Chapitre 1

Financial Distress and Repu-

tational Concerns

Financial distress occurs when a �rm cannot meet its obligations of re-

payment or renegotiates with its creditors to restructure to avoid or resolve a

default, or that it has �led for Chapter 11 under the US. Bankruptcy Code.

Franks and Torous (1989) document that in 1987, 17142 companies �led for

Chapter 11 compared with only 6298 in 1980. More recent �gures show that

in 2000, the total liabilities of all �rms that declared bankruptcy stood at $93

billion; in 2001, the corresponding �gure stood at more than $170 billion, in-

dicating a rising trend. Furthermore, the total number of business �ling for

bankruptcy was 37548 in the year 2003. Given the alarming increase in the

number of �rms �ling for bankruptcy, there is great interest among academics

and practitioners in understanding the reorganization process induced by �-

nancial distress.

Despite a large body of evidence that documents the strategic outcomes

and the costs of reorganization procedures, surprisingly few theoretical analy-

ses emphasize the interaction between distressed �rms restructuring process

and the behavior of managers in light of reorganization procedures.39

40 Chapitre 1

This chapter undertakes such an examination. One of the central ques-

tions we address is whether banks can induce accurate revelation by managers

of the �rm�s �nancial di¢ culties by o¤ering to renegotiate its debt claims.

This question is of importance because it a¤ects the e¢ ciency of the process

to resolve distress. It also has implications for �rms�restructuring policies.

It is striking that in many cases �nancially distressed �rms are reluctant

to implement a restructuring even if this would be e¢ cient. To our knowledge,

no paper in the literature gives an explanation for the �ndings that in prac-

tice too few (rather than too many) managers may come forward to accept

to renegotiate. The existing literature suggests that biases toward excessive

continuation of unpro�table �rms may stem from an inadequate design of

the reorganization process (Hotchkiss (1995), White (1989), and Gertner and

Scharfstein (1991)). Alternatively, Kahl (2002) suggests that creditors may be

tempted to postpone liquidation in order to learn more about the state of the

�rm and make a better informed liquidation decision. We suggest that other

factors outside of a bargaining problem in the restructuring process might be

at stake to explain the reluctance to accept renegotiations. Our explanation

relates to managers�reputational concerns. This chapter contributes to our

knowledge by giving a new insight to the managers� decision during �nan-

cial distress and o¤ers some implications for the design of the restructuring

process.

We analyze a situation in which a bank decides to o¤er a renegotiation

to a manager who is privately informed about the prospects of the �rm. We

show that a combination of factors, including the quality of monitoring and

reputational concerns, may explain managers�reluctancy to accept a renego-

tiation.

Chapitre 1 41

An explanation for the reluctance of managers to accept a renegotiation

o¤er arises if one recognizes that banks and managers have asymmetric infor-

mation about the type of the �rm and the state of nature. We suggest that

�rms�managers are prone to hide their �nancial di¢ culties and postpone the

reorganization decision in order to avoid the losses in terms of reputation that

follow a bankruptcy. A key element of our explanation is that �nancial dis-

tress a¤ects the �rm�s reputation as well as the manager�s reputation. If a

�rm enters �nancial distress, the �rm is highly stigmatized for its bankruptcy

and so is the manager to the detriment of future access to the credit market

and to the job market. The higher the stigma associated with �nancial dis-

tress, the harder it becomes to enforce entrepreneur�s revelation of �nancial

di¢ culties. In these circumstances we argue that a �exible debt restructuring

process such as an out-of-court renegotiation may induce accurate revelation

by �rms of their �nancial di¢ culties (assuming that the �rm managers who

accept the renegotiation o¤er are not �red) and improve the resolution of �-

nancial distress.

This chapter investigates reporting strategies of managers and the re-

sulting reactions to these reports by creditors. An obvious policy question is

whether banks can induce managers to report truthfully the �rm�s �nancial

situation.

The "expectation adjustment policy" predicts that managers will truth-

fully reveal their private information to align investors�expectations with their

own (Ajinkya and Gift, 1984). However, managers may sometimes bene�t from

issuing �nancial reports that manipulate market participant�s beliefs about

the �rm�s value. For instance, when a �rm has performed poorly, a manager

should be more inclined to provide encouraging statements about the �rm�s

future prospects. Such a disclosure is aimed at convincing investors that the

manager should be maintained in place because he is implementing a busi-

42 Chapitre 1

ness plan that will restore the company to �nancial health. In turn, managers�

incentive to misreport their private information is a¤ected by market partici-

pants�ability to assess the truthfulness of a management report. In our model,

banks o¤er a renegotiation in order to restrict the set of actions the �rm can

take.19 Namely, the bank does not want the �rm in distress to "gamble for

resurrection".

The relevance of the question regarding why managers might refuse the

renegotiation o¤er and the plausibility of our proposed explanation rely �rst

on the assumption that managers must have the choice about whether to

accept or not the renegotiation o¤er. In other words, renegotiation should

be o¤ered to distressed �rms rather than imposed. Financial distress can be

alternatively resolved through private workouts or legal reorganization under

Chapter 11 of the US Bankruptcy Code.20 Gilson, John, and Lang (1990) �nd

that, in a sample of 169 �nancially distressed �rms, about half of the �rms �led

for Chapter 11 and half were able to resolve distress through an out-of-court

renegotiation. Firms more likely to restructure their debt privately had more

intangible assets, less information asymmetry problems, owe more of their debt

to banks, and owe fewer lenders. Critical to the restructuring process is how

severe is the asymmetric information problem and how the lender evolves its

beliefs about the �rm�s �nancial distress. The lender could always �nd out the

truth by forcing the �rm in default into Chapter 11 bankruptcy at some cost.

This is a major example of the "costly state veri�cation" concept of Townsend

(1979). Yet, whenever the parties can agree on restructuring without going

through the formal bankruptcy, all �nancial distress can be resolved through

private workout.

19 See Gorton and Kahn (1993) for a model on the role of banks in debt renegotiations and theextent to which the bank can control borrowers�risk-taking activity.20 For theories of investment e¢ ciency of private workouts and Chapter 11, see the works ofMooradian (1994), and Bolton and Scharfstein (1996)).

Chapitre 1 43

A second key observation is that in most cases where managers have the

choice, they are reluctant to accept a reorganization plan. Large evidence il-

lustrates the biases toward the preservation of ine¢ cient �rms (Baird (1986),

White (1989), Gertner and Scharfstein (1991). Hotchkiss (1995) suggests that

poor post bankruptcy performance is a consequence of the US bankruptcy de-

sign (in particular, chapter 11), which gives liquidation-averse managers too

much power to save ine¢ cient �rms.21 Gertner and Scharfstein (1991) show

how chapter 11 may lead to overinvestment if �rms that should be liquidated

are reorganized. More precisely, they show that the key provisions of Chapter

11 reorganization law, such as the automatic stay, Chapter 11 voting, and the

maintenance of equity value in the reorganized �rm (deviations from absolute

priority rule) lead to increased investment. Alternatively, Bradley and Rosen-

zweig (1992) argue that management has too much power in Chapter 11 and

that they exercise this power in a self-serving manner. The debate over man-

agement�s role in the restructuring process has led to a number of proposals

for reform of the current system (this include Aghion, Hart and Moore (1992),

Baird (1986)) that would discipline managers appropriately. This strongly

suggests that reputational e¤ects should not be ignored.

Finally, our model shows that reputational concerns have implications for

the conditions under which �nancially distressed �rms will restructure. This

highlights some implications about the design of the restructuring process. We

�nd that the amount of new money necessary to induce the correct liquidation

decision from �nancially distressed �rms may exceed the amount necessary to

restore �rms� liquidity position. This additional amount serves to compen-

sate managers for the reputation harm caused by the revelation of �nancial

di¢ culties consecutive to a �nancial distress process.

21 Hotchkiss (1995) �nds that in the �rst three years after emerging from bankruptcy, between 35percent and 41 percent of all �rms experience a negative operating outcome. Gilson (1997) showsthat between one quarter and one third of distressed �rms reenter �nancial distress within a fewyears after emerging from debt restructuring.

44 Chapitre 1

If banks are constrained in the amount of new money consecutive to a

renegotiation, they might be unable to induce managers to reveal �nancial

distress, such that the liquidation decision is postponed thereby leading to an

ine¢ cient continuation of investments.

