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Journal of Financial Economics 27 (1990) 315-353. North-Holland
Troubled debt restructurings
An empirical study of private reorganization
of firms in default*
Stuart C. Gilson
The Unicersity of Texas at Austin, Austin, TX 78712, USA
Kose John and Larry H.P. Lang
New York University, New York, NY 10003, USA
Received November 1989, final version received May 1990
This study investigates the incentives of financially distressed firms to restructure their debt privately rather than through formal bankruptcy. In a sample of 169 financially distressed companies, about half successfully restructure their debt outside of Chapter 11. Firms more likely fo restructure their debt privately have more intangible assets, owe more of their debt to banks, and owe fewer lenders. Analysis of stock returns suggests that the market is also able to discriminate er ante between the two sets of firms, and that stockholders are systematically better off when debt is restructured privately.
1. Introduction With, the proliferation of leveraged buyouts (LBOs) and other highly leveraged transactions, there has been growing popular concern that the corporate sector is being burdened with too much debt. Much of this concern
*We would like to thank Edward Altman. Yakov Amihud, Sugato Bhattacharya, Keith Brown, Robert Bruner, T. Ronald Casper, Charles D’Ambrosio, Larry Dann, Oliver Hart, Gailen Hite, Max Holmes, Scott Lee, Gershon Mandelker. Scott Mason, Robert Merton, Wayne Mikkelson, Megan Partch, Ramesh Rao, Roy Smith, Chester Spatt, Gopala Vasudevan, and Richard West for their helpful comments. We are especially grateful to Michael Jensen (the editor) and Karen Wruck (the referee) for their many detailed and thoughtful suggestions. This paper has also benefited from the comments of participants at the 1989 American Economic Association Meetings, the conference on ‘The Structure of Governance of Enterprise’ at the Harvard Business School, and seminars at Dartmouth College, the Harvard Business School. the Univer- sity of Oregon, and the University of Pittsburgh. The second author acknowledges support from the Yamaichi Faculty Fellowship and the Garn Institute of Finance.
0304-405X/90,403.50 0 1990-Elsevier Science Publishers B.V. (North-Holland)
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is founded in the belief that highly levered firms could default in large numbers in a major recession (Wall Street Journal, 25 October 1958). At issue is whether corporate default is costly, and whether, as recently suggested by Jensen (1989a, b), private contractual arrangements for resolving default represent a viable (and less costly) alternative to the legal remedies provided by Chapter 11. This study investigates the incentives of financially distressed firms to choose between private renegotiation and Chapter 11. We analyze the experience of 169 publicly traded companies that experienced severe finan- cial distress during 1978-1987. Our investigation yields a number of insights into the corporate debt restructuring decision. In about half of all cases, financially distressed firms successfully restructure their debt outside of Chapter 11. Financial distress is more likely to be resolved through private renegotiation when more of the firm’s assets are intangible, and relatively more debt is owed to banks; private negotiation is less likely to succeed when there are more distinct classes of debt outstanding. An analysis of common stock returns provides complementary evidence on firms’ incentives to settle out of court. Abnormal stock-price performance suggests stockholders generally fare better under private renegotiation than bankruptcy. In advance of the outcome, the market appears to be able to identify which firms are more likely to succeed at restructuring their debt outside of Chapter 11. Finally, we present detailed descriptive evidence of how debt is restruc- tured outside of bankruptcy. Previous empirical research in corporate fi- nancial distress has dealt largely with formal reorganization in Chapter 11. Detailed case analyses of selected firms in our sample provide additional insights into firms’ incentives to choose between private renegotiation and Chapter 11. The study is organized as follows. Section 2 discusses firms’ incentives to choose between private renegotiation and bankruptcy as alternative mecha- nisms for dealing with default. Section 3 describes the data and methodology. Section 4 presents the empirical analysis of troubled debt restructurings. Section 5 concludes with a summary of the results. The appendix presents ten detailed case studies of firms that attempted to restructure their debt privately.
