Bankruptcy and Debt Finance

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1 Bankruptcy and Debt Finance Nicola Gennaioli CREI, UPF Barcelona, 19 October 2007

2 Big Picture Debt allows corporations and governments to finance their investments, consumers to smooth consumption. Debt needs to be enforced. What are the legal mechanisms behind the working of debt? Answer: look at default and bankruptcy. I will talk about two recent papers written with Stefano Rossi (SSE) on corporate bankruptcy and debt. The first is positive, the second normative.

3 Some Background Around the world, after a firm defaults, the state regulates the resolution of financial distress through state-mandated bankruptcy procedures. It is often forbidden to contract out of them. These procedures are court-supervised. A state appointed judge (or administrator) has discretion to take key decisions concerning the defaulting firm s liquidation, reorganization, refinancing... What factors shape the way bankruptcy works? How does it affect debt financing? How would the parties resolve financial distress by contract if they could? Is more contractual freedom desirable? Leading models of debt (e.g. Hart and Moore 1998) focus on creditors foreclosure, not on bankruptcy courts.

4 Judicial Discretion in Bankruptcy Gennaioli and Rossi (2007a): Ec101 model of the effect of judicial discretion in bankruptcy. Model explains a wealth of evidence. Idea: the bankruptcy judge is a producer. His incentives are shaped by demand and supply forces. A firm defaulted (consider ex-ante issues later). Liquidation yields λ, reorganization yields ρ or ρ with prob. 1/2. ρ > λ > ρ Fraction α of reorganization value pledged to creditors, the rest (1 α) is rents for debtors. α is creditor protection. Key parameter. Conflict of interest: debtor always wants to reorganize, creditor not. How do bankruptcy courts decide what to do?

5 Supply Side: Courts Decision-Making Court: fully-informed but potentially biased for the debtor or the creditor. Courts are on average unbiased. Court j maximizes weighted sum of the parties payoff. max λ 1 x ( ρ ) ( 1 ) ( ) j + ρ α + β α j x ρ j ρ x j ( ) Court s pro-debtor bias summarized by β j = β d,j /β c,j Courts incentives: more pro-debtor courts (i.e. higher β j ) reorganize more often, but less so if creditor protection α is higher.

6 Discretion, Bias and Creditor Protection β always reorganize (α ) β ρ λ / ρ reorganize iff state is ρ λ / ρ always liquidate (α ) β ρ 0 α

7 Demand Side: Debtors Venue Choice Focus here on debtor s first mover advantage (Jensen and Meckling 1976). Note: in U.S. 94% of Chapter 11 cases are filed by debtors. Debtors randomly allocated to natural venue β 0. Debtor i forum shops to court β in [ β, β ] iff: ( β β0 1 α) ρ( p p ) > Parameter c : restrictions placed by bankruptcy code on forum shopping. c i Debtors seek protection from creditors in courts with higher bias β, but this effect is weaker when creditor protection α is higher.

8 Forum Shopping and Bias Forum shopping creates systematic pro-debtor bias even if judges are on averageunbiased. If judges care to attract future cases, even otherwise unbiased judges establish a pro-debtor reputation. Costly ex-post and ex-ante (reduces debt capacity, also by increasing default). Key result: higher α reduces systematic pro-debtor bias, improving ex-post and ex-ante efficiency. This is due to three effects: Demand: Higher creditor protection reduces debtors incentives to forum shop. Supply: 1) Judges gain less by distorting reorganization decision. 2) Low future demand reduces judges incentives to establish pro-debtor reputation. High creditor protection avoids race to the bottom. If judges differ in competence, high creditor protection renders forum shopping is beneficial.

9 Facts about U.S. Chapter Forum shopping by debtors is widespread (e.g. Lo Pucki 2005) 2. Bankruptcy judges matter (Weiss-Wruck 1998; Bris et al. 2006, Chang and Schoar 2006): some are pro-debtors, others pro-creditor. 3. Judicial idiosyncrasies do not average out. Systematic pro-debtor bias (Franks and Torous 1993). 4. Recent fall in systematic pro-debtor bias occurred absent statutory changes to the code, and in conjunction with increase in creditor protection (Adler et al. 2006). Bankruptcy courts may have the wrong incentives. Possible reforms: increase creditor protection, restrict forum shopping, or allow parties to contract ex-ante on the bankruptcy venue...

