Essays in the resolution of bankruptcy and financial distress

Seth, Gunjan (2023) Essays in the resolution of bankruptcy and financial distress. Doctoral thesis, University of London: London Business School.

Abstract

This thesis focuses on the resolution of financial distress and bankruptcy and comprises of three chapters in this area. The underlying theme across these chapters is to understand and quantify the direct and indirect costs of distress, as well as innovations in bankruptcy resolution that might improve the overall efficiency of asset allocation in the economy. The first chapter investigates the role of rights offerings as a new market-based mechanism in resolving valuation uncertainties in U.S. Chapter 11 reorganizations. Using hand-collected data on these offerings, I document three novel facts: (i) in the last decade, they have been used to finance 45% of bankruptcy filings, (ii) hedge funds or private equity firms generally proposed them, and (iii) their occurrence is highly correlated with the performance of the stock market. In an instrumental variable setting, I find that compared with other sources of financing, rights offerings are associated with higher recovery rates, shorter time spent in Chapter 11, and lower bankruptcy refiling rates. They also allow firms to access new capital without resorting to asset liquidations, which are value reducing. Overall, these findings suggest that by alleviating key bargaining frictions in the bankruptcy process, rights offerings may improve the efficiency of resource allocation in the economy. The second chapter decomposes the raw fire sale discount into a quality component, a misallocation component, and a residual liquidity component. We find that distressed airlines undermaintain their fleets and, this quality impairment explains half of the discount. We find no evidence of misallocation to lower productivity users. While the raw discounts are much larger for Chapter 7 than Chapter 11 transactions, the difference is largely explained by longer periods of under-maintenance and consequently lower quality of aircraft sold in Chapter 7. The evidence suggests that the magnitude of welfare losses associated with fire sales are likely to be overstated. The third chapter explores whether sophisticated bankruptcy procedures are required to mitigate coordination failures and fire sale discounts arising from financial distress. The shipping industry provides a unique laboratory for examining the limits of Coase for resolving financial distress since the industry is largely detached from sovereign bankruptcy procedures. We find that 2 private contracts and institutions have evolved to resolve coordination failures: for example, we find a low incidence of vessel seizures, ports that compete to enforce creditor rights, and small fire sale discounts. However, we report significant spillovers of financial distress for other stakeholders, particularly environmental, who bear the costs of under-maintained vessels, including oil spills, and abandonment of derelict ships, which end up in toxic breaker yards.