Financial Reorganization under Pro-creditors Bankruptcy Laws

Financial Reorganization under Pro-creditors Bankruptcy Laws Gilles Recasens Designation of authors/Position: Gilles Recasens, Maître de Conférences Organization/University: University of Pau, CREG Complete Postal Mailing Address: IAE, avenue de l’Université, BP 576, 64012 Pau Cedex Contact Phone: 06 86 41 06 32 Email Address: gilles.recasens@free.fr JEL Classification: G330, K400 Abstract This article try to highlight the bankruptcy problem through, i) the characterization of the different approaches on the question, ii) the assessment of reorganization procedures in two particular bankruptcy systems. In fact, two main approaches on bankruptcy prevail around the world. On the one hand, pro-debtor systems are centered on the firm rescue and on the social consequences of bankruptcy. On the other hand, pro-creditors ones try to ensure a high protection of creditors interests and a strict application of financial contracts. These approaches have to be analyzed in the framework of the financial theory and in relation with the debate on the ex-post and the ex-ante efficiency of the bankruptcy system. Finally, the existing empirical results in Canada and in United-States tend to confirm that pro-creditors systems do not obtain worse results than the pro-debtor ones. This is very interesting because we could a priori fear a lot of inefficient reorganizations in tougher approaches. Key-words: bankruptcy, pro-debtor or pro-creditors systems, reorganization procedures, incentives, efficiency. Financial Reorganization under Pro-creditors Bankruptcy Laws Introduction The bankruptcy problem is recurrent in corporate finance. This question is linked with the crucial problematic on the financing and the investment choices. The modern financial theory shows that these choices are not independent in the framework of imperfect financial markets. The theory traditionally refereed to the distress problem throughout the bankruptcy costs. The recent literature underlines many other crucial points about bankruptcy. One of them is the choice to do between a pro-creditors approach of the problem and a pro-debtor one. In fact, the question is to determine the optimal bankruptcy system. The legislator can opt for a greater protection of the creditors interests or, on the contrary, for the protection of the debtor-in-place ones. Is this question important for the financial theory and for the businesses? The answer is clearly positive. Obviously, the bankruptcy problem is really interesting for the businesses point of view and for the society as a whole. It is clear that firm failure can entail numerous consequences on labor forces, inter-firms relations, financial markets, for example. We can also fear that bankruptcy can implies social costs, like unemployment costs or economic perturbations due to the disappearance of an economic partner, for example. But, the bankruptcy question also contains numerous interesting points for the financial theory. For example, we can imagine that relations between the financing and the investment decisions can be exacerbate in a bankruptcy framework, that is, a crisis between borrowers and lenders. What are the consequences of such a crisis? What is the best solution for the failing firm? What is the better bankruptcy system to implement this solution? 1 The first interest of this article is to characterize the different existing approaches on bankruptcy using a few examples on the real choices made in France, United-States, Canada, Great-Britain and Sweden. The idea is to replace this choices in the general framework of the financial theory. As we will seen, there exist two main approaches of the problem. On the one hand, the objective of pro-debtor systems, like the French or the American ones, is to rescue the failing firm so as to preserve employment and to alleviate all the other social consequences of the bankruptcy. On the other hand, in pro-creditors systems, like in Canada, Great-Britain or Sweden, the objective is to grant creditors a high level of protection and to enforce more strictly financial contracts. The second interest of this analysis is to compare the existing empirical results obtained in Canada, a pro-creditors system, and in United-States, a pro-debtor one. The comparison will integer criteria like the reorganization delay, the direct bankruptcy costs, the deviations from the Absolute Priority Rule, the recuperation rate, the success of reorganizations and the filtering errors that may occurs in the judge’s decisions. The comparison will show that the Canadian system entails relatively good results and allow to reorganize many distressed firms although one might a priori fear a lot of inefficient liquidations in such a system. This is really questioning for the existence of soft bankruptcy laws. The article is organized as follows. The section one will present some existing bankruptcy frameworks in the world. The section two will rely these legal frameworks with the financial literature on bankruptcy. The last section will discuss the empirical results obtained in Canada and United-States. I. Pro-debtor vs pro-creditors bankruptcy frameworks It is useful to tempt a comparison on existing bankruptcy systems around the world (see figure 1). Our objective is not to achieve a compilation of all the bankruptcy systems in place, but to characterize some existing approaches with a few examples. That’s why we will focus on French, American, British, Canadian and Swedish systems which represent some particular approaches on bankruptcy. 