Our results also suggest that strong monitoring by banks encourages

e¢ cient restructuring decision. In particular, if the probability of detecting

the manager�s attempt to hide �nancial di¢ culties is high enough, banks can

induce �nancially distressed �rms to renegotiate and reveal their default with

smaller amounts of restructuring than would be necessary if the probability of

detection is low.

We also derive results related to the conditions underlying the renegoti-

ation plan. We show that the optimal renegotiation o¤er imposes a cost on

managers who reject renegotiation o¤ers and postpone a necessary liquidation

process. By committing to impose a punishment on �rms which reject the

renegotiation o¤er and then are caught cheating about their �nancial shape,

banks can induce managers to accept reorganization plan with fewer amounts

of new loans than in the absence of such a commitment. A �nal result is that

even when banks take managers�reputational concerns into account when of-

fering a reorganization plan, managers may still reject the plan in equilibrium.

The remainder of the chapter is structured as follows. Section 1.1 is the

review of the literature. Section 1.2 presents the economic model. Section 1.3

describes the manager equilibrium behavior in the model with one �rm. Sec-

tion 1.4 analyzes the manager�s decisions in the debt restructuring process.

Section 1.5 extends the model to the case with two �rms. Section 1.6 of-

fers some investigations about the bank�s optimal renegotiation plan, taking

managers�reputational concerns into consideration. Section 1.7 concludes.

1.1 Related literature 45

1.1 Related literature

This chapter is related to di¤erent areas of literature.

One set of papers refers to the career concern literature initiated by

Holmstrom (1999) where managers take into account the impact of their de-

cisions on their reputations. Boot (1992) presents a model of divestiture and

takeovers where managers are concerned by the way in which the market will

interpret the termination of their projects. As in our model, this can lead to

the ine¢ cient continuation of projects. In particular, we show in our model

that there may be equilibria in which managers have incentives to refuse to

renegotiate and hide the �rm�s �nancial di¢ culties. Managers� decision to

renegotiate will depend upon the terms of the reorganization plan, but it will

also depend upon the consequences in terms of reputation. The reputational

e¤ect may itself be a function of whether others managers are accepting to

renegotiate.

A second large set of papers study the reorganization procedures in the

presence of asymmetric information. Bulow and Shoven (1978), Gertner and

Scharfstein (1991), and Aggarwal (1995) indicate that the presence of asym-

metric information between many small creditors and di¤erent priority groups

of creditors often act as a barrier on successful restructuring of �nancially

distressed �rms.22 In the same vein, Kahl (2002) shows how the lack of infor-

mation can induce creditors to undertake an ine¢ cient liquidation decision.

22 See Gilson (1997), Gilson, John and Lang (1990), and Frank and Torous (1994) on thecomparison of time and legal costs under private and public workout. Giammarino (1989)discusses the rationality behind �rms incurring costs for the resolution of �nancial distress.His results are built on the assumption that the court�s and the �rm�s assessment of thetrue value of the �rm�s assets are consistent such that the main source of disagreement ofchapter 11 is excluded.

46 Chapitre 1

Consequently, creditors may postpone their liquidation decision and wait

for more information about the �rm�s viability. As in our paper, the existence

of uncertainty about the distressed �rm�s prospects a¤ects the creditors liqui-

dation decisions.

While our analysis is related to this literature, there are two major di¤er-

ences. First, Kahl focuses on liquidation decisions for creditors as an e¢ cient

resolution of �nancial distress. Hence, a controlled liquidation in which cred-

itors leave leverage high is attractive in that it preserves the opportunity to

learn about the recovery of the �rm. In contrast, we argue that a renegotiation

o¤er allows the creditor to learn about the �rm�s �nancial situation. In par-

ticular, considering the case with multiple �rms, we show that the manager�s

decision to accept or reject the renegotiation conveys information to outsiders

concerning the �rm�s strategy with respect to its level of default. This in turn

a¤ects the resolution of �nancial distress. Second, we explicitly address the

question of whether or not managers will decide to reveal the �rm�s �nancial

di¢ culties and renegotiate given the existence of reputational concerns.

There also exists a theoretical literature that discusses regulatory re-

sponse to troubled banks. Rajan (1994), Corbett and Mitchell (2000) model

banks�treatment of their nonperforming loans under the assumption of asym-

metric information between insiders and outsiders. They show that when

regulators adopt a laissez-faire policy toward troubled banks and when man-

agers of insolvent banks would lose private bene�ts if the bank�s insolvency is

discovered, then troubled banks will roll over their defaulting loans in order to

hide their insolvency. Their focus is on bank rescue packages. We deal with

bank�s restructuring policy for �nancially distressed �rms.

1.2 The basic model 47

1.2 The basic model

The basic set-up is borrowed from Rajan (1994). Rajan o¤ers a theory

of business cycles driven by bank credit policy so that his focus is very dif-

ferent from the context we study in the following framework. We consider

an economy with managers and lenders. We start by presenting the decisions

the entrepreneur, the manager and the bank make at di¤erent points of time.

Then, we describe the basic structure of the model and present in more detail

the information environment. All participants are risk neutral.

1.2.1 Sequence of events

We consider a two-period investment model in which in period 0 a risk

neutral manager invests one unit of money in a project. In period 1, managers

observe the states of the world and each manager observes its level of default.

The bank then o¤ers to renegotiate the terms of the loan contract or not.

Since the bank does not observe either the states of the world or the type

of the �rm she�s dealing with, the loan contract cannot be made contingent

on the nonveri�able cash �ow. Managers decide then to accept or not to

renegotiate the loan contract. If a defaulting manager rejects the renegotiation

and continues the initial project, his attempt to hide default will succeed with

some probability denoted, �. After success or failure of defaults misreporting,

the �rm�s reported current cash �ow is observed by banks. Then the bank

updates the manager�s reputation. In period 2, the �rm�s future earnings

(re�ecting the repayment following the renegotiation) and costs associated

with hiding default are realized.

48 Chapitre 1

The timing of events is as follows.

Period 0

Entrepreneurs borrow from bank

Period 1

State of the world realized and loan default occurs

Banks o¤er renegotiation plans or not

Managers accept or reject

If defaulting managers reject, current cash �ow high with probability �

Report of current cash �ow situation realized and observed by banks

Banks update manager�s reputation

Period 2

Future loan repayments and costs realized.

1.2.2 Managers and technology

The model has three periods. In period 0, a continuum of risk neutral

managers have access to investment projects. Managers have no wealth such

that they must borrow from the bank to �nance the projects and have a zero

reservation utility. Each manager raises fund by issuing debt with face value

d: The initial investment yields a random cash �ow ~y in period 1.

In period 1, the �rst payo¤ arises. It can be either high (~y > 0) or zero.

If the payo¤ is zero and there is a debt payment due, the �rm is in default.

The probability that the �rm is in default depends both on the state of the

world, which can be good or bad and on the managers�ability, which is high

or low.

1.2 The basic model 49

A manager�s type determines the state-dependent probability that the

�rm experiences �nancial distress. Financial distress may occur in either state

of the world. However, the probability that a �rm experiences distress is

greater in a bad state of the world than in a good state.

There are three possible levels of levels of default, which re�ect the �rm�s

�nancial situation: no default, medium default re�ecting a viable �rm expe-

riencing temporary cash �ow problems and high default re�ecting a �rm ex-

periencing stringent �nancial di¢ culties. Our assumptions on defaults as a

function of the state of the world and the manager�s type are illustrated in the

following table.

Good state Bad stateHigh type No default medium defaultLow type medium default high default

Table 1: assumptions on cash �ow states

The manager observes privately the state of the world, its type, and the

level of default of the �rm. Banks do not initially observe the state of the

world although they have a prior on this variable. This is speci�ed in the next

subsection.

Assume that all �rms have projects that yield random revenues of ~y and

debts with face value of d: Given these assumptions on defaults, the �rms�cash

�ow statements are as follows. If a manager invests in a project that yields y,

where y is a realization of the random return ~y and has no default, then the

�rm�s current cash �ow state is equal to y�d, where d represents the paymentdue to the bank. In that case, the �rm is rich in internal funds so that it can

pay back the loan, i.e. y > d. Second, when a manager observes a medium

level of default, the �rm�s current cash �ows are y � d, with d � y < y, whichidenti�es that the �rm has lower cash �ows than in the previous case but is

still solvent.

