Financial Distress, Bankruptcy and Reorganization

7/29/2019 Financial Distress, Bankruptcy and Reorganization

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R. Jarrow et al., Eds.,Hand books in OR & MS, VoL 9 1995 Elsevier Science B.V. All rights reserved

Chapter 28Financial Distress, Bankruptcy and ReorganizationLemma W. SenbetCollege of Business an d Management, University of Maryland, University Park, M D 20742,US.A.James K. SewardA mo s Tuck School of Business Administration, Dartm outh University, Hanover, Ni t 03755,US.A.

1 . I n t r o d u c t i o n a n d o v e r v i e w

The decade of the 1980s saw some dramatic events in corporat e finance, leadingto wide attention to the role of corporate debt in public policy debates. Amongthese events are: (a) the increased reliance on the use of debt financing incorporate takeovers, restructurings and reorganizations; (b) the popularity (andsubsequent collapse) of the 'junk' bond or original issue high yield bond market;and (c) the savings and loan crisis. These debates have been recently fueled by thearrival and severity of an economic recession, raising public concerns about thepossibility of massive bankruptcies and their adverse consequences on the overallperf orma nce of the economy. 1 Correspondingly, the subject matte r of financialdistress and workouts has received a great deal of attention in the academicliterature by finance and legal scholars.

The purpose of this survey article is to synthesize the recent developments inthe topics of financial distress, bankruptcy and reorganization. We focus primarilyon developments in the corporate finance literature, although we summarizesome important contributions by legal scholars that bear on the issue. Whereappropriate, we also suggest research avenues of high promise. The subjectmatte r is quite extensive with many important features that cannot be instructivelyincluded in a single, general model. Consequently, we refrain from attemptingto work through a single structure that would have yielded no clear insights.Rather we organize the contributions around some unifying theoretical themes,and where available, we provide corresponding empirical evidence. 2

I Recent experience indicates that the number of corporations undergoing distress has increasedsubstantially. For example, White [1990] reports that 86,000 businesses, with aggregate liabilities of$36 billion, filed for bankruptcy in 1987.2 This approach is similar to the organization of the survey on capital structure by Harris &Raviv [1991].

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922 L.W. Senbet , J.K. Sew ardW e b e g i n b y se t ti n g f o r t h t h e l e g a l a n d e c o n o m i c ra m i f ic a t io n s o f t h e U . S .

B a n k r u p t c y C o d e , f o c u s i n g o n t h e B a n k r u p t c y R e f o r m A c t o f 1 97 8. I t is i m p o r t a n tt o h a v e a d e e p a p p r e c i a t i o n o f t h e m a i n p r o v i s i o n s o f t h e C o d e i n st u d y in g t h ee c o n o m i c i m p l i c a ti o n s o f f in a n c ia l d is tr e ss a n d f o r m a l b a n k r u p t c y p r o c e d u r e s .F o r m a l b a n k r u p t c y p r o c e e d i n g s e n t a i l a l i q u i d a t i o n p r o c e s s ( C h a p t e r 7 ) a n d ar e o r g a n i z a t i o n p r o c e ss (Chap ter 11 ) . U n d e r C h a p t e r 7 , t h e f i rm is s h u t d o w n b ya c o u r t - a p p o i n t e d t r u s te e , t h e f i r m 's a s se ts a r e s o ld , a n d t h e l i q u i d a ti o n p r o c e e d sa r e d i s t r i b u t e d i n a c c o r d a n c e w i th t h e a b s o l u t e p r i o r it y r u l e ( A P R ) . A b s o l u t ep r i o r i t y e s t a b l i s h e s a s t r i c t h i e r a r c h y o f d i s t r i b u t i o n a c c o r d i n g t o t h e s e n i o r i t y o fc l a i m s h e l d a g a i n s t t h e f i r m . W h i l e t h e p r o c e d u r e s e e m s r a t h e r s t r a i g h t f o r w a r d ,i t b e g s i m p o r t a n t i ss u es o f c o n f li c ts a m o n g c l a i m h o l d e r g r o u p s w i t h d i v e r sei n t e re s t s , v a l u a t io n o f a s se ts u n d e r a s y m m e t r ic a l ly i n f o r m e d p a r ti e s, a n d r e l a t e di n e f f ic i e n c i e s . C h a p t e r 1 1 is i n t e n d e d p r i m a r i l y f o r a r e h a b i l i t a t i o n o f a fi n a n c i a ll yd i s t re s s e d f i rm , a n d t h e i n c u m b e n t m a n a g e m e n t t e a m p l a y s a c r u c ia l r o l e int h e r e o r g a n i z a t i o n p r o c e s s . W e d e s c r i b e t h e e c o n o m i c i m p l i ca t io n s o f t h e m a i nr e o r g a n i z a t i o n p r o v i s i o n s , s u c h a s t h e a u t o m a t i c s t a y p r o v i s i o n , t h e e x c l u s i v i t yp r i v il e g e o f m a n a g e m e n t i n f il in g a r e o r g a n i z a t i o n p l a n , a n d n e w f in a n c in g b y a' d e b t o r - i n - p o s s e s s i o n ' . I n e v a l u a t in g t h e l e g a l r a m i f i c a t io n s , w e a l s o u n d e r s c o r et h e i m p a c t o f t h e b a n k r u p t c y p ro v i s io n s o n t h e b e h a v i o r o f c o r p o r a t e s t a k e h o l d e r so u t s i d e o f th e f o r m a l b a n k r u p t c y p r o ce s s .

O u r n e x t i t e m o n t h e s u r v e y a g e n d a is a th e o r e t i c a l e x a m i n a t i o n o f t h er e l a t i o n s h i p b e t w e e n f i n a n c i a l d i s tr e s s a n d e c o n o m i c d i st re s s . W e d o s o b y w a yo f s y n t h e si z in g t h e l i te r a t u r e o n b a n k r u p t c y a n d c o r p o r a t e f i n a n c ia l p o l ic y . A ni m p o r t a n t c o r o l l ar y o f t h e M o d i g l i a n i - M i l l e r [ 1 95 8 ] t h e o r e m , a s g e n e r a l i z e db y S t i g li tz [ 1 9 7 4] , is t h a t c o r p o r a t e b a n k r u p t c y is i m m a t e r i a l t o f i r m v a l u e .T h i s i m p o r t a n t i n s i g h t i s o f t e n m i s s e d i n d i s c u s s i o n s r e l a t i n g t o t h e e c o n o m i cc o n s e q u e n c e s o f c o r p o r a t e b a n k r u p t c y , w h i c h o f t e n c a s u al ly li n k e c o n o m i c d is tr e ssw i t h f i n a n c i a l d i s t r e s s . A s a r e l a t e d m a t e r , i t i s a l s o i m p o r t a n t t o g a i n a c l e a ra p p r e c i a t i o n o f th e d i c h o t o m y b e tw e e n b a n k r u p t c y a n d l i q u id a t io n ( t h e p r o c e s so f d is m a n t l i n g t h e f ir m ' s a ss e ts a n d s e ll in g t h e m - - e i t h e r p i e c e m e a l o r i n t h e i re n t i r e ty ) ; o t h e r w i s e l i q u i d a t i o n c o s ts m a y b e m i s t a k e n l y a t tr i b u t a b l e t o b a n k r u p t c yc o st s. I n d e e d , a t t h e h e a r t o f th e c o n t e m p o r a r y l i te r a t u r e o n f in a n c i al d is tr e ssis t h e d e t e r m i n a t i o n o f co s ts relevant t o b a n k r u p t c y . T h e s e c o s t s d e p e n d o n t h ee f f i c ie n c y o f r e s o l u t i o n o f f i n a n c ia l d i s t re s s .

T h u s , a n i m p o r t a n t c o m p o n e n t o f t h is s u r v e y is a s yn t he s is o f th e t h e o r e t i c a la n d e m p i r i c a l e v i d e n c e o n p r i v a t e a n d f o r m a l r e s o l u t i o n s o f f i n a n c i a l d i st re s s .A t t h e o u t s e t , w e r e c o g n i z e th a t t h e s e a l t e r n a ti v e m e t h o d s f o r r e so l v in g f in a n c ia ld i s t re s s a r e r e l a t e d i n t h e s e n s e t h a t t h e i n c e n t i v e s w h i c h v a r io u s c l a i m a n t g r o u p sh a v e t o r e o r g a n i z e a f i n a n c ia l ly d i s t r e s s e d f i r m d e p e n d o n t h e r e l a t i v e c o s t sa n d b e n e f i t s c o n f e r r e d b y e a c h m e t h o d . W e d i sc u ss v a ri o u s p r iv a t e m e t h o d s o fr e s o l v i n g f i n a n c i a l d i s t r e s s t h r o u g h d e b t r e s t r u c t u r i n g s , w o r k o u t s , a n d i n f o r m a lr e o r g a n i z a t i o n s i n t h e c a p i t a l a n d r e a l a s s e t m a r k e t s .

T h e r e a r e , h o w e v e r , p o t e n t i a l i m p e d i m e n t s t o t h e p r i v a t iz a t io n o f fi n a n ci a ld i s t r e s s . F o r e m o s t a m o n g t h e s e f r i c t i o n s a r e ( a ) t h e f r e e r i d e r p r o b l e m , ( b )i n f o r m a t i o n a l a s y m m e t r y , a n d ( c ) i n t e r - a n d i n t r a - g r o u p c o n f l i c ts o f i n t e r e s t .


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Ch. 28. Fin anc ial Distress, Bankruptcy an d Reorganization 923W e b e l i e v e t h a t i t i s i m p o r t a n t t o r e c o g n i z e t h a t t h e s e p o t e n t i a l i m p e d i m e n t sd o n o t n e c e s s a r il y e n g e n d e r s i g n if ic a n t b a n k r u p t c y c o s ts . C o n s e q u e n t l y , a p a r tf r o m e x a m i n i n g t h e s e p o t e n t i a l i m p e d i m e n t s i n d et ai l, t h e s u r v e y e m p h a s i z e si n n o v a t i o n s i n t h e d e s i g n o f c o r p o r a t e f i n an c i al c o n t r a c t s a n d c a p i ta l s t r u c t u r e sw h i c h e n d o g e n i z e t h e s e i m p e d i m e n t s i n t h e c o n t r a c t i n g p r o c e s s . W e p r o v i d ee x a m p l e s o f b o n d i n d e n t u r e ( a n d c o r p o r a t e c h a r t e r ) p r o v is i o n s a n d i n n o v a t io n s inf i n a n c i a l c o n t r a c t i n g d e s i g n e d t o m i t i g a t e , o r e v e n e l i m i n a t e , p o t e n t i a l p r o b l e m si n t h e r e s o l u t i o n o f f i n a n c i a l d i s tr e ss . W e r e c o g n i z e , h o w e v e r , t h a t o t h e r l e g a l a n dr e g u l a t o r y r e s t r i c t i o n s m i g h t p r e c l u d e f u l l u t i l i z a t i o n o f c e r t a i n p r i v a t e c o n t r a c t i n gm e c h a n i s m s . T h e r e is n o w a g r a d u a l a c c u m u l a t i o n o f e m p i r i c a l l it e r a t u r e w h ic hp r o v i d e s e v i d e n c e o n t h e d e t e r m i n a n t s o f r e l a ti v e u ti li z a ti o n o f p r i v a t e d e b tr e s t r u c tu r i n g s a n d f o r m a l b a n k r u p t c y p r o c e e d i n g s . I n o u r s u r v e y o f th is l i te r a t u r e ,w e h a v e f o u n d t h a t t h e n a t u r e a n d d e g r e e o f t h e c o m p l e x i t y o f c o r p o r a t e f i n a n c ia ls t r u c t u r e s is a c r u ci a l d e t e r m i n a n t b e t w e e n i n f o r m a l a n d f o r m a l r e st r u c tu r i n g s .