2 In practice, we can observe the existence of two types of bankruptcy systems. On the one hand, pro-debtor systems try to favor the firm rescue and to minimize the social consequences of bankruptcy. Such systems rely on the idea that the disappearance of distressed firms can entails social costs as unemployment costs, economic perturbations in businesses, and maybe other failures (contagion effect for suppliers). French and American systems are good examples of pro-debtor approaches. In France, the first objective of the bankruptcy law is to save the failing firm. The second objective is to preserve employment. The third objective is to reimburse creditors. Obviously, this reimbursement objective is a residual one because saving the firm and preserving employment imply some concessions from creditors. In United-States, the debtor-in-place has the possibility to seek for the court protection in engaging a Chapter Eleven procedure. He can so propose a reorganization plan. In pro-debtor systems, the law grants a lot of powers to the bankruptcy judge. In France, he has the discretionary power to decide to reorganize or to liquidate the firm without a creditors vote for the approbation of the reorganization plan. In UnitedStates, creditors can vote the plan (Unanimous Consent Procedure) but the judge can decide to force its approbation against creditors advice (Cram-down Procedure). The idea is that the judge, who is assumed to be impartial and independent, makes its decisions in the whole society interests and not in creditors or debtor particular ones1. An other provision of French and American bankruptcy laws is the better priority granted to new financing, that is, loans or trade-credits provided after the distress is revealed. The spirit of such a provision is to facilitate the rescue of the failing firm thanks to new financing from banks or suppliers and to avoid contagion effects in maintaining the firm in operations. But, banks or suppliers who accept to grant new financing enhance their global risk. So, rescuing the firm is more crucial for them. Pro-debtor systems that deliver incentives for new financing can be viewed as riskier systems simply in the sense that if the reorganization plan fails, more creditors claims will not be reimbursed. On the other hand, pro-creditors systems seek for a higher protection for creditors rights and a strict application of financial contracts. In this spirit, the debtor-in-place is often dismissed and the failing firm is liquidated. This is particularly the case in Sweden which represents an extreme example of pro- 3 creditors approaches. In this country, there only exists a liquidation procedure in practice2. The distressed firm is systematically sold in the framework of a piecemeal liquidation or as going concern. The British law is even a good example of tough bankruptcy approaches. As in Sweden, the debtor-in-place is systematically expropriated from its firm. The law grants sufficient powers to secured creditors to often imply liquidation. The Administration procedure (that is the name of the reorganization procedure in Great-Britain) is rare in practice because creditors have many possibilities to prevent it. They can use the no automatic stay provision to appoint a receiver in the aim to take possession of securities. Of course, this often entails the firm liquidation. The Canadian case is slightly different. It is an example of a procreditors approach with a possibility of reorganization. At the difference of the Swedish and the British cases, in Canada, the debtor-in-place is not directly expropriated. He can propose a reorganization plan designed with the systematic help from a professional administrator. The plan is voted by creditors and has to be confirmed by the bankruptcy court. To be acceptable, the plan has to respect some restrictive provisions about creditors rights such as, for example, reimbursing in integrality secured claims. Moreover, there is no automatic stay in reorganization for secured creditors. So, even if the law gives to the debtor-in-place a possibility of rescuing the firm, we can consider that there is no place for him to behave opportunely. This is the great difference between the Canadian system and the French and American ones that can be viewed as more permissive. In Canada, the administrator and creditors can exercise more control and the judge has no discretionary power as in France and United-States to impose violations on creditors rights. Before analyzing reorganization plans results in pro-creditors and pro-debtor systems, it can be interesting to make an overview about the financial problematic fields in relation with the bankruptcy process. This is the aim of the following section. 