50 Chapitre 1

The �rm with a medium level of default can best be seen as a solvent

�rm that is illiquid. In that case, the �rm�s debt may be under control but it

lacks the cash �ows to pay for raw materials, wages and to keep up its interest

payment. Hence, such �rms need to obtain new money for working capital

in order to keep going. Restoring credit �ows for such solvent �rms may lead

to a restructuring. Finally, when the manager observes a low signal, the �rm

is poor in cash such that it is unable to meet its debt obligations, hence the

outcome of the �rm equals zero.

The �rm in default may choose either to reveal the �nancial di¢ culties

(for example by engaging in a debt restructuring and discussing changes in its

repayment schedule with the bank) or to hide the default (by reporting high

current cash �ow state). If the manager succeeds in hiding the level of default

to the bank, it is able to report high cash �ow state (y� d). The manager hasa probability � that his default behavior goes unnoticed. Thus, (1� �) is theprobability that the manager�s attempt to hide �nancial di¢ culties is detected

by the bank. The variable (1� �) is a measure of the "e¤ectiveness" of bankmonitoring.23 We assume that:

Assumption 1: � = 0 for managers with high default, and � > 0 for

managers with a medium level of default.

The above assumption simply illustrates the fact when a �rmwith medium

default attempts to report good news instead, it will succeed with positive

probability �: In contrast, a �rm with a high level of default is already so in-

solvent that even if it attempts to hide its default it will become illiquid and

its �nancial distress will be discovered in the current period.

23 The variable � allows for comparison of our results across economies with di¤erent qual-ities of monitoring technologies by banks. It also introduces possible explanations for inter-national di¤erences in �rm�s restructuring plans.

1.2 The basic model 51

1.2.3 Banks

Although �nancial distress gives the creditor an opportunity to intervene,

it is an imperfect indicator of the �rm�s viability. For example, economically

viable �rms can have temporary cash �ow problems. This idea is formalized as

follows. We restrict our attention to two types of �rms in the economy: viable

�rms (�rms that report no default or a medium level of default) and �rms that

should be liquidated (�rms that report a high default). Viable �rms should

be continued because their projects yields random returns, y with, y � d so

that they can honor their debt claims eventually. However, "ine¢ cient �rms"

should be liquidated since the payo¤ is zero so that they are unable to meet

their debt obligations:

We introduce into the model a bank, who o¤ers (or not) to renegotiate

the loan contract on the basis of her prior about the state of the world. The

renegotiation process involves a situation where the bank (sole creditor) and

the troubled �rm (that can show evidence of loan defaults) discuss changes in

the repayment schedule. The creditor then de�nes how much "new money"

must be included in the rescheduling package and reach an agreement with

the �rm. For simplicity, we assume that, d is the amount of debt that is due

and is being renegotiated. The troubled �rm attempts to obtain new money,

f � 0, in order to �nance the required repayment. The new money can bestbe conceived of as a partial forgiveness of the debt. If the manager declines

the o¤er, then the ex-ante contract remains valid, i.e. the �rm is entitled to

make the debt repayment of d.

Because information on level of default and the state of the world is pri-

vate to managers, the bank does not know neither the state of the world nor

the true level of �nancial distress of �rms when she decides whether to of-

fer a renegotiation. However, the manager�s choice to continue or renegotiate

the contract, and the realization of the �rm�s current cash �ow state, con-

52 Chapitre 1

vey information about the state of the world and about each �rm�s �nancial

situation.

The feature of �nancially distressed �rms that we are intending to cap-

ture is the observation that creditors often implement a debt restructuring

once the �rm has very poor recovery prospects and the situation is severe

enough. However, because of problems of asymmetric information the deci-

sion to allow the �rm to continue its operations through a restructuring often

occurs before creditors know the exact level of default of �rms and even before

they know which �rms will ultimately need to be continued. What is impor-

tant is that banks�expected gain from a renegotiation that involves a debt

forgiveness is greater than what they would get when the �rm defaults on its

debt obligations.

We consider that a manager willing to renegotiate the loan contract

totally reveals the �rm�s situation of �nancial distress.24 In order to hide

�nancial di¢ culties, the manager must reject the renegotiation o¤er. The

manager might succeed in doing so with probability � and fail with probability

(1��). If the bank detects the manager�s attempt to hide �nancial di¢ culties,the manager incurs a cost equals to cH . The bank can impose a cost on

dishonest managers (or equivalently a �ne) or it may represent the bankruptcy

costs when the �rm proceeds with the legal action. Despite the decrease in the

manager�s revenues caused by his attempt to hide default, the manager may

still be willing to do so because of his reputational concerns. The manager�s

reputation corresponds to the bank�s belief about the manager�s type. The

bank updates the manager�s reputation using Baye�s rule after observing the

�rm�s current cash �ow state.

24 It is possible that �rms may choose to conceal only a portion of their levels of defaultwhen renegotiating their debts. For simplicity, we consider in this paper only the case where�rms�acceptance of a renegotiation reveals the total amount of default.

1.2 The basic model 53

1.2.4 Information structure

In the following to summarize the information the bank has (from table

1). When the manager rejects the renegotiation o¤er and reports high current

cash �ow, the bank does not know whether the entrepreneur is a high type

and the state is good, whether the manager is a low type, the state is good

and the manager succeeds in hiding the �rm�s �nancial di¢ culties, or whether

the manager is a high type, the state is bad and the manager succeeds in

hiding the �rm�s �nancial di¢ culties. Similarly, when the manager accepts

to renegotiate and reports medium current cash �ow, then the bank knows

about the �rm�s medium level of default and infers that the manager didn�t

try to hide the �rm�s �nancial di¢ culties. However, the bank does not know

whether the manager is a low type in �nancial di¢ culties, or whether he is a

high type in a bad state. Finally, when the bank observes "acceptance" and

0 (which corresponds to the payo¤ for a �rm with high level of default), the

bank knows that the manager is a low type and that the state is bad. The

bank�s beliefs are as follows.

� q is the bank�s prior regarding the probability that the state of theworld is bad.

� p is the bank�s prior regarding the probability that the manager ishigh-ability type.

� The bank updates, p the manager�s reputation using Baye�s rulewhenever it is possible. The bank�s posterior belief in the case of high

cash �ow state is denoted by ph. Let pm be the posterior belief in the

case of medium cash �ow state. Finally, let pl be the posterior belief in

the case of low cash �ow state.

54 Chapitre 1

1.3 Renegotiation in the model with one �rm

This section discusses particular feature of the model with one �rm: A

�exible debt restructuring process may induce a revelation by the �rm of its

�nancial di¢ culties. However, the manager�s decision to reveal the �nancial

di¢ culties of the �rm depends upon the consequences in terms of reputation.

We formalize the manager equilibrium behavior as follows.

We follow Rajan (1994) in writing the manager�s expected utility. The

�rst term represents the manager�s expected future revenues and the second

term is the manager�s reputation in the market. The general form of the

function is given by:

UE = (1� )(Expected future revenues) + Erep

where is the weight the manager places on his expected date 1 repu-

tation. The fact that a manager cares about the opportunity to get a job in

other �rms or to apply for new loans in the next periods makes him concerned

about the bank�s perception of his ability The term expected future revenues

includes the expected future net worth of the manager, the amount of new

money between the lender and the borrower consecutive to a renegotiation

o¤er, and the cost associated with hiding default.

We de�ne an equilibrium as a set of strategies (�g; �b), with � 2 fR;Agwhere � = R if the manager rejects the renegotiation o¤er or � = A if accepts

the renegotiation o¤er. Besides, �g refers to the strategy that a manager with

a default chooses in a good state and, �b to his strategy in a bad state. We

consider equilibria of the form (R;R) and (A;A).

We compute the di¤erent expected utility functions for each level of

defaulting �rm and for each decision. We focus on pure-strategy equilibria.

1.3 Renegotiation in the model with one �rm 55

We derive the equilibrium conditions for the manager�s choice of strategy

when a renegotiation is o¤ered by the bank and the bank�s updating of the

manager�s reputation. We �rst note a feature that is common to all equilibria

in an economy with only one �rm.

Lemma 1 The manager with high default always negotiates, whereas the high

type in a good state always continues.

Proof. See Appendix 1.8.3.

