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United States. Congress. House. Committee on the J.

Extension of family farmer bankruptcy provisions : hearing before the Subcommittee on Economic and Commercial Law of the Committee on the Judiciary, House of Representatives, One Hundred Third Congress, first session on H.R. 416 ... March 10, 1993 online

. (page 4 of 5)
Online LibraryUnited States. Congress. House. Committee on the JExtension of family farmer bankruptcy provisions : hearing before the Subcommittee on Economic and Commercial Law of the Committee on the Judiciary, House of Representatives, One Hundred Third Congress, first session on H.R. 416 ... March 10, 1993 → online text (page 4 of 5)
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those available under Chapter 11. This difference occurs primarily because Chapter 12



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34



weakens the absolute priority rule and changes the definition of adequate protection of
secured creditors, facilitating writedowns in secured debts to the current market value of
collateral. Thus, the major marginal effect of Chapter 12 is to encourage both inefficient
farmers who would otherwise liquidate and efficient farmers who would otherwise
continue their operations at greater expense to invoke the protection of bankruptcy and
reorganize their businesses. This provision increases direct bankruptcy costs by
encouraging farmers to file for bankruptcy. It also increases indirect costs by increasing
the number of farmers who choose to reorganize when the socially optimal decision
would be for them to liquidate.



A Model of Indirect Costs of
Bankruptcy

In any time period, a firm has the choice of continuing operation, reorganizing, or
liquidating. The economically efficient alternative, that is, the one that maximizes the
expected combined value of debt and equity, is not always chosen by management
because that alternative does not always maximize the expected value of equity alone. In
such cases, conflicts arise between the interests of debtholders and equityholders. These
conflicts occur because while both debtholders and equityholders share interesu in the
cash flow generated by a business, only equityholders control management decisions.
Since equity is the residual claimant to business cash flows, equity value can be increased
by capturing some of the cash flow claimed by debt. In an uncertain environment, equity
value can also be increased by increasing the riskiness of cash flow since equity enjoys
the upside risk while debt bears much of the downside risk because of limited liability
(see Ross, Westerfield, and Jaffe, pp. 421-424, for examples).

Table 4 indicates that three types of conflicts can arise between debtholders and
equityholders with respect to the choice to reorganize, liquidate, or continue business
without action. The first two types of conflict occur when the value of equity is
maximized by (1) continuing or (2) reorganizing the business, but the combined value of
debt and equity is maximized in liquidation. This situation will occur when the assets of
the firm can be more profitably employed in another business, but either the benefits of
liquidating the business will not accrue to equityholders and/or equityholders will lose
some benefits if the business is liquidated. The following examples illustrate how such
situations may arise:

(1) If the business is liquidated, any tax-loss carry-forwards disappear. Thus, there
may be a tax-based incentive for equity to choose to reorganize under
bankruptcy protection or continue operation without bankruptcy protection to
avail itself of this tax advantage.

(2) Debt exceeds the value of business assets, so equity would receive nothing on
liquidation, but by pursuing a high-risk business strategy there is a small chance
that a very good return for 1 year could result in some benefits accruing to
equity. If the high return isn't realized, debtholders pay the additional cost.
This problem is known as moral hazard.



35



T*bL* « — Conflicts amons aqulty uid d*bt, and Indirect •fflclancy costs



Totsl vslus
(dsbt ♦ equity)
Bsxlmlxlns
dsclsion



Equlty-nazlmltlns dsclsion



Llquldats



Rsorssnlzs



Contlnus



Llquldst*



Rsorganlzs



No conflict.



Not appllcabls.



Dlrsct and Indlrsct
bsnkruptcy costs



Ho conflict.



Indlrsct bankruptcy
costs incurrsd but
unsffsctad by
Chaptar 12.

Not appllcabla.'^



Not appllcabls.



Tranafsra froo dsbt
to squlty. No Indlrsct
costs Incurrsd. Only
dlrsct costs Incurrsd.



