Corporate Financial Distress and Reorganization: A Survey of Theoretical and Empirical Contributions.
| Autor | Silva, Vinicius Augusto Brunassi |
1 Introduction
This paper provides both a theoretical and empirical review of bankruptcy and reorganization studies. We elaborate a general review of reorganization and bankruptcy studies, shedding light on the different issues related to the topic. We follow Senbet and Wang (2010) in showing the main issues related to bankruptcy and reorganization. Moreover, we include recent papers and show more results from Brazilian studies. This type of survey provides a broad analysis of the literature related to a specific topic. For example, Senbet and Wang (2010) undertake an extensive review of issues related to corporate financial distress and bankruptcy and Almeida, Campello, Cunha, and Weisbach (2014) provide a substantial review on corporate liquidity management.
In addition to the theoretical and empirical results presented by Senbet and Wang (2010), our paper contributes to the literature by considering recent papers in the field and by addressing research conducted in Brazil right after the announcement of the new Brazilian bankruptcy law. We also link the findings mentioned throughout our paper with three real practical cases of reorganization in Brazil. We aim to present a simple illustration of a few characteristics surrounding the reorganization decision.
In 2005, Law 11,101 took effect in Brazil in order to provide better conditions for creditors to reorganize or liquidate companies facing financial distress. The new Brazilian bankruptcy law is based on Chapter 11 of the U.S. bankruptcy code. Reorganization seems to provide a good alternative for companies in bad situations, making it possible to preserve organizational values and enabling financially distressed firms to follow growth opportunities after a failure event. In the new Brazilian bankruptcy law, firms can either restructure debt under the supervision of the bankruptcy court or attempt to restructure debt out of court (recuperacao extrajudicial).
We provide a review of the empirical studies focusing on the resolution of financial distress. We first discuss papers that have estimated the direct cost of formal bankruptcy in the U.S. Next, we relate the studies that explain the characteristics of companies that have chosen a private workout. We also provide a brief review of the governance of distressed firms and the firms' outcomes after a Chapter 11 filing. Furthermore, we highlight studies conducted in Brazil after the new Brazilian bankruptcy law.
Finally, we examine the characteristics of the reorganization of three real Brazilian cases. We provide a brief description of each company, some information from the reorganization plan, and the decision from the minutes of the assembly. The data were extracted from documents of each firm facing reorganization. We analyzed the reorganization plan, the minutes of the lenders' meeting, and the list of creditors provided by the judicial trustee in charge of each case.
Our survey indicates that market frictions are critical to the reorganization decision. Information asymmetry plays an important role in creditors' demands and can enlarge coordination problems. The number of claimholders and the concentration of debt are also relevant to the outcomes of corporate financial distress. With a modest example, we show how such problems relate to practical cases of reorganizations.
The empirical papers in Brazil focus on debt reorganization, credit concession, conflict resolution, economic distress, and corporate governance. Nevertheless, researchers have not yet indicated the main drivers of success or failure in corporate reorganizations. This may be an important direction for future research.
This paper is structured as follows. The second section presents a theoretical review on reorganization and bankruptcy and highlights important empirical studies developed in the area. In addition, it presents studies that incorporate Brazilian data gathered after the new Brazilian bankruptcy law. The third section provides a case analysis of three Brazilian companies. The fourth section offers the discussion and final remarks.
2 Theoretical Reasons for Reorganization Choices and Bankruptcy: The Role of Asymmetric Information, Coordination, and Cost of Restructuring
The separation of investment and financial decisions for companies in perfect and frictionless capital markets makes bankruptcy risk irrelevant to firm value. According to Modigliani and Miller (1958, 1963), bankruptcy refers to the transfer of ownership from equity holders to other claimholders as soon as the value of assets drops below the value of debt. Hence, the value of a business entity cannot be affected by the bankruptcy costs of firms facing problems honoring promises to creditors.
