lecture21 bankruptcy e

8/8/2019 Lecture21 Bankruptcy E

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Lecture 21: Bankruptcy Law andFinancial Development

Development FinanceSpring Semester

2004

Bankruptcy Law

Provides for the resource reallocation from inefficientor less efficient to efficient uses, and creates theconfidence and the favorable environment forcreditors to be willing to transfer their unusedresources to where they are in demand.


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Bankruptcy Law: Basic Principles

Ensures an efficient outcome upon bankruptcy

resolution: the total firms value reaches the highestlevel after bankruptcy. Whether a firm shuts down, liquidates each of its assets,

sells all or reorganizes depends on whether that generatesthe highest value to the creditors, debtors and otherstakeholders (the employees).

Ensures exante efficiency i.e. before a firm goesbankrupt: Prevents borrowers from investing in risky projects and

defaulting.

Prevents creditors from profligate lending to those who arenot able to repay loans, and obviates their unwillingness tolend to those who have good projects.

Asset Grapping and Bankruptcy Law

There are conflicts among creditors of a firm. As thefirm is in financial distress (cash insufficient to paydue debts), those creditors who come first may getback all their loans, and those who are late mayreceive nothing.

This can encourage creditors to enter an asset grap

race and, hence, all receive less. And worse, it candestroy a firm that is just in temporary difficulty buthealthy in the long term.

Bankruptcy laws in market economies are designed toavoid this situation by resolving in order (not allowingindividual distrainment) with the bankruptcyproceedings.

See illustrative examples


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Bankruptcy Law: Replacing individualdistrainment with collective liquidation

When a creditor asks a firm (its debtor) for

distrainment, and the firm cannot repay the debt, itcan apply for bankruptcy. Creditors then recoverdebts in due court of the bankruptcy procedures.

The bankruptcy courts assign a trustee to liquidate allthe firms assets, and use the proceeds to repaydebts under the priority rule.

Creditors of the same priority get back funds inproportion to the nominal values of their loans. Thenquicker creditors receive no more than slower ones.

Creditors differ in seniority

Creditors priority in bankruptcy resolutionprocess

Fully secured creditors;

Partially secured creditors;

Unsecured creditors;

Preferred shareholders;

Common shareholders.


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Other stakeholders priority in bankruptcyresolution process

Bankruptcy laws in many countries provide that the

following stakeholders should have seniority overunsecured creditors, but below secured creditors:

Professionals/attorneys assigned to oversee orliquidate the firms assets;

Senior stakeholders (tax agency, employees).

Especially, some bankruptcy laws under the French civillaw system tend to protect the employees interests.

Salary and wage payments due to employees haveseniority even over secured debts.

Insolvency

A borrowing firm applies for or is required to apply forbankruptcy as it is unable to repay debts. Inability torepay debts is either temporary or irredeemable, andthus the resolutions differ from case to case, at leastin principle.

Illiquidity

Cash and liquid assets are insufficient to service debts(although the total value of assets exceeds the debtobligations).

Insolvency Debt service obligations exceed total asset value; or the

net worth is negative.

Insolvency is also called technical bankruptcy.


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Liquidation or Reorganization?

If a firm is only temporarily illiquid (cash and liquid

assets insufficient to pay due debts), bankruptcy andliquidation is unlikely to be the optimal solution.Reorganization and debt restructuring in the intactlegal status can increase the values to creditors (andthe debtor).

In contrast, if the firm is insolvent (its net worth isnegative), allowing reorganization under the controlof incumbent management is likely to prolong thefinancial distress and finally reduce the values to

creditors.

Liquidation or Reorganization Balancing creditors and debtors interests

There is no single optimal bankruptcy code. Anybankruptcy regime balances several objectives,including protecting the rights of creditors on the onehand, and obviating the premature liquidation ofviable firms on the other hand.

Bankruptcy laws favoring liquidation often protect

creditors (helping creditors to recover quickly part ofor all of their loans).

Bankruptcy laws favoring reorganization are moredebtor-friendly (maximizing the post-bankruptcyfirms value and ensuring debtors have incentives torepay debts).


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Balancing creditors and debtors interests -Differences among legal systems (1)

Creditor-friendly bankruptcy laws:

Automatic bankruptcy and liquidation as a firm isilliquid and requested for by a creditor.

Example: Hungary in the transition in 1992.

Effects:

Too many liquidations including viable firmsthat should have been able to repay debtsunder reorganizations.

Too many liquidations, beyond the resolutioncapacity of the courts and enforcementsystem.


Debtor-friendly bankruptcy laws : Borrowing firms have the right to reorganize themselves.

Example: Chapter 11 of the U.S. bankruptcy code.