The above lemma implies that in every equilibrium, the manager with a

high level of default in a bad state of the world always renegotiates, whereas

the high type in a good state always continues since it has no default. Hence

equilibria must be distinguished by the action taken by the low-type experi-

encing �nancial di¢ culties in a good state of the world and by the manager in

�nancial di¢ culties in a bad state.

1.3.1 Equilibrium (R;R) for the manager with mediumdefault

We now derive the equilibrium that involves continuation of the initial

project and hence the non revelation of �nancial di¢ culties by the manager

experiencing a medium level of default in either state of the world. The values

of the reputation terms are given in Appendix 1.8.1.

Suppose the state of the world is good. This information is private to the

manager, thus non observable by the bank. In this case, the only manager

subject to loan default is the low-ability type.

56 Chapitre 1

The expected utility for a low-ability manager who decides to continue

is given by :

U(RjR;R) = (1� )(y � d� (1� �)cH) + [�ph(RjR;R; q)

+(1� �)pm(RjR;R; q)]

The reputation term has two measures which re�ects the fact that when

the manager rejects renegotiation the bank does not know whether it is dealing

with a �rm that has no default or with a �rm with medium default which

manager is hiding the �rm�s �nancial di¢ culties (see table 1). The reputation

terms are de�ned as ph(RjR;R; q) in the former case, and as pm(RjR;R; q) inthe latter.

Now consider the case where the low-ability manager with a medium

level of default renegotiates. The expected utility is given by:

U(AjR;R) = (1� )(y � d+ f) + pm(RjR;R; q)

pm(AjR;R; q) is the manager�s reputation when the bank infers the man-ager is a high-type in a bad state of the world.

In summary, the low-ability manager with a medium level of default

chooses to continue his initial project rather than revealing default if the ex-

pected utility from continuing is greater than the expected utility from rene-

gotiating

(1� �)cH + f �

(1� )�[ph(RjR;R; q)� pm(RjR;R; q)] (1.1)

The manager with a medium level of default favors his reputation and

refuses a renegotiation of the terms of the loan whenever the expected cost of

hiding default and the amount of new money following a renegotiation are low

enough.

1.3 Renegotiation in the model with one �rm 57

Now assume that the state of the world is bad. If the high-ability manager

who experiences a medium level of default continues, the expected utility is

equal to:

U(RjR;R) = (1� )(y � d� (1� �)cH) + [�ph(RjR;R; q)

+(1� �)pm(RjR;R; q)]

Now consider the case where the low-ability manager with a medium

level of default renegotiates. The expected utility is given by:

U(AjR;R) = (1� )(y � d+ f) + pm(AjR;R; q)

Thus, we show that the expected utilities of a low-type with a medium

level of default in a good state of the world is identical to that of the manager

with a medium level of default in a bad state. The incentive compatible

constraints of managers with a medium level of default in each state of the

world are identical. They choose the same strategy in equilibrium. In addition,

when banks update the reputation of a manager with a medium level of default,

the only possible inference is that this manager is either a high-type in a bad

state or a low-type in a good state. Since these two types choose the same

strategy in equilibrium, pm(AjR;R; q) = pm(RjR;R; q).

Consider the incentive compatible constraint (1.1). This constraint im-

plies that the manager will refuse to renegotiate and reveal the �rm�s �nancial

distress whenever the expected cost of hiding default and the amount of new

money consecutive to a restructuring are low enough. In that case, the man-

ager will value maintaining his reputation in the market more than making a

restructuring decision.

58 Chapitre 1

For the constraint to be satis�ed, we need the RHS to be positive, i.e.

when ph(RjR;R; q) � pm(RjR;R; q): The assumptions of the model guaranteethat the RHS is strictly positive when q < 1: De�ne cR to be the critical

value equals to the RHS of the incentive compatible constraint. A necessary

condition for the equilibrium continuation to exist is that (1� �)cH + f � cR.It is straightforward to verify that cR increases with �: Hence, the weaker is

the bank monitoring activity (i.e. the higher is �), the larger the range of

values satisfying equation (1.1) for which it exists an equilibrium (R;R).

1.3.2 Equilibrium (A;A) for the manager with a mediumlevel of default

We explore in this subsection the equilibrium that involves renegotiation

of the initial project and hence the revelation of �nancial di¢ culties by the

manager experiencing a medium level of default. The reputation terms are

given in Appendix 1.8.1.

As in the case of the (R;R) equilibrium, the incentive compatible con-

straints are identical for the manager in �nancial di¢ culties in a bad state of

the world and the manager in �nancial di¢ culties in a good state of the world.

The expected utility for a manager with a medium level of default if he

refuses to renegotiate the terms of the loan contract is given by :

U(RjA;A) = (1� )(y � d� (1� �)cH) + [�ph(RjA;A; 0)

+(1� �)pm(AjA;A; q)]

The bank does not know whether the manager is a low-type in a good

state, or whether he is a high-type in a bad state (see table 1).

1.3 Renegotiation in the model with one �rm 59

The reputation terms are thus given by ph(RjA;A; q) and pm(AjA;A; q):In the latter case, again, the bank infers that the manager accepts the rene-

gotiation given a default and the bad state of the world.

The expected utility for a manager with a medium level of default who

renegotiates:

U(AjA;A) = (1� )(y � d+ f) + pm(AjA;A; q)

In summary, the low-ability manager with a medium level of default

chooses to renegotiate rather than hiding the �rm�s �nancial di¢ culties if the

expected utility from renegotiating is greater than the expected utility from

continuing. Hence, the manager will chooses to renegotiate and reveals his

default if:

(1� �)cH + f �

(1� )�[ph(RjA;A; 0)� pm(AjA;A; q)] (1.2)

The manager will renegotiate the terms of the loan contract if the new

loan and the cost of hiding loan defaults are high enough to o¤set the losses in

terms of reputational concerns. In that case, the manager will value making

the right restructuring decision more than saving his reputation in the market.

De�ne cA to be the critical value equal to the RHS of the incentive compatible

constraint. A necessary condition for the renegotiation equilibrium to exist is

that (1� �)cH + f � cA. It is straightforward to verify that cA increases with�: Hence, the weaker is the bank monitoring activity (i.e. the higher is �),

the larger the range of values satisfying equation (1.2) for which it exists an

equilibrium (A;A).

60 Chapitre 1

1.4 Analysis

In this section we �rst describe the pure strategy equilibria for the man-

ager with a medium level of default. More speci�cally, we focus on equilibrium

of the form (R;R) which refers to the case where the manager with a medium

level of default rejects the renegotiation o¤er in either state of the world and

equilibrium of the form (A;A) where he accepts the renegotiation o¤er in ei-

ther state of the world. Then, we address the possibility that a manager with

a medium level of default chooses di¤erent strategies across the states of the

world, i.e. equilibria of the form (R;A) and (A;R): Finally, we discuss what

would change in the presence of multiple managers.

1.4.1 Comparison of the equilibria of the form (R;R) and(A;A)

We describe the pure strategy equilibria in the model with one �rm. The

following proposition characterizes equilibria with state-independent strategies

for the manager with a medium level of default.

We combine the two manager�s incentive compatible constraints (1.1)

and (1.2), which gives:

cA � (1� �)cH + f � cR (1.3)

where cR represents the critical value for which the continuation equi-

librium holds and cA represents the critical value for which the renegotiation

equilibrium holds. We have the following proposition.

1.4 Analysis 61

Proposition 2 for every �, an equilibrium (A;A) exists if cA � (1� �)cH +f and an equilibrium (R;R) exists if (1 � �)cH + f � cR: As � increases,

equilibrium (R;R) becomes more likely while equilibrium (A;A) becomes less

likely.

Proof. Note that both cR and cA increase in � and (1 � �)cH decreases in�, such that, for given values of cH and f , as the probability � that manager�s

attempt to hide �nancial di¢ culties increases, equilibrium of the form (R;R)

becomes more likely while equilibrium (A;A) becomes less likely.

The weaker is the bank monitoring activity (or equivalently, the higher is

�), the larger the range of values satisfying equation (1.1) for which it exists an

equilibrium (R;R), which identi�es that managers will reject the renegotiation

o¤er and the smaller the region for which it exists an equilibrium (A;A); which

identi�es that managers will accept the renegotiation o¤er.

