An empirical examination of prepackaged bankruptcy

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

The sample firms typically filed a series of requests ("first-day orders") with the bankruptcy court on the day they filed for Chapter 11. Gaylord Container filed a typical set of first-day orders: payment of trade creditors in the ordinary course of business; payment of certain undisputed claims in the ordinary course of business; payment of employees in the ordinary course of business; maintenance of employee benefits; continuation of workers' compensation programs; continuation of employee retention programs; maintenance of cash management system; continuation of existing bank accounts; continuation of existing cash investment program; continuation of existing customer programs; and the making of limited capital expenditures without bankruptcy court approval. According to bankruptcy attorneys I talked to, judges will almost always agree to these orders as long as it appears that the firm's plan will be confirmed in under 90 days.

In general, firms structure their prepacks to look as much like a workout as possible. In a workout, trade creditors would generally not even be involved, nor for example, would the firm be required to close its existing bank accounts as required in a traditional Chapter 11. Thus if indirect distress costs are a function of time in distress and disruption of ordinary business operations, firms try to keep the indirect costs of a prepack as low as the indirect costs of a workout.

C. The Holdout Problem

The holdout problem in a workout occurs when an individual creditor has an incentive to reject a deal that collectively benefits all creditors (Roe (1987)). If all other creditors accept a lower-priority claim (like equity) while one holds out, then the value of the now-senior claim is increased at the expense of the tendering creditors. Under Chapter 11, as long as one-half of the creditors in each class by number, and two-thirds by value, vote to accept the plan, all claimholders are bound by the terms of the plan.(7)

Assessing the extent of the holdout problem in the sample firms is difficult. For the 11 firms that attempted exchange offers and solicited votes on a prepack as a backup, it seems clear that the holdout problem was an important reason for filing for bankruptcy. Had the minimum tender condition been met, these firms were willing to complete their reorganizations out of court.

For the other 38 sample firms, it is not so clear. Even if 100% of a firm's creditors vote for a prepackaged bankruptcy plan, this is no assurance that 100% would have voted for a workout, for in a workout the incentive to hold out is much stronger.

Firms do not routinely report the results of the voting on their prepackaged plans. I could find this information in financial statements or press reports for only 22 sample firms. Furthermore, those that do report only the percentage of voting claimholders that voted "yes." They do not report the number of creditors who effectively voted "no" by not voting at all. This distinction is important and makes it difficult to assess what the results of a vote for a workout would have been.