Master Thesis Title:The Choice of Bankruptcy Reorganization: Chapter 11, Prepackaged and Out-of-Court Workout Programme: Author: MSc Business Economics, Finance track Ke Xu ID: 10390049 Supervisor: Dr. Diego Salzman Date: 2013-07
Abstract In this paper, I empirically study how firms choose among Chapter 11 bankruptcy, prepackaged bankruptcy and out-of-court workout when facing financial distress. My sample consists of 154 economic distress firms starting debt reorganization from 2000 to 2010 though one of these three alternatives. My results reveal that the mainly determinants of the reorganization choice are operating performance, liquidity and coordination problem. Firms with better operating performance, degree of liquidity problem and holdout problem are more likely to reorganization outside of court. On the other hand, Chapter 11 firms are suffered from the most serious financial distress. Moreover, the 2005 new bankruptcy law does not significantly affect the choice in terms of liquidity, but it makes difference from operating performance and coordination problem.
Content 1. Introduction... 1 2. Theory and Related Literature... 4 2.1. The Mechanism of Chapter11... 4 2.2. Differences in Workouts and Prepacks... 6 2.3. Prior Evidence on the Bankruptcy Reorganization... 7 2.4. Related Research Methodology... 9 2.5. About the New Bankruptcy Law... 10 3. Hypotheses and Research Methodology... 11 3.1. Hypotheses... 11 3.2. Research Methodology... 13 4. Data and Description... 14 4.1. Sample Selection... 14 4.2. Sample characteristics... 16 5. Univariate Analysis... 19 5.1. Measurements of operating performance... 19 5.2. Degree of Liquidity Problem... 21 5.3. Creditor s Coordination Problem... 22 6. Multivariate Analysis... 23 7. Conclusion... 25 References... 28
The Choice of Bankruptcy Reorganization: Chapter 11, Prepackaged and Out-of-Court Workout 1. Introduction Since the prosperous of the world s business, numerous enterprises enter and exit the market every year. If a firm s cash flows are not sufficient to afford its outstanding debt, it means that the firm is facing financial distress and should be forced to take corrective action to avoid lose more. However, a firm facing financially distressed does not mean it should be liquidated, for it may still has opportunities to continue operating under the condition that free of liquidity crisis. Theoretically, there should be two goals for an efficient solution to recover from economic distress. Firstly, keep viable firms operating and liquidate unviable firms. Secondly, make the viable firms recover as quickly as possible, that is exactly what bankruptcy protection works for. It means that the senior managers of distressed firms should make decisions correctively and effectively. Usually, there are three common options available to continue business: traditional Chapter 11 bankruptcy 1, out-of-court debt reorganization and, a hybrid form, prepackaged bankruptcy. In this paper, I will compare the three different methods and investigate the characteristics of firms choosing the three alternatives in the United States. A number of surveys develop the relationship between Chapter 11 and restructuring outside the court, but few contains the discussion about the prepackaged bankruptcy. Prepackaged bankruptcy 2 is a growing mechanism, relative to traditional bankruptcy, for restructuring financially distressed firms. It is a debt reorganization contracts that agreed by creditors in advance to a company declaring its insolvency. And prepacks 1 Chapter 11 of the United States Bankruptcy Code, which governs the process of reorganization of economic distressed firms 2 Which referred as prepacks in the rest of this paper. 1
are often used in Chapter 11 filing. Similar to Chapter 11, prepackaged bankruptcy would also undergo the voting procedure. Confirmation of the restructure plan requires approval by more than 2/3 of total and half of each class of claimholder. The voting procedure may occur before or after the plan is filed. The difference between prepacks and Chapter 11 is that, with prepacks, the petition is simultaneously with the plan of reorganization. The world s first prepackaged bankruptcy case was Crystal Oil Company, which filed for prepackaged bankruptcy in 1986 and successfully recovered from financial distress less than three months. Creditors of Crystal received equity in exchange for debt claim. Since 1990s, the prepackaged bankruptcy became more widely used. As estimated by Baird and Rasmussen (2003), around a quarter of 93 large firms filing for Chapter 11 is prepacks in the year 2002. Besides, the increasing bankruptcy activities and widely adoption of legal protection induce the revolution of the bankruptcy law. In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was passed by Congress and signed into American Bankruptcy Code by President Bush, which makes it harder for consumers to clear their debts in what is known as a fresh start - or liquidation. As the consequence of the new law, the number of firms restructuring though Chapter 11 significantly decreased by 40.8% in 2006 and the detail information is showed in Figure1. [Insert Figure 1 here] So the contribution of this paper is that I will take the change of bankruptcy choice arisen from the new bankruptcy law into consideration as well as analysis the reorganization choice. As I know, no similar research has conducted about it. To the end, I divide the research periods into two parts: five years before and after 2005 (the year BAPCPA taking into effect). 2
