Financial Distress and Investment

One of my favorite articles  about the costs of bankruptcy is by David Cutler and Larry Summers (yes, that Larry Summers). Here is the abstract of the article:

Since 1984, Texaco and Pennzoil have been engaged in a legal battle over Texaco's usurpation of Pennzoil in the takeover of the Getty Oil Company. The stakes are huge: the jury award that has been upheld through several appeals calls for Texaco to pay Pennzoil more than $10 billion. The Texaco-Pennzoil case presents a unique natural experiment for studying debt burdens and bargaining costs. Essentially continuous market assessments of the prospects of both parties in a high stakes bargaining game are rarely as observable as they are in the case of publicly traded companies like Texaco and Pennzoil. Further, unlike in the Texaco case, financial distress is usually brought on by events impinging directly on a firm's operations, thus making the costs of distress difficult to measure.

This paper uses data on the abnormal returns earned by the shareholders of Texaco and Pennzoil to examine whether resources were "lost" in the course of the litigation. We find that the leakage involved in the forced transfer is enormous: each dollar of value lost by Texaco's shareholders has been matched by only about 30 cents gain to the owners of Pennzoil. Our estimates suggest that the Texaco-Pennzoil conflict has reduced the combined equity value of the two companies by about $2 billion. Further losses have been suffered by Texaco's bondholders, though these may be offset by the tax collections that would result if Texaco made a large payment to Pennzoil.
After documenting the large joint losses that Texaco and Pennzoil have suffered, we seek to identify their causes. Clearly one explanation is the fees that both companies will pay to the many lawyers, investment bankers, and advisors that have been retained. Even making generous allowance for these costs, however, we are unable to account for a large fraction of the loss in combined value. It appears that there have been additional costs to Texaco's shareholders from disruptions in Texaco's operations, difficulties in obtaining credit, incentive problems created by fears that Texaco would cease operations, and distraction of top management. 

(Note-- I'm biased in favor of this article--I've used the methodology first employed by Cutler and Summers to examine the efficiency of specific performance ). 

The argument that "difficulties in obtaining credit, incentive problems created by fears that Texaco would cease operations, and distraction of top management." hurt value is reasonable, but the paper doesn't provide much evidence of this. This has always bothered me. Today, I'll search for some evidence that fits in with a long finance literature on the impacts of the impacts of financing contstraints on investment.  One way the difficulties caused by the verdict might have killed value is by limiting investment. If Texaco's managers were distracted and Texaco's access to outside credit was limited, then we'd expect its investment to go down. If Texaco is passing up good investment opportunities because of the litigation, then this is a real cost of the litigation that might explain the drop in combined value of Texaco and Pennzoil.

So did investment at Texaco go down?

To answer this, I took a look at capital expenditure rates at Texaco and other oil companies (in the same NAICS code) between 1980 and 1994. I'll use a basic differences-in-differences  framework:

Inv(year i,company t)=a+b*Texaco_dummy+c*post_trial_dummy +d*Texaco_dummy*post_trial_dummy+error term

The key coefficient is d, whether or not something special happened to Texaco's investment after the  post trial verdict. Note that the investment variable is scaled by the size of the company to allow for comparison.

The results are inconclusive-- not surprising when there is only one variable receiving the treatment.  Texaco's investment indeed went down after 1984-1985. In 1980-1983, Texaco's capital expenditures equalled around 11% of gross PPE. In 1986-88 (the initial verdict was in late 1985), Texaco's capital expenditures went down to around 5.5% of hard assets. It sound like a big decline, confirming the Cutler-Summers speculation. The problem is that the capital expenditures of other oil companies went down even more, from around 15% of gross PPE in 80-83, to around 8% of gross PPE in 86-88.

The estimate of d is actually positive (around .01)-- Texaco's investment went down less than other company's investment after the verdict-- but the coefficient is nowhere near significant.

If the verdict had a bad effect on Texaco's capital expenditures, we can't find that effect in the midst of the heavy decline in investment for all oil companies during the period. Cutler and Summers' speculation about the cause of the value decline for Texaco remains speculation.

 

Comments

[Finance Dissertation]

well its soo good to see this information in your post, i was looking the same but there was not any proper resource, thanx now i have the thing which i was looking for my research.

[Mike Guttentag]

To show my lack of knowledge publicly in case others are in the same boat, I am wondering about the difference between a difference-of-difference analysis and what would be called an interaction effect by a social scientist. Your specification above of the coefficient d looks to me like what I would call a measure of an interaction effect.