A large literature has highlighted differences in bankruptcy laws across countries and the way these laws impact financial reorganization. While the resolution of financial distress varies from country to country, a distressed firm typically faces two alternatives when it comes to rearranging its capital structure: (1) a formal court-supervised bankruptcy procedure under bankruptcy law or (2) an informal out-of-court debt restructuring with creditors. The latter is commonly called a “workout” arrangement, wherein existing debt contracts are modified or new securities (debt or equity) issued in exchange for existing debt.
In one respect, creditors and equity holders, represented by the firm’s management, share an interest in avoiding the higher costs associated with a court-supervised reorganization. Nonetheless, in the U.S., thousands of firms file for Chapter 11 every year. Some legal scholars argue that the workout process is dysfunctional, especially when bonds are involved. In the U.S., Section 316(b) of the 1939 Trust and Indenture Act (TIA) prohibits majority-vote amendments that modify the “core” terms (principal, interest, or maturity) of a bond contract. Thus, change to an indenture requires the unanimous consent of creditors and, as a result, debt is often restructured via an “exchange offer” in which bondholders agree to a new package of securities against the old bonds.
Yet, exchange offers are also prone to impediments linked to the presence of asymmetric information between informed managers and less well-informed creditors, heterogeneous beliefs among investors, and coordination problems, especially in the presence of many creditors. Indeed, given that participation in an exchange offer is voluntary, each creditor has an incentive to withhold consent and retain its right to seek full repayment, creating a holdout problem. In practice, debtors typically impose a 90% minimum tender condition to reduce the impact of holdouts, paradoxically increasing the likelihood that the offer fails.
A consensus has emerged among legal scholars over the last 20 years that Chapter 11 has fallen under secured creditor control, especially with the increasing use of debtor-in-possession (DIP) financing usually provided by secured creditors. To the extent that secured creditors have gained an advantage over other stakeholders in Chapter 11, one would expect disadvantaged groups to pursue their interests outside of bankruptcy, which would suggest a higher incidence of exchange offers. Over the same period, innovations in credit markets and emerging strategies by institutional lenders and investors are also likely to have influenced the balance between Chapter 11 and out-of-court restructurings.
Lastly, creditors and equity holders have conflicting interests in distressed firms. On the one hand, equity holders favor continuation and risk-taking activities outside of Chapter 11 bankruptcy because they hold a call option on the firm’s cash flow, and equity could be erased in Chapter 11 following the application of the absolute priority rule. On the other hand, risk-taking by equity holders may reduce the recovery rate for creditor claims, implying creditors bear all the downside risk of continuation. Moreover, debt claims have priority in Chapter 11, especially if the claims are secured, and replaced by new securities (debt or equity). Thus, creditors overall may feel better protected under a court-supervised reorganization procedure like Chapter 11.
The many explanations for the two methods of distress resolution have given rise to a diverse empirical literature: some studies focus on court-supervised procedures, some on distressed exchanges, some papers examine the roles of specific investors or creditors (e.g., banks, hedge funds, CDS, etc.), while others focus on the impact of specific assets. In our extensive review of the literature on the choice between Chapter 11 and out-of-court restructuring, we have been unable to uncover any empirical work that considers the joint impact of contemporaneous asset holdings by all investors. The goal of our project is empirically to assess the impact of the many conflicting influences on the resolution of financial distress with a broad focus on the role of institutional lenders, investors, and creditors.
We identify a sample of 840 financially distressed, listed firms in the U.S. For each firm, we then search for evidence on the type of debt restructuring – exchange offer or Chapter 11 filing – over a 2-year window on either side of the distress occurrence. Chapter 11 firms are mainly identified from the LoPucki Bankruptcy Research Data, EDGAR 8-K filings, and Capital IQ. Exchange offer firms are mainly identified by searching Factiva news stories for “exchange offer” and “debt restructuring.” The final sample includes 131 Chapter 11 firms and 138 exchange offer firms.
To the distressed sample we add firm-level quarterly financial information from Compustat and Capital IQ for the four quarters prior to a Chapter 11 or exchange offer filing. Given our focus on institutional investors, we add detailed equity and bond holding information for each firm. Using Capital IQ, we record the name of each shareholder, number of common shares held, and owner type for each firm in the four quarters prior to filing. Bloomberg is the source of historical bond holding data. For each bond reported in Bloomberg, we record the rank of the bond (e.g., senior, subordinated, etc.), coupon rate, maturity, amount issued (which Bloomberg reports at face value in thousands of dollars), and whether the bond is in default at the time of filing. We also record the name of each bond holder, the holder’s institutional type, and the number of bonds held in each of the four quarters prior to filing.