- Corporate default and debt restructuring A firm that must restructure the terms of its debt contracts to remedy or avoid default is faced with two choices; it can either file for bankruptcy or attempt or renegotiate with its creditors privately in a ‘workout’. The alterna- tives are similar in that relief from default is obtained when creditors consent to exchange their impaired claims for new securities in the firm. Sometimes this exchange is implicit, as when the terms of a debt contract are modified.
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equitable’ - that is, if the market value of new securities distributed to each class under the plan at least equals what the class would receive a liquida- tion. In practice, cram-downs are extremely rare [IUee (197911. It is in the joint interest of all classes to avoid a cram-down, because application of the fair and equitable standard requires the court to determine the firm’s liquidation value and going-concern value in a special hearing. These hear- ings are considered extremely time-consuming and costly. Avoidance of cram-down also explains observed deviations from absolute priority, since classes that receive nothing under the plan (including stockholders) are deemed not to have accepted the plan, giving creditors an incentive to voluntarily relinquish part of their claims. Chapter 11 also provides for the appointment of committees to represent the interests of certain claimholder classes before the court. Committees normally consist of the seven largest members of a particular class who are willing to serve, and are empowered to hire legal counsel and other profes- sional help. Committees’ operating expenses are paid out of the bankrupt firm’s assets. Appointment of a committee of unsecured creditors is manda- tory in Chapter 11 cases; additional committees can be appointed to repre- sent other classes, including stockholders, at the discretion of the judge [DeNatale (1981>].
2.2. Determinants of the choice between bankruptcy and pricate renegotiation Whether financial distress is resolved through bankruptcy or private rene- gotiation depends on two factors. First, stockholders and creditors will collectively benefit from settling out of court when private renegotiation generates lower costs than bankruptcy. Under the lower-cost alternative, the resulting value of the firm will be higher, and the firm’s claims can be restructured on terms that leave each of the original claimholders better off. Claimholders’ incentives to settle privately will increase with the size of the potential cost savings from recontracting outside of Chapter 11. Second, the lower-cost alternative will be adopted only if claimholders can agree on how to share the cost savings. Attempts to settle privately are more likely to fail when individual creditors have stronger incentives to hold out for more favorable treatment under the debt restructuring plan. The remainder of the section develops this simple economic model of the corporate debt-restructuring decision, and derives empirical proxies for firms’ incentives to restructure their debt privately.
‘Previous empirical studies of out-of-court restructuring include Gilson (1989, 1990), who analyzes changes in corporate ownership and governance structure during financial distress, and Hoshi et al. (1990). who investigate the resolution of financial distress in Japan. Previous theoretical research into the choice between bankruptcy and private renegotiation includes
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2.2.1. Relative cost of formal bankruptcy cersus pricate renegotiation Although attempts have been made to measure the costs of Chapter 11 empirically [Warner (1977b), Ang et al. (1982), Altman (19841, Weiss (1990)], we currently know little about how these costs compare with the costs of private renegotiation. In analyzing the costs of financial distress, it has become common to distinguish between direct and indirect costs. Direct costs are out-of-pocket transactions cost (such as charges for legal and investment banking services). Indirect costs include all other costs related to the firm’s bankruptcy or debt restructuring. For example, managers may forego profitable investment opportunities because they are distracted by dealings with creditors or the bankruptcy court. Indirect costs also include the value of managers’ time spent in such dealings. It is widely believed among practitioners that direct costs are significantly higher for bankruptcy than private renegotiation, because the procedural demands and legal complexity of Chapter 11 result in inflated lawyers’ fees [Stein (198911. Formal legal motions must be drafted and argued before the bankruptcy judge at each step of the reorganization. An inordinate amount of time may be required to make any decision that lies outside the ordinary course of the firm’s business.3 When debt is restructured privately, legal costs are reduced because such decisions can be made more quickly. In addition, bankruptcy lawyers have an incentive to prolong the firm’s stay in Chapter 11, because their compensation is treated as a priority claim, which entitles them to be paid before any of the firm’s general unsecured creditors or sharehold- ers. These arguments suggest that indirect costs (as measured by the expendi- ture of managers’ time) are also higher for bankruptcy than for private renegotiation. The relative cost disadvantage of bankruptcy is offset by two factors. First, the Code’s automatic stay provision ameliorates the common pool problem inherent in distressed situations, by imposing a well-defined queuing order on creditors (who would otherwise rush to be first in line to collect payment on
