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«Abstract An impaired debt claim is similar to an equity ownership position or a 'creditor toehold' in the distressed rm. When the rm goes bankrupt ...»

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Toeholds and re-sales in bankruptcy auctions

B. Espen Eckbo and Karin S. Thorburn

Amos Tuck School of Business Administration

Dartmouth College

Hanover, NH 03755


First draft, July 19, 2000


An impaired debt claim is similar to an equity ownership position or a 'creditor toehold' in the

distressed rm. When the rm goes bankrupt and is sold in an open, ascending auction with

two bidders, the toehold induces the creditor to nance the lowest-valuation bidder and to push for overbidding. Examining mandatory bankruptcy auctions in Sweden, we nd strong toehold e ects: The greater the toehold the lower the probability that the old bank nances the winning bidder, and the higher the winning going-concern premium, both as predicted. Controlling for toehold e ects, there is no evidence that the going-concern premium is lower in business cycle downturns, in relatively distressed industries, or when sold to industry outsiders. Thus, there is no support for asset re-sale arguments, possibly because bidding with creditor toehold helps counteract re-sale tendencies in relatively illiquid auctions.

This paper has been prepared for presentation at the 2000 CEPR Summer Symposium in Financial Markets at Gerzensee, Switzerland. We have bene ted from the comments of Sandra Betton and Robert Hansen. Partial support from Tuck's Center for Corporate Governance, the Norwegian National Research Council (grant no.

125105/510) and the Swedish National Council for Crime Prevention is also gratefully acknowledged. Email addresses: b.espen.eckbo@dartmouth.edu and karin.thorburn@dartmouth.edu.

1 Introduction In Sweden, insolvent rms that fail to restructure their debt claims out-of-court are automatically sold in a court-supervised, cash-only bankruptcy auction. The auction results in either a piecemeal liquidation or the sale of the company's business as a going concern. The e ciency of such a mandatory auction system, relative to one including a renegotiation option such as Chapter 11 in the U.S. bankruptcy law, is an important but unresolved issue. On the one hand, it is possible that liquidity problems and lack of competition promote asset re-sales (e.g., Aghion, Hart, and Moore (1992) and Shleifer and Vishny (1992)). On the other hand, there may be a substantial risk that court-supervised debt renegotiations promote its own ine ciencies by biasing resource allocations towards poor management (e.g., Jensen (1991), Bradley and Rosenzweig (1992)). We address this controversy by examining the incentive of the main creditor of the bankrupt rm to nance a bidder in the bankruptcy auction in order to maximize debt recovery, and whether this incentive empirically counteracts the tendency for asset re-sales in potentially illiquid auctions.

While empirical evidence on auction bankruptcy is sparse, recent work based on Swedish data suggests that auctions are surprisingly e ective. Thorburn (2000) shows that auctions result in relatively low direct costs and produces debt recovery rates and going-concern survival rates that are no lower than what has been reported for Chapter 11 cases.1 Also, Thorburn (1999) nds that, although auction bankruptcy signi cantly lowers CEO compensation and increases turnover, there is no evidence that managers delay bankruptcy lings (which would have resulted in destruction of going-concern value). Stromberg (2000) reports estimates of liquidation values that are somewhat lower when the bankrupt assets are sold to industry outsiders, as predicted by asset re-sale arguments. However, he also reports that sale-backs of bankrupt rms to their old owners increase in periods of industry distress, and conjectures that sale-backs thus help avoid asset re-sales.2 The theoretical analysis in Stromberg (2000) captures the notion that a creditor's impaired debt claim is analogous to an equity position{or, in our vernacular, a "creditor toehold"{in the auctioned rm. The toehold impacts the creditor's nancing decision. Speci cally, in his model, the bankrupt rm is either "liquidated" in an auction or "sold back" to its previous owners at a 1 Ravid and Sundgren (1998) present evidence on direct costs and recovery rates of bankruptcy auctions in Finland.