4 II. The bankruptcy process Bankruptcy is a hard puzzle to solve because of many contradictory effects (see figure 2). In fact, as we will shown below, the bankruptcy process asks two great questions about the ex-ante efficiency of the system and the ex-post one. On the one hand, we can wonder if the bankruptcy system is sufficiently well designed to avoid ex-post inefficiencies? On the other hand, we can be worry about incentives delivered by the bankruptcy system to the debtor-in-place and its creditors ex-ante? As we will seen, these questions are not independent. We could also consider a third great question about the choice between informal workouts or formal procedures. Private arrangements provide a lot of advantages such as confidentiality or more freedom in re-contracting. But, formal procedures are useful in the sense that they imply the participation of all the creditors in the reorganization process. The main disadvantage of informal procedures rely on a hold-out problem. Some creditors, in anticipating the workout success, could be incited not to participate to renegotiations in the aim to benefit from their success, without participating to their costs [Gertner and Scharfstein, 1991]. Obviously, such a behavior can entail the failure of all the reorganization process. Other creditors can anticipate this attitude and adopt it as well. Formal procedures avoid such problems. That’s why we will now deliberately focus on them3. The ex-post efficiency of the bankruptcy system is really a great question. How could we justify a non natural ending for the firm failure (that is a liquidation due to the financing contract breach) if we assumed that the reorganization solution could be inefficient? Effectively, pro-debtor approaches are often justified by the existence of liquidation costs that can be sufficiently high to see the reorganization as a less costly solution. Liquidation costs, that come from assets specificity or informational asymmetry [Schleifer and Vishny, 1992], can prevent from selling the firm at the better price. That’s why the reorganization can be a better issue. But, it is really a difficult task for the bankruptcy judge to determine going concern and liquidation values of the distressed firm. So, he can make some filtering errors. In fact, he can reorganize an inefficient firm (a non economic viable one) or liquidate an efficient firm (economically viable). This proceeds respectively in Type I and Type II filtering failures [White, 1994, 5 Fisher and Martel, 1999]. Reorganizing the firm is the good solution only if there exists no better industrial alternative for the assets. Type I errors imply the loss of such a value and to bear the cost of a distortion in competition. Type II errors entails unemployment costs, economic perturbations costs due to the disappearance of a valuable partner in businesses, the loss of the going concern value. The design of optimal bankruptcy systems is really a difficult question because of all the above reasons and the crossing ex-ante and ex-post effects of the law. For some, the main objective of law is to avoid inefficient reorganizations in the aim to deliver to managers sufficient incentives ex-ante to well behave [Aghion, Hart and Moore, 1992]. The crucial role of the bankruptcy system is so its disciplining effect. This analysis is directly in relation with the over-investment question [Jensen and Meckling, 1976]. A tougher bankruptcy approach is assumed to diminish incentives to over-invest before distress. This effect minimizes the bankruptcy risk. For others, the law has to be biased in favor of the debtor-inplace, in giving a reorganization possibility, so as to enhance its incentives to invest sufficiently ex-ante in developing specific human capital for leading the firm [Berkowitch, Israel and Zender, 1994]. Such an investment prevent from failure. This is directly in relation with the under-investment problematic [Myers, 1977]. A softer bankruptcy system should enhance incentives to undertake valuable investment projects. Finally, the optimal bankruptcy system can be viewed as a device that balances ex-post the bargaining powers of the debtor-in-place and its creditors so as to preserve ex-ante their incentives to well behave [Recasens, 2001]. Governments regulations have to take into account all these crossing ex-ante and ex-post effects to opt for or against a pro-creditors