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Working Paper Series
Financial Distress and the Role of Capital
Contributions by the Owner Manager
S. Venkataraman
Working Papers Series
Issues in Financial Regulation
Research Department
Federal Reserve Bank of Chicago
December 1996 (WP-96-22)
FEDERAL RESERVE BANK
OF CHICAGO
L IB R A R Y
JAN
22
19 9 7
Financial Distress a n d the Role of Capital Contributions b y the O w n e r M a n a g e r
by
S. Venkataraman
Federal Reserve Bank of Chicago
R evised
September, 1996
* The views expressed here are my own, and not necssarily those of the Federal Reserve
Bank of Chicago or the Federal Reserve System. I would like to thank Allen Berger, Dave
Brown, Mark Flannery, Chris James, Joel Houston, Bob Mooradian, Aruna Srinivasan,
and the seminar participants at Emory University, University of Florida, McGill
University, University of New Orleans, the Norwegian School of Management, the Federal
Reserve Board, and the Federal Reserve Bank of Chicago for their useful comments. Any
errors are my own responsibility, of course.
Financial Distress a n d the Role of Capital Contributions b y the O w n e r M a n a g e r
Abstract
This paper examines the implications of bankruptcy law for owner managed firms.
These firms are typically (i) smaller, (ii) their value is closely tied to the skills of the
owner manager, and (iii) the owner manager represents a feasible source of capital
contributions ifthe' firm is in financial distress. The terms of such capital infusions,
codified as the new value exception (NVE) to the absolute priority rule (APR), has been
the source of considerable controversy, both in terms of its existence, and the economic
benefit, ifany, that it provides. W e show that when the owner manager cannot
contribute capital to the distressed firm, creditors allow him to retain some residual value
(i.e. A P R is violated) in order to create the appropriate incentives for the manager to exert
effort. In this setting, we then examine the role of capital contributions by the manager,
when his required return is increasing in the amount that he contributes. W e consider
both the case of symmetric and asymmetric information about the manager's ability to
contribute such capital. Such infusions are shown to provide superior outcomes to both
creditor financing and external financing. Creditors are better off because of the impact
of the infusions on the incentives of the manager. As a consequence, deviations from A P R
are less severe than they would have been in the absence of these infusions. Moreover,
some firms that would have been liquidated in the absence of such capital contributions
are now able to continue operations. These results suggest that the current debate over
the optimal design of bankruptcy procedures should address the role for capital
contributions by owner managers as well.
Financial Distress a n d the Role of Capital Contributions b y the O w n e r M a n a g e r
I. Introduction
A large and evolving literature in financial economics focuses on the performance
of the current laws governing corporate bankruptcies. While empirical studies have
examined the various aspects of firms before, during and after financial distress,
theoretical studies have tried to understand the conflicting incentives created in these
situations.1 There have also been several attempts to articulate the features that should
be present in an optimal bankruptcy code.2 While these studies, for the most part, have
assumed that the same bankruptcy rules should apply to all firms, several legal scholars
have argued that bankruptcy procedures should recognize that differences in the
ownership characteristics of small versus large firms creates very different incentive
problems, thus potentially requiring different methods for resolving these problems as
well.3 This concern is also reflected in the (failed) attempt by Congress in 1992 to pass a
bankruptcy reform bill that included a new small business chapter (Chapter 10) that
would apply to firms with debts of less than $2.5 million (Tabb (1993)).4
1 Some prominent examples from the vast empirical literature include Franks and
Torous (1989), Weiss (1990), Eberhart, Moore and Roenfeldt (1990), Gilson, John and
Lang (1990), and Brown, James and Mooradian (1993). Theoretical papers include Brown
(1989), Giammarino (1989), and Gertner and Scharfstein (1991), among others. John and
John (1992), John (1993) and Senbet and Seward (1993) provide comprehensive surveys of
this growing literature.
2 Examples of this include Harris and Raviv (1993), Bebchuck (1988), and Aghion,
Hart and Moore (1992,1994).
3
See, for example, LoPucki (1993), Nimmer (1987), Skeel (1993) and Tabb (1993).
4 The Bankruptcy Act (pre-1978) contained two separate procedures (Chapter X and
Chapter XI) which provided such a solution. The need to design laws to cater specifically
to small firm is attested to by their importance to the economy. For example, a recent
study by the Small Business Administration finds that ".. the nations smallest firms
created virtually all the new jobs between 1989 and 1991".
Certain aspects of smaller companies distinguish them from their larger
counterparts. First, managers of these firms typically maintain a significant ownership
position as well. Second, much of the value of these firms is critically dependent on the
talent and ability of the owner manager. Finally, the owner manager, in addition to the
preexisting creditors of the company and outside lenders, represents a potential source for
any capital infusions that might be required as a part of the successful reorganization of
the firm. These aspects have typically been ignored in the ongoing debate in the finance
literature on the optimal design of bankruptcy rules.