The ultimate aim of this paper is to find out the financial characteristics of the firms undergoing traditional Chapter 11 bankruptcy, prepackaged bankruptcy and out-of-court workout in the periods of 2000-2005 and 2006-2010. Based on the natural and features of different methods, one of my views is that firms with comparably optimistic operating performance and higher liquidity are more likely to restructure without the monitor of court. On the contrary, firms which are more severe of financial distress would reorganization under Chapter 11. And prepackaged firms lie in the middle. Another point is that firms filing for Chapter 11 are facing much more complex coordination problem. To test these hypotheses, I select the firms which have potential trend to bankruptcy and then search for the evidence one by one from public source, which leads 154 American companies falling in my sample. Among the 154 distressed firms, 55 of them choose the traditional Chapter 11, 76 firms undergo out-of-court workout and only 23 prepackaged firms appear in the sample. After that, I conduct univariate analysis to compare the differences between Chapter 11s, prepacks and out-of-courts in terms of operating performance, liquidity and holdout problem, respectively. Furthermore, multinomial logistical regression is employed to develop the combination of the determinants. The results support my hypotheses. The paper is organized as follows. Chapter 2 presents the theory and previous research review. Based on that, hypotheses and methodology is developed in Chapter 3. And the process of sample selection and the results of the sample characteristics are contained in Chapter 4. In Chapter 5 and Chapter 6, I analysis and compare the financial determinants of choice on restructuring with univariate and multinomial logistic analysis, respectively. Chapter 7 concludes this paper with a brief outlook. 3
2. Theory and Related Literature This chapter outlines the mechanism of traditional Chapter 11 bankruptcy, prepackaged bankruptcy and out-of-court restructuring and develops the previous empirical methodology and results. 2.1. The Mechanism of Chapter11 There are two alternatives for the majority of the firms that entering formal bankruptcy proceeding-liquidation (Chapter 7) 3 and reorganization (Chapter 11). In this paper, I will mainly consider the Chapter 11. Senbet and Seward (1995) explain the main objective of Chapter 11 is rehabilitation of a distressed firm. And the benefit of Chapter 11 bankruptcy is designed to allow firms to continue operating (Edith, Kose and Robert, 2008). Chapter 11 allows the business restructuring under the provision of the court and is applied for corporations, partnerships and individuals with no debt limit. In order to emerge from bankruptcy, distressed firms are expected to design a reorganization plan. And the body of a Chapter 11 case is the preparation, approval and administration of the restructuring plan, which including how to reorganize the debt and to what extent the debt could be paid. As a general rule, secured creditors have the priority to be fully paid than unsecured creditors. And a reorganization plan lasts about 5 years (could be extended to 10 years under certain situation). The duration of debtor survival from bankruptcy could vary from several months to several years, depending on the complex of bankruptcy. Since the restructuring procedures involved are complicated, the most important features are listed below. 1) Automatic stay provision 3 Chapter 7 of the United States Bankruptcy Code, which describes the process of liquidation under the law 4
Firms filing for Chapter 11 can benefit from automatic stay which occurs immediately after the bankruptcy petition is filed. It requires all creditors to stop the collection actions which include obtaining the debtor s property and creating or enforcing a lien against the debtor s property. Unless rejected by court, the financially distressed firms would be protected by automatic stay until emerging from bankruptcy. Under an automatic stay, all interest expense and principal to creditors are stopped. The automatic stay sets the financial distressed firms free from debt for a specific period so the firms could focus on their reorganization plan. 2) Voting procedure Before executing the reorganization plan, there is a voting procedure which is inevitable. The purpose of the voting procedure is to meet the Bankruptcy Code s requirement for a minimum level of approval. Simplified, the confirmation of the restructure plan requires approval by more than two thirds in dollar amount and more than half of in number of each class claimholders. This is less restrictive voting procedure than out-of-court reorganization which I will introduce later. The voting procedure may occur before or after the plan is filed. 3) Debtor in procession Debtor in procession is a special benefit provided to the financial distressed firms under Chapter 11. The debtors may loan and acquire financing by offering new lenders the first priority on the distribution of profit. In other words, this kind of debt is treated senior to other debt. The debtors are also permitted to reject or even dismiss contracts. The debtor in procession helps the distressed firms out of trouble and gives the debtors a new start. Finally, in addition to automatic stay, voting procedure and debtor in procession, the financial distressed firms restructuring under Chapter 11 bankruptcy could also 5
benefit from tax cancellation on indebtedness income and use of operating loss carryforwards when recognizing income tax. 2.2. Differences in Workouts and Prepacks Out-of-court debt restructuring 4 involves series activities regarding restructuring assets and liabilities of debtors, with the purpose of increasing efficiency and minimizing the costs of solving financial difficulties. Out-of-court workouts can generally be seen as alternative to Chapter 11 bankruptcy. However, Garrido (2011) claims that there, in insolvency systems, is no clear distinguish line between formal and informal restructuring actions. The highlights of out-of-court workouts, unlike the traditional Chapter 11 bankruptcy case, are adjustable and could be much easier to meet the unique needs of debtors business without changes in management and ease of negotiation. Additionally, the firms spend less time during reorganization in out-of-court workouts. Asquith, Gertner and Scharfstein (1994) state that the debtors choose to overcome financial distress in several ways, for instance, require accelerated payments and reduce further lending. Different with Chapter 11, the pass of the out-of-court reorganization plan must be accepted by all the claimholders, which is obviously much more strict and harder than that under Chapter 11 and would probably arises the holdout problem. Prepacks can be seen as the hybrid of Chapter 11 and out-of-court workouts, which may fill the gap between formal and informal reorganization in somewhat extend. The managers of firms with prepackaged plan would negotiate with creditors as workouts, but submit the reorganization plan to court so as to under protection by court. In other words, prepacks waive the provision of automatic stay by negotiation. While similar to Chapter 11, prepackaged bankruptcy would also undergo the voting procedure. Confirmation of the restructure plan requires approval by more than 2/3 of total and half of each class of claimholder, so the holdout problem could be solved 4 Referred as workout in the rest of the paper 6
