A Cost Sharing Approach in the Bankruptcy Mechanism

8/11/2019 A Cost Sharing Approach in the Bankruptcy Mechanism

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A Cost Sharing Approach in the Bankruptcy Mechanism

Nicolae STEF*

Abstract: We develop a simple theoretical model that analyzes the relationship

between the forgiveness degree of creditors and the choice of triggering a liquidation

procedure. Debtors will have the incentives to propose suboptimal programs. Such

reorganization plans are equivalent to a win-win situation compared to an alternative

liquidation procedure. They provide a rent for the debtor and an expected gain for the

claimants which is higher than the liquidation value but lower than the value incurred by the

plan with an optimal forgiveness degree attached. Nevertheless, when the suboptimal level

increases too much the financial burden of the creditors, the liquidation may be preferred. The

result holds independently of the law orientation i.e.pro-creditor or pro-debtor.

JEL classification: G33; D86; D21;

Keywords: Bankruptcy, Forgiveness Degree, Suboptimal Plan

* Ph.D Student,LaRGE, University of Strasbourg,

47 Avenue de la Fret Noire,

67000, Strasbourg, France,

[email protected]

(00)33667886041


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1. Introduction

In the corporate finance literature, the arbitration between liquidation and

reorganization was analyzed through different theoretical approaches. It allowed to bring to

the fore some sources that can influence the decision in favor of a certain legal procedure. For

instance, Brown (1989) noticed that the implementation of a reorganization procedure is more

difficult in the presence of conflicting incentives when each claimant wants to trigger the

liquidation in order to be paid first. Moreover, the asymmetric information and the divergent

interests can encourage the occurrence of costly bankruptcy (Webb, 1987) and induce the

equity holder to accept inefficient firms to continue their activity instead of those which are

economically viable (Mooradian, 1994). However, White (1989) argues that under different

bankruptcy priority rules, the survival of the firm is accepted only when it provides a higher

gain for the debt holders.

Although the reorganization decision can be affected by the level of monitoring

incurred by the senior and the junior creditors (Cornelli and Felli, 1997), the structure of the

debt can also play a significant role. According to the theoretical approach of Berkovitch and

Israel (1998), a short maturity of the total debt may help the firms reorganize more easily.

Nevertheless, free riders creditors can impede the choice of the best restructuration project

(Blazy and Chopard, 2004). The distribution of the voting power among the claimants may

produce some deviations from the efficient solution when there is a lack of coordination

among them. The bankruptcy timing or the default moment chosen by the debtor may also

affect the legal outcome (Bruche and Naqvi, 2010). Another factor that may influence the

arbitration is represented by the judges behavior. As a result, the decision to restructure the

company may be made using an informational signal transmitted by the court. Thus, the fact

that the lenient judges act differently than the strict judges can enhance the reorganization

probability of the firm (Frout, 2007).

Given these multiple theoretical sources, we should not overlook the heterogeneity of

the judicial systems. The legal background provides different rights and obligations to the

parties involved in the procedure (Beck, Demirg-Kunt and Levine, 2003). Hence, the

importance of such legal provisions will also have an impact on the arbitration such as the

possibility of replacing the incumbent management or imposing an automatic stay on the debt

interests (La Porta et al., 1998). However, the arbitration can also be influenced by the

presence of a grace period during which creditors offer to the debtors a certain time to

improve the firms financial situation before the liquidation is triggered (Broadie, Chernov


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and Sundaresan, 2007). In certain national legislations, some reorganization plans may be

accepted by the court as long as they respect the creditors interest and provide a clear

monetary advantage compared to the liquidation outcome even tough such plans were firstly

rejected by the claimants.1

In this diverse background, we would like to focus on the level of debt forgiveness

which can influence the outcome of a bankruptcy procedure. In respect to this source, we

consider a reorganization plan submitted to the court as a future contract that demands to each

party a certain degree of involvement sine qua non the plan cannot be implemented. The

concept of implication or involvement represents all the tasks and concessions that a party

must perform according to the contract. In our theoretical approach, we will imply the debt

forgiveness as a measure of the creditors involvement. It will also represent the type of

obligation that a contract plan demands to the creditors in order to set up its implementation.2

Moreover, the debtors contribution in a reorganization project will be associated to the total

concessions that she is willing to accept for the firms continuation such as the decreasing of

the operating costs, the wages reduction, the modification of the work schedule, the

accomplishment of a particular number of layoffs or the infusion of new capital. In addition,

every reorganization plan requires efficiency measures designed to increase the profitability.

The both parties can propose such actions e.g. the improvement of the product or the

management competence, the diversification of firms activity, finding new markets or

innovative advertising to attract more customers, renegotiation of unfavorable contracts etc.

From such a perspective, each reorganization plan includes a set of obligations or

commitments. Thus, the contract plan makes a division of the obligations between the

creditors and the debtor. The sharing is important for two main reasons. On the one hand, the

sharing approach will have an immediate effect on the returns of each party. Knowing that the

plan modifies the firm value, its payment scheme must cover at least the initial investment of

both side. If the sharing is unbalanced which means that the monetary obligation of one party

is very high, its expected earnings from the plan could be lower than the returns related to a

liquidation outcome. On the other hand, unbalanced distribution enhances the chances of

voting the firm dissolution. If we take the liquidation value of the firm as a benchmark, the

1 The cram-down procedure of the U.S. bankruptcy code may enforce some reorganization plans to be

implemented even though they have not been voted by the creditors (Franks and Torous, 1989).2

Given the complexity of our concept, the debt forgiveness matches with the analysis of our model. Futureresearch may address other types of involvement such as the payment rescheduling, granting a new loan or

providing a specialized assistance to the debtor.


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creditors incentive to refuse plans that offer recovery values lower than the benchmark will

increase.

Our paper argues that the sharing of the financial obligations between creditors and

debtor has a direct impact on the decision to accept the project. Hence, reorganization

programs with unbalanced distribution may not be voted nor accepted given that they compel

a too high level of involvement from the other party thus making the liquidation procedure to

be preferred. Some plans with inefficient distribution may be accepted when they provide to

the creditors an expected gain higher than the liquidation value. Consequently, the way in

which the obligations of the plan are shared influence directly the creditors decision.

The relevance of studying the involvement sharing relies on three major reasons.

Firstly, analyzing the task repartition of a reorganization contract can help understand why the

continuation of the firm may not be approved. When the plans configuration implies that the

expected gain of one party is less than the potential value that she could receive in the case of

firms liquidation, it is unlikely that the project would be implemented. If the plan could be

subject to some modifications so to correct this inefficiency, the firm could be saved.

Secondly, the research topic also allows comprehend in what conditions a reorganization

program that does not detain an optimal sharing can be voted. The features of the national

bankruptcy law, the asymmetric information or the time decision process associated to the

bankruptcy procedure may induct creditors to accept suboptimal plans. Such plans provide

them an expected gain compared to the liquidation value but which is lower than the earnings

related to the case of an optimal distribution of the tasks. Thirdly, the partition may be

improved to avoid the liquidation procedure. Performing an appraisal or using the services of

an audit company in order to increase the information amount of creditors may be used to

balance the involvement in such a way that the reorganization could be attainable.

The article is organized as follows. Section 2 presents our simple theoretical model. Its

analysis is developed on two legal backgrounds. The first one concerns the existence of a

friendly creditor bankruptcy system which provides a strong bargaining power to the creditors

whereas the second one considers a pro-debtor judicial environment. The results of the model

allow to establish the relevance of the cost sharing between creditors and debtor. Section 3

assesses the conditions and the elements that favor the acceptance of reorganization plans

with suboptimal sharing. Some measures of avoiding and minimizing the effects of such plans

are proposed in section 4. Section 5 describes a certain extension of the model in which the

monitoring efficiency is taken into account whereas section 6 treats the relationship between


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plans with suboptimal sharing and the violation of the absolute priority rule. The last section

summarizes and concludes.

2. Theoretical model

In some circumstances, a reorganization project may be rejected even when the

enterprise is characterized by a good history path at the moment of default. The type II error

may appear when the cost sharing attached to the investment project is made at the expense of

the other partner. For instance, a reorganization plan proposed by the equity holder can be

rejected if it requires a higher forgiveness degree from the claimants. The proposed level of

forgiveness can make the reorganization procedure too costly. In order to analyze the impact

of the financial sharing on the choice of triggering a liquidation procedure, we also need to

include other determinants that may have an influence on the forgiveness degree. We refer

here to the history path of the enterprise, the quality or the expected profitability of the

program and the share that each party3 can receive from the final outcome. The variables

relates to the most important elements that are normally included in the configuration of a

restructuration plan. Nevertheless, the different levels of forgiveness may influence the

decision to liquidate or not.

The first element is associated to the internal and external background which

generated the default situation. For example, the existence of a faulty management, a reduced

level of assets or a bad macroeconomic context can shape the history path. We will assess the

path usingA > 0 which represents the total value of assets at the moment of default. Having a

high value of A can signify a good economic situation of the firm when the bankruptcy

petition is filled. It will also imply ipso facto a potentially higher recovered value for the

creditors. We exclude the null value of A that can be related to a firm with no historical path

or simply a fictitious company. Such firms are predestined to be dissolved. In the absence of

any assets, even the liquidation procedure cannot be enforced because the liquidation costs

will not be recovered.4 Thus, we will focus our analysis on firms that detain assets with

positive value.

In general, a reorganization program is characterized by a certain design quality which

has a direct impact on the firms value. From a practical perspective, the influence will be

3

We consider the reorganization plan as a future contract. The debtor and the creditors will be treated as theparties of the contract.4We can encounter this legal approach in the bankruptcy systems of Belgium, Hungary, Poland or Romania.


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found in the estimates of the turnover and of the net income which are usually made for each

year of the reorganization plan. These estimates may enable creditors to evaluate how the plan

can improve the financial situation of the company. In addition, we will assess the program

efficiency in expected monetary terms. The implementation of a higher quality program

provides a better expected improvement of the statusquo. Furthermore, the expected impact

of a project will be assessed by > 0.

The plans payment is established through negotiations between the creditors and the

debtors. The negotiations are guided by the amount of rights granted by the judicial system.

Similarly, Gertner and Scharfstein (1991) consider that the way in which the legal rights are

used can influence the debtors bargaining power. The exclusive rights to propose a project

and/or to delay it are useful tools that the equity can use in order to achieve some personal

goals. According to Bebchuk and Chang (1992), the equity power increases when the

liquidation is subject to a loss value and when the delay right is associated to some financial

distress costs. The debtors bargaining position also becomes stronger when an equity

committee is put into operation for the shareholders interests or when the financial condition

of the firm is relatively good (Betker, 1995). However, the creditors are not just a devoid

category of rights or threat tools. When they have strong coordination incentives (Weiss,

1990) or the possibility to control or to replace the incumbent management (Betker, 1995), the

power to impose their own interests becomes stronger. Thus, the bankruptcy literature signals

that the relationship between creditors and debtors is performed most often on unequal

positions depending on the law orientation.

As in Acharya and Subramanian (2009), we will consider that the amount of rights

granted to one party of the contract plan helps establishing the orientation of the bankruptcy

code. We split the model into two analytical perspectives. The first one is based on a pro-

creditor environment in which the law grants the creditors with more rights during the

bankruptcy procedure. We will translate this in our model by the fact that the creditors

payment is not limited to a certain level. For the second case of a pro-debtor system, their

payment cannot exceed a maximum amount fixed in the contract plan given that the debtor

has more bankruptcy rights. In these perspectives, we will assess the influence of the sharing

on the decision to liquidate the firm.


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2.1 Stages of the decision making process

We will consider that the firm is in default and that a bankruptcy petition is filled at

the court. Hence, the creditors are notified about the firms situation and they start declaring

their debts. In order to increase the recovered amount and so to diminish the potential

financial loss in case of liquidation, the equity holder configures a reorganization plan5with a

certain level of debt forgiveness. The project is submitted to the creditors for voting. In the

following stage, the claimants assess the expected value that they can withdraw at the end of

the plan when the forgiveness level is optimal. They make a decision by comparing that value

with the value related to the debtors plan and taking into account the amount recovered from

the liquidation procedure. When the benchmark liquidation value is higher than the other two

values, the plan may be rejected.

If the judge agrees, the firm can reconfigure the project with another distribution of the

obligations and submit again the new plan to the creditors vote. However, she will make such

a modification if it still provides a gain compared to the liquidation outcome. Nevertheless, a

reorganization plan cannot be implemented nor voted without the consent of one party. A

project can be approved only when both parties agree with the terms of their monetary

contribution allocated in the plan. The process is illustrated in the following figure.

Figure 1. Decision making process of the model

0 1 2 4

2.2 Assumptions

The model makes three main assumptions which are presented bellow.

A1: We assume that the firm is in default. The amount of debt prior to the arbitration

between restructuration and liquidation will be denoted by DwithD> 0 while the total value

5We will consider that the firm has the legal right to request the reorganization procedure. Otherwise, the firm

must be dissoluted.

A bankruptcy

petition is filled.

The debtor proposes a

reorganization plan with

a certain degree of

forgiveness.

The claimants decide

by assessing their

gain associated to

the optimal level of

forgiveness.

The debtor

reconfigures or

not the plan

according to

the creditorsdecision.


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of the firms assets is given byAwithA> 0.6If the liquidation is triggered, the creditors will

receiveA cwhere crepresents the liquidation costs and/or costs related to the under pricing

of the assets (Shleifer and Vishny, 1992) and/or any other administrative and legal costs or

loss of tax credits (Ang, Chua and McConnell, 1982). Furthermore, the value that the

creditors can recover from the liquidation procedure depends on the history path or the

financial situation of the enterprise at the moment of default (D> A c). We can notice that

the presence of a better economic situation can provide a higher recovery of the debt while a

less good history path provides a costly liquidation.

A2: A certain level of monitoring (m > 0) can be attached to the reorganization

program in order to control the potential personal deviations of the debtor from the project

objectives or any other moral hazard issue. We assume that the implementation cost of the

project is given by mI> 0 whereI represents the standard cost of the reorganization program

when the debtor's interests fully coincide with those of creditors and no personal deviations

are incurred.7The implementation of such a project will generate an expected multiplication

of the total assets value denoted by . However, the monitoring act produces a certain impact

on the final outcome which is assessed through m.

A3: The firm reorganization is costly. Thus, a sharing of the implementation cost is

suitable. In our model, the cost of saving the firm is too high to be burdened only by one

party. This analytical approach will motivate the sharing act. The plan cost cannot be borne

only by the firm knowing that certain expenditures have already been incurred for its design.

The absence of their participation could also enhance a moral hazard problem which could

affect the outcome of the project. Nevertheless, if the investment is made only by the

creditors, it will reduce more their final gain than in a sharing cost case and it will affect the

efficient work incentives of the debtors. From this context, the proposal of a program could be

feasible.

Consequently, the implementation cost includes all the obligations that the parties

must meet in order to put through the plan. We suppose that the total cost will be shared by

the claimants with the debtors in a certain proportion called p. The creditors contributions

will be represented by the forgiveness of a certain part of the debt i.e.p mI. Furthermore, we

will treat p as the forgiveness degree of the creditors. The debtors contribution will be

6ForD= 0, it will not be the case of a cost sharing given that the contract plan will be unilateral. If the debtor

has sufficient funds to put forward the firm restructuration, the court presence will not be needed. If there is a

lack of ressources, a contract debt may be signed with a certain financial institution. Nonetheless, if the firm

demand will be rejected, our analysis will correspond to a voluntary liquidation which will imply that theliquidation outcome will get in the debtors pocket.7We will analyze the importance of the monitoring efficiency in section 5.


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associated to actions whose purposes will be to increase the firms efficiency such as a wage

reduction, a redefinition of the work time or any other costs related to other beneficial

measures.

