The Myth of the Residual Owner: An Empirical Study

Abstract

In economic theory, the residual owner is the perfect person to control the bankrupt firm. The residual owner risks its own money and has incentives identical to those of the firm. But in more than fifteen years of trying, scholars have not been able to specify a mechanism that would identify the residual owner of a bankrupt firm and put that residual owner in control. Despite this lack of success, scholars continue to frame their theories in terms of residual owners and continue to propose mechanisms. The most recent was proposed by Baird and Rasmussen in 2002.

This article recounts the theoretical debate and presents the findings of an empirical study. The principal finding was that no single residual owner class existed in the large majority of reorganizing firms studied. Instead, investors from more than one priority level shared the marginal dollar of gains or losses. The article concludes that no mechanism can identify and empower the single residual owner class because, in the large majority of cases, no single residual owner class exists.

The study included data on 78 to 86 of the 98 large, public companies that emerged from bankruptcy reorganization from 1991 to 1996. Tables present class-by-class data on percentage recoveries by unsecured and shareholder classes in each of the cases. Creditor investors were considered residual owners if they recovered at least 10% and less than 90% of their claims. Shareholders were considered residual owners if they received at least 10% of the stock of the emerging firm and that stock had a value of at least $5 million.

The data show that investors at different levels of priority shared residual owner status in more than 62% of the cases. The average number of investor priority levels in the reorganizing firms was 4.3; the median was 4. Subordinated debt existed in 70 of 86 cases (81%).

Keywords: residual owner, residual claimant, bankruptcy, bankruptcy reorganization, subordinated debt, priority, control rights, plan of reorganization, investor priority levels, corporate groups, bankruptcy judges

JEL Classification: G33, K22, K29, K49