Moreover, by applying, with the purpose of exerting pressure on the Creditor, those reorganization projects that must result in a substantial Thus, in 2003 the largest ever bankrupt in the USA’s history – the company “World Com” – succeeded in achieving an agreement with its creditors as to restructuring its liabilities. By transferring a past of its assets and providing shares in exchange for its debt liabilities, the company managed to reduce its debt from 30 billion USD to 3.5–4.5 billion USD. By the year’s end, the court is to bring its verdict concerning the achieved agreement.
reduction in a company’s liquidation value, the Manager sometimes have succeeded in getting the Creditor to make even more important concessions (which corresponds, naturally, to the interests not only of the CEOs, but also the owners of the old company). In those instances when the potential losses associated with the CEOs’ plan of trading debt liabilities for shares seem not to be “too great”, as noted by Y.
Bergman and J. Callen, the threat appears to be effective, and the creditors agree to give in to reasonable demands. They believe that in many cases it is this “trading” that provides the foundation for negotiat ing as to the destiny of existing debts between the company’s owners and creditors25.
The arsenal of effective threats applied by the Manager includes, as noted earlier, certain ultimatum like proposals to the effect that if the Creditor rejects the plan, its author will simply quit the company. Can the Manager, through blackmailing the Creditor with such prospects, negotiate an even greater share for himself in the reorganized company and force the Creditor to be content with the amounts of money that would not even be equal to the old company’s liquidation value And if such a possibility does exist, can the scope of the entailing concessions be clearly determined The authors of a monograph, specifically dis cussing the application of game models in studying the conflicts arising in the sphere of economic law, comment rather skeptically that there obviously exist no clear answer to either of these questions26.
It has been already mentioned earlier that one of the conditions for a company’s reorganization is the restructuring of debt liabilities and/or changing of property structure: the creditors thus become co owners of the new corporation. In this connection, considerable difficulties are given rise to by externalities and the problems associated with coordi nating the interests of different creditors. Consider, e.g., those cases when a part of debt is represented by corporate bonds circulating on the securities market. As has been shown by the practice of bankrupt cies of large US companies, the banks that have granted loans to a bankrupt company usually agree to more beneficial (for that company) Bergman Y., J. Callen Opportunistic Behavior in Debt Renegotiations and an Interior. – 1991, p. 138.
Baird D., R. Gertner, R. Picker “Game Theory and the Law”. – Harvard University Press:
Cambridge, Mass, 1998, p. 235.
financial terms of reorganization only when it becomes clear that the trust companies or banks representing the interests of their bonds’ owners are also ready to make appropriate concessions.
An acute conflict of interests, naturally, arises between the owners of secured and non secured liabilities. When trading for shares in the new companies, the owners of mortgage notes are trying to negotiate the amounts of money that would be at least no less than the value of mortgage securities. At the same time, growing risks and uncertainties during reorganization in some instances induce the owners of bale bonds to oppose the majority of other participants and to prefer the liq uidation of the bankrupt company27. Also, after reorganization has been completed, the privileged position of mortgage notes is gradually “be ing eroded”: in order to provide financing for the newly created com pany, the highest status, under the existing laws, is granted to the claims of those creditors who are ready to offer new loans to the com pany in question.
Assume, however, that the conflicting parties – say, the Manager and the Creditor – have failed to come to an agreement. It is only in this case that the judicial agencies in charge of bankruptcy proceedings must make the decision as to the company’s destiny and the entailing procedures of its liquidation or preservation. In the event of reorganiza tion they not only determine the “genuine value” of a new corporation, but also make the decision as to how the securities to be issued by that company against a particular amount of money are going to be distrib uted among all the interested parties.
It is not difficult to notice that the bankruptcy system described here can ensure sufficiently favorable conditions for reorganizing bankrupt Suppose, e.g., that in one year the value of the reorganized company, with probability of 4/5, may amount to 150 (money units), and with probability of 1/5 – 900 (the mathematic expectation of the company’s value will accordingly amount to 300), whereas this com pany’s today’s liquidation value is 190, while the claims of mortgage owners amount to 200. Assume that these participants’ attitude to risk is neutral; discounting, for simplicity’s sake, is disregarded. Then the majority of the participants will be for the company’s reor ganization (300>190), whereas mortgage owners will be against it – because their ex pected income (150·4/5 + 200·1/5 = 160) will be less than the income which they would have received in the event of the company’s immediate liquidation (190). Discussing bankruptcy of Macy, a large US trade company, O. Hart notes the influence of the liquida tion strategy supported by mortgage owners (see Hart O. “Firms, Contracts and Financial Structure”. – Clarendon Press: Oxford, 1995 p. 166).
companies. By contrast, the US procedures may be compared to the British bankruptcy practices. In the UK, the Manager of a debtor com pany has no right, without the Creditor’s consent, to file a petition in bankruptcy, and bankruptcy procedures as such are never imple mented through enforcement. (A somewhat similar situation can be seen in Canada, where the Creditor, after several months have passed since the formalization of a petition in bankruptcy, is granted the right to appropriate the debtor’s property28).
Among factors determining the specific features of the British bank ruptcy system, we are going to stress only the following circumstance.
In the UK, the prevailing majority of companies are serviced by only one creditor (floating charge creditor). Until a non financial company makes the decision as to placing its bonds with a comparatively wider circle of investors, the problems caused by externalities are not felt too acutely.
This system, in its essence, is close to the credit contract privately concluded between a borrower and a creditor, described in the previ ous section. In accordance with the standard credit contract, in the event of a borrower company’s insolvency, its “strategic” creditor may have justified claims to its incomes secured by sale of (part) of its prop erty, primarily liquid financial assets and inventory holdings.
