No full-text available
To read the full-text of this research,
you can request a copy directly from the authors.
The Importance of Deviations from the Absolute Priority Rule in Chapter 11 Bankruptcy Proceedings
Abstract
Departures from the absolute priority rule (APR) in Chapter 11 bankruptcy proceedings have been of great interest to finance scholars throughout the 1990s. In a recent article, Beranek, Boehmer, and Smith (1996, BBS) criticize three of the early articles in this area (Franks and Torous, 1989, Eberhart, Moore, and Roenfeldt, 1990, and Weiss (1990); collectively called the priority papers), among others. This paper reviews the BBS paper, explains why APR violations have been interesting to finance researchers, and documents the validity of the priority papers' focus.
... Beranek et al. (1996) detected no evidence of an incorrect application of legal priority rules by bankruptcy judges to secured creditors. They (incorrectly) claim that this is a central idea defended by absolute priority empirical studies (see Eberhart & Weiss (1998) for a defense of these studies). Their finding is subject to two conditions. ...
... In their study, equity did not receive any consideration in 33.8% of the cases.However,Eberhart & Weiss (1998) point out that this does leave some scope for absolute priority violations in the other 66.2% of firms.20 In the limit, with considerable default risk, this situation would evolve to that of a 100% equity capital structure.21 ...
This paper documents emerging patterns in deviations from absolute priority (DAPs) in Chapter 11 bankruptcies. Priority rules are violated in at least two-thirds of all cases, with equityholders benefiting in most situations of violation. However, DAPs have been decreasing over time, with the index of deviations from absolute priority rules more than halving over a 12-year period. This fact is best explained by the reduced bargaining power of the debtor, smaller complexity of the cases, and choice of bankruptcy venue. Interestingly, both unsecured creditors and equityholders now benefit from DAPs to the detriment of secured creditors.
... riority rule (APR) are important determinants of the recovery rate. The APR states that the value of the bankrupted firm must be distributed to suppliers of capital so that " [...] senior creditors are fully satisfied before any distributions are made to more junior creditors, and paid in full before common shareholders " (Schuermann, 2004, p. 11). Eberhart and Weiss (1998) confirm that the APR is routinely violated in the interests of speed of resolution. Creditors agree to violate the APR to resolve bankruptcies faster. 4 Firms in some sectors have a large amount of assets that can be easily sold on the market in case of default, while other sectors may be more labor-intensive, for example. a better data ...
... The APR states that the value of the bankrupted firm must be distributed to suppliers of capital so that " [...] senior creditors are fully satisfied before any distributions are made to more junior creditors, and paid in full before common shareholders" (Schuermann, 2004, p. 11). Eberhart and Weiss (1998) confirm that the APR is routinely violated in the interests of speed of resolution. Creditors agree to violate the APR to resolve bankruptcies faster. ...
This paper focuses on the key credit risk parameter – Loss Given Default (LGD). We describe its general properties and determinants with respect to seniority of debt, characteristics of debtors and macroeconomic conditions. Furthermore, we illustrate how the LGD can be extracted from market observable information with help of the adjusted Mertonian structural approach. We present a derivation of the formula for the expected LGD and show its sensitivity with respect to other structural company parameters. Finally, we estimate the 5-year expected LGDs for companies listed on the Prague Stock Exchange and find that the average LGD for this analyzed sample is in the range of 20–45 %. To the authors’ knowledge, these are the first implied market estimates of LGD in the Czech Republic.
... Often the management of a firm act pro-actively and put the firm up for receivership before the equity value of the firm hits zero. Several studies have also shown that equity owners receive some compensation even though debt holders have not been paid in full (Eberhart andWeiss (1998) andLonghofer (1997)) and data suggests that equity values stay positive even for insolvent firms (Betker (1995), Franks and Torous (1991) and LoPucki (1991)). From a bank perspective, various loan conditions allows the bank to force the firm into default if equity values fall below a specific nonnegative threshold ( Garbade (2001) C ji,t+H now represents some positive default threshold which can vary over time and differ between firms depending on firm-specific characteristics such as sector or industry classification, leverage, profitability, firm size or age and qualitative factors such as management style. ...
... Often the management of a firm act pro-actively and put the firm up for receivership before the equity value of the firm hits zero. Several studies have also shown that equity owners receive some compensation even though debt holders have not been paid in full (Eberhart andWeiss (1998) andLonghofer (1997)) and data suggests that equity values stay positive even for insolvent firms (Betker (1995), Franks and Torous (1991) and LoPucki (1991)). From a bank perspective, various loan conditions allows the bank to force the firm into default if equity values fall below a specific nonnegative threshold ( Garbade (2001) C ji,t+H now represents some positive default threshold which can vary over time and differ between firms depending on firm-specific characteristics such as sector or industry classification, leverage, profitability, firm size or age and qualitative factors such as management style. ...