bankruptcy system. An other important argument is as follows. We can fear that credit rationing is more severe in pro-debtor systems [Biais and Recasens, 2001]. Creditors are more incited to grant new loans if their interests benefit from a better protection. III. Empirical results in United-States and in Canada It can be insightful to compare the reorganization results in United-States, which represents an example of pro-debtor bankruptcy systems, and in Canada, which represents a pro-creditors approach (see table I). As 6 we will seen below, the results obtained in Canada are not globally worse than the American ones. This is really questioning for the interest of soft bankruptcy laws. The time spent in reorganization is lower, on average, in Canada than in United-States: 14 months [Fisher and Martel, 1999] against 25 [Eberhart, Moore and Roenfelt, 1990] at 30 months [Weiss,1990]. An advantage of the Canadian law is the more restrictive reorganization framework that imposes to the debtor-in-place less opportunities to differ the creditors vote. This results in a shorter procedure, on average. However, the direct bankruptcy costs are higher in Canada: 22,5% [Fisher and Martel, 1999] against 2,8% [Weiss, 1990]. This is a priori surprising because we could expect the contrary from a system that implies less time spent in reorganization. But, the Canadian bankruptcy law imposes to the debtor-in-place the assistance of a professional to design the reorganization plan. This provision does not exist in the American law. That can explain the difference in the observed direct bankruptcy costs. Nevertheless, we could think that such an assistance, although costly, can be crucial for the firm rescue. In United-States, frequent violations of the Absolute Priority Rule are observed: from 70% [Franks and Torous, 1989] to 78% of the cases [Weiss,1990]. This is due to the bargaining power given to the debtor-in-place by the law. He can use the provisions of the law to threaten the creditors to delay the reorganization achievement in the aim to extract more concessions. On average, the deviations represent 7,6% of the ex-post payments [Eberhart, Moore and Roenfelt, 1990]. Such violations are not possible in Canada because the law imposes a strict application of the Absolute Priority Rule for the court ratification of the reorganization plan. Moreover, the law does not give to the debtor-in-place so possibilities to behave opportunely in the reorganization process. The recuperation rate seems to be higher in United-States: 51% [Franks and Torous, 1994] against 38%4 [Fisher and Martel, 1999] of the face value of the claims. However, these results have to be interpreted in relation with the success rate of the reorganization plans. In United-States, 40% of the firms emerging from a formal reorganization face losses three years after the plan completion and 32% of them enter in a second reorganization procedure [Hotchkiss, 1995]. In Canada, we can note that 70% of the 7 reorganization plans are accepted and that 72% of them are achieved [Fisher and Martel, 1999]. So, only 28% of the accepted plans fail in Canada against 32% in United-States. These performances are not really so different. But, i) the Canadian system, although tougher, does not result in more failures in reorganization plans, ii) the announced recuperation rates in Canada and United-States have to be moderated by these failure levels. Finally, the chances to reorganize a non viable firm (Type I error) are higher in Canada than in United-States: the probability of such an error exceed respectively 44% against 10% [Fisher and Martel, 2000]. This result is really counter-intuitive because we could expect a higher level of Type I errors in a pro-creditors system than in a pro-debtor one. Moreover, the chances to liquidate a viable firm (Type II error) are higher in United-States than in Canada: the probabilities of such an error are respectively limited to 91% and 28%. This result is really surprising too. We could a priori expect a higher level of Type II errors in a pro-creditors system and a lesser one in a softer approach. To explain these results we can think that the American creditors have to develop a reputation of toughness ex-post so as to mitigate the softness of the law, in the aim to incite the debtor-in-place to well-behave ex-ante. This attitude results in lesser level of Type I errors and a higher level of Type II errors. In Canada, the higher protection of creditors interests let them to be more lenient. This results in a higher level of Type I errors and a lesser level of Type II errors. Even in case of failure in the reorganization process, the Canadian creditors can expect from the law a sufficient protection to enforce their rights. So, we can think that a tougher law enhances the chances to rescue the distressed firm in delivering incentives to creditors to be more lenient. Conclusion