Recovery rate, debt structure and valuation within U.S. bankruptcy law

The U.S. Bankruptcy Code is a frequently used channel to resolve corporate financial distress. In the code, liquidation (Chapter 7) and reorganization (Chapter 11) are two most crucial processes. My PhD thesis discusses several important issues around the U.S. Bankruptcy Code, including recovery rate determination in bankruptcy, debt valuation in bankruptcy under a two-class debt structure and determination of an optimal bankruptcy threshold. With the aim of linking corporate finance and asset pricing, new models of credit risk are developed in this thesis and fruitful empirical implications are generated. Specifically, the first main chapter is “Default and Recovery Rate under Chapter 11 with Multiple Debts”. This studies both theoretically and empirically the influence of debt structure on the outcome of debt renegotiation under Chapter 11. I investigate the trilateral negotiation in court-supervised formal bankruptcy. The model demonstrates how loans and bonds differ in terms of concentration level of debt owner and how this disparity impacts the action of the debtor company both before and after bankruptcy. The model developed in this chapter predicts that creditors’ ultimate recovery is higher for firms with more bank debt and less bargaining frictions and, despite the bank’s involvement improving total recovery, bondholders are still disadvantaged by the presence of senior bank creditors. Using a sample of 439 U.S. firms that filed for Chapter 11 during 1987-2014, I present evidence on the link between bank debt share and recovery rates that is supportive of the model’s prediction. The second main chapter is “Debt Structure and Valuation in U.S. Bankruptcy Code”. In this chapter I discuss the impact of bankruptcy procedure on security valuation by developing a credit risk model. As in the first chapter, the debt structure is in the form of two-class debt. A structural model of credit risk is built where default and liquidation are represented by two boundaries and a grace period is granted prior to liquidation. Within the setup, corporate debt is viewed as quasi Parisian corridor option and valuations are obtained via a partial differential equation formulation solved using a finite difference approach. The model can generate a credit spread for corporate debt which is more quantitatively consistent with the market credit spread. In this chapter I also show how the debt valuation is affected by several bankruptcy-related factors such as length of grace period. The last chapter, “Boundary Determination and Optimal Control Right Allocation in Financially Distressed Firms”, analyzes the determination of optimal default and liquidation boundaries in bankrupt entities. Compared with the previous chapter, this chapter reexamines the issue of debt valuation but allows the liquidation and renegotiation boundaries to be determined endogenously by valuing the maximization decision of involved parties. The model results show that different claim holders choose different default and liquidation boundaries to maximize the value of securities they hold, which leads to conflicts of interest between borrowers and lenders and also between different borrowers. The first-best outcome can be achieved if bondholders determine the liquidation boundary. Finally, the model shows that the optimal length of grace period, in the sense of firm value maximization, is roughly 6 months