INVESTMENT POLICY AND EXIT-EXCHANGE OFFERS WITHIN FINANCIALLY DISTRESSED FIRMS

This article examines the conflict of interest between shareholders an d bondholders in a setting in which firms can renegotiate the terms of existing debt with public debtholders. In particular, we consider one of the most common types of debt restructuring: the exit-exchange off er. Our analysis explores the relation between exit-exchange offers an d investment choice by the manager, and it concludes that managers, ac ting strategically on behalf of shareholders, may select inefficient i nvestment projects in order to enhance their bargaining position vis-a -vis creditors. Holding the upside potential of an investment project fixed, managers/shareholders prefer projects with lower payoffs in sta tes of bankruptcy because it induces individual bondholders to accept poorer terms in a debt-for-debt exit-exchange offer, thus generating a greater residual for shareholders in states of solvency. Additionally , we show how the investment inefficiencies in our analysis depend on (i) the inability of bondholders to coordinate their actions; (ii) the ability of managers to commit to suboptimal investment projects; and (iii) the coupling of an individual bondholder's decision to tender an d her decision to consent to allow the firm to strip fiduciary covenan ts. We suggest conditions under which a ban on coupled exit-exchange o ffers-or alternatively, constraints on ''debt-for-debt'' exchanges-wou ld be efficiency-enhancing.