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{Journals}acfi/40_3/z124/makeup/z124.3d Accounting and Finance 40 (2000) 233± 260 Financial distress, reorganization and corporate performance James Routledge a, David Gadenne b b a Faculty of Business, University of the Sunshine Coast, Queensland 4556, Australia Faculty of Business and Law, Central Queensland University, Queensland 4702, Australia Abstract Prospects for financially distressed companies in Australia have improved since the introduction of voluntary administration (VA) as an alternative to liquidation. This paper investigates whether companies that reorganise can be distinguished from those that liquidate under VA. In addition, performance of reorganised companies is examined to determine variables that distinguish `successful' from `unsuccessful' reorganisations. Significant variables in the logistic regression models developed differ between the analyses. The results of the analyses have implications for policy makers regarding efficiency of the VA procedure, as it appears the reorganisation decision is biased toward permitting inefficient firms to reorganise. Key words: Voluntary Administration; Reorganisation theory; Liquidation; Corporate performance JEL classification: M41; G33 1. Introduction Before the introduction of voluntary administration (VA), Australia's insolvency law offered little chance for distressed companies to reorganise their affairs. The new law provides distressed companies with a relatively simple, inexpensive and flexible procedure for addressing their problems (Keay, 1996). Accordingly, many companies choose VA to deal with financial distress. Over the first four years of operation (July1993 to June 1997) 5760 companies entered VA; during the 1996 ± 1997 financial year, 1764 companies appointed an administrator (Australian Securities and Investments CommisThe authors would like to thank Margaret Abernethy (Editor), delegates from the 1999 AAANZ conference, accounting staff at QUT, Donald Stokes (Associate Editor) and two anonymous referees for their helpful comments and constructive advice. # AAANZ, 2000. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF and 350 Main Street, Malden MA 02148, USA. {Journals}acfi/40_3/z124/makeup/z124.3d 234 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 sion (ASIC) 1998). Growth in use of VA presents significant opportunities and challenges for accounting professionals, and it is important that accountants understand the operation of the legislation and its suitability for particular clients. For example, timely recommendation to initiate VA by professional accountants may provide the company and its officers with important advantages as the company attempts to formulate a plan for its survival (Crutchfield, 1994). Moreover, distressed firms that reorganise will likely require continued professional assistance. Therefore, decision making associated with the operation of VA has become increasingly important. There is continuing interest in the development and refining of financial distress prediction models. Introduction of reorganisation legislation in Australia has provided an opportunity to develop and refine understanding of the reorganisation decision process for distressed companies. Accordingly, this paper adds to the scarce research in this area by developing a model of the reorganisation decision under VA. The model examines the explanatory power of historical accounting information in distinguishing Australian companies that reorganise from those that liquidate. A further contribution of this paper is its reference to reorganisation theory in model development. Prior studies in other jurisdictions have demonstrated the usefulness of coalition behaviour theory as a means of determining outcomes of financial distress decisions. The coalition behaviour theory is drawn upon in selection of predictor variables for the models developed, in addition to providing a reference to assist with understanding the reorganisation decision process. With the widespread use of VA, creditors are more often faced with a decision as to whether they should support a company's reorganisation. In making their decision regarding the company's prospects, creditors will probably rely on the recommendation of the insolvency accountant appointed as administrator. The insolvency accountant is required to assess the position of the company and recommend a suitable outcome within a short time frame. 1 Decisions by creditors and administrators may often be made without substantial or reliable information as to the company's future prospects. The quality of these decisions will affect the efficiency of the legislation's operation. Insolvency law provides an important filtering mechanism by providing the opportunity for inefficient firms to be liquidated. Accordingly, where insolvency legislation provides firms with the opportunity for reorganisation as an alternative to liquidation it should be designed to ensure that only efficient firms reorganise. This allows valuable resources to move to their highest value use (White, 1994). In order to inform future decisions made in VA, a second model developed in this paper examines the explanatory power of historical accounting information in determining whether a company will successfully reorganise. 1 See section 438A of The Corporations Law (Cth). # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 235 2. Part 5.3A (Voluntary Administration)Ð an overview The voluntary administration procedure was introduced as part of Australia's corporate insolvency regime in June 1993. The new legislation resulted from the Australian Law Reform Commission's General Insolvency Inquiry (1988) (Report No 45, the `Harmer Report'). The Commission recommended change to Australian insolvency law because of concern that there was: `little emphasis upon or encouragement of a constructive approach to corporate insolvency by, for example, focusing on the possibility of saving a business (as distinct from the company itself) and preserving employment prospects'. (Harmer Report, par. 53). The Explanatory Memorandum to the Corporate Law Reform Bill (1992, par. 448) observed that liquidation was frequently embraced by companies which could have continued trading and which may well have ultimately survived. Prior to the implementation of Part 5.3A, an insolvent company had few viable options other than proceeding with winding up. The company could attempt to institute a scheme of arrangement under Section 411 of the Corporations Law as an alternative to winding up. However, this provision was rarely used due to the time and cost involved in obtaining the necessary court approvals and meeting onerous requirements for scheme ratification (Crutchfield, 1994). Alternatively, the company could appoint an official manager if the company was certain to repay all creditors in full, which was an unlikely prospect for most distressed companies. The primary purpose of Part 5.3A is to provide a flexible and relatively inexpensive procedure in which a company can attempt to formulate an arrangement with its creditors. The objectives of administration are to save the company's business or, if this is not possible, to improve the return to creditors that would have resulted from an immediate winding up of the company. 2 Central to the operation of the legislation is protection of the company's property during the administration under the moratorium provisions. 3 The moratorium prevents action by creditors against the company or its property during the period of the administration. During the moratorium period, the appointed administrator is to investigate the company's affairs and formulate a proposal for a compromise arrangement with creditors, which may include a reorganisation plan, or alternatively recommend liquidation. 2 The objectives are outlined in s 435A of The Corporations Law (Cth). 3 Contained in Division 6 of Part 5.3A of The Corporations Law (Cth). # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 236 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 The decision as to whether a reorganisation plan will be accepted is made by a meeting of creditors. If creditors vote to approve reorganisation, the company will enter into a deed of company arrangement. The deed of arrangement is binding for the company and supporting creditors until its terms are completed, or until the company fails to comply with its provisions and winding up results. 3. Prior research and theoretical propositions In model development, this paper draws on prior literature relating to the coalition behaviour theory of the choice made by stakeholders regarding the future of a firm in financial distress. In prior financial distress studies model development is characterised by a lack of theoretical underpinning (Zavgren, 1983). This approach has been criticised as, in the absence of theory, the results do not permit generalisation, and a sustained correlation between variables and the event predicted cannot be expected (Ball and Foster, 1982; Blum, 1974). In this study, we attempt to overcome this problem by drawing on coalition behaviour theory and findings from other prior reorganisation studies in model development. 3.1. Theoretical model Ðcoalition behaviour Bulow and Shoven (1978) first applied coalition behaviour theory to determine whether a firm would continue or liquidate under the United States bankruptcy regime. They considered in their model three claimants to the cash flows and assets of the firm: bondholders, bank lenders and equity. The coalition that they described as driving decision making comprised the bank (lender) and equity. The key assumptions of the theory's operation in their analysis were (1) that the bank and equity holders have the bankruptcy decision power, and (2) that these stakeholders act in their own joint interests without considering the outcome for other claimants. Using coalition behaviour theory, Bulow and Shoven were able to establish the precise conditions under which bankruptcy would occur. The work of Bulow and Shoven (1978) demonstrated how financial distress decisions could be parsimoniously modelled by examining coalition behaviour. The simplicity of the theory allows its application to be extended to other financial distress decisions. Application of the model requires consideration of (1) parties that could form coalitions, (2) identifying the coalitions that might form to drive decision making, and (3) considering the decision that the coalitions would arrive at Ð based on the theory's key assumption of selfinterested behaviour. # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 237 White (1980, 1984, 1989) later applied coalition theory to investigate decision making under the United States Chapter 11 reorganisation procedure. 