The legal rules governing capital contributions by owner managers in return for an
equity stake in the firm are codified as the "new value exception" to the absolute priority
rule.5 This exception has been a source of considerable contention between debtors and
creditors, and there is also a large legal literature that discusses this aspect of the
bankruptcy code.6 7 The "new value exception" was a well established doctrine under the
Bankruptcy Act (pi*e-1978). It was based on the argument that the participation of the
owner manger in the reorganized firm provided benefits through continuity and the
preservation of the firm's reputation. It was also recognized, however, that ifsuch an
exception was not carefully monitored, there was also the possibility that managers could7
6
5
5 A summary of the relevant aspects of the new value exception is provided in
Section II of the paper.
6 Miscioscia (1993) provides a useful survey of the legislative history and the
academic debate over the new value exception. Baird and Picker (1991) examine the
implications of the automatic stay, cramdown and the new value exception. However, as
pointed out by Carlson (1992), it is difficult to isolate the effects of the new value
exception in their model. Nimmer (1987) discusses some of the policy implications of the
new value exception for small businesses, while Epling (1991) provides one of the few
available discussions of what such <*n "exception" should look like in practice.
7 The primary focus of this discussion, however, is primarily on whether the failure
of Congress to explicitly mention it in the Bankruptcy Reform Act of 1978 implies that the
feature is no longer a part of the Code.
3
misutilize the features. Consequently, the exception required that the owner had to
contribute a "substantial amount of capital", that such capital was not available from
other sources, and that the ownership interest was "reasonably equivalent" to the capital
contribution. It is not obvious-, however, what role such capital contributions from owner
managers play in improving the efficiency of the reorganization process. Nor is it clear
that such infusions represent a source of financing that provides benefits that are
unavailable when the firm utilizes either creditor financing or external financing. In fact,
Baird (1993a) goes so far as to suggest (page 266) that "the new value exception should
become a focal point for debate about bankruptcy policy because it admits of no such easy
resolution".
In order to investigate whether or not such a feature should be a part of the
current Bankruptcy Code, this paper develops a model of an owner managed firm that is
in financial distress. Specifically, the firm currently has insufficient funds to make the
promised payment to the single creditor in the firm. Consequently, the manager and the
creditor are renegotiating to restructure the claims and continue operations, ifpossible.
The alternative is to liquidate the firm (which can also be interpreted as the sale of the
firm to a less efficient owner manager). If the firm is to continue operations, two critical
inputs are required. First, a capital infusion is required to sustain operations, and
second, the manager has to exert effort that determines the ultimate cash flows generated
by the firm. This effort is not observable and hence cannot be contracted upon.
Consequently, the outcome of the renegotiation process depends critically on both the
level of capital infusions required and the incentives created by any restructuring of the
promised payments to the creditor.
W e begin by considering the case where the creditor provides the required capital
4
and restructures his debt claims. The optimal restructuring of the debt claim is based on
the trade-off between a higher promised payment and the adverse effects that this has on
the incentives of the manager to exert effort.8 Consequently, violations of the absolute
priority rule are required to provide incentives for the manager to put in the effort
required to maintain the value of the assets.9 Moreover, conditional on continuing
operations, managerial effort is still less than optimal, due to the well known debt
overhang problem (Myers (1977)). This lower effort level also implies that firms are
liquidated suboptimally. In the model, these results are unaffected by whether the capital
infusion that is required is provided by the preexisting creditor or by a new lender.
W e then consider the implications of the owner manager having sufficient personal
wealth to provide some or all of the capital infusion required to sustain the assets, with
this information being common knowledge. W e assume, however, that the economic rents
required by the manager in return for providing such capital are increasing in the fraction
of the capital that he provides. This would be the case, for example, ifthe manager is
risk averse or has alternate uses for his (scarce) capital. W e show that the creditor
prefers to have a part of the capital by raised through cash infusions from the manager.
In return, the creditor lowers the required payment from the firm relative to what would
have been required in the absence of capital infusions by the owner. This leads to an
improvement in effort incentives, and also results in some firms that would have been
inefficiently liquidated in the absence of cash infusions by the owner now continuing
operations.
8 This is similar to the trade-off identified in Bulow and Shoven (1979) and Froot,
Scharfstein, and Stein (1989).
9 This rationale for A P R violations is similar to argument in Eberhart and Senbet
(1993), Harris and Raviv (1993) etc.
5
W e finally consider the consequences of uncertainty on the part of the creditor on
whether or not the owner manager has funds available to make a capital infusion. The
symmetric information solutions are shown not to be feasible. Specifically, a "rich" owner
manager always has the incentive to mimic the "poor" owner manager. The creditor is
therefore forced to adjust the offers that he makes. To ensure nonmimicry, the creditor
increases the required payment in the offer to the "poor" manager, while reducing the
required payment in the offer to the "rich" manager. However, the creditor
simultaneously increases the capital infusion required of the "rich" owner. This has
implications for both the effort incentives and the continuation policy of the firm.
