Week 9 - Financial Distress and Bankruptcy Costs

Question 1

What can be done to reduce the debt overhang problem

Answer 1

Bond Restructuring

Question 2

Problem with Bond Restructuring

Answer 2

Trust Indenture Act of 1939

• Requires approval by all bond-holders to change principal, interest rates or maturity
• Only way to restructure a bond in the US is through an exchange offer with exit consents which modify non-payment terms of the old bond
• Swap old debt for a package of new debt, equity and cash
• non-tendering bondholders hold on to their claims so that there is no violation of the trust indenture act

Key Obstacle: When bondholders take the outcome of the exchange as independent of their decision to tender, the exchange fails - similar to free rider problem

Question 3

Reorganisation under Chapter 11

Answer 3

Chapter 11 is a structured bargaining process that has provisions meant to deal with some of the inefficiencies discovered

Key Provisions:
- Automatic Stay
- Debtor-in-Possession Financing
- Voting Procedure
-Cram-Down

Question 4

Automatic Stay

Answer 4

• Stops payments to unsecured creditors
• Secured Creditors cannot seize collateral
• Makes sure firm is not inefficiently ‘torn apart’ by creditors
• eliminates prisoner’s dilemma among creditors

Question 5

Debtor in Possession Financing

Answer 5

DIP financing allows the firm to issue new senior debt (even if this violates existing covenants)
- This is subject to bankruptcy court approval
- DIP financing increases the firm’s incentive to invest, because it alleviates debt overhang problems. It therefore preserves the going-concern value of the firm

Question 6

Chapter 11 Procedure

Answer 6

• Current management and board retain control
• Exclusivity period: management retains the exclusive right to file a reorganisation plan for 120 days
• committees and trustees representing classes of claimholders bargain over the reorganisation plan
• majority voting mechanism: 2/3 of face value and 1/2 of debtholders in each class have to agree
  unanimity across classes
• classification is the debtors’ discretion but claims must be sufficiently similar
• cram-down procedure> the court can impose a plan vetoed by one class of claimants

Question 7

How does the chapter 11 voting procedure overcome hold-out problems

Answer 7

Contrary to exchange offers, bondholders are not treated differently depending on their vote

• Under the trust indenture act firms cannot write covenants mimicking the chapter 11 procedure