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Resolution of financial distress: debt restructurings via Chapter 11, prepackaged bankruptcies, and workouts.

From the 1980s to the present, there has been a tremendous increase in default rates and bankruptcy activity of publicly traded firms.(1) The increase in bankruptcy activity has been accompanied by significant innovations such as prepackaged(2) and prenegotiated bankruptcies, and coercive tender (cash for debt exchanges) and exchange offers (debt and/or equity for debt exchanges). As a result, researchers have increased their efforts to enhance their understanding of methods used to resolve financial distress. (See Chen, Weston, and Altman (1995) and John (1993) for an extensive discussion of this literature.)

Traditionally, firms have used either an out-of-court workout (public or private) or a formal Chapter 11 bankruptcy to restructure their debt. Chapter 11 provides several benefits for distressed firms, allowing them to continue operations without the "harassment" of creditors. (See Gertner and Scharfstein (1991) for a detailed description of these benefits.) However, the primary disadvantage of a Chapter 11 reorganization is its relative cost. Gilson, John, and Lang (1990) and Jensen (1989) suggest that due to high restructuring costs of Chapter 11, firms have an incentive to reorganize voluntarily out of court via a workout. However, workouts are thwarted by holdout problems, as shown by Chatterjee, Dhillon, and Ramirez (1995), Coffee and Klein (1991), Gertner and Scharfstein (1991), Roe (1987), and Schwartz (1993).

As an alternative to Chapter 11s and workouts, the prepackaged bankruptcy plan, a recent innovation, has been portrayed as a solution to these problems. A prepackaged bankruptcy (a "prepack") is a reorganization of firm's debt contracts that has been negotiated or accepted by creditors prior to beginning of a bankruptcy proceeding. A prepack is a hybrid method that combines the benefits of Chapter 11 reorganizations with those of public workouts. Specifically, prepacks eliminate the holdout problem associated with workouts; at the same time, they avoid a prolonged stay in Chapter 11.

The current trend suggests at least three alternatives for debt restructurings: Chapter 11 reorganizations, prepackaged bankruptcies, and workouts. However, firms may not consider these choices as mutually exclusive alternatives. Previous empirical work does not analyze these restructuring methods simultaneously. Asquith, Gertner, and Scharfstein (1994), Franks and Torous (1994), and Gilson, John, and Lung (1990) focus on the differences between workouts and Chapter 11s. Concurrent work by Betker (1995a) and Tashjian, Lease, and McConnell (1996) is limited to examining the characteristics of prepacks. This paper examines empirically a contemporaneous and comprehensive sample of firms undertaking Chapter 11 reorganizations, prepackaged bankruptcies, and workouts.

Extant research is also limited in the configuration of the samples used. Gilson, John, and Lung (1990) investigate a sample of firms undergoing "private" reorganizations (bank renegotiations and private and public workouts). Their study focuses primarily on finns that attempt workouts; if the workout fails, the firm is classified as Chapter 11. Franks and Torous (1994) focus on large firms with publicly traded debt that either file for Chapter 11 or successfully implement a public workout.

This study analyzes the choice of restructuring methods. To this end, we develop a comprehensive sample of financially distressed firms that attempt to restructure their debt for the first time. The sample comprises of firms that attempt both private and public workouts, prepacks, and Chapter 11s.

Among others, John and Vasudevan (1995), Mooradian (1994), and White (1994) have modeled theoretically the elements of the restructuring choice. These models distinguish between firms in financial distress that are economically efficient and those that are economically distressed and should be liquidated. Our main purpose is to test several implications of these models.(3)

We provide evidence that the restructuring decision depends on 1) the degree of the firm's leverage, 2) the immediacy/severity of its liquidity crisis, 3) the extent of the creditor's coordination problem, and 4) the magnitude of the firm's economic distress.

First, we find that although all financially distressed firms are highly leveraged, they have different debt structures. Public workout firms have a significantly greater proportion of long-term debt to total assets than Chapter 11, prepack, or private workout firms. We also find that prepack firms have a more immediate liquidity crisis than Chapter 11 or workout firms, as shown by a significantly larger proportion of current debt due.

Second, our analysis suggests that the degree of coordination among creditors, as reflected by the nature and complexity of debt claims (the mix of public, private, and bank debt), is an important determinant of the restructuring decision. Firms with recalcitrant trade creditors and a significant level of bank debt may not have any alternative to filing for Chapter 11. Consistent with this view, firms filing for Chapter 11 have higher levels of trade credit and bank debt than firms using the other methods. Chapter 11 firms also have a relatively low proportion of public debt when compared with workout finns. The prevalence of public debt in workouts and its practical absence in Chapter 11 reorganizations suggests that firms with public debt are not likely to use formal bankruptcy procedures without first attempting an out-of-court restructuring.