more or less. The voting procedure may occur before or after the plan is filed. To study the characteristics of firms undergoing prepackaged bankruptcy, Tashijian, Lease and McConnell (1996) provide empirically data for 49 distressed firms that restructured through a prepackaged bankruptcy to complement previous research. They employ the measurement including the time spent in restructuring process, the direct cost, the recovery rate and violations of absolute priority of claimholders to get the conclusion that prepacks lie between traditional Chapter 11s and out-of-court workouts in all terms mentioned above. 2.3. Prior Evidence on the Bankruptcy Reorganization Reorganization is usually a long term process. Many early researches have been done to develop the natural of Chapter 11 bankruptcy and out-of-court restructuring. Frank and Torous (1994) summarize the duration of reorganization. They find that Chapter 11 reorganization requires significant more time in restructuring than the out-of-court workout- for an average of 10 months more in formal bankruptcy. And firms in Chapter 11 bankruptcy procedure spend more money on restructuring than out-of-court workouts. The bankruptcy cost includes direct and indirect cost. Direct cost includes the expenses for accountants, lawyers, consultants and other legal and service. Indirect cost, which do not has a clear definition, includes some kinds of opportunity cost. Although Chapter 11 bankruptcy most, Gilson, John and Lang (1990) still hold the view that the additional cost can be offset by the benefit of the automatic stay and debtor in possession. However, another view is provided by Li (1999) that the Chapter 11 procedure is the last resort to address the economic problem for the agency problem arisen from the legal procedure. For managers own and enjoy the control of their firms so that they may keep the inside information about the survival and profitability in the future of the firms, which is extremely essential in debt restructuring. 7
There also exist many researches about the determinants of bankruptcy choice. One conclusion is that firms in more severe distress tend to choose restructuring under protection. Gilson (1997) study the determinants of reorganization between Chapter 11 and out-of-court workout. He concludes that firms in less severe degree of distress tend to choose out-of-court workouts and more likely to emerge from bankruptcy, given that the stronger ability to generate cash flow to pay debt and continue operating. Torous (1994) find firms that with fewer distinct classes of debt and greater bank debt are more likely to choose private workout. And although all firms could have the option to file for Chapter 11, the cost of this method may affect the preference. Chatterjee, Dhillon and Ramírez (1996) combine the firm size and debt structure of financially distressed firms and complement the research. They conclude that small firms, on average, with low level of public debt file directly for traditional bankruptcy; while larger firms with relatively high level of public debt would choose public workout to restructure. Carapeto (2005) derives a bankruptcy bargain model which based on Sutton (1986) to compare prepacks and Chapter 11 and provide empirical evidence on different bargaining process for these firms. They find unsecured creditors are willing to accept just their outside option in prepacks, which supports the evidence of lower costs and probability of breakdown in the negotiation procedure in prepacks. By contrast, in Chapter 11s, unsecured creditors outside option is limited, which leads to the higher bankruptcy costs and greater likelihood of breakdown in the negotiations. Li (2013) provides an endogenous Chapter 11 filing model to study the nonlinear wealth transfer from shareholders to creditors around Chapter 11 filing, which suggests that the announcement of Chapter 11 filing is adverse information for shareholders. While it is relatively good news to claimholders if the firm is preparing a prepackaged bankruptcy (Tashijian, Lease and McConnell, 1995), for the payoff to claimholders is 20 percent higher on average than Chapter 11 s. 8
2.4. Related Research Methodology From an economic perspective, debt structure and firm size are basic determinants of bankruptcy choice. Various literatures have been made regarding the Chapter 11, private workout and prepackaged bankruptcy respectively. However, very limited researches have I found to analysis these three methods simultaneously. One of the most notable studies was made by Chatterjee, Dhillon and Ramírez (1996), which my paper is most related with. They sample 201 firms filing for Chapter 11, prepack or out-of-court workout from 1989 to 1992 and use univariate and multinomial logistical analysis 5 of series characteristics of these firms such as leverage degree, debt structure and magnitude of firm s economic distress to study firms initial plan of restructuring. They measure firm quality by its EBIDT as a proportion of total assets and revenues and analysis from the degree of financial distress and liquidity problem. The conclusion that firms which are filers of Chapter 11 usually have poor operating performance, low liquidity and creditors coordination problems and firms which have relatively sufficient operating cash flows would more likely to choose private workout. While prepacks are suit for the firms with relatively strong operating performance, but immediate liquidity crisis. To identify financial distress, Gilson, John and Lang (1990) sample the firms with 3-year stock returns from the bottom five percent of the New York and American Stock Exchange lists from the period 1979 to 1985. After that, they search the evidence of restructuring through the WSJ Index. While, in my opinion, focusing on the lowest stock returns leads to sampling firms with worst expected future reorganization outcomes, which cause potential bias. So I will look into the 5 Also known as softmax regression, a regression model widely used in statistics which allowing more than 2 outcomes and used to predict categorical data 9
