Managing Financial Distress and Valuing Distressed Securities: A Survey and a Research

Agenda
Author(s): Kose John
Source: Financial Management, Vol. 22, No. 3 (Autumn, 1993), pp. 60-78
Published by: Wiley on behalf of the Financial Management Association International
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Financial Distress Special Issue

Managing Financial Distress

and Valuing Distressed Securities:
A Survey and a Research Agenda
Kose John,Special Issue Editor

Kose John is Charles WilliamGerstenbergProfessorof Bankingand Finance

at the SternSchool of Business,New YorkUniversity,New York,New York.

0 The role of high leveragein corporaterestructuringand in understandinghow firmsdeal with financialdistress.A

the popularityof junk bonds (original-issue, high-yield
bonds) have been importantaspects of the corporatefi-
nance scene in the 1980s. As more and more firms have
defaulted on their debt and filed for bankruptcyin the
recent recession, financial economists, financial manag-
ers, andlegal scholarshavebecome increasinglyinterested
I wish to thank Teresa A. John for permission to draw from earlier
collaborativework on financial distress. I am also grateful to several
colleagues and friendsand otherresearcherswho reviewedmanuscripts
for the special issue andprovidededitorialadvice, especially Ed Altman,
Mitch Berlin, Steve Brown, Allan Eberhart, Stuart Gilson, Edie
Hotchkiss, Ed Kane, Ron Masulis, Jeff Netter,Tony Saunders,Lemma
Senbet, Bruce Tuckman,Gopala Vasudevan,and KarenWruck. I also
acknowledgehelpful discussions with them on the topics of this survey.
I am immenselygratefulto JamesAng, the Editorof FinancialManage-
ment for enormousencouragement,supportand guidanceon all aspects
of this special issue.
60
very active academic literaturehas developed in recent
years on variousaspects of dealing with financialdistress
and the privateand court-supervisedmechanisms of re-
solving default.At the same time, investorshave become
increasinglyconcernedaboutdefaultriskand valuationof
distressed securities incorporatingthe institutionalreali-
ties of troubled debt restructuring.The purpose of this
special issue is to showcasenew empiricaland theoretical
researchon these topics, i.e., managingfinancialdistress
and valuing corporatesecuritiesincorporatingpayouts in
troubledreorganizations.While the literatureon the first
topic, broadly defined, has become quite extensive in
recentyears,the literatureon the second topic is still in its
infancy.New researchon these topics is presentedin the
nine papersthat appearin this special issue.
The purposeof this surveyarticle is to summarizeand
synthesize the recent research in the areas of financial

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JOHN/ MANAGING
FINANCIAL
DISTRESS
distress, asset and debt restructuring,bankruptcyand val-
uationof distressedsecurities.1The new researchfeatured
in this special issue is also surveyedhere. Additionally,I
present an agenda for future research in the areas of
financial distress, design of contractsand proceduresto
deal with it, and techniquesfor the valuationof corporate
securities and contractsincorporatingstrategiesand out-
comes induced by the legal system governing breach of
contractualpromises.
The rest of the paperis organizedas follows. In Section
I, a simple conceptualframeworkfor managingfinancial
distressis presentedwhich providesa scheme for organiz-
ing the survey. Theoretical work and recent empirical
evidence on asset restructuringis summarizedin Section
II. Recent theory and evidence on privatedebt restructur-
ing (debtworkouts)is collected in Section III.Theoretical
andempiricalworkon the formalbankruptcy(Chapter11)
processis reviewedin SectionIV.Efficiencyaspectsof the
currentU.S. bankruptcyprocedure,the design of an opti-
mal procedureand proposals for bankruptcyreform are
discussed there. In Section V, the valuationof corporate
securities and contractswith significant probabilitiesof
default (triggeringrenegotiationand legal resolution) is
discussed. Each of these sections includes a brief survey
of relevantexisting literature,an overview of the papersin
this special issue which fall in thatarea,and some sugges-
tions for futureresearch.Section VI containsan agendafor
furtherresearchand concludingremarks.
I.ManagingFinancialDistress: A Model
The financing contractsof a firm can be loosely cate-
gorized into hardand soft contracts.An exampleof a hard
contractis a coupondebtcontractwhich specifies periodic
paymentsby the firmto the bondholders.If thesepayments
are not made on time, the firm is considered to be in
violation of the contractand the claimholdershave speci-
fied and unspecifiedlegal recourseto enforcethe contract.
Contracts with suppliers and employees may be other
'The literatureon financial distress, asset and debt restructuring,and
bankruptcyhas now become very extensive and I do not intendthis to be
an exhaustivesurveyof it. See JohnandJohn[70] and SenbetandSeward
[102] for other recent surveys. Wruck [116] also surveys in detail a
selected subset of empirical papers in the area. The area of financial
distress and resolutionmechanismsis closely relatedto that of optimal
design of contractsand securities, and to that of capital structure.The
Summer1993 issue of FinancialManagementfeaturesa special issue on
"SecurityDesign"editedby FranklinAllen. Forsurveyson thetheoretical
literatureon optimal securitydesign, see Allen [4], Allen and Gale [5],
Allen and Winton[6], and HarrisandRaviv [57]. Foran excellent survey
of the modem literatureon capital structure,see Harrisand Raviv [58].
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61
examples of hardcontracts.Commonstock and preferred
stock are examplesof soft contracts.Here, even thoughits
claimholdershave expectationsof receiving currentpay-
outs fromthe firmin additionto theirownershiprights,the
level and frequency of these payouts are often policy
decisions made by the firm.2These payouts can be sus-
pendedand/orpostponedbasedon the availabilityof liquid
resourcesremainingin the firm aftersatisfying the claims
of the hardcontracts.
The assets of a firm also have a naturalcategorization
based on liquidity.Cash or cash-like (marketable)securi-
ties areliquidassets.Long-terminvestments(suchas plant
and machinery)which may only produceliquid assets in
the futuremay be called "hard"assets.
The above categorizationsof the financingcontractsof
a firm and its assets give rise to a naturaldefinition of
financial distress.A firm is in financialdistressat a given
point in time when the liquid assets of the firm are not
sufficient to meet the currentrequirementsof its hard
contracts.Since financialdistressresultsfrom a mismatch
between the currentlyavailableliquid assets and the cur-
rent obligationsof its "hard"'financialcontracts,mecha-
nisms for managingfinancialdistressrectifythe mismatch
by either restructuringthe assets or restructuringthe fi-
nancing contracts,or both.
On the asset side, the hard assets can be wholly or
partiallyliquidatedto generateadditionalliquid assets to
meet the currentobligations.However,prematureliquida-
tion of illiquid assets results in the destructionof going-
concernvalue and involves the cost of liquidation.If this
avenueis pursuedto deal with financialdistress,the value
lost due to prematureliquidationof assets representsthe
cost of managingfinancialdistress.
Anotherset of mechanismsto deal with financial dis-
tress involves restructuringthe financial contracts. One
mechanismis to negotiate with the creditorsand restruc-
ture the terms of the hard contractssuch that the current
obligation is either reducedto an amountwhich is closer
to the cash currentlygeneratedby assets, or deferredto a
later date. Anothermechanismis to replace the hardcon-
tract with soft securities with residual ratherthan fixed
2Evenequitycontractsassociatedwith certainorganizationalformsmay
have mandatorypayoutrequirementsmakingit "harder"thanthose in the
corporateform. For example, a real estate investmenttrust(REIT)must
distributeat least 95% (90% prior to 1980) of its net annual taxable
income, excluding capitalgains and certainnoncashtaxable income, to
shareholders.Damodaran,John,andLiu [37] studychanges in organiza-
tional forms and document that financial distress and choice over the
restrictivenessof the associatedequity contractare majordeterminants.
62
payoffs. In general, debt restructuringinvolves replacing
an existing debt contract by a new contract with (i) a
reductionin the requiredinterestor principalpayments,
(ii) extension of maturity,or (iii) placement of equity
securities (common stock or securities convertible into
common stock) with creditors.Under the new contract,
thereis less financialdistress.
A thirdmode of financialrestructuringis to raise addi-
tional currentliquidity by issuing new financial claims
against future cash flows generatedby the assets, which
may avoid or reduceprematureliquidationof these assets.
Here, even though the original hard contract was left
unaltered,the structureof financingclaims was alteredby
thenew financingundertaken.Whenthe new claims issued
have a softercontractor longermaturity,the new package
of financingclaims are less onerouson the firm,resolving
financialdistress.
It should be pointed out that both asset restructurings
and debt restructuringscan be accomplishedprivatelyor
througha formalcourt-adjudicated process.Exactlywhich
method is implementedto reorganizea financially dis-
tressed firm depends on the relativecosts and benefits of
each mechanism.In a scenariowith completecontracting,
i.e., a complete state-contingentset of contracts are al-
lowed by the legal system, an initialdesign of contractcan
be madesuchthattherequiredfinancingcanbe undertaken
avoiding any prematureliquidation of assets. In other
words, the choice of initial contract would precludede-
faults of the type discussed above due to shortages of
liquidity, or it will be renegotiatedto avoid suboptimal
liquidations. However, in practice, the admissible con-
tractsare incomplete.Often,outside investorsor the court
system do not have the detailed informationrequiredto
enforce many contracts. For example, the currentcash
availablemay not be observableto these outside parties,
which would make contracts specifically contingent on
thesecash flows hardto enforce.Managersmayhave some
scope to divertsome of the cash flows to managerialperks
on their favorite (but unprofitable)projects, etc. In the
extreme, if managerscan appropriateall the cash flows,
then the managerswould always choose to defaultstrate-
gically anddivertthe cash to themselves.Of course, cred-
itors would anticipatethis andrefuse to lend. As Hartand
Moore [60] argue, one possible resolution is to give the
creditors, following nonpayment (default), the right to
liquidateassets andappropriatethe proceedsfromliquida-
tion within limits specified by the contract.Since liquida-
tion of assets results in loss of future cash flows to the
managers,the threatof liquidationwould deter strategic
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FINANCIAL / AUTUMN1993
MANAGEMENT
defaults.As we discussed above, suboptimalliquidations
can occur also following liquidity-induceddefaults.Debt
restructuringmay be a solution. Mechanismswhich facil-
itate debt restructuring(privateor court-supervised)will
reducethe costs of prematureliquidationfollowing liquid-
ity defaults. However, the same mechanismswill reduce
inefficiencies following a strategic default, encouraging
such defaults. The ex ante efficiency of the debt restruc-
turingmechanismswill dependon the relativeimportance
of these two effects. HartandMoore [60], HarrisandRaviv
[59], and Bolton and Scharfstein [28] develop related
arguments.
In additionto incompletecontracting,asymmetricin-
formationbetween debtorsand creditorsabout the value
of the assets (ongoing firmvalue or liquidationvalue) can
frustratemutuallybeneficialdebt renegotiation(see, e.g.,
Giammarino[52]). As Brown [30] points out, when there
is symmetricinformationbetweenmanagementandcred-
itors, a privateworkoutis always successful. Many of the
theoreticalmodels in the area examine the consequences
of incompletecontractingandasymmetricinformationon
the efficiency of contractingand the mechanismsto man-
age financialdistress arisingfrom breachof the termsof
the contract.
I will use the framework developed above to next
organize the survey of the theory and evidence on asset
restructuring(Section II), privatedebt restructuring(Sec-
tion III) and the formalbankruptcyprocess (Section IV).
II.Asset Restructuring
As outlined in the general frameworkdeveloped in
Section I, one set of mechanisms to deal with financial
distressinvolvesrestructuringthe asset side of the balance
sheet to generatesufficientcash to meet the requirements
of the hardcontracts.Assets can be sold (eitherpiecemeal
or in their entirety) to other firms or new management
teams. Asset sales can be accomplished privately or
throughcourt-supervisedstages either duringbankruptcy
reorganization(Chapter 11 of the BankruptcyCode) or
underthe liquidationprocess(Chapter7 of the Bankruptcy
Code). Each of these alternativeshas differentcosts at-
tached to them. Whether asset restructuringis actually
usedto managefinancialdistresswoulddependon its costs
relativeto those of financialrestructuring.3
3Therole of asset restructuringin improvinginvestmentincentiveswhen
risky debt is outstandinghas been analyzedby John [761 and John and
John[77]. John[76] providesa theoreticalrationalefor value gains from
JOHN/ MANAGING
FINANCIAL
DISTRESS
Shleifer and Vishny [104] study the liquidity costs
associatedwith interfirmasset sales promptedby financial
distress.4In identifyingthe determinantsof marketliquid-
ity, they focus on (i) fungibility(i.e., the numberof distinct
uses and users for a particularasset), (ii) participation
restrictions(e.g., regulationson foreign acquisitions,anti-
trustrestrictions),and (iii) creditconstraintsin the indus-
try.They arguethatthe pricereceivedin a distresssale may
have large liquiditydiscounts if the entireindustryis in a
downturn.In an illiquid secondary market,the costs of
asset restructuringare likely to be high, and financial
restructuringmay provide the dominant mechanisms of
dealing with financialdistress.
In an integratedmodel of asset and debt restructuring,
John and Vasudevan[74] examine how the cost of asset
sales, the currentliquidity position of the firm, and the
option value of its equity determinethe choice between a
private workout (with or without some asset sales) and
filing for the formalChapter11 process, possibly seeking
debtor-in-possession(DIP) financing. Since asset sales
may extinguish some of the option value of equity, there
is an endogenous cost of asset sales to equityholders(in
additionto the costs of illiquiditydiscussedby Shleiferand
Vishny [104]). When the combinedcosts of asset liquida-
tions arehigh, the firmmay file for Chapter11 bankruptcy
and seek new financingas DIP financingwhich has prior-
ity over existing debt. To determinethe expected payoffs
to equity underthe differentalternatives,the reorganiza-
tion process itself (both workouts and Chapter 11) is
modelled as an alternatingoffer bargaininggame with
asymmetricinformation,where the equityholdersare bet-
ter informedthanthe bondholdersor thejudge (in Chapter
11). Based on the allocation of value in equilibrium,the
outcomes include privaterestructuringwith and without
asset sales, andChapter11 filings with DIP financing.The
time spentin the Chapter11 reorganizationis endogenous
to the model and one of the possible outcomes is a "pre-
packaged"bankruptcywith a speedy reorganization.
spin-offs and asset sales and characterizesthe optimal allocation of the
pre-spin-off debt. John and John [77] demonstrateconditions for the
optimalityof limited recourseprojectfinancingarrangements.
4Asset sales in bankruptcymay have some advantagesover those done
privatelyoutsideformalbankruptcyproceedings.Purchasingassets from
a financiallydistressedfirmis less riskyin Chapter11 becauseasset sales
are executed by a court orderand are thus free from legal challenge. In
addition, if the seller subsequentlyfiles for Chapter11, the buyer may
have to returnthe assets as "avoidablepreference"or "fraudulenttrans-
fer."Giventhe materialcosts of beingchallengedor cancelled,asset sales
in Chapter11 may be preferredby potentialbuyers.
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63
John and Vasudevan[74] obtain severalempiricalim-
plications:
(i) Successful completion of debt workouts should
resultin increasedstock pricesandincreasedcom-
bined firm value. Chapter 11 filings should pro-
duce a negativeannouncementeffect. Firmswhich
privatelyrestructuretheirdebt have higher going-
concern value when comparedto firms which file
for Chapter 11. Average time spent by firms in
Chapter 11 reorganizationsis more than that in
workouts(Gilson, John, and Lang [55] document
evidence consistentwith these predictions).
(ii) Asset sales by distressedfirms to make debt pay-
ments have a positive effect on stock prices. This
is consistentwith the empiricalevidence in Lang,
Poulsen, and Stulz [87].
(iii) Deviations from absolute priority are higher in
workoutsthan that in Chapter11 reorganization.
Write-downsarelower in workouts.This is consis-
tent with Franksand Torous[48].
(iv) Write-downs in prepackagedbankruptcyfilings
will be lowerthanordinaryChapter11 reorganiza-
tion.
(v) The payoffs to bondholdersmonotonicallyincrease
in the indirectcosts of bankruptcy.
The frameworkof Section I, in characterizingfinancial
distress as a mismatch between the currently available
liquid assets and the current obligations of its "hard"
financialcontracts,suggeststhatafterfinancialdistresshas
occurred,managingit involvescorrectingthe mismatchby
either increasingthe liquidityof the assets (throughasset
sales) or decreasingthe "hardness"of the debt contracts
(throughdebt renegotiation).However,before the firm is
in financialdistressit can design the structureandthe form
of its debt contractsand choose its leverage and liquidity
policies suchthatits costs of financialdistressarereduced.
Opler [97] andJohn [75] study these issues empiricallyin
theircontributionsin this special issue. Leveragedbuyouts
have been increasinglyfunded in ways which appearto
reduce the risk and cost of financial distress. Leveraged
buyout financing methods include the use of specialist
sponsors, strip financing, covenants which require that
excess cash flows be paid to debtholdersand debt provis-
ions which allow deferralof interestpaymentsin periods
of financialdistress.Opler [97] documentsthe prevalence
of these innovative financing techniques and estimates
their impacton the risk-adjustedcost of debt in 63 LBOs
which occurredin 1987 and 1988. The results show that
64
sponsorshipby an LBO specialist lowers the weighted
averagecost of LBO debt and the imputedcost of capital
by roughly 60 basis points. In addition, debt provisions
which allow deferralof interestpaymentson junior debt
and which maintaina minimum bond value are used in
many of the LBOs in the sample. While these provisions
do not lower financingcosts, theiruse indicatesthatLBO
capital structuresare designed to avoid the need for debt
workoutsor Chapter11 proceedingsin periodsof financial
distress.
Given the above characterizationof financial distress,
a firm with high costs of financialdistress will reduce its
exposure in two ways: (i) increase the liquid component
of its assets, and (ii) reducethe extent of its hardcontracts
(such as debt). Based on this argument,John [75] postu-
lates (i) a positive relationshipbetweencorporateliquidity
and distresscosts, and (ii) a negativerelationshipbetween
leverageanddistresscosts.5A majorcomponentof distress
costs is the costs of illiquidityof assets.Thesecosts include
costs of distressed asset sales and loss of going-concern
value in liquidations.Some new proxies are proposedfor
the costs of illiquidity and the indirectcosts of financial
distress. These include Tobin's q, R&D and advertising
expenditures,an index of asset specificity and an index of
the probabilityof bankruptcy.The liquidityratio is docu-
mentedto be positivelyrelatedto these proxiesof financial
distresscosts. It is negatively relatedto proxies for alter-
nate sources of anticipatedliquidity such as intermediate
cash flows, debt financing, length of cash cycle and the
collateral value of assets. Total debt is also negatively
relatedto Tobin's q and asset specificity as well as mea-
sures of intermediatecash flows. Long-termdebt is also
negativelyrelatedto proxies for alternatesourcesof antic-
ipated liquidity such as intermediatecash flows, debt
financing,length of cash cycle and the collateralvalue of
assets.Totaldebt is also negativelyrelatedto Tobin'sq and
asset specificity as well as measuresof intermediatecash
flows. Long-termdebt is also negativelyrelatedto Tobin's
q and asset specificity. Overall, the evidence is strongly
consistent with the hypothesized relationshipsbetween
corporateliquidityand financialdistresscosts, andcorpo-
rate leverageand financialdistresscosts.