Active credit portfolio management is becoming a central part of capital and credit management within the banking industry. Stimulated by the Basel II capital accord the estimation of risk sensitive credit and capital management is central to success in an increasingly competitive environment. If any risk mitigation or value-enhancing activity is to be pursued, a credit portfolio manager must be able to identify the interdependencies between exposures in a portfolio, but more importantly, be able to relate credit risk to tangible portfolio effects on which specific actionable items can be taken. This analysis draws on the macroeconometric vector error correcting model (VECM) developed by De Wet et al. (2007) and applies the proposed methodology of Pesaran, Schuermann, Treutler and Weiner (2006) to a fictitious portfolio of corporate bank loans within the South African economy. It illustrates that it is not only possible to link macroeconomic factors to a South African specific credit portfolio, but that scenario and sensitivity analysis can also be performed within the credit portfolio model. These results can be used in credit portfolio management or standalone credit risk analysis, allowing practical credit portfolio management and value enhancing applications.
... where X ji,T +1 is the maximum loss exposure assuming no recoveries (typically the face value of the loan) and is known at time T , S ji,T +1 is the percentage of exposure which cannot be recovered in the event of default (sometimes called loss given default or severity), 25 and˜Land˜ and˜L is some future value of loss in the event of non-default at T + 1 (which we set to zero for simplicity). 26 Typically ...
... However, for simplicity we follow the standard assumption that exposure and severity are independently distributed. 26 It is common practice in the industry to set L to zero. 27 The beta distribution is usually chosen since it is bounded, such as on the unit interval, with two shape parameters which can be expressed in terms of mean and standard deviation of losses. ...
We develop a framework for modelling conditional loss distributions through the introduction of risk factor dynamics. Asset value changes of a credit portfolio are linked to a dynamic global macroeconometric model, allowing macro effects to be isolated from idiosyncratic shocks. Default probabilities are driven primarily by how firms are tied to business cycles, both domestic and foreign, and how business cycles are linked across countries. The model is able to control for firm-specific heterogeneity as well as generate multi-period forecasts of the entire loss distribution, conditional on specific macroeconomic scenarios.
... This discrepancy steers the behaviour of the investors (owners and creditors) as well as that of the management. Presumed, that the participants act rationally and are all well informed, and may calculate the occurring probability of the non-observance of the APR, the costs of this probable incidence will be part of the price (Eberhart & Weiss 1998). If the breach of the APR is more advantageous for the shareholders and its probability is built in their expectations, then this would generate a lower profit for them. ...
... Motivated by the linkage of bonds and CDS in the auction mechanism, Φ sen T and Φ sub T are also assumed to be the appropriate CDS recoveries. Note, however, that in practice, APR violations often occur and are widely examined (see, e.g., Betker [18] and Eberhart and Weiss [19]). Using the APR rule, a general spread representation as in Eq. (2) as well as independence of Φ and τ , the recoveries are deterministic functions of the companywide recovery X T and the fraction of senior to subordinated CDS spreads is given by ...
Credit spreads provide information about implied default probabilities and recovery rates. Trying to extract both parameters simultaneously from market data is challenging due to identifiability issues. We review existing default models with stochastic recovery rates and try calibrating them to observed credit spreads. We discuss the mechanisms of credit auctions and compare implied recoveries with realized auction results in the example of Allied Irish Banks (AIB).
... Finally, we code two key outcome variables that characterize distribution to junior claims (unsecured debt and equity), possibly as a result of APR deviations (Eberhart, Moore, and Roenfeldt (1990), Betker (1995), Eberhart and Weiss (1998)), using information from bankruptcy plans and supplemented by BankruptcyData.com and Datastream. ...
This paper studies the presence of hedge funds in the Chapter 11 process and their effects on bankruptcy outcomes. Hedge funds strategically choose positions in the capital structure where their actions could have a bigger impact on value. Their presence, especially as unsecured creditors, helps balance power between the debtor and secured creditors. Their effect on the debtor manifests in higher probabilities of the latter’s loss of exclusive rights to file reorganization plans, CEO turnover, and adoptions of KERP, while their effect on secured creditors manifests in higher probabilities of emergence and payoffs to junior claims.
... " Nonetheless, the case where there is trade only before the proposal is between the full disclosure case and the case of trade following the proposal analyzed in the paper (for a more detailed discussion see Section 7.1). 8 The ability of debtholders to short equity can thus mitigate deviations from priority, as studied by the bankruptcy literature, e.g., Eberhart and Weiss (1998). When the fund trades across two markets we have to consider different cases concerning the information each market has about the other. ...