three-year change in operating performance with the variable EBIT to Total Assets. The detail will be described in the sample section. To be further discussed, Denis and Rodgers (2007) measure the post-bankruptcy with the R+3 fiscal years data of Chapter 11s survivors. They identify the survivors by checking whether the firms in the sample still listed in the COMPUSTAT and get 58.2% of number of total firms surviving from bankruptcy. However, no detail about other kind of bankruptcy is provided. Moreover, they find that 61% of the survivors achieve positive operating margin and 44% of those achieve a positive industry-adjusted operating margin in at least one of the three years. In my paper, I will also conduct the survivor analysis with the similar approach. 2.5. About the New Bankruptcy Law The majority of formal bankruptcy firms follow the Bankruptcy Reform Act of 1978. Since the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) taking into effect in 2005, more firms are governed by it. According to the location of the company, the petitions are conducted in one of the 94 bankruptcy courts. Compared to the previous Code, the new bankruptcy law adds some new requirements which attempt to make it more difficult for firms to simply liquidation, and instead require the firms switch to Chapter 13 bankruptcy- under which the business is allowed to dismiss only after the firms has paid certain portion of their debts. These requirements include: increasing amount of document used to filing for bankruptcy, raising the direct legal fees, increasing compliance requirements for small firms and so on. One important change of New Bankruptcy Law is the applicability of automatic stay. There are some limitations for the stay provision in some re-filed cases. For example, if a firm files for Chapter 11 within one year of finish of the earlier one, the automatic stay in the new case would expire 30 days after filing. This rule is due to the 10
presumption that a repeat filing in such a short period is not in good faith and condition. As a consequence, a motion that the recovery is expectable and in good faith with creditors must be provided if a firm wants to re-file to seek the protection of the court. Besides, other significant change include stricter notice requirement applied for the violation of debtors, lien avoidance limitation and so on. Most of the new requirements provide protection to creditors and make it harder to debtors to dismiss their debt forgiven. And to answer whether these changes affect the choice of the restructuring methods, I will divide my research period into two periods, with the dividing line of the year 2005 3. Hypotheses and Research Methodology The objective of my paper is to analysis the incentives of firms to resolve the financial distress. Based on previous research, I will introduce three hypotheses and develop research methodology in this section. 3.1. Hypotheses One obviously view is that the firms choosing the restructuring methods based on the operating performance and the liquidity. Because of the Chapter11 s automatic stay feature, firms facing sudden liquidity crisis have comparable advantages to file for Chapter 11 bankruptcy protection, which could help the firms free of the debt immediately after petition. Beside the same feature applicable for, prepackaged firms have the access to negotiate with creditors before administration of restructuring plan. Therefore, I presume that prepackaged firms have similar but slighter liquidity crisis and stronger operating performance. On the other hand, more liquid firms are more likely to restructuring out of court. And firms with greater performance which 11
are easier to generate future cash flow and profit also tend to choose out-of-court reorganization. So there are 2 hypotheses listed following: H1: Firms with greater operating performance are more likely to reorganization out of court while Chapter 11 firms suffer from most severe degree of financial distress, and prepack firms falling in the middle. H2: Firms choosing Chapter 11 have more proportion of debt and out-of-court firms have more liquidity. Similarly, firms undergo prepackaged bankruptcy lie in the middle. The third view is that creditors coordination may affect the choice of restructuring due to the difference in the voting procedure. For instance, firms which have large number of creditors may face a coordination dilemma. The acceptance of Chapter 11 and prepackaged bankruptcy restructuring plan requires approval from more than one half in the number of shareholders and two-thirds in dollar amount, which is less restrictive than that of the out-of-court workout. So the firms which may face a coordination problem are more likely to select the traditional Chpater11 and prepackaged bankruptcy than out-of-court workout. Therefore, the third hypothesis is as follows. H3: Chapter 11 and prepackaged bankruptcy firms are more likely to face creditors coordination problem while the situation may relief to out-of-court firms. Overall, there are three hypotheses I need to test in this paper. In next section, I will introduce my research methodology. 12
