In general, a corporation in financial distress may take two routes. The first one corresponds to the liquidation in which the assets of the firm are sold either piecemeal or as a going concern. The proceeds from this sale are then divided among all the claimants in accordance with their priority rights. Alternatively, the firm may embark on a reorganization process whose purpose is to find a method to overcome the trouble. Typically, this process involves a negotiation between debtors and creditors with a view to establishing a new mechanism for the settlement of claims: writting off some of the claims, exchanging bonds and other debts with new notes, bonds, swapping new equities for old ones, injection of new capital. This paper aims at providing a formal analysis on the choice between these two options when firms get into financial difficulties.
We take a dynamic financial contracting approach to this issue. The dynamic agency model is first introduced by Green (1987) and Spear and Srivastava (1987). Built on the recursive method developed in these works, recently, a number of papers study optimal financial contract in a setting in which a risk neutral entrepreneur seeks funding from risk neutral investors to finance a project that pays stochastic cash flows over many periods. Their contracting relationship is subject to a moral hazard problem coming either from the unobservability of cash flows or from the hidden effort. All of these papers assume that the entrepreneur is liable for payments to the investors only to the extent of current revenues. Consequently, when facing a business failure, the firm possesses in hand only one option, that is liquidation. In this paper, to be able to simultaneously analyze the liquidation and the reorganization decisions, we introduce into a dynamic financial contracting model the possibility of costly recapitalization , one of possible formulations of reorganization.
Specifically, we consider a scenario where a risk neutral entrepreneur contracts with risk neutral investors to finance a business project. This project, once funded, generates at each date of its life an observable binary cash flows whose distribution depends on the unobservable effort of the entrepreneur. For simplicity, we assume that the set of feasible effort levels contains two elements, high or low effort. The distribution of cash flows under high effort dominates the one under low effort in the sense of first order stochastic dominance. Nevertheless, exerting high effort is costly since it deprives the entrepreneur of a private benefit B. The novelty of our paper lines in relaxing the usual limited liability condition of previous analysis. We assume that payments for the entrepreneur at each date can be negative. Negative transfers mean a new capital injection by the entrepreneur into the firm and so, are interpreted as recapitalization. In our setup, the recapitalization is costly and voluntary. Hence, in our model, in front of a financial difficulties, the firm can choose either to be reorganized by recapitalization or to be liquidated. The properties of an optimal financial distress procedure are highlighted through the characterization of the optimal contract between the entrepreneur and the investors.
In line with numerous contributions of the literature on repeated moral hazard, to find the optimal contract, we rely on dynamic programming technique. We use the expected discounted utility of the entrepreneur at the start of each date as the only state variable. We are able to fully characterize the optimal contract in an infinite horizon setting. We find that the firm is never recapitalized nor liquidated following a good performance. These two options are resorted to after a poor performance when the value of the entrepreneur's claim to future cash flows is low enough. There exists two possible procedures to cope with financial difficulties. When recapitalization cost is relatively high, the firm should be liquidated and no recapitalization is employed. By contrast, when recapitalization cost is low, in financial distress situation, the firm would be recapitalized up to the extent that liquidation risk is eliminated. We also show that our optimal contract is robust to the renegotiation possibility.
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Optimal Resolution of Financial Distress: A Dynamic Contracting Approach
