Disagreement and Capital Structure Complexity

By Kenneth Ayotte (University of California, Berkeley School of Law)

Complex capital structures are prevalent in many recent high-profile Chapter 11 bankruptcy cases.  One recent example is Toys ‘R’ Us, whose debt structure included dozens of subsidiary entities, with separate debt facilities against entities owning the intellectual property, the real estate, and international operations, among other asset groups.  Why do capital structures become fragmented and complex in this way, and what are the implications for bankruptcy law?

In my working paper, I suggest one reason why a firm’s owners may have the incentive to engineer fragmented capital structures, using the idea that investors may disagree about the values of the various assets that make up the firm.  Fragmenting the capital structure horizontally—that is, pledging different assets and asset groups to different creditor classes—allows the firm to sell asset-based claims that are targeted to the investors who value those assets most highly. This targeting is good for the firm’s owners, because it minimizes the firm’s overall cost of capital.

This complexity can become costly, however, when firms encounter financial distress.  The same disagreement-driven fragmentation that allows the company to borrow more cheaply up front can lead to costly valuation disputes in and around bankruptcy, since creditors place a higher valuation on their own collateral than do the other creditors.  This can lead to valuation disputes that are socially costly in terms of professional fees, delays, and lost opportunities.  An example of this is the Energy Future Holdings case.  Following it’s 2007 leveraged buyout, the capital structure was divided into two silos, with one silo of entities (called the “E” side) holding regulated power assets, and a separate silo of entities holding the non-regulated power assets (the “T” side), with separate creditor groups on each side.  The initial plan to avoid bankruptcy by converting E- and T-side debt into parent-level equity failed after more than a year of negotiations, as the two sides could not come to agreement about the relative value of the two sides.  The resulting bankruptcy took over four years to reach plan confirmation and generated over $500 million in professional fees, to the detriment of creditor recoveries.

The theory has several implications.  One is that disagreement about valuation can lead to inefficient liquidation of viable firms, as creditors may prefer to walk away with the collateral they value highly, rather than fight for that value in a reorganization where the other creditors (from their perspective) are clinging to inflated valuations of their own collateral.  These kinds of forces may have been at play in the Toys ‘R’ Us case.  The B-4 term lenders, including the hedge fund Solus Alternative Asset Management, believed they were better off monetizing their intellectual property collateral in a liquidation of Toys ‘R’ Us than backing a deal to keep existing stores open.  The recent cancellation of the auction of this collateral suggests that these lenders may have held optimistic beliefs than the marketplace about the value of these assets.

From an academic standpoint, the theory provides a new answer to a long-standing question in the literature: why do we need a corporate reorganization mechanism in the first place? Traditional answers to this question revolve around the need to solve illiquidity problems.  In the presence of disagreement, I suggest an alternative benefit.  A traditional Chapter 11 reorganization allows parties to walk away with securities backed by the assets they financed before bankruptcy, about which the creditors are likely to be more optimistic.  Thus, the creditors can continue “agreeing to disagree” about the values of their respective pieces, thus promoting settlement and avoiding socially costly valuation disputes.  This is not possible when the firm is sold as a going concern for cash, since cash has a commonly known value.

Finally, my model emphasizes that when capital structures are fragmented, bankruptcy costs can be driven by haggling and litigation over the value of the parties’ entitlements, even when the parties agree about what to do with the bankrupt firm.  This suggests that the time may be ripe for rethinking and improving the resolution of valuation disputes in bankruptcy.  In a related paper, published in University of Pennsylvania Law Review, Edward Morrison and I review valuation opinions in bankruptcy cases.

The full article is available here.

Selling Innovation in Bankruptcy

posted in: 363 Sale, Valuation | 0

By Song Ma (Yale School of Management), (Joy) Tianjiao Tong (Duke University, Fuqua School of Business), and Wei Wang (Queen’s School of Business).

The past decades have witnessed the emergence of patent sales in corporate bankruptcies. Yet we know little about the facts and rationales of these important economic transactions.

In this working paper, we assemble a comprehensive data set of US Chapter 11 filings, USPTO patent transaction documents, and court records on assets sales from the past three decades. We document three stylized facts on patent sales in bankruptcy. First, patent sales are pervasive — more than 40% of bankrupt firms sell at least one patent, and on average they sell 18% of their patent portfolios. Second, patent transactions occur immediately after bankruptcy filing — concentrating largely within the first two quarters after filing. Third, patents are frontloaded in general asset sales in bankruptcy — firms sell a disproportionately large quantity of patents in asset sales during the early period of reorganization.

Why do firms sell patents during bankruptcy? We design a set of empirical tests to study the economic decisions behind patent sales based on the two economic views on assets reallocation in bankruptcy, namely asset restructuring and financing through asset sales. Our results show that bankrupt firms reallocate patents that are more redeployable and trade in a more liquid market . We find no evidence that they sell underexploited or underperforming patents. This pattern of selling more liquid patents holds stronger in firms with financial distress, firms undergoing poor industry conditions, and firms lacking external financing. The combined evidence lends support to the view that firms sell innovation during bankruptcy for financing purposes rather than for asset restructuring. Additionally, we find that bankrupt firms try to retain the inventors of sold patents and continue to cite sold patents after their sale. The evidence overall suggests that a firm’s imminent financing needs interact with its intent to avoid bankruptcy costs in shaping a firm’s decision to sell patents in bankruptcy.

The full paper is available here.


The Roundtable will be off for the holidays. We’ll be back early after the New Year.

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

posted in: Valuation | 0

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.