Could Chapter 11 redeem itself? Wealth and welfare effects of the redemption option

Highlights

• Redemption option is a proposed reform to accelerate Chapter 11 procedure, by granting the value of a call on the firm assets to junior creditors as they exit negotiations upon bankruptcy filing.

• We evaluate the wealth transfers and welfare implications of the redemption option in a game-theoretic, continuous-time contingent claims model.

• Redemption option induces different, but not less frequent APR violations.

• By reducing bankruptcy negotiations from a three- to a two-player game, redemption option shrinks the scope for bargaining and increases the risk of liquidation.

• Redemption option aligns junior creditors risk preferences with those of shareholders, thereby fostering asset substitution prior to bankruptcy.

Abstract

A redemption option granted to junior creditors has been advocated to accelerate Chapter 11 negotiations and rebalance junior recovery with respect to senior claims. We develop a game-theoretic, continuous-time model of the leveraged firm under Chapter 11 to assess the wealth transfers and welfare impacts of such an amendment to the bankruptcy procedure. After fitting the model to Chapter 11 current outcomes, we show that the redemption option design overcompensates junior creditors, leading to different, but not less frequent, Absolute Priority Rule violations. Since the reform shifts negotiations from a three- to a two-player game, it reduces the scope for concessions in the bargaining process and raises the risk of liquidation. Importantly, the redemption option aligns junior creditors’ interests with those of shareholders, thereby increasing the incentives for risk-shifting prior to bankruptcy.

Introduction

The resolution of corporate financial distress impacts on claimants’ recovery and on the future performance of reorganized firms. Ex ante, its perceived efficiency determines creditors’ trust in their contractual rights and, ultimately, the soundness of the credit market. In modern economies, the legal bankruptcy procedure plays an instrumental role in resolving corporate financial distress. For firms opting to restructure under the protection of the bankruptcy law, the procedure defines a set of rules under which claimholders can negotiate. It also stands as an enforceable alternative for distressed firms trying to reach an out-of-court agreement with their claimholders through a private workout. As emphasized by Aghion et al. (1992), the bankruptcy procedure is designed to facilitate the bargaining process among claimants to avoid costly liquidation, while at the same time respecting initial contractual agreements as much as possible. In that spirit, empirical studies on the U.S. bankruptcy procedure (reorganization under Chapter 11, or liquidation under Chapter 7) have assessed its performance along the following dimensions: its duration, its liquidation rate, the creditors’ recovery, and the deviations from the Absolute Priority Rule (APR) it entails.¹

This paper examines the impact, along those same dimensions, of an amendment to the U.S. Bankruptcy Code. This amendment, which was recently proposed by the American Bankruptcy Institute (ABI), introduces a redemption option.² The ABI justifies the reform by pointing out that financially distressed corporations have been relying less and less on Chapter 11, often preferring faster and less costly out-of-court restructuring. Detailed excerpts from ABI (2014) explaining the redemption option can be found in Appendix A. Under the proposed change, a junior creditor is entitled to a share of the ongoing company, called the redemption option value, corresponding to the possibility of a post-bankruptcy increase in value of the debtors’ assets above the amount of the senior claims. Specifically, the junior creditor's share is “the value of a hypothetical option to purchase the entire firm with an exercise price equal to the redemption price [$\dots$] and a duration equal to the redemption period” (ABI, 2014, p. 209). The redemption price (i.e., the exercise price of the call option) is defined as “the full face amount of the claims of the senior class”. The redemption period ends at “the third anniversary of the petition date”. In other words, the junior creditor would receive the value of the call option written on the firm's assets with a strike price equal to the senior debt face value and a maturity of three years.³ That value could be paid “in the form of cash, debt, stock, warrants, or other consideration”, and it could be determined “through generally accepted market-based valuation models, including the Black-Scholes option pricing model”.

Following the publication of the ABI report, a burgeoning literature has emerged, examining the ramifications of the ABI's proposals. Recent papers summarize these proposals and explain how changes could potentially reduce the length of the reorganization process (see, e.g., PIMCO, 2015 and Wessels and de Weijs, 2015). Aside from its benefits, the ABI reform could potentially disadvantage senior creditors by limiting their rights to be paid in full before junior creditors, and could also disadvantage junior creditors by limiting their ability to veto an organization plan and delay the reorganization process; according to Adler and Triantis (2017), the ABI reform represents a significant reallocation of the rights the claimants would have enjoyed outside of bankruptcy.

