Heterogeneous Beliefs and the Choice Between Private Restructuring and Formal Bankruptcy

We present a novel theory to explain the puzzling issue regarding why certain firms in financial distress, that must renegotiate their debt prefer a formal bankruptcy procedure, which is more costly, over direct negotiations with their debtholders. Specifically, we show that claimholders’ heterogeneous beliefs about the possible results of a formal plan – and about judicial discretion in particular – may lead to such a preference. In our model, informal processes are preferred when the total value of all corporate claims in a formal procedure, according to each claimholder’s beliefs, is less than the total value of the firm’s assets in an informal process. In such a case, all claimholders believe that they will be better off under an informal process because there is a positive surplus that can be divided among the parties (Pareto Improving). The proposed model can predict which resolution would be chosen under any set of claimholders’ beliefs about the different determinants driving the outcome of a formal procedure, such as the cost of bankruptcy, the likelihood of deviation from the absolute priority rule in a reorganization plan, and the probability of the court adopting a reorganization plan. An empirical analysis of 252 defaults in Moody’s annual reports during the 1996-2011 period supports the argument that heterogeneous beliefs ad creditor coordination problems are important drivers of the decision to restructure under formal bankruptcy procedures rather than through private workouts.