4 The coalition behaviour approach, and particularly White's discussion of its application to firm reorganisation decisions, has since been used in development of reorganisation prediction models. 5 The model presented by White (1984, 1989) of the United States Chapter 11 bankruptcy reorganisation procedure assumed that a subset of interested parties, a coalition, controls the behaviour of the distressed firm. The coalition assumption operates when the firm is failing; that is, when the firm has insufficient assets to meet obligations due in the current period, and, to avoid bankruptcy, the firm must obtain new finance. White showed that the decision to reorganise or liquidate will be made by coalitions of equity holders (with management as assumed agent), (secured) lenders and unsecured creditors. She further suggested that the coalition would most often be comprised of equity holders and some particular group of creditors. Importantly, White (1984, 1989) demonstrated that the choice between reorganisation and liquidation is directly related to the firm's financial position, as this impacts on the decision that will be arrived at by the `coalitions' that arise. In summary, the following financial characteristics were postulated by White (1984, 1989) as having an effect on the reorganisation decision: * * * Equity commitment: owners' equity and managers' jobs will likely be eliminated in liquidation thereby providing incentive to form coalitions to avoid liquidation. Equity can also give up its claim to company assets to secure further borrowing. Leverage position: distressed firms that delay action will often have secured liabilities that will equal the total value of assets, leaving few free assets to secure borrowings or to pay unsecured creditors. Pay-off in reorganisation compared to liquidation: unsecured creditors will generally receive a zero or low return in liquidation, therefore, their 4 For extensive discussion of the coalition behaviour model and its application to US bankruptcy and reorganisation law see White's (1984) chapter in The Handbook of Modern Finance (revised 1989 and 1991). 5 John (1993), in summarising research in the area of financial distress, acknowledges the important work of Bulow and Shoven (1978) and White (1980, 1984, 1989) in modelling investment decisions by distressed firms. For discussion and recent reference to the model and its application see Ang and Chua (1980), Casey et al. (1986), Gertner and Scharfstein (1991), Hotchkiss (1995), Fisher and Martel (1995) and Campbell (1996). # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 238 * * J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 opportunity cost is low if the firm reorganises. Immediate pay-off to unsecured creditors also provides debt forgiveness. Future profitability: reorganisation will be worthwhile if the going concern value of the company exceeds the liquidation value of its assets plus costs of reorganisation. The amount of secured debt in the firm's capital structure: secured creditors are likely to oppose reorganisation if their security position is compromised, and are in the best position to block reorganisation. Concepts discussed by White in applying the theory to model the United States Chapter 11 reorganisation decision can be readily adapted to the context of reorganisation decisions under the Australian voluntary administration regime. While the negotiation framework is different under the United States legislation, similar parties are involved in deciding whether a company that has entered VA should reorganise or liquidate. Importantly, consideration of the model's application provides guidance as to the financial dimensions that distinguish companies that reorganise from those that liquidate. A summary of prior research relevant to firm reorganisation in various jurisdictions is presented in Table 1. This table summarises the financial dimensions that have been found useful in prior studies to distinguish firms that reorganise from those that liquidate. Significant financial dimensions (with the exception of firm size) are generally consistent with those that have been highlighted as important under the coalition behaviour model. The following section further discusses the coalition behaviour in the context of VA decision-making, and refers to the findings in prior research to develop a decision model for VA. 3.2. Development of propositions Review of literature in the previous sections has 1) demonstrated the usefulness of the coalition behaviour model as a means of analysing how various parties will behave with respect to the reorganisation decision; and, 2) identified variables that have been found in prior research to be useful predictors of outcomes for distressed companies. In this section, we refer to prior studies collectively, along with consideration of likely coalition behaviour in VA, to develop propositions regarding the reorganisation decision. Securing continued or additional funding for operations would be important for a distressed company attempting to avoid liquidation. However, obtaining the necessary funding may be difficult when the company has a high level of debt and little or no unsecured assets available to offer as security. Casey et al., (1986) found the level of free assets to be a significant discriminator between firms that liquidate and those that reorganise under the United States Chapter 11 procedure. Free assets were used as a proxy measure for the company's ability