10 Financial Distress and Debt Contracts Given the inefficiencies of state-mandated bankruptcy, why not to rely on contracts? Objection: optimal contracts are complex, especially due to conflicts among multiple creditors (e.g. Hart 2000). But many contracts are just forbidden by the bankruptcy code... Gennaioli and Rossi (2007b): what would happen without legal restrictions to contracts? Which debt contracts optimally resolve financial distress? When are they more or less efficient? Shed light on the possibility of contractual freedom vs. state intervention

11 Resolving Financial Distress by Contract Basic idea: debtors must be able to pledge the reorganized business as collateral, not just certain physical assets. Allows creditors to internalize upside of efficient reorganizations, yielding ex-post efficiency. Hurdle: low creditor protection. Reduces repayment under reorganization, creating pressure for a quick piecemeal sale. Tunneling creates a conflict between ex ante and ex post efficiency. How do optimal contracts and the efficiency with which they resolve financial distress depend on investor protection?

12 Example 1: High Investor Protection α Upon default, contract gives to creditor I both physical collateral and an equity stake in the reorganized firm. I is also given the right to reorganize or liquidate. He efficiently reorganizes because: α ρ λ ( α ρ < λ) ( α ρ + λ) / 2 Repayment =. Large α: I gets more under efficient reorganization than liquidation. Ex ante break even is likely. Simple Convertible Debt contract attains 1 st best if α high. Same as foreclosure + floating charge (get back to this contract later)

13 Example 2: Low Investor Protection α Now α ρ < λ. Same contract, but need debt write-down S: α ρ λ S ( α ρ + λ S) / 2 Total repayment =. If α low, break even unlikely. If I uninformed, similar contract induces E to reveal. Very low α: to ensure ex-ante financing, commit to allowing I to always liquidate ex post. For low α the optimal contract may be Straight Debt with Foreclosure, which sacrifices ex-post for ex-ante efficiency.

14 Example 3: Court s Expertise Assume courts estimate reorganization value with imprecision θ. If θ = 0, write complete contracts. If θ > 0, use convertible debt. But now courts enforce state contingent debt-write down: S( ρ) = S S( ρ) = 0 ( α ρ + λ) / 2 Repayment = (better than convertible, worse than foreclosure) Over-liquidation with prob. θ. (better than foreclosure, worse than convertible ) For α intermediate, Contingent Debt optimally relies on court s expertise and yields intermediate efficiency.

15 Optimal Contracts θ Foreclosure Contingent Debt +Courts Convertible Debt No Financing Third Best Second Best First Best First Best α S α C α O 1 α

16 Bottom Line State mandated bankruptcy procedures can produce inefficiencies and hamper the working of debt financing. Floating charge and convertibles allow investors to internalize upside of reorganization. These contracts help resolve financial distress, efficiently, even with many creditors and strategic default. Evidence suggests that, when used, these contracts work well (e.g. Franks and Sussman 2005, Djankov et al. 2007). However, these contracts are often legally forbidden by bankruptcy codes. A bankruptcy reform may prove cheap and beneficial by: 1. Increasing freedom of contracting by allowing floating charge. 2. Increasing legal protection against fraud.

17 Future Research: Governments How to optimally resolve sovereign debt crises? (e.g. Krueger 2001) Governments sporadically rely on physical collateral, but their creditors do rely on some for of collateral. Examples: trade sanctions, market exclusion, destruction of national economy. Key difference with corporations: governments actions (and collateral) have large third party effects. Examples: Government fails to internalize all national effects (e.g. limited ability to tax) Government fails to internalize international contagion With third party effects, international bankruptcy court is needed. Study optimal mix between contracts and regulation depending on: What is the relevant collateral/third party effect? What is the optimal bankruptcy procedure?

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