Out-Of-Court Restructuring: The Best Methods of Reducing Financial Distress

'Out-Of-Court Restructuring: The Best Methods of Reducing Financial Distress'

Financial distress is a term incorporate finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. It is a condition where a company cannot meet or has difficulty paying off its financial obligations to its creditors. If financial distress cannot be relieved, it can lead to bankruptcy.

Restructuring out-of-court allows a distressed company to renegotiate the terms of its debt contracts without filing for protection. Another name for restructuring out-of-court is a workout. The workout can be done in two forms, either through the renegotiation of debt contracts with private creditors or by means of a tender or an exchange offer. A typical workout represents a transaction involving at least two classes of securities, one of which is old debt and the other one is common or preferred stock or debt with different terms. The debtor makes an offer to the creditors to exchange the old debt with the goal reducing it and preserving the value of the company and preventing bankruptcy.

Generally, the firm has three options for how to restructure its debt out of court. Such as

(i) by alteration of the terms of the original debt contract without any changes in the priority of claims

(ii) by offering a priority-reducing exchange

(iii) by a priority jump in exchange offers

The first type of debt restructuring is usually applied to private debt holders. The renegotiation of private debt contracts can include a covenant waiver, a reduction of interest, an extension of the maturity of the debt, the placement of a new loan from an existing private creditor, or debt forgiveness. Private debt-holders are usually banks and non-bank financial institutions holding large amounts of secure debt of highest priority. In His research Asquith et al. show that private creditors seldom make unilateral concessions and would predominantly prefer to waive a covenant. Covenant waiving happens in about 78 per cent of all private debt workouts in the sample. This finding is consistent with Brown et al. who analyze the terms of restructuring distressed debt and obtain the result that private debtors usually extent the maturity of their debt and/ or waive the covenants without altering the priority of their distressed claims. Debt forgiveness is a rare event because private creditors, especially banks, have institutional constraints. Their debt is secured, and, therefore, they have no incentives to make concessions except for situations in which the company is severely distressed and claims of private debt-holders are impaired.

Priority-reducing exchange offers include swaps of common stock or of a package combining debt with lower priority and equity for the existing debt. The interest on new debt is usually paid in cash or common shares. Offering a priority-reducing exchange, companies can choose between two options, either to offer unregistered securities to bond-holders or to use the services of an intermediary for the purpose of the financial transaction.

Researchers Mooradian and Ryan in the year 2005, investigate the role of investment banks in the resolution of the information asymmetry problem in public workouts. Despite the fact that the costs of employing an investment bank are relatively high, the participation of an investment bank provides economic benefits resulting in the reduction of the information asymmetry and of transaction costs. Mooradian and Ryan show that the evaluation of the fair value of securities for the exchange by an investment bank sends positive signals to the creditors about the current financial position of the distressed company.

This results in a reduction in the creditors' uncertainty about the going-concern ability of the troubled company. The investment bank's opinion is classified by the debt holders as proof of confidence and motivates more of them to accept the exchange offer. This increases the percentage of successful debt reduction and leads to a better operating performance after restructuring.

The third type of debt reduction out of court is the design of exchange offers with an enhanced level of security and seniority of debt. Since a more senior status automatically implies a higher priority, this type of exchange offer is known as offers with priority jumps.

The possibility that offering claims with more senior priority to public debt-holders can be efficient in the resolution of the holdout problem is proved in the theoretical model by Gertner and Scharfstein and confirmed empirically by Brown et al, James, Chatterjee et al, and other researchers. The most dangerous impediments to public workouts are holdouts. The holdout problem prevents the firm from reducing public debt because small individual claimants believe that they are not pivotal in the exchange process and, therefore, can hold out without participating in the workout and obtain the total amount of their debt at the cost of participants of the exchange. Payoffs to senior creditors are generally higher than to junior claimants.

Therefore, granting senior debt to junior debt-holders in exchange will increase their payoffs in the case of liquidation in comparison to their current position and make holding out useless.

In addition to the advantages of the private workouts discussed above, Schwartz highlights that it is in the interest of all classes of creditors to follow a cost reducing strategy and to restructure their debt out of court. Since the administrative costs of filing for bankruptcy protection are high, workouts should be employed more frequently compared to legal bankruptcy. The claimants not only receive the share of the firm in the amount they would obtain if it came to bankruptcy, but also collect a portion of the savings from the avoidance of going to court. In especially severe cases of the holdout problem, when different classes of creditors do not find consensus about debt restructuring, coercive tactics can alleviate the holdout and force reorganization. Coercive offers are designed to make private bondholders worse off if they reject the workout. The company can offer an exit content which can be approved by consent of the majority of tendering bondholders. The acceptance of the exit offer allows the company to strip restrictive covenants of debt indentures and leave the non-participating bondholders with securities of minimal value. Therefore, it is advantageous for small debt-holders to participate in distressed restructuring instead of rejecting it. In coercive tenders senior debt is usually repurchased with cash, since cash is the only way to offer more senior claims to senior creditors, whereas junior debt is often exchanged for equity.

Coercive offers have no clear resonance in the financial literature. Some researchers emphasize the unfairness of the coercive tender offers pertaining to small creditors because of the limitations of the effective rights of minor debt-holders to vote for or against the debt restructuring. Other researchers, in contrast, defend coercive tactics and rate them as a reasonable and effective technique for the resolution of the holdout problem.

Moreover, researcher Chatterjee et al. in the year 1995, find that coercive tendering reduces the costs of public workouts and diminishes the old debt by more than 50 per cent.

Last but not least, several researchers analyze the complexity of the mix of public and private debt in troubled debt restructuring and the role of large private claimants in the resolution of information and holdout problems. James in the year 1996, finds that the composition of public debt exchange offers depends on the variety of different classes of creditors in the troubled firm. An involvement of private debt-holders in out-of-court restructuring positively affects the participation of small public bond-holders in the exchange.

Concessions of private lenders mitigate the necessity of exchange for the bondholders.

This has a direct impact on the reduction of the holdout problem and the outcome of the restructuring. Empirical findings show that if the bank does not participate in public exchange, the distressed offer contains about 0.78 cents of senior debt per dollar of junior debt and the effect of public debt reduction is low. If private debt-holders make concessions, waive a covenant or extend maturity, less senior debt is offered to the bond-holders and the outcome of the exchange results in a larger reduction of public claims.

In brief; out-of-court restructuring can be seen as an effective instrument of financial distress resolution which does not produce additional legal costs which arise when filing a bankruptcy petition. As a rule, companies try to restructure their debt out of court, and only if this attempt fails, is a formal bankruptcy the next step that can be taken. Public workouts usually take less time than the legal bankruptcy procedure.

According to Researchers Franks and Torous an average the company spends about 1.5 years restructuring itself out of court, whereas the reorganization takes over 2.5 years. Researcher, Gilson et al. provided similar results. In their sample companies are able to restructure themselves out of court within 15 months while unsuccessful restructuring ends in a bankruptcy and requires an additional 20 months for further reorganization. Therefore, out-of-court restructuring effectively reduces the time that a company spends in financial distress.

Nevertheless, public workouts are not safe from holdouts and information problems, which adversely affect distressed restructuring and can endanger the success of the outcome.

Theoretical models and empirical findings, however, confirm that in many cases holdouts and information asymmetries can be mitigated. Companies can offer more secured debt in exchange for the old, reduce the complexity of the debt, outsource the management of the exchange offer to investment banking specialists, and force coercive exit content agreements.