Haugen and Senbet (19781, Bulow and Shoven (1978), White (1983), Aivazian and Callen (1983), Green and Laffont (1987), Roe (1987), Kahn and Huberman (1988), Brown (1989), Giammarino (1989), Hart and Moore (1989). and Mooradian (1989). Much of this research views the firm’s bankruptcy decision as the outcome of a strategic game played between stockholders and creditors. An analogous problem is addressed in the ‘theory of litigation’, which analyzes the choice faced by plaintiffs and defendents between settling out of court or going to trial [Gould (1973)l. ‘For example, if a debtor wishes to retain the services of an investment bank, it must first file an application with the bankruptcy court. Applications can be made only after appropriate ‘notice and hearing’ has been given, which requires the firm to inform all creditors of the application in writing, and allow sufficient time for any objections to be filed. The court rules on the application at a special hearing. The time required for approval can be shortened if the debtor requires creditors to show cause, allowing the application to be approved within a few days if no objections are raised.
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creditors from exercising their nonbankruptcy right to sue the firm and seize collateral. Asset sales that would normally be in violation of the firm’s debt covenants will be allowed if the firm can convince the bankruptcy judge that such sales are necessary for the continued operation of the business. Second, since the debtor can undermine the value of lenders’ collateral and grant new lenders superpriority standing, fully secured lenders will in general prefer liquidation over reorganization. This may create additional pressure for asset sales in bankruptcy. In Chapter 11, creditors can initiate asset sales by ‘making a motion to sell assets’ before the court. In addition, Chapter 11 cases can be converted into Chapter 7 liquidations. Although conversion to Chapter 7 occurs for only about 5% of the bankruptcies that we examine, other studies have found much higher rates of liquidation. For a sample of Chapter 11 filings in the Southern District of New York (including nonpublic firms), White (1989) finds that about one-third either end up in Chapter 7 or as liquidating reorganizations. Finally, purchasing assets from a financially distressed firm is less risky in Chapter 11, because asset sales are executed by a court order and are thus free from legal challenge. In addition, assets that are purchased from an insolvent firm that subsequently files for Chapter 11 may have to be returned as a ‘voidable preference’ or ‘fraudulent transfer’. Given the costs incurred if an asset sale is later challenged or cancelled, potential purchasers of an asset will prefer to deal with firms in Chapter 11.
2.2.2. Factors affecting creditors’ willingness to settle outside of Chapter 11 Even if stockholders and creditors believe that their combined wealth will be higher if debt is restructured outside of Chapter 11, negotiations can break down if particular creditors hold out for more generous terms. The severity of the holdout problem will depend on the voting rules for determin- ing acceptance of the plan, the number of creditors who participate in the plan, and the type of debt that is restructured (bank loans, publicly traded debt, etc.>. In addition, creditors may withhold their consent from a restruc- turing plan if they dispute the value of the new securities being offered under the plan. Adopting a debt restructuring plan outside of bankruptcy generally re- quires the unanimous consent of all creditors whose claims are in default. Impaired creditors who are excluded from the plan can accelerate payment of their claims, or force the firm into bankruptcy by filing an involuntary Chapter 11 petition. Cross-default provisions in the firm’s debt contracts will increase the proportion of creditors who participate in the plan. Thus in a typical workout the potential holdout problem is quite severe because of the veto power held by individual creditors. This problem is less severe in Chapter 11, where approval for a reorganization plan is required only from a