Third, we provide further evidence to support the notion that better-quality liquid firms restructure their debt out of court via a workout, better-quality illiquid firms use prepacks, and lower-quality firms use Chapter 11 reorganizations (John and Vasudevan, 1995). We measure firm quality by its operating cash flows (earnings before interest, depreciation, and taxes (EBIDT) as a proportion of sales and total assets). We use the ratio of total liabilities, long-term debt, and current debt due to total assets as a proxy for the magnitude of financial distress of the firm. The immediacy or severity of the liquidity problem is captured by current debt due. Our results show that EBIDT as a proportion of assets and sales is greater for workout firms than that for Chapter 11 firms.

This evidence indicates that firms choosing a particular restructuring mechanism have distinctive financial and economic characteristics. Thus, differential information can be conveyed to the market when the choice is announced. We find that the Chapter 11 sample exhibits the strongest negative price reaction and that public workouts have the least adverse price reaction. The significant difference between Chapter 11 and prepack announcement period returns suggests that prepack firms are better quality than Chapter 11 firms.

Finally, it is interesting to note that on average, small firms with little or no public debt file directly for Chapter 11; larger firms with a significant amount of public debt first attempt to restructure their debt via public workouts. These results complement the results of Franks and Torous (1994) and Gilson, John, and Lang (1990). While we analyze a more general issue of the choice of method used to restructure, these two studies analyze factors leading to the failure of workouts (private for Gilson, John, and Lang; large public workouts for Franks and Torous).

The remainder of the paper is organized as follows. The theory and testable implications are described in detail in Section I. The data and sample selection procedure are discussed in Section II; Section III presents the stock and bond methodology. The empirical results are presented and discussed in Section IV, and Section V concludes the paper.

I. Theory and Testable Implications

Recent theoretical models demonstrate the relative conditions under which alternate restructuring methods are efficient. Optimally, when facing financial distress, economically nonviable firms should be liquidated, and economically viable firms should be able to renegotiate and continue operations. White (1994) models the choice of liquidating the firm under Chapter 7 or filing for Chapter 11. She shows that Chapter 11 is not a perfect screening device; it encourages managers to reorganize when they should liquidate. Mooradian (1994) models the choice between workouts and Chapter 11 and shows that an equilibrium exists in which a significant proportion of firms filing for Chapter 11 are inefficient.(4) The empirical implication of this work is that most firms filing for Chapter 11 are not economically viable.(5) While the extant research focuses on the reasons for economically nonviable firms to file for Chapter 11, economically viable firms have incentives to restructure debt under Chapter 11.

Economically viable firms may opt for Chapter 11 because of strategic reasons, severe information asymmetries, and the need for funding. Berkovitch and Israel (1991) show that when such firms face an overinvestment problem, they may choose a Chapter 11 reorganization over a workout.(6) John and Vasudevan (1995) provide a more comprehensive model of the reorganization process under asymmetric information. They show that the choice of restructuring method depends on the quality and liquidity of a firm. Their model predicts that good- and medium-quality liquid firms restructure their debt out of court, good-quality illiquid firms use a prepack, and lower-quality (liquid and illiquid) firms file for Chapter 11. The empirical implication from John and Vasudevan's model, tested in this paper, is that firms restructuring via workouts and prepacks are better quality than finns filing for Chapter 11.

Giammarino (1989) models the renegotiation process and argues that information asymmetries between debtholders and other claimholders produce severe coordination problems that leave Chapter 11 as the only viable alternative for resolving this problem. Brown (1989) and Gertner and Scharfstein (1991) present a model where the coordination problem among creditors is resolved through Chapter 11 reorganizations. Similarly, Mooradian (1994) suggests that economically viable firms file for Chapter 11 because it is the most effective mechanism for resolving the creditor's coordination problem.

The creditor's coordination problem is reflected in the nature and complexity of a firm's outstanding financial claims (measured by the mix of public and trade credit and private and bank debt). Asquith, Gertner, and Scharfstein (1994), Gilson (1995), and Gilson, John, and Lang (1990) use the proportion of public debt as a proxy for the creditor's coordination problem and document its importance in the outcome of debt restructurings. Our sample of first-time restructurings allows us to re-examine this issue in more detail.