In the first stage of the empirical analysis, we compare the two groups of firms. We find clear differences in the financial characteristics of firms in Chapter 11 and exchange offers: exchange offer firms are larger (total assets or liabilities), have more cash, higher current assets, more long-term debt, higher assets to liabilities ratios, lower current liabilities, and a lower current portion of long-term debt. The differences suggest that exchange offer firms focus on long-term debt issues. More than 95% of Chapter 11 firms and 75% of exchange offer firms report negative net income one quarter prior to filing, while both have positive EBITDA and negative EBIT, on average, with exchange offer firms faring significantly better. Overall, the data reveal greater financial difficulties for Chapter 11 firms just before filing.
We find no significant differences in capital structure between exchange offer and Chapter 11 firms in terms of different debt types, except that bonds and notes and unsecured debt are significantly higher for exchange offer firms. Nor is there any significant difference between the two samples in changes in the number of outstanding common shares.
In terms of bond holdings by investor type, exchange offer firms issue more bonds (in number and market value) and have more bondholders than Chapter 11 firms. Total shareholdings by investors are also larger for exchange offer firms, reflecting their larger size. The four largest investor types by bond holdings are investment advisors, insurance companies, banks, and hedge funds. The picture is slightly different for equity holdings. Investment advisors are present in almost all restructuring procedures, closely followed by individual investors (mostly top management), banks, hedge funds, pension funds, family offices, and insurance companies. Not surprisingly, bond holdings are more concentrated among fewer investor types. Senior unsecured bonds represent roughly two-thirds of all bonds reported for both Chapter 11 and exchange offer firms, followed by senior subordinated, second and first lien. Notably, the bond default rate one quarter prior to filing is much higher for Chapter 11 firms (85%) than exchange offer firms (11%).
In the second stage of our analysis, we estimate a binomial (logit) model of the firm’s restructuring decision (exchange offer or Chapter 11). The independent variables are added in four steps: (1) financial variables, (2) capital structure information (both at one quarter prior to filing), (3) shareholdings by investor type, and (4) bond holdings by investor type. At the first step, we find the probability of an exchange offer is positively related to firm size and financial health, and negatively associated with the current portion of long-term debt. The 2008 financial crisis has no evident impact. Adding information on debt structure adds nothing to the base model. However, the number of shares outstanding is negatively associated with the probability of an exchange offer.
While using financial information one quarter prior to filing is easily justified, it is not obvious which quarter should be chosen to measure equity or bond holdings. Each market has its own dynamics while equity and bond holders may adopt different behaviors to influence the firm’s decision. Thus, we consider all 16 combinations of the 4 quarterly equity and bond holdings measures. It turns out the highest explanatory power occurs when equity positions are measured one quarter, and bond positions four quarters, before restructuring. Overall, the models fit the data well, endorsing our approach that considers all investor groups and asset types at once.
Results show that the probability of an exchange offer increases with the proportion of shares held by all investor types except corporations, family trusts, and insurance companies. For bond holdings, there is evidence of a negative association for banks, insurance companies, and hedge funds, along with a positive association for corporations. In terms of ownership, more concentrated share holdings are associated with Chapter 11 whereas more concentrated bond holdings have little impact. Lastly, the likelihood of an exchange offer increases with the numbers of subordinated and secured bonds.
The results for hedge funds are interesting: hedge fund share holdings are positively associated with exchange offers, whereas hedge fund bond holdings are positively associated with Chapter 11. An explanation is that hedge funds behave opportunistically in restructuring, sometimes using bond holdings to support Chapter 11 and other times using shareholdings to support an exchange offer, depending on the circumstances. This is consistent with the active role of hedge funds documented in the restructuring literature.
Overall, our results indicate that investor groups have divergent effects on the restructuring decision: the impact of hedge funds is quite different from that of insurance companies, which is different for banks, corporations, and government investors. We also find that bond holdings have a different impact than equity holdings. Furthermore, the timing of the impacts of both investor groups and asset types differs as the firms approach restructuring. We believe this is the first evidence of dynamic effects in the context of financial restructuring. While our results are plausible, they are not always compatible with previous empirical findings, consistent with concerns about the partial nature of the analysis in earlier work.
Timothy C.G. Fisher is an Associate Professor at the University of Sydney
Jocelyn Martel is a Professor at ESSEC Business School
Lorenzo Naranjo is a Senior Lecturer at Washington University in St-Louis
This post is adapted from their paper, “The Role of Institutional Investors in Financial Distress Resolution” available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.