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specified majority of the creditors in each class of claims, and dissenting classes can be forced to comply with the plan under the Code’s cram-down provision. We hypothesize that the holdout problem is more severe (and the probabil- ity of successful private renegotiation, lower) when relatively more creditors are allowed to participate in the restructuring plan. An increase in the number of total votes to be cast increases the probability that at least one of the votes will be negative. Reasoning along similar lines, Smith and Warner (1979) conjecture that private negotiation of debt will be easier when the debt is privately placed (and owed to fewer lenders). On the other hand, having fewer creditors could result in more frequent bargaining deadlocks, if smallness of numbers causes individual creditors to feel more powerful and perceive greater dollar benefits to holding out. When there are few creditors - as in any bilateral bargaining situation involving few buyers and sellers - mutually beneficial trades will not always take place. If a negotiated solution is not forthcoming, the only way to break the deadlock may be to file for bankruptcy. A related consideration is the heterogeneity of the firm’s financial claims, or the complexity of its capital structure. Firms with more complex capital structures are hypothesized to succeed less often at restructuring their debt privately. The more that creditors’ claims differ in seniority rights, security, and other features, the more likely different claims are to be treated differently under any proposal restructuring plan (in the package of new securities offered to holders of each type of claim). As a result, there may be greater disagreement over whether the plan is equitable in its treatment of different claims. In practice, inter-creditor disputes are extremely common, even among creditors who hold the same general type of security (for example, members of a bank lending consortium). Achieving a consensus among creditors outside of bankruptcy will also depend upon what type of debt is being restructured. The holdout problem is especially severe for publicly traded bonds. Under the Trust Indenture Act of 1939, firms are prohibited from changing any of the ‘core’ terms of the bond indenture (the principal amount, interest rate, or stated maturity) unless every bondholder gives his/her consent. Although only a simple or two-thirds majority is generally required to change other covenants in the bond, amend- ment of the core terms is often critical to resolving financial distress. As a result, restructuring of publicly traded debt almost always takes the form of an exchange offer. In return for tendering their old bonds, bondhold- ers receive a package of new securities (often including some form of equity) that offers a lower cash payout. Since participation in the offer is voluntary, bondholders will have incentives to hold out if their individual tendering decision has little impact on whether the offer is successful; such incentives will be stronger when the bonds are more widely held. To encourage
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resulting ‘lemons’ problem. In Chapter 1lt stockholders have a much smaller information advantage over creditors. Firms are required to make extensive, regular disclosures of their financial and operating data to the court. Addi- tional information is contained in the court testimony of expert witnesses and management, and creditors can exercise their ‘rights of discovery’ to require additional disclosures from the debtor. Any continuing disputes over value can be arbitrated by the court. We use three variables as proxies for the severity of the holdout problem. First, troubled debt is more likely to be restructured outside Chapter 11 when there are fewer creditors. Second. debt is more likely to be restructured privately when relatively more of the debt is privately held by banks and insurance companies. In addition to the reasons discussed above, bank and insurance company debt is hypothesized to have this effect because such debt reduces the amount of information asymmetry between stockholders and creditors. Since these lenders are generally few in number, they have stronger incentives to monitor the firm than other kinds of creditors. Also, privately placed debt typically includes more financial covenants than other types of debt; even when firms are fully in compliance with these covenants, more information is implicitly revealed about firms’ financial and operating charac- teristics. Finally, holdouts by junior creditors will be less common when the firm’s market value is high in relation to the replacement cost of its assets. As discussed in section 2.2.1, more going-concern value is dissipated in bankruptcy than in private workouts when more of the firm’s assets are sold in bankruptcy. Junior creditors’ position in the absolute priority ranking ensures that they bear most of this cost, and they will offer less resistance to any proposed restructuring plan. Thus, firms with a higher market value/re- placement cost ratio will be more likely to restructure their debt outside of Chapter 11.
2.3. ‘Prepackaged’ Chapter 11
The preceding analysis is based on a simple dichotomy between bankruptcy and private renegotiation. However, the Code also permits firms to make a ‘prepackaged’ Chapter 11 filing, in which the bankruptcy petition and reorga- nization plan are filed together. Terms of the plan are negotiated in advance between the firm and its creditors, and a vote is taken almost immediately.