Gilson, John, and Lang (1990) argue that a Chapter 11 restructuring is preferable to a workout when there are a large number of trade creditors. Asquith, Gertner, and Scharfstein (1994) find that banks are generally reluctant to provide debt relief because their debt is secured and collateralized. Similarly, James (1995) finds that banks will not agree to restructure their debt for firms with public debt unless public bondholders also agree to restructure their debt. Gilson, John, and Lang (1990), on the other hand, find opposite results. They show that the presence of bank debt is positively associated with the success of a workout.

We argue that firms that perceive ex ante that they will be able to resolve both creditor's coordination and holdout problems prefer workouts. The alternative is either a prepack or a Chapter 11 reorganization. Direct filing for a prepack may be optimal for some firms when the debt structure allows them to prenegotiate with creditors. Specifically, we expect that firms filing for Chapter 11 reorganizations have more trade credit than firms attempting prepacks or workouts. The importance of public and bank debt on the choice of restructuring method remains an empirical issue.

Jensen (1989) suggests that high debt levels create an incentive for an out-of-court restructuring, since these firms suffer less erosion in economic value before default is triggered. Firms with high debt levels have an incentive to restructure out of court. Thus, we expect Chapter 11 firms to have lower levels of debt (total and long-term) than firms restructuring with prepacks or workouts.(7)

The resolution of financial distress is a complex process, and few studies simultaneously analyze the choices in restructuring mechanisms. Although the alternative restructuring methods are not mutually exclusive, we hypothesize that a firm's initial attempt at restructuring depends on the degree of the firm's leverage, the severity of the liquidity problem, the creditor's coordination crisis, and the magnitude of the firm's economic distress.

II. Data and Sample Selection

The preliminary sample for this paper is drawn from three different sources. First, we generated a sample of firms filing for Chapter 11, prepackaged bankruptcy, or distressed workouts from InDepth Data Inc., Salomon Brothers High Yield Research Reports, The Default Yearbook and Almanac by the New Generation Group, and Lexis-Nexis. We checked that firms using workouts had specific announcements of default, had taken actions to avoid Chapter 11, or were facing severe liquidity problems. We complemented this sample by adding poor stock performers during January 1989 to December 1992. These were firms for which we found references in the UMI CD-ROM News Abstracts to a default, bankruptcy, reorganization, debt negotiation, credit agreement, or debt restructuring. In the spirit of Gilson, John, and Lang (1990), poor performers are identified as those in the bottom 5% of firms traded on the NYSE/AMEX, based on three-year cumulative stock returns from the CRSP tapes. A majority of the private workout sample is from this data.

We further restrict our sample to first-time filers of Chapter 11, prepacks, and out-of-court workouts. Prepacks are limited to firms that do not have a joint exchange-offer/prepack filing or do not have a workout during the year prior to the filing. Firms announcing simultaneous prepacks and workouts are classified as workouts. We also check to ensure that Chapter 11 firms do not have a workout during the year prior to the filing. The preliminary sample of prepacks comprises 71 firms, of which 22 have previous workouts and 11 have simultaneous exchange-offer/prepack announcements. For the remaining 38 firms, we are able to find data for only 21. These firms include post-vote prepacks and leveraged buyouts. The final sample is described in Section IV. This sample is comprised of 65% NYSE/AMEX firms and 30% NASDAQ firms.

III. Methodology

This section describes the methodologies we use to estimate both stock and bond excess returns. A brief description and relation to previous studies is presented also.

A. Stock Methodology

We use standard event study methodology similar to Patell (1976) to estimate stock excess returns. The estimation period for the market model is from 200 days to 60 days prior to the announcement. Since these are financially distressed firms, we expect a majority of the returns to be generated by infrequent trading data. The Scholes-Williams (1977) procedure is used to adjust for the nonsynchronous trading problem.

B. Bond Methodology

We use the mean adjusted returns methodology adapted for bonds by Handjinicolaou and Kalay (1984) to estimate bond excess returns. The bond return is adjusted for changes in interest rate term structure using the Salomon Brothers composite high-yield bond index. To avoid data biases outlined by Warga and Welch (1993), the monthly bond prices do not include "matrix" prices and are drawn from the Salomon trader quotes or Moody's Bond Record. We use a ten-month interval around the event to estimate the comparison and announcement period returns. The comparison period is from month -5 to month +5 and excludes the announcement month and month +1.

IV. Descriptive Characteristics

We discuss the characteristics of our sample. We then analyze the financial characteristics of firms resolving financial distress with regard to the method they use.

A. Sample Characteristics

We present descriptive characteristics of the sample in Table 1. The sample is comprised of 70 Chapter 11 filings, 21 prepacks, 65 private workouts, and 45 public workouts.

