Corporate Reorganization as Labor Insurance in Bankruptcy

By Diana Bonfim (Banco de Portugal; Catholic University of Portugal – Catolica Lisbon School of Business and Economics) and Gil Nogueira (Bank of Portugal – Research Department)

Diana Bonfim
Gil Nogueira

How does corporate reorganization affect labor outcomes in bankruptcy? The existing literature argues that corporate reorganization affects the reallocation of labor because it retains workers in bankrupt firms. In some cases, bankrupt firms remain alive for too long and retain workers inefficiently. In other cases, reorganization reduces the probability of inefficient liquidation.

In this paper we show that resource retention is not the only determinant of labor outcomes in bankruptcy. The decision process in bankruptcy creates a principal-agent problem between firms’ claimholders and other stakeholders (e.g., workers, suppliers). Claimholders decide bankruptcy outcomes but other stakeholders with limited say in the bankruptcy process are also affected by these outcomes. 

Workers are among these stakeholders. They use job contracts with firms as a form of insurance in times of adversity. In the absence of corporate reorganization, workers lose these job contracts and experience persistent costs of job loss. Reorganization improves labor outcomes because it reduces the probability that workers lose the insurance provided by job contracts when the costs of job loss are high.

We test this hypothesis empirically using data from Portuguese reorganization cases. The institutional setting has several features that help design an adequate empirical strategy. First, reorganization cases are randomly allocated across judges. We use this random assignment as a source of variation in the probability of reorganization that is not affected by other factors that also influence workers’ careers. Second, Portuguese firms report financial statements annually, which we use to check whether reorganization affects labor reallocation to more productive or profitable firms. Finally, we link this data to a rich administrative employer-employee matched dataset, which allows us to track workers who eventually change jobs. This dataset is unique because it contains rich job descriptors. We use this data to establish a relationship between corporate reorganization and the scarring effect of bankruptcy on workers’ job functions.

We uncover three main findings. First, we measure the effect of corporate reorganization on the sorting of workers to productive and profitable firms. In five years, only about 20% of the workforce remains in reorganized firms. Many workers from reorganized firms find jobs with new employers. We find no evidence that reorganization affects the reallocation of labor to efficient or profitable firms.

Second, reorganization is an important source of labor insurance against negative productions shocks. In the short term, reorganization increases the probability that workers are employed. In the long term, reorganization increases wages and reduces the scarring effect of job downgrading that is often observed in recessions. Reorganization reduces the probability that workers move to less skill-intensive occupations and increases occupation wage premia. 

Third, we show that reorganization improves job transitions to new employers. Reorganization increases the average time it takes to leave a firm that files for bankruptcy by one year. Reorganization reduces the probability that workers move to low-paying jobs and increases the probability that workers find high-paying jobs with new employers.

Overall, our results show that corporate reorganization is an important source of labor insurance in bankruptcy, thereby mitigating the scarring effect of job loss. The full article is available here.

Restructuring Corporate Debt – A Different Kind of Cycle

By Mike Harmon (Gaviota Advisors, LLC) and Claudia Robles-Garcia (Stanford Graduate School of Business)

Mike Harmon
Claudia Robles-Garcia

Corporate leveraged finance cycles have followed a predictable pattern in the forty years that have ensued since the invention of the junk bond in the late 1970s. They expand as investors’ risk appetites grow and recede as default rates rise. The recession of credit cycles has historically facilitated a healthy “creative destruction” in the form of restructuring transactions which have enabled over-leveraged companies to fix their burdened balance sheets. While the current credit cycle is positioned to share some of the characteristics of past cycles, it is also shaping up to differentiate itself in some meaningful ways. First, companies entered the current crisis with significantly more debt, and with that debt bearing a much higher blended risk profile, than in past cycles. Second, the restructuring “fix” has required much more additional financing than previous cycles, due to the economic nature of the crisis. Third, companies have had much more contractual leeway to avoid default, and to solve their liquidity problems with more leverage, than they have in previous cycles. Fourth, many investors have been aligned with borrowers on their desire to maintain elevated leverage levels. And finally, and probably most importantly, the Fed’s actions have facilitated, and even encouraged, the raising of more leverage. As a result of all of these factors, we believe that this restructuring cycle is more likely to see companies emerge with significantly more debt than we have seen in previous cycles. This will exacerbate the highly publicized “zombie” problem (where companies that are technically insolvent have no real catalyst to restructure), which could impact economic growth, and will increase the likelihood of a more protracted restructuring cycle in the years to come.

The full article is available here.