The remainder of the paper is organized as follows. Section II contains a brief
description of the terms and judicial history of the new value exception. Section III
develops the model of financial distress, and examines the restructuring decision in the
absence of owner capital infusions. Sections IV and V examine the role of capital
infusions by the owner under symmetric and asymmetric information respectively. The
implications of these results for the new value exception are discussed in Section VI,
where we also consider some possible extensions..
I
II.
The Legislative History of the N e w Value Exception to the Absolute Priority Rule:
The Absolute Priority Rule (henceforth APR), that forms the core of the 1978
Bankruptcy Code, mandates that a junior claimant cannot receive any property under a
reorganization plan unless all senior claimants have consented to the plan or that the
6
senior claimants have been paid the full amount that was due to them.10 In applying
APR, courts have frequently been confronted by situations where the equity holders of the
firm propose that they be allowed to maintain a stake in the reorganized firm, in
exchange for contributions that they make. Ifthis proposal results in existing creditors
not receiving their full payment, one could argue that the proposal violates the rule of
Absolute Priority. However, under specific circumstances, referred to as the "new value
exception", courts have deemed that such a proposal is acceptable. Specifically, under this
rule, equity holders who contribute capital are allowed to retain an interest in the
corporation (even ifcreditors are not being made whole) as long as the court decides that
i.
The proposed contribution is necessary.
ii.
The contribution is in the form of cash.
iii.
The claim in the reorganized firm is "reasonably equivalent" to the new infusion of
capital.
The courts have rationalized this exception by appealing to situations in which
only the debtors are willing to contribute capital to the firm, i.e. they are the lenders of
last resort. Furthermore, courts have also recognized the potential benefits to the firm in
terms of maintaining continuity, preserving the firm's reputation, etc., in justifying this
new value exception. However, the courts have also insisted that any contribution has to
be in the form of cash (and not cash equivalents like the promise for future labor) for the
exception to apply (see C a s e
v. L o s A n g e le s L u m b e r ) .
Subsequent to the reform of the Bankruptcy Code in 1978, there has been
10
Markell (1991) provides a comprehensive discussion of both the origins of the
Absolute Priority Doctrine and the legislative history of the new value exception.
Consistent with the legal literature, we will refer to the pre-1978 bankruptcy laws as the
Bankruptcy Act and the post-1978 laws as the Bankruptcy Code.
7
considerable debate in legal circles about whether or not this new value exception still
exists. Much of the debate can be traced back to A h le r s
v . N o r w e s t B a n k W o r t h in g t o n ,
where the Supreme Court first raised questions about whether or not the exception still
existed under the Code. While the subsequent debate has focussed on interpreting the
language of both the Bankruptcy Code and additional cases, there now seems to be
growing agreement that the Bankruptcy Code does implicitly contain rules on the manner
in which contributions of capital by equity holders must be treated when the firm is in
financial distress.
While such a debate is obviously useful, it raises an obvious policy issue. What is
the economic role of capital contributions by owner managers? Answering this question is
the obvious first step to any cjiscussion of whether or not rules resembling the new value
exception should be a part of the Bankruptcy Code. There are two contrasting views of
this in the legal literature. Markell (1991) suggests that the N V E is not an exception at
all, but in fact a corollary to the APR. He argues that while owner managers should be
allowed to participate in the reorganization process, they should do so in a competitive
environment, such as an auction. The benefit of this, in symmetric information
environments, is that competition prevents the owner manager from exploiting creditors,
while under asymmetric information, the bids of the owner manager provide valuable
information to other bidders.11
In his discussion, Markell implicitly assumes that the owner manager of the firm
brings no specific skills that are not available under alternate management. This makes
the participation of owner managers effectively equivalent to that of outsiders. However,
11
For a slightly different perspective on the implications of asymmetric information
for the role of auctions in bankruptcy proceedings, see Baird (1993b) and the response by
Jackson (1993).
8
Baird (1993a) argues that in the pre-1978 Bankruptcy Act, the new value exception was
especially relevant only for firms that would have filed under Chapter XI. These were
firms where the stockholders were typically also the owner managers of the firm. In such
firms, value is largely dependent on the special skills that the managers bring to the firm.
Consequently, Baird views capital contributions by the owner manager in exchange for a
stake in the reorganized firm as providing an "equitable" sharing of the benefits of
managerial skills between the creditors and the shareholders. If this is the role of NVE,
then it is not obvious that it is an unreasonable feature of the Bankruptcy Code.
The model developed in the next section incorporates these elements discussed by
Baird in order to better understand the special role, ifany, that capital contributions by
owner managers might have, in affecting the outcome of the bankruptcy process. This
analysis should provide a better understanding of the need, either in its current form or
in an alternate guise, of an "exception" to the absolute priority rule.
»
III. A Model of Debt Restructuring
The economy lasts over three time periods, indexed by t0,tj and t2 respectively.
The manager of a firm, who is also its owner, has to make a decision at t0 on the best
possible use of the assets under his control.12 Ifthe decision is made that the assets
should not be utilized, they can be sold off at their liquidation value, which is normalized
to zero.13 If the manager decides to continue utilizing the assets, an additional
investment of I0 dollars is required at t0 to upgrade the facilities. Subsequently, the
12 For convenience, we will subsequently refer to the owner manager of the firm as
the manager.