[TABULAR DATA FOR TABLE 1 OMITTED]

The Chapter 11 and prepack samples have an almost equal distribution among NYSE/AMEX and NASDAQ while the workout sample is dominated by firms trading on the NYSE/AMEX. This suggests that larger firms may have a comparative advantage in restructuring their public debt out of court. An examination of the industry classification of our firms suggests that our sample is distributed across a broad category of industries, with a concentration in manufacturing, retail and wholesale trade, and service industries. In a separate analysis (not reported in the table), we find that the number of workouts peaks in 1990. Prepacks gradually increase over the period, reflecting the increasing popularity of these plans. The increase in prepacks and private workouts coincides with a decrease in Chapter 11 s and public workouts in 1991 and 1992. The decline in Chapter 11 and public workout activity may be due to a recovery in the economy. The Revenue Reconciliation Act of 1990 and the LTV court ruling in 1990 may also have resulted in the decline of public workouts (see Chatterjee, Dhillon, and Ramirez, 1995). The Act imposes a tax on the debt-forgiveness income resulting from repurchasing the firm's debt at a discount.

B. Financial Characteristics of Firms Implementing Distressed Debt Restructurings

This section investigates financial characteristics of firms using Chapter 11 reorganizations, prepacks, and workouts. These include firm size (measured by book value of total assets and sales) and debt levels (book value of total liabilities and long-term debt). The data are from Disclosure and Moody's Manuals for the year preceding the announcement of the restructuring. The median and mean values of these measures are presented in Panel A, Table 2. The z-statistic for the Mann-Whitney U-test of differences between groups is presented in Panel B, Table 2.

There are significant differences in terms of firm size and level of debt among the four restructuring methods. Prepack and Chapter 11 firms are significantly smaller (total assets and sales) than workout firms. Also, prepack and Chapter 11 firms have significantly lower debt (total liabilities and long-term debt) than workout firms. From Panel B of Table 2, all pairwise comparisons are statistically significant except for Chapter 11 and prepacks. The results of a Kruskall-Wallis test for group median comparisons (not reported in the table) [TABULAR DATA FOR TABLE 2 OMITTED] also suggest significant differences. Thus, firm size, total liabilities, and total debt characteristics of a firm are related to the choice of restructuring mechanism.

Gilson, John, and Lang (1990) establish that once a firm chooses to restructure its debt out of court, large firms are more successful at completing the workout. We find that in general, small firms tend to be first-time filers for Chapter 11 reorganizations. Our results suggest that larger firms may have a comparative advantage in restructuring their debt claims outside the court.

V. Determinants of the Choice of Debt Restructuring Method

We examine the impact on the choice of debt restructuring method of the degree of a firm's leverage, the severity of its liquidity problems, the extent of creditor's coordination, and the magnitude of the firm's economic distress. We use both univariate analyses and multinomial logit analyses in our examination.

A. Degree of Financial Leverage and Liquidity

We use the ratios of total liabilities, long-term debt, and current debt due to total assets to investigate the magnitude of firm's leverage and the liquidity problem faced by firms in our sample. The median and mean values of these ratios and the Mann-Whitney z-statistics for differences between groups are presented in Table 3.

Consistent with the financially distressed nature of our sample, we find high levels of debt across all firms, as indicated by the ratio of total liabilities to total assets. While all firms are highly leveraged, the debt structure across firms is different. Chapter 11 firms have significantly lower ratios of total liabilities to total assets than do prepack or public workout firms.(8) Workout firms have significantly larger [TABULAR DATA FOR TABLE 3 OMITTED! long-term debt to total assets than Chapter 11, prepack, and private workout firms. The median ratio is 0.48 for public workouts, 0.23 for Chapter 11s, 0.12 for prepacks, and 0.24 for private workouts.(9) These results are consistent with Jensen's (1989) prediction that firms with high levels of debt have an incentive to restructure their public debt out of court.

Another interesting difference among the groups is liquidity as measured by the ratio of current debt due to total assets. The median ratio is 0.03 for Chapter 11 firms, 0.32 for prepack firms, 0.04 for private workout firms, and 0.01 for public workout firms.(10) This result indicates that firms facing a more immediate liquidity crisis choose prepackaged plans.

B. Creditor's Coordination Problem

We measure the degree of the creditor's coordination problem by the ratio of trade credit to total assets (a proxy for the number of trade creditors), the proportion of bank debt to long-term debt (a proxy for senior secured debt), the ratio of public debt to long-term debt, and the number of public debt contracts outstanding (a proxy for bondholder's incentives to restructure out of court). Trade creditors are typically the most difficult group to negotiate with, and firms with many trade creditors are typically forced to file for Chapter 11. Also, since banks have little incentive to participate in workouts because they may fare better under Chapter 11 reorganizations, firms with a large proportion of bank debt tend to file for Chapter 11. Medians and means for each group of firms, as well as non-parametric statistics, are presented in Table 4.

