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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

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in making their leverage decisions and because rational lenders will consider them in
setting interest rates and when deciding to whom to lend. In iongrun equilibrium, given
constant returns to scale in fmancial intermediation, creditors will shift the expected costs
imposed by bankruptcy laws onto borrowers.

The effect of Chapter 12 bankruptcy provisions on interest charges to farm borrowers
can be estimated by multiplying the incremental costs of Chapter 12 bankruptcy over
Chapter 11 bankruptcy times the average annualized likelihood of a bankruptcy and then
dividing by the average debt/asset ratio of farm borrowers. Of course, the likelihood that
a farm will go bankrupt depends on many factors, including:

(1) Its financial structure, that is, how heavily it depends on debt financing,

(2) Interest rates and their variability, and

(3) Profits for the particular commodities the farm produces and their variability.

Explicitly modeling the probability of bankruptcy is beyond the scope of this report.
Therefore, some extreme cases are considered to infer the range of the potential effect
on interest rates faced by farm borrowers.

During 1987-89, a period of extraordinary bankruptcy activity, 9,522 farms filed for
bankruptcy under Chapter 12. This number represents about 1 percent of commercial
farms (gross sales over $100,000) per year or 0.25 percent of all farms that might qualify
for Chapter 12 (calculated as those farms with gross sales over $1,000 and reporting
fewer than 200 days per year of off-farm employment) per year. Thus, each farm has
between 1 chance in 100 and 1 chance in 400 of going bankrupt in a given year. This
condition, coupled with the estimate of the bankruptcy costs associated with Chapter 12,
yields an aimual expected cost on the order of between 0.25 and 1.0 percent per year of
total asset value. The incremental expected bankruptcy costs associated with Chapter 12
would be between 0.083 and 0.33 percent per year. If these costs were spread over cill
farm borrowers (who have an average debt/asset ratio of 32 percent), then interest rates
to farmers would have to be between 0.25 and 1.0 percent higher, in equilibrium, than
they would have been in the absence of Chapter 12.

However, the expected costs of bankruptcy will not be evenly distributed among farm
borrowers. Lenders charge higher interest rate premiums to borrowers who are in
weaker financial positions or refuse credit to borrowers who do not meet minimum
financial standards. In addition, the variables that determine the likelihood of bankruptcy
tend to be highly correlated. For example, a farm with a high debt to asset ratio is also
likely to be facing higher interest rates, both of which increase the probability of
bankruptcy. Therefore, the impact of the increased bankruptcy costs imposed by
Chapter 12 can be expected to fall disproportionately on financially weak or beginning
farmers who may have to pay additional bankruptcy risk premiums several times those
calculated above or be forced to forgo conventional financing.



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Conclusions

Bankruptcy costs are important for two reasons. They represent a deadweight loss to
society, and they are important in business decisions, including the borrower's choice of
leverage position and the lender's choice of interest rate. The results of this study
indicate that Chapter 12 may have substantially increased bankruptcy costs related to
farm businesses. Although direct bankruptcy costs are found to be on the order of 3
percent, considerably less than the 20 to 30 percent of estate value found in early studies
of small business and personal bankruptcy, the estimate of the upper bound of indirect
costs is surprisingly large at between 89.7 and 98.4 percent of farm asset value at the
time of bankruptcy filing. A conservative estimate of the incremental impact of Chapter
12 over Chapter 1 1 is that it raises indirect bankruptcy costs by about one-fourth.

To offset the costs Chapter 12 imposes on creditors, interest rates to farm borrowers will
have to be between 0.25 and 1.0 percent higher on average. Much higher costs will be
borne by financially weaker farm bortowers, either in the form of increased interest or
other charges or in their inability to obtain loans at any price.

From an economic perspective, bankruptcy should facilitate reorganizations that increase
the combined value of debt plus equity and discourage reorganizations otherwise.
Efficiency costs arise when uneconomic reorganizations are pursued. However, a fairness
issue must also be addressed. Bigger farms and businesses can reap considerable
rewards under Chapter 1 1, but the process is costly because of negotiating requirements
implicit in the absolute priority rule. Wage earners are protected under Chapter 13, but
farmers are not because of restrictive debt limits. The bankruptcy code should ideally
provide equal access while minimizing efficiency costs. Chapter 12 improved fairness at
the price of an apparently sizable increase in efficiency costs.

