Privatesector P U B L I C P O L I C Y F O R T H E Note No. 194 September 1999 Innovations in Bankruptcy--Pricing the Priority of Insolvency Claims Chad Leechor Following the wave of recent financial turmoil, many developing countries have learned the value of an effective bankruptcy system in deterring excessive use of debt and providing an orderly way to resolve a debt crisis. As a result, they are now reforming their bankruptcy systems, generally modeling them on those of advanced countries. But there is dissatisfaction with bankruptcy frameworks in advanced countries too. Some alternatives have been proposed. One is an options-based approach that provides an objective way of pricing creditor claims according to priority. With allowances for local conditions, this approach offers developing countries a chance to leapfrog existing bankruptcy practices and their limitations. Effective bankruptcy systems have implications It should be procedurally fair and efficient, for corporate governance and for securities mar- leaving little scope for strategic behavior kets. For corporate managers and controlling (holdouts and tactical delays). shareholders, the cost of bankruptcy includes the loss of corporate control and the risk of personal Existing insolvency systems seldom meet these liability. This threat serves as a restraint on the use tests. Because many give control of the firm and of debt. In the event of default an efficient and the reorganization agenda to a particular party, orderly transfer of corporate control to creditors often management or senior creditors, there is lit- reduces the likelihood of asset stripping and loot- tle scope for the best option to emerge. Existing ing by insiders. For creditors, available legal owners or managers are likely to propose recourse makes it possible to extend credit at a restructuring and keep the firm in business, reasonable cost. And in a cyclical downturn or in while creditors who have a limited stake and do the face of financial distress, creditors are less not share in the gains when a firm recovers likely to panic and liquidate securities on a mas- would tend to liquidate too many firms. sive scale. Existing practices generally provide little incen- An effective framework for bankruptcy should tive to find an efficient solution. In some cases do the following: creditors and shareholders have an opportunity It should facilitate the discovery of the best to vote on competing reorganization plans. All option for the firm, including preserving the claimants carry the same weight in the voting value of assets and finding any value the firm process, regardless of their seniority. Junior may have as a going concern. claimants, hoping for a concession from more It should preserve the absolute priority of senior creditors, have an incentive to delay the claims. Senior creditors should be fully paid off process. To save time and expenses, some senior before junior creditors are paid. claimants may allow junior claimants a greater The World Bank Group Finance, Private Sector, and Infrastructure Network Innovations in Bankruptcy--Pricing the Priority of Insolvency Claims share of the proceeds than warranted by the rule pants, but does not resolve the underlying con- of absolute priority. Where the necessary major- flicts of interest. ity is not achieved, the process can become pro- tracted. In some cases judges must intervene by Another promising new approach seeks to applying the cram-down rule, often for the sake realign the interests of the claimants so that they of expediency rather than efficiency. have an incentive to choose the value-maximiz- ing plan (Bebchuk 1988; Aghion, Hart, and Consider a simple example. An insolvent firm Moore 1995). A key innovation of this approach has two classes of creditors. Senior creditors-- is its procedure for pricing claims so that say banks--are owed US$1,000, and junior absolute priority is protected. creditors--say trade creditors--are owed US$600. Suppose the expected value of the Some aspects of this approach resemble existing firm under the best proposed liquidation plan bankruptcy procedures. To begin with, the court is US$1,000. If the bank creditors set the would grant a stay of, say, three months on all out- agenda, they would call for a quick liquidation, standing claims. The court would also appoint an an efficient outcome. But the trade creditors administrator responsible for drawing up a list of would opt for reorganization, which would all claims against the firm and soliciting reorgani- give them a small chance of partial recovery. If zation plans from participants and the general the trade creditors have a vote on the firm's public. These steps are much like existing prac- future, the bank creditors may be unable to tices, though somewhat more open. The new fea- implement the liquidation or may have to share tures deal with how to decide on the future of the the proceeds with the trade creditors. The out- firm and how to preserve the priority of claims. come would be inefficient and would violate absolute priority. After all claims are registered, the administrator would determine relative seniority among them Now assume that if the firm is restructured and according to established norms. The administra- kept as a going concern for a year, its expected tor would also issue, say, 100 reorganization value is US$1,300. The efficient solution would rights, which would entitle the holders to vote be to keep the firm in business. The bank credi- on the reorganization plan. Initially the adminis- tors would receive full payment plus interest, and trator would give the claimants call options to the trade creditors partial payment. The bank buy a share of the rights proportional to their creditors are unlikely to want to keep the firm in claims. These calls would have different strike business, however, since they have no stake in prices, depending on the seniority of the claims. the upside potential. The trade creditors would In addition, each claimant would have an oblig- correctly argue for reorganization. But since the ation to give up his or her reorganization rights banks have more votes, based on their larger if the next class of claimants choose to exercise claims, the liquidation plan may prevail, although their options. Thus the options would have the the banks might have to share the proceeds with characteristics of a call spread (box 1). the trade creditors. Once again, the outcome pro- tects neither efficiency nor absolute priority. The strike prices would play a crucial part in pro- tecting the priority of claims. The most senior A new approach creditors would have a strike price of zero, since they would have the first claim on the firm's In recent years bankruptcy specialists have come assets. The next class of creditors would have a up with new ideas to address the concerns. One strike price set so that the proceeds would be approach is to use prepackaged bankruptcy pro- sufficient to pay off more senior debt. In general, cedures like those of the United States; this the strike price would rise as the seniority of approach saves time and money for all partici- claims declines. As residual claimants, the share- BOX 1 CALL IT A SPREAD Options are simple once you know a few basic rules. A call have strike prices of US$95, US$100, or US$105. A Microsoft call option gives you the right to buy the underlying security, say a with a strike of US$95 is worth more than a call with a strike of common stock, at a stipulated price--the strike price, or strike. US$100 or US$105. When the stock price rises, the value of your call goes up, and You can buy a call option with one strike and sell a call on the when it falls, the value goes down. Owning a call is therefore same security with another strike. This position is a call spread. similar to owning a stock. If you Suppose you buy a Microsoft call at have sold, or shorted, a call, you a US$95 strike for, say, US$6 and at have an obligation to sell the stock. On September 30, 1999, this call option the same time sell a Microsoft call With a short call, you gain when the might have a value of US$10 with a US$100 strike for, say, US$3. stock price falls and lose when it You then own a call spread at a net goes up. The strike price of the call Symbol: MSQ = GT price of US$3. If the stock price is determines what price you pay or Underlying security: Microsoft Corporation above US$100 when the options receive for the stock. Strike price: US$95 expire, the call you own lets you buy Unlike stocks, options have an Expiration date: 12/17/1999 a share of Microsoft at US$95. But expiration date. If you own an Options exchange: Chicago Board you also have to sell a share of American call, you can exercise Microsoft at US$100 because of the your right to buy the underlying stock call you sold. Your revenue is US$5 at any time before its expiration. If you have sold a call, you may and your profit US$2. If the stock price is below US$95 when the be assigned (or compelled) to deliver the stock at any time. A options expire, you lose your investment of US$3. European call, however, allows the holder to exercise his or her Call spreads provide a low-cost and flexible position for securi- right only at its expiration. ties trading and are very popular among professional options Call options have different strike prices. Suppose Microsoft traders. They could also be a powerful tool for pricing creditors' stock is trading at US$100 a share. Active calls on Microsoft might claims in an insolvency proceeding. holders would receive options with the highest even shareholders' options, with a strike price of strike price. US$16, would have considerable value. Consider an example based on the previous one. At the end of the trading period the 100 reorga- The banks (owed US$1,000) would have the nization rights would go to those who exercise right to get the reorganization rights for free, and their options, and the party or coalition holding an obligation to sell them to the trade creditors a majority of the rights (fifty-one) would control at US$10 a piece. Selling 100 rights at US$10 a the firm's future. The reorganization plan piece would produce US$1,000, enough to pay selected by those holding reorganization rights off the bank creditors in full. The trade creditors might lead to a liquidation or a restructuring of would have the right to buy the 100 reorganiza- the firm. The holders of the rights might become tion rights at US$10 a piece, and an obligation to the new owners of the firm or might sell the sell them at US$16 a piece to the next class of rights to the party that submitted the winning claimants, the shareholders. The proceeds from proposal. As the reorganization plan is imple- that sale (US$1,600) would pay off all the debt. mented, the creditors would be paid through the sale of their reorganization rights and the firm Trading in the options on reorganization rights would emerge from bankruptcy. would be permitted before the stay period expires. The original claimants could sell options Where to use the new approach? to any interested buyers, including those who have submitted a proposed reorganization plan. The main advantage of this proposed approach The value of these options would depend on the is the opportunity it creates to discover and perceived value of the firm as well as the strike implement the best possible plan for the insol- price of each option. For example, if the firm is vent firm. The new owners choose the plan, not perceived to be worth US$500, the trade credi- parties with narrow or conflicting goals. Equally tors' option, with a strike price of US$10 to get 1 important, the approach preserves absolute pri- percent of the firm, would have little or no value. ority. No claimants receive a payment until those But if the expected value of the firm is US$2,000, with more seniority are paid in full. Innovations in Bankruptcy--Pricing the Priority of Insolvency Claims In addition, the approach provides no incentive for vance in many cases. Where there is a consen- holdouts, a particularly difficult problem under sus that the firm's value is significantly less than existing insolvency practices. Junior claimants, its outstanding debt, the procedure should such as shareholders or unsecured creditors, have move immediately to liquidation. There is no no say in the firm's future unless they are willing need to allocate and trade options. Where the to pay off more senior creditors. At the same time value of secured debt is large relative to total the firm is not held hostage to senior creditors with claims, the approach also might not apply. a limited stake. These senior creditors must give Secured creditors have a contractual right to up their control if a party with a better idea pays seize the collateral and may be uninterested in them off by exercising the call options. Arbitrary the options. But if the value of the collateral is decisions, like a cram-down or forced continua- less than the debt, the secured creditors may tion of a nonviable business, become unnecessary. want options to cover the shortfall. But the approach is not universally applicable. Look before you leap Its design presupposes a well-functioning capi- tal market and a well-established legal system, The options-based approach to bankruptcy has features lacking in most developing countries. strong intellectual appeal. But while well known Changes in the design are generally needed to to specialists, these new ideas have not yet been suit local conditions. implemented. The U.K. Treasury has received a proposal for bankruptcy reform based on this Viewpoint is an open forum intended to Without a well-functioning capital market, the approach and has commissioned a detailed encourage prospective buyer of the insolvent firm may lack review. The Mexican government has received a dissemination of and access to the liquidity needed to achieve control. similar proposal but has not yet made a decision debate on ideas, innovations, and best The financing method, a part of the proposed on it. By adopting this approach, adapted to local practices for expanding reorganization plan, typically includes cash circumstances, a developing country that lacks a the private sector. The needed to pay off creditors. If some of the final viable bankruptcy framework may be able to views published are those of the authors and holders of reorganization rights are willing to leapfrog existing bankruptcy practices and their should not be attributed hold the securities issued under the winning reor- well-documented shortcomings. to the World Bank or any ganization plan, the need for external financing of its affiliated organiza- tions. Nor do any of the may be mitigated. References conclusions represent official policy of the Aghion, P., O. Hart, and J. Moore. 1995. "Insolvency Reform in the Another possible constraint is lack of familiarity World Bank or of its UK: A Revised Proposal." Insolvency Law and Practice 11:67­74. Executive Directors or with options. Options markets tend to develop Bebchuk, L.A. 1988. "A New Approach to Corporate Reorganization." the countries they well after securities markets do. But a full- Harvard Law Review 101:775­804. represent. G-22 Working Party. 1998. "Recommendations on Managing Financial fledged options market is not essential. What is Crises." International Monetary Fund, Washington, D.C. To order additional needed is an adequate understanding of the Hart, O., R.L.P. Drago, F. Lopez-de-Silanes, and J. Moore. 1997. A New copies please call basic rules among the participants. An important Bankruptcy Procedure That Uses Multiple Auctions. NBER 202 458 1111 or contact Working Paper 6278. Cambridge, Mass.: National Bureau of variant of this approach proposes using auctions Suzanne Smith, editor, Economic Research. Room F11K 208, in place of options in pricing and allocating Hotchkiss, E.S. 1995. "Post-Bankruptcy Performance and The World Bank, reorganization rights (Hart and others 1997). Management Turnover." Journal of Finance 50:3­21. 1818 H Street, NW, Weiss, L.A. 1990. "Bankruptcy Resolution: Direct Costs and Violation Auctions have the appeal of being widely under- Washington, D.C. 20433, of Absolute Priority." Journal of Financial Economics 27:285­314. or Internet address stood. But they can replace only the trading in Weiss, L.A., and K.H. Wruck. 1998. "Information Problems, Conflicts ssmith7@worldbank.org. options. The basic pricing rules and the obliga- of Interest and Asset Stripping: Chapter 11's Failure in the Case of The series is also Eastern Airlines." Journal of Financial Economics 48:55­97. tion to give up the reorganization rights at the available on line (www.worldbank.org/ stipulated prices remain necessary. html/fpd/notes/). Chad Leechor (cleechor@worldbank.org), Even where these constraints do not exist, the Private Sector Development Department, Printed on recycled paper. options-based approach may have little rele- Business Environment Unit