Chapter 11 firms have significantly greater proportion of trade credit than prepack and workout firms. The median ratio of trade credit to total assets is 0.11 for Chapter 11 firms, 0.07 for prepack firms, 0.08 for private workout firms, and 0.05 for public workout firms. Firms with a greater [TABULAR DATA FOR TABLE 4 OMITTED] proportion of trade credit appear to use a court-supervised Chapter 11. Further, Chapter 11 firms have significantly higher levels of bank debt than prepack and workout firms.(11) These results suggest that the proportion of bank debt and trade credit is an obstacle to out-of-court restructurings and that bank debt and trade credit may be important determinants of firms' use of Chapter 11 to reorganize their financial claims. Banks typically hold senior and collateralized debt and, thus, are more likely to fare better in Chapter 11 reorganizations. As documented by Asquith, Gertner, and Scharfstein (1994), banks rarely provide debt forgiveness when restructuring debt.

Public workout firms have significantly higher public debt and hold a greater number of public debt contracts compared to private workout, prepack, and Chapter 11 firms. In fact, as reported in Table 5, only 38.8% of Chapter 11 firms, 58.8% of prepack firms, and 47.4% of private workout firms have public debt contracts outstanding prior to the announcement of the restructuring.

Thus, it appears that firms with a high proportion of public debt are more likely to attempt a workout first, rather than a court-supervised debt restructuring. Our results suggest that larger firms attempt public workouts. Again, the results do not contradict Gilson, John, and Lang (1990) because their study focuses primarily on firms that implement workouts in which Chapter 11 is a failed first-attempt workout. Our focus is examining factors that determine the choice of restructuring method. Thus, we design our sample such that [TABULAR DATA FOR TABLE 5 OMITTED] the workout sample includes both successful and unsuccessful workouts, and our Chapter 11 sample is comprised of firms for which the filing is their first attempt to restructure debt.(12)

Firms that file for Chapter 11 or a prepackaged bankruptcy typically target all of their public debt contracts. In contrast, public workout firms target 52% of their public debt. This suggests that firms with a large proportion of defaulted debt may find it optimal to file for a prepack or a Chapter 11, while firms with relatively few defaulted debt contracts may choose public workouts. Public workouts focus on restructuring specific debt contracts; their goal is avoiding bankruptcy. Chapter 11 reorganizations restructure all private and public debt of the firm.

Because of the simultaneity of the restructuring choice and the number of contracts restructured, another interpretation of the results is that the marginal cost of renegotiating all the debt in bankruptcy is exceeded by the marginal benefit of binding all the bondholders to the terms of the plan. A firm may not restructure all the contracts out of court, since it is costly to bind all debtholders to the terms of the offer.

The creditor's coordination problem is also reflected in the composition of outstanding public contracts. Senior debt comprises 37% of the public debt contracts outstanding for Chapter 11 firms and 40% for prepack firms. In contrast, only 24% of the public debt contracts for private workout firms and 29% for public workout firms are senior debt. Most of the outstanding public debt for workout firms consist of junior debt contracts. A substantial proportion of senior debt appears to present an obstacle to an out-of-court restructuring. Senior creditors may not have any incentive to negotiate out of court if it benefits the junior claimholders. Thus, the presence of senior public debt exacerbates the creditor's coordination problem. Further, as pointed out by Brown, James, and Mooradian (1993) and Gilson, John, and Lang (1990), if senior lenders are going to make concessions, they prefer to do so in Chapter 11 because junior claimholders are also typically required to make concessions. Thus, it is less likely that a transfer of wealth from senior to junior claims will take place.

C. Degree of Economic Distress

In this section, we analyze performance measures to determine the relative degree of economic distress faced by Chapter 11, prepack, and private and public workout firms. In the spirit of Hotchkiss (1995), we measure the level of economic distress in terms of the firm's past performance, which is the ratio of EBIDT to sales and to total assets for the year prior to the filing or announcement of a workout. In Table 6, we present the median and mean values and pairwise comparison across firms with different types of debt restructurings.