The participation of the debtor in the contract plan must also be paid. In general, the

reorganization plan admits a certain payment to the debtor that is well represented by the

wage and the cost production needed for the firms continuation. However, the debtor may

obtain some benefits when she exploits the rights provided by the court (Ayotte and Morrison,

2009). When she detains a certain voting power, its payment is necessary to allow the plans

implementation (White, 2011). However, the sum recovered by creditors depends on how the

bargaining power is distributed (Baird and Picker, 1991). In our theoretical framework, the

expected outcome of the plan will be divided and used to pay off the parties. At the end of the

program, the creditors will retain a certain part from the outcome denoted by d > 0. In

addition, the monitor act also prevents that the debtor increases unfairly and secretly its share

of pie i.e.1 d. Senbet and Seward (1995) noticed that the design of a reorganization plan

concerns two major issues: the way in which the plan will affect the firms assets and the

distribution of the reorganized firm value among the claimants. The first issue is counted

through whereas the assets distribution is related to d.

2.3 Model

The claimants will maximize their potential gain with respect to the monitoring level

and the forgiveness degree:

pm,max dmApmI (1)

The first term represents the final expected sum withdrawn by the creditors when the

project is completed while the second term is their part of investment which is equivalent to

the amount of debt which is forgiven. Furthermore, the maximization will be subject to the

following constraint:

(1 p)mI< (1 d)mA, (2)

The participation constraint of the debtor implies that the expected amount that will

remain after the payments of the partners will cover at least their initial effort. The constraint

will be binding at the optimal solution. For our model, we assumed that the cost sharing


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process cannot be incurred by a single side. Given that m> 0, the participation constraint can

be rewritten such as:

(1 p)mI< (1 d)A (3)

In order to capture the importance of the legal environment, two cases will be

considered. The first one is based on a pro-creditor environment in which the maximum

amount that the creditors can withdraw at the end of the reorganization program is not limited

to a certain level, but it depends in a percentage way only on d. From a different perspective,

the pro-debtor case considers that the maximum amount that the debt holders can withdraw

cannot exceedDwithD> 0.

2.3.1. Pro-creditor environment

The Lagrangian function can be written using (1) and (3)8.

L= dmApm I + 1 [(1 d)A (1 p)mI] (4)

The first order conditions are obtained through the maximization ofLwith respect to

mandp9.

m

L

= dA p2m I 1 (1 p)I= 0 (5)

p

L

= mI+ 1 m I = 0 (6)

The relationship (6) provides:

m= 1 (7)

Given that the participation constraint is binding at the optimal solution and the result

of condition (7), m*andp*will be the solution of the equations system consisting of:10

dAp*m*I m*I = 0 (8)

(1 d)A (1 p*)m* I= 0 (9).

Solving the above system, we obtain the optimal values of the forgiveness degree and

the monitoring level associated to the project.

8The constraint qualification of the Kuhn and Tucker theorem is verified given that the rank of the Jacobian

matrix associated to the participation constraint is one.

9The second order conditions are given by

m

L2

2

= 2pI > 0 and

p

L2

2

= 0. The objective function is also

concave.10The condition (8) is the simplified form of (5) using (7) whereas the condition (9) is the binding participation

constraint of the equity holder.


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m*=I

A

2

(10)

*Sp = 2d 1 (11)

The optimal monitoring is increasing with the quality of the program and the initial

value of the assets at the moment of default. Nevertheless, the optimal forgiveness level

depends directly on the percentage retained from the final outcome which can be set in the

plan. According to our theoretical approach, dmust be strictly higher than 0.5 in order to have

a positive *Sp . Such limitation concerns the pro-creditor environment which grants the

claimants with more rights. Logically, they will want to obtain at least half of the

reorganization pie given that the liquidation procedure doesnt cover fully the value of their

facial debt and the law supports their interest. However, the purpose of our model is tohighlight how the sharing can influence the creditors decision.

In the presence of rationality, the creditors choice will not be based only on their

degree of forgiveness. Thus, the amount that can be received in a triggered liquidation

procedure can be used as a benchmark (Bullow and Shoven, 1978). We will denote by VSthe

maximum expected gain given the optimal financial configuration of a project with *Sp and

m*.

VS

= dm*A*

Sp m*I (12)

Using (10) and (11), we can redefine VSsuch as:

VS=

I

A

4

)( 2 (13)

The reorganization procedure will be preferred when:

VS>A c (14)

S( *Sp ) = VSA+ c (15)

When the decision criterion (14) is valid, the implementation of the optimal

forgiveness level is crucial for the continuation of firms activity. Nevertheless, suboptimal

values can produce some distortions in such a way that the liquidation value could be

preferred. These values may be proposed to the other party if there is a rent-seeking behavior.

When the reorganization project has attached only the optimal monitoring, the legal

environment could lead to a lower forgiveness. Thus, the equitys financial burden will

increase but also the creditors real earnings compared to the liquidation value. However, such

plan may fail due to a lack of financial resources. The participation constraint could be


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reversed transforming the debtors participation in a sunk cost which can imply a greater

preference for liquidation assuming it is unlikely that she accept and get involved in an

unprofitable plan.

In certain conditions, the project can be voted even if the cost sharing is not optimal.

This may occur when the modification incurred in the plan still offers a surplus for the

claimants. When S( *Sp ) > 0 and the design of the program detains an optimal monitoring

level, we can determine the suboptimal threshold up to which such changes are possible e.g.

the value of the forgiveness degree that provides indifference between reorganization and

liquidation. The threshold sp will be the solution of the following equation:

dm*A sp m*I= A c (16)

sp = 2

2

)(

)2(24

A

IdAAce + (17)

For any p [*

Sp , sp ], the cost sharing of the plan resumes a win-win situation.

