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As a companys financial troubles grow more serious, a dramatic confrontation is becoming obvious, which takes its root in a conflict of interests between its main participants the owners of a borrower company, its CEOs, managers and creditors.

Joint stock companies usually have an interest in bankruptcy being formalized after the moment of default on a flow basis, that is, after the period during which it is revealed that current revenues have become smaller than expenses. Shareholders count on the possibility14 that a rapid interruption of current operations can enable them to salvage a greater part of their own capital.

Creditors are rather more inclined to demand that bankruptcy pro cedures be effectuated at a later stage, when a default on a stock basis is revealed, which implies that current revenues become persistently (for a long time) smaller than required expenditures. In this instance, creditors may rely on exchanging at least a part of stale debt for shares in the company which has declared the default.

In the previous section, we already mentioned the limitations that may appear when the solutions to problems resulting from a companys insolvency are being sought by resorting to decentralized (purely mar ket) measures. However, the establishment of centralized bankruptcy procedures (involving all interested parties) does not (nor can it) ex clude the application of market methods of financial regulation; such See Wruck K. Financial Distress, Reorganization, and Organizational Efficiency. Journal of Financial Economics, 1990, Vol. 27, pp. 419444.

procedures may be regarded, rather, as representing only one of the components of the infrastructure serving as a framework for market processes. In this connection, we should like to refer to one of the manifestations of these connections. Before appealing to court with a petition in bankruptcy, each party invariably tests the situation by mak ing an attempt to seek more beneficial terms through private agree ments with its partners.

The negotiations initiated shortly after a default on a flow basis is re vealed are usually more productive (and more often result in compro mise settlements), the narrower is the circle of strategic creditors15.

Experience has shown that many conflicts can be resolved during such negotiations16. If the participants are still unable to come to an agree ment, then bankruptcy procedures as regulated by the law are initiated.

Behind the confrontation of the interests of various participants, there is actually an objective conflict that of the functions which are to be realized during the process of bankruptcy. Such procedures have as their primary objective the compliance with the rules dictated by the existence of property rights. In the event of a companys persistent in solvency, this implies the sale of a debtors property on the most bene ficial terms (the first of the conditions listed in the first paragraph of this section) and the fulfillment of this companys obligations to all inter ested parties to a maximum degree.

For another thing, a companys liquidation, with sale of all its prop erty, is not always justified from the point of view of the economys functioning as a whole. Moreover, such actions are not always justified even on the basis of the abovementioned efficiency conditions being realized ex post: support to and reorganization of a viable company may result in a growth of its NPV (net present value). A companys liqui See, e.g., Gilson S., K. John, L. Lang Troubled Debt Restructurings: an Empirical Study of Private Reorganization of Firms in Default. Journal of Financial Economics, 1990.

Vol. 27, pp. 315354.

The above mentioned paper by S. Gilson, K. John and L. Lang gives the results of a study of 387 corporations whose shares were circulating on the New York and American Stock Exchanges (19781987) and were listed as the lowest 5% of shares (the least successful, according to the exchanges criteria). Up to one half (or, more exactly, 47%) of those companies that had faced serious financial problems and were, at least temporarily, insolvent, were able to achieve an agreement concerning the restructuring of their debts in the course of private negotiations with their creditors. Thus, only about one half of the insolvent companies had to directly undergo bankruptcy procedures.

dation must serve, in fact, as the evidence of it having exhausted all its potential for utilizing the assets in question within the framework of es tablished property structures; it is often followed, as mentioned earlier, by an irreversible destruction of all accumulated informational and or ganizational capital.

Earlier it has been noted that by far not every inefficient (non viable) company undergoes official bankruptcy procedures. The other side of this equation should be noted, too: by far not every company that has been officially declared bankrupt is truly non viable. In actual practice, the situations when a companys insolvency arises due to a temporarily unfavorable economic situation, e.g., a minor error in man aging cash funds, various transient shocks, etc., are rather common.

Liquidity problems, commonly associated with fluctuations on the fi nancial markets, especially often serve as direct causes of default.

In this connection, however, the following circumstance should also be taken into consideration. Suppose that a given industrial company may be utilizing state of the art technologies and sufficiently good equipment, and at the same time find itself in a troublesome financial situation due to transient market shocks or inadequate quality of management. Then the most probable method of reorganizing this company in the contemporary situation would be its takeover (with a possible subsequent replacement of the CEOs). However, if potential investors display no active interest in a company (while the lack of mar ket demand is not associated with any specific circumstances, like too large a size of a company), this may be interpreted as an indirect evi dence of the prospects for the reorganization of this company being rather dubious, or fraught with too many risks17.

As to the percentages of culling of private corporations through different channels, the results of the study by Ogden J., F. Jen and P. OConnor can be cited. These authors demonstrated that among approximately 5,000 American non financial corporations, whose shares were in public circulation at the end of the year 1995, by the end of one fifth had been out of operation (22%). More than three quarters of all vanished companies (848) had been taken over. And less than one tenth of the vanished compa nies (amounting to only 2% of the total number of corporations studied) chose to be offi cially declared bankrupt (see Ogden J., F. Jen, P. OConnor Advanced Corporate Fi nance: Politics and Strategies Prentice Hall: Upper Saddle River, N.J. 2003, pp. 626 627). Thus, the majority of the vanishing companies are being directly sorted out by the markets special sector the market for corporate control.