C o n t i n u i n g w i th o u r s u rv e y , w e d is cu s s c o u r t - s u p e r v i se d m e t h o d s o f fi n a n ci a ld i s t re s s ( o r f o r m a l r e o r g a n i z a t i o n s ) , f o c u s i n g o n t h e e f f ic i e n c y c h a r a c t e r i s t i c s o fs u c h m e t h o d s o f r e s o lv i n g b a n k r u p t c y d i s p ut e s ( a n d t h e a v a i la b l e e v i d e n c e ) a sw e l l a s t h e r o l e o f m a r k e t m e c h a n i s m s i n f o r m a l r e o r g a n i z a t i o n s . W h i l e t h e s em e t h o d s o f b a n k r u p t c y r e s o l u t i o n s e r v e a s a n a l t e r n a t i v e w h e n p r i v a t e w o r k o u t sf a i l , w e a l s o r e c o g n i z e t h a t i n n o v a t i o n s i n t h e l e g i s l a t i v e r e f o r m o f t h e b a n k r u p t c yp r o c e s s e s c a n f a c il it a te o r d i s c o u r a g e p r i v a te r e s o l u t i o n m e t h o d s . A s a n e x a m p l e ,t h e n o n u n a n i m i t y r e q u i r e m e n t a n d a u t o m a t i c s ta y p r o vi si o ns o f C h a p t e r 11r e o r g a n i z a t i o n s e r v e a s a t h r e a t a g a i n st t h e f r e e r i d e r p r o b l e m i n p ri v a t e w o r k o u t s .T h u s , t h e f o r m a l b a n k r u p t c y p r o c e ss , a s i t is s t r u c t u r e d u n d e r t h e 1 9 78 B a n k r u p t c yC o d e , m a y e n t a i l b e n e f i t s a s w e l l a s c o st s. T h e i n e f fi c i e n c y i ss u e s d i s c u s s e d s t e mm a i n l y f r o m b a r g a i n i n g a n d c o o r d i n a t i n g p r o b l e m s a m o n g c l a i m a n t g r o u p s a n df r o m j u d i c i a l d i s c r e ti o n i n t h e f i rm v a l u a t io n a n d c l a i m h o l d e r w e a l t h a l l o c a t i o np r o b l e m s .

W e r e v i e w t h e a v a i l a b l e e m p i r i c a l e v i d e n c e o n c o u r t - s u p e r v i s e d m e t h o d s o fr e s o l u t i o n , f o c u s i n g o n d e v i a t i o n s f r o m a b s o l u t e p r i o r i t y r u l e , a n d t h e d i r e c t a n di n d i r e c t c o st s o f f o r m a l b a n k r u p t c y p r o c e e d i n g s . T h e r e is c o n s i s te n t e v i d e n c es u g g e s t i n g t h a t d i r e c t b a n k r u p t c y c o s t s , s u c h a s f e e s t o b a n k r u p t c y l a w y e r s , t a xa c c o u n t a n t , a n d t r u s t e e s , a r e u n l i k e l y t o b e s ig n i f ic a n t d e t e r m i n a n t s o f t h e f i rm ' sc a p i ta l s t r u c t u r e w h e n t h e d e b t w a s o r i g in a l ly i ss u e d. T h e e v i d e n c e o n t h e i n d i r e c tc o s t s o f b a n k r u p t c y i s in c o n c l u s i v e . T h e s e c o s t s a r e d i ff ic u l t t o c o n c e p t u a l i z e , l e ta l o n e m e a s u r e e m p i r ic a l ly . T h e y a r e p r e s u m e d t o a r i se in t h e f o r m o f o p p o r t u -n i t y c o s t s , r e s u l t i n g f r o m s u b o p t i m a l a c t i o n s b y c o r p o r a t e s t a k e h o l d e r s , i n c l u d i n gc u s t o m e r s , s u p p l i e r s , a n d e m p l o y e e s , i n r e s p o n s e t o f i n a n c i a l d i s tr e ss . T h e f u n d a -m e n t a l d i f f ic u l ty i n e m p i r i c i s m a r is e s f r o m a n i n a b i l i ty t o d i s t i n g u i sh t h e s e c o s t sf o r m t h o s e t h a t w o u l d h a v e a r i s e n f o r m p u r e b u s i n e ss d i s lo c a t i o n a n d d is tr es s. W eb e l i e v e t h a t n o n e o f t h e p a p e r s r e v i e w e d h e r e h a s m e t t h is t e s t s a t is f a c to r i ly , a n dh e n c e t h is p r o b l e m r e p r e s e n t s a c h a ll e n g in g a v e n u e f o r f u t u r e r e s e a r c h . N o n e t h e -l e s s , t h e r e i s a n i m p o r t a n t g r o u n d w o r k e s t a b l i s h e d , w h i c h w e r e v i e w i n t h i s s u r v e y .

T h e r e is n o w a n i n c r e as i n g u t il iz a t io n o f c a p it a l m a r k e t d a t a i n e m p i r ic a li n v e s ti g a ti o n s o f f o r m a l b a n k r u p t c i e s t h r o u g h s h a r e p r i c e r e a c ti o n s s u r r o u n d i n g


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924 L .W. Senbe t , J .K . Sewardb a n k r u p t c y p r o c e s se s a n d a n n o u n c e m e n t s . T h e s e s t u d ie s h a v e e x p a n d e d t o i n cl u d et h e e f fe c ts o f b a n k r u p t c y o n c o m p e t i n g f ir m s t o s e e i f t h e r e a r e i n d u s t r y e f fe c tso f b a n k r u p t c y a n n o u n c e m e n t s . 3 T h e u s e o f c a p i ta l m a r k e t d a t a h a s a ls o h e l p e dt o d e m o n s t r a t e e f fi c ie n t s e c u ri ti e s p r i c in g o f d e v i a t io n s f r o m t h e a b s o l u t e p r i o r it yr u le . R e c e n t e m p i r i c a l e v i d e n c e s u g g es t s t h a t t h e A P R is f r e q u e n t l y v i o la t e d i nC h a p t e r 11 r e o r g a n i z a t i o n s , b u t t h a t t h e e q u i t y m a r k e t s g e n e r a l ly a n t i c ip a t e a n dp r i c e t h e s e d e v i a t io n s , a s d o c u m e n t e d b y t h e r e l a ti o n s h i p b e t w e e n s h a r e p r i c er e a c t i o n s a n d s u b s e q u e n t A P R v io l at io n s .

O u r s u r v e y t u r n s a t t e n t i o n t o t h e r o l e o f a s s e t a n d f in a n c ia l m a r k e t m e c h a n i s m si n r e s o l v i n g f i n an c i al d i s tr e ss u n d e r c o u r t - s u p e r v i s e d r e o r g a n i z a t i o n s a n d l iq u i d a-t io n s . A m a r k e t a p p r o a c h t o f o r m a l b a n k r u p t c y p r o c e e d i n g s h a s r e c e i v e d l it tl ea t t e n t i o n i n c o r p o r a t e f i n a n c e , b u t i t is a n e x c i ti n g s u b j e c t m a t t e r o f d e b a t e i n t h el e g a l li t e r a t u r e . A t t h e h e a r t o f d e b a t e is t h e r e l a t i v e e f f i c ie n c y o f m a r k e t v a l u a -t i o n s a n d j u d i c i a l v a l u a t i o n s i n t h e a p p r a i s a l o f t h e f i rm a n d a l l o c a t i o n o f cl a i m su n d e r f o r m a l b a n k r u p t c y . 4 T h e r e a r e s o m e i m a g i n a t i v e s u g g e s t io n s o f th e d e s ig no f n e w f i n a nc i a l in s t r u m e n t s t o m i n i m i z e c o n f li c ts o f i n t e re s t u n d e r a s y m m e t r i ci n f o r m a t i o n . A t h e m e t h a t r u n s t h r o u g h t h e a v ai la b l e p r o p o s a l s i s t h a t m a r k e tm e c h a n i s m s a n d i n n o v a t i o n s c a n b e e m p l o y e d t o i m p r o v e t h e e ff ic ie nc y , a n df a i rn e s s o f f o r m a l b a n k r u p t c y p r o c e e d i n g s . W e p r e s e n t t h e p e r s p e c t i v e s o f l e g als c h o l a r s in th i s s u rv e y , a n d h o p e t h a t t h e d e b a t e o n t h e m a r k e t a p p r o a c h t o f o r m a lb a n k r u p t c y p r o c e e d i n g s w i ll a l so i n te r f a c e w i t h t h e d o m a i n o f f i n a n c e s ch o l a rs .

T h i s s u r v e y h a s a l i m i te d p u r p o s e a n d c a n n o t i n c o r p o r a t e a ll t h e f a c e t s o f t h es u b j e c t m a t t e r - - f i n a n ci a l d is tr es s, b a n k r u p t c y a n d r e o r g a n i z a t i o n . A s a n e x a m p l eo f t h e r i c h n e s s o f t h e f a c et s , w e c o n c l u d e t h e s u r v e y w i t h a d i s c u s s i o n o f t h ei m p a c t o f f i n a nc i a l d i s tr e s s o n t h e b e h a v i o r o f t o p c o r p o r a t e m a n a g e m e n t , g o v e r -n a n c e s t r u c t u r e s , a n d t h e f i r m ' s d i v i d e n d p o l i c y . T h e l i t e r a t u r e h e r e i s s p a r s e a n dp r i m a r i l y e m p i r ic a l . I t f ac e s t h e s a m e c h a l l e n g e s a s t h e l i te r a t u re o n t h e m e a s u r e -m e n t o f in d i r e c t c o s t s o f b a n k r u p t c y i n th e s e n s e o f n o t c l e a r ly d i s e n ta n g l i n g r e a lf i n a n ci a l c o st s f r o m t h o s e t h a t w o u l d h a v e b e e n a t t r ib u t a b l e t o p u r e o p e r a t i o n a li n e f fi c i e n c ie s . H o w e v e r , t h is is a l s o a n e x a m p l e o f a c h a l l e n g i n g a v e n u e f o r f u r t h e rr e s e a r c h . I n c lo s in g , w e w i s h t o e m p h a s i z e s o m e g e n e r a l a r e a s o f r e s e a r c h t h a t a r eu n d e r d e v e l o p e d : t h e d i c h o t o m y b e t w e e n e c o n o m i c d i st re s s a n d fi n a n ci a l d i st re s s;t h e i n c r e a s i n g u s e o f c a p i t a l m a r k e t d a t a i n e v a l u a t i n g t h e r e l a t iv e e f f i c a c y o fC h a p t e r 1 1 a n d p r i v a t e w o r k o u t s ; i n t e r f a c e b e t w e e n l eg a l a n d f i n a n c ia l re s e a r c h ,p a r t i c u l a r ly o n t h e u se o f m a r k e t m e c h a n i s m s u n d e r f o r m a l , c o u r t - s u p e r v i s e db a n k r u p t c y p r o c e e d i n g s ; t h e d e s i g n o f i n n o v a t i v e f in a n c ia l c o n t r a c ts a n d c a p i ta ls t r u c t u r e s i n e n h a n c i n g e f fi c ie n c y i n p r i v a te w o r k o u t s a n d f o r m a l r e o r g a n i z a t i o n s .

3 As an exam ple, there is now considerable deb ate w ithi n the airline industry and the retailindustry about how bankruptcy court protection can be strategically utilized to alter a financiallydistressed firm 's cost structure. Healthy fir m s in the industry argue th at th is process, in turn,weak ens their own financial condition as they seek to remain comp etitive w ith the cou rt-protectedbankrupt firms.4 Th ere is also a continuing deb ate on th e efficiency of C hapter 11 in the leg al literature.M oreover, ou r survey gives some attention to 'pre-packaged' bankruptcies wh ich, we think, can beviewed as a 'convex combination' of Chapter 11 and private workouts.


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Ch. 28. Financial Distresa; Bankrup tcy an d Reorganization 925I t i s o u r h o p e t h a t t h i s s u r v e y fa c i l i t a t e s a n u n d e r s t a n d i n g o f t h e p r i n c i p a l i s su e sa n d s t i m u l a t e s f u r t h e r r e s e a r c h o n t h is t op i c .