2 Pulvino (1998) examines the asset re-sale hypothesis using a sample of individual airplane sales in the U.S., comparing sales in and outside periods of nancial distress. He nds that sales prices are somewhat lower than his model-price benchmark in periods of distress and higher in periods of non-distress.

price equaling the expected auction liquidation price. The less impaired the creditor's debt claim, the more she prefers the risk-free sale-back option.3 For certain parameter values, this sale-back "bias" causes the rm's assets to be deployed back to relatively low-value (ine cient) old owners. In his empirical analysis, Stromberg nds that the probability of a sale-back increases in a measure of the sale-back bias, as predicted, and he concludes that the salebacks favor the bank at the expense of other, junior creditors.

However, the creditor incentives that lead to the sale-back bias in Stromberg's analysis play a di erent role when we assume that all going-concern sales{including sale-backs{take place in open, ascending auctions. Eliminating the risk-free sale-back option implies that the creditor will now use her toehold strategically in the auction. Analogous to the role of equity toeholds in recent models of takeover bidding, creditor toeholds lead to aggressive bidding within our bankruptcy auction structure.4 However, the analogy is not complete. For example, with two bidders entering the auction, the toehold provides an incentive for the creditor to nance the lowest-valuation bidder and then push for overbidding. Such a strategy improves on the so-called "ratchet solution" (Hirshleifer (1995)) in the case of zero toeholds where the winning bidder ends up paying the second bidder's valuation.5 Thus, eliminating Stromberg's risk-free sale-back option not only eliminates the creditor's sale-back bias but pushes banks with impaired debt claims to get involved in the auction and help maximize the winning bid. To our knowledge, this possibility has been largely overlooked in the literature that warns of illiquidity and asset re-sales in bankruptcy auctions.

Our contention that Swedish going concern sales in general, and sale-backs in particular, are best characterized as taking place in open, ascending auctions is supported by our data: at the time of writing we have con rmed the presence of multiple bids for 60% of the going concern sales in the original Stromberg and Thorburn (1996) data base. Moreover, for the subcategory of salebacks, the percentage with rival bids is a non-trivial 47%. Across all cases, the number of bids averages 3.6 (median 2.0). Our empirical analysis is the rst to examine whether the winning bid 3 Intuitively, for a given expected liquidation price, if the expected debt recovery is high, the risk-free sale-back option dominates due to the potential downside for the creditor of selling in the auction.

4 See, e.g., Burkart (1995), Singh (1998) and Bulow, Huang, and Klemperer (1999) for models of takeover bidding with toeholds, and Betton and Eckbo (2000) for comprehensive empirical evidence on the e ect of toeholds on takeover bids. Hotchkiss and Mooradian (1999) analyze a related creditor toehold e ect in the context of Chapter 11 for the case where a creditor/management coalition requests an auction of the bankrupt rm.

5 The conditions under which the equityholders of the bidder rm agree to the overbidding strategy is discussed below.

premium in these contests are impacted by creditor toeholds. Interestingly, since creditor toeholds are exogenously determined and observable at the outset of the auction, this analysis can be carried out using simple regression techniques mapping the toehold size onto the winning bid premium, as suggested by theories of overbidding.6 We measure the winning bid premium as ln(p=vl ), where p is the winning bid value and vl is given by the trustee's initial estimate of the value of the auctioned assets if liquidated piecemeally.7 The role of the going-concern auction is to establish the price above and beyond the piecemeal liquidation value of the rm. We think of vl as capturing the common value component, while bidders use their individual private going-concern valuations to compete in the auction. To avoid econometric issues of endogeneity, we measure, for most purposes, creditor toeholds using only the common value component vl that is observable at the beginning of the auction.

Our new data also allows us to classify the bankrupt rm's old bank nancing decision. Interestingly, our multinomial probability estimation shows that the greater the expected toehold, the greater the piecemeal liquidation probability and the lower the probability that the old bank nances the winning bid. At rst, this appears to support the key nding of Stromberg (2000) that the probability of a sale-back increases in the sale-back bias (i.e., when the risk-free sale-back option tends to pay o a large portion of the outstanding senior and bank debt). However, our result does not support the Stromberg sale-back bias interpretation because the creditor toehold pushes the bank to nance the winning bid also when the buyer is a new owner (i.e., when it is not a sale-back) as well as when there are competing bids in the auction (i.e., when the sale-back option is not risk-free).

