No-Fault Default, Chapter 11 Bankruptcy, and Financial Institutions

The existing Chapter 11 bankruptcy process is time-consuming and financially costly for firms, which causes many firms that file for bankruptcy to eventually liquidate due to the value dissipation during bankruptcy (see, e.g., Morrison (2007) and Hotchkiss et al. (2008)). This leads to significant social and private costs, and reduces the documented tax-shield and agency-cost-reduction benefits of corporate leverage. In No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions, we propose and theoretically analyze the idea of a “no-fault-default” structure for corporate debt, which facilitates harvesting the benefits of leverage without the associated deadweight costs of bankruptcy.

The main idea of no-fault-default debt is to enable the firm to transform its debt claims into equity claims upon default on the debt, thus allowing a reallocation of control rights to bondholders with minimal disruption of the business operations of the firm. Put differently, when a bondholder demands payment at maturity, the company can choose to make the payment or surrender equity in the company. If the company does not have enough funds to make the promised payment to the bondholders, the bond converts automatically into equity—a transaction not requiring bankruptcy—and the firm also issues new debt with a longer maturity in exchange for the old debt. If the current shareholders wish to maintain corporate control, then they would need only to put up additional cash needed to buy the new equity. As with normal debt, other features like covenant restrictions—such as provisions which trigger early payment to the bondholders—can be included. We also show that no-fault-default debt remains feasible, with some modifications (such as adding a conversion option) even in the presence of well-known frictions like risk-shifting moral hazard.

We then examine the conditions under which the Chapter 11 process may still serve a useful role, even when no-fault-default debt is utilized. We show that there may be situations where labor contracts with managers would be efficient (in terms of increasing firm value) to renegotiate, but the managers do not want to renegotiate because they earn rents from continuing the contracts. We provide an analysis in which we conclude that the ability to invalidate previously-negotiated labor contracts in bankruptcy provides a valuable role for the Chapter 11 process. A takeaway of this analysis is that it shows that, although there can be useful features of the Chapter 11 process, the deadweight costs of bankruptcy in Chapter 11 are unnecessary.

Finally, we discuss how our proposal of no-fault-default debt has important implications for financial institutions and financial stability broadly. A well-known feature of financial institutions is that they are protected by both explicit safety nets (like deposit insurance) as well as implicit safety nets (i.e. bailouts) if they are institutions whose failure is deemed to be harmful to financial stability. As for deposit-insured banks, in our no-fault-default proposal, if operating control transfers from the shareholders of the bank to the bondholder (subordinated debtholders) but the value of a bank exceeds its deposit obligations, then the new owners (bondholders) can cover the depositors’ claims without involving the FDIC. However, once the bondholders own the bank, all the non-deposit debt becomes equity. Moreover, regardless of who has operating control, the FDIC must cover the claims of the depositors if the value of the bank is below the total amount of deposits. Thus, our proposal works in concert with deposit insurance, as we recognize the many advantages of deposit insurance noted in the earlier literature (e.g. Bryant (1980), Diamond and Dybvig (1983), and Merton and Thakor (2019)). Turning to bailouts of institutions which do not have an de jure government protection, it is recognized that ex post efficiency considerations during crises—such as the desire to thaw frozen credit markets or avoid financial contagion—can compel governments to inject taxpayer funding to bail out failing institutions, despite the cost (e.g. Philippon and Skreta (2012), Tirole (2012), Acharya and Thakor (2016)). We discuss how our proposed no-fault-default debt may reduce the burden placed on taxpayers in resolving bank failures, in a way that has distinct advantages compared to existing schemes like bail-in debt and CoCos. We note that there may still be a limited role for bailouts in some cases, but an important point of our analysis is that this role will be substantially diminished with our proposed scheme.

This potential role of no-fault-default debt with financial institutions carries potentially significant implications for financial stability. There is a prominent view that financial stability can be enhanced by increasing capital ratios in banks, and that implementing higher capital requirements will not impose high private costs on banks or high social costs (e.g. Thakor (2014)). To some extent, this view is reflected in the Basel III minimum capital ratio requirements. Our proposal complements higher capital requirements in that it reduces the likelihood that the bank’s shareholders will choose to let control transfer to the uninsured creditors. Our analysis points to an alternative—with our proposal, it may be possible to allow banks to operate with lower levels of capital without sacrificing financial stability since risk-shifting moral hazard is attenuated. Finally, our result that with no-fault-default debt, financially-distressed banks can be infused with equity without a government bailout (with a transfer of control from the shareholders to the uninsured creditors) is germane for microprudential regulation. In particular, it generates lower risk at the individual bank level without necessarily asking banks to hold more equity upfront or altering the competitive structure of banking.

The complete paper is available for download here.