When applying A. Rubinstein’s game bargaining model, it can be ar gued that in the UK and Canada the Creditor enjoys far greater exit op tions. Because of this, the equilibrium determining the distribution of funds resulting from a company’s liquidation, or the securities issued by a new company as a result of reorganization, can be substantially tipped in favor of the Creditor.
In order to make more explicit the special role being played, during such bargaining, by the ratio between the current market value of a company continuing its activity (estimated value of the plans being of fered) and the liquidation value of an old company, let us return to US bankruptcy legislation. In the USA, the Creditor’s exit options are repre sented, as noted earlier, mainly by his rights to the bankrupt company’s liquidation value.
Suppose that a company is continuing its economic operations, and it becomes known that its current market value is not higher than the liquidation value (an explicit evidence of the market’s pessimistic atti The procedure of bankruptcy in Canada is discussed in a special section.
tude to the prospects of an alternative utilizations of the assets owned by the company in question). In this case, the Creditor, in accordance with established bankruptcy procedures, may reject the provision con cerning an automatic suspension of all claims and immediately put forth his claims to the bankrupt company’s property.
However, it follows that the choice between a bankrupt company’s liquidation or reorganization by no means can always ensure an effi cient solution: it may be made in favor of reorganization exactly at the moment when the prospects for such a “reorganization” are rather far from beneficial. It is true that the decision concerning a company’s re organization may simply result from the fact that this company’s very outdated (or highly specialized) equipment cannot find any potential buyers on the market, and thus its market value becomes low. The low liquidation value of property (serving as the grounds for the court’s de cision to reorganize the company) as such may be an evidence an unfa vorable estimation, on the part of the majority of the participants in the economic process, of the prospects for this property’s alternative utili zation (in our example, the obsolete industrial equipment).
Nevertheless, despite all the reservations, bankruptcy procedures are often constructed so as to ensure an adequate comparison be tween the potential benefits offered by a bankrupt company’s reorgani zation and those incomes that may be generated by the sale of its property on the market. This comparison, in particular, constitutes “the core” of US bankruptcy legislation. According to a number of experts (R. Pozner, M. White), in the USA and France bankruptcy procedures are somewhat “biased” toward preservation and/or subsequent reor ganization of companies experiencing financial troubles29. In the UK, as noted earlier, these procedures have a certain “bias” in the opposite direction.
Reorganization and liquidation of an insolvent company often repre sent two alternative opportunities in bankruptcy. However, in actual practice this opposition may become only temporary. The US experi Earlier, we cited the results of a survey of approximately 5,000 US corporations, whose shares were being publicly circulated (Ogden J., F. Jen, P. O’Connor “Advanced Corpo rate Finance: Politics and Strategies” Prentice Hall: Upper Saddle River, N.J., 2003, pp. 626–627). Among the 107 companies declared bankrupt in 1996–2000, 95 were maintained and reorganized, while only 12 companies were liquidated, that is, no more than 1% of the total number of the companies which “had expired” since the end of 1995.
ence has shown that quite a few plans end up in the liquidation of a “re organized” company, or in the necessity of a new reorganization (re structuring of financial liabilities)30.
The frequent failures of reorganization may be explained by several factors, some of which have been mentioned earlier in this paper.
Therefore we are going to make here only a reference to the very im perfect information that is often taken as the foundation for the plans of restructuring the economic operations aimed at “extending the life” of a bankrupt company. M. White, Professor at the University of Michigan, points out the following specific features of “pooling equilibrium” in sig nal models describing the situation of bankruptcy and applied to them the term “filtering failure” (failure to achieve “filtering”)31.
Thus, the CEOs of “non viable” companies (e.g., companies utilizing outdated technologies and worn out equipment) strive to prove that the costs of the company’s reorganization would not be too high. In face of the still asymmetrical information flows, the determination of the true scope of these costs turns out to be quite an expensive affair (substan tial expenditures are needed, in the first place, simply for estimating the real amount of expected costs). Besides, the CEOs’ opponents – the creditors – are by no means interested in a noticeable “fall” in the mar ket value of the property which is subject to conflicting claims.
Quite often a company encounters financial difficulties due to the fact that its products have become outdated and are less in demand (an evidence of the transition to the final phases in the product’s life cycle).
Then, even after a “cosmetic” reorganization, as well as the restructur ing of financial liabilities, haven taken place, the market price may still be lower than aggregate costs. This situation has been describes in de tail in economic theory. The “reorganized” company will, for a certain period of time, continue its activity in instances when its price is higher than variable costs; the period of the company’s unprofitable function ing is determined by the amount of its accumulated liabilities, as well as by other factors.
Hotchkiss E. Postbankruptcy Performance and Management Turnover. – “The Journal of Finance”, 1995. Vol. 50, pp. 3–21.
White M. Corporate Bankruptcy as a Filtering Device: Chapter 11 Reorganizations and Out of Court Debt Restructurings. – “Journal of Law, Economics, and Organization”, 1994. Vol. 10, pp. 268–295.
1.3. Choices of bankruptcy procedures Bankruptcy legislation, as it currently exists in the developed market economies, has been subject to intense criticism. Some of its limita tions are clearly exemplified by the USA’s bankruptcy procedures dis cussed in the previous section. The choice between a company’s liqui dation and reorganization depends on each of the participants’ actions, aimed at increasing their incomes (or reducing the revealed losses).
Given the contemporary bankruptcy practices in the majority of coun tries, the strong market positions of one of the parties involved, its self ish interests and manipulations may result in an inefficient decision as to the future destiny of a bankrupt company. The role of these circum stances is especially important in situations when it becomes possible to exert political pressure and engage the judicial agencies for a per sonal benefit, while the judges and bankruptcy commissioners are cor rupt.