‘Under section 1126(b) of the Code, any claimholder who accepts or rejects a reorganization plan that is proposed prior to filing for Chapter 11 is deemed also to have accepted or rejected the plan for purposes of plan confirmation, provided that the debtor has disclosed all relevant information for making an informed decision as provided under nonbankruptcy law.
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Prepackaged Chapter 11 is thus a hybrid of conventional bankruptcy and private renegotiation that incorporates certain features of each recontracting alternative. In practice, successful prepackaged filings are extremely rare. Although prepackaged filings can significantly reduce the time that firms spend in court and obviate the need for costly creditors’ committees, disputes involving the plan are still possible after filing. We were informed by a professional bankruptcy consultant that only 5% to 10% of the largest bankruptcies begin as prepackaged filings, and that fewer than half of these are successful (the original plan is accepted). Only one firm in the sample made a prepackaged Chapter 11 filing [see the case of Crystal Oil in the appendix]. The company spent a total of only three months in bankruptcy, compared with a median of eighteen months for all bankrupt firms in the sample.
- Data and sample selection Although identifying bankrupt firms is fairly straightforward, there are few legal or institutional guideposts for deciding what constitutes a debt restruc- turing. In contrast to Chapter 11 cases, most debt restructurings do not have a well-defined beginning or ending date. Restructuring rarely begins or ends with a formal public announcement. and no special documents have to be filed with any government agency. Information about the restructuring dis- closed in normal Securities and Exchange Commission (SEC) filings often lacks detail. Sometimes the same debt ‘is restructured on a number of successive occasions, or different classes of debt are restructured concur- rently as separate transactions. This study uses the same sampling procedure and definition of a debt restructuring as Gilson (1989,1990X This definition emphasizes the economic similarities between Chapter 11 and private renegotiation as alternative mechanisms for dealing with financial distress. A firm is financially distressed if it has insufficient cash flows to meet the payments on its debt. To avoid or remedy a default, the firm must reduce or defer the payments, or replace the debt with securities having residual rather than fixed payoffs. Consistent with this simple intuition, a debt restructuring is defined as a transaction in which an existing debt contract is replaced by a new contract, with one of the following consequences: (i) required interest or principal payments on the debt are reduced; (ii> the maturity of the debt is extended; or (iii) creditors are given equity securities (common stock or securities convertible into common stock). In addition, the restructuring must be undertaken in re- sponse to an anticipated or actual default. This last requirement ensures that the sample includes only restructurings that are undertaken by financially distressed firms. As reported later in table 3, approximately two-thirds of
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profitable firm may wish to amend certain terms in its debt to enable it to invest in a positive-NPV project. Extreme negative stock returns are a relatively unambiguous indicator of poor financial performance. Inspection of the source documents reveals that 56% of firms in the sample explicitly restructured their debt to avoid bankruptcy. The remaining firms either received a going concern qualification from their auditors during the restruc- turing, where in default, or experienced a change in control at the hands of creditors (as evidenced by a creditor-initiated senior-management change or placement of stock with creditors). A second advantage is that the sample contains a more representative cross-section of debt restructurings than if the search had been based on reported cases of default. The latter criterion would exclude firms that restructure their debt to avoid default; evidence reported in the next section suggests that such preemptive restructuring is fairly common. Similarly, a sample that consists of defaults reported by Moody’s or Standard and Poor’s would exclude firms that have no publicly traded debt; such firms make up 54% of the current sample. Potential biases inherent in the sampling proce- dure are discussed in the next section. Information on debt restructuring plans and other relevant data are obtained from the WSJ, the Moody’s manuals, the Capital Changes Reporter, and the Q-File directory of 10k reports and proxy statements. Additional data are obtained from the exchange-offer circulars issued by firms that restruc- tured their publicly traded bonds. The market value/replacement cost ratio is constructed using data from the COMPUSTAT data base, and is described in Lang et al. (1989). Because stock returns (and market values) of highly levered firms are extremely volatile, we use a three-year average of this variable in the empirical analysis. The bank-debt ratio is defined as the book value of debt owed to banks and insurance companies divided by the book value of total liabilities. Eighty-five percent of all firms in the sample owe debt to banks, while only eleven percent owe debt to insurance companies; results are qualitatively the same when the numerator includes only bank debt. The number of creditors is approximated by the number of distinct classes of debt referenced in the long-term debt section of Moody’s, Data used to construct these variables predate as closely as possible the start of the firm’s debt restructuring or bankruptcy.