The empirical literature has examined other reforms undergone by the U.S. bankruptcy procedure, most notably the 1978 Bankruptcy Reform Act⁴ and the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). Franks and Torous (1989), Bebchuk (2002), and Adler et al. (2013), among others, find that the 1978 Bankruptcy Reform Act induced lower bankruptcy costs and stronger ex ante debtor protection, which caused more distressed firms to seek protection under Chapter 11. But these authors also document a lengthy and costly reorganization process, with frequent deviations from the APR. Teloni (2015) shows that the BAPCPA resulted in shorter Chapter 11 cases, and, at the same time, increased the reliance of firms on prepackaged bankruptcy. The author also notes an increase in the fraction of firms that soon refile for Chapter 11. Warren and Westbrook (2008), however, find that the 2005 reform produced little effect on the length of the Chapter 11 procedure.

By contrast to such ex post investigations and to the legal academic literature, we study the potential consequences of the redemption option by relying on a contingent-claims model of the financially distressed firm.⁵ In the spirit of Annabi et al. (2012), we analyze Chapter 11 negotiations as a non-cooperative game played between three classes of claimants (equity holders and senior and junior creditors). Our model is then adapted to a situation akin to the implementation of the proposed ABI reform: as the distressed firm files for bankruptcy, junior creditors are offered a lump sum value (e.g., the redemption option) and exit the negotiation game, while equity holders and senior creditors bargain over the remaining value of the firm. The evaluation of the redemption option therefore involves comparing the outcome of a negotiation game involving three players, where claimants have different priorities and can veto a reorganization plan, to a negotiation game involving two players, where proposals may have a “take it or leave it” flavour, under the supervision of the Court.

Our main findings are the following. As expected, granting the redemption option value to the junior creditors reduces the duration of the bankruptcy procedure and the total bankruptcy costs. Also as intended, the proposed reform favours unsecured claims at the expense of senior claims. While the overall fairness of the bankruptcy procedure is not improved, the proposed reform operates a shift in APR violations: those at the expense of senior creditors become the most frequent. We find that the redemption option, as it is currently designed, is an overly generous compensation for junior creditors, who are paid in full in most scenarios; the wealth transfers among creditors can nonetheless be reduced by allowing a smaller fraction of the redemption option value to junior creditors.

However, removing one of the claimant from the negotiation process has consequences that go beyond the wealth transfer and the shortening of the procedure intended by the proposed reform. We find that it results in an increase in the risk of liquidation, as senior creditors and equity holders are left in a more difficult position to negotiate a reorganization agreement. Moreover, the redemption option aligns the interests of junior creditors with those of shareholders in that they, too, would have an incentive for risk-shifting prior to bankruptcy. This, in turn, could increase the default risk of firms.

Our paper contributes to at least three strands of literature. First, it adds to the literature on bankruptcy design and its repercussions. A poorly designed bankruptcy procedure would prevent the optimal allocation of capital, ultimately turning into a drag on economic growth, and a threat to financial stability. Alternatively, an efficient reorganization process should allow distressed but viable firms to emerge sounder and continue to add value to the economy (Helwege and Zhang, 2016, Allen and Gu, 2018). For that reason, the current design of Chapter 11 and the debated reform proposals regularly attract the attention of law, economics and finance scholars (White, 1994, Dhillon et al., 2007, Kang et al., 2020, among many others). They also stand as a benchmark that other countries analyze for their own reforms (Tarantino, 2013). Our paper also contributes to the role of debt priority structure in managing risk incentives among claimholders (Black and Cox, 1976, Barclay and Smith, 1995). The bankruptcy law plays an important role in mitigating conflicts of interest among creditors with different degrees of priority (Bigus, 2002). We argue that granting an option-like payoff to junior creditors in financial distress has the unintended consequence of jeopardizing the management of agency conflicts as it was initially contracted in the capital structure. Finally, our paper contributes to the modelling of decision-making in bankruptcy negotiations (Annabi et al., 2012, Antill and Grenadier, 2019). Given that the Chapter 11 procedure entails collective bargaining, non-cooperative games seem appropriate to analyze claimants’ decisions. In addition, our modelling recognizes the non-passive role played by the bankruptcy judge.

The remainder of the paper is structured as follows: Section 2 reviews the game-theoretic model of Annabi et al. (2012) and presents the modifications embodying the redemption option reform proposal. The solution of the negotiation game, with or without the reform, is detailed in Section 3. Section 4 analyzes the impact of introducing the redemption option on the outcomes of the bankruptcy procedure. Section 5 is a conclusion.