Bankruptcy (Finance)

A central tenet in economics is that competition drives markets toward a state of long-run equilibrium in which inefficient firms are eliminated and those remaining in existence produce at a minimum average cost. Consumers benefit from this state of affairs because goods and services are produced and sold at the lowest possible prices. A legal mechanism through which most firms exit the market is generally known as insolvency and/or bankruptcy.

Bankruptcy occurs when the assets of a firm are insufficient to meet the fixed obligations to debtholders and it can be defined in an accounting or legal framework. The legal approach relates outstanding financial obligations to “the fair market value” of the firm’s assets while an accounting bankruptcy would simply be a negative net worth in a conventional balance sheet (Weston and Copeland, 1992). Under bankruptcy laws the firm has the option of either being reorganized as a recapitalized going concern (known as Chapter 11 in the USA or administration in the UK) or being liquidated (Chapter 7 in the USA or liquidation in the UK).

Reorganization means the firm continues in existence and the most informal arrangement is simply to postpone the payment required (known as extension) or an agreement for creditors to take some fraction of what is owed as full se ttlement (composition). Liquidation, however, occurs as a result of economic distress in the event that liquidation value exceeds the going concern value. Although bankruptcy and liquidation are often confounded in the literature, liquidation (dismantling the assets of the firm and selling them) and bankruptcy (a transfer of ownership from stockholders to bondholders) a re really independent events.

The efficient outcome of a good bankruptcy p rocedure, according to Aghion (1992), should either:

1. Close the company down and sell the assets for cash or as a going concern, if the present value of expected cash flows is less than outstanding obligations; or

2. Reorganize and restructure the company, either through a merger or scaling down or modifying creditors’ claims.

Each country has its own insolvency laws, but bankruptcy remedies are very similar in most industrialized nations, incorporating in various ways the economic rationale for,

• fairness among creditors;

• preservation of enterprise value;

• providing a fresh start to debtors; and

• the minimization of economic costs.

There is, however, a widespread dissatisfaction with the existing procedures, as laws have been developed haphazardly with little or almost no economic analysis about how regulations work in practice. Governments and legal structures have not kept pace with the globalization of business and internationalization of financial markets and they have particularly not kept pace in the area of resolving the financial problems of insolvent corporations. For both bankruptcy and insolvency procedures, the key economic issue should be to determine the legal and economic screening processes they provide, and to eliminate only those companies that are economically inefficient and whose resources could be better used in another activity.

Company insolvencies have increased very sharply in the last few years, and currently stand at record levels in many countries. Several factors may severely affect corporate default, and although the combination of recession and high interest rates is likely to have been the main cause of this rise in defaults. The more moderate increases in company failures, which have accompanied more severe downturns in the past, suggest that other factors may also have been important. One important common determinant in companies’ failures is the general economic conditions for business; the other is the level of debt. Both capital leverage (debt as a proportion of assets) and income gearing (interest payments as a proportion of income), together with high levels of indebtedness in the economy, may lead to companies’ insolvencies.

Recent developments in the theory of finance have considerably advanced our understanding of the nature and role of debt. Debt, unlike any other “commodity,” entails a “promise” to pay an amount and the fulfillment of this promise is, by its nature, uncertain. Many of its features, however, can be understood as means of overcoming uncertainty, transaction costs, and incomplete contracts, arising from asymmetric information between the parties concerned.

The risk of bankruptcy and financial distress, however, highlights the fact that conflicts of interest between stockholders and various fixed payment claimants do still exist. These conflicts arise because the firm’s fixed claims bear default risk while stockholders have limited-liability residual claims and influence the managerial decision process. Bankruptcy procedures often do not work well, because incomplete (private) contracts cannot be reconciled so laws have to step in. Bankruptcy, as such, does not create wealth transfers to shareholders or undermine the provisions of debt finance but it creates, due to asymmetric information, a conflict of interest between creditors and shareholders, which harms companies’ prospects.

The implications of these conflicts of interest have been explored by a number of researchers, including Jensen and Meckling (1976), Myers (1977), and Masulis (1988). One consistent message in these papers is that these conflicts create incentives for stockholders to take actions that benefit themselves at the expense of creditors and that do not necessarily maximize firm value.

Jensen and Meckling (1976) argue that rational investors are aware of these conflicts and the possible actions firms can take against creditors. Thus when loans are made they are discounted immediately for the expected losses these anticipated actions would induce. This discounting means that, on average, stock-holders do not gain from these actions, but firms consistently suffer by making suboptimal decisions. If the firm is confronted with a choice between investment and debt reduction, it will continue to invest past the efficient point. Then creditors will prefer a debt reduction to investment and, since there are no efficiencies, stockholders must prefer investment.

However, if the actions of the owners (managers or shareholders) are unobservable, several complications arise. First, there is asset substitution. Since the owner only benefits from returns in non-default states, risky investments of given mean return will be chosen in preference to safer investments (moral hazard). Owners benefit from the upside gains from high risk investments but do not bear the costs of downside losses. Those are inflicted on creditors rather than shareholders. This is the standard consequence that debt can cause firms to take on uneconomic projects simply to increase risk and shift wealth from creditors to stockholders.

Second, there is underinvestment. Owners do not benefit from the effort that they apply to improve returns in insolvency states. Those accrue for creditors not owners. Since some of the returns to investments accrue to bond-holders in bankrupt states, firms may be discouraged from carrying out what would otherwise be profitable investments (Myers, 1977).

Third, there is claim dilution, that is an incentive for owners to issue debt that is senior to existing debt. Senior debt has priority over existing debt in the event of bankruptcy; it can therefore be issued on more favorable term s than existing debt, which leaves existing creditors’ claims intact in the event of bankruptcy.

The literature suggests, therefore, that bankruptcy impediments to pure market solutions are concerned with the free rider and holdout problems caused by the inconsistent incentives arising in a business contract specifying a fixe d value payment between debtor and creditor, particularly given limited liability. Limited liability implies ”moral hazard” and “adverse selection” due to asymmetric information problems. Consequently, the prospect of corporate insolvency may result in increased borrowing costs and, simultaneously, a reduction in the amount of funds available.

Next post:

Previous post: