An empirical examination of prepackaged bankruptcy

Financial Management (Financial Management Association), Spring, 1995 by Brian L. Betker

Prepackaged bankruptcy is an increasingly popular means of restructuring financially distressed firms. A prepackaged bankruptcy (a "prepack") calls for a firm to negotiate a reorganization plan with its creditors, and possibly solicit acceptances of the plan, prior to filing for bankruptcy.(1) The firm then files for Chapter 11 and simultaneously files a plan of reorganization. Given the advance negotiation with creditors, a confirmation hearing can be scheduled quickly, leading to a quick exit from bankruptcy. In the fastest such case to date, In-Store Advertising filed for Chapter 11 on July 8, 1993 and had its reorganization plan confirmed just 29 days later. Table 1 compares "traditional" Chapter 11 filings by public firms, distressed exchange offers, and prepackaged bankruptcies between 1986 and 1993. More firms completed prepacks than exchange offers in both 1992 and 1993; prepacks constituted 19% of distressed restructurings in 1993.

Prepackaged bankruptcy has been described as a hybrid of two methods of reorganizing troubled firms: workouts and bankruptcy. Prepacks are said to combine the low direct and indirect costs of a workout with the benefits of formal reorganization. McConnell and Servaes (1991) note three reasons that firms might file a prepackaged Chapter 11 instead of completing an out-of-court workout: binding holdout claimants, avoiding cancellation of indebtedness income, and preserving the firm's net operating loss carry forwards.

Despite the increasing frequency of prepacks, existing evidence on the costs and benefits of prepackaged bankruptcy is anecdotal (Hansen and Salerno (1991), McConnell and Servaes (1991), Altman (1992)). McConnell and Servaes (1991, p. 94) ask if prepacks "are motivated by real economic gains, and if so, what are the sources of such gain?" In an effort to identify the sources of the economic gains associated with this form of restructuring, I study 49 prepackaged bankruptcies filed between 1986 and 1993

I first examine the direct costs of financial distress and the actions that the sample firms take to minimize the indirect costs of financial distress. I find that the direct costs of prepackaged bankruptcies are comparable to those previously reported for "traditional" Chapter 11 filings. Firms routinely pay the pre-bankruptcy expenses of informal bondholder committees and bank creditors. Thus, most of the direct expenses are incurred during the often lengthy negotiations that take place prior to filing.

Sample firms spend less time in financial distress than firms in traditional Chapter 11, suggesting that the indirect costs of prepacks are relatively low. Sample firms also attempt to reduce indirect financial distress costs by [TABULAR DATA FOR TABLE 1 OMITTED] minimizing the disruption in normal business activities that can accompany a traditional Chapter 11 filing. Firms often get bankruptcy court permission, for example, to pay trade creditors in the ordinary course of business, even though by law the firm has the right to suspend payments until it emerges from bankruptcy. By leaving trade creditors unimpaired, firms also avoid bargaining with a diverse (and likely hostile) creditor group.

Tax planning plays an important role in debt restructurings, but its effect on the workout or bankruptcy decision has not been investigated empirically.(2) The two most widely cited tax benefits of Chapter 11 are avoiding cancellation of indebtedness (COD) income and preserving the firm's net operating loss carryforwards (NOLs).(3) I estimate nevertheless that not a single sample firm would have had to pay taxes on COD income had its prepack been completed as a workout instead.

Prepacks do, however, offer advantageous treatment of net operating loss carryforwards. The main benefit is not in preserving the NOLs per se; few firms would have lost any more NOLs in a workout than they did in their prepack. Rather, the main benefit of Chapter 11 is that it puts a less restrictive limitation on annual use of NOLs relative to a workout. I estimate that the present value of future taxes saved by restructuring through a prepack instead of a workout averages around $9 million, or 3% of total assets.

Sample firms fall into two categories: those that attempt exchange offers and at the same time solicit votes for a prepack in case the exchange offer fails and those that file prepacks directly. Firms that file prepacks directly realize significantly larger tax savings from bankruptcy than firms that first attempt exchange offers, suggesting that tax considerations play an important role in firms' debt restructuring decisions.

I include two case studies that provide additional insight into the decision to restructure in or out of Chapter 11. These cases also highlight factors common to other sample reorganizations: the role that distressed-security or "vulture" investors play in aligning the incentives of potentially conflicting claimholder classes and the way the voting mechanism in Chapter 11 allows firms to bind non-voting claim holders.