Private Workouts Research Articles

Chapter 11 versus Private Workout: Value-Based Responses to Corporate Distress

In this study, I utilize emerging perspectives in value creation and appropriation to examine how a corporation’s ability to cultivate ex ante relational capital with more powerful versus less powerful stakeholders impacts the relative attractiveness of the two most common strategic responses to corporate distress – Chapter 11 bankruptcy and private renegotiations (workouts). By drawing upon prior conceptualizations of workouts as the less expensive and more efficient alternative to Chapter 11, I find through propensity score matching and regression analysis on a matched sample of 243 bankruptcies and workouts that greater ex ante relational capital with more powerful stakeholders is associated with a greater likelihood of reorganizing through workouts compared to Chapter 11, while possessing greater relational capital with less powerful stakeholders is associated with a greater likelihood of reorganizing through Chapter 11 compared to workouts. However, investors, whose support is critical to private workout success, don’t differentiate between the value of relational capital cultivated with more and less powerful stakeholders unless information asymmetry is high.

Zombie Firms, Corporate Restructuring and Relationship Banking: Credit Guidance as a Key to Tackle Zombie Lending?

Abstract Economists have examined the rise of so-called zombie firms in recent years. Such firms remain in financial distress for a prolonged period while financial creditors keep them alive through continued lending. Based on signaling theory, we investigate zombie firms in the context of corporate restructuring and relationship banking. Combining a theoretical approach with a multiple case study on German medium-sized firms facing private workouts, we derive the following main propositions: (i) Banks face information asymmetry and may have incentives for loan extension (i.e., rescheduled installments and additional collateral) when deciding about restructuring financing. In the case of financing unviable restructuring strategies, this can lead to the emergence of zombie firms. (ii) For this reason and in contrast to recent research, not only weakly capitalized but also healthy banks may face such incentives and might end up in financing zombie firms. (iii) Relationship banking reduces bank information asymmetry. Thus, it may enable banks to detect clients’ distress situations in the early stages and to support resolving them. Hence, guiding and inspecting banks (i.e., credit guidance) to carry out supportive relationship banking might be a key to preventing the emergence of zombie firms. The propositions bear several implications relevant to academic research, bank management and banking regulation.

Restructuring Non-Performing Loans for Bank Recovery: Private Workouts and Securitisation Mechanisms

Resolving regimes of non-performing loans (NPLs) have raised concerns among supervisory authorities and banking regulators. NPLs play a central role in the linkages between poor lending and credit risks. This has implications for the management of asset quality and for the stability of the firm and the financial sector. A high stock of NPLs is undesirable to investors which can lead a decrease in the stock price, profitability loss and potentially to a distressed scenario. In the aftermath of the global crisis, the early resolution of NPLs requires coordinated insolvency proceedings and harmonised restructuring tools. The EU legislation introduced minimum loss coverage layers of capital for NPLs to address newly formed losses. Specifically, the supervisory toolkit implemented in the European Banking Union aims to improve the classification of loan quality and establish common practices to monitor non-performing exposures. This article argues that there is a need to enhance private arrangements within the resolution of distressed debts – alternative to public support such as asset management companies and securitisation mechanisms – which in turn would make it more manageable to reduce the NPL on banks’ balance sheet.

Can innovative reforms and practices efficiently resolve financial distress?

The last few years have seen a phenomenal upsurge in the number of corporate bankruptcies. The vulnerabilities that were lying dormant within contemporary bankruptcy regimes suddenly became apparent, causing concerns within the international corporate community. Consequently, researchers, practitioners, and policy makers from all over the world became actively engaged in emphasizing the importance of efficient bankruptcy reforms to promote a rescue culture. The primary objective of an insolvency framework should be to provide quick, transparent, and cost-effective solutions for resolving financial distress and promoting a synergetic environment conducive to the proliferation of healthy debt repayment practices, increased trust factors between creditors and debtors, and a better survival rate for viable businesses. In this paper, we present a qualitative review of various insolvency reforms introduced in several countries between 2005 and 2013 for efficiently resolving financial distress. We delve into a discussion of the prevalent practice of resolving distress through the courts (formal procedure) or out of the courts (private workout) settlements, the supporting literature, and the limitations involved in the process. Overall, our goal was to summarize and synthesize empirical data and highlight the strengths and weaknesses of the proposed insolvency reforms to provide a better understanding of common ways of resolving financial distress. The data shows evidence that several countries have improved their bankruptcy ranking (doing business reports) by empowering creditors (by expanding their rights under bankruptcy), speeding up court procedures, promoting out-of-court procedures, and regulating insolvency practitioners. Lastly, we adopt a normative approach by proposing a list of legal changes that should drive legislators' actions in order to provide sustainable ways for resolving distress (e.g., transparency, early filling, extension of floating charges, electronic management of bankruptcy files, etc.).