Panel B of Table 6 shows that workout and prepack firms have significantly higher ratios of EBIDT to sales than Chapter 11 firms. The median ratio is -0.60% for Chapter 11 firms, 2.95% for prepack firms, 2.80% for private workout firms, and 7.89% for public workout firms. The EBIDT to sales of public workouts is greater than that of prepacks, which in turn is greater than that of Chapter 11 firms, though not all differences are statistically significant at conventional [TABULAR DATA FOR TABLE 6 OMITTED] levels. Similar results are reported for the ratio of EBIDT to total assets. This suggests that firms restructuring out of court have better economic prospects than those that restructure under Chapter 11. In addition, the variability of EBIDTs (not reported in the table) is larger for Chapter 11 firms than for prepack and workout firms.

It is important to note that using EBIDTs as a proxy to compare the magnitude of economic distress between Chapter 11 firms and prepack firms may confound the statistical test, since not all firms that file for Chapter 11 are inefficient. As shown by Mooradian (1994) and White (1994), Chapter 11 is not a perfect screening device; some firms that are not in economic distress may still file for Chapter 11 to resolve the creditor's coordination problem. To the extent that this occurs, our analysis of EBIDTs is likely to be biased and may fail more frequently to reject the null hypothesis of equal EBIDTs.

Despite this caveat, our results support the view that workout and prepack firms are in less economic distress than Chapter 11 firms. This evidence is consistent with the hypothesis that better firms restructure out of court; illiquid better-quality firms restructure using a prepackaged bankruptcy; and firms facing more serious economic and financial distress use Chapter 11 reorganizations.

D. Multinomial Logit Analysis of Choice of Debt Restructuring Method

The previous sections have presented evidence from univariate analysis of several financial characteristics of distressed firms that restructure their debt using one of the methods studied here. One problem with this type of analysis is that it is difficult to interpret the marginal contribution of the different determinants of restructuring choice. Also, we have argued that the choice of restructuring method is a complex process that involves the simultaneous consideration of the choices available. Thus, in this section, we conduct a multinomial logit analysis to simultaneously examine the debt restructuring choice, using several of the variables employed in the previous analysis. The results are presented in Table 7.

The logit analysis compares the characteristics of firms restructuring debt with Chapter 11 to those using prepacks, private workouts, and public workouts. We find that the results are consistent with the univariate analysis described in the previous sections. Chapter 11 firms have significantly [TABULAR DATA FOR TABLE 7 OMITTED] lower long-term debt than public workout firms. This evidence is consistent with Jensen (1989), who argues that firms with a large proportion of debt have incentives to restructure out of court.(13)

The results predict that the ratio of current debt due to total assets is an important determinant of the choice of debt restructuring method. Firms with large amounts of current debt due tend to choose prepacks over Chapter 11s. This evidence is consistent with the hypothesis that the immediacy or severity of the liquidity crisis influences a firm's choice of restructuring.

Another important determinant of the firm's choice of restructuring method is the degree of creditor's coordination. In the logit analysis, we include the ratio of bank debt to total assets and the number of public contracts and examine the impact of these variables on the choice of debt restructuring method. We find that prepack, private workout, and public workout firms have lower bank debt than Chapter 11 firms. This result is consistent with Asquith, Gertner, and Scharfstein (1994), who find that banks have little or no incentive to restructure out of court. The fact that firms filing for Chapter 11 have more bank debt than prepack firms is further evidence that firms facing more severe coordination problems have no alternative to a traditional Chapter 11 reorganization.

The results also support the view that in the presence of publicly traded debt, firms will most likely use a public workout rather than a court-supervised restructuring. Evidence consistent with this argument is provided by the significant number of public contracts. Unfortunately, we cannot use the amount of public debt in the analysis because it is highly correlated to bank debt. We perform a separate analysis using public debt instead of bank debt and find results similar to those using number of public debt contracts.

Finally, we examine the impact of a firm's degree of economic distress on the choice of restructuring method. [TABULAR DATA FOR TABLE 8 OMITTED] We use the ratio of EBIDT to total assets to examine this hypothesis. Firms filing for Chapter 11 have significantly lower ratios than firms using prepacks, private workouts, and public workouts. This result provides support for the John and Vasudevan (1995) model in which better-quality firms attempt to restructure their debt out of court, good-quality firms with liquidity problems use prepacks, and lower-quality firms use traditional Chapter 11 reorganizations.

In conclusion, the evidence is consistent with that observed in the univariate analysis. The results of the logit analysis provide further evidence that the restructuring decision depends on the degree of the firm's leverage, the severity of its liquidity problem, the extent of creditor's coordination, and the magnitude of the firm's economic distress.

VI. Information Content of the Choice of Debt Restructuring Method

Theoretical models based on the efficiency of firms restructuring debt suggest that the choice of restructuring mechanism adopted by a firm has information content.(14) The restructuring decision has valuation implications, since better-quality firms are likely to prefer an out-of-court restructuring. Filing for Chapter 11, besides conveying information regarding the lack of agreement among claimholders over the financial restructuring, conveys relevant information on the economic condition of the firm in distress.