Hedge funds are heavily involved in restructurings through their debt holdings. A concern is that funds might short the equity of their debtors, reject a restructuring proposal, and trigger an inefficient liquidation to gain from their short position. We analyze the strategic game between a firm manager, who makes the proposal, and a fund, which trades in the firm’s securities. We show that if other investors are expected to buy in the equity market and the markets for debt and equity are informationally segregated then the manager's proposal allows the fund to profitably execute the above firm value destroying strategy.
... Nevertheless absolute priority is quite often violated. For publicly traded firms Eberhart and Weiss (1998) and other authors cited by them show that absolute priority was violated in approximately 50-70% of out-of-court workouts and bankruptcies, depending on the particular sample used. Similarly Berkowitz and White (2004) document widespread absolute priority violation for small firms. ...
This paper extends the costly enforcement model of optimal financing to the case of investment projects financed by several lenders when the legal and economic situation in the emerging market economy does not allow for commitment to contracts and for securitization of credit contracts through use of collateral. We consider the asymmetric situation when only one lender is a big strategic investor. All other lenders are small passive investors. We first provide the sufficient and necessary condition for renegotiation proofness. Then we show that the optimal verification is deterministic. We also discuss the conditions under which the optimal contract is a debt contract. Our methodological framework may be used for example for the analysis of credit provision in food supply chains, where often many small non-strategic investors (small farm-level producers) interact with some big strategic investor (the advanced technology supplier) in the explicit or implicit crediting of some parts of food supply chain like the food processing plants or storage facilities.
... The first branch of these extensions is to permit the deviations of absolute priority rule (APR) in Chapter 11 bankruptcy proceedings. The importance of violations from APR has been addressed in the literature. Eberhart and Weiss (1998) clearly point out that APR is explicitly or implicitly assumed in many seminal finance models, such as Merton (1974) and Myers (1977). The APR is adhered since shareholders receive nothing until debt holders have been fully paid. The APR is also assumed in most of the early structural models. However, empirical studies indicate that the ...
In this paper, we review the most important and representative capital structure models. The capital structure models incorporate
contingent claim valuation theory to quantitatively analyze prevailing determinants of capital structure in corporate finance
literature. In capital structure models, the valuation of corporate securities and financial decisions are jointly determined.
Most of the capital structure models provide closed-form expressions of corporate debt as well as the endogenously determined
bankruptcy level, which are explicitly linked to taxes, firm risk, bankruptcy costs, risk-free interest rate, payout rates,
and other important variables. The behavior of how debt values (and therefore yield spreads) and optimal leverage ratios change
with these variables can thus be investigated in detail.
KeywordsOptimal capital structure-Structural model-Capital structure model-Credit risk
... Because default is costly and violations to the absolute priority rule in bankruptcy proceedings are so common, in practice shareholders have an incentive to put the firm into receivership even before the equity value of the firm hits zero. 10 In fact, several authors have found that in 65% to 80% of bankruptcies, even shareholders receive something without debt-holders necessarily having been fully paid off (see, for instance, Eberhart and Weiss 1998, and references therein). Moreover, we see in practice that equity values remain positive for insolvent firms. ...
This paper presents a new approach to modeling conditional credit loss distributions. Asset value changes of firms in a credit portfolio are linked to a dynamic global macroeconometric model, allowing macroeffects to be isolated from idiosyncratic shocks from the perspective of default (and hence loss). Default probabilities are driven primarily by how firms are tied to business cycles, both domestic and foreign, and how business cycles are linked across countries. We allow for firm-specific business cycle effects and the heterogeneity of firm default thresholds using credit ratings. The model can be used, for example, to compute the effects of a hypothetical negative equity price shock in South East Asia on the loss distribution of a credit portfolio with global exposures over one or more quarters. We show that the effects of such shocks on losses are asymmetric and non-proportional, reflecting the highly nonlinear nature of the credit risk model.
... These two authors, as well as LoPucki and Whitford (1993), find that onequarter to one-third of reorganized firms subsequently restructure their debt. Betker (1997), Branch (1998), Eberhart and Weiss (1998), and Ravid and Sundgren (1998) have also recently examined the efficiency of the Chapter 11 bankruptcy process. ...
We analyze the postbankruptcy cash flows for a sample of firms that emerged from Chapter 11 reorganization between 1983 and 1993. We evaluate the rate of return available to investors who owned all of the debt and equity claims on the firm as it emerged from bankruptcy. On average, this return matches the performance of benchmark portfolios during the five years following emergence. Although postbankruptcy operating margins are poor, the market appears to accurately assess the firm's prospects at the time it emerges from bankruptcy. Superior returns are generated by high growth-option firms that invest heavily following emergence from bankruptcy.