Heterogeneous Beliefs and the Choice between Private Restructuring and Formal Bankruptcy

We present a novel theory to explain the puzzling issue regarding why certain firms in financial distress, that must renegotiate their debt prefer a formal bankruptcy procedure, which is more costly, over direct negotiations with their debtholders. Specifically, we show that claimholders' heterogeneous beliefs about the possible results of a formal plan - and about judicial discretion in particular - may lead to such a preference. In our model, informal processes are preferred when the total value of all corporate claims in a formal procedure, according to each claimholder's beliefs, is less than the total value of the firm's assets in an informal process. In such a case, all claimholders believe that they will be better off under an informal process because there is a positive surplus that can be divided among the parties (Pareto Improving). The proposed model can predict which resolution would be chosen under any set of claimholders' beliefs about the different determinants driving the outcome of a formal procedure, such as the cost of bankruptcy, the likelihood of deviation from the absolute priority rule in a reorganization plan, and the probability of the court adopting a reorganization plan. An empirical analysis of 252 defaults in Moody's annual reports during the 1996-2011 period supports the argument that heterogeneous beliefs and creditor coordination problems are important drivers of the decision to restructure under formal bankruptcy procedures rather than through private workouts.

Resolution of Corporate Financial Distress:An Empirical Analysis of Processes and Outcomes

In this article, Jacobs,Karagozoglu, and Naples Layish focus on determining which types of firms are able to successfully remain independent entities through the resolution of their financial distress. The authors empirically investigate the determinants of the process utilized to resolve financial distress (private work-out versus public bankruptcy filing) and also the outcome (liquidation versus reorganization).After developing various qualitative-dependent variable models, they estimate and compare several accounting and economic variables measured at the time of default that they expect can influence the resolution process and outcome.Results reveal the ordered logistic regression specification achieves the best balance between in-sample fit, consistency with financial theory, and out-of-sample classification accuracy, as compared to more elaborate techniques, such as local regression or neural networks.The authors find the public resolution process to be associated with larger firms that have less tangibility, a greater proportion of secured debt in their capital structures, or higher risk measures. The private resolution process is likelier for firms that have more total leverage, greater measures of liquidity, a higher proportion of subordinated debt in their capital structures, or reside in a debtorfriendly bankruptcy court district.Regarding the resolution outcome, the authors find that firms that are more likely to be liquidated than reorganized have greater liquidity, more secured debt, lower cumulative abnormal returns on equity, higher loss given default, a less favorable auditor9s opinion, or they will default in a better part of the credit cycle. Finally, firms more likely to be reorganized have greater leverage,more intangible assets, or a prepackaged bankruptcy. They conclude that their model is useful for risk managers and investors who are in the market for distressed or defaulted debt.

How do banks resolve firms’ financial distress? Evidence from Japan

The main purpose of this paper is to investigate how banks resolve firms’ financial distress in Japan. Our results show that distressed firms that have more unsecured bank debt are more likely to restructure debt successfully out of court. Second, private debt restructuring is conducted during the year in which a financially distressed firm would be compelled to report negative net worth because of substantial accounting losses if no debt restructuring plans were implemented. Third, firms that are already in a negative net worth situation are more likely to receive debt forgiveness and/or debt-for-equity swaps. Finally, both the 1-year-lagged total liabilities-to-assets ratio and accounting losses are positively related to the private workout level. These results suggest that banks resolve firms’ financial distress in shareholders’ and creditors’ interests. We argue that, along with bankruptcy laws, the stock exchange rules and the fact that banks are allowed to hold shares in these firms affect the resolution of firms’ financial distress.

Belief updating, debt pricing and financial decisions under asymmetric information

Abstract This paper studies debt holders’ belief updating, valuation of corporate debt, and equity owners’ financing decisions during financial distress under asymmetric information. This is done within a continuous-time framework, where the relevant state variable is assumed to follow an Arithmetic Brownian motion (ABM). ABM can take negative values and has very realistic feature compared with Geometric Brownian motion (GBM). Using Chapter 11 of U.S. Bankruptcy Code as a costly screening device, we can characterize which firm will choose private workouts (in the form of strategic debt service) and which will choose to file for the Chapter 11 Bankruptcy procedure (in the form of debt–equity swap) when the firm is in financial distress. Using arguments similar to equilibrium refinements, we give a clear picture of how debt holders’ beliefs about the firm’s types are updated according to the state variable and the firm’s default behavior, and describe optimal strategies of both parties under those beliefs. We also provide an approximate solution to the debt pricing problem under asymmetric information.