4. Results
4.1. Sample characteristics Most of the debt-restructuring activity in the sample is clustered in the years 1981-1985 (see table 1). This is consistent with the timing of the general economic recession of the early 198Os, when one would expect there
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Table 1 Time series of corporate debt-restructuring activity, by starting date and eventual outcome of restructuring. Sample consists of 80 firms that successfully avoid bankruptcy by restructuring their debt out of court, and 89 firms that are unsuccessful in restructuring their debt and file under Chapter 11 of the U.S. Bankruptcy Code. The sample period is 1978-1987.”
Year
Number of attempted debt restructurings
Percentage of restructuring attempts that end in bankruptcy 1978 9 11. 1979 8 50. 1980 11 63. 1981 18 66. (^1982 38) 47. 1983 28 46. 1984 25 60. 1985 20 60. 1986 10 50. 1987 2 100. Total 169 52. “A debt restructuring is defined as a transaction in which an existing debt contract is replaced by a new contract, with one of the following consequences: (i) required interest or principal payments on the debt are reduced, (ii) the maturity of the debt is extended, or (iii) creditors are given equity securities (common stock or securities convertible into common stock). All restruc- turings are undertaken in response to an anticipated or. actual default. Sources used to determine firms’ financial status include the WSJ, Commerce Clearing House’s Capital Changes Reporter, the Moody’s manuals, and the Q-file directory of annual 10k reports and proxy statements.
to be relatively more reported cases of financial distress. Seventy-six percent of the debt restructurings in the sample begin in this period. Also indicated is the percentage of restructuring attempts that eventually fail, and end with a Chapter 11 filing. The sample is about evenly divided between successful and failed attempts. Except in the first and last years of the sample period (when the number of events is extremely small), there does not appear to be any time trend in the observed failure rate. The frequency of events corresponding to the beginning and conclusion of debt restructurings is listed in table 2. Separate figures are reported for successful and failed restructuring attempts. Primary sources used to identify these events include the WSJ and firms’ 10k reports. Panel A of the table reveals that in a number of cases, negotiations took place prior to the starting date identified from public sources. Forty-seven initial references in fact pertain to the final resolution of a debt restructuring. We believe that we have come reasonably close to identifying the true starting dates for 90 firms (53 percent of the sample), where the initial event either takes the form of a default (52 firms) or an announcement that the firm has just commenced (or
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Table 3 Selected attributes of 80 successful corporate debt restructurings undertaken to avoid bankruptcy between 1978 and 1987.a Attribute (^) Percentage of sample Panel A: Incidence of default during debt restructuring b Payment default 36. Technical default (^) 21. Unspecified default (^) 17. All defaults (^) 66. Panel B: Stockholder approcal for restructuring plan Approval for issuance of new common stock specified under plan Approval of asset sales specified under plan No stockholder approval required Panel C: Type of debt restructured
Bank debt (by firms that have bank debt outstanding) (^) 90. Publicly traded debt (by firms that have publicly traded debt outstanding) (^) 69. “See table 1 for a definition of debt restructuring and bankruptcy. bA payment default is defined as a default on an interest or principal payment; included are cases where a firm unilaterally suspends payment on its debt, even though no default is formally declared by creditors. A technical default is defined as a default on a financial covenant in the firm’s debt. Sources used to determine whether debt is in default include the Moody’s manuals, Commerce Clearing House’s Capital Changes Reporter, the Q-file directory of annual 10k reports and proxy statements, and Standard and Poor’s Bond Owner’s Guide.