2 . L e g a l a n d e c o n o m i c r a m i f i c a t io n s o f t h e U . S . B a n k r u p t c y C o d eT h e p r o c e s s o f r e s o l v i n g th e d i s p u t e s t h a t a r i s e in f o r m a l c o r p o r a t e b a n k r u p t c y

is c u r r e n t l y g o v e r n e d b y th e B a n k r u p t c y R e f o r m A c t o f 1 9 78 ( h e r e i n a f t e r , t h e~ C o d e ') . 5 T h e r o l e o f a f o r m a l b a n k r u p t c y p r o c e e d i n g is to p r o v i d e a c o l l e ct i vep r o c e d u r e f o r th e r e s o l u t i o n o f i m p a i r e d c o n t r a c t u a l c l a i m s h e l d a g a i n s t t h e f i rm .A b a n k r u p t c y f i l i n g m a y b e v o l u n t a r y o r i n v o l u n ta r y , d e p e n d i n g o n w h e t h e r t h ep r o c e d u r e i s i n i t i a t ed b y th e i n c u m b e n t m a n a g e m e n t . o r b y t h e f ir m ' s c r ed i to r s .T h e m a j o r i t y of b a n k r u p t c y f il in g s b y U .S . c o r p o r a t i o n s a r e v o l u n t a r y . T h e C o d ea l t e r s th e p o w e r s , d u t i e s a n d r e s p o n s i b i l i t i e s o f t h e f i r m ' s c o n t r a c t u a l c l a i m a n t sr e l a t iv e t o t h e n o r m a l o p e r a t i o n o f a s o lv e n t, o n g o i n g e n t i t y u n d e r c u r r e n tc o m m e r c i a l a n d t a x la w . S i n c e b a n k r u p t c y l a w s u p e r c e d e s t h e c o m m e r c i a l c o d e ,i t s e e m s l i k el y t h a t t h e i n c e n t iv e s a n d b e h a v i o r o f t h e c l a i m a n t s m a y b e a f f e c t e db y t h e o p p o r t u n i t y t o e n t e r f o r m a l b a n k r u p t c y . C o n s e q u e n t l y , a n u n d e r s t a n d i n g o ft h e m a i n p r o v i s i o n s o f t h e C o d e i s n e c e s s a r y i n o r d e r t o d e t e r m i n e t h e e c o n o m i ci m p l i c a t i o n s o f f i n a n c ia l d is t re s s a n d f o r m a l b a n k r u p t c y p r o c e d u r e s .

F o r t h e m a j o r i t y o f t h e c o r p o r a t i o n s t h a t e n t e r f o r m a l b a n k r u p t c y p r o c e e d i n g s ,t h e 1 97 8 C o d e p r o v i d e s a l i q u i d a t i o n p ro c e s s ( C h a p t e r 7 ) a n d a r e o r g a n i z a t i o np r o c e s s ( C h a p t e r 1 1 ) . C h a p t e r 7 l i q u i d a t io n s a r e r e la t i v el y s t r a i g h t f o r w a r d p r o c e -d u r e s . T h e c o u r t a p p o i n t s a t r u s t e e w h o t h e n s h u t s d o w n t h e fi rm . T h e t r u s t e es e ll s o r a b a n d o n s t h e f i r m ' s a s s et s , a n d t h e p r o c e e d s a r e t h e n t u r n e d o v e r t o th ec o u r t f o r d i s t r i b u t i o n t o t h e f i r m ' s c l a im a n t s . T h e s e n i o r i t y o f p a y m e n t d i s t r ib u t i o nis w e l l -d e f i n e d a c c o r d i n g t o t h e a b s o l u t e p r i o ri ty r u l e ( A P R ) . A c c o r d i n g t o t h is r u le ,o n c e t h e c o u r t e s t a b l i s h e s t h e h i e r a r c h y o f c l a i m a n t s , a j u n i o r c l a im c a n r e c e i v e n op a y m e n t u n t i l a l l s e n i o r c l a i m s a r e f u ll y p a i d . T h u s , p a y o f f s t o t h e f i r m ' s c l a i m a n t sd e p e n d d i r e c tl y o n t h e v a l u e s w h i c h t h e t r u s t e e o b t a i n s b y l i q u i d a t i n g a ll o f t h ef i r m ' s a s s e t s, a s w e l l a s t h e a s s i g n e d s e n i o r i t y o f t h e c l a im .

I n p r i n c i p l e , t h e d e s i g n o f a n e q u i t a b l e a n d e f f ic i e n t b a n k r u p t c y l a w is r e l a t i v e l ys t r a i g h t f o r w a r d . I d e a l l y , t h e C o d e w o u l d b e s t r u c t u r e d s o t h a t e f f i c ie n t f i rm s ( i .e . ,a s s e t v a l u e s a r e h i g h e s t i n t h e i r c u r r e n t u s e , a n d g o i n g c o n c e r n v a l u e e x c e e d sl i q u i d a t i o n v a l u e ) w o u l d b e r e o r g a n i z e d a n d c o n t i n u e t o s u rv i ve , w h i l e o n ly

5 Bankruptcy law s da te bac k centuries in other advanced countries. A quo tation from theEconomist [February 24, 1990] provides a glimpse of an historical perspective on bankruptcy laws:'The word bankruptcy comes from banca rotta, I tal ian for broken bench. The custonr was thatwhen a m edieval t rader fa i led to pay his credi tors h is t rading bench w as broken. S ince bankruptcywas taken of f the s t reets and put in to the s ta tu te book i t has become rather compl icated. . .En gland 's f irst ban krup tcy law, signed by H enry V III in 1542, was an "Act against such personsas do make bankrupt". For centuries Brit ish bankrupts went to debtor 's prison: Charles Lamb, anessayist , thought they should be ha ng ed. . . In contrast , one o f Amer ica 's a t t ract ions to immigrantswas i ts very lack of a debtor 's prison. Bankruptcy is st i l l viewed in America as a side-effect ofen t r ep reneur sh ip . '


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926 L.W. Senbet, J.K. Sewardine f f ic ien t f irms would be l iqu ida ted . Whi te [1989] , however , a rgues th a t i t mayn o t b e p o s s i b l e t o c o n s t r u c t a b a n k r u p t c y l a w wh i c h p r o v i d e s t h i s o u t c o m e . T h edif f icul ty is that conf l ic ts of interes t between c la imant c lasses lead to diversepre f e r e nce s fo r the r eso lu t ion of f inanc ia l d i st r e ss . I n genera l , s en ior c la imantsf a v o r p r e m a t u r e s h u t d o wn a n d t h e l o s s o f g o i n g c o n c e r n va l u e in o r d e r t o p r e s e r v ethe va lue of the i r c la ims . The r es idua l na tu re o f jun ior c la ims , such as co m m onequi ty , impl ies tha t i t s va lue i s inc r eased by main tena nce of the f i rm as an ongoinge n ti t y. As a c o n s e q u e n c e , f o r m a l b a n k r u p t c y l a w l e a ds t o o n e o f t wo u n d e s i r a b l eo u t c o m e s : e i t h e r t h e C o d e a l l o ws inefficient f i rms to r eorgan ize a nd surv ive , o r theCo de leads to ine f fic ien t l iqu ida t ion of v iab le f i rms . The prov is ions of the 1978Ac t e f fe c t iv e l y l e a d t o t h e f o r m e r o u t c o m e .

Th e ine f fic ienc ies c r ea ted by the t r ans f e r s o f wea l th am on g the f i rm ' s d i s tinc tc l a i m a n t c l a s s e s a r e f u r t h e r c o m p l i c a t e d b y t h e p r o b l e m o f asymmetric infor-mation. T h e p r e s e n c e o f a sy m m e t r i c i n f o r m a t i o n i n d u c e s d i s a g r e e m e n t o v e r t h eaggrega te va lue of the as se t s to be d i s t r ibu ted among the f i rm ' s c la imant c la s ses .F u r t h e r m o r e , s i n c e b a n k r u p t c y l a w e n c o u r a g e s t h e r e s o l u t i o n o f i m p a i r e d c l a i m st h r o u g h a b a r g a in i n g p r o c e s s, c l a i m a n t g r o u p s m a y i nt e n t io n a l l y m i s r e p r e s e n tthe i r op in ion of aggrega te f i rm va lue . For exam ple , i f f i rm va lue i s smal l , s en iorc la imant en t i t l ements wi l l genera l ly ensure tha t they a r e a l loca ted a l a rge r p ropor -t ion of the c orpo ra t io n ' s a s se ts . Conver se ly , jun io r c la imants have an incen t ive topre sen t in f la ted e s t ima tes o f f i rm va lue .

Th e p r im ary purp ose of Ch apte r 11 i s r ehab i l i t a t ion of a f inanc ial ly d i s t r e s sedf ir m . On c e t h e f i rm e n te r s C h a p t e r 11 , t h e i n c u m b e n t m a n a g e m e n t p r e p a r e s ar e o r g a n i z a t i o n p l a n wh i c h p r o p o s e s a n a l l o c a t io n o f f ir m v a l u e a m o n g t h e e x is ti n gc l a i m a n ts . A l t h o u g h f o r m a l r e o r g a n i z a t i o n p r o c e d u r e s a r e s o m e w h a t c o m p l i c a t e d ,we c a n d e s c r i b e t h e e c o n o m i c i m p l i c a t i o ns o f t h e m a j o r p r o v is i o n s o f C h a p t e r 11 .( A s u m m a r y o f t h e se f e a t u r e s a p p e a r s i n T a b le 1 .)

Firs t , an automatic stay provision s tops a l l p r inc ipa l and in te r es t payments due toc red i to r s , I n add i t ion , in te r es t ceases to acc rue on a l l ou t s tand ing unsecured deb t .This e f f ec t ive ly ex tends the matu r i ty o f the f i rm ' s deb t ob l iga t ions and r educ es them a r k e t v a l u e o f t h e d e b t h o l d e r s ' c l a im o n t h e f i rm ' s as se ts . T h e p r o v i s i o n a l s oprevents secured c r ed i to r s f rom se iz ing the i r co l la te r a l . F ina l ly , the au tomat ic s tayprec ludes c r ed i to r s f rom cance l l ing cont r ac t s and ha l t s l awsui t s aga ins t the f i rm .R e l a t e d l y , t h e c o u r t m a y v o i d c e rt a i n t r a n s fe r s a n d c o n t r a ct s t h a t o c c u r r e d p r i o rto the bankruptcy f i l ing . Thus , f o r example , Chapte r 11 may a l low the f i rm toe l imin a te cos t ly l abor o r l ease con t r ac ts .

T h e f 9 7 8 A c t a l s o m a n d a t e d t h a t t h e i n c u m b e n t m a n a g e m e n t t e a m r e m a i n i ncont ro l o f the f i rm ' s a s se t s , excep t in ex t r eme cases such as f r aud . I n te r es t ing ly ,m e r e i n c o m p e t e n c e i s n o t a s u f f i c i e n t m o t i v e t o r e m o v e i n c u m b e n t m a n a g e m e n tu n d e r C h a p t e r 11. B e y o n d s i m p le e n t r e n c h m e n t , C h a p t e r 1 1 a l so c o n v ey s i m p o r -tan t add i t ion a l adv antage s to ma nag em ent . F i r st , f o r the in it i al 120 day pe r iodaf te r f i l ing , incumbent management r e ta ins the exc lus ive r igh t to f i l e a r eorga-n iza t ion p lan . S ince th i s p lan of ten forms the bas i s f o r subsequent ba rga in ingamong the d ive r se c la imant g roups , th i s exclusivity r e p r e s e n t s a v a l u a b l e p o we r .Exten s ions of the exc lus iv i ty pe r iod bey ond the in it i al 120 day pe r iod a r e qu i te


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TableBasic

Ch. 28 . F ina nc ia l Di st ress, B ankr up tcy an d Reorg an i za t ion1Chapter 11 reorganization features

927

1. The automatic stay Stops principal and interest payments to unsecured creditors. Secured creditors lose the right to take possession of collateral, but may receive'adequate protection' payments; Executory contracts can be assumed or rejected. If rejected, these claims thenbecome unsecured creditors.2. The debtor-in-possession Typically he current management and board of directors retain control. Management initially maintains exclusive right to file a plan of reorganization andsolicit acceptances by the committees. Exclusivity period extends for 120 days tofile the plan and an additional 60 days to seek approval. Extensions are common.

Debtor-in-possession financing effectively allows the court to strip senioritycovenants and collateral from existing debt. Allows incremental senior borrowing.3. Reorganization Plan must be approved by all classes of creditors and the court. Exception is thecramdown procedure. Threat of delay of reorganization plan by management. Transfers wealth fromsome creditor classes to equity. Bargaining powers favor debtors, but creditors can(i) propose an alternative cramdown;(ii) ask for a lift of the automatic stay;(iii) request conversion to Chapter 7 liquidation;(iv) refuse to lend new funds;(v) block asset sales.

common, especially in the case of large, complex bankruptcies. In addition, oncethe firm has filed for bankruptcy, the debtor-in-pos session can ob tain new debtfinancing and those creditors will be prov ided seni or status. This provision isintended to encourage new lending and protect the integrity of any new loans asthe firm reorganizes. As we shall discuss in detail later, in the absence of such aprovision, new funds may n ot be forthcoming, there by dimini shing the likelihoodthat the firm can emerge from bankr uptcy as a viable entity.

