Essays on bankruptcy and the resolution of financial distress
Longhofer, Stanley D.
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https://hdl.handle.net/2142/20015
Description
Title
Essays on bankruptcy and the resolution of financial distress
Author(s)
Longhofer, Stanley D.
Issue Date
1995
Doctoral Committee Chair(s)
Kahn, Charles M.
Department of Study
Economics
Discipline
Economics
Degree Granting Institution
University of Illinois at Urbana-Champaign
Degree Name
Ph.D.
Degree Level
Dissertation
Keyword(s)
Economics, Finance
Economics, Theory
Language
eng
Abstract
That a firm's initial equityholders often emerge from Chapter 11 bankruptcy proceedings with more value than the absolute priority rule (APR) would suggest is now a generally accepted fact. The form in which this value is distributed, however, is less well understood. In particular, why do the original shareholders of some firms emerge from Chapter 11 bankruptcy with stock in the reorganized firm, while others receive warrants? The first essay of this dissertation proposes that informational asymmetries provide the answer to this question. By proposing a reorganization plan in which they receive warrants, the original stockholders of a firm with good future prospects can signal their superior information to the creditors in a way that firms with poor prospects will not wish to mimic.
Violations of the APR are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. The second essay shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely to occur, raising the interest rate firms must pay when borrowing. Both of these problems arise even when APR violations have no impact on the borrower's incentive to undertake risk-shifting behavior.
"Typical folklore in corporate finance tells us that existing proportionate priority and absolute priority rules in bankruptcy have evolved in order to eliminate inefficiencies that result when lenders ""rush"" to retrieve their assets from a firm in financial distress. The final essay of this dissertation shows that when a firm is faced with a moral hazard problem first-come, first-served rules reduce lenders' incentives to free ride on the monitoring efforts of each other. As a result, these rules may reduce the total social cost of loan contracts compared to other bankruptcy rules. These first-come, first-served rules mimic important contractual arrangements found in real world debt contracts."
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