13 This "liquidation" can be interpreted as the sale of the assets to another
management team (Giammarino and Nosal (1994)).
manager needs to exert effort, q, at txin order to maximize the value of the assets. The
choice of effort, directly influences the probability of generating a value (cash flow) of X
dollars at t2,with zero cash flows being generated otherwise. The effort exerted by the
entrepreneur costs him Kq2 units (in dollar units) of disutility.14 This effort is
unobservable (and can therefore not be explicitly contracted upon) to other participants in
the economy. All participants in the economy are assumed to be risk neutral, and the
risk free rate is normalized to zero. Finally, all the parameters of the model are assumed
to be common knowledge. This assumption is relaxed in Section V.
F ir s t B e st
In deciding whether or not to continue operations at t0,the manager first needs to
know the optimal amount of effort that he would exert conditional on continuing, and the
value associated with doing so. Conditional on continuing operations, the manager's
choice of effort is the solution to
m a x ^ X + (1 - <7) 0] - K q 2
(1)
implying an optimal effort level of
X
<7=—
(2)
2K
To ensure that this optimal effort level is a feasible probability ,we restrict K to be
greater than X / 2 for the purposes of subsequent analysis. The value to the manger from
14
The quadratic cost function is assumed primarily for analytical convenience. The
flavor of the results will remain unchanged for a generic cost function with the usual
properties.
10
exerting this effort is
(3 )
q X -K q 1 = —
4K
.
At t0,therefore, the entrepreneur would consider it worthwhile to upgrade the assets and
continue operations only ifthe benefit to him exceeds the investment I0,i.e. whenever
X2
— >L
(4 )
4 K
As can be seen from (4), the manager is more likely to continue operations when the
managerial cost parameter, K, and the cost of refurbishing the assets, I0,are low, and/or
the magnitude of the future cash flow, X, is high. W e examine the implications of
preexisting promised payments to outsiders on the continuation and effort decisions of the
managers next.
D e b t R e s tr u c t u r in g
Suppose now that the firm needs to make a payment of B 0 dollars at t0 to its
creditor (assumed to be a singe, homogeneous entity).15 This liability can be interpreted
as having arisen because of past borrowing conducted by the firm. Since the firm
currently has no cash or liquid assets to pay this liability, in the absence of renegotiation,
the firm is immediately liquidated, yielding zero dollars to both the creditor and the
15
The assumption of a single creditor is made primarily for simplicity. As pointed
out by Gertner and Scharfstein (1991) and Mooradian (1994), the presence of multiple
creditors creates a variety of additional incentive problems as well.
11
owner manager (recall that the liquidation value is zero). It is also possible, however,
that the creditoi can provide the funds required at t0,i.e. I0 dollars, in exchange for a
promised payment of B 2 dollars at t2. Ifhe is willing to do so, we assume that the creditor
can make a take it or leave it offer to the manager. The ability to make a take it or leave
it offer obviously confers considerable bargaining strength to the creditor. This
bargaining strength is restricted, however, by the fact that the manger subsequently
makes the unobservable effort choice, which depends on the terms of the creditor's offer.
The equilibrium under these circumstances is identified next.
Proposition 1: IfX 2/ 8 K > I0 ,the optimal strategy for the creditor is to provide the firm
with I0 dollars, adjust the promised payment to B2 to X / 2 and continue operations. IfX 2
/ 8 K < I0 ,the creditor does not provides funds and the firm is liquidated.
Proof: Suppose the creditor does provide the funds to allow the firm to continue. The
creditor recognizes that when there is a promised payment of B dollars due at t2,the
manager's optimal level of effort solves
(5)
M ax q [ X - B ] + ( \ - q ) 0 - K q 2
<7
implying an optimal choice of effort, as a function of the debt outstanding, of
q (B ) =
—— —
2K
(6)
Consequently, the creditor's optimal choice of B 2 solves
max q ( B ) B
(7)
B
where q(B) satisfies (6). This implies that B 2=X / 2. For the decision to provide funds to
12
have been rational e x
a n te ,
it must be true that
q ( B 2) B 2 > I0
(8)
Substituting for the optimal level of B 2 leads to
X2
—
8 K
(9)
■
The preceding condition is more stringent than that required for the project to be positive
N P V (see equation (4)), implying that even when debt can be renegotiated, there are
situations where viable projects are prematurely liquidated due to the lack of funds to
sustain ongoing operations. The results can also be interpreted as highlighting the role of
violations of the absolute priority rules in providing superior incentives. This credible
threat of the manager to run down the assets is frequently used to justify both the
observed deviations from absolute priority and to highlight the need for allowing for
(selective) violations of APR.16 Our result is also related to Diamond's (1993) argument
that long-term debt should allow the issue of additional future debt that is senior, since
the issuance of senior debt in the future effectively dilutes the claims of existing creditors
in the same way as A P R violations, which could improve managerial incentives.
P u b lic D e b t:
16 The violation of A P R in bankruptcy has been pointed out by Daigle and Maloney
(1994), Eberhart, Moore and Roenfeldt (1990), Franks and Torous (1989) and Weiss (1990)
among others. Papers that have examined the benefits of A P R violations include Brown
(1989) ,Giammarino (1989), Bergman and Callen (1992) and Eberhart and Senbet (1993)
among others.
13
Instead of providing all of the capital, I0,required at t0 and having to settle for a
promised payment of B 2 dollars at t2,the creditor could make available only a fraction,
al0,with the remainder having to be obtained externally (1 < a < 0 ). The creditor
requires Bc dollars at t2 in exchange for providing these funds. The outside claimant
(referred to as the public) receives B p in exchange for providing (1-a) I0. Notice that the
structure of the model, namely only two possible cash flows, with the lower one set to
zero, results in there being no difference between debt and equity, or any difference based
on the priority of claims.
In this case, assuming .that the firm is not liquidated, the maximization problem
faced by the creditor can be written as
M ax
qBc -
a/0
(10)
subject to
X - ( B r + Bc )
(11)
H
2K
qBp
- 0 —«)/0
(12)
where (10) represents the creditor's expected payoff, (11) represents the effort incentives
of the manager when obligations of B c and B P are due to other claimants at t2,and (12)
represents the conditions under which outsiders are willing to provide funds. The next
proposition characterizes the solution and compares it to the case where the creditor
provides all the funds.
14
Proposition 2: The optimal solution in the presence of public financing is equivalent to the
solution when the creditor provides all the funds I0.
Proof: Substituting for a from the rational pricing constraint for the public (equation (12),
which must be binding) into the maximand (10) and the incentive compatibility condition
(11) allows us to restate the problem as
M ax
q ( B p + B c ) - I ()
{Bp.Bc}
(13)
♦•
Subject to
=
X ~ { B P + Bc)
(14)
2K
with the associated solution
X
BP + B C
(15)
2
Moreover, the creditor finds such an arrangement to be worthwhile iff
X
> L
(16)
8K
liquidating the firm otherwise.
■
Intuitively, the proposition merely highlights the idea that conditional on the firm being
in distress, there is an optimal amount of debt overhang (X/2). If only the creditor
restructures his claim, he provides all the funding while simultaneously setting the
optimal level of the overhang. If financing from the public is available as well, the
15
combination of the payments to the public and the creditor satisfy the "optimal overhang"
requirement (equation (14)), and the creditor reduces the amount of capital he contributes
to the firm by the market value of the public debt. However, this changes neither the
value to the creditor conditional on continuing operations, nor the circumstances under
which operations are continued.
It is interesting to consider these results in the light of the argument that
violations of A P R can be avoided by appealing to public sources of capital, potentially
through an auction. Such an argument presumes, of course, that there is symmetric
information about the value of the firm and that any contributions that can be made by
existing management can be replicated by others as well. Potential problems with
auctions in the presence of asymmetric information have been recognized (Baird (1993b)).
The results in Proposition 2 highlight the fact that ifcurrent management can provide
valuable input not available elsewhere, the reliance on outside funding is not sufficient to
mitigate the problems of A P R violations. Since creditor and outside funding are
equivalent in the context of the model, we ignore the latter for the purposes of subsequent
analysis.
IV. Debt Restructuring with Managerial Cash Infusions:
Now consider the more complicated case where the debtor does possess the
capability of providing some capital to the project at t0. Moreover, the creditor is assumed
to be aware that the manger possesses this capital, allowing him to require that the
debtor provide some of the capital required to sustain the assets. Specifically, suppose
that the creditor requires that the debtor provide E dollars (0 < E < I0 ) ,and that the
debtor will provide the rest and simultaneously change the promised payment required to
16
B 2.
Several comments on this modelling structure are in order. The assumption that
the creditor is aware that the manager possesses the funds might seem unreasonable.
This is relaxed in Section V. Furthermore, ifthe manager has cash available, an obvious
alternative to the renegotiation process developed here is for the manger to either pay the
creditor the promised payment at t0 or to buy back the debt. The first alternative might
be unpalatable ifB0 is sufficiently large. For the buyback, an obvious issue that affects
the feasibility of the process is the magnitude of the premium demanded by the creditor.
If this premium is high enough, the manager might once again decide that it is not
worthwhile to conduct a repurchase. The analysis assumes, therefore, that B 0 is
sufficiently large, and the premium demanded by the creditor is large enough to preclude
a buyback, leaving renegotiation as the only feasible alternative.