1.4.2 Comparison of the equilibria of the form (R;A) and(A;R)

In this section we address the possibility that a manager with a medium

level of default chooses di¤erent strategies across the states of the world.

Proposition 3 Equilibria of the form (R;A) do not exist.

The proposition states that it is impossible to have an equilibrium where

managers in �nancial di¢ culties refuse the renegotiation process when they

are in a good state and accept to renegotiate the terms of the loan when the

state of the world is bad.

62 Chapitre 1

Proof. In equilibrium, the bank assumes that the state is good and sets

q = 0 in updating the manager�s reputation when the manager continues his

initial project. In contrast, when the manager accepts the renegotiation o¤er

the bank assumes that the state is bad and sets q = 1.

Consider a good state of the world. The expected utility for a �rm expe-

riencing �nancial di¢ culties if the manager refuses to renegotiate the terms of

the loan contract is given by :

U(RjR;A) = (1� )(y � d� (1� �)cH) + [�ph(RjR;A; 0)

+(1� �)pm(RjR;A; 0)]

The manager�s expected utility when he accepts the renegotiation o¤er

is given by:

U(AjR;A) = (1� )(y � d+ f) + pm(AjR;A; 1)

The manager chooses to continue when the state of the world is good if:

(1� �)cH + f �

(1� ) [�ph(RjR;A; 0)� pm(AjR;A; 1)]

Note that ph(RjR;A; 0) � pm(AjR;A; 1) which implies that the RHSof the inequality is negative and hence, the equation is not satis�ed. Conse-

quently, equilibrium (R;A) does not exist.

Proposition 4 Equilibria of the form (A;R) exists for some range of values

of f and (1� �)cH :

1.4 Analysis 63

The proposition states that an equilibrium exists for a limited range of

pairs where managers with defaulting loans are willing to renegotiate the terms

of the loan when they are in a good state and refuse the renegotiation process

when the state is bad.

Proof. Consider a good state of the world. In this case, the manager�s

expected utility from accepting the renegotiation o¤er is:

U(AjA;R) = (1� )(y � d+ f) + pm(AjA;R; 0)

Now, the manager expected utility from rejecting the renegotiation is:

U(RjA;R) = (1� )(y � d+ f) + [�ph(RjA;R; q) + (1� �)pm(RjA;R; 1)]

The manager chooses to renegotiate when the state is good if:

(1� �)cH + f �

(1� ) (1.4)

Now, we consider the case when managers are in a bad state of the world.

The manager�s expected utilities are identical to the above equations and the

incentive compatible condition is:

(1� �)cH + f �

(1� ) (1.5)

Comparing the two incentive compatible constraints (1.4) and (1.5) im-

plies that each must be satis�ed with equality in order for the equilibrium to

exist.

64 Chapitre 1

The necessary and su¢ cient condition for the existence of equilibrium

(A;R) is (1 � �)cH + f = (1� ) , which is greater than the critical value c

A

from equation (1.3). Hence, in order for the equilibrium to exist, the sum

(1��)cH + f must exceed the value for the existence of the equilibrium of theform (A;A). Hence, for parameter values for which equilibrium (A;R) exists,

equilibrium (A;A) exists as well.

Our results relating to equilibria in the one-�rm model resemble those

that can be obtained in the absence of a renegotiation o¤er (see Rajan in a

context of bank credit policies). However, two di¤erences exist. First, in our

model, the manager�s decision to accept or reject the renegotiation conveys

information about the �rm�s strategy with respect to its level of default which

in turn a¤ects the resolution of �nancial distress. The manager�s decision, in

addition to the �rm�s current cash �ow state, is used by the bank to update its

priors which are then used in updating the manager�s reputation. When there

is no renegotiation, banks observe only the �rm�s reported current cash �ow

state, and hence, obtain no direct information about the manager�s strategy

regarding the level of default. Second, the bank that o¤ers a renegotiation

can impose a cost on a �rm that rejects the o¤er then reports a low current

cash �ow state. This cost, that does not exist in a model in which the bank

is absent, increases the probability of the �rm�s revealing its level of default.

These features lead to the result that the mere objective of a renegotiation

o¤er, even one with little amount of new money to restore �rm�s solvency,

motivates �rms to reveal the true �nancial situation more often (i.e. for a

larger range of parameter values) than when no renegotiation is o¤ered.

1.4 Analysis 65

1.4.3 Discussions of assumptions: the case with multiplemanagers

One of the questions of interest is whether the equilibrium strategy cho-

sen by a manager with a medium level of default in a bad state can di¤er

from the strategy chosen by the manager with a medium level of default in

a good state. The bank only knows the �nancial situation declared by the

manager when o¤ers to renegotiate the terms of the loan contract. The bank

cannot distinguish between �nancial di¢ culties stemming from the bad state

and �nancial di¢ culties arising from idiosyncratic ability. Consequently, the

manager�s decision to accept or decline the renegotiation o¤er is not state de-

pendent. We now discuss what would change in the presence of two managers.

When we allow for the possibility of multiple managers, the main dif-

ference is that managers� strategies become interdependent due to the fact

that the bank has two sources of information, namely each manager�s level

of default reporting. The bank thus takes into account manager 1�s decision

to accept or not the renegotiation and the �rm�s current �nancial situation in

order to update its beliefs about manager 2�s reputation, given the latter�s con-

tinuation/renegotiation decision and current �nancial situation. A manager�s

�nancial situation reporting helps the bank update its prior on the state of

the world. The bank then uses the posterior to update the other manager�s

reputation.

The bank evaluations of managers are now state dependent. Thus, when

a manager decides to accept or decline the renegotiation o¤er, he must take

into account the other manager�s expected strategy and �nancial situation

declared given the state of the world. He must as well consider the e¤ects of

this reporting on the bank�s updating of the original manager�s reputation.

66 Chapitre 1

Given the strategic interaction between manager�s decision, it is reason-

able to suspect that, conversely to the one manager model the equilibrium

strategies chosen by managers in each state of the world may now di¤er. A

natural conjecture, is that �rms in �nancial di¢ culties might be more willing

to renegotiate and reveal distress in a bad state than in a good state. Since

others managers are more likely to be in �nancial distress in a bad state, the

market will revise upward its prior in the bad state. Hence, the reputational

e¤ects of revealing distress will be less unfavorable.

1.5 Renegotiation in the model with two �rms

In this section, as before, we consider equilibria in pure strategies. More

speci�cally, we focus on equilibria in which the �rst manager (indexed by 1)

and the second manager (indexed by 2) adopt the same strategies if they are

same types. The manager 1�s expected �nancial situation is a function of

the state of the world and the manager 2�s expected situation enters into the

reputation terms for manager 1. Following Rajan (1994), we set = 12so that

it drops out of the incentive compatibility conditions. We can thus illustrate

our assumptions in the following table.

Good state Bad stateHigh type high cash �ow medium cash �owLow type medium cash �ow low cash �ow

Table 2: assumptions on cash �ow states

As in the previous section that describes the model with one �rm, all

equilibria are characterized by the fact that managers with high default al-

ways renegotiate whereas managers with no default always continue. Hence

equilibria must be distinguished by the action taken by managers experiencing

�nancial di¢ culties in a good state of the world and in a bad state.

1.5 Renegotiation in the model with two �rms 67

Again, we de�ne an equilibrium as a set of strategies (�g; �b), chosen by

managers with a medium level of default in a good and in a bad state, respec-

tively, with � 2 fR;Ag where � = R if the manager rejects renegotiation or� = A if he accepts. To illustrate the implications of the two managers model,

we �rst describe equilibrium (R;R) where managers experiencing �nancial dif-

�culties continue rather than renegotiate, when they are in a good state of the

world and when they are in a bad state. Second, we present equilibrium rene-

gotiation (A;A): Then, we provide an analysis of the conditions under which

the equilibria exist.

1.5.1 Equilibrium (R;R) for managers with a mediumlevel of default

We now derive the equilibrium that involves continuation of the initial

project and hence the non revelation of �nancial di¢ culties by managers ex-

periencing �nancial di¢ culties in each state of the world. All the reputation

terms are given in appendix 1.8.2.

