Debt-to-equity conversion is a commonly used legal tool for financial restructuring of ailing businesses, yet systematic evidence on the consequences of debt-to-equity conversion for firm outcomes is scarce. Drawing on a novel dataset of bankruptcy reorganizations from Slovenia and exploiting variation in the incidence of debt-to-equity conversion across firms, we provide the first empirical analysis of the role of debt-to-equity conversion in bankruptcy reorganization as a determinant of post-bankruptcy firm survival. To address endogeneity concerns, we use a plethora of controls and fixed effects, quantify the sensitivity of our estimates to selection on unobservables, and rely on instrumental variable methods. We find that debt-to-equity conversion is robustly negatively associated with prospects of post-bankruptcy firm failure. Our findings provide a novel input into ongoing debates about the appropriate design of corporate bankruptcy institutions.

Introduction

Debt-to-equity conversion (DEC, in short) is a frequently utilized legal tool for alleviation of financial distress of firms nearing or experiencing insolvency (see, e.g., Chatterji and Hedges, 2001; Gilson et al., 1990; Gilson, 1990; James, 1995). From the creditors’ standpoint, DEC is often an attractive mode of debtor’s financial restructuring. Without DEC, creditors can often hope to recover only a small fraction of their claims. By reducing the company’s overall debt burden, DEC increases the prospects of claim recovery, even for creditors who choose not to take part in DEC. DEC further allows creditors to obtain control over the ailing business. DEC thereby provides creditors with the upside that the business will recover and that the value of their equity will grow. Institutionally, DEC can take place either during out-of-court financial restructuring or, when enabled by the legislative framework, within in-court bankruptcy reorganization proceedings. Empirical evidence on the effect of DEC on the performance of financially restructured business, however, is scant. Especially little is known about the consequences of bankruptcy-based DEC for post-bankruptcy firm outcomes. The corresponding lack of empirical evidence is unsettling because DEC has been routinely considered, or even advocated, as a mechanism of corporate bankruptcy resolution (Claessens et al., 2001; Hart, 2006; Laryea, 2010; Eric´ and Stosiˇ c, ´ ۲۰۱۵). In theory, DEC is expected to aid post-bankruptcy firm performance for two primary reasons. By lessening the debtor’s debt burden without an accompanying decrease in the firm’s assets, DEC instantaneously strengthens the firm’s balance sheet. An improved debt-to-equity ratio in turn enhances the firm’s borrowing position as well as the firm’s status vis-à-vis the customers, suppliers, and other business partners. In addition, by changing the firm’s ownership structure, DEC holds potential to improve decision-making at a critical juncture for the struggling business. Yet at the same time, DEC is not a guarantee that the business will succeed ex post. The firm’s new owners (creditors who opted for DEC) may come in conflict with the old owners or management, or continue to repeat errors that possibly contributed to the firm’s pre-bankruptcy turmoil.