Transactions Costs and Capital Structure Choice: Evidence from Financially Distressed Firms

Abstract

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...

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