3.2. Research Methodology To estimate the hypotheses mentioned above, I employ the research methodology similar with Chatterjee, Dhillon and Ramírez (1996).There are two steps regarding my solving procedure: a. Univariate Analysis In this part, I will compare the firms from three aspects, operating performance, degree of liquidity and creditors coordination, with univariate analysis. The purpose of univariate analysis is to test the three hypotheses separately. It is simple but essential. More specifically, the market-to-book ratio and ratios of operating income to total assets and operating income to revenues can be used as proxies for operating performance, and the proportion of current liabilities, long-term debt due in one year, long-term debt and total liabilities for capital structure. Moreover, for the creditors coordination, I measure it with the credit trade, number of public debt contracts outstanding and the proportion of long-term contracts. With the descriptive analysis of panel data, I could get the characteristics of the firms undertaking Chapter 11, prepacks and out-of-court restructuring. And this is the basic part of this research. b. Multinomial logistic Analysis Moreover, to check the combination effects toward the preference to restructuring method, I would attempt to employ multinomial logistic regression to compare the firms choosing prepackaged bankruptcy and out-of-court reorganization relatively to those choosing traditional Chapter 11 bankruptcy. It is a particular solution to estimate the relative probabilities of different discrete outcomes with the linear combination of the indicators. In my models, Y takes value 1 if the firms undertaking Chapter 11 restructuring, 2 with prepacks and 3 with out-of-court workouts, making the situation that Y equals one the base. The regressions are as following: 13
Pr (Y = 2) ln Pr (Y = 1) = α + β Operating Income 1Market to Book + β 2 Total Assets + β 3 Current Liabilities Total Assets + β 5 Accounts Payable Total Assets + β 4 LongTerm Debt Total Assets + β 6 LongTerm Contracts Total Liabilities + u Pr (Y = 3) ln Pr (Y = 1) = α + β Operating Income 1Market to Book + β 2 Total Assets + β 3 Current Liabilities Total Assets + β 5 Accounts Payable Total Assets + β 4 LongTerm Debt Total Assets + β 6 LongTerm Contracts Total Liabilities + u The advantage of these models is I would easily get the differences between each two bankruptcy alternatives. Meanwhile, based on the outcomes of univariate analysis, I could further get the combination effect of the variables. 4. Data and Description The basic purpose of sample collection is to find out the firms facing financial distress from 2000 to 2010 and have taken the reorganization action. Meanwhile, the sample should contain the information of restructuring activity and necessarily related accounting and financial data. So I could analyze the characteristics of financial distressed firms according the restructuring method they use. 4.1. Sample Selection Since there is no direct ways to obtain the information of financially distressed firms, especially for the firms undertaking out-of-court workout, so, to the end, I employ the two-step sampling methodology similar to Gilson, John, and Lang (1990). My final sample consists of 154 financially distressed firms which undergo restructuring through Chapter11, prepacks or out-of-court workouts during the period from 2000 to 2010. 14
Firstly, I adopt the measurement of three-year change in ratio of EBIT to Total Assets for all American firms with initial total assets above $100 million from the period 2000 to 2005 and 2006-2010. I restrict the $100 million total assets to make its information more likely accessible from public resource. And I use two separate research periods and the benchmark of the year 2005 to check the influence from new bankruptcy law on the determinant of restructuring. The necessarily balance data for calculating the three-year change in ratio of EBIT to total assets is obtained from CRSP/COMPUSTAT Merged. After that, I list the ratio from high to bottom and keep the firms in the bottom 5 percent, which result in 1744 potential observations for 1340 firms. So far, I have the dataset of firms which are facing economic trouble and have the tendency to reorganize. Secondly, I search for potential observations for the evidence of Chapter 11, out-of-court or prepack restructuring 5 years around the sampling year one by one. The case of prepackaged bankruptcy could be obtained from the UCLA-LoPucki Bankruptcy Database. And for the evidence of Chapter11 and out-of-court, I search for Dow Jones Newswire, Thomson Reuters, Mergent Online and the Wall Street Journal. Additionally, if the firm appears more than once evidence of Chapter11, prepack or out-of-court workout, I just keep the data information about the first restructuring activity. I also keep the record the data three year after structuring to do the survival analysis later. My final sample consists of 154 financially distressed firms restructuring through Chapter11, prepacks or out-of-court workouts from 2000 to 2010. The advantage of the sampling methodology is that I use a consolidated method to choose the financially distressed firms, in which way I exclude the restructuring activities by non-distressed firms, especially for the firms undergoing out-of-court workouts. For there may be several objectives for the act of reorganizing, for instance, 15
the purpose of making the firm more profitable, better organized or a response to a crisis. Since I only interested in the firms that facing financial distress, I could restrict the firms with the benchmark of the three-year change in ratio of EBIT to total assets. Another highlight is that I use the same approach to sample all firms, rather than sampling the three alternatives from three different sources which could lead different characteristics. The limitation of the sampling method is I only select the firms with total asset more than 100 million, which I ignore the evidence of small firms for choosing bankruptcy alternatives. So the discussion of preference of small firms to restructuring in not included in my paper. 4.2. Sample characteristics I show the descriptive characteristics of the sampling firms in Table 1. Panel A shows the number of three types of restructuring each year from 2000 to 2010. The categorization is based on the starting year the firms attempt to reorganization. Among the 154 sampling firms, 55 of them choose the traditional Chapter 11, 76 of them choose out-of-court workout while only 23 case of prepacks appear in the sample. Nearly half of the sampling firms undergo restructuring outside the court and the portion is still the largest after 2005, which can be interpreted that out-of-court workout is still the most common way to solve financial distress regardless of the launch of new bankruptcy law. Moreover, when examining the distribution year-by-year, there is a significant decline in the year 2005 and, after that, cluster in the year 2008. The first phenomenon is due to the Bankruptcy Abuse Prevention and Consumer Protection Act taken into effect and the clustering primarily resulted from the global financial crisis. The disappointing macro-environment leads more and more firms lost the ability to afford their debts. 16
