Reorganization strategies and securities valuation under asymmetric information

This paper examines optimal reorganization strategies during financial distress and securities valuation under asymmetric information. We model strategic interactions between debtholders and equityholders in a game-theoretic setting that can accommodate the varying bargaining powers of the two claimants. Two reorganization strategies are considered: Chapter 11 (debt-equity swap) and private workout (strategic debt service). Using Chapter 11 as a costly state verification device, we characterize in equilibrium which firms choose Chapter 11 and which choose private workout. In particular, we show how the bank's belief about the type of firm evolves by observation of reorganization strategies. We also derive closed-form solutions to both the equity and debt valuation problems under asymmetric information and show that credit spreads increase with the degrees of asymmetric information.