Managing financial distress and valuing distressed securities: a survey and a research agenda - Financial Distress Special Issue

Financial Management (Financial Management Association), Autumn, 1993 by Kose John

in Miller and Modigliani |93~. The typical boundary condition used in these models to denote bankruptcy is that of strict absolute priority rule triggered when firm value falls below the promised principal payment.(15) The entire firm value without any liquidation costs is assumed to be passed to bondholders in default. This assumption is at odds with reality in several important ways: (i) as defined in Section I, the cash-flow criterion of default happens when the current liquidity of the firm is inadequate to meet its current obligations, say, required coupon payments; (ii) asset liquidations involve significant costs of liquidity and loss of going-concern value; (iii) there are important strategic The role of high leverage in corporate restructuring and the popularity of junk bonds (original-issue, high-yield bonds) have been important aspects of the corporate finance scene in the 1980s. As more and more firms have defaulted on their debt and filed for bankruptcy in the recent recession, financial economists, financial managers, and legal scholars have become increasingly interested in understanding how firms deal with financial distress. A very active academic literature has developed in recent years on various aspects of dealing with financial distress and the private and court-supervised mechanisms of resolving default. At the same time, investors have become increasingly concerned about default risk and valuation of distressed securities incorporating the institutional realities of troubled debt restructuring. The purpose of this special issue is to showcase new empirical and theoretical research on these topics, i.e., managing financial distress and valuing corporate securities incorporating payouts in troubled reorganizations. While the literature on the first topic, broadly defined, has become quite extensive in recent years, the literature on the second topic is still in its infancy. New research on these topics is presented in the nine papers that appear in this special issue.

The purpose of this survey article is to summarize and synthesize the recent research in the areas of financial distress, asset and debt restructuring, bankruptcy and valuation of distressed securities.(1) The new research featured in this special issue is also surveyed here. Additionally, I present an agenda for future research in the areas of financial distress, design of contracts and procedures to deal with it, and techniques for the valuation of corporate securities and contracts incorporating strategies and outcomes induced by the legal system governing breach of contractual promises.

The rest of the paper is organized as follows. In Section I, a simple conceptual framework for managing financial distress is presented which provides a scheme for organizing the survey. Theoretical work and recent empirical evidence on asset restructuring is summarized in Section II. Recent theory and evidence on private debt restructuring (debt workouts) is collected in Section III. Theoretical and empirical work on the formal bankruptcy (Chapter 11) process is reviewed in Section IV. Efficiency aspects of the current U.S. bankruptcy procedure, the design of an optimal procedure and proposals for bankruptcy reform are discussed there. In Section V, the valuation of corporate securities and contracts with significant probabilities of default (triggering renegotiation and legal resolution) is discussed. Each of these sections includes a brief survey of relevant existing literature, an overview of the papers in this special issue which fall in that area, and some suggestions for future research. Section VI contains an agenda for further research and concluding remarks.

I. Managing Financial Distress: A Model

The financing contracts of a firm can be loosely categorized into hard and soft contracts. An example of a hard contract is a coupon debt contract which specifies periodic payments by the firm to the bondholders. If these payments are not made on time, the firm is considered to be in violation of the contract and the claimholders have specified and unspecified legal recourse to enforce the contract. Contracts with suppliers and employees may be other examples of hard contracts. Common stock and preferred stock are examples of soft contracts. Here, even though its claimholders have expectations of receiving current payouts from the firm in addition to their ownership rights, the level and frequency of these payouts are often policy decisions made by the firm.(2) These payouts can be suspended and/or postponed based on the availability of liquid resources remaining in the firm after satisfying the claims of the hard contracts.

The assets of a firm also have a natural categorization based on liquidity. Cash or cash-like (marketable) securities are liquid assets. Long-term investments (such as plant and machinery) which may only produce liquid assets in the future may be called "hard" assets.

The above categorizations of the financing contracts of a firm and its assets give rise to a natural definition of financial distress. A firm is in financial distress at a given point in time when the liquid assets of the firm are not sufficient to meet the current requirements of its hard contracts. Since financial distress results from a mismatch between the currently available liquid assets and the current obligations of its "hard" financial contracts, mechanisms for managing financial distress rectify the mismatch by either restructuring the assets or restructuring the financing contracts, or both.