Votermedia Finance Blog

October 16, 2008

The End of Corporate Bankruptcy

Filed under: Uncategorized — Mark Latham @ 1:13 pm

OK, this is a naive idea. Somebody please tell me what’s wrong with it. And/or has it been proposed before?

It’s well known that bankruptcy is a socially costly process. If it were only a matter of occasional negative outcomes in risky business enterprises, followed by transfer of ownership and control from equity holders to debt holders, then it wouldn’t be so bad. But the costly legal proceedings for determining and settling various debt claims, the interruption of business during this process, the lower value of dismembered assets compared to an ongoing business, and the loss of employment, all compound the financial calamity. Can’t we avoid this somehow?

Most bankruptcies are not instantaneous disasters where lightning strikes a healthy firm and the next day it’s bankrupt. It usually happens in stages, as bad news gradually comes out and/or business conditions deteriorate. Why don’t firms issue more equity at the first sign of trouble (losses, falling equity value), and then issue more equity later if there are further losses?

A likely reason is that the market would interpret these stock issues as signals that the problems are even worse than they seem. The CEO and Board apparently know that more bad news is coming, and want to sell stock before the price goes down further.

Another reason could be the option value of equity, which increases with leverage. Shareowners of a near-bankrupt firm can play “heads we win, tails you lose” with the debtholders. The potential bankruptcy costs will be mostly borne by the debtholders, so why should the shareowner-elected Board help them?

Both the signalling problem and the option value problem can be resolved, however, if the firm is contractually committed to issuing stock when its stock price has fallen. I suggest writing such a commitment into the firm’s long term debt contracts. Debtholders would pay the shareowners for this added protection, via lower interest rates on the debt.

This commitment could be in the form of an interest rate premium paid on the debt, which is an escalating function of the firm’s leverage measured using the market value of equity. As long as the premium escalates fast enough as leverage increases, shareowners will prefer to issue more stock rather than pay extra to the debtholders. (I suggested a specific premium schedule in “How To Transform a Failed Japanese Bank”, but have not done the modeling and analysis to estimate how high it needs to be. In that paper, the Japanese government played the role of long term debtholders, because they were guaranteeing the bank’s deposits.)

Why don’t we already see this feature in bond contracts? Choose one or more of:

  1. It’s a bad idea. (Please let me know why.)
  2. No one thought of it.
  3. It’s good for shareowners but bad for the CEO and Board.
  4. Got any other reasons?

To expand on reason #3: Maybe this would put management on a shorter leash, raising a flag at the first sign of bad results. In particular, if stock issues put significant downward pressure on the firm’s share price, this may be a market signal that management can not be trusted with more cash. It may lead to a proxy fight or takeover bid, and job loss for the CEO and Board. Such mechanisms would have to become more important for weeding out bad management, if bankruptcy is no longer peforming that function.

Another likely reason for #3 is option-laden CEO pay. Not only do CEOs have large option holdings, but their total pay grants (cash, options, etc) each year are option-like, rising in good years but never negative in bad years. Their preference for volatility is stronger than shareowners’, leading them to choose excessive leverage.

So if it’s reason #3 (as I suspect), shareowners would need some powerful improvements in corporate governance before they could overcome CEO and Board resistance to this automatic equity issue feature. I’ll post about corporate governance soon, but notice that this is not an obstacle for my previous post’s “Lehman recapitalization idea“. If the U.S. government is recapitalizing a bankrupt firm, they could implement this feature in the newly created long term debt.

This analysis offers a perspective on the $2 billion taxpayer payment to induce a firm to issue $8 billion worth of preferred stock, which I hypothesized in “Should the U.S. buy preferred stock?” It’s socially optimal for a troubled firm to issue equity (preferred or not) to the market, but against the narrow interests of the CEO and Board. So it makes sense to use a carrot and/or a stick to make it happen. (There are close parallels to the pricing of environmental externalities, like a pollution tax [stick] versus granting a free quota to current polluters [carrot] and creating a market where they can sell down their quotas for cash.)

Maybe a combination of carrot and stick would work best, such as a reduced tax rate on equity for firms that implement automatic equity issue. That would also reduce the risk that limiting leverage by this mechanism may put the firm at a competitive disadvantage, since higher equity means higher taxes. So we’re back to the complexities of tax reform.

What if sudden bad news drops the share price to the point where the premium payable to debtholders is extremely high, and the share price is already so low that it’s almost impossible to recapitalize by market issues alone? In effect, this mechanism would trigger bankruptcy earlier than the current system would. I’ll argue that’s a good thing, because a recapitalization could then be implemented using a process like my Lehman recapitalization idea without interrupting business operations, while there’s still enough asset value in the firm to cover all its short term liabilities.

1 Comment

  1. Afterthought: Since my proposed increase in cash interest payments would of course be onerous in an under-performing business scenario, other ways to design the penalty incentive could be:

    – paying bondholders in stock on top of the fixed cash bond interest; or

    – making the bonds convertible into stock at a favorable ratio, contingent on a trigger level of leverage measured using the market value of equity.

    Comment by Mark Latham — March 6, 2016 @ 9:25 am

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