Even in renegotiation, however, one might expect that since the problem in this
model is created by debt overhang, the optimal solution would be to have the manager
provide all the capital required at t0. This assumes, of course, that the creditor possesses
all the bargaining power in the negotiating process. W e assume a slightly different
structure to the bargaining. Specifically, ifthe entrepreneur contributes a fraction X(E) =
E / I0 of the funds required for the continuation of the firm, he insists on getting at least
a fraction A.of the benefits.17 Consequently, a feasible offer (B,E) to the entrepreneur has
to satisfy
17
This can be interpreted as an increasing cost of capital schedule for capital
provided by the manager. It can be justified by either appealing to outside investment
opportunities available to the manager or on the basis of managerial risk aversion. The
precise form assumed is primarily to ensure the presence of interior solutions for the
amount of capital infusions by the manager, without directly modelling the bargaining
game between the creditor and the manager.
17
q [ X - B 2] - K q 2 > E + X { E ) [ q X - I 0]
(17)
The complete optimization problem now facing the creditor (again, conditional on deciding
to continue operations) is given by
max
(18)
qB — ( l0 — E )
B
Subject to
X - B
(19)
<7 =
2K
and
q[X - B 2] - K q 2 > E + X{E)[qX
- /„ ]
(20)
The optimal solution to the constrained maximization problem faced by the creditor is
given in the following proposition.
Proposition 4: The optimal face value of debt, B, and the optimal capital infusion, E, by
the entrepreneur, are given by
B =
X
I()K
2
2X
(21)
-------
and
=
E
X -B .
2X
Io =
L
InK
1+-
(22)
Procrf: Notice, first that the creditor's problem (18)-(20) is equivalent to solving
w
B
(X-B)B
(A: - B ) It
-----/, + ---2K
2X
(23)
18
This follows directly from substituting from the incentive compatibility condition (19) and
the rational pricing constraint (20) for the manager. The first order condition (for (23))
leads to the optimal value of B in (21). Solving out for E from (20), which must be
binding, leads to the value of E.
i
There are a few aspects of this solution that are worth highlighting. The first two terms
in (23) are similar to those that the creditor would consider when he is the sole provider
of funds at t0. The last term captures the effects of allowing the manager to contribute
capital to the project. As can be seen from (21), the creditor sets the face value of their
promised payment to be lower than it would have been in the absence of managerial cash
infusions.18* This leads to better effort incentives. Moreover, the promised payment to the
creditor is decreasing as the cost of managerial effort, K, increases. Finally, it follows
from (23) that the capital infusion required from the manager is increasing in K and the
initial investment I0.
Finally, we consider the implications of this additional flexibility provided by
entrepreneurial cash infusions on the decision on whether or not to continue operations.
Proposition 4: When managerial cash infusions are feasible, renegotiation results in the
firm continuing operations under a larger set of circumstances.
Proof: The profit to the creditor from the acceptance of a proposal (E,B) is given by
K c ( E, B) = q ( B ) B - { l 0 - E )
<24
For the creditor to agree to the terms characterized in proposition 4, it must be the case
18 Recall that in the absence of cash from the entrepreneur, the creditor sets the face
value of the debt to X/2.
19
that the profits under these terms are non-negative. Substituting for the terms, and
rearranging, leads to
*L >, _
— '0
k
4
,V * '
2
(25)
8X2
as the condition under which the creditor is willing to participate in the transaction.
Comparing this to equation (9), one can see that the right hand side of (25) is smaller,
implying that the creditor is willing to continue operations under a larger set of
circumstances.
The analysis of this section suggests, therefore, that the ability of managers to
make cash infusions enhances the efficiency of the renegotiation process in two ways.
First, the reduction in the debt overhang in the reorganized firm creates superior
incentives for the manager. Second, as a consequence of this superior effort exerted by
the manager, firms that might have been liquidated in the absence of such infusions can
now emerge successfully from financial distress. The analysis does suggest, however, that
cash infusions are not sufficient to ensure that all efficient firms continue operations.
V. Capital Infusions and Private Information
A concern about the equilibrium described in the previous section is that the
assumption that the creditor knows that the manager has the funds available to
contribute to the firm. In most circumstances, the creditor might in fact be uncertain
about the wealth of the manager, making it difficult to implement the solutions described.
W e therefore examine the implications of relaxing this assumption here. For simplicity,
20
suppose managers fall into two categories: Rich managers (type R) have sufficient capital
to satisfy any capital infusion request that might be required, while poor managers (type
P) do not have any capital available. The creditor does not know the type of the manager,
knowing only the probability, 5, that the manager is rich.
Recall that under symmetric information, the creditor will offer to restructure the
debt in the poor entrepreneur's firm to X/2. At the same time, the creditor will require a
cash infusion from the rich manager and set the face value of debt to less than X/2 (see
Proposition 4). If the creditor offers these two alternatives under asymmetric information,
it is possible that the rich entrepreneur might find it worthwhile to hide the fact that he
is rich in order to avoid contributing capital.19 W e show in the next proposition that this
is in fact always the case.
Proposition 5: If the creditor offers the symmetric information package, the rich manager
will always mimic the poor entrepreneur by picking the package that does not require
cash infusions.
Proof:See Appendix..