Автор: Екатерина Няимовна Антонова НИУ ВШЭ Ставка восстановления является одним из ключевых параметров оценки возможных потерь при наступлении дефолта по корпоративной облигации наряду с вероятностью дефолта и подверженностью риску при наступлении дефолта. Она показывает, какую долю привлеченных средств эмитент возвращает владельцу облигации в случае ее дефолта. Однако оценке ставки восстановления, в отличие от оценки вероятности дефолта, долгое время не уделялось достаточного внимания в научных работах. Цель настоящего исследования – создать модель для оценки ставки восстановления по корпоративным облигациям российских эмитентов.
In this chapter, we explore whether there can be the optimal priority rule, that is, the rule that can prevent inefficient additional lending (loan evergreening) and avoid debt overhang. We extend our model to analyze the cases of firms with both efficient and inefficient additional investments. First, we consider whether using the super-priority rule to avoid debt overhang is simply equivalent to depriving the existing senior creditor of the right to liquidate the defaulting firm. Next, we consider debtor-in-possession (DIP) finance, which gives super-priority to the junior creditor, but requires “accurate adequate protection” for senior creditors, such that the existing senior creditors are given security for their own credit. We demonstrate that efficient decision making regarding additional investment is achievable under both “super-priority” and “accurate adequate protection.” Furthermore, we evaluate the legal reforms in Japan in the 2000s based on the theoretical results derived from our model.
This paper derives the theoretical underpinnings behind the following observed empirical facts in credit risk modeling: The probability of default, the seniority, the thickness of the tranche, the debt cushion, and macroeconomic factors are the important determinants of the conditional probability density function of the recovery rate given default (RGD) of a firm's debt and its tranches. In a portfolio of debt securities, the conditional probability density functions of the recovery rate given default of tranches have point probability masses near zero and one, and the expected value of the recovery rate given default increases as the seniority or debt cushion increases. The paper derives other results as well, such as the fact that the conditional probability distribution function associated with any senior tranche dominates that of any junior tranche by first-order. The standard deviation of the recovery rate given default of a senior security need not be greater than that of a junior security. It is proved that the expected value of the recovery rate given default need not increase as the proportional thickness of the tranche increases.
Hedge funds are heavily involved in corporate restructurings. What makes their involvement distinct from other investors is
that hedge funds can trade across the securities of a firm, holding either long or short positions in each security. We analyze
the choice of a restructuring proposal by a firm’s manager in the presence of a hedge fund as a potential investor in the
firm. We show that, under certain market conditions, there is an equilibrium where the firm’s manager makes a proposal for
which a hedge fund finds it profitable to short-sell the equity of the firm, buy the debt of the firm, and via its debtholdings
lead the firm to a value-reducing outcome to gain on its short equity position. The necessary and sufficient market conditions
under which the aforementioned equilibrium occurs are that the debt and equity markets are segregated and that other traders
in the equity market are net buyers on average.
This empirical research has studied the choice of debt restructuring model carried out by the companies listed at PT. BEJ which is caused by the fact that the companies have difficulty paying their debts. The result of observation considers it important to reevaluate the factors that affect the choice of debt restructuring model as the result of negotiation among the Firm, creditor and Firm investor. Considering the 1998 SKBI No. 31/150/KEP/DIR which obliges credit restructuring by analyzing based on the debtor's business prospect and its pay ability in line with cash flow projection, the firm's financial characteristics and industrial conditions are the determining factors of the choice of Debt Restructuring Model. Negotiations to choose the model of debt restructuring are discussed in asymmetric information contexts. The debt restructuring model that can be chosen by the Firm is not mutually exclusive. The Firm can combine the existing models, which is certainly with the agreement of the creditor and investor. With the possibility to combine debt restructuring models which can be chosen by considering the effects of determining factors, the analysis model used is SUR (Seemingly Unrelated Regression). The Firm's Internal financial characteristics is proxied by Liquidity, Capital Structure, Asset, and its profitability. While Industrial Condition is measured with Industrial output growth and Firm's Competitive Capability, which is an interconnection between the industrial condition and the profitability achieved by the Firm. Debt restructuring models to choose include Rescheduling, Asset Sales, Equity Swap, Bond Swap, and Hair-Cut. The result of the data processing of the 67 companies which carried out debt restructuring during 1998-2002 shows the tendency to debt restructuring model influenced by the Firm's Internal financial characteristics and its industrial conditions.
