Negotiating Debt Covenants in Bankruptcy Court

In this paper we theorize how bondholders and shareholders negotiate debt covenants after a firm has already filed for bankruptcy. This event triggers unique turmoil in the transfer of control rights between shareholders and creditors, and it further opens a window of opportunity for debt-holders to seek improvement in existing debt covenants as a return for approving the reorganization plan. Therefore, when a firm files for chapter eleven, it also shifts bargaining strength from shareholders to debt-holders hence the latter can exploit this situation for their own utility maximization and negotiate improvements in debt provisions as a further insurance upon deceleration of interest debt payments. The key difference between negotiating debt covenants during the normal business cycle and at the bankruptcy court is that in the latter case creditors gain the upper hand and therefore can request to further tighten debt covenants. Our goal in this study is to find the optimum levels of improvement in debt covenants creditors can request and receive within various sets of information, and to investigate how these equilibrium solutions interact with different economic variables. We construct four Nash equilibrium bargaining games with different information asymmetry levels between two types of creditors, senior and subordinate, and shareholders of a bankrupt firm, which can be either good or bad. We examine various separating and pooling equilibria, and different sensitivities to the type of creditors and bankrupt firms, the debt-holders and the firm's discount rates, the probability of having the reorganization plan approved, the available information set, the level of risk-aversion, the economic cycle, the promised coupon rate, and the continuous bargaining costs. We contribute to the financial literature by directing our attention towards a distinctive period of corporate restructuring and the negotiations that follow. To the best of our knowledge, this unique episode is yet to be explored