The creditor can try and screen the managers by offering two different packages
(Br,E r) and (BP,0), and designing the parameters of these offers so that the rich manager
selects the packages (BR,ER), while the poor manager selects (BP,O).20 W e assume, for
19 The poor manager, since he has no capital, obviously cannot select the offer meant
for the rich manager. The assumption that the poor manager has no capital thus
simplifies the analysis considerably by requiring that we only need to check the non
mimicry constraint for the rich manager.
20 Recall that by assumption the poor entrepreneur has no capital. Therefore, E P = 0
is the only feasible component of his package.
21
now, that the creditor finds it valuable to have both manager types continue operations.
The complete contracting problem faced by the creditor is to design these packages in
order to maximize expected wealth, i.e.
(26)
Subject to
q{BR ) { X - B R )~ Kq{B Rf - E R > q{BP ){X - BP )~ Kq{BP f
9{BR) { X - B R ) - K q { B R )2 - E
[ M
x - i 0]
(27)
(28)
where q(B) = (X-B) / 2K. The expected payments to the creditor are represented by (26).
The self selection constraint for the type-R entrepreneur is represented by (27), while (28)
represents his participation. Notice that the corresponding conditions for the poor
entrepreneur are not needed since (i) he cannot mimic a rich entrepreneur due to the lack
of funds, and (ii) the poor entrepreneur will always participate in the transaction since his
expected from doing so are strictly positive (since liquidation leads to a payoff of zero).
The solution to this problem is provided next.
Proposition 6: The optimal offers by the creditor satisfy
(29)
(3 0 )
p-2(l-5)
22
where p is the Lagrange multiplier associated with the participation constraint (24). The
equity infusion E R is implicitly defined by the equation
x
E
r
=
-
br
2X
4>
(31)
Proof: See Appendix.
Several aspects of this solution are worth noting. First, the lagrange multiplier, p,
must be less than or equal to zero (Novshek (1993)). If p is zero, the solutions revert
back to those characterized in Proposition 3 (i.e the symmetric information solutions). W e
know, from Proposition 5 that this solution is not feasible under asymmetric information,
implying that p must be strictly less than zero. If p is negative, however (or equivalently,
ifthe participation constraint (27) is binding), several observations can be made about the
terms of the contracts under asymmetric information relative to the symmetric
information counterparts.
Proposition 7: If the Lagrange multiplier p is strictly negative, the following must hold:
i.
The value of B R is less than its symmetric information counterpart.
ii.
The value of E R is greater than its symmetric information counterpart.
iii.
The value of B P is greater than its symmetric information counterpart.
Proof: See Appendix.
The manner in which the creditor adjusts the terms of the offers to the two
managers in response to asymmetric information is quite intuitive. To discourage the rich
manager from selecting the package meant for the poor type, the creditor requires a
higher payment (i.e. he scales down his claim less) from the manager who cannot
23
contribute capital than he would have under symmetric information. Simultaneously, he
makes the offer intended for the rich manager more attractive by (i) scaling down the
claim more than would have been the case under symmetric information, and (ii)
requiring greater equity participation, which increases the "rents" paid to the manager.
However, there is still a role to be played by such equity contributions, since, once again,
they lead to superior incentives (at least for the rich manager).
The preceding analysis has assumed that it is worthwhile for the creditor to make
offers to ensure that both types of managers accept and continue operations. It is
possible, however, that under some situations, the creditor might find it worthwhile to
only allow the manager who is willing to contribute capital to continue operations, while
liquidating the firm where such capital contributions are not forthcoming. Even in these
equilibria, however, there is a positive role to be played by the contribution of capital by
the owner manager.
VI. Implications and Extensions
A growing body of literature examines the implications of various aspects of the
Bankruptcy Code in promoting efficiency. An investigation of the role of capital
contributions by the owner manager of a firm that is in financial distress represents an
area that has largely been overlooked by this literature. While such contributions might
not typically be forthcoming in the context of large publicly traded firms, they are a
feasible source of financing for smaller firms. The terms under which such contributions
can be made has been the source of considerable judicial wrangling. Much of this debate,
however, has been over the interpretation of the language in the Bankruptcy Code. This
paper, on the other hand, examines the economic benefits, of such capital infusions, in a
24
model that incorporates the features that distinguish these smaller firms from their
larger counterparts.
The results of the paper suggest that for closely held firms, where future value is
largely dependent on managerial effort, A P R violations are very likely to occur. This
result by itself is not new, having been identified by a variety of different authors (see
footnote 16). W e show that allowing for capital contributions by the owner manager can
reduce the magnitude of these A P R violations, while simultaneously improving the
manager's incentive to exert effort. This results in restructured firms having a lower
leverage, and allows firms that would have been liquidated in the absence of such
infusions to continue operations. These benefits occur despite the fact that the required
return of the owner manager increases as a function of the capital that he contributes to
the firm. Finally, we also show that the spirit of these results remains unchanged when
one moves to an environment where there is uncertainty about the ability of the manager
to contribute capital to the firm. While these results highlight the effect that these
infusions have on the incentives of the manager of the firm, and thus have important
implications for the current debate on the new value exception, it is useful to consider
some aspects of the problem that have not been formally modelled.
