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This study provides evidence that transactions costs discourage debt reductions by financially distressed firms when they restructure their debt out of court. As a result, these firms remain highly leveraged and one-in-three subsequently experience financial distress. Transactions costs are significantly smaller, hence leverage falls by more and there is less recurrence of financial distress, when firms recontract in Chapter 11. Chapter 11 therefore gives financially distressed firms more flexibility to choose optimal capital structures. * Harvard Business School. I am especially grateful to Harry DeAngelo, Linda DeAngelo, Richard Ruback, Ren6 Stulz, and two anonymous referees for making many constructive suggestions that greatly improved the article. I thank Edie Hotchkiss for generously allowing me to use her data on liquidation costs. Finally, I thank the following for their helpful discussions and comments:The Journal of Finance capital structures cite transactions costs as the reason why firms do not instantaneously adjust their leverage ratios in response to changes in their target ratios. However, research is mixed on whether transactions costs are large enough to plausibly explain leverage choices by most firms (Myers (1984), Shyam-Sunder and Myers (1995)).Transactions costs are potentially very important to financially distressed firms. The debt adjustments contemplated by these firms are quite large, and financial distress may have pushed them far away from their optimal capital structures. To get their debt levels down, financially distressed firms must either persuade creditors to write down their claims, or retire the debt by selling assets and/or new securities. However, for a number of reasons these options may be quite costly: firms cannot unilaterally force a financial settlement on all creditors, giving individual creditors an incentive to hold out; various regulations discourage institutional lenders from writing down their principal or exchanging debt for equity; income from debt forgiveness is taxed; managers have much better information than outsiders about the firm's business prospects; and financially distressed firms may be forced to sell assets at fire-sale prices (or be unable to find buyers at any price, e.g., because their whole industry is distressed). Roe (1983) and Bebchuk (1988) argue that barriers to reducing debt in a reorganization are so strong that Chapter 11 should be replaced with an alternative system that either requires or encourages firms to adopt equity-heavy capital structures.My empirical analysis consists of three parts. First, I show that leverage remains high after both out of court restructuring and Chapter 11 reorganization, although it remains much higher after out of court restructuring. The median ratio of long-term debt (face value) to the sum of long-term debt and common shareholders' equity (market value) is 0.64 for firms that restructure their debt out of court, and 0.47 for firms that reorganize in Chapter 11. In general, sample firms end up more highly...

This paper studies senior management compensation policy in 77 publicly traded firms that filed for bankruptcy or privately restructured their debt during 1981 to 1987. Almost one‐third of all CEOs are replaced, and those who keep their jobs often experience large salary and bonus reductions. Newly appointed CEOs with ties to previous management are typically paid 35% less than the CEOs they replace. In contrast, outside replacement CEOs are typically paid 36% more than their predecessors, and are often compensated with stock options. On average, CEO wealth is significantly related to shareholder wealth after firms renegotiate their debt contracts. However, managers' compensation is sometimes explicitly tied to the value of creditors' claims.

This paper examines whether firms emerging from conglomerate stock breakups are able to affect the types of financial analysts that cover their firms as well as the quality of information generated about their performance. Our sample comprises 103 focus‐increasing spin‐offs, equity carve‐outs, and targeted stock offerings between 1990 and 1995. We find that, after these transactions, sample firms experience a significant increase in coverage by analysts that specialize in subsidiary firms’ industries, and a 30–50% increase in analyst forecast accuracy for parent and subsidiary firms. The improvement in forecast accuracy is partially attributable to expanded disclosure. However, forecast improvements for specialists exceed those for non‐specialists, leading us to conclude that corporate focus can facilitate improved capital market intermediation by financial analysts with industry expertise.