More Phoenix Than Vulture: The Case For Distressed Investor Presence in the Bankruptcy Reorginization Process

Abstract

Firms in Chapter 11 bankruptcy are presumed to have going-concern value, with operational efficiencies, even though they are usually technically insolvent. A primary objective of Chapter 11 bankruptcy proceedings, therefore, is to protect such going-concern value from the potentially inefficient and destructive behavior of competing and self-motivated creditors. Commentators have often described the challenges of Chapter 11 proceedings as the “residual actor problem.” When the firm is solvent, shareholders, as the residual owners, know that their wealth, often reflected by a publicly traded stock value, is closely tied to firm value, and hence to the success of managerial decision-making. Consequently, it is in shareholders’ interests to champion strategies for long-run profit maximization. By contrast, when the firm is insolvent and in Chapter 11, shareholders’ claims are, by definition, negligible, and creditors cannot be relied upon to maximize an insolvent firm’s value. Senior creditor classes, whose debt may be fully secured or “above water,” will presumably favor risk-averse strategies that maximize the probability of recovering the full value of their loans. Junior creditors, who face low probabilities of appreciable recovery, will prefer high-risk strategies because there is little to lose and potentially something to gain by “swinging for the fences.” The unfortunate result in many bankruptcies is discord between two groups of potential decision makers: overly risk-averse creditors holding claims that are close to or are “above water,” and overly risk-tolerant creditors with claims that are far “below water.” The dynamic is “a basic form of the prisoner’s dilemma: the aggregation of individualistic, albeit rational, decisions leading to an inferior collective result.” An appropriate goal for Chapter 11 proceedings, therefore, is the effective provision of a collective forum for the re-creation of an efficient residual claimant class by creating a new “above-water” equity actor whose self-interest is aligned with the long-run value maximization of the firm. This study examines how the increased presence of distressed-debt investors in bankruptcy proceedings has greatly affected the residual actor problem. The thesis of this paper is that distressed-debt investors generally have a salutary impact on the residual actor problem of bankruptcy by expediting business reorganizations and protecting going-concern enterprise values.