Resolving Financial Distress--Workouts Versus Bankruptcy

Abstract

We study the rationale behind the firm's choice between a workout and bankruptcy filing in financial distress. We emphasize the information and control rights issues in the choice. That is, only the manager knows whether the firm is economically viable but signaling this information is impossible since, with the desire to keep his control position, the manager always claims the firm is a good one no matter what the true situation is. Unable to separate the good firm from the bad, a private workout incurs information cost. On the other hand, the role of Chapter 11 bankruptcy is to resolve the information problem at certain cost. The firm's choice between workout and Chapter 11 takes these factors into account. Our model explains a sequence of empirically verified patterns of firms' choices. Also, our predictions clarify certain misconceptions about the firm's rationale. For example, we show that the relative bargaining power of the manager in workout and Chapter 11 does not affect the firm's choice.

JEL Classification: G33