Finally, the empirical results obtained on reorganization procedures in Canada, a pro-debtor system, and in United-States, a pro-debtor one, highlight the debate on the bankruptcy problem. As we seen, two main approaches on this question are in opposition. On the one hand, the pro-debtor position relies on the idea that it is essential to rescue the distressed firm and to alleviate the social consequences of bankruptcy. On 8 the other hand, the pro-creditors position is funded on the research of a higher protection for the creditors rights and on the strict application of financial contracts. In fact, this debate has to be replaced in the more general question of the trade-off to be found between the ex-post and the ex-ante efficiency of the bankruptcy system. The issue ex-post, for the bankruptcy judge, is to take good decision in the aim to avoid filtering errors and to balance the bargaining powers of the debtor-in-place and its creditors. This is directly linked with the question on how to deliver incentives to well-behave ex-ante and to ensure investment project financing. The Canadian example shows that a pro-creditors system can really be competitive to ensure the firm reorganization. The empirical results in Canada are globally not worse than the United-States ones. It is shown that it is possible to reorganize a lot of firm in a pro-creditors approach. The creditors can be more lenient with the distressed firm because they are well protected. So, the chances to rescue the firm are enhanced in such a system. This is a very interesting result because we could a priori fear a lot of inefficient liquidations in a tough bankruptcy law. But, why there exist soft bankruptcy approaches if the tougher ones are so efficient? We wonder if the under-investment problem is not crucial to answer to this question. Is the fight against the lack of sufficient incentives to undertake new investment project the real explanation of the existence of soft bankruptcy laws, above all, in countries where the entrepreneurial spirit is not very developed? This question will be the source of further researches. 9 Appendix Table I : empirical reorganization results in United-States and in Canada Reorganization delays Bankruptcy costs Absolute Priority Rule (APR) deviations Creditors reimbursement rate Success rate Filtering errors (reorganizing non viable firms) Filtering errors (liquidating viable firms) Canada Fisher and Martel [1999, 2000] On average, this delay is 25 months for 50 days on average between the plan Eberhart, Moore and Roenfelt [1990], 29 proposition and the creditors vote (plus months for Franks and Torous [1994], 30 one month for the court ratification). 14 months for Weiss [1990]. In these months on average for the creditors studies, the achievement of the reimbursement, to ten years for the plan reorganization plan can respectively be : completion. six, thirteen and eight years. Direct costs : 2,8% of the asset book 22,5% of the asset book value. value (when the firm fails) for Weiss [1990]. Indirect costs: between 10 and 23% of the firm market value for Andrade and Kaplan [1998]. There exist violations: in 70% of the cases for Franks and Torous [1989], 78% of the cases for Weiss [1990]. For Eberhart, Moore and Roenfelt [1990], on average, the deviations in favor of the shareholders represent 7,6% of the expost payments. Creditors benefit from 51% of the facial Juniors can benefit, on average, from value of their claims, for Franks et 38% of the facial value of their claims. Torous [1994]. For Hotchkiss [1995], 40% of the firms 70% of the reorganization plans are emerging from a formal reorganization accepted. 72% of them are achieved. So, face losses three years after the plan 50% of the plans are successful. completion. 32% enter in a second reorganization procedure. For Fisher and Martel [1999], the The likelihood to reorganize a non viable likelihood to reorganize a non viable firm are between 44% to 100%. firm are between 10% to 100%. For Fisher and Martel [1999], the The likelihood to liquidate a viable firm likelihood to liquidate a viable firm are are between 0% to 28%. between 0% to 91%. United-States 10 Figure 1: pro-creditors vs pro-debtor bankruptcy systems Pro-creditors systems Pro-debtor systems Sweden Great-Britain Canada United-States France Debtor-in-place is dismissed Failing firms are sold Debtor-in-place is dismissed 2 collective procedures (liquidation and administration) and 2 private (receivership and administrative receivership) No automatic stay Debtor-in-place can propose a reorganization plan under administrator assistance Creditors vote the plan No automatic stay for secured creditors 2 procedures (Chapter Eleven vs Chapter Seven) Debtor-in-place can propose a plan Better priority for new financings Creditors vote the plan Judge can impose the plan (cramdown procedure) Continuation, cession, liquidation, règlement amiable