The results presented in this study suggest that there are distinctive financial and economic characteristics that influence the choice of the debt restructuring method. The existence of such characteristics indicates that information is conveyed to the market when the choice of method is announced. To examine this hypothesis, we investigate the security price reaction to the announcements of a debt restructuring. The results of this analysis are presented in Table 8. Stock returns are for the announcement period, days [0,+1]. Bond returns are for the announcement month, month [0]. If a firm has multiple bond issues, only the most frequently traded bond or targeted issue is included in the analysis.

For Chapter 11 firms, the announcement period stock return is -12.19%, and the month [0] bond return is -3.74% with z-statistics of -12.99 and -12.40, respectively. Further, 33% of the announcement period stock returns and 36% of the month [0] bond returns are positive. The sign test z-statistics are -2.77 and -0.90 for stocks and bonds, respectively. Thus, outliers do not appear to be driving the statistical significance of the results.

In contrast, prepack firms have an announcement period stock return of -2.05% and a month [0] bond return of 0.17% with z-statistics of -0.78 and 0.49, respectively.(15) The security returns for Chapter 11 and prepack firms are significantly different from each other at the 0.05 level. This evidence is consistent with the notion that differential information is released during announcements of prepacks and Chapter 11 reorganizations.

The announcement period stock return for private workouts is -2.76% and the bond return is -0.98% with z-statistics of -3.72 and -3.11, respectively. For public workouts, the announcement period stock returns are -1.83% and the bond returns are -0.54% with z-statistics of -1.35 and -3.30, respectively.

The results suggest the existence of significant differences in the information revealed during the announcement of the debt restructuring method. A hierarchy similar to that observed for the EBIDTs is observed for stock returns. The Chapter 11 sample exhibits the strongest negative price reaction, with public workout returns having the least adverse price reaction. Prepacks and private workout firm's returns have intermediate reactions. The significant differences between Chapter 11 and prepack stock returns lend support to asymmetric information models and suggest that prepack firms are better quality than Chapter 11 firms. This evidence is also consistent with the notion that among the bankruptcy alternatives, prepacks appear to be more efficient in preserving firm value. If a workout is not feasible, then under certain conditions, firms appear to prefer prepacks to Chapter 11 reorganizations.

VII. Conclusions

This paper empirically examines a comprehensive sample of firms in financial distress and contemporaneously compares Chapter 11 reorganizations, prepackaged bankruptcies, and workouts as mechanisms for resolving financial distress. We perform univariate and multinomial logit analyses of several financial characteristics of these firms and provide evidence that the debt restructuring decision depends on the degree of firm's leverage, the severity of the liquidity crisis, the extent of creditor's coordination, and the magnitude of the firm's economic distress.

Chapter 11, prepack, private workout, and public workout firms exhibit differences in the degree of liquidity and financial distress. Prepack firms have a significantly larger proportion of current debt due compared with Chapter 11 and workout firms, reflecting the need for immediate debt relief by these firms. Workout firms have a significantly greater proportion of long-term debt to total assets than Chapter 11 firms. This provides evidence for Jensen's (1989) hypothesis that firms with greater debt have more incentive to restructure out of court.

The nature and complexity of debt claims is different among firms using different types of debt restructurings. Firms filing for Chapter 11 have greater bank debt and trade credit than prepack or workout firms. Our results suggest that if firms perceive ex ante that they can resolve the creditor's coordination and holdout problems they will prefer workouts or prepacks. On the other hand, those firms facing significant coordination problems (as reflected by a complex debt structure or a large proportion of bank debt) may not have any alternative to filing for Chapter 11.

The results also indicate that more firms filing for Chapter 11 are in economic distress than are prepack and workout firms. The ratio of EBIDTs to sales and total assets are greater for prepack firms than for Chapter 11 firms. Private and public workout firms also have greater EBIDT ratios than Chapter 11 firms. The magnitude of these ratios suggests that better-quality firms restructure out of court, relatively good-quality firms with liquidity problems use prepackaged bankruptcies, and lesser-quality firms opt for a traditional Chapter 11.

An analysis of security price reaction provides evidence that the choice of restructuring method conveys information to the market. Chapter 11 announcements have the largest negative stock and bond price response, while public workouts have the least adverse price response.

Finally, there are significant differences in firm size and level of debt among the firms using the three restructuring mechanisms studied in this paper. Prepack and Chapter 11 firms are significantly smaller (total assets and sales) and have significantly lower debt levels (total liabilities and long-term debt) than workout firms. These results suggest that larger firms have a comparative advantage in restructuring their debt claims out of court.

