Optimal Capital Structure and Bankruptcy Choice: Dynamic Bargaining vs. Liquidation

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By Samuel Antill and Steven R. Grenadier (Stanford Graduate School of Business)

In this work, we develop and solve a continuous-time dynamic bargaining model of Chapter 11 reorganization. We include many features of the Chapter 11 process, such as the automatic stay, suspension of dividends, the exclusivity period, post-exclusivity proposals by creditors, and the potential for forced conversion to Chapter 7. The reorganized firm may issue new debt and continue operating. Moreover, both debtors and creditors face uncertainty over future asset values as they debate reorganization plans. We solve for the equilibrium and the corresponding expected payoffs to creditors and equityholders.

Using this equilibrium, we proceed to model a firm’s optimal capital structure decision in a framework in which the firm may later choose to enter either Chapter 11 reorganization or Chapter 7 liquidation. Creditors anticipate equityholders’ future reorganization incentives and price them into credit spreads when the debt is issued (ex ante). The implied capital structure results in both higher credit spreads and dramatically lower leverage than existing models suggest. Giving creditors more bargaining power in bankruptcy typically leads to higher leverage and ex ante firm value, consistent with empirical evidence. If reorganization is less efficient than liquidation, the added option of reorganization can actually make equityholders worse off ex ante, even if the firm is eventually liquidated.

The full article is available here.

Momentive: Law Firm Perspectives

On October 28, 2017, the United States Court of Appeals for the Second Circuit handed down its decision in In re MPM Silicones, L.L.C., holding that where an efficient market exists, the appropriate cram-down interest rate in Chapter 11 cases is the market rate, distinguishing the formula rate applied by the Supreme Court in Till v. SCS Credit Corp. in Chapter 13 cases. The Second Circuit wrote that “the market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.” The Second Circuit also disallowed the senior creditors’ claim for a make-whole payment, although the Third Circuit had allowed such a claim in In re Energy Future Holdings Corp.

Law firms have so far reacted unanimously that this decision is a win for secured creditors as it ameliorates the risk that unsecured creditors could extract value from the debtor at the secured creditors’ expense. Weil writes that “it seems like the Bankruptcy Court, now freed from Till, will find that an efficient market exists, and will adjust the interest rate on the replacement notes accordingly.”

Nevertheless, some firms predict that there may still be areas future controversy. Davis Polk warns that this decision “could result in expensive litigations between debtors and secured creditors as to whether there exists an efficient market and, if so, what the efficient market rate should be.” Norton Rose Fulbright also emphasizes that the next step for secured creditors is to focus on when an efficient market exists.

Firms have also noticed the decision’s implication for debtor-side strategy. Baker McKenzie suggests the possibility that “a debtor may engage in forum shopping to file its case in a jurisdiction that applies the formula approach,” or “be even more sensitive to the potential for exit financing quotes to be used as evidence against [debtors] in establishing a market rate.”

On the issue of the make-whole premium, Davis Polk highlights that the circuit split may increase forum shopping for distressed issuers with potentially significant make-whole obligations. It expects future issuers to draft clearly around the issue of make-whole obligation to provide for future Chapter 11 cases.

(By Jianjian Ye, Harvard Law School, J.D. 2018.)

Creditor Rights and Corporate Debt Structure Around the World

By Kose John (New York University & Temple University), Mahsa S. Kaviani (Temple University), Lawrence Kryzanowski (Concordia University), and Hosein Maleki (Temple University)

In this study, we document that the strength of creditor protection influences corporate debt structures. Using data from 46 countries, we find that managers choose more concentrated debt structures and use more bank debt relative to other debt types in countries with better creditor rights protection. The choice of more concentrated debt structures in the face stronger creditor rights is made for two main reasons.

First, more concentrated debt structures increase the probability that a firm can successfully renegotiate distressed debt with its creditors. Therefore, concentrated debt structures can reduce expected bankruptcy costs.