One suggestion for mitigating the negative efficiency consequences of Chapter 12 has
been to allow secured creditors to share in any appreciation of the property for the
duration of the reorganization plan similar to the 1111(b) election under Chapter 11.
The ex post evidence on such a requirement is mixed, although it would certainly lower
the incentive for equityholders to abuse the bankruptcy code.

Although Chapter 12 has been cited for its effectiveness in maintaining family farms, it is
an expensive means of helping a limited number of distressed farmers and has negative
efficiency effects on the economy. The costs of Chapter 12 will ultimately be borne by
other high-risk farm borrowers, including beginning farmers.

Finally, the following should be emphasized:

(1) Direct evidence is limited to two States (North Carolina and South Dakota)
where other researchers have gathered some basic statistics,

(2) We have no evidence on the precise distribution of costs among bankers, other
farm bortowers, and other interested parties, and

(3) We do not have evidence on exactly how interest rates or other lending
practices have changed because of Chapter 12.



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References

Altman, Edward I. "A Further Empirical Investigation of the Bankruptcy Cost Question,"
Journal of Finance. 39(September 1984): 1067-1089.

Baxter, Nivens. "Leverage, Risk of Ruin and the Cost of Capital," Journal of Finance.
22(September l%7):395-403.

Brealey, Richard, and Stewart Myers. Principles of Corporate Finance . Second Edition.
New York, NY: McGraw-Hill Book Company, 1984.

Collender, Robert N. "The Quarterly Agricultural Credit Conditions Surveys,"
Department of Economics and Business, North Carolina State University. Unpublished
manuscript. No date.

Collender, Robert N., and Theodore A. Feitshans. "Estimates of Bankruptcy Costs Under
Chapter 12." Presented at the AAEA annual meetings in Vancouver, BC, August 9-12,
1990.

Haugen, Robert, and Lemma Senbet. 'The Insignificance of Bankruptcy Costs to the
Theory of Optimal Capital Structure," Journal of Finance . 33(May 1978):383-393.

Haugen, Robert, and Lemma Senbet. "Bankruptcy and Agency Costs: Their Significance
to the Theory of Optimal Capital Structure," Journal of Financial and Quantitative
Analysis. 23(March 1988):27-38.

Janssen, Larry, Scott Peterson, and Burton Pflueger. Characteristics of Chapter 12 Farm
Reorganization Bankruptcy Filings and Approved Reorganization Plans . Economics Staff
Paper Series No. 89-2. Economics Department, South Dakota State University,
Brookings, June 1989.

Janssen, Larry, and Brian Schmiesing. Examination of Farm Bankruptcy Debtors and
Their Creditors . Economics Department Research Report 87-6. South Dakota State
University, Brookings, August 1987.

Miller, Merton. "Debt and Taxes," Journal of Finance . 32(May 1977):261-275.

Ross, Stephen A., Randolph W. Westerfield, and Jeffrey F. Jaffe. Corporate Finance .
Second Edition. Homewood, IL: Richard D. Irwin, Inc., 1990.

Stanley, D. T., and M. Girth. Bankruptcy: Problem. Process. Reform . Washington, DC:
The Brookings Institution, 1971.

U.S. Congress. House. Conference Report of H.R. 5316, Bankruptcy Judges, United
States Trustees, and Family Farmer Bankruptcy Act of 1986. 99th Congress, 2nd session,
2 October 1986. Congressional Record , vol. 132, p. 28144.



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U.S. Department of Agriculture, Economic Research Service. A gricultural Income and
Finance: Situation and Outlook . AFO-40. February 1991.

U.S. Department of Agriculture, Economic Research Service. A gricultural Resources:
Situation and Outlook . AR-26. June 1992.

Warner, Jerome B. "Bankruptcy Costs: Some Evidence," Journal of Finance. 32(May
1977):337-347.

White, Michelle J. "Bankruptcy Costs and the New Bankruptcy Code," Journal of
Finance. 38(May 1983):477-488.



