Financial Distress and Restructuring Models

By Chen, Yehning; Weston, J. Fred et al. | Financial Management, Summer 1995 | Go to article overview

Financial Distress and Restructuring Models


Chen, Yehning, Weston, J. Fred, Altman, Edward I., Financial Management


The basic social motivation for the legal, bankruptcy-reorganization process is to preserve organization value. One of the primary purposes of bankruptcy law is to facilitate the restructuring of financially distressed firms. The laws seek to provide a recontracting process that enables firms to once again invest in value-creating opportunities. Or, where liquidation values are greater than the going-concern evaluation, firms should be forced to liquidate or be sold to some other entity where this inequality is reversed. Many issues in this recontracting process have been identified. Can the distress be removed and a positive going-concern value be re-established, or will liquidation result in a higher value? How can the interests of the central parties (owners, managers, creditors, employees, and consumers) be balanced? What are the effects on security prices and claims of owners, creditors, and other stakeholders?

In recent years, the legal rules for bankruptcy, reorganization, and other recontracting processes have been reassessed. Proposals have been made to change the 1978 Bankruptcy Code (or, indeed, to eliminate the Chapter 11 reorganization option entirely), which prevails in the United States, as well as to reform the bankruptcy laws of many other countries. Issues of legal reform have been analyzed by Adler (1992), Bebchuk (1988), Bradley and Rosenzweig (1992), and Roe (1983), among others.(1) These reform proposals have been criticized by Altman (1993a), Bhandari and Weiss (1993), LoPucki (1992), Warren (1992), and Whitman (1993).(2)

Some central analytical issues raised by the bankruptcy process include: 1) the time in bankruptcy; 2) the effects on security prices preceding, during, and after the relevant "bankruptcy announcement" date; 3) default losses; 4) application of absolute priority versus relative priority rules; 5) managerial incentives and the effects on managerial turnover and executive compensation; 6) the role of exchange offers; and 7) the performance of the firm after emerging from bankruptcy proceedings. Our understanding of the relationships among these elements has been advanced by the development of formal models of financial distress by Altman (1993b), Berkovitch and Kim (1990), Brown, James, and Mooradian (1993), Bulow and Shoven (1978), Diamond and Dybvig (1983), Franks and Torous (1989), Gertner and Scharfstein (1991), Giammarino and Nosal (1994), Hart and Moore (1994), Heinkel and Zechner (1993), Jensen and Meckling (1976), John (1993), Myers (1977), and Scott (1981).(3) Empirical evidence has been gathered on the issues set forth.(4)

The theoretical literature on financial distress is couched in complex models. However, the underlying concepts are straightforward and can be conveyed by relatively simple models. Also, despite their apparent generality, the predictions of the theoretical models are dependent upon their underlying (explicit or implicit) assumptions or postulates. This will be clear from our analysis. Our discussion is organized into seven sections. Section I provides a general framework. Section II develops base case formulations. Section III examines how debt maturity can affect investment efficiency. Section IV allows the firm to alter the seniority of its claims holders. Section V analyzes the role of exchange offers. Section VI introduces financial intermediaries into the bankruptcy process. Section VII develops several important implications concerning how the bankruptcy process should operate. Section VIII furnishes concluding remarks.

I. General Framework

The literature depicts three major players in the financial distress game: the shareholders (equity holders), banks (more generally financial institutions), and public debtholders. The literature aligns the goals of managers with those of the shareholders, an underlying assumption that focuses the analysis and that we follow. Banks (financial institutions) are defined as debtholders with whom the shareholders can directly negotiate. …

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