Financial Distress, Bankruptcy and Reorganization

This chapter discusses the recent developments in the topics of financial distress, bankruptcy and reorganization. It focuses primarily on developments in the corporate finance literature, although it also describes some important contributions by legal scholars that bear on the issue. The chapter presents the legal and economic ramifications of the U.S. Bankruptcy Code, focusing on the Bankruptcy Reform Act of 1978 as it is considered important to have a deep appreciation of the main provisions of the U.S. Bankruptcy Code in studying the economic implications of financial distress and formal bankruptcy procedures. To present the theoretical examination of the relationship between financial distress and economic distress, the chapter presents the Modigliani–Miller theorem. An important component of this chapter is a synthesis of the theoretical and empirical evidence on private and formal resolutions of financial distress. At the outset, it is recognized that the alternative methods for resolving financial distress are related in the sense that the incentives that various claimant groups have to reorganize a financially distressed firm depend on the relative costs and benefits conferred by each method. The various private methods of resolving financial distress are described through debt restructurings, workouts, and informal reorganizations in the capital and real-asset markets.