Firstly, the debt holders will have an estimated gain higher than the liquidation outcome even

if it is not the highest one possible. Secondly, the participation constraint will be slack leaving

a positive rent for the debtors. Hence, programs with suboptimal forgiveness degree may be

accepted11

.

2.3.2. Pro-debtor environment

The pro-debtor environment corresponds to a friendly debtor bankruptcy system which

provides a weak negotiation power to the creditors. Such a position limits their expected

payments. Hence, their payment is limited to a certain value D. In order to control for this

aspect, we will introduce a new constraint which will be binding at the optimal solution.

dmA


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can replace m*in the binding participation constraint of equity holder (3). We can obtain the

optimal forgiveness degree related to a friendly debtor judicial system.12

*

wp =

ID

AddID

'

))(1(' 2 (20)

We can notice that the optimal share that should be proposed to the debt holders is

depending on the history path of the firm. The first derivate of *wp with respect toAis strictly

negative. Having a good history path at the moment of default can be a guarantee of the

competence and the creditworthy character of the debtors. It supposes that the firm has a

satisfactory financial situation that doesnt imply such a higher degree of forgiveness from the

creditors compared to the situation when the firm has a poor history. In the latter case, the

debtors incentives to engage in the rescue of the firm are weaker. Firms with negative history

issues need a higher support from the creditors. When the reorganization program is too

costly, most probably the liquidation will be voted. However, we can notice that the

participation constraint will be binding when m* and *wp are attached to the plan. The plan

with an optimal design leaves no rent for the debtor when the legal environment is pro-debtor.

Table 1. Impact of history path

History path (A) Cost Share of

Debtors (1 *w

p )

Cost Share of

Creditors ( *w

p )

High value Positive Negative

Low value Negative Positive

Furthermore, we can redefine VW using (19) and (20) such as:

VW =D ))(

)1('1(

2Ad

AddID

(21)

The reorganization procedure could be preferred when:

VW >A c (22)

W( *wp ) = VW A+ c (23)

Even in the case of a pro-debtor environment, suboptimal forgiveness values can be

proposed by the equity holder. In order to ease their burden and to obtain a certain rent, their

incentives to promote a project with a higher p can increase. Such a decision may affect

12The constraint qualification is also verified. The Jacobian matrix associated to the participation constraint and

the creditors gain constraint has the rank two.


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negatively the expected value recovered by the creditors from the plan (VW). If the design

implies a suboptimal forgiveness degree that makes W(p) negative, the debt holders can

reject it. Nevertheless, if the modification of the sharing still leaves a lower rent compared to

the liquidation value, claimants could be induced to accept the proposal. Given that W

(*

wp )

> 0 and the optimal monitoring degree is attached to the plan, the thresholdw

p is determined

using:

dm*A wp m*I =A c (24)

wp =

ID

AdcAD2

2

'

))('( + (25)

The reorganization can be voted even when the sharing of the implementation cost is

not optimal. If *wp < p< wp and the condition (22) is true, the equity holder can obtain a

certain gain reducing their cost share. wp is the maximum forgiveness level that can be

demanded to the claimants which ensure that their expected earnings from the plan exceed the

liquidation value. The debtor with a certain legal power may propose a project with such a

design. If the debt holders agree the terms of the suboptimal sharing, the continuation of the

firms activity can occur.13

2.4 Importance of the forgiveness degree

The objectif of our model is to analyze wheter a reorganization plan is accepted or not.

For the moment, we are not interested in the realized ex post outcome of the plan.

Furthermore, the mechanism of choosing and proposing a certain level of forgiveness to the

creditors can establish when a liquidation procedure may be chosen. In addition, the following

table presents the importance of the forgiveness level when the optimal monitoring level is

attached to the design of the plan and WS, ( * ,WSp ) > 0. The last condition renders the

possibility that a reorganization plan with optimal or suboptimal sharing can be implemented.

Otherwise, the creditors liquidation recovery will be higher than the maximum expected

returns from a plan with optimal distribution and the liquidation procedure would be then

preferred.

13We illustrate these conclusions using a numerical example in the Appendix A.


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Table 2. Importance of the financial sharing between creditors and debtor14

Value ofp

proposed to

creditors

Sign of the

Debtors expected

returns

Sign of

WS, (p)

Outcome of the

legal procedure

wsp , < p Positive Negative Liquidation

*

,WSp


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approve the implementation of a suboptimal plan. It will imply that their expected returns will

be superior to the liquidation benchmark and the debtor will obtain a positive expected value.

In certain conditions, the debtor may acquire a gain by reducing the total expected earnings of

the creditors. Those conditions will be analyzed in the following section.

Finally, a project with a lower forgiveness degree renders Gnegative. It would be the

most desirable situation for the claimants when they can increase their recoveries at the

expense of the equity holder. But the debtor will have no incentive to propose or accept plans

that dont provide him at least his returns from a liquidation procedure. The dissolution of the

firm will be the probably outcome due to a lack of resources and a refusal of the contract

terms. According to our theoretical model, even if the plan is proposed by the claimants, the

sharing cost is required in order to reduce their burden and to use the information knowledge

in the benefit of the program. If the debtor refuses to take part, the plans implementation may

be hampered. However, if the judge is strict and the debtors behavior is the primarily cause

for the firms financial distress, such plans could be implemented. In this case, the judge

could treat the debtors loss as a penalty for his irresponsible behavior. If the law forbids such

a court order, an increase of the forgiveness level may be appropriate to save the firm.