Consider a good state of the world. In that case, the only manager

experiencing �nancial di¢ culties is a low type. The expected utility for a

�rm experiencing �nancial di¢ culties if the manager refuses to renegotiate

the terms of the loan contract is given by :

ULh (RjR;R) = y � d� (1� �)cH

+p[�p1h(Rj(R;R); q2h(R)) + (1� �)p1m(Rj(R;R); q2h(R))]

+(1� p)[�(�p1h(Rj(R;R); q2h(R)) + (1� �)p1h(Rj(R;R); q2m(R)))

+(1� �)(�p1m(Rj(R;R); q2h(R)) + (1� �)p1m(Rj(R;R); q2m(R)))]

68 Chapitre 1

Manager 1 does not know manager 2�s type. With probability p manager

2 will have no default (see table 2) and refuses the renegotiation o¤er, in which

case, the reputation terms for manager 1 are given by: p1h(Rj(R;R); q2h(R))and p1m(Rj(R;R); q2h(R)): With probability (1 � p) manager 2 will be lowtype and will have a medium level of default. In that case, the manager will

continue and hide �nancial di¢ culties with probability � or reveal the true

�nancial situation with probability (1� �):

The manager�s expected utility when he accepts the renegotiation o¤er

is given by:

ULh (AjR;R) = y � d+ f + p[p1m(Rj(R;R); q2h(R))]

+(1� p)[�p1m(Rj(R;R); q2h(R)) + (1� �)p1m(Rj(R;R); q2m(R)))]

p1m(Rj(R;R); q2h(R)) represents manager�s 1 updated reputation whenthe bank infers that manager 1 is a high type, given that he refuses to rene-

gotiate and given that manager 2 continues and reports no �nancial trouble.

We may now write the low type incentive compatible constraint in a good

state of the world. The low type will renegotiate rather than continue in a

good state of the world when:

(1� �)cH + f � p�[p1h; q2h � p1m; q2h]

+(1� p)�[�p1h; q2h + (1� �)p1h; q2m

��p1m; q2h + (1� �)p1m; q2m] (1.6)

1.5 Renegotiation in the model with two �rms 69

Consider now a bad state of the world. In that case, the only type

of interest is the high type. The expected utility if the manager refuses to

renegotiate is given by :

UHb (RjR;R) = y � d� (1� �)cH

+p[�(�p1h(Rj(R;R); q2h(R)) + (1� �)p1h(Rj(R;R); q2m(R)))

+(1� �)(�p1m(Rj(R;R); q2h(R)) + (1� �)p1m(Rj(R;R); q2m(R)))]

+(1� p)[1� �cH ]

With probability p manager 2 is a high type hence, has a medium level of

default (see table 2) and continues. In that case, manager 2 succeeds in hiding

�nancial di¢ culties with probability � or reveal the true �nancial situation

with probability (1��):With probability (1� p) manager 2 is a low type andhas low cash �ows. In that case, the bank infers that the state of the world is

bad and hence that manager 1 is a high type. Consequently, the bank knows

that manager 1 tried to hide the �rm�s �nancial di¢ culties and imposes a cost

cH on him.

The manager�s expected utility when he accepts the renegotiation o¤er

is given by:

UHb (AjR;R) = y � d+ f

+p[�p1m(Aj(R;R); q2h(R)) + (1� �)p1m(Aj(R;A); q2m(R))]

+(1� p)

70 Chapitre 1

We may write the high type incentive compatible constraint in a bad

state of the world as:

(1� �)cH + f � p�[�(p1h; q2h � p1m; q2h)

+(1� �)(p1h; q2m � p1m; q2m)]

�(1� p)�cH (1.7)

A necessary condition for the continuation equilibrium (R;R) to exist is

that the RHS of each incentive compatibility constraint is positive. However,

given our assumptions on defaults, there exist parameter values for with the

RHS of at least one of the IC constraints is negative. In other words, for

certain combinations of q a manager�s reputation is lower when he continues

and reports no �nancial di¢ culties than when he negotiates the term of the

loan or when he refuses to renegotiate while reports medium level of default.

To understand why a manager�s reputation may be higher when he re-

veals �nancial di¢ culties than when he refuses to renegotiate and reports no

�nancial troubles, it is necessary to look back at our assumptions on defaults.

More speci�cally, in a bad state of the world all �rms are in �nancial distress,

but only the high type has a medium level of default. Hence, if the bank�s

prior q regarding a bad state of the world is high enough, then revealing a

medium level of default signals good news about the manager�s type. In that

case, high types may be willing to renegotiate rather than hide the �rm�s �-

nancial distress when they are in a bad state of the world. A higher reputation

associated with revelation rather than non revelation of distress by high-type

managers in bad states is supported by evidence whereby the healthier �rms

are the �rst to reveal �nancial di¢ culties during a bad state. Managers im-

prove their reputation for making the correct restructuring decision in doing

so.25

25 For example, Bhattacharya and Ritter (1983) show that �rms use disclosure to signal

1.5 Renegotiation in the model with two �rms 71

1.5.2 Equilibrium (A,A) for managers with a mediumlevel of default

We now turn to equilibrium (A;A) in the model with two �rms, which

involves renegotiation of the initial project and hence the revelation of �nancial

di¢ culties by managers experiencing �nancial di¢ culties.

Consider a good state of the world. In that case, the only manager

experiencing �nancial di¢ culties is a low type. The expected utility for the

manager who negotiates is given by :

ULh (A) = y � d+ f + pp1m(Aj(A;A); q2h(R))

+(1� p)p1m(Aj(A;A); q2m(A))

With probability pmanager 2 has no default and refuses the renegotiation o¤er.

Hence, the bank infers that the state is good. When manager 1 renegotiates

and reports a medium level of default, the bank knows that the manager is a

low type and assigns a value of zero to p1m(Aj(A;A); q2h(R)):With probability(1 � p) manager 2 will be low type hence, has a medium level of default and

thus renegotiates. In that case, manager 1�s updated reputation is given by

p1m(Aj(A;A); q2m(A)):

The expected utility for a �rm experiencing �nancial di¢ culties if the

manager continues is given by the following equation.

information about their quality to the markets. The literature that addresses the issue ofhow �rms signal the net value of their anticipated "growth opportunities" includes Yosha(1995), Detragiache (1994), Grossman and Hart(1980), Jovanovic (1982), and Boot andThakor (2001).

72 Chapitre 1

ULh (R) = y � d� (1� �)cH

+p[�p1h(Rj(A;A); q2h(R)) + (1� �)p1m(Rj(A;A); q2h(R))]

+(1� p)[�p1h(Rj(A;A); q2m(A)) + (1� �)p1m(Rj(A;A); q2m(A))]

We may now write the incentive compatible constraint in a good state of

the world. The low type will renegotiate rather than continue in a good state

when:

(1��)cH+f � �p1h(Rj(A;A); q2h(R))�(1�p)�p1m(Rj(A;A); q2m(A)) (1.8)

Consider now a bad state of the world. In that case, the only type of

interest is the high type. The manager�s expected utility when he accepts the

renegotiation o¤er is given by:

UHb (A) = y � d+ f + p[p1m(Aj(A;A); q2m(A))] + (1� p)

The expected utility for a �rm experiencing �nancial di¢ culties if the

manager refuses to renegotiate the terms of the loan contract is given by :

UHb (R) = y � d� (1� �)cH

+p[�p1h(Rj(A;A); q2m(A)) + (1� �)p1m(Rj(A;A); q2m(A))]

+(1� p)[1� �cH ]

We may write the high type incentive compatible constraint in a bad

state of the world as:

(1� �)cH + f � p[�p1h(Rj(A;A); q2m(A)) + (1� �)(p1m(Rj(A;A); q2m(A))]

�(1� p)�cH (1.9)

1.5 Renegotiation in the model with two �rms 73

A necessary condition for equilibrium (A;A) where managers experienc-

ing �nancial di¢ culties continue, to exist is that the RHS of each incentive

compatibility constraint is positive. We now present the conditions under

which this would hold.

1.5.3 Analysis of the equilibria (R;R) and (A;A) in themodel with two �rms

We describe the pure strategy equilibria (R;R) and (A;A) in the model

with two �rms. Recall from previous section that we look at parameter val-

ues for which the RHS of the incentive compatible constraints in the (R;R)

equilibrium are positive.

Note that in contrast to the model with one �rm, the incentive com-

patibility conditions associated with a given strategy are not identical across

states of the world. This is due to the fact that manager 2�s expected �nan-

cial situation enters into the reputation terms for manager 1, and manager

2�s expected situation depends on the state of the world. Hence, manager 1�s

optimal strategy is indirectly a function of the state of the world, and two

incentive compatibility constraints must be satis�ed for each equilibrium to

exist.