No conflict.



ICooblnstlons labslsd not appllcabls will not occur undsr ths assumptions of rational aconoaic behavior.



The third type of conflict is when the value of equity is maximized by reorganizing the
business, but the combined value of debt and equity is maximized by simply continuing
operations. This situation will occur when the assets of the firm are already in their most
profitable use, but equityholders have the opportunity to shift more costs onto
debtholders through the bankruptcy process than equityholders have to bear in the
reorganization process.

For purposes of this paper, an important difference between the first two types of
conflict situations and the last is that indirect bankruptcy costs are not accrued in the
latter. Reorganizing in the latter situation is a bid by equityholders to transfer wealth
away from debtholders without necessarily affecting actual business operations. Such
opportunities arise from many possible circumstances. Brealey and Myers (p. 657) cite
the following possibilities as examples:

(1) If the firm's assets are sold off, it is easy to determine what is available to pay
the creditors. However, this is not the case under reorganization. Creditors are
generally paid in a mixture of cash and promises of future payments. Such a
promise may not be worth as much as its face value, but the bankruptcy court
usually looks at the face value of the promised payments and may regard the
bondholders as paid off in full.

(2) Bankruptcies often take a long time before a plan is presented to the court and
agreed to by each class of creditors. Senior claimants may be prepared to
accept a smaller payoff as part of the price of getting a plan accepted.

(3) While a reorganization plan is being prepared, the court may allow additional
borrowing. Postpetition creditors have priority over the old creditors and their
debt may even be secured by assets that are already mortgaged to existing
debtholders. Thus, existing debt may loose value and equityholders gain
favorable financing terms on new borrowing.



36



Table 4 also indicates several possible conflict situations that will not arise involving
instances where (1) debtholders favor while equityholders oppose reorganization or (2)
equityholders favor while debtholders oppose liquidation. If reorganization is
economically efficient, it will always be chosen by rational equityholders because any
benefits from reorganization accrue to equityholders rather than debtholders. Therefore,
conflicts will not arise because creditors want to reorganize and equityholders want to
liquidate or continue without reorganizing. If equityholders choose liquidation, this
choice also will be economically efficient, because equity is the residual claimant.
Therefore, conflicts will not arise because equityholders want to liquidate and creditors
wish to continue or reorganize.

If management makes an economically inefficient decision, that is, one that maximizes
the expected value of equity but does not maximize the expected combined value of debt
plus equity, then additional indirect bankruptcy costs may be imposed on the economy.
The magnitude of such costs is the difference in total firm value (debt plus equity)
associated with the two alternatives.

As noted above, such indirect costs occur in only two instances (table 4):

(1) Equity value is maximized by continuing to operate without bankruptcy
protection, but combined debt and equity value is maximized under liquidation,
and

(2) Equity is maximized by reorganizing under the protection of bankruptcy, but
combined value of debt and equity is maximized under liquidation.

The provisions of Chapter 12 have minimal effects on the first instance, the choice
between liquidation and continuation. Therefore, the following analysis focuses on the
choice between liquidation and reorganization. White showed that, under simplifying
assumptions, an upper bound can be placed on indirect bankruptcy costs. Her model
and my modification of it is described in detail in the appendix. White showed that this
conflict will arise only if:

(1) The expected value of the shortfall in payments under a reorganization plan,
plus

(2) The debt forgiven in reorganization exceeds

(3) The difference between net liquidation value of the business and net value of
the business under reorganization.

The expected value of the shortfall in payments refers to the extent to which actual
payments fall short of payments promised in the plan.

Recall that (3) is the measure of total indirect bankruptcy costs. However, such costs are
not directly observable and are difficult to measure. Thus, the beauty of White's model
is to establish a relationship between readily observable quantities, the expected loss
incurred by creditors (debt forgiven plus shortfalls in payments) because of
reorganization of an inefficient business, and indirect bankruptcy costs. The expected
creditor losses represent the upper bound on these costs, which in turn are deadweight
losses to the economy. Note that not all creditor losses are deadweight losses to the



10



37



economy, since the transfer of wealth among parties doesn't always change the use or
productivity of resources.