to secure additional borrowings, and were measured as the ratio of # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 239 uncollateralised assets (i.e. not given as security) to total assets. The coalition behaviour model suggests that parties interested in pursuing reorganisation may implement various strategies to secure additional funds. For example, equity holders may give up their remaining claim over the company's assets to secure support of major lenders. In addition, where unsecured creditors can be coerced to accept less than the face value of their claims, the resultant debt forgiveness will free up assets. However, as the level of debt in the company's capital structure increases it would become harder for coalitions to successfully implement these strategies to secure reorganisation. As leverage increases, equity's claim over the company's assets will diminish, thereby reducing its ability and incentive to have the company attempt reorganisation. Moreover, debt forgiveness achieved by paying unsecured creditors less than the face value of their claims may not be sufficient to secure additional funding if the company's leverage is extremely high. Therefore, it is proposed that the company's leverage will affect the reorganisation decision. Highly levered firms are expected to have difficulty gaining support for reorganisation and funding for continued operations from various creditor coalitions. This discussion suggests there are two aspects of leverage that will affect the reorganisation decision: 1. the amount of debt in the company's capital structure, which will affect its ability to secure the cooperation of coalitions of creditors that might provide additional funds in reorganisation; and 2. the level of equity in the company's capital structure, and the incentive for the equity (and management) to avoid liquidation. The following proposition summarises our expectation regarding the effect of leverage on the likelihood of reorganisation: Proposition 1: Highly levered companies are less likely to reorganise. Fisher and Martel (1995) and Comerford (1976) identified liquidity as a significant financial dimension affecting reorganisation. Fisher and Martel (1995) examined the impact of a firm's liquidity on the creditors' decision as to whether reorganisation should proceed. The level of return offered in reorganisation was found to affect the decision of unsecured or under-secured creditors. They suggested this was due to creditors recognising that liquidation would provide the unsecured creditors with poor returns after claims with priority were satisfied. The prospect of an improved cash payment under a reorganisation plan, made possible by the firm's short-term liquidity, was likely to secure creditors' acceptance regardless of the company's long term prospects. Therefore, higher levels of short-term liquidity should increase the likelihood that unsecured creditors will work to secure reorganisation in # AAANZ, 2000 Study Objective Financial Frost-Drury, Greinke & Shailer (1998) Australia 26 companies Campbell (1996) 121 Closely Held Firms United States Develop statistical model that distinguishes distressed companies entering voluntary administration that reorganise from those that liquidate, and healthy companies. Working Capital Total Assets Natural Log of Total Assets Develop prediction model to forecast probability of bankruptcy reorganisation. Return on Assets (Profitability) Natural Log of Total Assets (Size) Non Pledged Assets (Free Assets) Fisher & Martel (1995) 338 Firms Canada Determine factors that distinguished reorganisation plans accepted from those rejected by creditors Hotchkiss (1995) 197 Firms United States Jensen-Conklin (1992) 45 Firms United States Liquidation= reorganisation payoff rate Cash Payments Total Payments Secured Claims Total Liabilities Examine post bankruptcy performance of firms that had undergone Larger firms (Natural Log of Total reorganisation under U.S. Chapter 11 procedure. Assets) associated with lower probability of reporting negative income (Size) Successful plans were proposed by Exploratory empirical analysis concerned with determining the `existence of any indicia regarding the likelihood of a plan's potential larger firms (Total Liabilities) for full consummation' Nonfinancial Number of secured creditors Number of undersecured, secured creditors Type of business Industry performance Retention of CEO in bankruptcy (continued) J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 Significant Variables {Journals}acfi/40_3/z124/makeup/z124.3d 240 # AAANZ, 2000 Table 1 Prior research Capital structure: level of debt= equity interest. Examine the potential information value of accounting data in distinguishing firms in bankruptcy that reorganise versus those that liquidate. Non Collateralised Assets Total Tangible Assets (Free Assets) Net income Total Assets (Earnings Prospects) Level of Free Assets positively related to successful reorganisation Distinguish firms that reorganise from those that liquidate or continue operating Exploratory study to determine the characteristics of firms that Larger firms were significantly more reorganised and continued to exist for up to three years from time of successful (Size) bankruptcy filing Develop a multivariate model based on financial characteristics to MDA model included the following distinguish firms that succeed in Chapter 11 reorganisation compared ratios: to