Finally, the voting process for the approval of a reorga nizat ion plan may be ad-vantageous to the in cum ben t man age ment and the shareholders. Restructur ing ofpublic debt outside of the bank ruptc y process (i.e. , informal or private workouts)is governed by the T r u st I n d e n t u r e A c t o f 1 9 39 . The Act mandates that any changesto an outst andin g public bond's interest, principal, or matur ity can be made only ifappr oved by 100% of the issue's holders. In practice, this virtuall y preclu des anychange in these terms directly. Consequentl y, informa l restr ucturin g of public debtgenerally takes the form of an e x c h a n g e @r . In bankruptcy, however, the votingprocess for approval of a debt r estructu ring plan is different. First, approval of areorg aniz ation plan r equires an affirmative vote by two-thirds in face value andone-half of the number of holders in each class. Thus, Chapter 11 would be es-pecially advantag eous to firms with complex capital structures or a small group ofobstinate holdouts. Moreover, the bankruptcy court has the power to bind dissent-


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928 L .W. Senbe t , J .K . Sewardi n g p a r t i e s t o a r e o r g a n i z a t i o n t h r o u g h t h e c r a m d o w n p r o c e d u r e . T h i s p r o c e d u r ea l l o w s t h e c o u r t t o c o n f i r m a r e o r g a n i z a t i o n p l a n t h a t h a s b e e n v e t o e d b y o n e o ft h e c l a i m a n t c la ss es . A l t h o u g h t h e v o t i n g p r o c e s s f o r t h e a p p r o v a l o f a r e o r g a n i z a -t i o n p l a n f a v o r s a C h a p t e r 1 1 f ilin g , o n e i m p o r t a n t d i s a d v a n ta g e o f t h e b a n k r u p t c yp r o c e s s is t h a t i t is a c o l le c t i v e p r o c e d u r e . T h i s e f f e c t i v e ly a c c e l e r a t e s t h e d u e d a t ef o r a l l o f t he f i r m ' s l i ab i l i t i e s . Thus , r e l a t i ve t o t he ca s e o f a p r i va t e r e s t r uc t u r -i n g w i t h a s in g l e c la s s o f c re d i t o r s , f o r m a l b a n k r u p t c y s u b s t a n t i a ll y i n c r e a s e s t h en u m b e r o f d i v e r se c l a i m a n t c l as se s i n v o lv e d in t h e p l a n o f r e o r g a n i z a t i o n .

R e l a t e d t o t h e v o t i n g p r o c e ss is t h e p r o v i s i o n in t h e C o d e t h a t e n c o u r a g e st h e p a r t i e s t o b a r g a i n d u r i n g t h e r e o r g a n i z a t i o n p r o c e s s . T h i s , i n c o n j u n c t i o nw i t h t h e o t h e r p o w e r s b e s t o w e d u p o n m a n a g e m e n t , a l l o w s e q u i t y c l a i m a n t s t or e t a i n s o m e f r a c ti o n a l o w n e r s h i p i n m a n y r e o r g a n i z e d f ir m s , d e s p i t e t h e f a c t t h a ts e n i o r c l a i m a n t s d o n o t r e c e i v e t h e i r f u l l e n t i t l e m e n t ( i . e . , a b s o l u t e p r i o r i t y i sv i o l a te d ) . B e c a u s e t h e i n c u m b e n t m a n a g e m e n t r e m a i n s i n c o n t r o l o f t h e f ir m , t h ea b il it y to e x t r a c t e c o n o m i c c o n c e ss i o n s f r o m s e n i o r c l a im a n t s c a n b e v i e w e d a sc o m p e n s a t i o n f o r e x ti n g u is h in g t h e o p t i o n t o d e l a y th e p r o c e s s a n d t o i n v e st fu n d si n ex ces s i ve l y r i s ky p r o j ec t s .

T h u s , t h e B a n k r u p t c y C o d e i m p a ct s th e b a l a n c e o f p o w e r a m o n g m a n a g e r s ,e q u i t y h o l d e r s , a n d t h e f i rm ' s re m a i n i n g s t a k e h o l d e r s i n e c o n o m i c a l l y i m p o r t a n ta n d i d e n t i f i a b l e w a y s . S i n c e th e C o d e s p e c i f ie s t h e s e t o f r u l e s u n d e r w h i c hc l a i m a n t s b a r g a i n f o r t h e i r e n t i t l e m e n t s , i t a l s o in f l u e n c e s th e b e h a v i o r o f t h ev a r i o u s s t a k e h o l d e r s o u t s i d e o f t h e f o r m a l b a n k r u p t c y p r o c e s s. T h i s p o i n t i si m p o r t a n t b e c a u s e i t s u g ge s ts t h a t a n y r e f o r m o f th e C o d e m u s t a ls o c o n s i d e r it si m p a c t o n t h e b e h a v i o r o f c o r p o r a t e s t a k e h o l d e r s o u t s i d e o f t h e f o r m a l b a n k r u p t c yp r o c e s s . N e x t , w e c o n s i d e r t h e l i n k a g e b e t w e e n a f i r m ' s c a p i t a l s t r u c t u r e p o l i c i e sa n d t h e f i r m ' s d e c is i o n t o e n t e r f o r m a l b a n k r u p t c y . A s w e s h a ll s e e, t h e i m p o r t a n c eo f th i s li n k t o th e t h e o r y o f c a p i t a l s t r u c t u r e d e p e n d s u p o n t h e c o s t li n e s s o fb a n k r u p t c y . A n u n d e r s t a n d i n g o f t h is r e l a t i o n s h i p i s c r u c i a l i n d is t in g u i s h i n gb e t w e e n e c o n o m i c d i s t r e s s a n d f i n a n c i a l d i s t r e s s .

3 . Bankru ptcy and corporate f inanc ia l po l icyT h e o r ig i n o f t h e e a r ly li t e r a tu r e o n t h e r e l a t io n s h i p b e t w e e n b a n k r u p t c y

a n d c o r p o r a t e c a p i t a l s t r u c t u r e d e c i s i o n s c a n b e f o u n d i n t h e s e m i n a l w o r k o fMod i g l i an i & Mi l l e r [ 1958 , 1963] . The i r i n i t i a l ana l ys i s e s t ab l i s he s t ha t , i n pe r f ec ta n d f r i c ti o n l e s s c a p i t a l m a r k e t s , f i r m v a l u e is u n a f f e c t e d b y f in a n c i a l p o li c y . T h eo r i g in a l p r o o f o f t h e c e l e b r a t e d M o d i g l i a n i - M i l l e r t h e o r e m is p r e d i c a t e d o n t h ea s s u m p t i o n o f r is k le s s d e b t . T h e t h e o r e m w a s l a t e r g e n e r a l i z e d b y S t ig l it z [1 9 7 4]a n d o t h e r s w h o a r g u e d t h a t , i n p e r f e c t a n d f r i c t i o n l e s s m a r k e t s , t h e i r r e l e v a n c eo f c o r p o r a t e f i n a n c i a l p o l i c y e x t e n d s b e y o n d t h e i s s u a n c e o f r i s k l e s s d e b t a n de q u i t y s e c u r i t i e s t o o t h e r f o r m s o f s e c u r i t i e s , i n c l u d i n g r i s k y d e b t , p r e f e r r e d s t o c k ,a n d a l l k i n d s o f h y b r i d s e c u ri t ie s . T h e t h e o r e m h o l d s b o t h i n a si n g le p e r i o d a n dm u l t i p e r i o d f r a m e w o r k s o th a t f i rm v a lu e is a ls o i n d e p e n d e n t o f d e b t m a t u r i tys t r u c t u r e d e c i s i o n s .


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Ch. 28. Financial Distress, Bankruptcy an d Reorganization 929

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Senior ebt _ _ ~. / / . . " . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

/ i o i o r O _ f . . . . . . . . . ./ / ' / / / /

' ' ' ~ 6 6 ' ' 1 ' o b 6 ' ' l a b b ' ' ~ i o b 6 ' ' ~ , d o 6 ' ' d o ' o r ) ' ' ~ o b ' ' 4 d (RrmValueF i g . l .

T h e c o r o ll a ry o f t h e M M t h e o r e m is t h a t c o r p o r a t e b a n k r u p t c y i s i n c o n se -q u e n t i a l t o f i r m v a l u e , s i n ce t h e o p e r a t i n g o r i n v e s t m e n t d e c i s i o n s a r e c o m p l e t e l ys e p a r a b l e f r o m t h e f i n a n c in g d e c is i on s . F i g u r e 1 p r o v i d e s a n i n t u it i v e i ll u s t r a ti o no f th i s r e su l t. C o n s i d e r t h e a l l o c a t io n o f t h e f i r m ' s a g g r e g a t e c a s h f lo w s b e t w e e nt h e e q u i t y c l a im a n t s a n d b o n d h o l d e r s o n t h e m a t u r i t y d a t e o f th e f i r m ' s d e b ts e cu r it ie s . I n t h e M o d i g l i a n i - M i l l e r f r a m e w o r k , t h e a m o u n t o f c o r p o r a t e i n d e b t -e d n e s s h a s n o e f f e c t o n t h e v a l u e o f t h e f i r m ' s a s s e ts n o r o n t h e r i s k i n es s o ft h e t o t a l c a s h f l o w s t r e a m g e n e r a t e d b y t h e f i r m ' s a s se t s. D e b t f i n a n c i n g s i m p l yp a r t i t io n s t h e c a s h f lo w s s o t h a t g r e a t e r f i n a n c ia l l e v e r a g e a l t e r s t h e a m o u n t o f r is kb o r n e b y th e b o n d h o l d e r s . W h i l e o b v i o u s , t h is i m p o r t a n t i n s i g h t is o f t e n m i s s e d i nd i sc u s si o ns r e l a t in g t o t h e e c o n o m i c c o n s e q u e n c e s o f c o r p o r a t e b a n k r u p t c y . T h e r eis n o n e c e s s a r y l i n k ag e b e t w e e n b a n k r u p t c y a n d t h e f i r m ' s o p e r a t i n g p e r f o r m a n c e ;b a n k r u p t c y d o e s n o t c a u s e e c o n o m i c d is tr es s o r p o o r p e r fo r m a n c e . W e w i ll c o n s i d e rt h e d i s t i n c t i o n b e t w e e n f i n a n c i a l d i s t r e s s a n d e c o n o m i c d i s t r e s s l a t e r i n t h i s c h a p -t e r , b u t w i s h t o e m p h a s i z e h e r e t h a t a c le a r a p p r e c i a t i o n o f t h is d i c h o t o m y g r e a t lye n h a n c e s a n a p p r e c i a t i o n o f t h e v o l u m i n o u s d e b a t e s u r r o u n d i n g t h e c o n s e q u e n c e so f c o r p o r a t e b a n k r u p t c y . F o r i n s t a n c e, i t is t e m p t i n g t o p o i n t t o n e w s s t o r i e s o f d i s-t r e s s e d f i r m s as e v i d e n c e o f a , ca u sa l r e l a t i o n s h i p b e t w e e n i m p e n d i n g b a n k r u p t c ya n d a d e t e r i o r a t i o n i n p r o f i t a b i l i t y o r a d e c r e a s e i n p r o d u c t d e m a n d . T h e c r u c i a lc o n s i d e r a t i o n is w h e t h e r a n i d e n t ic a l b u t o t h e r w i s e n o n d i s t r e s s e d f i r m ( d u e t o lo wf i n a n c ia l l e v e r a g e ) w o u l d f a c e a s im i l a r d e t e r i o r a t i o n i n i ts o p e r a t i n g p e r f o r m a n c e .

