Monthly Archives: November 2013

Corporate reorganization rules is to be judged and the fundamental problem of valuation: CONCLUDING NOTE ON THE DIVISION OF VALUE

There is another line of work that in closing would be worth noting. This work has sought to analyze the effects that the distribution of value in Chapter 11 has on ex ante decisions.
Some of this work has shown that a sequential distribution of value — that is, a distribution in which equityholders receive no value if the value of debt exceeds the value of the assets — might have some negative ex ante effects. For example, such sequential distribution might lead to excessive risk-taking in financial distress prior to filing for bankruptcy (see Gertner and Scharfstein ); discourage the initiation of bankruptcy proceedings when such initiation is desirable (see Baird; and lead to excessive entrenchment of managers-owners (see Bebchuk and Picker and Berkovitz, Israel, and Zender ). Thus, the question arises whether this work implies that the prevailing bargaining-based approach, which enables equityholders to extract some value even when debtholders are not paid in full, might be desirable after all. Monotheistic Concept

Drawing such a conclusion from the above work is not warranted. To begin, while the work on ex ante effects has shown that sequential division might have some negative ex ante effects, it also has found that such division might have some beneficial ex ante effects. 

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE OPTIONS ALTERNATIVE TO EXISTING RULES end

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE OPTIONS ALTERNATIVE TO EXISTING RULES endNote that between the distribution of the options and the date T, a trading in the options might take place and some rights might accordingly be passed from one hand to another. But, unlike the auctions method, the effectiveness of the options method does not depend on whether outside buyers acting in the market will value V correctly. Another related feature of the options approach, which might be viewed as attractive, is that it is decentralized. Each participant will be able to decide for itself how to go about using its rights, and no participants will be able to complain that they are getting less than their entitlement.

Having thus far dealt with the effects of the options approach on value division, let us now turn to its effect on the maximization of the value of the company’s assets. To begin, the approach would shorten the reorganization process, though it would not do so as much as the auctions approach would.

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE OPTIONS ALTERNATIVE TO EXISTING RULES continue

Under the options approach, the units of RC will not be initially distributed to the participants but rather held by a clearing agent (CA), and the participants will be given instead rights (options) toward the clearing agent С A. Participants that wish to exercise their rights will have to do so by a date T that follows shortly the distribution of options — say, a month following this distribution.

Specifically, in our example, each debtholder will get a type-A right. This right may be redeemed by CA for $1, but if it is not redeemed it will entitle the right holder to get one unit of RC. Each equityholder will get a type-B right, which entities its holder, if submitted by date T, to purchase one unit of RC for $1.

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE OPTIONS ALTERNATIVE TO EXISTING RULES

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE OPTIONS ALTERNATIVE TO EXISTING RULESAnother alternative to the existing bargaining approach is the “options approach.” This approach was put forward in Bebchuk and subsequently also advocated by Aghion, Hart and Moore and Hart.

Like the auctions approach, the options approach seeks to eliminate bargaining -and with it the costs and deviations from contractual priority that accompany it. Furthermore, the options approach seeks to do so in a way that would ensure that no participants would get less than the value of their entitlement. Under the approach, all the participants in a reorganization would receive certain options with respect to the new tickets of the reorganized value. The division of value would result from the participants’ own decisions concerning the exercise of the options given to them. And the options would be designed so that, whatever the reorganization value, no participants would ever be able to complain that they would end up with less than the value to which they are entitled.

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE AUCTIONS ALTERNATIVE TO EXISTING RULES continue

In contrast, under the auctions approach, the two issues will be kept quite separate. The question of what should be done with the assets will be dealt with first by auctioning these assets. Thus, the resolution of this question will not have to wait until the issue of division is sorted out. And the auction procedure, according to its supporters, is bound to produce the maximum value for the assets. To begin with, it will take little time until the assets will start operating outside insolvency proceedings (with their accompanying costs and inefficiencies). Furthermore, if the auction works sufficiently well, we can expect the assets to move to their highest-value use, in which they will operate under an optimal capital and governance structure.

