Do Creditors influence Corporate Governance in Bankruptcy?
If the creditors are not paid, they usually rely on the legal system to force payment. If a firm has more liabilities than assets, it is insolvent and there is not enough for all creditors to collect what is owed. At this point, the firm enters the bankruptcy system where a court decides who is paid, how much and whether the firm survives. Most firms voluntarily declare bankruptcy occurs when creditors petition a bankruptcy court and the agrees the firm is insolvent.
Bankruptcy is a complicated process, but the goal is to fairly settle the claims of all of the creditors depending on the priority of their loans and the security interests they hold. There are two general types: Chapter 7 and Chapter 11. In Chapter7, the firm is liquidated which means all assets are sold and the proceeds divided among the creditors. More common, however, is Chapter 11, where the firm is allowed to restructure its liabilities and perhaps emerge from bankruptcy as a viable firm. Chapter 11 is more common because there are many stakeholders, such as employees, who prefer that firms stay in business. Accordingly, there is pressure on lawmakers to set up bankruptcy rules to give companies a chance to restructure their liabilities and start fresh.
The usual result when a company successfully emerges from Chapter11 bankruptcy is that stockholders of the old firm completely lose their investment and control. Some former creditors emerge as the new stockholders. This occurs because there is not enough value in the company to pay creditors, so as part of the negotiations in bankruptcy court, creditors who are not paid in full agree to take equity in the reorganized firm. As the former
stockholders receive value only after the creditors are paid, there is nothing left for them and their stock becomes worthless. Hence, when a company emerges from bankruptcy and starts trading in the stock market, the shares being traded are not the same shares as the pre-bankruptcy shares. Instead, they are new shares that were initially issued to pre-bankruptcy creditors as part of the bankruptcy settlement.
A key feature of the bankruptcy process is that all decisions are presided over by a bankruptcy judge who has a lot of discretion. Creditors often ask the judge to take actions such as replacing management of the firm, but this will only happen if the judge agrees with the reasoning. Accordingly, although creditors have a strong position in bankruptcy because they are owed money and have the right to approve any settlement, they do not have the power to unilaterally dictate terms to the judge. Instead, the whims of the judge and the vagaries of a complicated set of bankruptcy laws may restrict the ability of creditors to make changes governance. For example, the bankruptcy rules include an “exclusivity” rule that allows the bankrupt company the sole right to propose a restructuring for the first 18 months of the bankruptcy. This rule prevents creditors from presenting competing proposals that may make more economic sense. Why allow management how the company could restructure? Large investors have suggested this rule limits the power of creditors to quickly make changes and shorten the bankruptcy process.