The central question: Does the bankruptcy process make sure that firms in bankruptcy are inefficient, and that inefficient firms end up in bankruptcy?

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1 Bankruptcy White (1989) Bankruptcy the closing down of firms that are inefficient, use outdated technologies, or produce products that are in excess supply. The central question: Does the bankruptcy process make sure that firms in bankruptcy are inefficient, and that inefficient firms end up in bankruptcy? Liquidation the basic bankruptcy procedure used by firms that are closing down and not able to pay all their debts. Without it: a race by individual creditors in order to secure claims Crucial aspect: the priority rule Tore Nilssen Economics of the Firm Lecture 6 slide 1

2 In practice (US): APR - the absolute priority rule. Priority 0 secured creditors, with claim of particular assets (or their values) 1 administrative expenses of the bankruptcy process 2 claims with statutory priority (tax claims, unpaid wages, etc.) 3 unsecured creditors claims (trade credit, damage claims, long-term bonds) - subordination agreements? 4 equity (shareholders, owners) Tore Nilssen Economics of the Firm Lecture 6 slide 2

3 Three basic priority principles Me first All creditors are assumed unsecured; no claims have statutory priority Creditors are ranked in order of the date loans were made, with earliest claims ranked highest. Anything remaining goes to equity holders. Last lender first As Me first but with ranking in reversed order. Equal priority All creditors have the same ranking and are therefore paid the same fraction of their claims face values. Tore Nilssen Economics of the Firm Lecture 6 slide 3

4 A model of the bankruptcy decision Management makes decisions maximizing the value of equity. If the firm fails the firm s assets are insufficient to pay current obligations it obtains new financing from a shortterm lender called the bank. Decisions are now taken by the coalition of equity and bank in order to maximize their joint value. Other creditors are called the debt. A two-period model. No discounting. A firm has no cash in hand. But it has outstanding debt: D 1 due in period 1 D 2 due in period 2 Liquidation value if liquidated in period 1: L Liquidation not enough to cover period-1 debt: L < D 1 In order to avoid bankruptcy in period 1, the firm must obtain a new loan from the bank in period 1: B 1 = D 1 The firm is willing to give the bank all its equity to obtain this loan, since without it, the firm has no value. Tore Nilssen Economics of the Firm Lecture 6 slide 4

5 If loan is granted and the firm continues, its gross earnings (i.e., before debt payments) equal P 2. Efficiency: The firm should be continued at period 1 if P 2 > L. The firm should file for bankruptcy at period 1 if P 2 < L. How do the priority rules perform? It depends on whether or not there is any uncertainty involved. No uncertainty Me first Bankruptcy: Coalition receives nothing, because L < D 1. Continuation: Coalition receives P 2 in period 2, but must pay old debt D 2 and new debt B 1. Coalition chooses continuation if: P 2 D 2 B 1 > 0. This condition implies P 2 > B 1 + D 2 > B 1 = D 1 > L. Tore Nilssen Economics of the Firm Lecture 6 slide 5

6 Under the me-first rule, continuation will be chosen only when it is economically efficient. Coalition chooses bankruptcy if: P 2 D 2 B 1 < 0. The bank is not willing to make the loan that would make continuation possible. But there are cases in which P 2 D 2 B 1 < 0, at the same time as P 2 > L. In such cases, debt holders at period 1 would gain P 2 L if continuation were chosen. L B 1 + D 2 P 2 Efficiency Me first Under Me first, some firms end up in bankruptcy that should continue from an efficiency viewpoint. When the coalition chooses to continue, it must share the gain from continuation with the old debt holders by paying them in full. Tore Nilssen Economics of the Firm Lecture 6 slide 6

7 Last lender first The interesting case: B 1 < P 2 < B 1 + D 2 Now, the bank has higher priority than the debt. The coalition earns zero in case of continuation: the bank is paid in full, but there is nothing left for equity. Thus, the coalition is indifferent between bankruptcy and continuation. L B 1 B 1 + D 2 P 2 Efficiency Last lender first Summing up no uncertainty All the priority rules lead to too much bankruptcy Liquidation imposes a cost on debt holders that is ignored by the coalition An externality problem The problem is greatest under the me-first rule since it gives the most to the debt holders and thus creates the greatest externality. Tore Nilssen Economics of the Firm Lecture 6 slide 7

8 Uncertain value of continuation Suppose that if the firm continues, then, in period 2, with probability p, it earns P 2 + G; with probability (1 p), it earns P 2 G. Assume: P 2 + G > B 1 + D 2, and D 1 < P 2 G < D 2. Does a higher value of G imply greater uncertainty? - Not necessarily, since G affects both expectation and variance of the period-2 value. Me-first rule With continuation, the coalition gets P 2 + G D 2 in the good outcome, nothing in the bad outcome. Expected return from continuation: p(p 2 + G D 2 ) B 1. Continuation chosen if p(p 2 + G D 2 ) B 1 > 0, i.e. p(p 2 + G) > pd 2 + B 1 = pd 2 + D 1. Efficient with continuation when: p(p 2 + G) + (1 p)(p 2 G) L > 0, i.e. p(p 2 + G) > L (1 p)(p 2 G). Continuation chosen when bankruptcy efficient? If so, pd 2 + D 1 < p(p 2 + G) < L (1 p)(p 2 G), which requires that L > pd 2 + (1 p)(p 2 G) + D 1 ; this cannot happen (contradicting White s claim). Tore Nilssen Economics of the Firm Lecture 6 slide 8

9 Last lender first Since B 1 = D 1 < P 2 G, the bank gets fully repaid in bad times under last lender first. So continuation is chosen if p(p 2 + G D 2 B 1 ) > 0, i.e. p(p 2 + G) > p(d 2 + B 1 ) = p(d 2 + D 1 ). An extreme focus on the good outcome. Continuation chosen when bankruptcy efficient requires that L > p(d 2 + D 1 ) + (1 p)(p 2 G); but even if p is very small, so that D 1 is of little importance, this cannot happen: By assumption, L < D 1 < P 2 G. Again, a contradiction of White s claim. Summing up uncertainty In contrast to the case without uncertainty, we may now get situations where continuation is chosen even if bankruptcy would be efficient. But: The examples in White s text do not show this. Reorganization Too many firms go bankrupt. Scope for remedies to get firms through financial crises? Reorganization US and Norwegian law very different. Voluntary reorganization free-rider problem. Better to let management decide when to reorganize? Tore Nilssen Economics of the Firm Lecture 6 slide 9

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