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE AUCTIONS ALTERNATIVE TO EXISTING RULES

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE AUCTIONS ALTERNATIVE TO EXISTING RULESThe structural problems of the prevailing bargaining-based approach have led to much research work on alternative arrangements. One approach that has been natural for researchers to explore is relying on the market to address the problem of valuation.

Roe suggested selling a sample of 10% of the reorganized company’s tickets on the market to get the market’s estimate of the value of these tickets — and then to distribute the remainder of the tickets on the basis of this estimate. In Roe’s proposal, the market was just used to get an estimate of the reorganization value by extrapolating from a 10% sale. Subsequent work, however, did not see a reason to stop at 10% rather than sell the full 100% and developed the “auctions approach.”

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE EFFECT OF EXISTING RULES ON DIVISION OF VALUE continue

Thus, the equityholders have an “option value,” and to forgo it they must be compensated by having the reorganization plan provide them with a value exceeding this option value. This element of the model of Bebchuk and Chang is consistent with the empirical evidence that, as the value of the company’s assets gets closer to the value of the debt (and thus as the option value gets larger), the larger the amount that the equityholders get.
Second, if the equityholders delay agreement, then, as discussed earlier, the company can be expected to incur during the lengthy process “financial distress costs” that will dissipate some of the value that debtholders can expect to receive at the end of the process. 

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE EFFECT OF EXISTING RULES ON DIVISION OF VALUE

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE EFFECT OF EXISTING RULES ON DIVISION OF VALUEThe existing bargaining-based approach leads to a division of value that often deviates from the division that is prescribed by the participants’ contractual rights (or, in the case of involuntary tort creditors, from the division that is prescribed by the relevant legal rules). What each class gets under the existing process depends not only on the value to which it is entitled but also on various factors that affect the strength of its bargaining position under the existing rules. In particular, because the equityholders can often block or at least delay the approval of a plan, they will have some bargaining power even in those cases in which the value of debt exceeds the total reorganization value.

Corporate reorganization rules is to be judged and the fundamental problem of valuation: THE EFFECT OF EXISTING RULES ON REORGANIZATION VALUE

The existing bargaining-based process appears to fall substantially short of the goal of maximizing total reorganization value. This happens both because value is often dissipated during the process and because the ultimate outcome of the process might not be value-maximizing.

(i) The dissipation of value during the reorganization process: The reorganization process under the existing rules takes substantial time (see White, Lopucki and Whitford, Weiss, and Gertner and Scharfstein ). During this time, substantial value might be dissipated. To begin with, the Chapter 11 process involves substantial administrative costs. Indeed, the fees paid to lawyers, accountants, and other professionals in a Chapter 11 reorganization of a publicly traded company are often on the order of tens of millions dollars. (In one recent reorganization of a major corporation, for example, the administrative expenses of the company and of the creditors committee came to $3.5 million per month — see Cutler and Summers ).

Corporate reorganization rules is to be judged and the fundamental problem of valuation:THE BARGAINING-BASED APPROACH OF EXISTING RULES

Corporate reorganization rules is to be judged and the fundamental problem of valuation:THE BARGAINING-BASED APPROACH OF EXISTING RULESThis essay surveys the literature on Chapter 11. I start by discussing the objectives by which the performance of corporate reorganization rules is to be judged and then consider the fundamental problem of valuation that arises in corporate reorganization. I next turn to examine the performance of the prevailing bargaining-based approach to reorganization, both in terms of its effect on total reorganization value and in terms of its effect on the division of this value. Finally, I examine the two alternative approaches that have been put forward to the approach of existing rules — that of auctioning the reorganized company’s asset (put forward by Baird and Jensen ) and that of using options to reorganize the company’s ownership (put forward by Bebchuk ).

The way in which the law has dealt with this problem of valuation is by leaving the division of reorganization value to a process of bargaining among the participants.