Panel B presents the industry distribution of the sample according the SIC code 6 from the period 2000 to 2010. As can be seen, the sample is distributed across almost all the categories, which indicates the sample is effective and comprehensive. More than 40 percent of the distressed firms are in the division manufacturing and the second biggest group is classified as wholesale and retail trade. [Insert Table 1 here] Additionally, the mean values (medians in the parentheses) of financial characteristics of the sampling firms are presented in table2. Panel A and panel B show the statistic summary in two periods respectively. There are obviously differences in terms of the size of total assets, total liabilities and long-term debt among the three alternative methods. The distressed firms choosing out-of-court restructuring are significantly with the largest size and prepack firms are the smallest, while the Chapter 11 firms lie in the middle in the all four measurements. The average book value of total assets is 2685 million for Chapter 11, 1208 million for prepacks and 4389 million for out-of-courts. The medians are significantly lower than means, which suggests that some extremely large firms existing. When comparing the two periods, it could be illustrated that the scale of the total assets and total liabilities increased for all the three types of reorganization-no interchange within these three. More large firms than before are facing financial distress in the period from 2006 to 2010. The table illustrates that the financial characteristics indeed affect the choice of restructuring. The larger firms are more likely to reorganize outside the court and the smaller firms may have a relatively advantage in prepacks. The conclusion is consistent with the Chatterjee, Dhillon and Ramirez s (1996). 6 [Insert Table 2 here] The Standard Industrial Classification, a standard for classing industries by a four digit code which is established in 1937. The system is widely used in United States. 17
I also examine the post-reorganization survival and performance using the method similar to Denis and Rodgers (2007). The first attempt is simply check whether the firms are still listed on the COMPUSTAT three years after the beginning of reorganization. This step is to calculate how many firms could survive from restructuring. R refers to the year the firms start restructuring and firms are followed three years after R. Secondly, I check each firms to seek for the evidence of positive change in operating income for at least one year during the period R to R+3. Operating performance is measured by operating income before depreciation and taxes. Table 3 provides the detail of the analysis. Percent of the number of reorganized firms through different bankruptcy methods are presented in the parentheses. We could see that 88 (more than 57%) of total firms, which is slightly less than Denis and Rodgers (2007) s finding, are still listed on COMPUSTAT and 92 firms have positive change in operating income at least one year within three years after the reorganization. The results indicate that the majority of the financial distressed firms could emerge from the reorganization. More specifically, nearly 50% of Chapter 11 firms could be found on COMPUSTAT, 52% for prepackaged firms and around 63% for out-of-court firms. For the change of operating performance, 55% of firms choosing Chapter 11 have the upwards trend at least one year during three years after emergence from Chapter 11, 52% for prepacks and 64% for out-of-courts. [Insert Table 3 here] Overall, the efficiency of bankruptcy reorganization is optimistic. Chapter 11 firms the least portion could survive. The reason may because firms filing for Chapter 11 are facing more serious financial distress, more eager to seek for the legal protection. 18
The details, the characteristics of traditional Chapter 11, prepackaged bankruptcy and out of court workout, would be discussed in the following chapter. 5. Univariate Analysis The objective of univariate analysis is to get the characteristics of three types of firms and how managers choose one method over another. In this part, I analysis the preference of distressed firms towards bankruptcy from three perspectives: operating performance, liquidity and the degree of creditors holdout problem for the two periods, 2000-2005 and 2006-2010, respectively. 5.1. Measurements of operating performance In this section, I measure the degree of financial distress faced by three alternatives. I use the ratio of market-to-book ratio as a proxy of market expectation and capital structure and the ratios of operating income to total assets and revenue as proxies of operating performance. Table 4 presents the results of analysis. The first column identifies the variables and column 2 to column 4 list means and medians (in the parentheses). The results of different tests, t-test for differences in means and Mann-Whitney Z-test for medians, are presented from column 5 to column 7. Panel A shows the data from 2000 to 2005 and Panel B list the information from 2006 to 2010. [Insert Table 4 here] The results reveal that firms with different level of distress would choose different restructuring methods. Firms choosing out-of-court restructuring have relatively high market-to-book ratio than those of traditional Chapter11 and prepackaged bankruptcy, although all values are less than 1. It implies that market expectation towards the recovery of the firms choosing out-of-court restructuring is not such 19
disappointed as those of another two ways. The results are significance both in means and medians and also consistent with the previous studies. Furthermore, I calculate the ratios of operating income to total assets. Chapter 11 firms seem to suffer from the most severe financial distress while firms choosing out-of-court restructuring have relatively strong ability to generate cash flow, and prepacks firms lie in the middle. However, only the differences between traditional Chapter 11 and out-of-court are significant in both mean and median ratios. No significant differences are found in another two pairs. The ratios of operating income to revenue show slightly different results-prepacks have greater profit than out-of-court firms, but not significance. When comes to the year 2006 to 2010, there is little difference for the measurements of operating income. In contrast to the period from 2000 to 2005, the firms filing for traditional Chapter 11 bankruptcy show greater ratio of operating income to total assets than that of prepackaged firms. This result suggests that Chapter 11 firms tend to have better profitability than before, which could be seen as a consequence of the stricter New Bankruptcy Law. One point to note in this section is that EBIT may not an accurate variable to measure the operating performance of financially distressed firms. As mentioned by Mooradian (1994), not all the Chapter 11 filers are in economic distress. Due to the specific voting requirement, some of them may just want to avoid creditors holdout problem. So the use of EBIT is likely to cause an upward bias for the Chapter 11 and prepack firms. Although this may occur, my results still comply with the previous conclusion and the hypothesis- the out-of-court firms have better operating performance than Chapter 11 firms. 20
5.2. Degree of Liquidity Problem I use operating income to measure the firms operating performance. When measuring the degree of liquidity problem faced by distressed firms, I employ the ratios of current liabilities, debt due in one year, long-term debt and total liabilities to total assets. Table 5 presents the liquidity situation of distressed firms restructuring though Chapter 11, prepackaged and out-of-court. Panel A reports the ratios for the starting year of restructuring during the period 2000 to 2005 while Panel B lists the data from year 2006 to 2010. [Insert Table 5 here] From the perspective of capital structure, all the three kinds of firms have high level of debt. The mean ratio is 0.79 for Chapter 11s, 0.99 for prepacks and 0.51 for out-of-court workouts, which is consistent with the definition and nature of the financial distress. Firms choosing out-of-court have comparably less severe current liquidity problem while prepack firms are facing the most serious situation in terms of the ratios of current liabilities and debt due in one year to total assets. The ratio of current liabilities to total assets of Chapter 11 firms is significantly greater than that of firms restructuring out-of-court. Another interesting finding is the same pattern, other than Chatterjee, Dhillon, and Ramirez (1996) s, can be found in the magnitude of long-term debt. The mean ratio is 0.42 for prepacks, 0.29 for Chapter 11 and 0.13 for out-of-court workouts. The results suggest that prepack firms have larger proportion of long-term debt than Chapter 11 and out-of-court firms which suggest that prepack firms have obviously weak solvency, although the tests are not significance between Chapter11 and prepack. When comparing the period from the year 2000 to 2005 and the period from 2006 to 2010, there is no obviously different trend for firms choosing one reorganization 21
method over another one. The prepack firms have the most severe liquidity problem and the out-of-court firms, still, have the greatest operating performance. The results indicate that the adoption of New Bankruptcy Law in 2005 does not significantly affect the choice among the Chapter 11, prepack and out-of-court in terms of the degree of liquidity. 5.3. Creditor s Coordination Problem Thirdly, univariate analysis of the creditor s coordination problem is presented in table 6. It is measured by the ratio of account payable to total assets, number of long-term debt and the ratio of long-term contracts to total liabilities. [Insert Table 6 here] The variable account payable could be seen as a proxy for the number of creditors. The mean value of trade credit of Chapter 11 firms is 0.10, the same as that of prepack firms and greater than that of out-of-court firms. The differences are significant between Chapter 11s and out-of-court workouts and between prepacks and out-of-court workouts. Moreover, the number of long-term debt and ratio of long-term contracts to total liabilities are proxies for the degree of holdout problems. The larger number of long-term contracts, the higher probability of creditors coordination would be, and vice versa. It appears that the out-of-court firms have more long-term debt than prepacks and Chapter 11s, for the average number of long-term debt is 4.92. The value is 3.50 for prepacks firms and 2.94 for Chapter 11 firms. Although the differences are not significant, there are differences in the ratio of long-term contracts to total liabilities. Chapter 11 firms and prepack firms have significantly greater long-term contracts per dollar of debt, which suggests these two types of firms face the more serious holdout problem and creditor coordination situation could be hardly optimistic. 22
When take the second period into consideration, no significant difference can be found in all three measurements. It could be seen a difference which brought by the new bankruptcy law. The effect from holdout problem is not as significance as previous period. So far, I have studied the choice to restructure debt from three parts through traditional Chapter11 bankruptcy, prepackaged bankruptcy and out-of-court workout with univariate analysis. To conclude, the results suggest that firms with greater operating performance and more liquidity are more likely to choose out-of-court restructuring, and have the slightest level of creditors holdout problem. And firms doing the worst and suffered from holdout problem may file for Chapter 11 while prepackaged firms lie in the middle. 6. Multivariate Analysis The evidence of the characteristics of financially distressed firms that restructuring in three alternatively has been shown in the previous study. However, the limit of this methodology is also obviously, for it only provides the results from one perspective one step and, in other words, no marginal effect reflected. In realistic world, the situation is much more complicated that the choice of reorganization is always involved in several potential measurements simultaneously. Therefore, I conduct the multinomial logistic regression in this chapter to exam the reorganization choice of financially distressed firms. Same as previous presentation, the analysis is divided into two periods. Table 7 presents the results of multinomial logistic regressions. [Insert Table 7 here] The results of regressions calculate the probability that distressed firms choosing prepackaged bankruptcy or out-of-court workouts, rather than traditional Chapter 11 23