Under the terms specified in the model, bondholders would like to have the
manager contribute capital to the firm. This might seem inconsistent with the litigation
(frequently initiated by creditors) associated with the NVE. One explanation for this
might be the judicial indecision about the status of the NVE, which might make it
rational for the bondholders to expect to benefit from appealing to the judicial system.
Moreover, such litigation might also be rational if(i) there is disagreement about the
value of the assets in the firm, (ii) there are multiple creditors in the firm, or, (iii) ifthe
25
rents demanded by the manager in exchange for capital infusions are significantly greater
than the manner in which they are modelled in this paper. These dimensions represent
interesting potential extensions of the model.
W hile the results of this paper highlight the benefits of m anagerial capital
infusions, alternate methods for resolving financial distress do exist. Two popular
alternatives that have been suggested in the literature are the use of options (Aghion,
H art and Moore (1992, 1994), for example) and the use of auctions for the disposal of
assets (see Baird (1993b) and Jackson (1993)). In order to be implemented, both these
solutions require well functioning m arkets. A s pointed out by V ishny and Shleifer (1992)
the potential buyers of the distressed firm 's assets, who might be in the same industry,
might also be experiencing financial distress, reducing the possibility that a sale of assets
w ill provide a fa ir price. Moreover, to the extent that the value of assets is dependent on
the manager, this provides him w ith a bargaining position that is different from that
available to the public. Consequently, these solutions are unlikely to be effective in
elim inating the problem.
F in a lly , it is im portant to recognize that the problems in financial distress are not
eliminated by capital infusions by the owner manager either. T h is paper represents ju st
one part of the complex issue of the optimal design of bankruptcy procedures that trade
off the costs of m arket mechanisms against the bureaucratic costs of ju d icially mandated
ru les.21 However, the analysis of the benefits of capital infusions in the context of certain
types of firm s raises a more general issue. There is growing concern that the existing
21
Bowers (1993) provides an extrem ely interesting discussion of this tension between
the role of m arkets (based on a perfect markets-zero transactions cost approach (PMZTC )) and bureaucratic procedures like bankruptcy (based on im plicit zero bureaucratic
cost assumptions).
26
bankruptcy procedures, that apply uniformly to different types of firms, are the primary
source of many of the perceived problems. Procedures that recognize the different
incentives and relationships that exist in firms as a function of their ownership and
financial structure might in fact be the critical element of an optimal bankruptcy code.
27
Appendix
Proof of Proposition 5:
Suppose we designate the packages offered to the poor and rich manager by (BP,E P) and
(BR,E r)respectively. Under the symmetric information solution, recall that B P = X/2 and
E P = 0, while B R = X/2 - (I0K/2X) and E R = (X-BR)I0/ 2X. Moreover, q(B) = (X-B)/2K. The
expected profit to the entrepreneur, conditional on the package (B,E) selected, is given by
q(B\X-B]-Kq{B)2- E
Ifthe rich entrepreneur selects that package intended for the poor entrepreneur, his
expected payoff is
X2
16K
(A2)
The expected payoff from selecting the package designed for him yields
3/pX [ /Q
16X2 8
X2
16 K
(A3)
which is clearly lower, implying that the rich manager will always prefer the offer meant
for the poor manager.
Proof of Proposition 6:
After substituting for the optimal effort level of the manager at a given level of debt
overhang, i.e. q(B)=(X-B)/2K, the optimization problem faced by the entrepreneur can be
rewritten as
Max
* Z i ! L B R - ( l n - E R)
2K
-(1-5)
L 2K
CA4)
J
Subject to
( X - B P?
4K
x
E
r
4K
-
b r
2
/„
<0
X
+Er <0
CA5)
(A6)
28
It
Oo
The Lagrangian for the problem can now be written as (see Novshek (1993)):
± J } e. b k - ( i 0 2K
e k)
+ (1-8) \ x - b '
L 2K
b
,1 + P
\
(X -B * )2
4K
4K
+ E.
(A.7)
The first order conditions with respect to ER,BR and BP,when simplified, lead to
(A.8)
Y = -(8 + p)
(A.9)
B
_ ^-C1-8) y
H -2(1 -S)
(A.10)
Notice that in this solution, p must be strictly less than zero. Otherwise, the packages
are the symmetric information ones, which cannot be a solution (see Proposition 5). Since
(A.6) must be binding, one can solve out for the definition for E R.
Proof of Proposition 7:
Part (i)
When p=0, the solutions under symmetric and asymmetric
information are identical. If the constraint is binding, p < 0. But
the solution for B R is increasing in p implying that it is lower.
Part (ii)
Follows directly from (i) and the implicit definition of E R.
Part (iii)
Follows from the fact that the coefficient in (27) is equal to one when
p=0, and is decreasing in p. Consequently, it is strictly greater than
one whenever p < 0 (i.e. whenever the constraint is binding).
29
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@FedFRASER