Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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JWBT436-c20 JWBT436-Baker February 11, 2011 10:30 Printer Name: Hamilton

FINANCIAL DISTRESS AND BANKRUPTCY 363

comparative industry counterparts. This finding is consistent with critics’ con-

tention that inefficiencies in the Chapter 11 process inhibit complete restructuring.

The results of Heron, Lie, and Rodgers (2009) are also consistent with a clien-

tele effect. Certain pre-investors preferred fixed income claims before bankruptcy

and are similarly reluctant to hold residual claims thereafter. This preference may

reflect investor tax or income status or regulatory requirements. For example, while

federal and state banking laws permit U.S. banks to take equity claims when re-

structuring nonperforming loans, regulators base capital requirements for banks

and insurance companies on the financial risk of their assets.

In practice, Asquith, Gertner, and Scharfstein (1994) report that banks waive

covenants but rarely reduce principal. James (1995) also reports that banks are

reluctant to make concessions. In his sample of 102 distressed restructurings, only

31 percent of deals result in banks taking equity. Given relatively illiquid markets

for equity claims on emerging firms, prepetition creditors may rationally prefer a

fixed income claim on a firm with a suboptimal capital structure.

Kahl (2002) views repeated Chapter 11 filings as part of a creditor-controlled

dynamic liquidation process. As an old adage suggests: Borrow $1,000 and you

have a creditor; borrow $1,000,000 and you ...