Thus, our nding changes the interpretation of Stromberg's own empirical result and o ers an alternative and broader explanation for the observed impact of the creditor toehold: The greater the old bank's toehold, the greater the bank's incentive to nance relatively low-valuation bidders and push for overbidding. The low valuation lowers the probability that the winning bid is actually 6 The key theoretical results in, e.g., Burkart (1995) and Singh (1998) requires the initial toehold to be determined exogenously. Unlike equity toeholds, which are actively traded in the market both prior to and during a takeover contest (see, e.g. Betton and Eckbo (2000)), the illiquidity of Swedish debt markets (and absence of "vulture" funds) almost certainly ensures that the creditor toehold size at the time of the bankruptcy ling does not re ect strategic debt purchases or sales anticipating the auction.

7 At the beginning of the auction, the trustee{with the assistance of an industry consultant{lists the assets of the bankrupt rm and price out their values individually. As shown below, the nal price paid in piecemeal liquidation auctions averages only 8% (median 2%) above the trustee's initial estimate, suggesting that vl is a good estimate of ^ the nal liquidation value.

nanced by the old bank. Since overbidding should result in higher winning going-concern premiums, this explanation further requires that the going-concern premium is increasing in the bank's toehold at the beginning of the auction. This is precisely what our premium regressions show: The winning going-concern premium is strongly increasing in the bank's creditor toehold size. We also nd that bank nancing of the winning bid has a positive impact on the winning bid premium beyond the toehold e ect. These results reject the notion that bank involvement in the auction is detrimental to the interest of other junior creditors.

Finally, controlling for toehold e ects, we address the re-sale hypothesis of Shleifer and Vishny (1992). This hypothesis maintains that rms tend to le for bankruptcy at a time when there is widespread illiquidity in the rm's industry. As a result, the rm risks being sold to industry outsiders that may be less e cient in managing the rm's assets and thus may place relatively low bids in the auction. Thus, we examine whether the going-concern premium depends on buyer identity, industry liquidity and aggregate demand conditions represented by the business cycle.

As argued by Maksimovic and Phillips (1998), while bankruptcies may be caused by ine cient management, they may also be a result of low product demand (which a ect e cient rms as well). Thus, the probability of ine cient bankruptcy outcomes (such as asset re-sales) should be greater in periods of depression. Our sample period includes two distinct business cycle regimes in Sweden{a boom followed by a major recession. Overall, we nd little support for the re-sale argument. Since our model suggests that banks have a greater incentive to "make the market" for the auctioned rm the more severely distressed their debt claim, a consistent explanation for this evidence is that bidding with creditor toehold e ectively counteracts a tendency for asset- re sales.

The rest of the paper is organized as follows. Section 2 discusses theoretical bidding arguments using either equity or creditor toeholds. Section 3 provides a description of the Swedish auction bankruptcy system and of our extensions to the original Stromberg-Thorburn data set. Section 4 presents test of empirical hypotheses related to the bank's bidding and re nancing behavior, as well as the asset re-sale hypothesis. Section 5 concludes the paper.

2 Toeholds and overbidding: Theory In this section, we examine the bank's incentive to re nance a buyer in the bankruptcy auction and the optimal bidding strategy for such a buyer. We start by recapturing the main intuition behind the overbidding result developed by Burkart (1995) and Singh (1998). While their results concern bidding with equity toeholds, they are developed in the context of open, ascending auctions which resemble actual bankruptcy auctions. Similar to the discussion in Hotchkiss and Mooradian (1999), we then extend the overbidding results to the case of bidding with creditor toehold. Since the bankrupt rm is auctioned by a trustee, the free-rider problems identi ed by Grossman and Hart (1980) is non-existent. Thus, the auction is for the entire rm and it will be sold to the highest bidder. Moreover, since we are ultimately focusing on creditor toeholds, we assume there is at most one bidder with such a toehold.

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