M o r e o v e r , l i q u i d a t i o n a n d b a n k r u p t c y a r e o f t e n d i s c u s s e d i n t h e l i t e r a t u r e a st h o u g h t h e y a r e r e l a t e d . L i q u i d a t i o n is t h e p r o c e s s o f d i s m a n t l i n g t h e f i r m ' s a s s e t sa n d s el li ng t h e m ( e i t h e r p i e c e m e a l o r in th e i r e n ti r et y ) t o n e w m a n a g e m e n tt e a m s . L i q u i d a t i o n is o p t i m a l w h e n t h e v a l u e o f t h e f i rm ' s e x is t in g r e s o u r c e si s h i g h e r i n a l t e r n a t i v e u s e s . H e n c e l i q u i d a t i o n s h o u l d b e v i e w e d a s a c a p i t a lb u d g e t i n g d e c i s i o n w h i c h i s i n d e p e n d e n t o f t h e w a y in w h i c h t h e f i r m is f i n a n c e d .L i q u i d a t i o n a n d b a n k r u p t c y a r e s e p a r a t e , i n d e p e n d e n t e v e n ts . (S e e H a u g e n &


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930 L.W. Senbet , J .K. SewardS e n b e t [ 1 97 8 ] f o r f u r t h e r d i s c u s si o n o n t h i s i s s u e .) A h i g h ly p r o f i t a b l e f i rm w i t hh i g h l e v e r a g e m a y r e m a i n v i a b l e a s a g o in g c o n c e r n , i r r e sp e c t iv e o f b a n k r u p t c y ,w h i l e a n u n p r o f i t a b l e f i r m m a y b e l i q u i d a t e d e v e n i f i t h a s n o d e b t i n it s c a p i t a ls t r u c t u r e . I t is i m p o r t a n t t o re s is t th e t e m p t a t i o n o f c o n f o u n d i n g b a n k r u p t c ya n d l i q u id a t io n , b e c a u s e l i q u i d a ti o n c o s ts m a y b e m i s t a k en l y c h a r a c t e r i z e d a sb a n k r u p t c y c o s ts . T h e l a t t e r , i f s i g n if ic a n t , a r e d e t e r m i n a n t s o f t h e f i rm ' s c a p i t a lS t r u c t u r e , b u t l i q u i d a t i o n c o s t s a r e i n c o n s e q u e n t i a l t o c o r p o r a t e f i n a n c i a l p o l i c i e so r d e b t d e c i s i o n s .

I n t h e e v e n t t h a t b a n k r u p t c y i s c o s t l y , i t f i l l s a n i m p o r t a n t v o i d b e t w e e n t h ec o r n e r r e s u l t o f t h e M o d i g l i a n i - M i l l e r t ax a d j u s te d m o d e l a n d t h e o b s e r v e dl i m i ta t i o n s o n t h e a m o u n t o f d e b t f in a n c in g e m p l o y e d i n p r a c ti c e . A l t h o u g h t h ec o s t l in e s s o f b a n k r u p t c y a n d f i n a n c i a l d i s tr e s s is n o t t h e p r i m a r y s u b j e c t o f th i sp a p e r , i t is a p p r o p r i a t e t o h i g h li g h t w h a t h a s c o m e t o b e k n o w n a s t h e ' t r a d e - o f ft h e o r y ' . M o d i g l i a n i & M i l l e r [ 1 9 6 3 ] a r g u e t h a t t h e t a x c o d e f a v o r s d e b t o v e r e q u i t yf in a n c i n g b y a ll o w in g t h e f i r m 's i n t e re s t e x p e n s e t o b e d e d u c t e d f r o m g r o ss i n c o m ef o r c o r p o r a t e t a x p u r p o s e s . S i n c e a n a d d i t i o n a l d o l l a r o f d e b t g e n e r a t e s t h em a r g i n a l b e n e f i t o f a t a x d e d u c t i o n w i t h o u t a n y o f f s e t t i n g c o s t i n t h i s f r a m e w o r k ,f i r m v a l u e i s m a x i m i z e d b y u t il iz i n g as m u c h d e b t a s p o s s i b l e to f i n a n c e c o r p o r a t ei n v e s t m e n t d e c i s io n s . O t h e r f i n a n c ia l e c o n o m i s ts , s u c h as K r a u s & L i t z e n b e r g e r[ 1 9 73 ] , S c o t t [ 1 9 76 ] , a n d K i m [ 19 7 8 ], su g g e s t t h a t t h e c o s ts o f b a n k r u p t c y m i g h tp r o v i d e a r e c o n c i l i a t io n b e t w e e n t h e o b s e r v e d l im i ts o n t h e u s a g e o f d e b t a n dt h e p r e d i c t i o n s o f t h e t a x - a d j u s t e d M o d i g l i a n i - M i l l e r a n a l y si s o f f i n a n c i a l p o l ic y .T h e i n t u i t i o n p r o v i d e d f o r t h e e x i s t e n c e o f f i n i t e , o p t i m a l c a p i t a l s t r u c t u r e s i ss t r a ig h t f o r w a r d . D e b t c a p a c it y is li m i te d , b e c a u s e c o r p o r a t i o n s t r a d e - o f f t h e t axs a vi n gs g e n e r a t e d b y t h e d e d u c t i b il it y o f i n t e r e s t p a y m e n t s a g a i n s t t h e e x p e c t e dv a l u e o f th e c o st s i n c u r r e d i n t h e e v e n t o f b a n k r u p t c y . U n f o r t u n a t e l y , t h e s e e a r lym o d e l s f a i le d t o p r o v i d e a n y ri g o r o u s e c o n o m i c j u s ti f ic a t io n f o r t h e e x i s te n c e o ft h e s e b a n k r u p t c y c o s ts .

T h u s , a t t h e h e a r t o f t h e c o n t e m p o r a r y l it e r a t u r e o n t h e r e l a ti o n s h i p b e -t w e e n c o r p o r a t e f i n a n c i n g d e c i s io n s a n d f i n a n c i a l d i s tr e s s i s t h e i s s u e o f w h e t h e rb a n k r u p t c y is c o st ly . B a n k r u p t c y c o s ts m a y p o t e n t i a l l y e m e r g e d irec t ly i n th e f o r mo f c o u r t f e e s i n v o lv i n g t h i rd p a r t y a d v i s o r s t o t h e f i rm , s u c h a s l a w y e r s , ta x a c c o u n -t an t s , t r u s t ee s , e t c . , o r i n d i r e c t l y i n t h e f o r m o f c o s t ly d i s r u p t i o n s i n t h e r e l a t i o n s h i po f t h e f i r m w i t h c u s t o m e r s , s u p p li e rs , a n d e m p l o y e e s . I f m a r k e t m e c h a n i s m s e x is t,s u c h a s t h o s e d e s c r i b e d i n H a u g e n & S e n b e t [ 1 9 8 8 ] , w h i c h a l l o w f i r m s t o e s c a p et h e d e a d w e i g h t c o s ts o f b a n k r u p tc y , t h e n b a n k r u p t c y ha s n o i m p a c ( o n c o r p o r a t ec a p i t a l s t r u c t u r e d e c i s i o n s . I f , h o w e v e r , b a n k r u p t c y c o s t s a r e n o t a l w a y s a v o i d a b l e ,t h e n v i r t u a l l y a l l d i m e n s i o n s o f t h e f i r m ' s f i n a n c i a l c o n t r a c t i n g d e c i s i o n a r e i m -p a c t e d . T h i s l a t t e r r e s u l t f o l lo w s b e c a u s e t h e c h a r a c t e r i s ti c s o f t h e f i r m ' s fi n a n c i a lc o n t r a c t s i n f l u e n c e t h e l i k e l ih o o d o f b a n k r u p t c y a s w e l l a s th e m a g n i t u d e o f th ec o s t s i n c u r r e d . C o n s e q u e n t l y , f o r e x a m p l e , f i n a n c i a l c o n t r a c t c h a r a c t e r i s t i c s s u c ha s m a t u r i t y , s e n i o r i ty , c o m p l e x i ty , c o l l a t e ra l , c o v e n a n t s , a n d p u b l i c vs . p r i v a t e a r el i k e ly to i n f l u e n c e t h e f i r m ' s b a n k r u p t c y d e c i s i o n .

T h e n e x t t w o S e c t i o n s c o n s i d e r t h e t h e o r e t i c a l a n d e m p i r i c a l e v i d e n c e o np r i v a t e a n d f o r m a l r e s o l u t i o n s o f f i n a n c i a l d i s tr e s s. I t is u s e f u l t o r e c o g n i z e t h a t


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Ch. 28. Finan cial Distress, Ban kruptcy a nd Reo rganization 931t h e s e a l t e r n a t i v e m e t h o d s f o r r e s o l v i n g d i s t r e s s a r e r e l a t e d , s o t h a t t h e i n c e n t i v e sw h i c h v a r io u s c l a i m a n t g r o u p s h a v e t o r e o r g a n i z e t h e f ir m d e p e n d o n t h e r e l a ti v ec o s ts a n d b e n e f i t s c o n f e r r e d b y e a c h m e t h o d . T h e c o s t li n e s s o f f i n a n c ia l d i s tr e s sd e p e n d s o n t h e d e s i g n o f r e s o l u ti o n p r o c e d u r e s w h i c h fa c i li ta t e m a i n t e n a n c e o fm a x i m u m f i rm v a l u e . W e s h a ll a r g u e t h a t , c u r re n t l y , a n u m b e r o f f a c t o r s ex i stw h i c h p o t e n t i a l l y i m p e d e c o s tl e ss f o r m a l o r i n f o r m a l r e o r g a n i z a t i o n o f f in a n c ia l lyd i s tr e s se d f ir m s. W e a l s o s u g g es t a n u m b e r o f m a r k e t m e c h a n i s m s w h i c h m i g h t b eu t i li z e d t o e n h a n c e t h e e f f ic i e n c y o f f o r m a l a n d i n f o r m a l r e s o l u t i o n p r o c e d u r e s .

4 . P r i v a t e m e t h o d s o f r e s o l v i n g f in a n c i a l d i s t r e ssI n t h is s e c t i o n , w e e x a m i n e v a r i o u s m e t h o d s o f re s o l v i n g fi n a n c i a l d is t re s so u t s i d e t h e b a n k r u p t c y c o u r t s y s t e m . O u r d i s c u s s i o n f o c u s e s o n t h r e e a l t e r n a t i v e s

w h i c h a r e a v a i l a b l e t o c o r p o r a t e m a n a g e r s f o r d e a l i n g w i t h f i n a n c i a l d i s t r e s s I n p a r t i c u l a r , w e c o n s i d e r t h e f o l l o w i n g : ( 1 ) f i n a n c i a l r e s t r u c t u r i n g s ; ( 2 ) a s s e ts a le s ; (3 ) i n fu s i o n s o f n e w c a p i t a l f r o m o u t s i d e s o u r c e s . T h e a c a d e m i c l i t e r a t u r ef o c u s e s p r i n c i p a l l y o n t h e r e s t r u c t u r i n g o f th e f i r m ' s fi n a n c ia l c l a im s w h i c h , f o rr e a s o n s w e d i sc u s s b e l o w , a r e t y p ic a l ly i m p l e m e n t e d t h r o u g h a n e x c h a n g e o f f er .G e n e r a l l y , t h e s e i n f o r m a l , o r p r iv a t e , re o r g a n i z a t i o n m e c h a n i s m s a r e d e s i g n e dt o m i t i g a t e , o r p o s s i b ly e v e n e l i m i n a t e , t h e c o s t s o f b a n k r u p t c y . W e a l so d i sc u s sc o n d i ti o n s u n d e r w h i c h th e s e i n f o r m a l re o r g a n i z a t i o n m e t h o d s m a y b e i m p e d e d ,p o s s i b l y g i v i n g r i s e t o s i g n i f i c a n t c o s t s o f f i n a n c i a l d i s tr e s s . W e t h e n g e n e r a l i z eo u r d i s c u ss io n t o c o n s i d e r a d d i ti o n a l m a r k e t m e c h a n i s m s a n d i n n o v a t io n s t h a tm a y r e d u c e , o r e l im i n a t e , t h e p o t e n t i a l im p e d i m e n t s t o t h e i n f o r m a l r es o l u t io n o ff i nanc i a l d i s t r e s s .4.1 . D ebt res tructurings an d pr ivate wo rkouts