However, further research demonstrates that bankruptcy costs can be crucial for firms' debt decisions. Information asymmetry, coordination problems, heterogeneity between creditors, and bankruptcy institutions play an important role in the resolution of financial distress. Kim (1978), Kraus and Litzenberger (1973), Leland (1994), and Scott (1976) show the link between bankruptcy and the existence of an optimal capital structure. Tradeoff theory presumes considerable costs related to financial distress and bankruptcy. While direct costs include court fees, lawyers, and tax accountants, indirect costs include inefficient investments and disruption among stakeholders' contracts.
The choice of debt structure influences what happens in bankruptcy according to Aghion, Hart, and Moore (1992) and Haugen and Senbet (1978). From an ex ante perspective, several studies analyze the importance of bankruptcy with respect to debtors' investments, leverage, and incentives prior to bankruptcy situations, such as those of Bebchuck (2002), Berkovitch and Israel (1999), Cornelli and Felli (1997), and Schwartz (1998), among others. These researchers shed light on the conflict between debtors and representative creditors.
Kordana and Posner (1999) expand the analysis by considering bargaining with multiple creditors. They incorporate the operation of the voting rules in Chapter 11. Moreover, Bisin and Rampini (2006), Bolton and Scharfstein (1996), Bris and Welch (2005), Hackbarth, Hennessy, and Leland (2007), Hege and Mella-Barral (2005), Thadden, Berglof, and Roland (2010), and Winton (1995) also present a multiple-creditor model considering ex ante contracting problems or an ex post analysis of problems related to individual and collective liquidation rights of creditors. The studies point out that firms may face fewer problems in the future in cases where they have raised money from a single lender. Coordination problems arise in the presence of many creditors and can be extremely costly for all parties. Hence, the participation of heterogeneous creditors (and different types of debt contracts) in each firm's capital structure will make resolving financial distress more difficult.
An ex post analysis of costs related to financial distress provides an option for firms to resolve distress through formal or informal reorganization procedures. The costs of financial distress in some cases can exceed any remaining firm value; thus, companies end up being dissolved. A possible alternative is to adopt a reorganization plan that addresses the problem. Basically, the choice of restructuring is made according to the least-cost alternative. However, it is not easy to identify the choice that stakeholders view as the least expensive decision. Costs depend on the market frictions that are specific to the situation of each company. To provide a solution for distress, companies can raise money from outside investors and reorganize through debt restructuring and asset sales.
In addition to considering liquidation as an outcome, Broadie, Chernov, and Sundaresan (2007) clarify that the possibility of a court reorganization leads to conflicts of interest between borrowers and lenders. According to their first-best result, reorganization is beneficial to both stakeholders through higher debt capacity, lower credit spreads, and firm value creation.
The cost of liquidation and asset restructuring depends on the fraction of the assets that need to be sold and what operational relationship the liquidated assets have with those that are retained. Haugen and Senbet (1978) argue that bankruptcy costs should not be significant because claimants in financial distress should be able to negotiate out of court without affecting the underlying value of the firm. Moreover, Haugen and Senbet (1978), Jensen (1989), and Roe (1983) suggest that private reorganizations are more efficient in theory because they solve financial distress at a lower cost.
Nevertheless, some problems may appear in out-of-court cases, and costs can rise significantly. In short, resolving financial distress through private reorganization can be costlier due to holdout problems, information asymmetry, and conflicts of interest. Gilson (1997) shows that transaction costs can interfere with corporate debt reduction in cases of out-of-court reorganization.
Although a private workout can create better financial conditions for the company in distress, some creditors may choose to hold out in the restructuring process in situations where the posterior value of a claim may be higher than the value received for participating in the private reorganization. This is known as the creditor holdout problem.
In addition, the possibility of rejecting a restructuring plan, even when it is clearly advantageous for the whole company, makes resolving the financial distress a bit more difficult. Obviously, this type of problem is more likely in firms with a large number of creditors, but this is not the only condition.
The creditor holdout problem can be reduced through less stringent voting requirements, a procedure that might be achieved in court restructuring. Haugen and Senbet (1988) provide possible alternatives to eliminate the holdout problem...
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