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Appendix-White's ModeP

White assumes a two-period model, both the interest rate and the discount rate are zero,
and that secured loans are riskless because they are tied to assets having market value
equal to the amount of the loan. We relax the latter assumption since the provisions of
Chapter 12 allow a writedown in secured claims. She then defines the following
variables:

L = nonstochastic liquidation value;

T, = transaction costs of liquidation;

C = present value of future earnings (free cash flows) of the firm if it

continues business without reorganization;
R = present value of future earnings (free cash flows) of the firm if under

reorganization [assume C=R since no information is available

concerning the effect of bankruptcy filing on future earnings];
Tr = transaction costs of reorganization;

U, = principal amounts due on the firm's unsecured loans at t=l,2;

S = principal amounts due on the firm's secured loans at t=2;

P, = the firm's nonstochastic earnings in t=l; and

Pj + g = the firm's earnings in t=2, where g is a random variable distributed

normally with mean and variance a\g).

Thus, earnings from continuation are C = P.+Pz+g with expectation E(C) = Pj+Pz.

Farmowners are assumed to choose the state that maximizes the expected value of their
equity. The value of equity if liquidation occurs in t=l is

max[L-T,-S-U,-Uj, 0] (1)

because of the ability to seek bankruptcy protection.

Consider the value of equity under reorganization. The firm's unsecured liabilities are
written down to r, percent and secured liabilities to r, percent of their previous level.
This may occur under Chapter 12 if the market value of collateral is less than the
principal amount since the absolute priority rule is not imposed under Chapter 12.
Finally, transaction costs, T„ are incurred at t = 1. Since earnings are assumed to be the
same as under continuation, the firm's outflows in t=l are T, + r„U,. It can reorganize
in t=l if earnings, P„ exceed this amount or if it can obtain a new loan. To secure a
new loan collateral must exceed need or r„U, + T, - P, < L - T, - r.S. The value of
equity under reorganization is



pP, + g - r„U, - r.S - S"] f(g) dg (2)

where S** = r„U, + T, - P„ the amount borrowed in t=l. Equity is assumed to receive
nothing in t=l. In t=2 it receives any positive- earnings net of debt payments as cut back



^e discussion below closely follows While, p. ASOff.

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under the reorganization plan, or nothing. The minimum level of earnings necessary to
avoid liquidation in t=2 is Pj + g = r„Uj + r.S + S**. Let b' be the implicit cutoff level
of g.

Ex ante bankruptcy costs are generated if the firm chooses reorganization when
liquidation is the economically efficient choice. From an economic efficiency viewpoint,
the best use of the firm's assets is that alternative having the highest value among the
choices L - T„ C, or R - T,. Thus, liquidation is preferred to reorganization if L - T, > R
- T„ but the farm owner will choose to reorganize if (2) > (1). These two conditions
imply

(L - T,) - (R - T,) < F(b')[P, + u,. - r.S - S" - r^U^] (3)

+ (1 - rJ(U, + U,) + (1 - r.)S

where Fib') = f fig) dg, the cumulative probability of bankruptcy in t=2.' The

left-hand term is the loss to society from farms staying in business when they should be
liquidated. The first term on the right-hand side is the expected value of the shortfall in
payments to debt after the cutback specified in the reorganization plan. The second and
third terms are the amount of debt forgiven under the reorganization plan. Thus, as
noted by White, the expected loss incurred by debtholders because of reorganization of
an inefficient business represents the upper bound on these deadweight costs.

This result was derived under the simplifying assumption of a zero interest rate. With a
nonzero interest rate, discounted present values would be substituted for dollar amounts
in (3) and its interpretation changes accordingly:

[PV(L)-PV(T,)] - [PV(R)-PV(T,)] < (4)

PV(expected shortfall in plan payments)
-t- PV(debt forgiveness and lost opportunity costs)

where PV indicates present value.



'To get this result note ( i -Fib') ) = j fig) dg. Also u^. < is the expected value of g given

b'

bankruptcy and u, the expected value of g given no bankruptcy. Since the overall mean of g is zero, the
conditional means are related by the expression u,(l-F(b')| = Us|F(b')l.

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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 5 of 5)