Second, better creditor protection reduces the creditors’ monitoring incentives. The managers can form more concentrated debt structures to boost the monitoring incentives of creditors when creditor rights are strong. This monitoring is beneficial for the firm, as it results in higher firm value by reducing the problem of risk shifting (investment in high-risk, negative net present value projects by managers when a firm has risky debt outstanding).

We confirm our cross-country findings in a difference-in-difference analysis of corporate debt structure’s response to creditor rights reforms in Brazil, France, Italy, and Spain. The results are robust to various controls, alternative dependent variables, endogeneity concerns, and alternative estimation methods. Our sample consists of 25,700 unique firms and spans from 2001 to 2014.

The full article is available here.

The Future of Solvency and Adequate Capitalization Analysis

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By Michael Simkovic, Seton Hall University School of Law

Valuation, solvency, and adequate capitalization analyses play a crucial role in corporate reorganization. Courts and bankruptcy professionals have often complained about the expense, delay, subjectivity, and unpredictability inherent in traditional approaches to valuation.

However, newer methods based on market prices for equity, debt, or options and derivatives are supplementing, and in some cases supplanting more established approaches. One proposal is that instead of looking to bond or equity prices, courts should look to credit spreads between corporate and treasury bonds. Because investors could eliminate almost all credit risk by selling a corporate bond and purchasing a treasury bond, the difference in yield between a corporate bond and a treasury bond must compensate investors for the additional risks of non-payment of corporate bonds.

Credit spreads offer a clear indicator of market actors’ expectations about the likelihood of default and the likely losses given default. With a single assumption about recovery rates—which can be grounded in historic data or sometimes backed out from contemporaneous market data—one can reconstruct a daily market estimate of a debtors’ probability of default.

Credit-spread based approaches are faster, less expensive, and more objective than current approaches. An example is provided below using data for Caesar’s Entertainment Operating Company:

 

Figure 1. Caesars risk-neutral market-implied probability of default from CDS and bond spreads (preliminary analysis).

 

The traditional financial analysis performed by the Examiner in Caesars required months of work and only looked at a few specific dates. The preliminary market-based analysis above was completed by a law professor in a few days, and indicates capital adequacy on a daily basis.

If market-based approaches to solvency analysis could be used with confidence in many large corporate bankruptcy cases, the collective savings to debtors’ estates over a decade could easily be in the tens of millions of dollars.

 

Earnings Management and Firm Value in Chapter 11

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Timothy C.G. Fisher, University of Sydney

Ilanit Gavious, Ben-Gurion University of the Negev

Jocelyn Martel, ESSEC Business School & THEMA

 

Earnings management occurs when managers deliberately manipulate the company’s earnings either to mislead stakeholders about the underlying economic performance of the company or to influence contractual outcomes. We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11.

Using the UCLA-LoPucki Bankruptcy Research Database, we merge a sample of 261 U.S. public firms that filed for Chapter 11 between 1995 and 2009 with firm-level financial information. We construct three measures of earnings management, two of which are accounting (accrual) manipulation measures (discretionary accruals and abnormal working capital accruals) and one a real activities manipulation measure (abnormal operating cash flows).

We find that upward earnings management (more positive or less negative abnormal accruals/operating cash flows) prior to filing significantly reduces the likelihood of confirmation, while downward earnings management significantly increases the likelihood of confirmation. We also find that the likelihood of emerging from Chapter 11 is significantly lower with upward earnings management. The impacts on confirmation and emergence are primarily due to the influence of earnings management values that are one- and two-standard deviations above or below the mean. Thus, our findings are consistent with creditors rewarding unduly conservative earnings reports while punishing overly optimistic earnings reports. We also find that auditor choice (Big 4 vs. non-Big 4) directly affects the probability of confirmation and of emergence from bankruptcy.

Overall, we find that upward management of earnings destroys economic value by making the survival of the firm less likely, an effect that has not previously been uncovered in the literature.

