Asymmetric Information and the Structure of Financial Reorganization Contracts: Theory and Evidence
Posted: 6 Nov 1996
This article proposes a signaling model of financial reorganization in which the firms, operating in a cash constraint environment, use the provisions of the reorganization proposal, in particular the mix of cash and deferred payments, to signal their viability to uninformed unsecured creditors and possibly reduce the incidence of filtering failures in bankruptcy. Among the predictions of the model, we find that there exists a sequential equilibrium in which the proportion of cash payments increases with the firm's type. In addition, we show under what conditions pooling equilibria and hence, filtering failures, can arise. Evidence from an original sample of 393 Canadian firms in court-supervized reorganization confirms that the probability of success in reorganization increases with the proportion of short term cash payments (three to six months) to unsecured creditors, when controlling for the fact that firms are cash constrained. Also, the probability of acceptance of a proposal by unsecured creditors increases with the proportion of up-front payments (one month) and the perceived probability of success of the proposal by unsecured creditors.
JEL Classification: D82, G33, G34, K22
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