ing concluded with the sale of new debt or equity securities, with the issue proceeds used to help finance the restructuring. In four additional cases the restructuring ended with creditors receiving an equity interest in the firm, either directly or as a result of interest being paid in equity securities instead of cash. Starting and ending dates for bankruptcy are generally better defined. Of the 89 firms in the sample that filed for Chapter 11, 32 leave bankruptcy when their reorganization plans are formally confirmed by the court. An additional ten firms are merged into nonbankrupt firms, and four are liqui- dated following the conversion of their cases to Chapter 7 proceedings. For the remaining 33 firms, either bankruptcy was still in progress at the time of this writing (eight firms), or it was not possible to determine precisely when or how the firm emerged from Chapter 11. Some general attributes of the 80 successful debt restructurings in the sample are presented in table 3. Reported default rates in panel A indicate whether any of the firm’s outstanding debt is in default; data limitations preclude a finer breakdown by particular classes of debt (secured debt, trade debt, etc.). Although defaults on senior securities and related ‘material’ events must be reported in the firm’s 10k report, the amount and detail of
S. C. Gilson et al., Primre debt restructurings 331
disclosure vary significantly. For example. a firm is not required to report when it first started to restructure its debt, or that it has been in discussion with creditors concerning a possible default. A firm might disclose that it has restructured its ‘subordinated debt’, without specifying how particular claims in this category have been restructured. A default may go unreported if the firm does not file its 10k report; filing omissions by financially distressed firms are fairly common [Gilson (199O)l. As well, firms and creditors exhibit a penchant for secrecy in these transactions. For example, the debt restructur- ing of Tiger International Inc. (included in the appendix) began when the WSJ reported that the firm unilaterally suspended payments on about half of its $1.8 billion in debt:
Tiger said that a total of $350 million in interest and principal on its bank and institutional debt is scheduled for payment in 1983. But the company wouldn’t disclose how much of the S350 million would be affected by its decision to ‘temporarily defer’ debt service on $ million of its total debt. Tiger also wouldn’t disclose when specific payments were due on any of the $350 million. Asked for elaboration... a company spokeswoman said she didn’t know whether the company had missed a deadline for any payments on the $ million in debt.... Tiger’s lenders, whom the company declined to identify, were informed of the decision at yesterday’s meeting. (WSJ, 15 February 1983,5)
Fifty-three firms (66.3 percent of the sample) were in default before success- fully restructuring their debt. Since 29 of these restructurings begin with a default (see table 2), 24 firms did not default until after entering negotiations with creditors to restructure their debt. In 51 firms (64 percent of the sample), no default occurred, or occurred after the debt restructuring began. Thus, firms often begin restructuring their debt before any actual default (or without any default occurring). Explicit stockholder approval was required for only 18.8 percent of all restructuring plans that were adopted (panel B). In most of these cases, approval was required to issue common stock under the plan, either as a requirement imposed by the firm’s stock exchange, or because it was neces- sary to increase the number of authorized shares. For the remaining 81. percent of all cases where such approval was not obtained, the possibility exists that adoption of these plans was not always in the best interests of stockholders. Where managers have the authority to accept or reject a restructuring plan, there is no assurance that they will make the decision that maximizes stockholders’ wealth. Gilson (1989, 1990) finds that turnover of senior managers and directors is lower when firms restructure their debt outside of Chapter 11. Thus, managers cou!d have incentives to settle with
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restructuring (that is, there must either be a reduction in interest or principal payments, an extension of the debt’s maturity, or a distribution of equity securities to creditors). Since firms do not always disclose the exact terms on which debt is restructured, figures in the table represent lower bounds on the frequency with which these terms are actually incorporated in restructuring plans. New equity securities are distributed to creditors in almost 74 percent of all successful restructurings. A similar percentage of restructurings results in a reduction in promised payments on the debt. The least common provision in these agreements is an extension of maturity. Different classes of debt also appear to be restructured on substantially different terms. Approximately 49 percent of bank debt restructurings provide for an extension of maturity, compared with only 6.7 percent of restructurings of publicly traded debt; this latter result is consistent with firms offering shorter-maturity debt in ex- change