P. Bolton and D. Scharfstein, in their theoretical model18, differenti ate between liquidity default, when cash inflow during a certain (not too long) period of time proves insufficient, and a strategic default, when a companys revealed insolvency has originated from its CEOs strategy aimed at buying out the company after it becomes clear of debt. From the point of view of efficient management, as follows from the authors argumentation, it is by far not always reasonable to undertake a com panys liquidation shortly after its default (especially liquidity default). If the participants CEOs and creditors conclude contracts on optimal terms, strategic default may no longer be attractive in the eyes of the CEOs.

In reality, however, it is not easy to find any distinct criteria that might help to subdivide private companies undergoing a period of financial trouble into viable (in terms of economics) and non viable. Balance sheets as such contain little information for making adequate judg ments as to the degree of efficiency of one or other method for an al ternative utilization of real assets. Difficulties of this sort have often been mentioned in literature on economics: by a number of the most common accounting indices, the companies on the verge of bankruptcy (or those that have directly revealed their inability to make payments against current liabilities) may closely resemble those operating in the most dynamic sectors of the economy19, and this resemblance can hardly be regarded as simply accidental.

As an example of the conditions influencing the choice between a companys liquidation and reorganization, the contemporary US prac Bolton P., D. Scharfstein Optimal Debt Structure and the Number of Creditors. The Journal of Political Economy, 1996. Vol. 104, pp. 125.

Thus, P. Booth and B. Hutchison made an interesting comparison between basic eco nomic indices of 33 Australian companies that have been registered as insolvent, and new Australian corporations whose shares have for the first time entered public circula tion. The authors could not distinguish any considerable statistical differences between these two groups. Both were demonstrating not only lower profitability indices (as com pared to the economys averages), but also comparatively lower liquidity. Moreover, in both groups the specific weight of borrowed funds in total liabilities (the size of the finan cial lever) was found to be considerably greater than the average indices computed for all companies see Booth P., P. Hutchison Distinguishing Between Failing and Growing Firms: a Note on the Use of Decomposition Measure Analysis. The Journal of Business Finance and Accounting. 1989, pp. 267271).

tice may be reviewed (the peculiarities of legislations on bankruptcy existing in other countries will be dealt with later).

In accordance with Article 11 of the 1978 Law, the filing of a petition in bankruptcy by a borrower company may automatically grant it a cer tain pause: in those instances when a company continues to function and its market value remains above zero, creditors (including the own ers of mortgages notes) for a certain time cannot set up their claims to the property owned by that company.

Article 11 of the Law On Bankruptcy grants to managers an exclu sive right to develop, during the first 120 days after bankruptcy registra tion, their plans for reorganizing a bankrupt company (in some in stances this period may be extended by a court decision). At the same time, within 180 days the reorganization plans developers must obtain the creditors approval of their variants of reorganization. If the CEOs have failed to produce such a plan (or it is not supported by the credi tors), the latter may offer their own plan of the companys reorganiza tion20. In a vast majority of cases such a project is presented by the CEOs of a company experiencing a critical situation21.

As a rule, the discussion of the plans for a companys reorganization and the subsequent court decision lasts for no longer than one or one and a half years. The period of reorganization is usually lengthier, espe cially in the economys more capital intensive sectors. Thus, the aver age reorganization period of bankrupt railway companies in the USA in the last century exceeded 13 years22.

Modern analysis of the interactions between the main participants in bankruptcy procedures the creditors and CEOs of a borrower com pany often makes use of game models, and particularly of the well known bargaining model offered by A. Rubinstein23.

Reorganization plans suggested by banks are usually less trusted by participants, and sometimes by the judicial authorities as well. Therefore, in the majority of cases such plans are submitted for several experts estimations, and are reviewed far more thor oughly and carefully.

Weiss L. Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims. Journal of Financial Economics, 1990. Vol. 27, pp. 285314.

Warner J. Bankruptcy Costs: Some Empirical Evidence. The Journal of Finance, 1977. Vol. 32.

Rubinstein A. Perfect Equilibrium in a Bargaining Model. Econometrica, 1982. Vol.

50, pp. 97110.

In accordance with this models general logic, let us assume that two persons participate in bargaining a borrower companys CEO (here inafter the Manager), and a representative of united creditors (here inafter the Creditor). In this conflict, each party has access to certain means of exerting pressure on its partner in the negotiations.

The Manager can, as noted earlier, suggest a plan for the com panys reorganization. However, in accordance with US legislation, the Creditor may veto the implementation of this plan, if therein it is envis aged that the creditors claims to property be secured by amounts that are not even as high as the companys liquidation value.

On the other hand, the Manager may make the Creditor face a situa tion when the former quits his post for another job with a higher income.

Consequently, the Managers share in the incomes of the company be ing reorganized in accordance with his plan is expected to be no less than the salary he can hope to receive at another company. The less the losses caused by the Managers quitting his position and the subse quent devaluation of the specific investments of human capital, the stronger the Managers position in the conflict with the Creditor will be, all other positions being equal.

The US practice of choosing between liquidation and reorganization may be an evidence of the fact that the CEOs and owners of a borrower company in many cases succeeded in implementing a plan that en abled creditors to trade their debt notes (bonds) for shares in a new company in an amount that was only slightly greater than the old com panys liquidation value. In accordance with such an agreement, a companys former obligations are redeemed by its shares (if it contin ues to exist) or the shares in a newly organized corporation. Having achieved an agreement with its creditors as to property rights redistri bution and the courts approval, the company may continue to oper ate24.

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