3. Why accept projects with suboptimal forgiveness ?

The main finding of our theoretical approach argues that the equity holder may have

the incentives to propose reorganization plans with suboptimal forgiveness level for claimants

when the modifications of the plans ensure the ex postefficiency. Such plans are equivalent to

second best projects. They characterizes a win-win situation in which the creditors and the

debtor obtain a higher expected return compared to an alternative dissolution procedure.

Although these projects do not provide the maximum expected gain for the debt holders, they

may be accepted in certain situations. We will present furthermore some situations or

elements that can induce the creditors to accept them.

The character of the national bankruptcy law can play an important role in the

implementation of such plans. A soft law that takes into account the potentialy social loss of a

winding-up procedure may increase the judges incentives to accept the continuation of the

firms activity through a reorganization. Soft judicial systems can be encountered in the U.S.

or France which are mainly view as debtor friendly systems. They are quite different from

those of U.K. and Germany which have a certain predilection for the enforcement of the

contracts (Biais and Recasens, 2001). However, the law may strengthen the debtors


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bargaining position. For instance, the Chapter 11 of the U.S. Bankruptcy Code offers them the

first right to propose a project for a period of 120 days which can also be extended by the

judge. Nevertheless, the approval of suboptimal plans may be favored when the law doesnt

require a consent from the creditors like in the case of Spain, the U.S. or France (La Porta et

al., 1998).

Even in the case of a friendly creditor law, the acceptance of such reorganization

proposals may be due to the the lack of information required for the setting up of a better plan.

Senbet and Seward (1995) noticed that the asymmetric information may produce some

divergences between the insiders and the claimants concerning the true value of the firm. In

the context of a distorted information, the debt holders possibility to design a more favorable

project is limited. If the appraisal cost is too important and the firms suboptimal project

respect the fairness criterion16

, it is unlikely that the judge would reject it.

According to Mella-Barral (1999), the timing decision process in a bankruptcy

procedure can influence the creditors behavior. They may accept some compromises when a

costly liquidation may be induced by an early triggering. The equity holder may use delay

tactics to obviate the liquidation (Jackson and Scott, 1989). If the delay costs17

incurred by the

reject of a plan with suboptimal forgiveness produce a certain loss kthat provides WS, k , she willhave the incentives to lie about the efficiency in order to convince the creditors to vote such a

plan. The relationship that we just described is presented by the condition (27).

dm

Apm I > L > dmApm I (27)

The left hand term represents the expected gain promised to the creditor whereas the

realized value recovered at the end of the program is included in the right hand term. L

represents the liquidation value of the firm which is equal to A c. According to the above

relationship, we can determine the sanction level for the cheater debtor.

Penalty= min {dm(

) A, G} (28)

When the gain extracted by the debtor, G,is sufficiently high, the debtor has the right

to obtain at least the promised earnings of the plan i.e. the difference between the left term

and the right term of relationship (27). The penalty is indicated when the cheated behavior is

proved and not when the realization of

is related to the economic evolution of the market.

A penalty clause attached to the plan may represent a guarantee against such a behavior. It can

improve the debt holders protection by reducing the equity holders incentives to propose

reorganization plans with false expected returns. However, the inclusion of a penalty clause

must also be accepted by the judge. If the court considers that such a clause is an element of

pressure on the business activity, it is unlikely that the penalty could remain attached to the

contract plan. Nevertheless, the creditors should detain the appropriate tools to detect such

behavior. In this matter, the efficiency of the monitory act can play a key role.

5. How to monitor the debtor ?

In our theoretical approach, we didnt make a distinction of the monitoring type that

can be attached to the plan design. The quadratic form of the creditors potential gain included

in the relationship (1) provides a certain freedom to decide the monitoring efficiency. Thus,

we will consider that the monitoring action is efficient when m (0,1] given that its impact on

the reorganized firm value is higher than its influence on the implementation cost i.e.m> m.

Conversely, the monitoring act will be treated as inefficient for m> 1. However, the presence


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of the cost sharing allows an arbitration between the two types of monitoring. We will address

this issue according to the law orientation.

In the case of a friendly creditor law, we can rewrite the relationship (13) using (10)

such as:

VS(m*, *Sp ( m*)) =I

A

4

)( 2=m*I (29)

We can notice that a higher value of the optimal monitoring increases the maximum

expected gain that can be withdrawn by the creditors when the plan has an optimal

configuration. If the claimants would have the possibility to decide the monitoring type, their

expected gain with an inefficient monitoring would be superior or at least equal to the gain

related to an efficient monitoring.

VS(m* < 1, *Sp ( m* 1, *Sp ( m* > 1)) (30)

Under a pro-creditor judicial system, the creditors incentive to choose an inefficient

monitoring would be higher. In fact, the deficiencies of such a monitoring are offset by the

amount of rights that the law grants to the creditors. An imperfect monitoring can be incurred

especially when there is a high informational gap between the parties of the contract plan. If

the creditors dont detain the experience and the appropriate monitoring tools, an inefficient

monitoring is more likely to be attached to the plan. In this context, a friendly creditor law

will work in the claimants interest. However, the result holds when the plan has an optimal

design and the creditors can decide the monitoring type.

Based on the same reasoning, we assess the pro-debtor system case. Thus, we can

rewrite (21) using (19) such as:

VW(m*, *Wp (m*)) = m*Am*I (31)

Solving the quadratic equation, we obtain the following results presented in table 3.

Table 3. Monitoring decision when the law is pro-debtor

Condition Result Restriction

A < I VW(m* > 1) < VW(m* < 1) None

2

1) < VW(m* < 1)m ]1,1

I(

I 1) > VW(m* < 1)m )1

I,1(


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The creditors incentives to choose an efficient monitoring increase when the contract

plan requires a higher amount of investment in order to save the firm. A higher I implies a

higher implementation cost of the plan i.e. a higher degree of forgiveness. Given that the

judicial system protects more the debtors interests, the creditors will have to offset the lack of

rights using a different alternative. In a pro-debtor environment, the decision to monitor

efficient would be most probable for firms that necessitates costly reorganization. However,

the result may also be explained by the riskiness of the contract that can be included in . We

treated the importance of the risk in the Appendix B.

6. Suboptimal plans and violation of the absolute priority rule

According to our theoretical approach, a violation of the absolute priority rule (APR)

represents the situation when the debtor acting as residual claimant will receive a return

before the creditors will be paid in full18

. The violation may be used to provide to the debtor

the incentives to undertake the right investment decision (Berkovitch and Israel, 1998).

Moreover, the violations represent payoffs from the debt holders to the firm (Longhofer and

Carlstrom, 1995). An accepted plan with a suboptimal sharing can imply a violation of the

APR given that it will provide a certain gain to the debtor compared to the liquidation

procedure and a partial payment of the initial debt, D. Nevertheless, not all the suboptimal

plans can be treated as plan that violates the APRof a reorganization procedure. Some plans

may provide the expected full payment of the facial debt and also a residual return for the

equity holder especially when the realized value of is higher and when the debt holders are

granted with more rights. Hence, a plan that imposes a violation of the APR represents a

particular case of a suboptimal plan.

The model assesses the creditors decision to accept the reorganization plan. It does

not treat the realized outcome of the bankruptcy. Hence, a potential existence of an APR

violation depends on the ex postresults that are obtained during or at the end of the plan and

on the bargaining power of debt holders. Our model allows establishing a relationship

between the plans design and the creditors decision. Nonetheless, if we perceive the

suboptimal plans as plans that violates directly theAPR, the literature signals some benefits of

such a regime. For instance, it decreases the incentives of equity holder to chose only projects

18

We adopted a homogeneous approach of the creditors. If there was a separation between junior and seniorclaimants, the violation of APR would represent a situation in which the junior creditors would recover a part of

their debts before the senior creditors would be repaid in full.


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that match with their unique skills even though such projects doesnt increase so much the

firm value like the general ones (Bebchuk and Picker, 1993). The APR violation can also

increase the entrepreneurs incentives to protect some sunk investments (Berkovitch, Israel

and Zender, 1998). However, the motivations to accept such plans which are presented in

Section 3 will hold.

7. Conclusions

In this paper, we set up a static theoretical model that analyzes the impact of the

forgiveness degree on the legal outcome of the bankruptcy mechanism. Furthermore, we

provide an original approach of the reorganization plan which we treated as a future contract

that demands to each party a certain degree of involvement. The concept of involvement

describes all the necessary tasks and concessions that a party must perform according to the

contract plan. The idea behind our approach argues that the level of contribution in the

implementation cost of the plan will influence the creditors decision. However, each

reorganization program implies a certain sharing of its cost implementation. We considered

that the creditors participate at the finance of the program with a certain forgiveness of the

debt.

Furthermore, we develop our model on two perspectives. The first one is based on a

pro-debtor environment in which the claimants recovery is not limited to a certain fixed

value written in the contract plan. Conversely, we treated the case of a friendly debtor system

which limits the creditors expected payment. Our model predicts that reorganization plans

with suboptimal sharing are the most likely plans to be voted by creditors and/or accepted by

the court. Suboptimal projects or plans with a second best sharing are characterized by two

main features: 1) they provide to the debtor an expected gain which is at least equal to the

earnings of the liquidation outcome and 2) the expected returns of debt holders are higher than

the liquidation value of the firm but lower than the recovered value of the plan with an

optimal distribution. Nevertheless, if the proposed level of forgiveness increases too much the

burden of the creditors, the liquidation may be preferred. However, a plan with an optimal

sharing doesnt provide any gain for the debtor irrespective of the law orientation.

We also identify some elements that favor the approval of such plans. Having a soft

judicial system increases the debtor incentives to submitt a suboptimal project especially

when she has the first right to propose a reorganization plan and she can act as a debtor in

possession like in the U.S. or the Belgium bankruptcy system. The existence of assymmetric


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information or the benevolent character of creditors can also determine its implementation.

However, some measures that can minimize or avoid the effects of a suboptimal sharing are

available. The signing of ex ante covenants that balance the information level between

partners, the legal replacement of the incumbent management, the setting up of a bankruptcy

appraisal or the appointement of a trustee charged with the plans design are some efficient

measures that can be employed in order to improve the creditors recovery.

Under a pro-creditor environment, we noticed that the creditors incentives to opt for

an inefficient monitoring are higher. However, an efficient monitoring will be preffered when

the law is more debtor friendly and the firm restructuration is costly. Thus, the law might

influence the creditors behavior but these statements are subject to an empirical validation.

Altough we develop a simple model, more extended works can be done in order to

better understand the relevance of the involvement concept in the design of a contract plan.