A n a c t u a l o r i m p e n d i n g d e f a u l t o n t h e f i r m ' s e x is t in g d e b t o b l i g a t i o n s ist y p i c a l ly t h e e v e n t t h a t i n i t i a t e s t h e p r o c e s s o f r e s o l v i n g f in a n c i a l d i s t r e s s. T h i sd o e s n o t i m p l y t h a t d e f a u l t c a u s e s f i n a n c ia l d i st re s s , b u t r a t h e r t h a t i t p r o v i d e sc r e d i t o r s w i t h t h e c o n t r a c t u a l r i g h t t o re n e g o t i a t e c e r t a i n a s p e c t s o f th e i r c l a ima g a i n s t t h e f i rm . A d e f a u l t c a n o c c u r e i t h e r b e c a u s e t h e f i r m f a il s t o m a k e as c h e d u l e d p a y m e n t t o t h e c r e d i to r s , o r b e c a u s e t h e f ir m v i o l at e s o n e o r m o r e o ft h e r e s t r i c t iv e p r o v i s i o n s c o n t a i n e d i n t h e i n d e n t u r e . I n t h e f o l l o w i n g d is c u s si o n ,w e d o n o t d i s ti n g u i s h b e t w e e n t h e c a u s e s o f a d e f a u lt , b u t r a t h e r f o c u s o nit s c o n s e q u e n c e s . T h e r e is an a b u n d a n c e o f a t t e n t i o n i n b o t h t h e a c a d e m i cl i te r a t u r e a n d t h e p o p u l a r p r e ss a b o u t in f o r m a l r e o r g a n i z a t i o n o f c o r p o r a t ef i n a n c i a l s t r u c t u r e s t h r o u g h debt restruc tur ings an d pr ivate w orkouts . W e d e f i n e ad e b t r e s t ru c t u r in g a s a n a g r e e m e n t b y t h e f i r m ' s c r e d i to r s t o m o d i f y a n y t e r m ( s )o f a n o u t s t a n d i n g f i n a n c i a l cl a i m c u r r e n t ly h e l d a g a i n s t t h e f i r m . W e v ie w t h e t e r mb r o a d l y s o a s t o e n c o m p a s s b o t h p u b l i c a n d p r i v a t e l o a n a g r e e m e n t s . W e n o t e ,h o w e v e r , t h a t p u b l i c l y - h e l d c r e d i t a r r a n g e m e n t s a r e s u b j e c t t o d i f f e r e n t d i s c l o s u r ea n d r e g u l a t o r y c o n s t r a i n t s t h a n p r i v a t e d e b t . A s a r e s u lt , t h e s e t o f f e a s i b l e d e b t


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932 L.W. Senbet, J.K. Sewardr e s t r u c t u r i n g t e c h n i q u e s o u t s i d e o f f o r m a l b a n k r u p t c y p r o c e e d i n g s w ill d e p e n d o nw h o h o l d s t h e f i r m ' s c r e d i t o b l i g a t i o n s . C o m m o n r e s t r u c t u r i n g t e c h n i q u e s i n c l u d ee x c h a n g e o f f e r s , t e n d e r o f f e rs , c o v e n a n t m o d i f i c a t i o n , a n d ( i n th e c a s e o f p r i v a t ed e b t ) m a t u r i t y e x t e n s io n o r i n t e re s t r a t e a d j u s t m e n t s .

H a u g e n & S e n b e t [ 1 97 8 ] p r o v i d e a n e a r ly t h e o r e t ic a l a n a ly s is o f t h e l in k a g eb e t w e e n i n f o r m a l d e b t r e s t r u c tu r i n g s a n d b a n k r u p t c y c o s ts , a n d t h e f i rm ' s f in a n c ia lp o l i c y d e c is i o n s . T h e y u t i li z e th e s p i ri t o f t h e M o d i g l i a n i a n d M i l le r n o - a r b i t r a g ea p p r o a c h t o a r g u e t h a t t h e c o s t s o f f i n a n c i a l d i s tr e s s a r e i n si g n i fi c a n t t o t h e t h e o r yo f c a p it a l s t ru c t u r e . T o u n d e r s t a n d t h e i r a r g u m e n t , c o n s i d e r a fi rm t h a t e n c o u n t e r sf i n a n c i a l d i s t r e s s a n d m u s t r e s t r u c t u r e i t s f i n a n c i a l c o n t r a c t s . H a u g e n a n d S e n b e tn o t e t h a t t h e f i r m c a n e l e c t t o r e s o l v e fi n a n c i a l d i s tr e s s t h r o u g h ( 1 ) a f o r m a lr e o r g a n i z a t i o n i n v ol v in g th e c o u r t s y s te m , o r ( 2 ) in f o r m a l r e o r g a n i z a t i o n t h r o u g ht h e f i n a n c i a l m a r k e t s . H e n c e , t h e c o s ts o f re s o l v i n g f i n a n c i al d is t re s s m u s t b eb o u n d e d b y t h e l e a s t c o s tl y o f t h e s e t w o a l t e r n a t i v e r e s o l u t i o n m e c h a n i s m s . I na d d i t i o n , t h e y a r g u e t h a t , i n g e n e r a l, t h e p r e s e n t v a l u e o f t h e t r a n s a c t i o n c o st s o fi n f o r m a l r e o r g a n i z a t i o n a r e l ik e l y t o b e s m a l l , o r e v e n i n s ig n i fi c a n t, a t t h e t i m e o ft h e f i r m ' s i n i t i a l c a p i t a l s t r u c t u r e d e c i s i o n s . H e n c e , a l l r a t i o n a l c l a i m h o l d e r s w i l la g r e e t o r e s t r u c t u r e i n t h i s m a n n e r . S i n c e c a p i t a l m a r k e t p a r t i c i p a n t s r e c o g n i z et h a t i t is in t h e i n t e r e s t s o f a ll c l a i m h o l d e r s t o s u p p o r t t h e m o r e e f f i c ie n t m e t h o do f r e s t r u c t u r i n g , b a n k r u p t c y c o s t s s h o u l d n o t b e s u f fi c ie n t ly l a r g e t o o f f s e t t h e t a xs u b s i d y g e n e r a t e d b y d e b t f i n a n c i n g . H e n c e , t h e y a r g u e , b a n k r u p t c y c o s t s d o n o te x p l a i n t h e c o r p o r a t e d e c i s io n t o l im i t t h e a m o u n t o f d e b t f i n a n c in g u t i li z e d tof u n d r e a l i n v e s t m e n t s d e c i s i o n s . T h e i n t u i t i o n f o r t h is r e s u l t is t o r e c o g n i z e t h a ti n f o r m a l r e s tr u c t u r i n g s r e p r e s e n t a n a l t e rn a t i v e t o fo r m a l b a n k r u p t c y p r o c e e d i n g sa n d i t p a y s c l a i m a n t s t o ' p r i v a t iz e ' b a n k r u p t c y a w a y f r o m t h e c o u r t sy s t e m , if t h ei n f o r m a l r o u t e o f r e s o l v in g f i n a n c i a l d is t re s s i s c o s t -e f f ic i e n t. J e n s e n [ 1 98 9 , 1 9 9 1 ]p r o v i d e s a s i m i la r a r g u m e n t i n s u p p o r t o f t h e p r i v a t i z at i o n o f b a n k r u p t c y . S i m i l arv i e w p o i n t s w e r e a l so e x p r e s s e d f o r c e f u l l y i n t h e l e g a l l i t e r a t u r e b y R o e [1 98 3].

T h e p r e c e d i n g d i s c u s s i o n f o c u s e s o n t h e i n c e n t i v e s a n d o p p o r t u n i t i e s f o r c o r -p o r a t e i n s i d e r s t o r e s t r u c t u r e a d i s t r e s s e d f i r m ' s f i n a n c i a l c l a i m s t h r o u g h t h ec a p i t a l m a r k e t s . H o w e v e r , t h e p r i v a t iz a t io n o f t h e b a n k r u p t c y p r o c e s s c a n a l s ob e i n i t i a t e d b y o u t s i d e arbitrageurs. T o s e e th i s, s u p p o s e t h a t t h e m a r k e t v a l u e so f a d i s t r e s s e d f i r m ' s p u b l i c l y - t r a d e d s e c u r i t i e s r e f l e c t t h e e x p e c t a t i o n t h a t s i g n i f -i c a n t b a n k r u p t c y c o s t s w o u l d b e i n c u r r e d a s a re s u l t o f t h e c l a i m a n t s ' f a i l u r e t os u c c e s sf u l ly i m p l e m e n t a n i n f o r m a l r e o r g a n i z a t i o n . O u t s i d e a r b i t r a g e u r s c a n b u yu p t h e o u t s t a n d i n g s e c u r i t i e s a t p r e v a i l i n g m a r k e t v a l u e s t o p r e v e n t t h e c o s t l ya l t e r n a t iv e o f a fo r m a l r e o r g a n i z a ti o n . T h e p o t e n t i a l a r b i t ra g e p r o f i t w o u l d b e t h eb a n k r u p t c y c o st s, n e t o f th e t r a n s a c t i o n s c o s ts , o f in f o r m a l r e o r g a n i z a t i o n . O n c et h e o l d d e b t is e l i m i n a t e d i n it s e n t i r e t y s o a s t o p r e v e n t a n y w i n d f a l l g a in t ot h e r e m a i n i n g b o n d h o l d e r s , n e w d e b t c a n b e i s s u e d t o t a k e o p t i m a l a d v a n t a g e o ft h e c o r p o r a t e t a x s u bs id y . T h e e x p e d i e n t o f o u t s id e t a k e o v e r , a s a n a l t e r n a t iv e t op r i v a t e w o r k o u t a n d r e c a p i t a l i z a t i o n b y th e o r i g i n a l c la i m a n t s , is al s o d i s c u s s e d i nH a u g e n & S e n b e t [ 1 97 8 ]. T h e m a i n i m p l i c a t i o n o f t h is a n al y si s is t h a t t h e c a p i t a lm a r k e t s p r o v i d e a m o r e e f fi c ie n t f o r u m f o r t h e r e s o l u t i o n o f fi n a n ci a l d i st re s s, a n dh e n c e o n e w o u l d n o t e x p e c t t o o b s e r v e a su b s t a n t ia l a m o u n t o f c o u r t- s u p e r v i s e d


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Ch. 28. Finan cial Distress, Ba nkrup tcy and R eorganization 93 3r e o r g a n i z a t i o n a c ti vi ty . H o w e v e r , i t s e e m s c l e a r t h a t a l a r g e a n d g r o w i n g n u m b e ro f c o r p o r a t i o n s e l e c t to f o r g o t h e a l te r n a t iv e o f a p r i v a te w o r k o u t . A s H a u g e n& S e n b e t [1 97 8] r e c o g n i z e , f a il u r e t o u t i li z e c o s t -e f f e c t i v e p r i v a t e m e c h a n i s m sf o r r e s o l v i n g f i n a n c i a l d i s t r e s s m u s t b e p r e d i c a t e d u p o n : ( 1 ) o u t r i g h t i r r a t i o n a l i t yb y t h e f i r m ' s f i n a n c i a l c l a i m a n t s o r m a r k e t p a r t i c ip a n t s , o r ( 2 ) i m p e d i m e n t s t ot h e a r b i t r a g e o r p r i v a t e w o r k o u t p ro c e s s e s. M u c h o f t h e s u b s e q u e n t l i t e r a t u r e o ni n f o r m a l d e b t r e s t r u c t u r i n g s f o c u s e s o n a t t e m p t s t o i d e n t i f y t h e p o t e n t i a l i m p e d i -m e n t s t o i n f o r m a l r e o r g a n i z a t i o n s 6 T h e n e x t tw o s e c t i o n s e x a m i n e t h e t h e o r e t i c a la n d e m p i r i c a l e v i d e n c e w h i c h f o c u s e s o n t h e i m p l ic a t io n s o f th e s e i m p e d i m e n t s .4.2 . Potent ia l impedime nts ' to privat izat ion o f f inanc ial d is tress