Bankruptcy Tourism and the European Union’s Corporate Restructuring Quandary: The Cathedral in Another Light

By Samir D. Parikh (Lewis & Clark Law School)

Samir D. Parikh

For the last decade, the European Union has been reconceptualizing its corporate restructuring framework with the hope of bolstering capital markets and improving cross-border lending. Unfortunately, the system remains plagued by two intractable problems: divergent substantive law at the Member State level and jurists unaccustomed to guiding reorganization cases. The result is a system beset by uncertainty and disparate treatment. The EU is intent on addressing these problems, but progress has been elusive. The EU must work through recommendations and directives to encourage Member States to align substantive restructuring law with policy design. But Member States have been unresponsive to the EU’s recent efforts. The prospect of addressing these intractable problems in the foreseeable future is grim. Therefore, this Article breaks with current scholarship and urges the EU to adopt a radical alternative. The EU should consider making legal and structural changes that will facilitate bankruptcy tourism. I argue that affording corporations increased discretion as to the location of restructuring cases will aid in creating judicial hubs of optimal law and experienced jurists. The EU has the power to adopt my recommendations by simply modifying its own law and procedure, which should accelerate implementation timelines.

Ultimately, economists foresee an impending financial correction. The EU’s restructuring framework is unprepared to offer predictable and comprehensive reorganization outcomes for the next wave of distressed corporations. This Article proposes a novel vantage point from which to assess policy alignment.

For previous Roundtable posts on for bankruptcy tourism, see Wolf-Georg Ringe, “Bankruptcy Forum Shopping in Europe.”

The full article is available here. Forthcoming in the University of Pennsylvania Journal of International Law.

Corporate Restructuring under Relative and Absolute Priority Default Rules: A Comparative Assessment

By Jonathan Seymour, Steven L. Schwarcz (Duke University School of Law)

Jonathan Seymour
Prof. Jonathan Seymour
Steven L. Schwarcz
Prof. Steven L. Schwarcz

The European Union recently adopted a Restructuring Directive intended to facilitate the reorganization of insolvent and other financially troubled firms. Although the central goal of the Directive parallels that of Chapter 11 of U.S. bankruptcy law—to protect and maximize the value of financially distressed but economically viable enterprises by consensually reorganizing their capital structure—the Directive introduces an innovative but controversial option: that EU Member States can decree that reorganization negotiations should be subject to a relative priority default rule, as opposed to the type of absolute priority default rule used by Chapter 11.

The purpose of the default rule—whether relative or absolute priority—is to provide a mechanism whereby a plan of reorganization may be approved notwithstanding failure of the parties to reach a consensus. Such a “cram down” plan reflects that one or more classes of impaired creditors or shareholders dissents. In that case, the EU’s relative priority default rule would allow confirmation of the cram down plan so long as senior classes are treated more favorably than junior classes. In contrast, Chapter 11’s absolute priority default rule would require senior classes to be paid in full before junior classes receive any distribution under the cram down plan.

EU officials argue that relative priority would provide a fairer and more pragmatic default rule than absolute priority. We disagree. As explained below, we believe that a relative priority default rule would, perversely, make consensual reorganization plans less likely. We also illustrate why a relative priority default rule could produce unfair and economically undesirable outcomes.

A relative priority default rule would make consensual reorganization plans less likely because, unlike an absolute priority default rule, it would not function as a penalty default. Absolute priority functions as a penalty default because it would require a costly and contentious going-concern valuation of the debtor, in order to determine what share of the equity in the reorganized debtor is necessary to pay the claims of senior classes in full before any remaining value may be paid to junior classes. To avoid that cost and contention, the parties are motivated to negotiate a consensual plan, even if they would have to give up some value.

Relative priority, in contrast, would not operate effectively as a penalty default rule. A debtor could gain approval of a nonconsensual (i.e., cram down) plan without any valuation of the reorganized business. Even if a valuation is required, a simple and relatively inexpensive floor or ceiling valuation should suffice, rather than the precise valuation required under absolute priority. Parties therefore would have little incentive to compromise.

A relative priority default rule also would permit unfair outcomes. Our article shows how such a default rule would permit shareholders to retain much of the value in a reorganized business, while forcing creditors to accept significantly less than full payment. That could make debt investments less attractive in EU Member States that adopt a relative priority default rule. At the same time, relative priority would create incentives, as was the case in the early years of the U.S. bankruptcy laws, for senior and junior classes to collude to “squeeze” intermediate classes. Additionally, by reducing the risk of insolvency for shareholders and management, relative priority could operate as a subsidy for overleveraged businesses and encourage risky behavior.

For all of these reasons, we believe that EU Members States should avoid adopting a relative priority default rule. Our article also responds to potential defenses of that option. We demonstrate that relative priority is unnecessary to deter holdout creditors from obstructing the plan negotiation process. We additionally explain why relative priority is not needed to promote successful reorganizations of small and medium sized businesses. To the extent that traditional Chapter 11-style reorganization has not worked well for small businesses in the US, we suggest that the recent Small Business Reorganization Act provides a better restructuring model by permitting such businesses to reorganize on a “best efforts” basis.

The full article is available here.