offers to discourage holdouts (see section 2.2.2). Although 51. percent of bank debt restructurings result in bank lenders receiving equity in the firm, holders of publicly traded debt are given equity securities 86. percent of the time. The latter difference is a likely consequence of various legal and regulatory factors that make it prohibitively costly for banks to hold large amounts of equity in publicly traded companies. In particular, banks are constrained from holding significant blocks of stock in other firms by section 16 of the Glass-Steagall Act, the Bank Holding Company Act and the Federal Reserve Board’s Regulation Y, although temporary exceptions are granted when stock is obtained in a debt restructur- ing. In general, banks must divest their stockholdings after approximately two years, although extensions are possible. Second, creditors can be held legally liable to other claimholders if the firm’s financial condition deteriorates subsequent to their assuming a controlling interest in the firm and exercising ‘undue influence’ over its business [Douglas-Hamilton (1975), Smith and Warner (1979)]. A given percentage equity ownership in a firm might, for purposes of proving legal liability, be assumed to confer greater control on a small group of bank lenders than a dispersed group of public bondholders. Finally, a controlling shareholding in a firm could be construed as an ‘insider relationship’, thus obliging banks to return any monetary consideration received from the firm as a ‘preference item’ if it later files for bankruptcy. Banks may prefer to receive relatively less equity in a debt restructuring if they assess a high probability that the firm will subsequently become bankrupt. The preceding simple classification of restructuring terms provides a gen- eral overview of how these deals are structured. Given the complexity and idiosyncratic nature of these transactions, some useful insights can also be gained by direct examination of individual cases. The appendix presents detailed case descriptions of ten debt restructurings in the sample. The cases are intended to be a representative cross-section of various restructuring plan
331 XC. Gilson et al., Pricate debt restructurings
types and outcomes. These case descriptions provide evidence that comple- ments evidence presented in the next section, where we attempt to identify fzctors conducive to restructuring debt outside of Chapter 11. Table 5 contrasts selected characteristics of firms by whether or not they successfully restructure their debt outside of Chapter 11. Firms that privately restructure their debt have a higher market value/replacement cost ratio and have relatively more bank debt than firms in Chapter 11. The means and medians of both variables are significantly different between subsamples at the 1 percent level of significance. Both differences are consistent with the theory developed in section 2. Firms with a higher market value/replacement cost ratio are hypothesized to find bankruptcy more costly than private renegotiation, and to be less prone to holdouts by junior creditors. Firms with more bank debt outstanding can more easily renegotiate their debt because banks are more sophisticated and less numerous than other kinds of credi- tors, resulting in fewer holdouts. The mean number of debt contracts (approximated by the number of entries in the long-term debt section of Moody’s) is marginally higher for firms that restructure their debt privately, but the difference is not statisti- cally significant, and the medians are identical. Alternatively, we define the standardized number of debt contracts as the number of contracts divided by the book value of total liabilities. This variable is significantly lower for firms that restructure successfully; mean and median differences (not shown) are significant at the 2 percent and 7 percent levels, respectively. The standard- ized number of debt contracts, or the number of creditors per dollar of debt, is arguably a better proxy for creditors’ incentives to hold out. Anecdotal evidence suggests that holdouts are relatively more common among smaller creditors, possibly because they have less wealth at risk if the restructuring attempt fails. Firms that restructure their debt privately are also generally larger, as measured by the book value of assets and the number of shareholders and employees. Both mean and median book values of assets are higher for firms that restructure successfully, although only the difference in medians is statistically significant using a Wilcoxon rank-sum test (p-value of 0.02). Firm size may be a proxy for the number of creditors or the complexity of the firm’s capital structure; the simple correlation between the book value of assets and the (nonstandardized) number of debt contracts is positive and significant (0.72, with a p-value of 0.00). The two groups of firms are fairly similar in overall leverage (measured by the ratio of total liabilities or long-term debt to total assets), and mean stock-price performance (measured over the current and preceding two years). On the other hand, median unadjusted and net-of-market returns are significantly higher for the firms that restructure privately, according to a Wilcoxon rank-sum test for differences in medians (p-values of 0.04 and 0.05,