I n t h is s e c t io n , w e e x a m i n e t h e i m p a c t o f t h e f o l lo w i n g im p e d i m e n t s t o t h er e s o l u t i o n o f f in a n c ia l d i st re s s t h r o u g h p r i v a te r e o r g a n i z a t i o n m e c h a n i s m s : ( 1 )f r e e r i d e r p r o b l e m ; ( 2 ) a s y m m e t r i c i n f o r m a t i o n ; ( 3 ) i n t e r - a n d i n t r a - g r o u p c o n f l ic t so f in t e r e s t . A l t h o u g h w e d i sc u s s t h e s e i m p e d i m e n t s i n d e ta i l , it is i m p o r t a n t t on o t e t h a t t h e i r e x i s t e n c e d o e s n o t n e c e s s a ri ly r e n d e r b a n k r u p t c y c o s ts s i g ni fi c an tt o t h e t h e o r y o f o p t i m a l c a p i ta l s tr u c t u r e . W e d e s c r ib e h o w t h e s e i m p e d i m e n t s ,p a r t ic u l a r ly t h e f r e e r i d e r p r o b l e m , c a n b e e l i m i n a t e d b y i n c l u si o n o f s im p l ep r o v i s io n s i n t o c o r p o r a t e c h a r t e r s a n d b o n d i n d e n t u r e s . M o r e g e n e r a ll y , w e w o u l de x p e c t t o o b s e r v e i nnova t ions i n th e d e s i g n o f c o r p o r a t e f i n a n c i a l c o n t r a c t s a n dc a p i t a l s t r u c t u r e s w h i c h e n d o g e n i z e t h e p o t e n t i a l i m p e d i m e n t s i n t h e c o n t r a c t i n gp r o c e s s. W e s u g g e s t th a t c o r p o r a t e d e c i s i o n - m a k e r s s h o u l d r e c o g n i z e th e b e n e f i t so f a d o p t i n g f in a n c i n g a r r a n g e m e n t s t h a t m i t i g at e , o r e v e n e l i m i n a t e , p o t e n t i a lp r o b l e m s i n t h e r e s o l u t i o n o f f i n a n c ia l d i s tr e s s in t h e b a n k r u p t c y p r o c e s s . A c a s ei n p o i n t i s a n i n c r e a s e d u s a g e o f t h e str ip f ina ncin g t e c h n i q u e w h i c h a l l o w s t h ef i n a n c i a l c l a i m a n t s t o h o l d b o t h t h e d e b t a n d t h e e q u i t y c l a i m s i s s u e d b y t h e f i r m .W e r e c o g n i z e , h o w e v e r , t h a t o t h e r l e g a l a n d r e g u l a t o r y re s t r ic t io n s m i g h t p r e c l u d ef u l l r e a l i z a t i o n o f c e r t a i n s o l u t i o n s . F o r e x a m p l e , c u r r e n t l i m i t a t i o n s o n t h e a b i l i t yo f U . S . b a n k s t o h o l d l o n g - t e r m c o r p o r a t e e q u i t y st ak e s m a y i n h ib i t t h e r a n g eo f f e a si b l e r e s o l u t i o n m e c h a n i s m s . W e d i sc u ss t h e i m p l ic a t io n s o f s o m e o f t h e s er e s t r i c t i o n s i n m o r e d e t a i l b e l o w .4.2 .1. The f ree r ider pro ble m

A f i n a n c i a l r e s t r u c t u r i n g o f t h e f i rm ' s e x i s ti n g d e b t o b l i g a t io n s is t y p ic a l ly in -t e n d e d t o r e l a x th e f ir m ' s c a sh f lo w p r o b l e m s b y : (1 ) r e d u c i n g i n t e r e s t p a y m e n to b l ig a t io n s , o r ( 2 ) e x t e n d i n g t h e m a t u r i t y d a te . I n f o r m a l r e n e g o t i a t i o n o f c r e d i t o rc la im s d e p e n d s o n w h e t h e r t h e d e b t o b l i g a ti o n is p u b li c o r p r iv a t e . T h e r e s t r u c t u r -i n g o f p u b l i c d e b t i s g o v e r n e d p r i m a r i l y b y t h e T r u s t I n d e n t u r e A c t o f 1 93 9. T h i sA c t r e q u i r e s u n a n i m o u s c o n s e n t b y t h e h o l d e r s o f a p a r t i c u l a r c l a s s o f d e b t s e c u -

6 Senbe t & Seward [1991] propose an indifference proposition for the equivalence of threeprivate workout mechanisms -- informal reorganization initiated by corporate insiders (equity-holders), informal reorganization initiated by bondholders, and informal reorganization initiatedby outside arbitrageurs - - in well-functioning markets. They examine the relative efficacy of thesereorganization procedures in more general settings characterized by frictions.


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934 L.W. Senbet , J .K. Sewardr i t i e s i n o r d e r t o c h a n g e t h e d e b t o b l i g a t i o n ' s m a t u r i t y , p r i n c i p a l , o r c o u p o n r a t eo f i n t e r e s t . T h e s e s t r i n g e n t v o t i n g r u l e s e f f e c ti v e l y p r e c l u d e a d e b t r e s t r u c t u r i n g i nw h i c h t h e h o l d e r s o f an y o u t s t a n d i n g p u b l ic b o n d s a g r e e t o a l t e r t h e s e t e r m s . A sa r e s u l t , v i r t u a l l y a l l i n f o r m a l p u b l i c d e b t r e s t r u c t u r i n g s a r e a c c o m p l i s h e d t h r o u g ha n exchange o f f e r .I n a t y p i c a l e x c h a n g e o f f e r , t h e f i r m a l lo w s t h e h o l d e r s o f a p a r t i c u l a r c la s s o f t h ef i r m ' s d e b t s e c u r i t i e s t h e r i g h t t o e x c h a n g e t h e i r e x i s t i n g c l a i m s f o r a n e w c l a s s o fs e c u r i t ie s . A s u c c e s s fu l e x c h a n g e o f f e r g e n e r a l l y e n h a n c e s t h e f i rm ' s c r e d i t q u a l i ty ,t h e r e b y e n h a n c i n g t h e v a l u e o f t h e r e m a i n i n g b o n d s w h i c h a r e n o t t e n d e r e d . S i n c ee x c h a n g e o f f e r s g r a n t h o l d e r s t h e r i g h t ( b u t n o t t h e o b l i g a t i o n ) to p a r t i c i p a t e ,s o m e b o n d h o l d e r s m a y e l ec t t o ' h o l d - o u t ' i n t h e e x p e c t a t i o n t h a t t h e p o s t -e x c h a n g e o f f e r v a l u e o f t h e i r e x i st in g c l a im w i ll e x c e e d t h e v a l u e o f p a r t i c i p a t i o ni n t h e e x c h a n g e . S i n c e a l l b o n d h o l d e r s h a v e s i m i l a r i n c e n t i v e s , t h e e x c h a n g e o f f e ris li k e l y t o f ai l. T h i s p r o b l e m c o u l d b e s o l v e d i f t h e i s s u e r i n d u c e s t h e r e q u i r e dl e v e l o f p a r t i c i p a t i o n b y s u f fi c ie n t ly i n c r e a s i n g t h e v a l u e o f t h e c l a im s o f f e r e d i nt h e e x c h a n g e . U n f o r t u n a t e l y , t h e f i rm m a y f in d t h a t t h e c o s ts o f r e so l v in g t h ef r e e r i d e r p r o b l e m i n t h is w a y c a n b e s u f f ic i e n tl y l a r g e s o a s t o e l i m i n a t e a l l o ft h e e c o n o m i c b e n e f i t c r e a t e d b y a su c c e ss f ul d e b t r e s tr u c t u ri n g . G r e e n & J u s t e r[ 1 9 92 ] s t u d y t h e s t r u c t u r e a n d t i m i n g o f d e b t r e s t r u c t u r i n g d e c i s i o n s b y f i n a n c ia l lyd i s t r e s s e d f i r m s . T h e y s h o w t h a t t h e f i r m ' s d e c i s i o n t o e x c h a n g e o r r e p u r c h a s eo u t s t a n d i n g d e b t i s a s e p a r a b l e , t w o - p a r t d e c i s i o n . F i r s t , t h e f i r m m u s t d e c i d e o nt h e a m o u n t o f d e b t t o r e p u r c h a s e . T h e n , t h e f i r m c a n d e t e r m i n e t h e p r i c e to o f f e ri n t h e e x c h a n g e . T h e y a l s o s h o w t h a t i t i s o f t e n t i m e s o p t i m a l f o r t h e f i r m t o d e l a yt h e e x c h a n g e o r r e p u r c h a s e i n o r d e r t o e f f ic i en t ly r e d u c e t h e r o l e o f f r e e r i d e r s int h e r e s t r u c t u r i n g p r o c e s s .

A t l e a s t t w o o t h e r a p p r o a c h e s t o w a r d s m i t i g a t i n g t h e h o l d - o u t p r o b l e m s h o u l db e m e n t i o n e d : ( 1 ) e n d o g e n i z e t h e i m p e d i m e n t a t t h e t i m e o f t h e fi rm ' s in i ti a l c a p -i t a l s t r u c t u r e d e c i s io n ; ( 2 ) c o e r c i v e p a r t i c i p a t i o n . T h e f ir s t a p p r o a c h is a n a l y z e d b yH a u g e n & S e n b e t [1 98 8]. T h e y su g g e s t t h a t t h e b o n d h o l d e r f r e e r i d e r p r o b l e m c a nb e e l i m i n a t e d t h r o u g h s im p l e , in n o v a t i v e b o n d i n d e n t u r e p r o v is i on s , s u c h a s ( a)g r a n t i n g t h e b o n d t r u s t e e t h e r i g h t t o a c c e p t o r r e j e c t t e n d e r a n d e x c h a n g e o f f e rso n b e h a l f o f a l l b o n d h o l d e r s ; ( b ) b y m a k i n g t e n d e r o f f e rs b i n d i n g o n a ll h o l d e r sw i t h i n t h e c la ss , o n c e a m a j o r i t y o f b o n d h o l d e r s h a v e t e n d e r e d t h e i r h o l d in g s ; ( c )i n c l u d i n g a ' c o n t i n u o u s ' c a l l p r o v i s i o n , w h i c h a l lo w s t h e f i r m t o c a ll t h e b o n d sa t t h e p r i c e r e g i s t e r e d i n t h e m o s t r e c e n t t r a d e . T h e s e s u g g e s t i o n s h i g h l i g h t t h ef a c t t h a t t h e p o t e n t i a l i m p e d i m e n t s t o a s u c c e s s f u l f i n a n c i a l r e s t r u c t u r i n g o f t e na s s u m e t h a t t h e f o r m o f t h e f ir m ' s d e b t f i n a n c e is e x o g e n o u s l y s p e c i f i e d . H e r e ,w e a r g u e t h a t s e c u r i t y d e s i g n a n d c o r p o r a t e c a p i t a l s t r u c t u r e d e c i s i o n s s h o u l d b ee n d o g e n i z e d i n o r d e r t o r e d r e ss t h e p r o b l e m s t h a t m a y a r is e in t h e b a n k r u p t c yp r o c e s s .

I n p r a c t i c e , c o r p o r a t i o n s h a v e r e l i e d u p o n c o e r c iv e t e c h n i q u e s i n o r d e r t os u c c e ss f u ll y i m p l e m e n t e x c h a n g e o f f e rs . A l t h o u g h t h e T r u s t I n d e n t u r e A c t r e q u i r e su n a n i m o u s a p p r o v a l b y a ll h o l d e rs w i t h in a p a r t ic u l a r c l as s o f p u b l ic d e b t i n o r d e rt o c h a n g e t h e m a t u r i t y , in t e r e s t , o r p r i n c i p a l f e a t u r e s o f t h e s e c u r i ty , c o v e n a n t sc a n b e c h a n g e d o r w a i v e d b y a s im p l e m a j o r i ty o r s u p e r - m a j o r i t y v o t e . T h e


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Ch. 28. Financial Distress, Bankruptcy and Reorganization 93 5m o d i f i c a t i o n o f b o n d c o v e n a n t s is t y p ic a l ly a c c o m p l i s h e d t h r o u g h a t e c h n i q u ek n o w n a s c o n s e n t s o l i c i t a t i o n s o r ex i t consents .

T h e c o m b i n a t i o n o f e x it c o n se n t s a n d e x c h a n g e , o r te n d e r , o f fe r s w o r k s a sf o ll o w s . A d i s t r e s se d f i r m a n n o u n c e s a n e x c h a n g e o f f er , b u t c o n d i t i o n s t h e o f f e ro n a b o n d h o l d e r v o t e t o c h a n g e o r e l i m i n a t e t h e i s s u e ' s c o v e n a n t ( s ) . T h e i s s u e ra l s o c o n d i t io n s i t s a c c e p t a n c e o f t h e e x c h a n g e d d e b t o n a p p r o v a l o f t h e c o n s e n ts o l i c it a t io n b y t h e r e q u i s i t e m a j o r it y . T h e l o s s i n v a l u e f o r t h o s e b o n d h o l d e r sw h o e l e c t t o r e t a i n t h e i r o r ig i n a l, s t r i p p e d d e b t c l a i m g e n e r a l l y o u t w e i g h s t h eb e n e f i t s o f e l e c t i n g t o n o t p a r t i c i p a t e . A s a r e s u l t , f i n a n c i a l l y d i s t r e s s e d f i r m s c a nd e s i g n f in a n c i a l r e s t r u c t u r i n g p r o g r a m s w h i c h s im u l t a n e o u s l y s t ri p th e p r o t e c t i o no f ex i st in g b o n d i n d e n t u r e s a n d c o e r c e p a r t i c i p a t i o n i n t e n d e r o r e x c h a n g e o f f e rs .C o f f e e & K l e i n [ 1 99 1 ] a r g u e t h a t p a r t i c i p a t i o n i n t h e e x c h a n g e o f f e r s h o u l d b es e p a r a t e f r o m , n o t c o n d i t i o n a l o n , t h e v o t e t o s t r i p c o v e n a n t s . T h i s s e p a r a t i o n o ft h e v o t e a n d t h e e x c h a n g e d e c i s i o n w o u l d m i t i g a t e th e c o e r c i v e e l e m e n t o f t h ist e c h n i q u e .