Reorganization strategies and securities valuation under asymmetric information

This paper examines optimal reorganization strategies during financial distress and securities valuation under asymmetric information. We model strategic interactions between debtholders and equityholders in a game-theoretic setting that can accommodate the varying bargaining powers of the two claimants. Two reorganization strategies are considered: Chapter 11 (debt–equity swap) and private workout (strategic debt service). Using Chapter 11 as a costly state verification device, we characterize in equilibrium which firms choose Chapter 11 and which choose private workout. In particular, we show how the bank's belief about the type of firm evolves by observation of reorganization strategies. We also derive closed-form solutions to both the equity and debt valuation problems under asymmetric information and show that credit spreads increase with the degrees of asymmetric information.

Bankruptcy as an Auction Process: Lessons from Sweden

The traditional U.S. Chapter 11 bankruptcy process in which financial claims are renegotiated under court protection and the firm continues to operate under existing management has long been criticized by economists as an inefficient way of dealing with financially distressed companies. In this paper, the authors make the case for a mandatory auction bankruptcy system of the kind now used in Sweden—one that requires all companies filing for Chapter 11 to be sold in open auctions soon after the filing.After discussing the notable features of and differences between the U.S. and Swedish bankruptcy systems, the authors summarize recent research (much of it their own) on the benefits and possible drawbacks of the Swedish system. Among the most notable findings of this research, there is no evidence that mandatory bankruptcy auctions in Sweden lead to “fire‐sale” discounts in auction premiums. Moreover, the fact that three‐quarters of the Swedish companies that filed for bankruptcy survived as going concerns should allay concerns that an auction system will produce excessive liquidations. At the same time, the post‐bankruptcy operating profitability of the companies that emerge from Swedish auctions as going concerns tends to be on a par with that of their (non‐bankrupt) industry peers. Such post‐operating performance, when combined with a 75% rate of reorganization (versus liquidation), suggests that allowing auction investors—instead of the bankruptcy court—decide which companies survive and how they get capitalized and restructured has been quite effective in accomplishing the two aims of a bankruptcy system: (1) preserving intact all economically viable enterprises while (2) eliminating the excess capacity that results from prolonging the existence of companies that are never expected to earn high enough returns on capital to attract private investment.Consistent with these findings, the U.S. in recent years has seen a sharp increase in the use of auctions in Chapter 11 bankruptcies, though on a voluntary rather than a mandatory basis. Such a change reflects the growing recognition of the role of auction processes in reducing bankruptcy costs and preserving going‐concern values as U.S. capital market participants push harder for private workouts, “prepackaged” Chapter 11 filings, and auction sales in Chapter 11.

The influence of managerial incentives on the resolution of financial distress

This study investigates the influence of managerial incentives on the resolution of financial distress. Our model predicts that when creditors and equityholders prefer different resolution methods, the likelihood of choosing Chapter 11 over private renegotiation is related to the ownership structure of the distressed firm. Empirical test results using a sample of 81 voluntary Chapter 11 firms and 65 private workout firms support the model’s prediction. We show that managerial ownership is positively related to the incidence of Chapter 11 filing when there is conflict between equityholders and creditors over the choice between Chapter 11 and a private renegotiation. Consistent with prior literature, we also find that the choice of resolution methods depends on the extent of creditor holdout problems and the level of economic distress. We also performed the analysis of a subsequent 5 years of post-distress performance for all sample firms. The majorities of firms that file for Chapter 11 lose their independence and are either acquired or liquidated. However, more than half of firms in private workouts survived as independent firms.

Can the Trade-off Theory Explain Debt Structure?

We examine the optimal mixture and priority structure of bank and market debt using a tradeoff model where banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior tradeoff between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the tradeoff theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The tradeoff theory also generates predictions consistent with international evidence. In countries where the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.

Can the Tradeoff Theory Explain Debt Structure?

We examine the optimal mixture and priority structure of bank and market debt using a tradeoff model where banks have the unique ability to renegotiate outside formal bankruptcy. Flexible bank debt offers a superior tradeoff between tax shields and bankruptcy costs. Ease of renegotiation limits bank debt capacity, however. Optimal debt structure hinges upon which party has bargaining power in private workouts. Weak firms have high bank debt capacity and utilize bank debt exclusively. Strong firms lever up to their (lower) bank debt capacity, augment with market debt, and place the bank senior. Therefore, the tradeoff theory offers an explanation for: (i) why young/small firms use bank debt exclusively; (ii) why large/mature firms employ mixed debt financing; and (iii) why bank debt is senior. The tradeoff theory also generates predictions consistent with international evidence. In countries where the bankruptcy regime entails soft (tough) enforcement of contractual priority, bank debt capacity is low (high), implying greater (less) reliance on market debt.