For instance, assessing the involvement by a parameter is not an exhaustive approach. The

concessions that the creditors have to accept are various. The debt forgiveness does not imply

the same degree of involvement as the debt rescheduling. In some circumstances, it may

provide a fresh start when the creditors are willing to forgive a part of their debt (Ayotte,

2002). The debt forgiveness also allows to avoid the bankruptcy costs when they are high

(Hege and Mella-Barral, 2000). The model should be developed by considering the different

type of involvement that a party must perform. Moreover, the heterogeneity of creditors is an

assumption that should be integrated in a further analysis (Cornelli and Felli, 1997). Given the

priority in payment, it is likely that the involvement of senior creditors is not equivalent with

the one of junior claimants. Furthermore, a dynamic approach may allow the integration of

the delay costs especially in the presence of perishable assets.


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Appendix A

In order to illustrate the importance of the forgiveness degree on the choice of

triggering the liquidation procedure, let us consider the following example of a firm

characterized by a history path ofA= 50 with a facial debt of 80. The bankruptcy costs c are

equal to 5, thus the potentially liquidation gain is L=A c= 45. A reorganization project has

the following features: = 1.2, d= 0.8 and I= 18. Such values provide an expected gain to

the creditors superior to the liquidation value when the monitoring and the forgiveness level

are optimal. Otherwise, the liquidation would be preffered. We also use this example to prove

the possibility of having suboptimal projects. Let us now consider our two cases.

1. Pro-creditor environment

The optimal forgiveness degree will be p* = 0.6 while the optimal monitoring

associated to the project will be m* = 1.66. According to the condition (12) , the expected

gain of creditors VS will be equal to 50. Hence, a plan with this design offers strong

implementation incentives given that S= VS (A c) = 50 45 = 5. But if the project is

proposed by a debtor with a rent-seeking behavior, she may increase the financial burden of

their partners in such a way that the liquidation act would be suitable. Keeping the optimal

monitoring, ifp= 0.75 than V= 42.5 with = 2.5 and G= 7.5.

We can also determine the threshold value that allows an expected positive rent

i.e. sp = 0.7. We can notice in Figure 1. that projects with p[0.6 , 0.7] may be accepted by

the claimants as long as they provide a surplus compared toL.

Figure 1.

0.2 0.4 0.6 0.8 1

p

20

40

60

80

Gain Value

H0.6 ,50L

H0.7 ,45LL

V


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2. Pro-debtor environment

We will assume that the maximum amount that can be withdrawn by the claimants,

D, is 70. We obtain the following optimal design: p* = 0.54 and m* = 1.45 which would

generate an expected gain VW = 49.21 and a maximum surplus W= 4.21. In this case, the

threshold value wp would be equal to 0.65. We can notice in Figure 2. that if the forgiveness

level proposed is higher thanwp when keeping the optimal monitoring, the liquidation value

Lis prefered.

Figure 2.

0.2 0.4 0.6 0.8 1p

10

20

30

40

50

60

70

Gain Value

H0.54 ,49.21 L

H0.65 ,45LL

V

The debtor may configure a second best design that may be accepted by the creditors.

For example, if the suboptimal level p is 0.6 than the claimants expected return V will be

equal to 47.03. Such a return provides a surplus compared to the liquidation value i.e.= V

L = 2.03 which is less than the case of an optimal sharing i.e. < W . In certain

circumstances, the creditors may accept a plan with such a design. Moreover, the equity

holder will obtain a rent G= 2.18. We will also consider the suboptimal plans as the projects

that integrate a forgiveness degree for creditors which respect the following condition: 0.54 0.65, the investment part

of the claimants transform the firms dissolution into a more rationale decision.


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Appendix B - Integrating risk into the model

Until now, we didnt introduce a risk feature for the reorganization plan in the model.

The way in which the managers view the risk has an importance to their attitude to avoid the

firms ruin (Rose-Ackerman, 1991). In general, projects submitted to the court entail a certain

degree of riskiness of which creditors can be aware. Some of them can be successful whereas

some plans can have a higher probability of failure. We will introduce such a feature through

. For the simplicity of the analysis, we will consider as the expected successful impact of

the plan. Less risky projects are characterized by a high value of which is equivalent to a

higher expected efficiency of the plans implementation. We will consider this approach when

the cheater behavior is excluded.

Moreover, the voting of the reorganization project is favored by the existence of an

important difference between the threshold value,ws

p , , and the optimal value of the

forgiveness, *,WSp . When the difference between those values increases, the number of

suboptimal projects that can be proposed to the debt holders grows too. Thus, there are more

possibilities to reconfigure the sharing cost of the plan and there will be more chances that

one of those modifications to be accepted by the claimants. The following proposition

summarizes the results of table 2.

Proposition 1.A higher gap between the threshold implication value and the optimal

value increases the chances of voting the reorganization plan.

Analyzing sp and wp , we can observe that higher liquidation costs favor the increase

of the threshold values in both cases. Costly liquidations make reorganization a viable and

more desirable option. When such costs are high, creditors will have the incentives to avoidthem. In effect, a costly liquidation offers an incentive to propose suboptimal plans knowing

that at least one plan must be accepted in order to avoid the firm dissolution. When those

costs are important, the possibilities to deviate from the optimal forgiveness degree of

creditors increase i.e.[*

Sp , sp ] and [*

wp , wp ] become larger. As a result, the probability of

voting the reorganization plan increases when the liquidation costs are higher. An opposite

effect is played by the standard effort required by the plan. A higher implementation cost will

have a negative impact on the creditors payment and also on the threshold values that permitthe adoption of second best projects.


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0

,>

c

p ws (32)

0

,

Documents

A Cost Sharing Approach in the Bankruptcy Mechanism