It is common to classify insolvency (and bankruptcy) regimes on a hard-soft scale, determined by the harshness of the penalties imposed once default takes place. An immediate asset foreclosure, dismissing owners from operating the concern in bankruptcy proceedings or banning managers from future directorships are considered hard while a grace period, a chance for a fresh start or the imposition of a debt restructuring on the creditor are considered soft. Chapter 11 of the American bankruptcy code is often considered a model of a soft law, while English Law is often considered a paradigmatic example of a hard law because it permits the secured creditor virtually untrammeled repossession rights to its collateral in the event of default, notwithstanding any costs borne by unsecured creditors or other stakeholders.
We recommend a different classification, according to the role that the original debt contract plays in the resolution of the company's financial distress. At one end of the spectrum is a regime of freedom of contracting, where the role of the court is limited to enforcing the debt contract, and at the other end is a regime of judicial activism, where the courts have the power to review and modify any contractual right that the creditor was granted at the inception of the loan. Earlier work by Franks and Sussman has demonstrated that although lending agreements negotiated under a freedom of contracting regime tend to generate hard debt contracts, in practice the implementation of the contract may be soft. For example, it might be in the creditors' best interest to wait before exercising their default rights, or to restructure a certain part of the debt in order to increase the prospect of recovery for the remainder.
It is worth noting that for economists freedom of contracting is an extension of the concept of a competitive equilibrium, where the objects to be traded are not just commodities (like beer or pork pie) but, also, contingent rights (for cash or for assets that can be repossessed conditional on default). Although economic theory guarantees that the equilibrium allocation that results from such competitive trade is, under certain (strong) assumptions, efficient, economic theory is not oblivious to the possibility that due to ‘market failures’ an efficient allocation may not result. In the case of financial distress, the academic literature has focused on two potential failures: first, a creditors run, where creditors treat the assets of the distressed company as a ‘common pool’ from which they are incentivized to grab as much as they can and often at the earliest opportunity in order to jump the queue and, second, that repossessed assets would be auctioned off at fire sale prices resulting from industry or economy-wide distress. It follows that the question as to whether freedom of contracting ‘works’ is as much an empirical as it is a theoretical question.
In this paper, we study the resolution of financial distress in the shipping industry, where the extraterritorial nature of the assets makes it relatively difficult for any state to impose any mandatory arrangements, leaving debtors and creditors with the freedom to write their own contracts. This raises two important issues. First, a freedom of contracting regime requires a well-developed rule-of-law, to enforce the contracts that debtors and creditors agree among themselves. It follows that in order to operate a well-functioning freedom of contracting regime, the industry would have to develop not just contractual mechanisms to deal with creditor runs and asset grabbing but, also, enforcement mechanisms. This would require the cooperation of a sufficient number of sovereign states, for example to arrest vessels where the owner has defaulted. Second, by its very nature, the industry has commercial relationships with a multitude of on-shore agencies - banks, charterers, insurers, suppliers, cargo owners - each operating under its own national legislation. Contractual mechanisms are necessary to avoid or mitigate the many legal ambiguities that may arise and cause jurisdictional conflicts.
We find that the most important measure that the industry has taken in order to achieve these outcomes is to design well-defined property rights on the pool of the company's assets thereby preventing ‘a common pool’ problem. Once a creditor's rights are well defined the incentive to grab assets is largely eliminated. Asset partitioning is achieved by an elaborate structure of subsidiaries, often owning one vessel only. Within each subsidiary, an elaborate nexus of contracts defines an unambiguous order of seniority, an orderly queue that defines the order in which creditors are satisfied. The rule of law is established by a small set of semi-private ports and registers of property rights (flags) that have built up a reputation for strong, efficient and incorruptible contract enforcement.
Interestingly, the order of seniority deviates from the standard on-shore order, where labor (crew) is made senior to the mortgage so that if the owner has defaulted to the bank and owes wages to the crew, both have an aligned interest in diverting the vessel to a rule-of-law port where it can be repossessed by the bank, and auctioned in order to pay the crew, the bank and other creditors.
We also examine three costs of distress: coordination failures leading to the arrest of ships, the direct costs of arrest and auction, and the fire sale discount. We find that most arrests are not caused by coordination failures, but rather are precipitated by debtors whose equity is far out of the money and where the ships are close to their break up values. The direct costs of arrest and auction are 8% of a vessel's value, and there is an average fire sale discount of 26%. However, when we control for the low quality of such ships (due to under maintenance), their low value, and corrupt versus non corrupt ports, the discount is no more than about 5%. In separate tests, we find an equivalent under maintenance effect in aircraft operated by airlines in Chapter 11 bankruptcy; this provides some confirmation that the fire sale discount in distressed sales of assets may contain a large systematic quality bias.
While it would be unwise to generalize from shipping and aircraft to other industries, particularly for those industries with intangible assets, we believe the results in this paper contribute to the discussion on the role of judicial activism in bankruptcy procedures. This might be even more relevant for emerging markets where legal resources are scarce. The paper also highlights the ability of commercial contracts to resolve potential conflicts between different creditors and different bankruptcy regimes across national jurisdictions, raising the question as to whether the quest for international harmonization of bankruptcy rules can provide the Holy Grail sought by policy makers.
Julian Franks is a Professor of Finance at London Business School.
Oren Sussman is a Reader in Finance at Saïd Business School, University of Oxford.
Vikrant Vig is a Professor of Finance at London Business School.