Firms apply for bankruptcy, but keep on managing andreorganizing themselves under the courts monitoring.

Effects:

Too many bankruptcy firms asking for reorganizations.

Borrowing firms management and equity holders preferreorganization to liquidation for their control duringreorganization, not for the efficiency considerations.

The general tendency is to reform toward debtor-friendlybankruptcy laws, encouraging reorganization rather thandebtor punishment.

But it is only efficient in strong legal environments.


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Developing countries:

Criteria to determine insolvent firms for bankruptcyproceedings are unclear and complicated.

The sanction systems are often weak, in effect leadingto debtor-friendly bankruptcy laws, though they maybalance both parties interests in the letter of the law.

This may have two effects: The firms ability to access credit is limited as creditors know

they are not fully protected or the bankruptcy resolutionprocess is not transparent.

Insolvent firms keep on operating resulting in inefficientusage of resources. (Example: insolvent firms in South-EastAsia after the 97-98 financial crisis).

Implications of informationasymmetries in bankruptcy resolution

Should we impose strictly that junior

stakeholders are always considered only if allsenior claims have been resolved?


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Different expectations

Normally, firms may be more optimistic than the

creditors about the firms prospects. As a result, thedebtor believes that the expected payment to thecreditor is greater than the creditor believes he isreceiving.

Information asymmetries result in a dead-weight loss.The bankruptcy code affects this loss.

If the creditors provide the debtor with increasedincome in the bankruptcy state (not entirely taking outall of the firms assets), and compensate for byincreasing interest rates in the nonbankruptcy state

sufficient to leave creditors just as well off, this willperhaps lead to a more efficient outcome than that ofthe absolute priority rule.

Adverse selection

Information asymmetries affect the possibility ofadverse selection in the process of applying for loans.

One of the arguments for debtor imprisonment is thatthey discourage from applying for loans by those whodo not intend to repay them, or who know they areunlikely to be able to repay them.

Today, however, the issue does not center onsending to prison those who do not fully repay theirloans, but on how much they should be allowed tokeep in the bankruptcy state.


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Incentives

Hidden actions should be taken into account of

bankruptcy resolution.On the verge of bankruptcy, the borrowing firm tendsto undertake risky business activities in the hope of aresurrection, or has incentives to strip assets.

Furthermore, given that the firm gains nothing afterbankruptcy, its management is unwilling to engage inbankruptcy proceedings, or may hamper suchproceedings.

Bankruptcy procedures can create an incentive by

giving the firms owners and incumbent managementan equity interest even though the senior claims havenot been fully met.

Risk sharing

Bankruptcy provisions can affect the degree of risksharing.

As a contract entails the debtor retaining 20% equityinterest following bankruptcy, in order for the lenderto receive the same expected return as in a normalcontract, the lender must receive a higher interestrate before bankruptcy.

Risk sharing: Transfers income from the borrower to the lender in the

good state (the nondefault state); and

In exchange for greater income of the borrower in the badstate (the default state), when the debtor is likely to valueincome.


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Isolated bankruptcy and systemic bankruptcy

Systemic bankruptcies (debt crises) are different from

isolated bankruptcies in that a wide range of firms inan economy are insolvent at the same time.

A bankruptcy code is not an efficient regime to dealwith systemic bankruptcies: As a single firm goes bankrupt, a reasonable inference can

be made that the firm itself did something wrong. Withsystemic bankruptcies, many firms may be doing well, butbe insolvent due to the bad macroeconomic settings, andsharply increased interest rates as a crisis occurs.

As a mass of firms in an economy go bankrupt, the court

system may not have the capacity and resources to resolvethe situation.

Isolated bankruptcy and systemic bankruptcy

A bankruptcy code is not an efficient regime to dealwith systemic bankruptcies:

As a financial panic occurs (usually associatedwith systemic bankruptcies), there is virtually noway to determine exactly the values of assetsand liabilities of a firm.

Mass sales of assets push down their marketprices far below their actual values.

Many assets of a firm are another firmsliabilities, and both firms fall into financialdistress.

Both firms and banks are in difficulty.


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A proposed solution to systemic bankruptcy

A special code a Super Chapter 11???

Default provisions should be specified to facilitatethe quick bankruptcy resolution.

Focus should be placed on reorganization ratherthan liquidation.

The incumbent management should bemaintained.

Another important implication ofbankruptcy law

Bankruptcy law affects the likely outcome if a disputehas to be resolved by the courts. Hence, it alsoaffects the outcome of the bargaining process outsideof the courts to avoid the uncertainty and delay ofrelying on court-mandated resolutions.

Market-based Resolution of Financial Distress

LECTURE 22

lecture21 bankruptcy e

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