To access the full article, please click here.

The Effect of Executive Compensation on Recoveries

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By Andrea Pawliczek, Leeds School of Business, University of Colorado – Boulder

 

The structure of executive compensation will influence an executive’s behavior. For debt holders, this influence becomes especially important when a firm nears bankruptcy because this is when the debt holders’ value is at risk.

 

Consider the actions of an executive of a financially distressed firm depending on his compensation. As bankruptcy becomes likely, an executive with only equity compensation (i.e. stock and options) is likely to gamble for solvency as his wealth is entirely dependent on the firm’s stock price. For example, RadioShack, whose CEO had no debt-like compensation, undertook such a strategy, purchasing a 2014 Super Bowl ad for $4 million when the company was already in significant financial distress. Although the ad was popular and resulted in a 12% jump in the firm’s stock price the next morning, it did not help the fortunes of the company, which declared bankruptcy just over a year later on February 15, 2015.  Alternatively, an executive with debt-like compensation (e.g., pensions and deferred compensation) does not lose everything in the case of bankruptcy. This executive would have incentives to preserve firm value (i.e. assets that have value in liquidation or more value to the reorganized firm) to generate higher recoveries for himself and other debt holders in the event of bankruptcy.

 

While this prediction is established theoretically, there is no prior empirical evidence supporting this idea. Using a sample of 104 Chapter 11 bankruptcies of large public firms, I find that debt-like compensation – specifically Supplemental Executive Retirement Plans (SERPs) – is associated with higher recoveries to unsecured debt in bankruptcy. (SERPs are in almost all cases a form of unsecured debt that is at risk in bankruptcy. The only exception is if SERP assets are held in a secular trusts. Secular trusts are rarely used in compensation of executives at large public firms, however, because they result in the loss of tax deferral.) Recoveries to unsecured debt are 22% higher for a firm whose CEO holds sample mean levels of debt-like compensation compared to a firm whose CEO holds no debt-like compensation. I also document that debt-like compensation is associated with efforts to preserve more liquid assets prior to bankruptcy (e.g., cuts to research and development expenses).

 

The complete paper can be downloaded here.

Taking a Deeper Look into Momentive

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By Michael Vitti, Duff & Phelps

Much has been written about Momentive. Nevertheless, some relevant questions are not often addressed, if at all. I recently attempted to answer some of these questions in a recently published article:

How much economic value was taken from the secured creditors if one believes they should have received the market rate of interest?

The answer (almost $200 million) may be higher than some would have expected. This higher than expected number occurs because the cramdown interest rate decreased, while the market interest rate increased, between August 26, 2014 (the date analyzed in the bankruptcy court’s opinion) and October 24, 2014 (the date the debtor emerged from bankruptcy).

Is there a limit to the amount of implied lender’s costs, profits, and fees that should be removed from the market interest rate when determining the cramdown interest rate?

The answer must be “yes.” To demonstrate this point, consider the first lien debt, which was worth approximately $50 million less than face value on August 26 and approximately $140 million less than face value on October 24. Did the lender’s implied costs, fees, and profits almost triple between August 26 and October 24? Not likely. This is perhaps the simplest way to demonstrate the need for a limit.

Could future courts use the same methodology employed in Momentive yet arrive at the market interest rate by making a reasonable change in one or two assumptions?

The answer appears to be “yes.” Use of the historical average spread between the 7 year treasury and prime rate (instead of the 50 basis points used in Momentive) results in the market interest rate as of August 26. Combining that change with an increase in the credit risk premium to the high end of the range referenced by the plurality in Till (300 basis points) results in the market interest rate as of October 24.

The full article is published in NACVA’s QuickRead. Part 1 is available here while Part 2 is available here.