Proposition 5 There exist critical values crr and caa, with caa > crr, such

that an equilibrium (R;R) exists if crr > 0 and (1��)cH + f � crr: Moreover,an equilibrium (A;A) exists if (1� �)cH + f � caa:

Proof. See Appendix 1.8.3.

The description of equilibria (R;R) and (A;A) is similar to that for the

model with one �rm.

74 Chapitre 1

However, the main di¤erence is that in the model with two �rms, the

critical value crr is the minimum of the critical values implied by each of

the incentive compatibility conditions for the equilibrium continuation (R;R).

Similarly, the critical value caa is the maximum of the critical values implied by

each of the incentive compatibility conditions for the equilibrium renegotiation

(A;A).

1.6 The bank�s optimal renegotiation o¤er

In this section, we discuss the optimal renegotiation plan and explore the

conditions underlying the renegotiation o¤er by the bank taking into account

the managers�reputational concerns. The parameters identi�ed in the previous

sections that in�uence managers�willingness to engage in a renegotiation are

the state of the world, the amount of new money following the renegotiation,

the expected costs of hiding default, and the reputation formed in the market.

Let �cH be the maximum feasible value of cH which is the cost associated

with hiding default supported by the manager. The maximum level of cH can

vary across countries and depends on regulatory institutions that deal with

distressed �rms. It may also exist some limits on the maximum amount of

new money f , which we will denote by �f: We have the following proposition.

Proposition 6 The bank will choose cH = �cH in any renegotiation process.

Proof. Note that imposing a cost cH has no e¤ect on the bank�s cost

function. Hence, the bank will always choose the maximum level of �cH . If �cH

is su¢ ciently high to induce managers to accept the renegotiation o¤er with

certainty, hence inducing equilibrium (A;A) to exist, then the bank will o¤er

a renegotiation process with only small amount of new loans f .

1.6 The bank�s optimal renegotiation o¤er 75

On the contrary, if �cH is su¢ ciently low to encourage managers to reject

the renegotiation, then the bank must o¤er a larger amount of new money f

to induce the manager to consider the renegotiation o¤er.

We consider now the minimum level of new money fA to induce managers

to renegotiate with certainty. We thus state the following proposition.

Proposition 7 Let fA = cA � (1 � �)cH . Equilibrium (A;A) exists for all

f � fA:

Proof. This proposition states that for every value of � there is a minimum

amount of new money fA such that the bank can always induce managers to

renegotiate the loan contract. From equation (1.2), we have (1��)cH+f � cA,and using the above proposition we get f � fA. Hence, an unconstrained

bank in the amount of new money can always induce managers to accept

renegotiation and revelation of �nancial di¢ culties. This minimum amount

necessary to induce renegotiation increases in �:Given that � is a parameter for

supervision, the weaker the level of bank monitoring, the greater the amount

of new money necessary to induce managers to renegotiate.

This proposition illustrates that renegotiation can compensate managers

for the negative reputational e¤ect of revealing �nancial di¢ culties and induce

them to accept a reorganization process. However, the amount of new money

necessary to induce the correct liquidation decision may exceed the amount

necessary to restore �rms�solvency. We denote by �fA the minimum amount of

new money when cost of hiding default is limited. �fA is equal to zero if �cH is

su¢ ciently high to induce the manager to reveal �nancial di¢ culties. Finally,

we de�ne fR = cR � (1 � �)cH as the maximum amount of new money such

that the bank can induce managers to systematically reject the renegotiation

o¤er.

76 Chapitre 1

Using equation (1.1), we have (1��)cH+f � cR, and from the above de-�nition we get f � fR: Hence, fR is the maximum amount of new money suchthat equilibrium (R;R) exists with certainty. Similarly, we denote �fR as the

maximum amount of new money to induce managers to reject renegotiation,

using the constrained cost of hiding default, �cH : We thus state the following

proposition.

Proposition 8 Let f � be the optimal amount of new money consecutive to

a renegotiation. Then, �fR � f � � �fA, with f � = �fA when banks want the

manager to renegotiate with certainty.

Proof. The proposition states that the bank o¤ers renegotiation with an

amount of max[0; �fR], since otherwise the o¤er would be rejected. This also

implies that if the bank is constrained in the amount of new money and if

�f � fR then no renegotiation will occur. Similarly, the bank never o¤ers anamount exceeding �fA, given that such a new loan would induce renegotiation

acceptance with certainty. If the bank wants to induce equilibrium (A;A),

where managers renegotiate, then she must o¤er exactly fA: The optimal

amount of new money consecutive to a renegotiation will be the value f � in

the range �fR � f � � �fA which maximizes the bank�s expected utility.

In summary, when the bank takes into account managers�reputational

concerns, the optimal restructuring plan will involve imposition of the max-

imum feasible value of the cost, cH imposed on dishonest managers that re-

ject the renegotiation o¤er then report �nancial di¢ culties. In addition, the

amount of newmoney, f consecutive to a renegotiation o¤er may be low enough

so that with positive probability the renegotiation plan will be rejected. Man-

agers�reputational concerns can result in the equilibrium rejection of optimal

recapitalization plans.

1.7 Conclusion 77

1.7 Conclusion

The theory presented in this chapter models managers�behaviors during

�nancial distress when asymmetric information exists between creditors and

managers regarding the �rm�s viability. We show that the uncertainty about

a �rm�s future prospects creates incentives for �nancially distressed �rms to

disguise the true �rm�s �nancial state and to postpone their liquidation deci-

sion. Although a bank may induce managers to forgo misreporting by o¤ering

a �exible reorganization plan, managers� reputational concerns may involve

rejection of the renegotiation o¤er and continuation of ine¢ cient �rms.

Banks may be incline to o¤er greater concessions in order to induce

�nancially distressed �rms to accept renegotiation and to reveal �nancial dif-

�culties. More speci�cally, the amounts of new money necessary to induce the

correct liquidation decision may exceed the amount necessary to restore �rms�

solvency. This additional amount aims at compensating managers for the rep-

utation harm following the revelation of �nancial di¢ culties consecutive to a

�nancial distress process. If banks are constrained in the amount of new money

consecutive to a renegotiation, they might be unable to induce managers to re-

veal �nancial distress, such that the liquidation decision is postponed leading

to an ine¢ cient continuation of investments.

An implication of our analysis is that the optimal renegotiation o¤er

imposes a cost on managers that reject reorganization o¤ers and then postpone

liquidation process. By committing to impose a punishment on �rms which

reject the renegotiation o¤er and then are caught cheating about their �nancial

shape, banks can induce managers to accept reorganization plan with small

amounts of new money. If the cost of hiding default is high enough, banks

can induce �rms to renegotiate with only negligible amount of new money.

This result shows the informational role played by banks�renegotiation plans

in our model. The bank�s renegotiation o¤er forces the �nancially distressed

78 Chapitre 1

�rms to reveal their �nancial di¢ culties. Alternatively, the manager�s choice

to continue or renegotiate the contract conveys information about the �rm�s

�nancial situation (the state of nature) and the �rm�s type.

Yet, we show that in equilibrium, managers may still decide to reject the

renegotiation o¤er. Even when banks take managers�reputational concerns

into account when o¤ering a reorganization plan, rejection of the plan may

occur in equilibrium. In particular, we show that a combination of factors, in-

cluding the quality of bank monitoring and managers�reputational concerns,

can explain the reluctance of managers to accept a renegotiation. A large

strand of the literature has interpreted the managers�leaning toward continu-

ation rather than liquidation as a consequence of ine¢ ciencies in the �nancial

process arising from the di¢ culties that creditors have in implementing the

correct liquidation and investments decisions. These di¢ culties may stem, for

instance, from coordination problems among many small creditors and di¤er-

ent priority groups of creditors (Gertner and Scharfstein (1991) and Aggarwal

(1995). Alternatively, Kahl (2002) suggests that the long-term nature of �-

nancial distress is a by-product of an e¢ cient resolution of �nancial distress.