Objectives : save the firm and preserve employment Better priority for new financings Creditors cannot vote the plan Important powers granted to the judge Seeking a higher protection for creditors interests Enforcing financial contracts Rescuing the distressed firm Alleviating the social consequences of bankruptcy 11 Figure 2: the bankruptcy process Hold out problem [Gertner and Scharfstein, 1991] Informal reorganization Financing Investment Distress Reorganization Formal procedures Liquidation Credit rationing is more severe in pro-debtor systems [Biais and Recasens, 2001, La Porta and al, 1997, 1998] Over-investment [Jensen and Meckling, 1976] Under-investment [Myers, 1977] To avoid inefficient reorganization [Aghion, Hart and Moore, 1992] To bias the law in favor of the debtor-in-place [Berkowitch, Israel and Zender, 1994] To balance negotiating powers [Recasens, 2001] Assets specificity and informational asymmetries entail liquidation costs [Schleifer and Vishny, 1992] To avoid filtering failures [White, 1994, Fisher and Martel, 1999] Ex-ante incentive effects of the bankruptcy system 12 Ex-post efficiency of the bankruptcy system References Aghion P., Hart O., Moore J. [1992], « The Economics of Bankruptcy Reform », The Journal of Law, Economics and Organization, July, 523-546. Andrade G., Kaplan S.N. [1998], « How Costly is Financial (Not Economic) Distress ? Evidence from Highly Levereged Transactions that Became Distressed », The Journal of Finance, vol 53, n°5, 14431494. Berkovitch E., Israel R., Zender J.F. [1994], « The Design of Bankruptcy Law: A Case for Management Bias in Bankruptcy Reorganizations », working paper, University of Michigan. Biais B., Recasens G. [2001], « Corrupt Judges, Upwardly Mobile Entrepreneurs and Social Costs of Liquidation : The Political Economy of Bankruptcy Laws », working paper, Université de Toulouse I, Université Bordeaux 1. Eberhart A.C., Moore W.T., Roenfelt R.C. [1990], « Security Pricing and Deviations from Absolute Priority Rule in Bankruptcy Proceedings », The Journal of Finance, vol 45, n°5, 1457-1469. Fisher T.C.G., Martel J. [1999], « Should We Abolish Chapter 11 ? Evidence from Canada », Journal of Legal Studies n°28, 233-257. Fisher T.C.G., Martel J. [1999], « Empirical Estimates of Filtering Failure in Court-Supervized Reorganization », document non-publié, THEMA, Université de Cergy-Pontoise. Fisher T.C.G., Martel J. [2000], « The Bankruptcy Decision : Empirical Evidence from Canada », document non-publié, THEMA, Université de Cergy-Pontoise et Université Wilfrid Laurier. Franks J.R., Torous W.N. [1989], « An Empirical Investigation of US Firms in Reorganization », The Journal of Finance, vol 44, n°3, 747-767. Franks J.R., Torous W.N. [1994], « A Comparison of Financial Recontracting in Distressed Exchanges and Chapter 11 Reorganizations », Journal of Financial Economics, vol 35, n°3, 349-370. 13 Gertner R., Scharfstein D. [1991], « A Theory of Workouts and the Effects of Reorganization Law », Journal of Finance, vol 46, n°4, 1189-1222. Gilson S.C., John K., Lang L. [1990], « Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default », Journal of Financial Economics, vol 27, n°2, 315-353. Hotchkiss E.S. [1995], « Postbankruptcy Performances and Management Turnover », The Journal of Finance, vol 50, n°1, 3-22. Jensen M.C., Meckling H. [1976], « Theory of the Firm: Managerial Behavior, Agency Cost and Ownership Structure », Journal of Financial Economics, vol 3, 305-360. Myers S.C. [1977], « Determinants of Corporate Borrowing », Journal of Financial Economics, vol 5, 147-175. Recasens G. [2001], « Aléa moral, financement par dette bancaire et clémence de la loi sur les défaillances d’entreprises », Finance, vol 22, n°1. Shleifer A., Vishny R.W. [1992], « Liquidation Values and Debt Capacity: A Market Equilibrium Appoach », The Journal of Finance, vol 47, n°4, 1343-1366. Thorburn K.S. [2000], « Bankruptcy Auctions : Costs, Debt Recovery and Firm Survival », à paraître, Journal of Financial Economics. Weiss L.A. [1990], « Bankruptcy Resolution: Direct Costs and Violations of Priority of Claims », Journal of Financial Economics, vol 27, 285-314. White M.J. [1994], « Coporate Bankruptcy as a Filtering Device : Chapter 11 Reorganizations and Outof-Court Debt Restructurings », Journal of Law, Economics and Organizations, vol 10, 268-295. 14 Footnotes 1 See Biais and Recasens [2001] for an analyze of judge corruption on bankruptcy issue. See Thornburn for an analysis of bankruptcy in Sweden. The law consider the possibility to reorganize the firm. The 2 procedure is called Composition. But in practice, a lot of other provisions of the bankruptcy law deter from its application. 3 See Gilson and al [1990] and Franks and Torous [1994] for good analysis of compared advantages of informal vs formal reorganization procedures. 4 These numbers relate some promised payments and not some achieved ones. 15