Conventional economic reasoning suggests that formal insolvency proceedings should commence once the greater of the going concern value or the liquidation value of a firm falls below the value of its liabilities. Since this test is difficult to apply in practice, an additional cash flow test is needed: formal insolvency proceedings should commence if a firm is not able to pay its due debts. Two factors complicate this analysis: risk-shifting incentives of shareholders/managers in the vicinity of insolvency and the (rapid) decline of a firm's going concern value once it approaches insolvency. The former problem should be addressed by a liability rule for wrongful trading. Based on a review of the current legal position in the United States, the United Kingdom and Germany, a uniform European rule is proposed that imposes liability on managers of insolvent companies for trading while they knew or should have known that insolvency was more probable than not, unless they can show that they took all reasonable steps to avoid insolvency. The decline of a firm's going concern value once it approaches insolvency provides all stakeholders with an incentive to try a workout to save as much of the going concern value as possible. However, workouts often fail in practice due to free-rider effects. Cooperation duties are proposed as a means to support workouts. Such duties should be triggered once a workout is initiated. It is suggested that bankruptcy rules, in general, and rules on the initiation of bankruptcy proceedings, in particular, should in principle be enabling rather than mandatory.
With a state preference model, we illustrate how differences in bankruptcy code across countries affect managerial incentives and firm value. We examine bankruptcy codes of the G-7 countries in some detail and tie differences to model outcomes. We substantiate the economic effect of these differences by contrasting outcomes of specific bankruptcies and with the pre-filing performance of bankrupt firms from different countries. We then use a constrained optimization model to show that code differences also affect managers of financially healthy firms. These code-induced incentives and empirical evidence raise implications for bankruptcy policies, financial research, and policies affecting economic growth.
This paper presents a new approach to modeling conditional credit loss distributions. Asset value changes of firms in a credit portfolio are linked to a dynamic global macroeconometric model, allowing macro effects to be isolated from idiosyncratic shocks from the perspective of default (and hence loss). Default probabilities are driven primarily by how firms are tied to business cycles, both domestic and foreign, and how business cycles are linked across countries. We allow for firm-specific business cycle effects and the heterogeneity of firm default thresholds using credit ratings. The model can be used, for example, to compute the effects of a hypothetical negative equity price shock in South East Asia on the loss distribution of a credit portfolio with global exposures over one or more quarters. We show that the effects of such shocks on losses are asymmetric and non-proportional, reflecting the highly non-linear nature of the credit risk model.
This book offers a unified presentation of dynamic term structure models and their applications to the pricing and risk management of fixed income securities. The basic fixed income securities and their properties and uses as well as the relations between these securities are explained. The book presents and compares the classical affine models, Heath-Jarrow-Morton models, and LIBOR market models, and demonstrates how to apply those models for the pricing of various widely traded fixed income securities. The book has a number of distinctive features compared to other fixed-income texts. It offers a balanced presentation with both formal mathematical modelling and economic intuition and understanding. A separate chapter gives an introduction to stochastic processes and the stochastic calculus needed for the modern financial modelling approach used in the book. A separate chapter explains how the term structure of interest rates relates to macro-economic variables and to what extent the concrete interest rate models are founded in general economic theory. The book focuses on the most widely used models and the main fixed income securities, instead of trying to cover all the many specialized models and the countless exotic real-life products. The detailed explanation of the main pricing principles, techniques, and models as well as their application to the most important types of securities will help with the understanding and application of other models and price other securities. The book includes separate chapters on interest rate risk management, credit risk, mortgage-backed securities, and relevant numerical techniques.
The New Basel Accord will allow internationally active banking organizations to calculate their credit risk capital requirements using an internal ratings based (IRB) approach, subject to supervisory review. One of the modeling components is loss given default (LGD), the credit loss incurred if an obligor of the bank defaults. The flexibility to determine LGD values tailored to a bank's portfolio will likely be a motivation for a bank to want to move from the foundation to the advanced IRB approach. The appropriate degree of flexibility depends, of course, on what a bank knows about LGD broadly and about differentiated LGDs in particular; consequently supervisors must be able to evaluate "what a bank knows." The key issues around LGD are: 1) What does LGD mean and what is its role in IRB? 2) How is LGD defined and measured? 3) What drives differences in LGD? 4) What approaches can be taken to model or estimate LGD? By surveying the academic and practitioner literature, with supportive examples and illustrations from public data sources, this paper is designed to provides basic answers to these questions. The factors which drive significant differences in LGD include place in the capital structure, presence and quality of collateral, industry and timing of the business cycle.
This paper focuses on a key credit risk parameter – Loss Given Default (LGD). We illustrate how the LGD can be estimated with the help of an adjusted Mertonian structural approach. We present a derivation of the formula for expected LGD and show its sensitivity analysis with respect to other company structural parameters. Finally, we estimate the five-year expected LGDs for companies listed on Prague Stock Exchange and find that the average LGD for the analyzed sample is around 20–50%.
As for recent Japanese bank behavior, there exist two inefficacies. One is credit crunch, that is, banks hesitate to lend money to new good projects. The other is excessive additional loan to bad-performing firms. These two perverse bank behaviors look like contradictive each other. In this paper, we explain these contradictive behaviors stem from the violation of the absolute priority rule (APR) among the stakeholders in Japan. Under the legal violation of priority rule, the borrowers with inefficient projects can finance from a new junior creditor, transferring the credit value of the senior creditor to the new junior one. In such a situation, it is the best behavior for the senior creditor, i.e. bank, which tries to protect the value of his senior credit, to finance the inefficient project by himself before the junior creditor might lend money. This behavior implies inefficient excessive additional loan. Furthermore, since banks expect not to avoid such ex-post inefficiency and the accompanied loss due to the violation of APR, they are unwilling to lend to the originally efficient project in ex-ante. This results in credit crunch.
In a June 12, 1990 Wall Street Journal article entitled "Warning Flag: When a Firm's Stocks and Bonds Diverge," the stocks and bonds of companies such as Pan Am and TWA were cited as being clearly mispriced. How, the article asked, could Pan Am's stock be trading at $2.50 per share when its senior debt was only worth 30 to 40 cents on the dollar? A managing director of a mutual fund was quoted as stating the prices were "totally ridiculous," and he further remarked, "Either the bond is too cheap or the stock is too high." The article noted that, "At least in theory, if a company's creditors' can't be fully paid, its stock, which ranks lower among its financial obligations, is next to worthless." In other words, the absolute priority rule (APR) will be followed. The APR states that creditors should be fully compensated before shareholders receive any portion of the bankrupt firm's value.
This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a ''spot exchange rate.'' Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps.
I present new evidence on the direct costs of bankruptcy and violation of priority of claims. In a sample of 37 New York and American Stock Exchange firms that filed for bankruptcy between November 1979 and December 1986, direct costs average 3.1% of the book value of debt plus the market value of equity, and priority of claims is violated in 29 cases. The breakdown in priority of claims occur primarily among the unsecured creditors and between the unsecured creditors and equity holders. Secured creditors' contracts are generally upheld.
This paper analyzes the pricing of two types of secured debt and shows that secured debt can be used to increase the value of the firm. In particular, it is shown that some profitable projects will not be undertaken by a firm which can use only equity or unsecured debt to finance them but will be undertaken if they can be financed with secured debt. Secured debt is priced for a firm with two assets and some unsecured debt outstanding. The pricing results are used to illustrate the benefits of the security provision of secured debt.
Many corporate assets, particularly growth opportunities, can be viewed as call options. The value of such ‘real options’ depends on discretionary future investment by the firm. Issuing risky debt reduces the present market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy. The paper predicts that corporate borrowing is inversely related to the proportion of market value accounted for by real options. It also rationalizes other aspects of corporate borrowing behavior, for example the practice of matching maturities of assets and debt liabilities.
If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived. Since almost all corporate liabilities can be viewed as combinations of options, the formula and the analysis that led to it are also applicable to corporate liabilities such as common stock, corporate bonds, and warrants. In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default.
The author examines the determinants of equity's absolute priority deviation in seventy-five bankruptcies. Previous research emphasizes the shareholders' option to delay a reorganization. In practice, managers control this option, and agency problems between managers and shareholders can be severe in bankruptcy. Equity's bargaining power should depend on managers' incentives and creditor control over managers. Empirical evidence indicates that priority deviations are larger when the firm is closer to solvency, banks hold fewer claims, the chief executive officer (CEO) holds more shares, CEO pay and shareholder wealth are positively related, and the firm retains the exclusive right to propose a bankruptcy plan. Copyright 1995 by University of Chicago Press.
This paper presents a multiperiod model of firm valuation derived under the assumptions that bankruptcy is possible and that secondary markets for assets are imperfect. Given the assumption that the probability of bankruptcy is zero, the model is formally identical to that proposed by Modigliani and Miller. Under plausible conditions the model implies a unique optimal capital structure. Comparative statics analysis is used to obtain a number of testable hypotheses which specify the parameters on which optimal financial policy depends. Implications for the debt policy of the regulated firm are also considered.
Announcements of successful leveraged buyouts (LBOs) during January 1985 to April 1989 caused a significantly negative return
on outstanding publicly traded nonconvertible bonds. Yet the average risk-adjusted debt holder losses are less than 7 percent
of the average risk-adjusted equity holder gains. Bond losses are related to the pre-LBO rating, but only weakly to equity
holder gains. We demonstrate that trader-quoted data from a major investment bank offers conclusions about the effects of
LBOs on debt holders different from those drawn from commonly used matrix and exchange-based data (such as Standard & Poor’s
Bond Guide data). This has important implications for event studies involving debt instruments.
This paper considers the cost of Pension Benefit Guaranty Corporation (PBGC) insurance for single-employer defined benefit pension plans. It derives a formula for the PBGC's liability that explicitly recognizes the two necessary conditions that must arise for the PBGC to sustain a loss. First, the corporation sponsoring the pension Iund must undergo bankruptcy and, second, this pension plan must be underfunded. The PBGC's liability is valued as a contingent put option and expressed as infinite series of modified Bessel functions. The comparative statics of the model are examined and are quite consistent with economic intuition. Copyright 1994 by Ohio State University Press.
The theory of financial leasing views financial leases as substitutes for secured debt. Empirical studies have reported a high positive correlation between lease ratios and debt ratios and that lessors earn higher rates of return than lenders. These results contradict traditional leasing theory. They are explained in this paper by recognizing the role bankruptcy costs play in the lease/borrow decision and the nature of the assets to be acquired by a firm. Leasing is shown to involve lower bankruptcy costs than borrowing. Our empirical analysis shows that lessee firms have lower retained earnings relative to total assets, higher growth rates, lower coverage ratios, higher debt ratios, and higher operating risk than non-lessee firms. Lessee firms also have significantly lower Altman Z-scores, a measure of bankruptcy potential. Overall, our results indicate that as bankruptcy potential increases, lease financing becomes an increasingly attractive financing option. We also find evidence to support an industry clientele effect in financial leasing.
Some of the authors of empirical bankruptcy studies have misinterpreted the "absolute priority rule" (APR) and erroneously concluded that at least some bankruptcy courts are failing to enforce the law. This paper clarifies the APR and explains why departures from it are permitted by the US bankruptcy code in certain circumstances.
We develop a simple approach to valuing risky corporate debt that incorporates both default and interest rate risk. We use this approach to derive simple closed-form valuation expressions for fixed and floating rate debt. The model provides a number of interesting new insights about pricing and hedging corporate debt securities. For example, we find that the correlation between default risk and the interest rate has a significant effect on the properties of the credit spread. Using Moody's corporate bond yield data, we find that credit spreads are negatively related to interest rates and that durations of risky bonds depend on the correlation with interest rates. This empirical evidence is consistent with the implications of the valuation model. Copyright 1995 by American Finance Association.
The purpose of this paper is to understand the institutional features of Chapter 11 from an empirical examination of thirty firms that have emerged from reorganization. We find the recontracting framework of Chapter 11 to be complex, lengthy, and costly. Violations of absolute priority in favor of stockholders are frequently encountered. These deviations may result from the bargaining process of Chapter 11 or from a recontracting process between creditors and stockholders which recognizes the ability of stockholder‐oriented management to preserve firm value. An example of such recontracting addresses Myers' underinvestment problem. An investigation of the effects of Chapter 11 on the pricing of risky debt is also provided.
In his article Determinants of Corporate Borrowing, Myers (1977) says that it is not guaranteed that the maximum value of the firm is reached before the maximum value of the debt is utilized in the case in which the interest payment is fully tax deductible, but the tax shield is lost if the firm goes bankrupt. I have shown here that even in such a case the maximum value of the firm will always be achieved before the maximum available debt is utilized.
Claims ultimately awarded to shareholders of firms in reorganization were examined for a sample of thirty filings under the 1978 Bankruptcy Reform Act. The authors measured the amount paid to shareholders in excess of that which they would have received under the absolute priority rule and found that this amount represents, on average, 7.6 percent of the total awarded to all claimants. Evidence is also reported that common share values reflect a significant proportion of value ultimately received in violation of absolute priority, suggesting that deviations from the rule were expected by the equity markets. Copyright 1990 by American Finance Association.
This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. The authors apply the foreign currency analogy of R. Jarrow and S. Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a 'spot exchange rate.' Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps. Copyright 1995 by American Finance Association.
Asymmetric information and conflicts of interest between equity and debt holders can force a distressed but efficient firm to liquidate and may enable a distressed inefficient firm to continue. In the extreme, if it is costless for an inefficient firm to mimic an efficient firm in a debt restructuring, efficient and inefficient firms are equally likely to continue or liquidate. This article shows that Chapter 11 procedures impose costs on inefficient firms that would otherwise mimic efficient firms. This separation induces voluntary filing for bankruptcy by inefficient firms and consequently enables efficient firms to continue when they would otherwise be liquidated. Copyright 1994 by American Finance Association.
This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation. Copyright 1994 by American Finance Association.
AN ISSUE OF CONCERN to the theory of business finance over the past two decades has been the effect of financial structure on the valuation of firms. The traditional presumption is that a firm's value is a concave function of its financial leverage, and that an optimal financial leverage exists where the slope of the function is zero.' This argument is suspect to the extent that it attempts to value a firm's securities in isolation from the rest of the capital market. The pathbreaking works by Modigliani and Miller (MM) have provided the foundations for studying the effect of financial structure on the valuation of firms in equilibrium. MM (1958, 1969) establish that the total value of the firm, in the absence of taxes, remains constant across all degrees of financial leverage. Building on the foundations laid by MM, numerous authors2 have confirmed the MM no-tax thesis using a variety of equilibrium approaches. MM (1963) and some of these authors have shown further that a proportional corporate income tax provides sufficient economic incentive for firms to maximize their use of debt financing. However, in the five-year period from 1966 to 1970 the capital needs of nonfinancial corporations in the United States were financed approximately by two-thirds equity and one- third debt.3 Furthermore, the average corporate debt ratio (which reflects the valuation of equity at market value) is only approximately 20 percent.4 Even these highly aggregated figures suggest that an element of major importance to financial managers and the investing public is missing from the MM theory. Robicheck and Myers (1965, p. 20) and Hirshleifer (1970, p. 264) suggest that bankruptcy costs may represent the major missing element and that incorporating these costs within the foundations laid by MM may support the concept of an optimal capital structure. The importance of bankruptcy costs was particularly well demonstrated by Miller (1962) when he explicitly utilized bankruptcy costs to * Visiting Associate Professor of Finance, Purdue University, on leave from the Ohio State University. Acknowledgement. This paper is based on Chapter Five of my Ph.D. thesis (Kim (1974)) at State
Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely to occur, thereby making debt financing more costly. Together, these results support the view that APR violations create an impediment to efficient financial contracting. I am grateful to Charles Calomiris, Charles Carlstrom, Joseph Haubrich, Charles Kahn, * Stephen Peters, Joo Santos, Bruce Smith, James Thomson, Anne Villamil, seminar participants at the University of Connecticut, several anonymous referees, and the editor, Anjan Thakor, for helpful comments. The views expressed here are my own and do not necessari...
This study assesses the stock return performance of 131 firms emerging from Chapter 11. Using differing estimates of expected returns, we consistently find evidence of large, positive excess returns in 200 days of returns following emergence. We also examine the reaction of our sample firms' equity returns to their earnings announcements after emergence from Chapter 11. The positive and significant reactions suggest that our results are driven by the market's expectational errors, not mismeasurement of risk. The results provide an interesting contrast, but not a contradiction, to previous work that has documented poor operating performance for firms emerging from Chapter 11. 1 The Equity Performance of Firms Emerging from Bankruptcy With large corporate bankruptcies being commonplace during the late 1980s and early 1990s, there has been a notable increase in the number of firms emerging from bankruptcy (Altman (1993)). When firms emerge from bankruptcy, they often cancel the old st...
The post-emergence performance of firms emerging from chapter 11
- Edith S Hotchkiss
Hotchkiss, Edith S., 1995, The post-emergence performance of firms emerging from chapter 11, Journal of
Finance, 50, 3-21.
Security pricing and deviations from the absolute priority rule in bankruptcy proceedings Absolute priority rule violations and risk incentives for financially distressed firms The equity performance of firms emerging from bankruptcy, forthcoming
- Eberhart
- C Allan
- T William
- Rodney L Moore
- Roenfeldt
Eberhart, Allan C., William T. Moore and Rodney L. Roenfeldt, 1990, Security pricing and deviations from the absolute priority rule in bankruptcy proceedings, Journal of Finance, 45, 1457-1469. ? and Lemma Senbet, 1993, Absolute priority rule violations and risk incentives for financially distressed firms, Financial Management, 22, 101-116. ? , Edward I. Altman and Reena Aggarwal, 1998, The equity performance of firms emerging from bankruptcy, forthcoming, Journal of Finance
Do Bond Prices Reflect Absolute Priority Violations? Evidence from US Airline Secured Bonds
- T Pulvino
Pulvino, T., 1997, "Do Bond Prices Reflect Absolute Priority Violations? Evidence from US Airline Secured Bonds," Northwestern University Kellogg Graduate School of Management Working Paper.
The equity performance of firms emerging from bankruptcy, forthcoming
- I Edward
- Reena Altman
- Aggarwal
, Edward I. Altman and Reena Aggarwal, 1998, The equity performance of firms emerging
from bankruptcy, forthcoming, Journal of Finance.