RESOLUTION OF FINANCIAL DISTRESS - DEBT RESTRUCTURINGS VIA CHAPTER-11, PREPACKAGED BANKRUPTCIES, AND WORKOUTS

The resolution of financial distress is a complex process involving th ree non-mutually exclusive debt restructuring methods: Chapter 11 reor ganizations, prepackaged (''prepack'') bankruptcies, and workouts. (A workout is an out-of-court debt restructuring done through either priv ate negotiation or a public workout that takes the form of a tender or an exchange offer.) Few studies simultaneously analyze the choice of these restructuring methods. This paper examines empirically a compreh ensive sample of firms in financial distress and compares their restru cturing methods. We perform univariate and multinomial legit analyses of several financial characteristics of these firms. We provide eviden ce that the debt restructuring decision depends on the degree of the f irm's leverage, the severity of its liquidity crisis, extent of credit or's coordination, and the magnitude of the firm's economic distress. The results of our analysis indicate that firms that perceive ex ante that they will be able to resolve the creditor's coordination and hold out problems prefer workouts. The alternative is a prepack or a Chapte r 11 reorganization. Direct filing for a prepack is optimal for some f irms when the debt structure allows them to prenegotiate with creditor s. However, as a first attempt to restructure debt, the use of prepack s is quite limited in our sample. It appears that this method is more often used in combination with a workout or following a failed attempt to restructure debt out of court. First, we find that although all fi nancially distressed firms are highly leveraged, they have different d ebt structures. Public workout firms have a significantly greater prop ortion of long-term debt to total assets than Chapter 11, prepack, or private workout firms. We also find that prepack firms have a more imm ediate liquidity crisis than Chapter 11 or workout firms. This is evid enced by a significantly larger proportion of current debt due. Second , our analysis suggests that the degree of coordination among creditor s, as reflected by the nature and complexity of debt claims (the mix o f public, private, and bank debt), is an important determinant in 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, films filing for Chapter 11 have higher levels of trade credit and bank debt than do firms using the other methods. Banks can be an obstacle for workouts since they no rmally hold senior and collateralized debt and thus are likely to fare better under Chapter 11. Chapter 11 firms also have a relatively low proportion of public debt when compared with workout firms. The preval ence of public debt in workouts and its practical absence in Chapter 1 1 reorganizations suggests that firms with public debt are not likely to use formal bankruptcy procedures without first attempting a workout . Third, we provide further evidence to support the notion that workou t and prepack firms are better quality than Chapter 11 firms. We measu re firm quality by operating cash flows (measured by earnings before i nterest, depreciation, and taxes as a proportion of assets or sales). We find that operating cash flows are lower for Chapter 11 firms than for prepack and workout films. An implication of our analysis is that firms choosing a particular restructuring mechanism have distinctive f inancial and economic characteristics. Thus, different information may be conveyed to the market when the choice is announced. Consistent wi th this argument, we find that announcements of first-time restructuri ngs generally lead to negative price reactions. However, we document t hat Chapter 11 firms experience the most negative stock price reaction , while public workouts experience the least adverse price reaction. F urther, the significant difference between Chapter 11 and prepack anno uncement period returns suggests that prepack firms are better quality than Chapter 11 firms. Finally, it is interesting to note that on ave rage, small firms with little or no public debt file directly for Chap ter 11, while larger firms with a significant amount of public debt fi rst attempt to restructure their debt via public workouts. It appears that large firms have a comparative advantage in restructuring public debt out of court.