Financial Distress, Lender Passivity and Project Finance: The Case of Eurotunnel

The paper analyzes the difficulties of Eurotunnel, both the largest project finance company and one of the largest private workout in the history. Eurotunnel’s distress was primarily due to the wrong governance structure set up at the origin. Long-term contracts, far from limiting agency conflicts between the firm’s different claimants, led to major conflicts between initial sponsors. Once trapped by huge costs overruns, the banks transferred a significant part of their risks to poorly informed individual shareholders. We also investigate why the numerous banks did not trigger bankruptcy despite Eurotunnel’s chronic distress. Lender passivity was mainly due to highly specific assets, political pressures and the threat of legal pursuits under the French debtorfriendly bankruptcy law. If passive, the banks made no concessions in debt restructurings and the firm remained highly leveraged. Overall, the case suggests that (i) managerial opportunism is a minor problem in project finance. The failure of large project companies may be primarily due to unresolved conflicts between owners (ii) governance problems associated to dispersed equity ownership may be worse in project companies than in other less indebted firms (iii) banks can find optimal to maintain a firm in chronic financial distress in order to keep a high bargaining power in subsequent restructurings while avoiding a costly bankruptcy.

Chapter 11, Private Workouts and Corporate Debt Pricing under Asymmetric Information

This paper studies the valuation of risky corporate debt, the firm's financing decisions and firm strategy during financial distress under asymmetric information. Using Chapter 11 as a costly state verification mechanism in a simple continuous-time setting, we characterize which firms will choose to file for the Chapter 11 Bankruptcy procedure and which will choose private workouts (in the form of strategic debt service) when the firm is in financial distress. The model predicts that firms with more intangible assets, higher book value and less information asymmetry are more likely to restructure their debt privately, and their stockholders are systematically better off. We also provide a closed-form solution to the debt pricing problem. The formula reduces to the well-known results of Merton, Black and Cox, Leland and others if the private information can be costlessly revealed.

Absolute Priority Rule Violations, Credit Rationing, and Efficiency

Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely to occur, thereby making debt financing more costly. Together, these results support the view that APR violations create an impediment to efficient financial contracting. Journal of Economic LiteratureClassification Numbers: G33, G38, K20.

Financial Distress as a Noncooperative Game: A Proposal for Overcoming Obstacles to Private Workouts

In the past several years, academics have increasingly expressed dissatisfaction with Chapter 11.' Among other complaints, critics point out that reorganizations of major public companies are expensive and usually take a number of years to complete.' In addition, from the scant empirical information available, failure rates appear high. One study shows that 38.3% of reorganized companies liquidate within four years.3 Accordingly, academic writers have cast about for alternatives to court-supervised reorganizations. Suggestions include proposals for an all-equity capital structure, market-based solutions like mandatory auctions,5 and measures designed to encourage private workout agreements which avoid the need for judicial supervision altogether.6

MANAGING DEFAULT: SOME EVIDENCE ON HOW FIRMS CHOOSE BETWEEN WORKOUTS AND CHAPTER 11

As more and more U.S. companies default on their debt and file for bankruptcy, financial economists have become increasingly interested in understanding how companies deal with financial distress. In particular, academic concern has focused on whether the costs of resolving default are excessive, and whether the process by which firms recontract with their creditors can be made more efficient. Companies have good reason to be concerned with these issues as well. In 1990, almost $25 billion worth of junk bonds went into default, and 749,956 U.S. firms filed for bankruptcy. The costs of restructuring the balance sheets of troubled companies can be daunting. LTV Corporation, for example, has spent over $150 million on legal and other professional fees since it filed for chapter 11 in 1986. And this figure ignores other, potentially greater, costs of financial distress such as any loss of business occasioned by the bankruptcy. There are two basic methods for reorganizing troubled companies: private workouts and formal bankruptcy. In either case, new financial claims are exchanged for the firm's outstanding debt contract on terms the firm finds more affordable. The net effect of the exchange is either to reduce the level of interest and principal payments, to extend the payment dates, or to substitute equity for debt. The main difference between the two approaches is that, in bankruptcy, this exchange is supervised by the court. Viewed in this light, the workout-bankruptcy choice has an obvious parallel with the decision faced by plaintiffs and defendants over whether to settle out of court or go to trial.