G e r t n e r & S c h a r f s t e i n [1 99 1], b u i l d in g u p o n a n e a r l i e r w o r k w h i c h a n a l y z e st h e i n v e s t m e n t d i s t o r t i o n s c r e a t e d b y r i sk s h if t in g [ J e n s e n & M e c k l i n g , 1 9 7 6] a n du n d e r i n v e s t m e n t [ M y e r s , 1 9 7 7] , s h o w h o w : ( 1 ) t h e p o s s ib i l it y o f d e b t r e s t r u c t u r i n g sa f f e c t s t h e i n v e s t m e n t d e c i s i o n s o f f i n a n c i al l y d i s t r e s s e d f i r m s a n d ( 2 ) t h e u s e o fc o n s e n t s o l i c it a t io n s a l t e r s i n v e s t m e n t d e c i si o n s. O n e o f t h e i r p r i n c i p a l f in d i n gsis t h a t i n f o r m a l d e b t r e s t r u c t u r i n g s t y p ic a ll y d o n o t r e s t o r e e f f i c ie n t i n v e s t m e n ti n c e n t iv e s . R a t h e r , e x c h a n g e o f fe r s m a y s e r v e t o r e d u c e t h e b u r d e n o f d e b to b l i g a t i o n s b y s i m p l y e x t r a c t i n g w e a l t h f r o m t h e p a r t i c i p a t i n g c r e d i t o r s .T h e i m p a c t o f e x c h a n g e o f fe r s o n i n v e s t m e n t i n c e n ti v e s d e p e n d s o n t h e p r e s -e n c e o r a b s e n c e o f sen ior i t y c o v e n a n t s . A s e n i o r i t y c o v e n a n t i s a p r o v i s i o n i nd e b t c o n t r a c t s , w h i c h p r e c l u d e s t h e f i rm f r o m i ss u in g n e w s e c u r i t ie s w i t h a m o r es e n i o r c l a i m . T h i s p r o v i s i o n i s i n t e n d e d t o p r o t e c t t h e s e n i o r i t y p o s i t i o n o f af i r m ' s o u t s t a n d i n g s e c u r i ti e s a g a i n s t t h e d i lu t iv e e f f e ct s o f s u b s e q u e n t f i n a n ci n gd e c i s i o n s . T h e u s e o f a c o n s e n t s o l i c i t a t i o n a l lo w s t h e f i r m t o s t r i p th e s e n i o r i t yc o v e n a n t , t h e r e b y a l lo w i n g t h e f i r m t o o f fe r a m o r e s e n i o r s e c u r i t y in t h e e x c h a n g e .G e r t n e r a n d S c h a r f s t e i n f i nd t h a t a s e p a r a t i o n o f t h e v o t e t o s tr i p c o v e n a n t s a n dt h e d e c i s i o n t o p a r t i c i p a t e i n a n e x c h a n g e o f f e r d o e s e n h a n c e t h e e f fi c ie n c y o fc o r p o r a t e i n v e s t m e n t d e c is io n s.

M o r e g e n e r a l l y , th e s e f in d i ng s o f f e r s o m e n e w e v i d e n c e o n t h e a b i li ty o f b o n dc o v e n a n t s t o p r o t e c t c r e d i t o r s a g a i n st e x p r o p r i a ti v e b e h a v i o r b y m a n a g e r s a n ds t o c k h o l d e r s . D i v e r g e n t v ie w s o n t hi s is s u e a r e o f f e r e d b y S m i t h & W a r n e r [ 19 7 9]& M c D a n i e l [1 98 6]. T h e u s e o f c o n s e n t s o l ic i t at i o n s t o s tr i p c o v e n a n t p r o t e c t i o ni n d i s t re s s e d e x c h a n g e o f f e r s is m o r e c o n s i s t e n t w i t h t h e v i e w a d v o c a t e d b yM c D a n i e l . H e a r g u e s t h a t b o n d c o v e n a n t s p ro v i d e t h e l ea s t p r o t e c t i o n a t p re c is e lyt h e t i m e w h e n t h e y a r e m o s t n e e d e d . T h e u s e o f ex i t c o n s e n t s b y d i st r e s s e d f ir m s ino r d e r t o i m p l e m e n t c o e r c iv e e x c h a n g e o f f e rs su g g e st s t h a t e v e n w e l l -t h o u g h t - o u tc o v e n a n t s c a n b e c i r c u m v e n t e d u n d e r c e r ta i n c o n d it io n s , t h e r e b y r e d u c i n g t h e i rv a l u e a s a n i n t e g r a l l i m i t a t io n o n t h e o p p o r t u n i s t i c b e h a v i o r o f e q u i t y h o l d e r s .T h e s e f in d i n g s s u g g e s t t h a t a d d i t i o n a l r e s e a r c h o n t h e r o l e o f b o n d c o v e n a n t s i nc o n t r o ll in g a g e n c y p r o b l e m s b e t w e e n b o n d h o l d e r s a n d s t o c k h o l d e r s is n e c e ss a ry .


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936 L.W. Senbet, J.K. Sew ard4.2.2. Information aayrnrnetry

T h e p r o b l e m o f d e s ig n i n g a n d c o m p l e t i n g a n i n f o rm a l d e b t r e s t ru c t u r in g ise x a c e r b a t e d i n t h e c a s e o f f in a n c ia l ly d i s t re s s e d f i r m s b y i n f o r m a t i o n a s y m m e t r i e s .A s y m m e t r i c i n f o r m a t i o n e xi st s in a n y t r a n s a c t io n w h e r e o n e p a r t y k n o w s m o r ea b o u t t r u e v a l u e t h a n a n o t h e r p a r ty . I n o r d e r t o u n d e r s t a n d t h e r o le o f a s y m m e t r i ci n f o r m a t i o n i n d i f f e r e n t f i n a n c i a l t r a n s a c t i o n s , c o r p o r a t e m a n a g e r s a r e t y p i c a l l ya s s u m e d t o p o s s e s s private i n f o r m a t i o n a b o u t t h e t r u e e c o n o m i c v al u e o f th e f ir m .F o r e x a m p l e , a s u b s t a n t i a l n u m b e r o f m o d e l s i n th e c a p i t a l s t r u c t u r e l i t e r a t u r ea s s u m e t h a t i n s id e r s h a v e p r i v a t e i n f o r m a t i o n a b o u t t h e f i rm ' s c a s h f lo w s t r e a mo r i ts f u t u r e i n v e s t m e n t o p p o r t u n i t ie s . T h e e x i st e n ce o f a s y m m e t r i c i n f o r m a t i o ni n t h e c a s e o f f in a n c i al ly d i s tr e s s e d f i r m s e m a n a t e s f r o m t w o p o s s i b l e s o u r c e s .F i r st , c o r p o r a t e i n s i d e r s a n d o u t s i d e i n v e s t o r s m a y , b a s e d u p o n t h e i r d i f f e r e n ti a li n f o r m a t i o n , s i m p l y d i s a g r e e a b o u t t h e v a l u e o f th e f ir m . S e c o n d , w h e n t h e f i r m isf i n an c i a ll y d i s tr e s s e d , i n s id e r s m a y h a v e a n i n c e n t i v e t o in t e n t i o n a l ly m i s r e p r e s e n tv a l u e i n o r d e r t o c o n v i n c e b o n d h o l d e r s t o a g r e e t o e x c h a n g e t h e i r e x i st in g c la i m sf o r l o w e r v a l u e d s e c u ri t ie s .

I n t h i s c o n n e c t i o n , e v e n t h e s t a t e o f fi n a n c i a l di s tr e ss c a n b e m i s r e p r e s e n t e db y a p r i v a t el y i n f o r m e d e n t r e p r e n e u r , d e p e n d i n g o n t h e n a t u r e o f t h e d e b tc o n t r a c t , a s r e c e n t l y d e m o n s t r a t e d b y H e i n k e l & Z e c h n e r [1 99 3]. T h e y s h o w t h a ti n f o r m a t i o n a l a s y m m e t r y m a y p r e v e n t c o n t r a c t r e n e g o t i a t i o n p r i o r t o m a t u r i t y i ft h e d e b t o u t s t a n d i n g is a p u r e d i s c o u n t b o n d . T h e i n s i d e r s o f a f i rm w i t h p o o rp r o s p e c t s m a y h i d e t h e d e f a u l t s ta t e a n d h e n c e t h e i r w o r t h l e s s p o s i t i o n , a n dt h o s e w i t h g o o d p r o s p e c t s m a y d e c l a re d e f a u l t w i t h t h e e x p e c t a t io n o f fa v o r a b l ed e b t r e n e g o t i a t i o n . T h e i n e f fi c ie n c ie s r e s u l ti n g f r o m n o t d e c l a r i n g d e f a u l t p r i o rt o m a t u r i t y m a y b e m i t i g a t e d b y a n a l t e r n a t i v e d e s i g n o f d e b t c o n t r a c t w i t hr i s k y i n t e r m e d i a t e p a y m e n t s , s u c h a s a c o u p o n o r s i n k i n g f u n d p a y m e n t s a n db a n k r u p t c y i n st it u ti o n a l a r r a n g e m e n t s p e r m i t t i n g d e v i a ti o n s f r o m a b s o l u t e p r i o ri tyr u l e s ( A P R s ) . ( W e w il l h a v e m o r e t o s ay a b o u t A P R s i n th e n e x t s e c ti o n . )

T h e a s y m m e t r i c in f o r m a t i o n e f f e c t o f f i n a n c ia l d i st re s s s u g g e st s t h a t a g r e a t e rp r o p o r t i o n o f t h e s e c u r i ti e s o f f e r e d in a d i s tr e s s e d e x c h a n g e o f f e r s h o u l d c o n t a i ncont ingent p a y m e n t f e a tu r e s . T h e r e a s o n w h y c o n t i n g e n t p a y m e n t s e c u ri ti e s a r eu s e f u l i s t h a t t h e i r f u t u r e v a l u e s w i l l a d j u s t m o r e r e a d i l y t o t h e r e v e l a t i o n o fi n f o r m a t i o n a b o u t t h e t r u e v a l u e o f t h e f i r m ] T h e r e a r e , o f c o u rs e , d i f fe r e n tt y p e s a n d c l as s e s o f fi n a n c ia l s e c u r it ie s w i t h d i f f e r e n t d e g r e e s a n d f o r m s o fp a y m e n t c o n t i n g e n c ie s - - c o m m o n e q u i ty , w a r r a n t s , c o n t in g e n t v a lu e r ig h ts , a n dc a l l p r o v i s i o n s , t o n a m e ju s t a f e w . F r a n k s & T o r o u s [ 19 8 9 ] i n d i c a t e t h a t af e w f i n a n c i a l l y d i s t r e s s e d f i r m s , i n f a c t , i s s u e d d e b t w i t h w a r r a n t s o r c o n v e r t i b l es e c u r i ti e s i n e x c h a n g e f o r d e f a u l t e d d e b t . U l t i m a t e l y , t h e n , t h e r e s o l u t i o n o f t h isi s s u e i n v o l v e s a security design p r o b l e m . ~

T h e r e a r e , h o w e v e r , v a r i o u s le g a l, r e g u l a t o r y a n d i n s t it u t io n a l r e s t r i c t io n s t h a tl i m i t th e t y p e s o f s e cu r i ti e s t h a t d e b t h o l d e r s m a y b e a b l e o r w i ll in g t o a c c e p t i ne x c h a n g e f o r th e i r c l a i m s . .T h e s e r e s t r ic t i o n s m a y i m p e d e t h e c o m p l e t i o n o f a n e x -

7 A mo re com plete discussion of this issue is contained in Senb et & S ewa rd [1991].Heinkel & Zechner [1993]


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Ch. 28 . F ina nc

Financial Distress, Bankruptcy and Reorganization

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