Creditors may postpone their liquidation decision to learn more about the

distressed �rm�s viability and base a �nal liquidation decision on better in-

formation. In contrast to these models, our theory emphasizes that managers

care about their reputation which a¤ects their future access to the credit mar-

ket and job market. It can explain the reluctance to reveal the �rm�s �nancial

di¢ culties and to accept a renegotiation as the result of uncertainty about the

stigma associated with �nancial distress. The stigma of default in�uences not

only the decision to terminate a project, but also the choice of projects and the

decision to reveal default. This implies that continuation versus liquidation

decisions, and investment decisions are a¤ected by the degree of uncertainty

about a �rm�s future prospects.

1.8 Appendix 79

1.8 Appendix

1.8.1 Reputational terms in the model with one �rm

Reputation terms for equilibrium (R;R)

ph(RjR;R; q) represents the manager�s updated reputation when he re-jects renegotiation, given that the bank expects �rms in �nancial distress in

each state of the world to reject renegotiation.

ph(RjR;R; q) = p[(1� q) + q�]p[(1� q) + q�] + (1� p)(1� q)�

and, pm(RjR;R; q) represents the manager�s reputation when he rejectsrenegotiation and reports a medium level of default.

pm(RjR;R; q) = pq(1� �)pq(1� �) + (1� p)(1� �)(1� q)

Reputation terms for equilibrium (A;A)

ph(RjA;A; 0) represents the manager�s reputation when he continues andreports no loan default given that the bank expects �rms in �nancial di¢ culties

in each state of the world to renegotiate. Consequently, the bank believes that

the state of the world is good and sets q = 0.

ph(RjA;A; 0) = p

p+ (1� p)�

and, pm(AjA;A; q) represents the reputation for a manager when thebank infers that the manager renegotiates given a default and a bad state.

pm(AjA;A; q) = pq

pq + (1� p)(1� q)

80 Chapitre 1

Reputation terms for equilibrium (R;A)

ph(RjR;A; 0) is the manager�s reputation when he continues and reportsno default such that the bank infers that the state is good and sets q = 0.

Replacing q by its value in the corresponding reputation terms, we get:

ph(RjR;A; 0) =p[(1� q) + q�]

p[(1� q) + q�] + (1� p)(1� q)�=

p

p+ (1� p)�

pm(RjR;A; 0) represents the manager�s reputation when he continuesand reports a medium level of default.

pm(RjR;A; 0) = 0

pm(AjR;A; 1) represents the manager�s reputation when he renegotiatesand reports a medium level of default. The bank assumes that the state is bad

and sets q = 1:

pm(AjR;A; 1) = 1

1.8 Appendix 81

Reputation terms for equilibrium (A;R)

The reputation terms are given by: pm(RjR;A; 0) represents the man-ager�s reputation when the manager agrees to renegotiate. Then, the bank

believes that the state of the world is good and sets q = 0.

pm(RjA;R; 0) = 0

and, ph(RjA;R; q) represents the manager�s reputation when the man-ager refuses the renegotiation o¤er and reports high cash �ow state.

ph(RjA;R; q) = 1

and, pm(RjA;R; 1) represents the manager�s reputation when he rejectsthe o¤er then reports a default. In that case, the bank infers that the state is

bad and sets q = 1:

pm(RjA;R; 1) = 1

82 Chapitre 1

1.8.2 Reputational terms in the model with two �rms

Reputation terms for equilibrium (R;R)

p1h(Rj(R;R); q2h(R)) represents manager�s 1 updated reputation whenhe continues and reports no default, given that the bank expects managers to

follow strategies corresponding to (R;R), and given that manager 2 has no

default and refuses to renegotiate as well.

p1h(Rj(R;R); q2h(R)) = p(1� q)[p+ (1� p)�] + pqp�2

(1� q)[p+ (1� p)�2] + pqp�2

The term p1m(Rj(R;R); q2h(R)) represents manager�s 1 updated reputa-tion when he refuses to renegotiate the terms of the loan but his attempt to

hide �nancial di¢ culties fails, given that manager 2 reports no default and

continues.

p1m(Rj(R;R); q2h(R)) = p2q�

p2q�+ (1� p)(1� �)[p+ (1� p)�]

p1h(Rj(R;R); q2m(R)) represents manager�s 1 updated reputation whenhe continues and reports high cash �ows, given that manager 2 reports medium

current cash �ows and refuses to renegotiate as well.

p1h(Rj(R;R); q2m(R)) = p(1� q)(1� p) + pqp�[p+ (1� p)�](1� q)(1� p) + pqp�

1.8 Appendix 83

p1m(Rj(R;R); q2m(R)) represents manager�s 1 updated reputation whenhe refuses to renegotiate the terms of the loan but his attempt to hide �nancial

di¢ culties fails, given that manager 2 reports medium current cash �ows and

continues.

p1m(Rj(R;R); q2m(R)) = p2q

p2q + (1� p)2(1� �)2

Reputation terms for equilibrium (A;A)

The bank knows that the state is good when a manager continues. There-

fore, when manager 1 renegotiates and reports a medium level of default, the

bank infers that the manager is a low type and assigns a value of zero to the

reputation term. The reputation terms for manager 1 are given by:

p1m(Aj(A;A); q2h(R)) = 0

The term p1m(Aj(A;A); q2m(A)) represents manager�s 1 updated reputa-tion when he negotiates and reports a medium level of default, given that the

bank expects managers to follow strategies corresponding to (A;A), and given

that manager 2 has a medium level of default and negotiates as well.

p1m(Aj(A;A); q2m(A)) = p2q

p2q + (1� p)2(1� �)2

84 Chapitre 1

When the bank observes that both managers continue while one of them

reports a medium level of default, the bank assumes that the state of the world

is good. Thus, when manager 1 continues, the bank knows that the manager

is a low type and assigns a value of zero to the reputation term.

p1m(Rj(A;A); q2h(R)) = 0

The term p1h(Rj(A;A); q2h(R)) represents manager�s 1 updated repu-tation when he continues and reports high cash �ows, given that the bank

expects managers to follow strategies corresponding to (A;A), and given that

manager 2 has high current cash �ows and refuses to renegotiate as well. Note

that the bank assumes that the state is good.

p1h(Rj(A;A); q2h(R)) = p1h(Rj(A;A); q2m(A))

= 1

1.8 Appendix 85

1.8.3 Proofs

Proof of Lemma 2

Consider a manager with a high level of default. This manager can not

hide his loan defaults by assumption (1), that is for him: � = 0:

If the manager with a high level of default in the bad state of the world

accepts to renegotiate the loan, his expected utility is:

U(A) = (1� )(f � d) + pl(A)

The expected utility is equal to the additional new money, f following

a renegotiation minus the initial debt due at date 1, d. When the manager

agrees to renegotiate the terms of the loan, he reveals his level of loan default.

Doing so signals the manager�s type to the bank who thus assigns a value of

zero to the managers�reputation.

If the manager with low cash �ows decides to reject renegotiation and

continues the initial project, his expected utility is:

U(R) = (1� )(�d� cH) + pl(R)

where cH is the cost of hiding loan defaults supported by the manager.

By assumption (1), again the manager�s reputation is zero. Since the expected

utility from renegotiating the terms of the loan is greater than the expected

utility from continuing, U(A) > U(R), the low-ability manager will never

choose to continue his initial project when cash �ow state is low. In addition,

the manager with no default will always continue his initial project, since he

is in a good state and has no default.

86 Chapitre 1

Proof of Proposition 6

Equilibrium (R;R)

De�ne the RHS of the two manager�s incentive compatible constraints

(8) and (9) as c7r and c8r, respectively;

(1� �)cH + f � c7r

(1� �)cH + f � c8r

De�ne crr = min[c7r; c8r]: Let the critical value crr be the minimum of

the critical values implied by each of the incentive compatibility conditions for

the continuation equilibrium (R;R). Then necessary and su¢ cient conditions

for the continuation equilibrium (R;R) to exist are: (1) crr > 0 and (2) (1 ��)cH + f � crr:

Equilibrium (A;A)

De�ne the RHS of the two manager�s incentive compatible constraints

(10) and (11) as c9a and c10a, respectively;

(1� �)cH + f � c9a

(1� �)cH + f � c10a

De�ne caa = max[c9a; c10a]: Let the critical value caa be the maximum of

the critical values implied by each of the incentive compatibility conditions for

the renegotiation equilibrium (A;A). Then a necessary and su¢ cient condition

for the renegotiation equilibrium (A;A) to exist is: (1� �)cH + f � caa: