Systemic Financial Distress and Auction-Based Bankruptcy Reorganization

Abstract

Financial reorganization under bankruptcy reduces a firm's debts to a serviceable level through negotiations overseen by courts. Markets have been suggested as an alternative to such negotiations, recognizing that equity holders and junior claimants have call options to buy the firm back from senior creditors. This paper further develops this market-based approach when claimants are severely cash-constrained and there is merit in having existing owners-managers remain in control. The scheme arranges creditors in a queue to be serviced in sequence from the firm's operating cash flows. Creditors bid for their position in this queue, and those accepting a greater proportionate reduction in the face value of their claims (perhaps those most pessimistic about the firm's prospects) are placed ahead of the others. A pre-existing hierarchy of claims is honored by having claimants bid for their positions within the relevant segment of the queue. No one in the queue (including owners who are last) is paid anything until the (reduced) debts of the first in line are fully discharged using the firm's operating cash surpluses. The queue then moves up and the next claimant in line is serviced. The paper shows that, in equilibrium, the aggregate debts of the firm are reduced to a level that is more serviceable and that provides the owner-manager with a positive expected residual return. We discuss the appropriateness of this scheme to situations of systemic financial distress, including the East Asian crisis.