This result was derived under the simplifying assumption of riskless secured loans. I
interpret creditor losses to include lost opportunity costs allowed under both Chapters 11
and 12 reorganizations. Therefore, total indirect bankruptcy costs attributable to
bankruptcy are the sum of the following:

(1) The present expected value of the shortfall in plan payments,

(2) The debt forgiven in reorganization, and

(3) The present value of any lost opportunity costs on creditors' secured claims.

The addition of the last item apphes only to cost estimates under both Chapters 11 and
12, although differences in provisions of Chapter 11 and 12 bankruptcies affect the
magnitude of opportunity costs creditors must bear.



Estimates of Indirect Bankruptcy
Costs Under Chapter 12

I use published data on farm bankruptcies from North Carolina and South Dakota and
White's estimates for Chapter 11 bankruptcy costs for all industries. The North Carolina
data were collected from 106 Chapter 12 cases filed at the Eastern District Federal
Bankruptcy Court in Wilson, NC, between November 26, 1986, and November 17, 1987.
The South Dakota data were collected from 72 initial farm Chapter 11 filings at Federal
Bankruptcy Court in Sioux Falls, SD, fi-om January through October 1985 and from 101
Chapter 12 cases filed at Federal Bankruptcy Courts in Sioux Falls and Pierre, SD, from
November 1986 through February 1988.

Published data are not available on shortfalls in plan payments. White had the same
problem with her data. She assumed that these costs would be captured elsewhere in
her analysis and chose to ignore them. I assume that they are small relative to other
costs because plan payments are very small compared with writedowns, so I also ignore
this term.

Available per farm statistics on the direct and indirect costs of bankruptcy are presented
in table 3. Estimates are made for the average writedown on unsecured and
undersecured debt and for the lost opportunity cost from changes in the adequate
protection requirement. Average writedowns total $221,660 per farm in North Carolina
and $200,800 per farm in South Dakota.

To estimate the lost opportunity cost on secured debt, consider that adequate protection
is usually applied to the pre-confirmation stage of the bankruptcy case. Although some
courts may extend the concept of adequate protection post-confirmation with respect to
continued use by debtor post-confirmation, adequate protection is not the standard for
payments under either a confirmed Chapter 12 plan or Chapter 11 plan. Thus, any
losses would accrue during the period between filing the petition and confirmation of the'



11



38



plan. As per table 1, this period generally extends for about 125 days under Chapter 12
or 180 days under Chapter 11.

The value of the lost opportunity cost can then be computed by assuming that debtors in
possession under Chapter 12 pay creditors the going rental rate on farmland in their
State for the relevant period if real estate values are declining or nothing if they are
stable or rising. For North Carolina and South Dakota in 1987-88, land values were
either stable or rising. Therefore, the opportunity costs related to delay in the exercising
of foreclosure rights for these States and years was the investment income lost by secured
lenders. If the prevailing rate on debt with similar risk was 14.5 percent (Collender),
then the opportunity costs would be 125 days or 4 months interest at the prevailing rate
times the value of collateral at the time of filing the bankruptcy petition. The per farm
value of these potential losses on secured claims is $10,328 in North Carolina and
$11,697 in South Dakota.

My estimate of total indirect bankruptcy costs under Chapter 12 is $231,988 per farm in
North Carolina and $212,497 in South Dakota. These values represent 98.4 percent of
average asset value at the time of filing in North Carolina and 89.7 percent in South
Dakota.