 

Cram-down interest rates in controversy

posted in: Cramdown and Priority, Valuation | 0

By Maxwell Tucker of Squire Patton Boggs

The correct method to determine the adequacy of the “cram-down” interest rate offered under a contested Chapter 11 plan remains subject to debate.  Most bankruptcy courts first cite the “prime plus” formula set forth in Till v. SCS Credit Corp., 541 U.S. 465 (2004)(plurality opinion), then refer to various risk factors that may require an upward adjustment from the prime rate.

The recent bankruptcy court opinion issued in In re Couture Hotel Corporation, found in my blog post linked here, provides an excellent roadmap for parties contesting cram-down interest rates.  The debtor’s Chapter 11 plan proposed to repay the loan with principal and interest amortized over thirty (30) years, and proposed that interest shall accrue at the rate of 4.25% interest per annum.  The lender objected to the plan, contending that an interest rate in excess of 10% was required.  Both parties offered expert testimony in support of their contentions.

For reasons explained in the opinion, the bankruptcy court disagreed with each expert’s testimony.  The sixty-two page Couture Hotel opinion, rich in fact findings, provides detailed reasons for the court’s rejection of the respective experts’ risk adjustments, while refraining from giving an advisory opinion as to what interest rate would be adequate.

New AIRA Standards on Distressed Business Valuation

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By Michael D. Pakter, Gould & Pakter Associates, LLC

Michael_D._PakterGiven the increasing number of professionals who are performing business valuation engagements, the Association of Insolvency & Restructuring Advisors approved Standards for Distressed Business Valuation (“AIRA Standards”), effective March 1, 2014, to improve the consistency and quality of practice among its members.

In Part 1 of a 2 part article, the author submits that the selection of applicable valuation standards is impacted by the valuation analyst’s professional certifications, his or her association memberships and credentialing, the asset, business, or interest being valued and the applicable forum. The author provides an overview of the AIRA Standards on distressed business valuations and shares views on what standards business valuation professionals should consider in a distressed business valuation engagement.

In Part 2 of the 2 part article, the author discusses some of the unique issues regarding valuations of distressed businesses relating to engagement development, procedural steps in the business valuation engagement, and generally accepted valuation approaches. The AIRA Standards note that traditional valuation methods may require significant adjustments to reflect the unique financial or operating issues associated with a firm in distress, the legal context of the valuation and the intended purpose of the valuation.

The author concludes that despite the widespread use by business valuation analysts of a specific company risk premium in a “build­up” or “capital asset pricing model” there remains limited academic research on quantification of specific company risk premiums, which generally remains in the realm of the financial analyst’s judgment.

To read the full article see Part 1 and Part 2.

The Weakest Link in Intercreditor Agreements Breaks Again in Momentive

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By Lawrence Safran, Mitchell A. Seider, Keith A. Simon, and Adam J. Goldberg of Latham & Watkins LLP

Intercreditor agreements among secured creditors with respect to common collateral are often limited to lien subordination, as opposed to claim subordination. The agreement governs each secured creditor’s rights over the common collateral, without imposing claim subordination, which would require junior creditors to subordinate their claims and turn over all of their recoveries, whether or not derived from proceeds of collateral. Intercreditor agreements that provide only for lien subordination typically include a reservation of rights for junior creditors to retain all of their rights as unsecured creditors; however, the formulation of this reservation varies from agreement to agreement, and the exact language used can be critical in a court’s analysis.

The recent decision in In re MPM Silicones, LLC, Case No. 14-22503 (RDD) (Bankr. S.D.N.Y. Sept. 30, 2014) (Momentive) reflects the emerging trend of courts to narrowly interpret restrictions on junior creditors in these intercreditor agreements, where the restrictions are ancillary to the distribution of the common collateral’s value. In Momentive, the Bankruptcy Court found that the general reservation of rights as unsecured creditors serves to “ameliorate obligations that [junior secured creditors have] undertaken elsewhere in the agreement.”

This article explores recent case law arising from disputes over intercreditor agreements before bankruptcy courts, the issues and rulings in Momentive, and lessons that market participants should draw from the decision.

To read more, click here.

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