty-six countries, we show that firms form more concentrated debt structures in countries with stronger creditor protection. We propose a trade-off framework of optimal debt structure and show that in strong creditor rights regimes, the benefit of forming concentrated structures outweighs its cost. Because strong creditor protections increase liquidation bias, firms choose concentrated debt structures to improve the probability of successful distressed debt renegotiations. Firms with ex ante higher bankruptcy costs, including those with higher intangibility, cash flow volatility, R&D expenses, and leverage, exhibit stronger effects. Firms with restricted access to capital are also affected more. A difference-in-differences analysis of firms’ debt structure responses to creditor rights reforms confirms the cross-country results. Our findings are robust to alternative settings and a battery of robustness checks.

Fairness and Flexibility: Understanding Corporate Bankruptcy’s Arc

The paper grows out of two observed trends in corporation bankruptcy practice: first, reorganizations are increasingly structured by deals agreed to by insiders (including controlling creditors) before cases are filed, and bankruptcy courts have shown a willingness to adopt these deals within the chapter 11 process, despite concerns that the deals might not strictly comply with the Bankruptcy Code. But at the same time, there is a growing backlash – seen not only in academic writing, but also in appellate court decisions – against the flexible, deal culture that the bankruptcy courts have embraced. My paper shows that these opposing forces are not new. By looking at the long history of corporate bankruptcy – going back to the initial railroad insolvencies before the Civil War – I show how the story of American corporate reorganization law exhibits a distinctive pattern: a long, slow wave, drifting between flexibility and fairness. I argue that movements toward the extreme “fairness” pole are inherently unstable. In particular, because moves to extreme fairness tend to render reorganization systems unusable, the need for a functional reorganization system will inherently force a move back from fairness and toward flexibility. I conclude by arguing that changes to help the legitimate interests of small players getting crushed in the current system are worthwhile, but “reforms” that ultimately help distressed debt investors or other asset managers extract greater returns from bankrupt corporations are misguided at best. Moreover, as shown by an analysis of the prior reign of tremendous fairness – from about 1938 to 1978 – such a system is inherently unstable because the corporate reorganization system becomes unworkable. Rigidity increases the pressure for change. The best solution then is to scale back the extremes of the present ultra-flexible chapter system, without going so far as to thwart its very utility.

DISTRESSED DEBT INVESTMENTS IN INDIA What more needs to be done to strengthen regulations

The paper suggests possible use of government guarantees and credit default swaps for turning around distressed infrastructure sector assets in India, where project finance bank loans are predominant source of funding. The paper lays down the evolution of distressed debt regulation through secondary research and argues out that even now with the introduction of Insolvency and Bankruptcy Code, 2016, political/regulatory risk is unmitigated. The 'turnarounds' can be made more effective if fairly priced government guarantees can be modelled on the lines of credit default swaps. Distressed debt investors would then include the cash outflows for this guarantee in their valuation models. The paper uses a structural model to estimate probability of default on a sample of power companies and then lays down the conceptual framework for pricing the government guarantee. The paper concludes that this further improvement in regulations will, at the end of the day, be beneficial to banks, distressed debt investors, governments and even tax payers.

The Anatomy of Distressed Debt Markets

Over the last 30 years, the distressed debt market has come a long way and is now a legitimate investment asset class, albeit with periodic dramatic activity. Despite the benign credit cycle in US markets since the last great financial crisis, there are still more than 200 financial institutions in the United States, and a large number operating in other countries, such as Italy, Brazil, and India, specializing in investment in distressed and defaulted bonds and nonperforming loans. We document this novel and intriguing investment market, with a discussion of size, strategies, and performance. We also present new empirical results on pre- and postdefault experience, leveraging our unique databases on bond and loan prices and our indexes of performance of defaulted bonds and bank loans. The results show that the investment performance in distressed debt is not particularly impressive over the entire sample (1987–2016). For the last 10 years (2006–2016), however, the results are much better for overall outperformance, especially those using several strategies with respect to the seniority of the debt and market timing. This is due perhaps to favorable changes for creditors in the US bankruptcy code in 2005.

When Junior Lien Zombie Loans Rise from the Dead: An Examination of Cure Rates

Junior lien mortgage debt proliferated during the housing market run up as borrowers used piggyback loans to buy homes or extract home equity. Defaulted second liens now trade in the distressed debt market at large discounts. In this paper, we examine the previously understudied second lien cure rate topic and find that the size and status of the associated senior mortgage are important cure rate predictors as are other borrower debt usage characteristics revealed in credit bureau data that includes borrowers' household debt. Results should be of interest to distressed debt investors, lenders, and policymakers alike.

The Anatomy of Distressed Debt Markets

Over the last 30 years, the distressed debt market has come a long way and is now a legitimate investment asset class, albeit with periodic dramatic activity. Despite the benign credit cycle in US markets since the last great financial crisis, there are still more than 200 financial institutions in the United States, and a large number operating in other countries, such as Italy, Brazil, and India, specializing in investment in distressed and defaulted bonds and nonperforming loans. We document this novel and intriguing investment market, with a discussion of size, strategies, and performance. We also present new empirical results on pre- and postdefault experience, leveraging our unique databases on bond and loan prices and our indexes of performance of defaulted bonds and bank loans. The results show that the investment performance in distressed debt is not particularly impressive over the entire sample (1987–2016). For the last 10 years (2006–2016), however, the results are much better for overall outperformance, especially those using several strategies with respect to the seniority of the debt and market timing. This is due perhaps to favorable changes for creditors in the US bankruptcy code in 2005.

Liquidity versus Wealth in Household Debt Obligations: Evidence from Housing Policy in the Great Recession

We exploit variation in mortgage modifications to disentangle the impact of reducing long-term obligations with no change in short-term payments (“wealth”), and reducing short-term payments with no change in long-term obligations (“liquidity”). Using regression discontinuity and difference-in-differences research designs with administrative data measuring default and consumption, we find that principal reductions that increase wealth without affecting liquidity have no effect, while maturity extensions that increase only liquidity have large effects. This suggests that liquidity drives default and consumption decisions for borrowers in our sample and that distressed debt restructurings can be redesigned with substantial gains to borrowers, lenders, and taxpayers. (JEL E21, G21, G51, R38)

Liquidity vs. Wealth in Household Debt Obligations: Evidence from Housing Policy in the Great Recession

We use variation in mortgage modifications to disentangle the impact of reducing long-term obligations with no change in short-term payments (“wealth”), and reducing short-term payments with approximately no change in long-term obligations (“liquidity”). Using regression discontinuity and difference-in-differences research designs with administrative data measuring default and consumption, we find that principal reductions that increase housing wealth without affecting liquidity have no effect, while maturity extensions that increase only liquidity have large effects. Our results suggest that liquidity drives borrower default and consumption decisions, and that distressed debt restructurings can be redesigned with substantial gains to borrowers, lenders, and taxpayers.

Strategy and Force in the Liquidation of Secured Debt

This article provides an empirical and theoretical study of the processes for the liquidation of secured debt. The empirical portion of the study includes an empirical base of 74 profiles of distressed secured loans randomly selected from the portfolios of three lenders (one finance company, one bank, and one insurance company). Those profiles include information on such topics as how the lenders decide which loans to terminate, what happens to the debtors after the lender decides to terminate the relationships, how successful the lenders are in obtaining repayment, and how much the process of termination costs. The theoretical portion of the study builds on the base of empirical evidence in two ways. The first part of the theoretical discussion presents a model of the economics of distressed debt. I argue that debtors are surprisingly capable of protecting themselves even in the face of demands for payment from their lenders, relying on the substantial incidence in my profiles of transactions where the debtors either refinanced their loans or paid them off with cash flow generated from continued operations or sale of the underlying collateral. As a related point, I argue that extremely poor results lenders face in cases where they foreclose rebut the concerns of some academics about the ability of lenders to use foreclosure to capture valuable assets from their borrowers. The second part of the theoretical discussion addresses broader questions about the connection between the market for distressed debt and the larger market for the initial issuance of debt. First, based on the very low frequency of liquidation and the poor results that lenders obtain on liquidation, I argue that the principal reasons that lenders take collateral are the strategic advantages it gives them; the enhancement of their power to liquidate collateral by force is of so little value that it cannot plausibly be viewed as a general justification for those transactions. Accordingly, legal reforms of the secured-credit system should focus more on the serious policy issues raised by those strategic advantages than on perceived difficulties in obtaining a reliable right to liquidate. I close by addressing the long-standing concern that rules hindering creditors' collection efforts will affect the willingness of lenders to issue new loans. My evidence of the low frequency of business failure and bankruptcy strongly suggests that the concern is for the most part unfounded.

Deep finance: sovereign debt crises and the secondary market ‘fix’

Links between ballooning national debts and official aid conditionalities are well understood. Private sovereign debt markets, in contrast, have been largely overlooked outside mainstream economics. Yet, since the 1980s, a ‘secondary market regime’ in sovereign bonds has transformed financial geographies and legal practices, facilitating the build-up of riskier sovereign debts and strengthening specialized distressed debt investors. This secondary market ‘fix’ has enabled the international financial system to muddle through successive crises. Using the recently concluded Argentine debt saga as an example, I show how the secondary market regime’s effects on debtors are intertwined with, but distinct from, those of structural adjustment programmes; in cases of resistance to neoliberalism, ‘deep’ secondary market debt structures serve to push countries (back) into the neoliberal fold.

National Anti-Vulture Funds Legislation: Belgium's Turn

Sovereign distressed debt investors can create holdout problems during sovereign restructurings. Scholars have suggested a wide-range of normative solutions to alleviate these holdout problems, including ad hoc deals, the creation of a multilateral international sovereign bankruptcy framework, the insertion of collective-action clauses into bonds, the expansion of judicial discretion, and the return of the doctrines of comity and sovereign immunity. However, national legislatures have increasingly begun to exhibit a preference for adopting national legislative solutions to this issue. In 2015, Belgium passed the broadest Anti-Vulture Funds Law to date, which is significant because the law impacts the Euroclear payment system. While this law has received high praise from the United Nations and from other nations also considering passing similar legislation, a careful analysis demonstrates it is not sensitive to the benefits that vulture funds bring, such as providing incentives to sovereigns to form more efficient capital structures, providing a moral hazard counterbalance, serving as liquidity providers on the secondary distressed-debt market, and providing information to the market. If adopted by other nations, Belgium’s law can eliminate the secondary distressed debt market by blocking liquidity-providers from the market. As a result, national legislatures should avoid using Belgium’s law as model law, but rather, enact legislation that enhances active settlement discussions without compromising the bargaining power or rights of either the sovereign or the vulture funds.

Working at Workouts: Commercial Real Estate Debt in Distress

In 2010 Drive Property Solutions, a special servicing firm in Chicago, had partnered with Spiner Capital to win an FDIC auction of distressed debt. Included in that auction was the defaulted mortgage note on Northwinds Community Crossing, a retail strip mall in suburban Savannah, Georgia, which had been in default since November 2009. Sam Schey, an asset manager at Drive, needed to decide how to maximize recoveries from the nonperforming loan.

The Basics of Private Equity Funds

Private equity (PE) refers to illiquid investments or securities that are not publicly traded on an exchange, such as venture capital, mezzanine or distressed debt, leveraged buyouts, timber, oil and gas properties, and real estate. A limited partnership agreement (LPA) defines the terms of the relationship between the general partners (GPs) and the limited partners (LPs). The structure and compensation arrangements used by PE firms are highly standardized and a working knowledge of frequently employed terms and arrangements of LPAs is important to understanding the division of the profits and the drivers of returns in the industry. This note describes some of the basic features of LPAs with a particular focus on the basic terminology and compensation practices that relate to GPs and LPs. Excerpt UVA-F-1731 Rev. Sept. 15, 2015 The Basics of Private Equity Funds Private equity (PE) refers to illiquid investments or securities that are not publicly traded on an exchange. The investments can take many forms: venture capital (VC) (seed and early stage); mezzanine or distressed debt; leveraged buyouts; timber, oil, and gas properties; and real estate. The typical PE firm is organized as a limited partnership. The general partners (GPs) of the firm organize a fund and seek capital from the limited partners (LPs). A limited partnership agreement (LPA) defines the terms of the relationship between the GPs and LPs. The structure and compensation arrangements used by PE firms are highly standardized and a working knowledge of frequently employed terms and arrangements of LPAs is important to understanding the division of the profits and the drivers of returns in the industry. This note describes some of the basic features of LPAs with a particular focus on the basic terminology and compensation practices that relate to GPs and LPs. The Basics GPs invest in deals that they believe offer an opportunity to earn high risk-adjusted returns. To achieve this objective, they must find and evaluate deals and, when necessary, provide managerial and operational support to their investee companies. For the most part, GPs provide only a small portion of the funding for their investments (frequently 1% of the capital) and therefore they organize a fund and seek capital from LPs to fund their investments. Because of the high risk and illiquid nature of the assets, investors in PE funds are typically restricted to accredited investors. LPs include, among others, pensions and insurance companies, endowments, and high-net-worth individuals. GPs retain virtually all the important decision-making authority in a fund and, by comparison, LPs are usually passive investors with little say in the fund's direction. . . .

The perceived moral reprehensibility of strategic mortgage default

Defaulting on a mortgage is widely viewed as being immoral, but no prior study has examined the intervening roles of financial outcome and default intent. We find that the public is significantly more accepting of a defaulting borrower who earns a zero or negative return on his investment than one who earns a positive return. This moral viewpoint changes significantly when the default is strategic in nature. Defaulters are judged significantly less harshly by those who more so blame the lender for the current financial crisis, those who have previously strategically defaulted, and males. When asked to suggest a “morally appropriate” settlement offer to lenders to resolve the distressed debt, beyond the financial outcome and default intent remaining significant, we further find that those who more so blame the lender, those who view their home as more of an investment rather than a consumption good, those who have previously strategically defaulted, those with lower income levels, and minorities suggest significantly lower settlement offers.

RECENT DEVELOPMENTS IN CONSUMER CREDIT AND DEFAULT LITERATURE

AbstractThis survey discusses recent contributions to the quantitative literature on unsecured consumer debt and default, and some ongoing challenges for the literature. Key topics include the sources of the rise in personal bankruptcies, the importance of asymmetric information and the effects of developments in information technologies on consumer credit markets, delinquency and informal bankruptcy, debt collection and restructuring of distressed debt, the cyclical behavior of consumer debt and default, and the insurance role of household debt. Implications for welfare analysis and policy design are discussed. Several theoretical contributions and approaches to modeling the consumer credit markets are also highlighted.