Brown, James, and Mooradian[31], Asquith,Gertner,
and Scharfstein [15], Lang, Poulsen, and Stulz [87],
Hotchkiss [64], and Ofek [96] presentevidence of asset
5Thenegativerelationshipbetween leverageand distresscosts has been
documentedin severalearlierstudies,e.g., TitmanandWessels[105]. See
John[75] for a summaryof this researchanda completelist of references.
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FINANCIAL / AUTUMN1993
MANAGEMENT
restructuringby firms in distress.All of the above papers
document that asset sales are frequentlyused by finan-
cially distressedfirmsin theirsample.Brown,James,and
Mooradian[3 1] find thatfirmswhich sell assets aredistin-
guishedby multipledivision or multiplesubsidiaryopera-
tions.Conversely,most of thefirmswhichdo not sell assets
operate only a single division. They also find that the
announcementof asset sales elicits insignificantabnormal
stock returns.However,the announcementeffect is posi-
tive for the subsetof seller firms which also subsequently
avoidbankruptcy.Lang,Poulsen,andStulz [87] document
that the abnormalreturnis higher for sellers who use the
proceedsfrom asset sales for retiringdebt. Asquith,Gert-
ner, and Scharfstein[15] conclude that asset sales are an
importantmeans of avoiding bankruptcy.They find that
only threeout of 21 companiesthatsell over 20% of their
assets go bankrupt.
The overall evidence seems to suggest that although
asset sales are used to deal with financialdistress,in most
cases they are used in conjunctionwith debtrestructuring.
III.PrivateDebt Restructuring
Informal reorganizationof corporatefinancial struc-
turesthroughdebtrestructuringsandprivateworkoutscan
be used to "soften"the hardcontractswhich caused finan-
cial distress. Consistent with the model of Section I, to
remedy financial distress the firm will reduce or defer
payments on its debt contractsor replace debt with soft
securitieshavingresidualratherthanfixedpayoffs.Wecan
define a debt restructuringas a transactionin which an
existing debt contractis replacedby a new contractwith
(i) a reductionin the requiredinterest or principalpay-
ments, (ii) extension of maturity,or (iii) placement of
equity securities(common stock or securitiesconvertible
into common stock)with creditors.Privatedebtrestructur-
ing is surveyedin this section, and debt reorganizationin
a court-adjudicated formalbankruptcyprocessis surveyed
in Section IV.
Haugenand Senbet [61], [62] arguethatcapitalmarket
mechanismscould accomplishthe restructuringof prob-
lematic hard contractsand replacing them with a softer
mix. They arguethat the transactionscosts of these "pri-
vate" mechanisms are small and should form an upper
bound on the costs of managingfinancialdistress.Jensen
[67], [68] has also arguedthat since these privaterestruc-
turingsrepresentan alternativeto formalbankruptcypro-
ceedings, it pays to "privatize"bankruptcyif this informal
mechanism is cost-efficient. Roe [100] has also made
similarargumentsin the legal literature.
 FINANCIAL
JOHN/ MANAGING DISTRESS
A simpleconceptualframeworkis developedin Gilson,
John, and Lang [55] to determine the choice between
private restructuring and formal bankruptcy process,
which is based on two factors.Let AC be the cost saving
by choosing the first alternativeover the second. If AC is
positive, by choosing the firstalternative,the firm'sclaims
can be restructuredto leave each of the originalclaimants
better off (they share the incrementalvalue AC collec-
tively). The largeris AC,the strongerarethe claimholders'
incentivesto settle privately.However,the privatealterna-
tive will be adoptedonly if thereis unanimousagreement
on how to shareAC. Impedimentsto reachinga settlement
on a private restructuringcan be (i) holdout problems
encounteredwhen a firm's debt is held by a large number
of diffuse creditors, (ii) informationalasymmetriesthat
can arise betweenpoorly informedoutsidecreditorsand a
better informedmanageror insiders of the firm, and (iii)
conflicts among differentgroupsof creditors.
A. HoldoutProblem
Achieving an agreementamongcreditorsoutsideof the
formalbankruptcyprocess will dependupon what type of
debt is restructured,e.g., privatedebt or public debt. The
restructuringof publicdebtis governedby the TrustInden-
ture Act of 1939, which requiresunanimousconsent of
every bondholder to change the maturity,principal or
coupon rate of interestin the bond indenture.Such strin-
gent votingrulesprecludea debtrestructuringin whichthe
core terms of widely held public debt can be changed.
Consequently,almostall restructuringsof publicdebttake
the form of an exchange offer.
An exchange offer and the resultingholdout problem
can be understoodbased on the frameworkdeveloped in
Section I. In an exchange offer,the bondholdersare given
the option to exchange their old bonds for a package of
new securities(often includingsome form of equity). The
idea here is to swap the existing "hard"contract for a
"softer"mix. Since participationis optional, individual
bondholdersmay choose to "hold out"in the expectation
that their bonds would be more valuable (in the post-
exchange, less-distressedfirm) than the new package of
securities. Since all bondholdershave similar incentives
(assumingthatthey do not collude), the exchange offer is
likely to fail. The termsof the new packetof securitiesare
often set to coerce participation.Coercive techniquesare
used by corporationsto implement successful exchange
offers. Exchange offers are often accompaniedby modifi-
cation of the covenants of the original bonds through a
techniqueknownas consentsolicitationsor exit covenants.
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65
In these cases, the tenderingbondholdersarealso askedto
vote to change or eliminate the existing debt covenants.
The acceptanceof the exchangeddebt is madeconditional
on approvalof the consent solicitation by the required
majority. In these cases, the consent solicitation is so
designedthatthe benefitsof nonparticipationareexceeded
by the loss from holding onto the old bonds strippedof
covenants. Kahan and Tuckman [81] and Gertner and
Scharfstein[50] analyzethe holdoutproblemsin exchange
offers and consent solicitations.
Gertnerand Scharfstein[50] have predictionsfor the
effect of workoutsand consent solicitationson the invest-
ment decisions of financiallydistressedfirms. They con-
cludethatinvestmentincentivesarenot typicallyimproved
by debt workouts.Kahanand Tuckman[81] analyze con-
sent solicitations and empirically examine bondholder
wealth effects on announcementsof consent solicitations.
When the bondholdersact atomistically,i.e., on theirown
(without forming coalitions), it is shown that coercive
consent solicitations may be necessary for a successful
covenant change. The evidence, however, is that bond
prices increaseon announcementof consent solicitations.
This suggeststhatbondholdersmay collude andact coher-
ently in the face of coercive consent solicitations.
B. InformationalAsymmetry
Often, corporateinsidersand managementknow more
aboutthe value of the firm,its assets, its futurecash flows,
etc., than outside investors, including creditors.In such
cases, asymmetricinformationexists between corporate
insidersandcreditors,such thatthe creditorscannotprop-
erly evaluate the new package of claims proposed in a
workout.They also believe that the debtor-management
may misrepresentthe value of the firm. Giammarino[52]
models such a scenarioand shows that the creditorsmay
actually reject mutually beneficial private restructuring
andchoose, in equilibrium,a court-imposedproposalwith
the attendantdeadweightcosts. In other words, informa-
tionalasymmetrycan thwartan agreementfor an attractive
settlement.Brown [30], on the other hand, examines the
choice between privateworkoutsand the bankruptcypro-
cess in a symmetricinformationsetting.By modellingthe
rules of the court-adjudicatedprocess, Brown [30] shows
that the equilibriumalways involves a successful private
workout.
John and Vasudevan [74] analyze the firm's choice
between workouts(possibly with asset sales) and Chapter
11 filing (with subsequent DIP financing) in a setting
wherethereis asymmetricinformationbetweenthe corpo-
66
rate insiders and the creditors/courts.The details of the
model andresultsarediscussedin Section II. Gertner[49]
also examinesthe signallingrole of the securitiesissued in
distresseddebtrestructurings.6See also MyersandMajluf
[95].
C. Coalitionsand Conflicts
Fora typicalfirmwith a complex capitalstructurethere
are severalgroupsof claimants,includingdifferentclasses
of debtholders,tradecreditors,stockholders,management,
etc. Even when the privatereorganizationcosts are less
thanotheralternatives(leaving a largeraggregatevalue of
assets), its distributionamongthe variousclaimantscould
be criticalto a successful debt restructuring.The bargain-
ing issues involvedin modelingthe intergroupconflicts of
interests and coalition formation have been studied in
Bulow andShoven [34], GertnerandScharfstein[50], Hart
and Moore [60], John and Vasudevan[74], Harris and
Raviv [59], Kaiser [82], Walzer [106], and Bergmanand
Callen [20], [21]. These conflicts of interest can lead to
distortationsin investment(underinvestment,overinvest-
ment and excessive continuationor liquidation).Details
will be discussed in Section IV.B. on the efficiency of the
bankruptcyprocess.
D. EmpiricalEvidenceon DebtWorkouts
Gilson, John, and Lang [55] was the first systematic
empirical study of debt workouts. They investigate the
incentives of financially distressed firms to restructure
theirdebtprivatelyratherthanthroughformalbankruptcy.
They analyze the experienceof 169 publicly tradedcom-
panies that experienced severe financial distress during
1978-1987. Eighty of these firms successfully avoided
bankruptcyby restructuringtheirdebt out of courtand 89
firmswereunsuccessfulin workingouttheirdebtprivately
and filed underChapter11 of the U.S. BankruptcyCode.
The studyfinds thatthe asset characteristicsand financial
characteristicsjointly determinethe firm'schoice between
informaland formal reorganizationmechanisms(as sug-
gested in ourmodel of Section I). More specifically,finan-
cial distress is more likely to be resolved throughprivate
workouts,when (i) a greaterproportionof the firm'sassets
are intangible,(ii) a greaterproportionof its debt is bank
debt, and (iii) the firm has fewer lenders (fewer distinct
classes of debt outstanding).
6White[1 15] also studiesthe choice between liquidationversuscontinu-
ation in an asymmetricinformationsetting.
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FINANCIAL
MANAGEMENT
/ AUTUMN1993
The economic reasoning underlyingthese findings is
suggestedby the model of Section I and the frameworkof
Gilson, John, and Lang [55] summarizedearlier in this
section. On the asset side, intangibleassets proxy for the
destructionof going-concernvalue which would occur if
financial restructuringfails and asset restructuringis re-
quired.In fact, Gilson, John,andLang [55] use the differ-
ence between marketvalue and the replacementcost of
assets (scaled by replacementcost) as the proxyvariable.
The value saved (AC) if the firm maintains operating
continuity through a workout is higher, the higher the
proportionof intangibleassets. Factors(ii) and (iii) above
affect the probabilitythat a settlement is reached in the
bargainingprocessleadingto a successful workout.Firms
with banksas dominantcreditorscan moreeasily renego-
tiate their debt because banks are more sophisticatedand
less numerousthan other kinds of creditors,resulting in
fewer holdouts.Similarly,conflicts of interestamong dif-
ferentclasses of creditorsaremoremanageablethe smaller
the numberof distinctcreditorclasses.
Gilson, John, and Lang [55] also provide evidence on
the principaltermsof restructuringthe debt for the firms
in their sample. As mentionedearlier,debt restructuring
involves "softening"the hardcontractby reducinginterest
or principal payments, extending the debt maturity or
distributingequity securitiesto creditors.In about73% of
all successful workouts,there is a reductionin promised
paymentson the debt. In about74%of successful restruc-
turings,new equitysecuritiesaregiven to creditors.Exten-
sion of maturityis only observed in 49% of workouts.
Differentclasses of debt also appearto be restructuredon
substantiallydifferentterms.Approximately49% of bank
debt restructuringsprovide for an extension of maturity,
compared with only 6.7% of restructuringsof publicly
tradeddebt;this latterresultis consistentwith firmsoffer-
ing shorter-maturity debt in exchangeoffers to discourage
holdouts (see the section on holdouts above). Although
51.4% of bank debt restructuringsresult in bank lenders
receivingequityin thefirm,holdersof publiclytradeddebt
are given equity securities 86.7% of the time. The latter
difference is a likely consequence of various legal and
regulatoryfactors that make it costly for banks to hold
large amountsof equity in publicly tradedcompanies.7
71Inparticular,banks are constrainedfrom holding significantblocks of
stock in other firms by Section 16 of the Glass-SteagallAct, the Bank
Holding CompanyAct and the FederalReserve Board's RegulationY.
Temporaryexceptions may be grantedwhen stock is obtainedin a debt
workout.Moreover,banks must divest theirstockholdingsafterapprox-
imately two years, althoughextensions are possible. Second, creditors
JOHN/ MANAGING DISTRESS
FINANCIAL
Gilson, John,and Lang [55] also documentsome mea-
sures of the relativecosts of workoutsversus Chapter11.
The average length of time spent by 89 firms in Chapter
11 is over20 months;the averagelengthof the 80 workouts
is about 15 months.The differencein costs is significantly
higherin the 30 cases in the Gilson-John-Langsamplethat
involvedprivaterestructuringof publicly tradeddebt. The
average time for exchange offers (which is the common
mechanismfor restructuringpublic debt) in the sample is
just under seven months. Gilson, John, and Lang [55]
provide the only availableevidence on the direct costs of
privateworkouts.The offer-relatedcosts of these exchange
offers, on average,is only 0.65% of the book value of the
assets. By contrast,the averagelegal andprofessionalfees
reportedin the Chapter 11 process range from 2.8% to
7.5% of total assets. Gilson, John, and Lang [55] also
provide indirect evidence of the relative costs of formal
and informal reorganizationsusing evidence from stock
returns.To the extent that workoutsare less costly than
Chapter 11, both shareholdersand creditorsshould gain
when debtworkoutssucceed.The Gilson-John-Langstudy
documents that shareholdersof companies that success-
fully worked out their debt realized an average 41% in-
crease in stock value over the period of workout (i.e.,
startingwith announcementof the default),net of general
market movements. On the other hand, firms which at-
tempteda workoutbut failed and filed for Chapter11 had
an average cumulative stock return of -40% over the
restructuringperiod ending with the Chapter11 filing. At
least partof the 81%differencein these returnsrepresents
the market'sestimate of relativecost savings between the
two mechanisms.8Theyalso findthatthemarketis capable
of predictingthe outcome of the workoutattempt.
In subsequentwork, Asquith,Gertner,and Scharfstein
[15], Brown, James, and Mooradian[32], and Franksand
Torous[48] examinedebtworkoutsfurther.Asquith,Gert-
ner, and Scharfstein[15] examine workoutsof 102 firms
which issued junk bonds and then subsequentlyencoun-
tered financial distress. Their findings include: (i) asset
can be held legally liable to other claimholdersif the firm's financial
conditiondeterioratessubsequentto theirassuminga controllinginterest
in the firm and exercising"undueinfluence"over its business(Douglas-
Hamilton [41]). For recent analyses of the optimalityof banks holding
equity in borrowingfirms, see Berlin,John,and Saunders[24] andJohn,
John, and Saunders[79]. See also Johnand John [71].
8A fraction of this 81% difference may also representemerging new
information,i.e., the firmsultimatelyfiling Chapter11 aresystematically
less profitableafter attemptsat restructuringbegan. Such information
may come out graduallyover the restructuringperiod.
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67
sales and capital expenditurereductions are commonly
used by firmsin financialdistress;(ii) banksrarelyforgive
principalon outstandingloans or providenew financingin
a workout;and (iii) workout of public debt throughex-
change offers is an importantdeterminantof the success
of the overall workout.
Hoshi, Kashyap,and Scharfstein[63] explore the role
of main-bankrelationshipsin reducingthe costs of finan-
cial distressin Japan.They presentevidence thatJapanese
firms in industrialgroups - those with close financial
relationshipsto their banks, suppliers,and customers-
invest more and sell more than nongroupfirms. Parallel
resultsarefound for nongroupfirmswhich do have strong
ties to main banks.
Gilson [54] documentsthat corporatedefault leads to
significantchanges in the ownershipof firms' equity and
the allocationof rights to managecorporateresources.In
his sample of 111 firms in financialdistressduring 1979-
1985, banklendersfrequentlybecome majorstockholders
or appointnew directors.On average,only 46% of incum-
bent directorsremainwhen bankruptcyor debt restructur-
ing ends. Directors who resign hold significantly fewer
seats on otherboardsfollowing theirdeparture.Common-
stock ownershipbecomes more concentratedwith large
blockholdersand less with corporateinsiders.Gilson [53]
documents changes in top managementfollowing finan-
cial distress (52% annualturnover)which is significantly
higher than that for a random sample (12%) and that
categorizedas poorly performingbut not financiallydis-
tressed(19%).
Brown, James, and Mooradian[32] examine debt re-
structuringsmade by financially distressed firms under
asymmetricinformation.Their model of public debt ex-
change offers predictsthat firms with unfavorableprivate
informationwill offerequityclaimsto convincebondhold-
ers thatthe firm'sprospectsare poor. However,when the
private lender is well-informed,offering equity in a re-
structuringconveys favorableprivateinformationto out-
siders. Consistent with their analysis, they find positive
averageabnormalreturnsaroundthe reorganizationsthat
offer equity to privatelenders and senior debt to public
debtholders. In contrast, they find significant negative
averageabnormalreturnswhen privatelendersareoffered
senior debt and public lenders are offered equity. Franks
and Torous[48] examinemanyaspectsof workoutswhich
were examinedin Gilson, John, and Lang [55]. They also
find that(i) less liquid andless solvent firmsenterChapter
11 andthat,consequently,write-downsof creditors'claims
are larger in Chapter 11 comparedto workouts,and (ii)
68
deviations from the rules of strict absolute priorityrule
(APR) are largerin workouts.9
IV.The Chapter 11 Process
An alternativemechanism for dealing with financial
distressis the formal,court-supervisedbankruptcyprocess
(of financialrestructuring)governedby Chapter11 of the
U.S. BankruptcyCode. Although in the previous section
we highlightedthe relatively lower direct costs of work-
outs comparedto bankruptcy,the formalprocesshas bene-
fits as well as costs. Some of the benefits are as follows:
(i) The automatic stay provision of the Bankruptcy
Code protects the firm from creditorharassment
while it reorganizes.
(ii) The less restrictivevoting rulesin Chapter11 make
it easier to get a reorganizationplan accepted.
(iii) The BankruptcyCode allows the firm to issue new
debt that is senior to all "prepetition"debt. Such
debtor-in-possession(DIP) financing is valuable
because the firmcan borrowon cheapertermsthan
withoutit.
(iv) The interest on prepetitionunsecureddebt stops
accruingwhile the firmis in bankruptcy,freeingup
scarce cash. For a detailed discussion of the fea-
tures of the Chapter11 process, see Gilson, John,
and Lang [55] or White [113], [114].
An emergingliteraturein law andfinancequestionsthe
optimalityand efficiency of the existing bankruptcyreor-
ganizationprocess and proposesalternativesystems. This
literatureis surveyedin Section IV.A.EberhartandSenbet
[43] contributeto this literature.The empiricalevidence
on the Chapter11 process and its efficiency is surveyedin
Section IV.B. A summary of Bi and Levy [26] is also
includedthere.Aspects of financialdistressamongbanks
andturnaroundstrategiesarealso discussedin thatsection,
along with the contributionsof DeGennaro, Lang, and
Thomson [38] and Barrowand Horvitz [17].
A. Efficiencyof the BankruptcyProcedure
Financial contracts specify how resources are to be
allocatedbetween investorsand firms.Bankruptcyproce-
dureswhich governthe breachof contractualpromisesare
generally containedin the legal system and not specified
9The absolute priority rule (APR) states that creditorsshould be fully
compensatedbefore shareholdersreceive any portion of the bankrupt
firm'svalue.Recentempiricalstudies,however,have shownthatthis rule
is seldom followed (see Section IV.B.).
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FINANCIAL / AUTUMN1993
MANAGEMENT
in the contractexplicitly.However,the bankruptcyproce-
dures are implicitlya partof every contractand affect the
allocationof resourcesjust like the financialcontracts.For
example, formal bankruptcyproceduresestablish the al-
ternativeto a privateworkoutsettlementandhence affect
the natureof such settlements(see John and Vasudevan
[74] and Gilson, John, and Lang [55]). Bankruptcyrules
may affect investmentpolicy, extent of liquidation and
operating decisions through their effects on bargaining
outcomes. The availability of funds for investment,the
capital structuresandthe type of investmentschosen may
all be influenced by bankruptcy rules. Therefore,
designing efficient bankruptcyproceduresis important.
A largebody of researchon the efficiency of the bank-
ruptcy process focuses on its effects on the investment
policy of the firm. Two types of investmentdistortions
arisewhenthe firmis in financialdistress.Whenriskydebt
is outstanding,equityholdersrefuse to contributecapital
for positive net present value investments because the
returns will accrue largely to bondholders.This is the
underinvestmentproblemstudiedby Myers [94], and sub-
sequently by John and Kalay [72]. The second problem
(introduced by Jensen and Meckling [69]) is that
equityholdersmay overinvestin riskyprojects,i.e., under-
take risky but negative net present value projects when
risky debt is outstanding. Problems of risk-shifting or
excessive continuationare differentmanifestationsof the
same problemof overinvestment.
Bulow and Shoven [34] and White [111], [112] were
among the first to point out thatthe featuresof the bank-
ruptcycode will affect investmentdecisions by distressed
firms. Bulow and Shoven [34] and White [111], [112]
argue that the coalition of equity and the bank makes
continuation decisions based on its private gains from
restructuring.This decisionto continueor to liquidatemay
not be efficient. Coordinationproblemswhich arise in the
presenceof multiplecreditorsareanalyzedin Gertnerand
Scharfstein[50] and Bolton and Scharfstein[28]. Gertner
and Scharfstein[50] arguethat the benefit of bankruptcy
is that, in Chapter 11, unanimity of debtholdersis not
requiredto effect changes in the debt contract.This miti-
gates holdoutproblemsand, along with the otherfeatures
of currentbankruptcylaw (automaticstay and violations
of absolutepriorityrule), tends to increaseinvestment.
The net benefit of such increasedinvestmentdepends
on the incentives generated by the characteristicsof
contracts-in-place,such as maturitystructure,covenants
and the priorityof privateversus public debt. The Bank-
ruptcyCode improvesefficiency when underinvestmentis
JOHN/ MANAGING
FINANCIAL
DISTRESS
a problem(e.g., when the firmhas short-termpublic debt,
senior bank debt, and the public debt has senioritycove-
nants).
Berkovitchand Israel[22] show thatfirmsfacing over-
investmentincentives are more likely to file for Chapter
11 protection,while firms facing underinvestmentincen-
tives aremore likely to renegotiatein a workout.Bebchuk
[19] points to more acute incentives to overinvestin the
presence of deviationsfrom absolutepriorityrules, when
firms are not in financialdistress.
Eberhartand Senbet [43] demonstratein a contingent
claims framework,thatAPR violationsplay an important
role in amelioratingthe shareholder/bondholder agency
conflict. Specifically, departuresfrom the APR mitigate
the incentivefor shareholdersto increasethe risk of finan-
cially distressedfirms.Moreover,the effectiveness of this
mitigation increases as the firm approachesbankruptcy
and as traditionalmethods,such as conversionprivileges,
lose effectiveness. Berkovitchand Israel [22], and Kalay
and Zender[83] make relatedarguments.
Most of the papers summarizedabove take the bank-
ruptcy procedure as a given and examine its effect on
aspects of investmentefficiency. Anothergrowing litera-
ture has begun to address issues of optimal design of
bankruptcyrules.Bebchuk[18], White [113], Bradleyand
Rosenzweig [29], Aghion et al [2], Zender[117], Aghion
and Bolton [1], Kalay and Zender [83], Harrisand Raviv
[59], Altman [12], Easterbrook[42], Merton [91], and
Berkovitch, Israel, and Zender [23] are attempts in this
direction.
Roe [100], Bebchuk [18], White [113], Bradley and
Rosenzweig [29], and Aghion et al [2] containproposals
of reformwhich involve implementinga "textbook"pro-
cedureof selling the firmanddividingthe proceedsamong
creditorsand old equityholdersaccordingto the APR. The
new owners of the firm would make decisions about
whetherto continueoperationsor liquidateandwhetherto
retain the old managersor to replace them. They would
choose the alternativeswith the highest value. An advan-
tage of these proposalsis thatthe firm would end up with
an all-equitycapital structureat the end of the bankruptcy
procedure which would avoid the waste and delays of
intergroupconflictsandprotractedbargaining.10Although
loAghion,Hart,and Moore [2] and Altman [12] contain evaluationsof
some of these reformproposals.Easterbrook[42] arguesthatthe cost of
liquidationsandauctionsmay be largeenoughtojustify the currentcostly
bankruptcyprocess. Roe [101], Baird [16], Bebchuk [18], Bradleyand
Rosenzweig [29], and Weiss [110] criticize the existing bankruptcy
procedure.
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69
the argumentsover valuationand liquidationare avoided,
the risk-shiftingincentives in investmentpolicy induced
by APR allocation will remain prior to entering bank-
ruptcy.To strikea balance between conflicting efficiency
objectives, White [113] proposes biasing the allocation
towardsequity and managementdeviatingfrom strictad-
herence to APR (similar in spirit to Eberhartand Senbet
[43]). Zender[117], Aghion andBolton [1], andKalayand
Zender[83] deriveoptimalcontractsunderwhich control
of the firm is transferredand claims are adjustedwhen
performanceis sufficientlypoor.The above studies really
address the question of an efficient process of resolving
financial distress, given the firm is in financial distress.
However a bankruptcyprocess which resolves financial
distress efficiently is only consideringhalf the picture.If
resolutionof defaultis maderelativelycostless thenit may
encouragedefaulttoo often andraisingfinancingformany
worthwhileprojectsmay become difficult.In otherwords,
there may be a tension between efficiency of ex post
resolution of default and ex ante contractualefficiency.
This has to be a considerationin the design of an optimal
bankruptcylaw.11
A relatedpoint is that optimal bankruptcylaw cannot
be analyzed independentlyof optimal security design.
After all, bankruptcylaw specifies rules governing the
breachof stipulatedcontractualtermsin specific financial
contracts. For example, debt contracts specify the
debtholder'sinvestment,the specific paymentsto which
he is entitled, and covenantsincludingconstraintson the
borrower's behavior (see John and Kalay [72]). Bank-
ruptcyrules specify the legal proceduresto be followed if
the promisedpaymentsare not made or if the covenants
are violated. Therefore,design of an optimalbankruptcy
procedure should be viewed in combination with the
broaderproblemof optimalcontractdesign.
HarrisandRaviv [59] takean importantfirststep in this
directionof designingan optimalbankruptcyprocedureas
a part of an overall contractdesign problem. They ap-
proachthe problemof contractdesign as one of choosing
a game to be played among the partiesto the contractas
opposed to choosing a contingentallocations scheme. In
anenvironmentof incompletecontracting(wherethereare
restrictionson the kinds allocationschemes which can be
enforced), the allocations of resourcescan sometimes be
1"Bolton and Scharfstein[28] use this trade-offin their analysisof some
aspects of debt structure:the numberof creditorsa company borrows
from; the allocationof security interestamong creditors;the intercredit
covenantsgoverningrenegotiationof debt contracts.
70
improvedby designing a game in which players respond
to actions and/or statementsmade by other players. The
improvementis possible because equilibriumstrategies,
and hence outcomes, can depend on aspects of the envi-
ronment even though allocation schemes contingent on
such aspects are not enforceable.
The setting of the Harrisand Raviv model, similar to
thatin HartandMoore [60], is thatof an entrepreneurwho
needs outside financing for a positive net present value
project.The cash flows generatedare appropriableby the
entrepreneurbut not the proceeds from liquidation of
assets. The threat of seizing and liquidating the firm's
assets (whicheliminatesa correspondingfractionof future
cash flows) is the only way to induce the entrepreneurto
pay out cash to investors. Since liquidation is strictly
suboptimalin every state of the world, an optimal bank-
ruptcyprocedurewouldbe one whichminimizestheextent
of liquidation while providing sufficient payouts (cash
and/orliquidationproceeds)to induceinvestorsto contrib-
ute the requiredcapital. Harrisand Raviv [59] show that
debt with a bankruptcycourtwhich can impose violations
of APR is a Pareto improvementrelative to contracts
without a bankruptcycourt.The additional,limited state-
contingency achieved by the presence of a bankruptcy
court is shown to be sufficientto achieve optimal alloca-
tions in the Harrisand Raviv [59] environment.12
Berkovitch, Israel, and Zender [23] argue that bank-
ruptcy law with a managementbias (which places the
managerin a favorablebargainingposition in renegotia-
tions) plays a role in providing the manager with the
correctex ante decision-makingincentives.Withoutsuch
a commitmentfeature of the bankruptcylaw, managers
will underinvestin developing firm-specifichumancapi-
tal.
JohnandJohn [78] studythe dynamicsof top-manage-
ment compensationin firms going throughfinancial dis-
tress. They arguethatthe amountand structureof external
claims outstandingaffect the design of top-management
compensation.If the externalclaim is riskydebt,top-man-
agementcompensationshouldhave incentivefeaturesand
pay-performancesensitivitythataredecreasingin the debt
ratioof the firm.When the firm is in financialdistress,the
pay-performancesensitivity should be extremely low.
'2Inthe HarrisandRaviv [59] environment,any legal structurewhich can
induce the additional(possibly limited) state-contingencyin outcomes
will accomplishthe optimalallocation,with a correspondingcontract.In
this sense, theirsolutionis not specific enoughto pinpointthe"attractive"
featuresthat a good bankruptcyprocedureshouldhave. Furtherwork is
requiredin this area.
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/ AUTUMN1993
Whendebtis restructured
increasingequityorconvertible
components,the incentivefeaturesin the compensation
structureshould be significantly increased. Gilson and
Vetsuypens[56] documentempiricalevidence consistent
with these predictions.
B. EmpiricalEvidenceon the Chapter11
Process
The empiricalwork on the formal bankruptcyprocess
has been primarily on (i) direct and indirect costs of
bankruptcy,(ii) announcementeffects of bankruptcyfil-
ings, (iii) deviations from absolute priorityrule, and (iv)
efficiency of bankruptcyreorganizations.
The legal, administrativeandadvisoryfees thatthe firm
bears as a direct result of entering and undergoingthe
formalbankruptcyprocesshave been called "directbank-
ruptcy costs." Warner [108], [109] studies 11 railroad
bankruptciesduring 1933 to 1955 and finds the average
directcosts to be about5.3% of firm'smarketvalue at the
time of the bankruptcyfiling. Ang et al [14] investigatea
sample of 86 firms that filed for bankruptcy(and eventu-
ally liquidated)in the WesternDistrict of Oklahomabe-
tween 1963 and 1979. Theyreportmeanandmediandirect
costs (as a percentage of total liquidationproceeds) of
7.5% and 1.7%, respectively. More recently, Ferris,
Jayaraman,andMakhija[46] reportlargerdirectadminis-
trative costs of bankruptcyfor small firms, based on a
sampleof liquidationsand reorganizationsthatwere filed
during 1981-1991 in the U.S. BankruptcyCourt(Western
District of Tennessee). Their mean (median) costs are
27.73% (0.91%) of the assets reportedat the initiationof
bankruptcy,and 41.49% (25.65%) of the total disburse-
ments at the end of the process. For reorganizations,they
find thatthe mean (median)costs are 21.55% (1.88%) of
the reportedassets, and 15.10%(3.41%) of the total dis-
bursements.These are higher than previously reported
estimates for reorganizationsby small and large firms.
Weiss [109] analyzes a sample of 37 firms that filed for
bankruptcybetween 1980 and 1986, and finds average
directcosts to be 2.9%of the book value of assets priorto
filing.
Indirectcosts of bankruptcyareopportunitycosts aris-
ing from suboptimalactions associated with bankruptcy,
e.g., the firmlost its firstmoveradvantagein developinga
new productto a competitorwhen it was going throughthe
formal bankruptcyprocess. Lost sales and competitive
advantage,higher operatingcosts, lost investmentoppor-
tunities,and loss of consumerconfidence are all potential
indirectcosts. Gilson, John, and Lang [55] argue that all
 DISTRESS
FINANCIAL
JOHN/ MANAGING
value lost throughdestructionof going-concernvalue rep-
resentsindirectbankruptcycosts. They use "marketvalue
+ replacementcosts"as a proxyfor these costs. Altman[8]
measuresthe differencebetween the earningsrealized in
each of the three years priorto bankruptcyand earnings
that could have been expected at the beginningof each of
those years, to compute indirectcosts of bankruptcy.All
deviations of actual profits from their expected counter-
partsaredenotedas indirectcosts of bankruptcy.Although
a good startingpoint, such a definitionwould include all
deviations from expected profits (even those which are
unrelatedto financing).
A numberof studies document a significant negative
abnormal return (around -16%) on announcement of
bankruptcyfiling (e.g., Clarkand Weinstein[35], Gilson,
John,and Lang [55], and Eberhart,Moore, and Roenfeldt
[44]). Bankruptcy announcement effects on the share
prices of competingfirmshave been investigatedby Lang
and Stulz [86] (and in a small sample earlierby Aharony
and Swary [3]). Lang and Stulz [86] document that the
equity value of competing firms in the industry of the
bankruptfirm decreasedon the averageby one percentat
the time of bankruptcyannouncement.However,the stock
prices of competing firms with low leverage in highly
concentratedindustriesincreasedby 2.2%.
In this special issue, Bi and Levy [26] examine the
announcement effect of bond downgradings on stock
prices of downgradedfirms.Theirresultsprovideinsights
into the dynamicsof the ratingprocess used by the rating
agencies, Moody's and Standard& Poor's. Their results
show thatthe averageabnormalreturnof the subsampleof
firms which subsequentlyfile for Chapter11 bankruptcy
is significantlymore negativethanthe matchingsampleof
firms which had a similardowngradingbut did not file for
Chapter11. Althoughthe authorsinterprettheirresultsto
signify that the market'sinformationis finer than that of
the ratings agency, it may have more to do with the
dynamics of the ratingsprocess. If the ratings agency is
conservativein their downgradings,such that the down-
gradings are done in multiple stages, then the marketis
simply reactingappropriatelyto the informationwhich is
already available to the market and the rating agency,
althoughnot fully reflectedin the partialinitialdowngrad-
ing.
According to the absolute priorityrule (APR) of allo-
cating the value of a bankruptfirm, the senior claimants
receivetheirfull contractualpromisedpaymentbeforeany
class with a morejuniorclaim receives anything.Although
APR is followed strictlyin Chapter7 liquidations,a num-
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71
ber of recent studies document that APR is frequently
violated in Chapter11 reorganizationsand informaldebt
restructurings,e.g., see Franksand Torous[47], Eberhart,
Moore, and Roenfeldt [44], and Weiss [109]. Eberhart,
Moore, and Roenfeldt [44] find that APR violations ac-
countfor 7.6%of the totalamountpaidout to all claimants
and that they are anticipatedby investorsex ante. Franks
and Torous[48] documentthatthe rateof APR violations
is largerin informalworkouts(+9%) comparedto that in
Chapter11 reorganizations(+4%).
Betker [25] explores the cross-sectionaldeterminants
of equity's deviationfrom absolutepriorityin 75 Chapter
11 reorganizations.EmpiricalevidenceindicatesthatAPR
deviation is larger when: the firm is closer to solvency;
bankshold fewer claims; the CEO holds more shares;the
firm'soriginalCEOis retainedor replacedfrom inside the
firm;and CEO pay and shareholderwealth are positively
related.See also LoPuckiand Whitford[89].13
Systematic empirical evidence on the efficiency of
bankruptcyreorganizationswould be importantto the
study of mechanismsfor managingfinancialdistressand
understandingthe design of optimal bankruptcyproce-
dures. Hotchkiss [64], [65] contain the only available
evidence on the post-reorganizationperformanceof firms
emerging from Chapter11. In Hotchkiss [65], she exam-
ines the performance of 197 public companies which
emergedfrom Chapter11 bankruptcy.Almost 40% of the
samplefirmscontinueto experienceoperatinglosses in the
two years following bankruptcy,while over 16%file for
Chapter11 for a second time. Managementoften retains
substantialinfluence over restructuringdecisions during
bankruptcy,and frequentlyis not replaceduntil a plan of
reorganizationhas been confirmed. The continued in-
volvement of pre-bankruptcymanagementin the restruc-
turingprocess is stronglyassociatedwith poor post-bank-
ruptcy performance. The substantial number of firms
emergingfrom Chapter11 which are not viable or which
need furtherrestructuringsuggeststhattheremay be a bias
towardcontinuationof unprofitablefirms. The evidence
does not indicatethatthe Chapter11 reorganizationplays
an effective role in rehabilitatingdistressedfirms.