bankruptcy. The variables include market-to-book ratio (a proxy for capital structure and market expectation), the ratio of operating income to total assets (a proxy for operating performance), the ratios of current liabilities and long-term debt to total assets (proxies for debt structure), the ratio of accounts payable to total assets (a proxy for credit trade) and the ratio of long-term contracts to total liabilities (a proxy for creditors holdout problem). The six columns provide the results from the year 2000 to 2005, 2006-2010 and 2000-2010 and the results are consistent with the univariate studies. More specifically, from the year 2000 to 2005, one important determinant of preference towards different methods is operating performance. The firms undergoing out-of-court restructuring have significantly higher market-to-book ratio than firms choosing Chapter 11 bankruptcy, as well as the ratio of operating income to total asset. The performance of prepackaged firms is also better than the firms filing for Chapter 11, but worse than firms restructuring debt privately. This is consistent with Chatterjee, Dhillon, and Ramirez (1996), who argue that firms with greater performance are more likely to restructuring outside of court. The table suggests that degree of creditor s coordination is another determinant of choice of reorganization. More specifically, out-of-court firms have the greater ratio of long-term contracts to total liabilities than chapter 11 firms, so do the prepackaged firms but the difference is not so obvious. This finding is consistent with the hypothesis that firms filing for traditional Chapter 11 bankruptcy may face more severe coordination problem. However, the results do not support Jensen (1989) s conclusion that firms with larger proportion of debt are more likely to choose out-of-court restructuring. The table shows that the firms undergoing private reorganization have lower ratios of both current liabilities and long-term debt to total assets than Chapter 11 firms, but the 24
results are not significant. The marginal effect of the variables is not significant when comparing the difference between prepacks and Chapter 11, the reason may because the sample is not large enough and there may exists collinearity within the variables. From a vertical perspective, the first feature that distinguished between Chapter 11 and prepackaged bankruptcy is the proportion of current liabilities, the coefficient for the variable current liabilities to total assets is 3.38. But no significant variables are found, which can be interpreted that Chapter 11 bankruptcy and prepackaged bankruptcy are relatively similar in most aspects. Moreover, the variable accounts payable to total assets affects the choice between out-of-court workout and Chapter 11 bankruptcy most. When comparing two periods, one difference is that firms choosing prepackaged bankruptcy and out-of-court workouts show lower value of long-term contracts per dollar of total liabilities in the later five years. And for prepackaged firms, the market-to-book ratio and leverage are both lower than Chapter 11 firms. But from long term view (2000-2010), as the data presented from 2000-2010, the conclusion is similar with the previous results. 7. Conclusion Using a sample of 154 economic distressed firms from 2000 to 2010, I empirically study how these firms select to conduct debt reorganization among traditional Chapter 11 bankruptcy, prepackaged bankruptcy and out-of-court workout in this paper. In addition to examining the determinants of bankruptcy choice, I also look into whether there is change before and after 2005- the year Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) taken into effect. 25
The process and nature is different among Chapter 11, prepacks and private workout. Chapter 11 is a legal procedure which the debtors could benefit from the automatic stay provision, less strict voting rules and debtor in procession. Undoubtedly, it is costly both from time and money. Prepackaged bankruptcy is similar with Chapter 11 except for the negotiable with creditors in advance. And as a consequence, prepackaged firms give up the right of automatic stay. Out-of-court restructuring is the fastest and most costless procedure, compared with Chapter 11 and prepackaged bankruptcy. It is feasible, but on the other hand, the restructuring plan must be confirmed by all the claimholders. My study results estimate the determinants of bankruptcy choice from three aspects though univariate analysis. Firstly, I look into the income data the year before reorganization. I find that firms using out-of-court restructuring are more likely to have relatively greater operating performance than firms under Chapter 11 and prepackage bankruptcy. Secondly, out-of-court firms have the highest liquidity, then the prepack firms, and Chapter 11 firms seem to experience the most severe financial distress. Finally, the firms which urgently want to solve the creditors holdout problem may choose the Chapter 11 bankruptcy. The results support my three hypotheses and consistent with the previous study, also, they are reasonable in reality. If the debtors are facing desperately distress, managers may eager to stop the debt obligation immediately and require legal protection even it is costly. While in other situation, if a firm still has the ability to continuously operate and pay the debtor, the managers may negotiate with creditor privately. So the restructuring could be run fast and efficient. To examine the combination effect of the determinants, I structure two multinomial logistical regressions, setting Chapter 11 as base, to compare the differences. I find the most important determinant of the choice between Chapter 11s and prepacks is the leverage, and the portion of long-term debt affect the most between Chapter 11s and out-of-courts. 26