1 The assets of public firms filing for bankruptcy increased from $1.67 billion in 1980 to a peak of $83.20 billion in 1991 (The Bankruptcy Yearbook and Almanac, 1993, New Generation Research Inc.).

2 Prepackaged plans have grown dramatically and represented approximately one third of all large (over $100 million) bankruptcy plans filed during 1992 (The Bankruptcy Yearbook and Almanac, 1993, New Generation Research Inc.).

3 We do not investigate the differential costs associated with the choice of restructuring mechanism, given the extensive literature in this area. In particular, Betker (1995b) documents that the direct costs of Chapter 11 are the highest, followed by prepacks. Public workouts have the lowest costs. Several other researchers, including Altman (1984) and Gilson, John, and Lung (1990), provide evidence that Chapter 11 reorganizations are more expensive than workouts.

4 In the Mooradian (1994) model, Chapter 11 provides an incentive for inefficient firms to reorganize under Chapter 11 rather than mimic out-of-court restructurings. However, the procedure allows firms that should be liquidated to continue operation. Even in this scenario, Chapter 11 is beneficial, as it reduces overinvestment for inefficient firms filing for Chapter 11 and allows efficient firms to renegotiate their debt out of court, allowing them to continue instead of being liquidated.

5 Hotchkiss (1995) provides support for this view. In her study, firms filing for Chapter 11 continue to perform poorly during a five-year period following reorganization.

6 Creditors might not provide debt relief, via a workout, to firms facing overinvestments but might agree to renegotiate under Chapter 11 under which managers save the cost of overinvestment in exchange for a share of the savings (APR violations in Chapter 11). Eberhart and Senbet (1993) provide arguments for the role of APR violations in ameliorating the risk-shifting incentives present in financially distressed firms.

7 Because long-term debt is often in the form of public debt, the proportion of total and long-term debt to total assets may also impact the degree of the creditor's coordination problem. Agency issues associated with debt discussed in Bae, Klein, and Padmaraj (1994) and Crabbe and Helwege (1994) are not addressed in this paper.

8 This result differs from Franks and Torous (1994), who find that firms entering Chapter 11 have more debt than firms involved in workouts, and Gilson, John, and Lang (1990), who find no significant differences in leverage ratios. The divergence of results may be due to differences in sample selection. Franks and Torous (1994) include only firms with publicly traded debt, which tend to be larger firms. Gilson, John, and Lang (1990) primarily consider firms initiating a workout. Our analysis indicates that firms that file for Chapter 11 for the first time are, on average, small firms with little publicly traded debt and relatively lower leverage.

9 Gilson, John, and Lang (1990) define long-term debt as any interest-bearing debt including notes and current debt due. We define long-term debt as reported in the Moody's Manual.

10 As with other financial variables, current debt due is measured for the year prior to the restructuring announcement. Some firms may have defaulted on their debt in the year prior to restructuring, so that debt is reported as current debt due.

11 We distinguish between bank and private debt by examining the debt structure as reported in Moody's. If the description specifically mentions that the lender is a bank, then it is classified as bank debt. Otherwise, it is classified as private debt.

12 To ensure that it is the firm's first attempt to restructure, we examine all our sources for information on restructuring. In the absence of any information, we assume that it is the firm's first attempt.

13 Because public debt is classified as long-term debt, this result may reflect the overwhelming presence of public debt in public workouts.

14 Brown, James, and Mooradian (1993) document the presence of information effects on the type of securities used in debt restructurings.

15 Most prepack firms are already in default on their public debt and have already negotiated a reorganization plan by the time they file a petition for bankruptcy. In contrast, filing a traditional Chapter 11 precipitates default. Thus, the default and bankruptcy filings may have different information content. However, as documented by Bi and Levy (1993), the market appears to derive information about a future Chapter 11 filing from bond downgradings. In any event, we investigate the security price reaction around the default date for prepack firms and find a two-day, day [0,1], return of -3.59% with a z-statistic of -1.38. There is no statistical difference between the default and bankruptcy filing dates in our sample.

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Sris Chatterjee is Associate Professor of Finance at Fordham University, New York, NY. Upinder S. Dhillon is Associate Professor of Finance at Binghamton University, Binghamton, NY. Gabriel G. Ramirez is Associate Professor of Finance at Binghamton University and Stern School of Business, New York University, New York, NY.
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Author:Chatterjee, Sris; Dhillon, Upinder S.; Ramirez, Gabriel G.
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Date:Mar 22, 1996
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