13Anumberof theoreticalstudies (see, e.g., Brown [30], Giammarino
[52], John and Vasudevan[74], and Bergman and Callen [20], [21])
suggestthatAPRviolationsare,in fact,rationalresponsesby bondholders
and the courts to debtor-managementbargainingpower engenderedby
the formalreorganizationprocess. Harrisand Raviv [59] arguethatAPR
violations may be partof an optimallydesigned bankruptcyprocedure.
See also Eberhartand Senbet [43].
72
Massive numbers of insolvencies have plagued the
thriftindustry(savings& loans (S&Ls)andmutualsavings
banks)throughoutthe 1980s and into the 1990s, which has
led to the depletionof the governmentfund establishedto
insure the deposits in these institutions.The costs of re-
solving the thriftinsurancemess are estimatedto be $125
billion to $150 billion. Unlike industrialfirms in financial
distress, which undertakeasset and/ordebt restructuring,
thriftsoften operatein an insolventconditionfor extended
periods.DeGennaro,Lang,andThomson[38] andBarrow
and Horvitz [17] examine turnaroundstrategiesused by
troubledthriftsand theireffectiveness.
DeGennaroet al [38] examine a sample of 300 large
insolventthrifts,of which 24%recoveredbetweenthe end
of 1979 andthe end of 1989. They contrastthe turnaround
strategiesadoptedby these recoveredinstitutionsto those
used by thriftsthatfailed. When the crisis surfacedin the
early 1980s, these recoveringfirms operatedin a fashion
similarto failing firms.However,in the mid-i1980s,recov-
ering thriftspursuedrisk-minimizingstrategieswhile the
nonrecoveringthrifts pursued risky, high-growth strate-
gies. They find no evidence thatmanagersof nonrecover-
ing thriftsconsumed more perquisitesthan their counter-
parts.
Barrowand Horvitz [17] examine the performanceof
insolventthriftsunderthe ManagementConsignmentPro-
gram (MCP). MCP was adopted,in 1985, by the Federal
Savings and Loan InsuranceCorporation(FSLIC) in an
attemptto minimize the acute adverseincentiveproblems
present when insolvent thrift institutionsare allowed to
continue in operation.The new managementteams, se-
lected by federalregulatorsandcompensatedon a contract
basis, were expectedto maintainservice to depositors,and
improve the condition of the thrift's books and records,
while more permanentsolutionswere explored.
The evidence indicates that the chances of the MCP
institutions recovering to solvency were significantly
lower than the chances of similarlyinsolvent institutions
thatwere allowed to operateoutside of directgovernment
control.The authorsarguethatthis is a consequenceof the
absence of a profit motive and the induced conservative
strategiesunderMCP.
V.Valuationof Distressed Securities
As the numberand diversity of financially distressed
firmshave increased,the marketfor distressedfirms'debt
andequitysecuritieshas capturedthe interestof the invest-
ment community.As of August 31, 1992, Altman [11]
estimates the marketvalue of the debt securitiesof firms
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FINANCIAL / AUTUMN1993
MANAGEMENT
which have defaultedon theirdebt and/orfiled for protec-
tion underChapter11 bankruptcyas approximately$20.5
billion ($42.6 billion in face value). Securitieswhichyield
a minimum ten percent over comparablematurityU.S.
Treasurybonds, i.e., 16.6% or above, are estimated to
amountto $71 billion in parvalue (with severalissuersand
600 issues) and about$37 billion in marketvalue. Adding
privatedebt with public registrationrights, privatebank
debt and tradeclaims of defaultedand distressedcompa-
nies bringsthe totalbook value of defaultedanddistressed
securitiesto $284 billion (marketvalue, $177 billion).14
Althoughthe markethas attracteda lot of attentionfrom
investors, researchon models of valuationfor securities
with significantprobabilityof default is still preliminary.
Altman [9] underscoresthe institutionalfactorsof default,
restructuringandbankruptcyreorganizationsas important
in valuing these securities.However,the existing models
of high-yield bonds do not explicitly incorporatethese
factors in the valuationmodels. This is an importantarea
for furtherresearch.
An importantingredientof valuationwhich has been
examined in the existing literatureis the probabilityof
default. Numerous studies have developed models that
estimate the probabilityof default. Market-relatedmea-
sures of bond default probabilitieshave complemented
traditionalcredit techniques which concentrateon firm-
specific aspects of bonds. Creditquality upon initial issu-
ance, that for seasoned bonds, bond rating changes over
time driven by changes in default probabilities,actual
default rate of bonds, have all been documented (see
Altman [7], [10], and Altman,Eberhart,and Zekavat[13]
for a review of this literature).Altman, Eberhart,and
Zekavat[13] studythe severityof defaultfor91 firms(with
232 bonds) that defaultedand emerged from Chapter 11
betweenJanuary1980 andJuly 1992.They documenttotal
losses investorswouldhave incurredif they boughta bond
at issuance and held it until completion of bankruptcy
reorganization.
Many of the previousstudies (see Altman [10, Ch. 6])
estimate the unconditionalprobabilitythata firm will file
bankruptcy.These studiesgenerallyanalyzematchedsam-
ples of bankruptandnonbankruptfirms,using accounting
informationand other firm characteristicsas explanatory
14Theseestimatesare from Altman [11]. Altman[9], 11] also describes
the market for these securities and analyzes their performance.The
Altman-MerrillLynch & Co. Index of Defaulted Debt Securities(mar-
ket-weightedmeasureof 233 differentdefaultedsecuritiesfrom 89 firms)
is reported on a monthly basis by Merrill Lynch and also on the
Bloombergsystem. See also Altman [10].
 FINANCIAL
JOHN/ MANAGING DISTRESS
variables.Gilson, John, and Lang [55] estimate the prob-
ability of Chapter 11 conditional on the firm being in
financialdistress.They studyhow asset andliabilitystruc-
tures help predict whether financial distress is resolved
througha privateworkoutor throughformal bankruptcy
underChapter11.
A contributionin this area is made by Coats and Fant
[36]. They apply a "neuralnetwork"to the estimationof
the futurefiscal healthof corporations.The distinctadvan-
tages of this new methodology for recognizing arbitrary
discriminatingpatternsin financial data are highlighted.
The commonly used tool for classificationand prediction
is a multiple discriminantanalysis (MDA) of financial
ratios. But the MDA technique has limitations deriving
from its relianceon the assumptionsof linearseparability,
multivariatenormality,andindependenceof the predictive
variables. A neural network, being free from such con-
strainingassumptions,is able to achieve superiorresults.
The neuralnetworkmodel in theirpaperuses the Cascade-
Correlationapproachin Fahlmanand Lebiere [45].
An importantdeterminantof the value of distressed
securities is the lack of liquidity and marketability(see
Altman [10]). This is also an importantinstitutionalfactor
which has not been incorporatedinto the valuationmodels
of distressedsecurities.Shulman,Bayless, andPrice [103]
take an importantstep in this direction.They examine the
determinantsof yields, relativeto Treasuries,for an exten-
sive sampleof individual,seasoned,high-yieldbonds.The
impactof defaulton yield spreadsfor individualhigh-yield
bonds is incorporatedusing a default model which pro-
duces an expected probabilityof default for each bond.
Default risk, along with marketabilityrisk and otherchar-
acteristics on yield spreads is modelled using a factor
analytic (LISREL)technique.The empiricalresults indi-
cate that both marketabilityrisk and default risk are im-
portantin explaining yield spreadsfor high-yield bonds.
Additional refinements among criteria discussed in this
paper should lead to a more rigorousanalysis of market-
ability and betterpricing of high-yield bonds.
Since default risk and the losses to bondholders in
default are importantdeterminantsof high-yield debt, a
large traditionalliteraturehas focused on the probability
of defaultfrom asset andliabilitycharacteristicsand other
financialratios of the firm. However,these techniquesdo
not value completely the defaultrisk definedby the prob-
ability of default as well as the payout at default. The
correspondencebetween the option to defaultin corporate
bondsunderlimitedliabilityandstock options,recognized
in Black and Scholes [27], led to many applicationsof the
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73
option pricing theory to value corporateliabilities with
various contractualfeatures. Merton [90] examined the
risk structureof interestrates and Ingersoll [66] used this
correspondenceto valueconvertibleandcallablecorporate
liabilities. These arejust two examplesof the valuationof
corporatesecuritieswhich may be addressedusing option
pricing theory (see Park and Subrahmanyam[98] for a
surveyof this literature).
While the insights offered by this researchare import-
ant,the abilityof this approachto explainthe yield spreads
between corporate bonds and comparable default-free
Treasurybondshas been questionedin recentpapers.The
empirical findings of Jones, Mason, and Rosenfeld [80]
indicatethatexisting contingentclaims pricingmodels do
not generatethe levels of yield spreadswhich one observes
in practice.Over the 1926-1986 period, the yield spreads
on high-gradecorporates(AAA-rated)rangedfrom 15 to
215 basispointsandaveraged77 basispoints;andtheyield
spreadson BAAs (also investment-grade)rangedfrom 51
to 787 basis points, and averaged 198 points. Kim,
Ramaswamy,and Sundaresan[85] show that the conven-
tional contingent claims model due to Merton [90] is
unableto generatedefaultpremiumsin excess of 120 basis
points, even when excessive debt ratios and volatility
parametersare used in the numericalsimulation.
The contingentclaims models mentionedabove do not
incorporatemany real world institutionalfeatures of de-
faultandthe Chapter11 bankruptcy.The settingallows for
no frictions as in Miller and Modigliani [93]. The typical
boundaryconditionused in these models to denote bank-
ruptcyis thatof strictabsolutepriorityrule triggeredwhen
firm value falls below the promisedprincipalpayment.15
The entire firm value without any liquidation costs is
assumed to be passed to bondholders in default. This
assumption is at odds with reality in several important
ways: (i) as definedin Section I, the cash-flow criterionof
default happens when the currentliquidity of the firm is
inadequateto meet its currentobligations, say, required
coupon payments; (ii) asset liquidationsinvolve signifi-
cant costs of liquidityandloss of going-concernvalue (see
Section II); (iii) there are importantstrategic aspects to
defaults,debtrenegotiations(in privateworkoutsor Chap-
ter 11 reorganizations)and liquidationswhich affect allo-
cation of value (see Section III); (iv) there are significant
deviationsfrom absolutepriorityrule in the allocationsin
the bankruptcyprocess (see Section IV.B.).These institu-
tional features of default and its resolution should be
15Geske [51] considerscoupon defaults,as well.
74
incorporatedinto valuationmodels of securitieswhich are
in distress or have a high probabilityof distress. To my
knowledge, none of the existing models accomplish this
task.
Kim, Ramaswamy,and Sundaresan[85] take an im-
portantstep in this direction.They incorporatefeature(i)
above into their model and focus on the default risk of
coupons in the presence of dividends and interest rate
uncertainty.Numerical solutions are employed to show
thatthe resultingyield spreadsare sensitiveto interestrate
expectationsbut not to the volatility of the interestrates.
Interactionbetween call provisions and default risk in
determiningyield spreadsis explicitly analyzed to show
thatthe call provisionhas a differentialeffect on Treasury
issues relative to corporateissues. They also show that
theirmodel is capableof generatingyield spreadsconsis-
tent with levels observedin practice.
Longstaff and Schwartz [88] present a simple frame-
workof valuingriskydebt wherethey allow for deviations
from APR. They are able to derive simple closed-form
valuationexpressionsfor riskyfixed-rateandfloating-rate
debt as well as for interest-rateswaps where one or both
of the counterpartiesmay default.16Their model also
generates credit spreads similar to actual credit
spreads.
VI.An Agenda for FutureResearch
and Conclusions
Some promisingareasandtopics for futureresearchare
suggestedby the currentliteraturesurveyedin Sections II,
III,IV,andV.They arelisted below withthe corresponding
section indicatedin parentheses.
(i) What is the relationshipbetween the structureand
characteristicsof the assets and the natureof the
externalclaims used for financing?For example,
should assets with high cost of liquidation,organ-
ized in a single division (as opposed to multiple
divisions),with a high degreeof focus, be financed
with softer contracts?Should the contractinclude
featuresto facilitatelow-cost debtworkouts?What
arethe dynamicsof asset sales andliquidationsfor
a firm going throughfinancial distress, workouts
and/or formal bankruptcyprocess? Should the
more liquid assets be sold earlieror the ones with
16Brown and Smith [33] consider two innovations,market-to-market
swaps andforwardrate swaps, as mechanismsfor managingdefaultrisk
in swaps,andfind thatthe formermanagesriskmost effectively.See also
Ramaswamyand Sundaresan[99].
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FINANCIAL
MANAGEMENT
/ AUTUMN1993
poorerperformance?How do these strategiesaf-
fect firm performanceafter distress and/orbank-
ruptcyreorganization?17 (See Section II.)
(ii) Thereis some documentedevidencethatthe nature
of the debt contract,the complexity of the capital
structure, the number of creditors involved,
whetherthe debt is publicor privatedebt andwhat
fractionof debt is bankdebt, are all factorswhich
could affect the success of a relatively low-cost
privateworkout.Empiricalwork relatingfeatures
andinnovationsin financialcontractingto the costs
and difficulty of resolving default would be inter-
esting. Theoreticalwork in this area is not exten-
sive and further work is needed.18 The general
problem is that of optimal security design with
particularemphasis on renegotiatingthe contract
in certaincontingencies.Inmanyinterestingcases,
the reductionof costs in ex post renegotiationmay
come at the expense of ex ante contractualineffi-
ciency. For example, if resolution of default is
made less costly, the incentive effect of the debt
contractmay also be weaker.These trade-offsmay
yield interesting results. (See Sections III and
IV.A.)
(iii) Our knowledge of workoutsof public debt is pre-
liminary. What are the features of an optimally
designeddistressedexchangeoffer?Whatlegal or
regulatoryreform can improve the prospects for
publicdebtworkouts?Whatrolecan marketmech-
anisms play to facilitate painless renegotiationof
public debt?On all these questions,both theoreti-
cal andempiricalworkis needed.(See SectionIII.)
(iv) The role of banks in facilitatingdebt workoutsor
relatively costless Chapter 11 reorganizations
needs furtherstudy. If the bank is an informed
creditorit may have a special role in the manage-
ment of financial distress (existing evidence is
mixed). Comparisonswith othercountriessuch as
Japanand Germanywhere the banksplay a more
active role would be fruitful.The role of banks in
debt restructuringmay bear in importantways on
the current debate on "universalbanking," i.e.,
whether banks should be allowed to underwrite
17Hotchkiss[64] exploressome aspectsof the dynamicsof asset sales and
post-bankruptcyperformanceof firms.
'sSee Diamond[39], [40] andBolton andScharfstein[28] for theoretical
work in this directionand Opler [97] for empiricalwork.
 FINANCIAL
JOHN/ MANAGING DISTRESS
securitiesand/orhold equityin borrowingfirms.19
(See Section III.)
(v) What is the role of managementand the board of
directorsin financial distress?There is some evi-
dence to suggest (a) managerialturnoverin finan-
cially distressedfirms is significantlyhigher than
poorly performing but nondistressed firms; (b)
managerialactions do not seem to be responsible
for Chapter11 filings;20and (c) incumbentman-
agersoften retaintheirjobs throughthe Chapter11
process until confirmationof the reorganization
plan. Furtherwork is needed to sort out several
issues: (a) Is the increasedmanagerialturnoverin
financialdistressproductive?(b) Why does finan-
cial distress, ratherthan declines in performance
below presettargetlevels, triggermanagementre-
placement? (c) Are managerial compensation
structuresdesigned to provide the correct incen-
tives in financial distress?What are the incentive
effects of financial distress on management,and
consequently,on investment,productivity,and ef-
ficiency? (See Sections IV.A. and IV.B.)
(vi) A systematic study of sources and strategies of
financing while in financial distress, including
debtor-in-possession(DIP) financing, is yet to be
done. (See Section IV.B.)
(vii) Design of an optimal bankruptcyprocedureis a
challenging avenue for furtherwork. The import-
ance of ajoint solutionto the problemof designing
an optimal securityand an optimal legal structure
to resolve breach of contractualterms has been
discussed in Section IV.A. Althoughan important
stephas been takenin HarrisandRaviv [59], many
important aspects of the problem remain. (See
Section IV.A.)
(viii) On the empiricalside, a systematiccomparative
study of the featuresandefficiency characteristics
of the bankruptcyprocedurein the differentcoun-
tries(UnitedStates,Japan,Germany,U.K., France,
Netherlands,etc.) is yet to be done. Insights from
such research will facilitate conceptualizing an
19Berlin,John,and Saunders[24] andJohn,John,and Saunders[79] are
theoreticalmodels of universalbanking.Section III.D. surveysrelevant
empiricalevidence on debt workouts.
20Khannaand Poulsen [84] studyboth the kind and perceivedqualityof
decisions managers take over a three-yearperiod prior to their firm
making a Chapter 11 filing. Based on comparisons with a matched
sample,they concludethatexogenousfactors,andnot managerialincom-
petence or their self-serving decisions, led to the bankruptcyfiling.
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75
optimal bankruptcyprocedure.Furtherempirical
work relatingpost-reorganizationperformanceof
firms with specific featuresof the Chapter11 pro-
cess would also be fruitful(see Hotchkiss[64] and
Section IV.B.).
(ix) A systematic study of strategicbankruptcyfilings
is yet to be done. (See Section IV.B.)
(x) What are the public policy aspects of corporate
limited liability,default, financialdistress and re-
organization?What are the social costs? Should
debtfinancingbe encouragedby the social planner
by giving it preferentialtax treatment(i.e., tax
deductibilityof interestpayments)?See John and
Senbet [73] and Miller [92].
(xi) It has been noted thatvaluationof debt and equity
securities with significant probabilityof default
and/or bankruptcyis a promising area for future
research.The existing models do not incorporate
payouts to these claims being determinedby the
strategic aspects of the methods of resolution of
default (such as workoutsand/orChapter11 reor-
ganization).Evaluationof investmentstrategiesin
distressedsecurities(which may involve accumu-
lating a controllingshareof bonds and participat-
ing in the negotiationsas a dominantplayerand/or
acquiringcontrol in the reorganizedfirm) is also
interesting.Valuationof distressedsecurities and
designing investmentstrategiesin these securities
areresearchareasof high promise.(See SectionV.)
I have surveyed the fairly extensive theoretical and
empirical literatureon the mechanismsfor managingfi-
nancial distress and resolving default in Sections II, III,
and IV. Althoughmuchhas been learned,many important
aspectsrequirefurtherstudy.The literatureon valuationof
distressedsecuritiesis surveyedin Section V. Developing
models for valuationof distressedsecuritiesand strategies
for investing in them, incorporatingstrategic aspects of
default and resolution, is a promising area for futurere-
search.
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