White's model derives the maximum costs that would be incurred if all firms that
reorganize should have liquidated and if all lender losses are necessary to justify the
decision by equityholders to reorganize. These cost estimates will be an upper bound on
the level of these indirect costs associated with Chapter 12 bankruptcy filings. This
estimate is likely to be too high for two reasons. First, some Chapter 12 cases probably
involve only direct costs and transfers among equityholders and debtholders without other
efficiency costs to the economy. Second, in cases that do involve indirect costs, some
lender losses are probably greater than the minimum necessary to economically justify
the decision by equityholders to reorganize.

The model is better suited for comparing alternative bankruptcy provisions. To establish
bounds on the marginal indirect bankruptcy costs associated with Chapter 12, I estimated
the differences in costs between Chapter 11 reorganization and Chapter 12
reorganization. Again, two factors, provisions affecting opportunity costs and writedowns
lenders must suffer, affect indirect bankruptcy costs in Chapter 12 compared with
Chapter 11.

The relative magnitude of lost opportunity costs under Chapter 12 compared with
Chapter 1 1 is indeterminant. Lenders receive more protection for claims secured by real
estate under Chapter 11 than under Chapter 12, but lose opportunity costs on their
secured claims for a longer period under Chapter 11 than under Chapter 12. For the
specific data available, these differences decrease my estimate of indirect bankruptcy
costs under Chapter 12 compared with Chapter 11 by up to 2.1 percent of asset value at
time of filing. The decrease occurs because of the longer pre-confirmation period during
which opportunity costs accrue. If land values are falling rapidly, lost opportunity costs
could be higher under Chapter 12 because the adequate protection rule protects Chapter
1 1 creditors from erosion of their interest in property after filing of the bankruptcy



12



39



petition, while Chapter 12 specifically states that payment of fair market rent is sufficient
to provide adequate protection if real estate values are declining.

Writedowns under Chapter 12 can be expected to be greater than under Chapter 11
because of the changes in the provisions for the unsecured portion of secured creditors*
claims. Under section 1129(b) of Chapter 11, unsecured claims, including the
undersecured portion of a secured creditor's claim, are entitled to absolute priority. If
the Chapter 1 1 plan is to be confirmed under the "cram down" provisions with respect to
a class of unsecured claims, including the undersecured portion of a secured creditor's
claim, then such creditors must be paid in full or no junior class, including the debtor,
may receive any payment or retain any property under the terms of the plan. This
provision provides some bargaining power for all unsecured creditors.

Under Chapter 12, creditors are not provided the opportunity to vote and the absolute
priority rule is not in effect. The Chapter 12 debtor is required at a minimum to pay
unsecured claims an amount not less than each unsecured creditor would receive if the
case were liquidated under Chapter 7. The same rule also applies in Chapter 11.
However, in Chapter 11, if unsecured creditors were to reject such minimal liquidation
pajTTient, then as indicated above, the plan could not be confirmed unless the creditors
are paid in full or no junior class receives or retains any payment or property under the
plan. In distinction, Chapter 12 provides that if an unsecured creditor objects to the
plan, the plan may be confirmed as long as the debtor simply promises to pay "projected
disposable income" over a 3- to 5-year period for the payment of such claims. As a
practical matter, in most Chapter 12 cases little or no payment is made to unsecured
creditors including any unsecured portion of a secured creditor's claim. For example, in
North Carolina, unsecured creditors including the unsecured portion of secured creditors'
claims received an average of 5.8 cents on the dollar for cases filed between November
1986 and November 1988 (Collender and Feitshans). For South Dakota Chapter 12
cases, the corresponding number is 1.5 cents on the dollar (Janssen, Peterson, and
Pflueger).

The best basis for comparing Chapters 11 and 12 (table 3) is with data from farm
bankruptcy filings in South Dakota. A second basis is White's estimates of Chapter 11
costs for businesses in New York during 1980. The South Dakota data lack information
on direct bankruptcy costs. However, the effect of Chapter 12 on direct bankruptcy costs
is probably minor, especially in relation to its effect on indirect costs. In contrast,
estimates of indirect bankruptcy costs under Chapter 1 1 range from 52.2 percent for
farmers filing in South Dakota in 1985 to 59.4 percent for White's group of New York
businesses in 1980. Both estimates are considerably less than the estimates of 89.7 to
98.4 percent of assets for Chapter 12.

