I present a model of a financially distressed firm with outstanding bank and bond debt. I rely on the objective criterion of investment efficiency to lead the reader through the journey and choices facing the distressed firm and its creditor through the many choices facing each constituency along the long and tortuous way – seen from the perspective of US corporate and bankruptcy law – culminating in the firm’s financial restructuring either in- or out-of-court) or its liquidation.
During the late 1980s there was a dramatic increase in the leverage of U.S. corporations, raising concerns about the corporate sectors’ financial stability. Indeed, by June 1990, 156 (24%) of the 662 companies that issued high-yield bonds between 1977 and 1988 had either defaulted, gone bankrupt, or restructured their public debt. The face value of those distressed bonds amounted to nearly $21 billion.
The central question raised by those distressed firms is easy to put but hard to answer: What is the effect of financial distress on a firm’s operating performance? There are two competing views. The first, an application of the Coase Theorem, holds that there are no real effects of financial distress. Critical to this view is the distinction between financial and economic distress. Admittedly, most firms in financial trouble also suffer from poor operating performance. No amount of financial maneuvering can save these economically distressed firms. If, however, a firm’s capital structure prevents from pursuing its value-maximizing operating strategy, creditors will restructure their claims to maximize firm value. We should expect financially distressed firms to do poorly on average, but no worse than if they had no leverage.
The second view — implicit in the leading theory of capital structure — is that financial distress hampers operating performance. In this view, the Coase Theorem fails; financial renegotiation is inefficient and operating distortions are introduced.
Distinguishing between these two views is important for understanding a variety of issues: capital structure decisions; the costs of tax policies which affect the level of corporate debt; the impact of wide-scale financial distress during a recession; and the role and effects of specific provisions of bankruptcy law.
Unfortunately, it is difficult to distinguish empirically between financial and economic distress. Is a financially distressed firm liquidated because renegotiation is inefficient or because the firm is not economically viable? Is a firm’s poor operating performance the result of underlying business problems or an inappropriate capital structure? Unfortunately, the empirical attempts to distinguish between financial and economic distress are limited to specific environments in which it is relatively easy to make such distinction.
The theoretical distinction between financial and economic distress emerges in the important work of Bulow and Shoven (1978) and the follow-up work of White (1980, 1983). These models demonstrate how conflicts among creditors can lead to inefficiencies when a firm is in financial distress. The impediment to efficient renegotiation in these models is the assumption that the firm cannot renegotiate with bondholders, although they can renegotiate efficiently with a bank. On the one hand, because public bondholders claim part of the cash flows from new investment, distressed firms can have difficulty issuing equity or debt for new investment. This, they may pass up positive net present value investments.
This article pursues two research goals. The first is to show that these investment inefficiencies are still a problem even when firms can renegotiate with bondholders. We analyze the implicit renegotiation that takes place when firms offer a basket of new securities and cash in exchange for the original public bonds. Public debt restructurings almost always take the form of exchange offers because the Trust Indenture Act of 1939 requires unanimous bondholder consent before a firm can alter the principal, interest, or maturity of its public bonds. Exchange offers effectively alter these features but, since nontendering public bondholders maintain their original claim for payments on the firm, the Trust Indenture Act is not violated.
Despite the frequency with which exchange offers have been made — 73 of 156 distressed junk bond issuers have successfully completed exchanges between 1977 and 1990 — there is at least one substantial obstacle to successfully completing an exchange. Those bondholders who do not tender can see the value of their bonds rise if the exchange offer is successful, since tendering bondholders forgive part of the debt and reduce the default risk of the issuer. Although public bondholders as a group would be better off if the exchange offer goes through, those with small stakes have an incentive to hold out. Thus, it can be very difficult to complete an exchange.
This free-rider problem can be, and often is, mitigated by offering a more senior security in exchange for the public bonds, one with shorter maturity, or, when it is available, cash. Moreover, in these types of exchanges bondholders may be willing to tender at below-market prices because they fear that holding out will make them effectively junior to the new securities. But, the important point is that even though these types of offers enable firms to restructure their public debt profitably, they do not, in general, result in efficient investment. The problem is that in deciding whether to tender, public bondholders take the firm’s investment policy as a given. Thus, individual bondholders — each with small stakes — fail to take into account their effect on the firm’s investment decision, despite the fact that their decisions, taken as a whole, affect investment behavior.
The second principal goal of this article is to analyze the effects of bankruptcy law on investment. I conclude that the key features of the law — the automatic stay, the voting rules for plan approval, and the power of shareholders to retain value for themselves — all act to increase investment both in and out of bankruptcy. Whether this increases efficiency depends on whether the firm would otherwise have underinvested or overinvested as a result of financial distress. I characterize the aspects of the firm’s debt structure — the seniority of bank debt relative to public bonds, the maturity structure, and the existance of covenants restricting debt issues — that lead to underinvestment or overinvestment. I am then able to identify the situations in which Chapter 11 reorganization increases or decreases investment efficiency.
This article is organized as follows. Section 1 presents my benchmark model of workouts when bonds restructurings are not possible and bankrupt firms are liquidated, not reorganized. I build on the Bulow and Shoven model to analyze the effects of priority and maturity on investment after the onset of financial distress. Section 2 introduces the possibility of public bond restructurings through exchange offers and compares the results of this model to those of Section 1’s benchmark model. I show that if there is no restriction on senior debt issues, exchange offers do not affect the costs of financial distress but do place more of the burden of distress on bondholders. If covenants restricting the issue of senior debt exist, however, exchange offers can be used to eliminate them and, thereby, increase investment. In this case, exchange offers may reduce the debt burden so much as to lead to overinvestment and exacerbate inefficiencies. We show that it is sometimes efficient to eliminate seniority covenants, but investment efficiency is greater if a firm can only remove them with a vote that is separate from an exchange offer. Section 3 introduces the possibility of reorganization rather than liquidation upon default. I review some of the key legal issues of Chapter 11 and analyze their effects on investment. Section 4 concludes.