However, the comparison can be improved by adjusting the South Dakota data for farm
real estate value changes between 1985, the year the Chapter 11 data cover, and 1987,
the year most of the Chapter 12 data cover. During this period, farm real estate values
decreased 9.6 percent. If farm values had remained constant, writedowns under Chapter
12 cases might have been as much as $23,400 less. Simultaneously, the value of assets
would have been $23,400 greater. The combined impact of these adjustments would be
to lower my estimate of total indirect bankruptcy costs under Chapter 12 to 73.3 percent

13



40



of assets at time of filing. This estimate indicates that indirect bankruptcy costs under
Chapter 12 are about one-fourth (23 percent) greater than under Chapter 11.

The last column of table 3 shows the approximate incremental effect of Chapter 12 on
bankruptcy costs. The effect is minimal for direct costs but in the neighborhood of 11.8
to 32.7 percent of asset value for indirect costs. Of this total, writedowns account for
13.9 to 32.7 percentage points, and changes in adequate protection rules account for -2.1
to percentage points. It should be recognized that the difference in writedowns and
lost opportunity costs between Chapters 12 and 11 is a rough estimate since the data are
not from the same time period. In South Dakota, average per acre farmland values fell
20 percent from April 1, 1985, through February 1, 1987 (U.S. Department of
Agriculture, Economic Research Service, 1992). The effect of further declines in asset
values on Chapter 11 reorganization plans is impossible to gauge without data. However,
reorganizing under Chapter 1 1 would probably be increasingly difficult as losses increase.

Chapter 11 also gives creditors the ability to capture or recover any future appreciation
in the secured assets by making the 1111(b) election. The ability to capture or recover
future appreciation would have benefited secured creditors in Chapter 12 cases filed in
South Dakota in 1987, but not those in North Carolina. South Dakota farm real estate
values rose an average of 33.9 percent between the 1987 calendar year and the 1990
calendar year (table 5). North Carolina farm real estate values, however, were down 0.6
percent during the same period. While the effect of such a provision would be to reduce
indirect bankruptcy costs, the magnitude of the effect is uncertain and depends on the
volatility of asset values.

Finally, this report addresses only a subset of indirect cost issues. For example, the
report does not address changes in operating revenues caused by declaring or threatening
to declare bankruptcy. These changes in costs not explicitly modeled are thought to be
small relative to changes in costs that are modeled explicitly. The magnitude of costs per
farm in such a case would be no greater than if bankruptcy actually occurred. However,
the aggregate economic costs could be much greater if many farmers benefited from
threatening to use Chapter 12 without actually declaring bankruptcy. No information
concerning reorganizations without bankruptcy is available.



Table 5 - Aver«g« per ecre nominal value of farm real eitatc In North Carolina and South Dakota. 1987 and
1990



1987




1980


Percent change
1987 to 1990




-—Dollar. — -




Percent


l,26ll




1.2532


-0.6


251.




3*0


33 9



North Carolina
South Dakota

^Computed as the avaraga of farm real estata valuaa r»:x)rtad as of February 1, 1987. and February 1. 198
^Computed as tha avaraga of farm real estata values reported ai of January 1. 1990. and January 1. 1991.
Sourca: Computed frofn USDA. 1992.



14



41



Expected Bankruptcy Costs

Expected bankruptcy costs are important because rational borrowers will consider them


1 2 4

Online LibraryUnited States. Congress. House. Committee on the JExtension of family farmer bankruptcy provisions : hearing before the Subcommittee on Economic and Commercial Law of the Committee on the Judiciary, House of Representatives, One Hundred Third Congress, first session on H.R. 416 ... March 10, 1993 → online text (page 4 of 5)