those that failed Quick Assets Total Assets (Liquidity) Quick Assets Current Liabilities (Liquidity) Total Debt Total Assets (Leverage= Stability) Net Income Total Assets (Profitability) Current Assets Current Liabilities (Liquidity) Net Income Stockholders Equity (Profitability) {Journals}acfi/40_3/z124/makeup/z124.3d To understand the institutional procedures of Chapter 11 from an empirical examination of firms that have emerged from Ch. 11 proceedings. J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 # AAANZ, 2000 Franks & Torous (1989) 30 Firms United States Casey, McGee & Stickney (1986) 113 Firms United States Hong (1983) 99 Firms United States LoPucki (1983a, 1983b) 41 Firms United States Comerford (1976) 52 Firms United States 241 {Journals}acfi/40_3/z124/makeup/z124.3d 242 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 coalition with other claimants. Acceptance of an immediate payment of less than the face value of unsecured creditors' claims also provides some amount of debt forgiveness, improving the company's overall position. The following proposition is therefore suggested: Proposition 2: Companies with higher levels of short-term liquidity are more likely to reorganise. White (1984, 1989), in modelling the outcome of bankruptcy proceedings, demonstrates firms that successfully reorganise have more attractive earnings prospects. Casey et al., (1986, p. 252) noted that firms expected to operate profitably in the future should be able to generate funds internally or obtain funds from external borrowing in order to emerge successfully from bankruptcy proceedings. In some circumstances, past profitability may be a valid indicator of reasonable future earnings prospects. For example, a company with a profitable underlying business operation may become insolvent due to cash flow problems associated with rapid expansion. This type of company would be an ideal candidate for reorganisation. The short breathing space provided by the Part 5.3A moratorium provides an opportunity for restructuring immediate obligations while preserving the profitable underlying business. Gilson et al., (1990), in examining features of firms that privately restructure debt versus those that reorganise under Chapter 11, report that firms privately renegotiating debt had significantly superior performance as measured by stock returns. Their explanation for the difference was that superior performance is associated with a smaller reduction in going concern value, which results in a higher firm market value=firm liquidation value. This increased the incentive to renegotiate debt privately, rather than risk asset sales likely to result from a Chapter 11 reorganisation. Where a company can demonstrate going concern value, various coalitions will form where parties see the opportunity to share in this going concern value of the company. The following proposition summarises our expectation: Proposition 3: Companies with good earnings prospects (indicated by past profitability) are more likely to reorganise. Secured creditors play a significant role in coalition behaviour and determination of the reorganisation decision. Campbell (1996) demonstrated that the number of secured creditors was an important factor in distinguishing between firms that reorganise and those that liquidate under the United States Chapter 11 procedure. Campbell's (1996) study involved 121 firms that had reorganised under Chapter 11, and found that a greater number of secured creditors increased the likelihood of liquidation. White (1984) had previously posited this relationship on the basis that secured creditors are in # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 243 the best position to block a reorganisation attempt. Chaterjee et al., (1996) provide evidence that restructuring decisions depend, in part, on the extent of the `creditors co-ordination' problem as reflected by the nature and complexity of debt claims. Moreover, Giammarino (1989) suggests that information asymmetries between debt holders reduces the likelihood of reorganisation. Clearly, secured creditors are faced with an important decision as to whether they will attempt to block reorganisation with intent to realise their security. In contradiction to the view that secured creditors hinder reorganisation, Fisher and Martel (1995) found that firms with a larger amount of secured claims were more likely to be reorganised. However, their study involved firms that attempted to reorganise under Canadian bankruptcy law where secured creditors enjoy a veto power over reorganisation attempts. They suggested that secured creditors, particularly banks, have a greater amount of information about the viability of firms attempting reorganisation. Fisher and Martel (1995) argued that where support of secured creditors for reorganisation is obtained, a positive signal is sent to other creditors. They suggested this signaling would minimise problems with creditors withholding their support for a reorganisation plan Ð often referred to as `hold-out' problems. Under the VA regime, general secured creditors do not enjoy a similar veto power, which may minimise `holdout' problems. However, one class of secured creditors, those with a substantial charge over all the company's assets, do have the option of avoiding administration by enforcing their charge within a `decision period' of ten days from when they are notified of the administrator's appointment. 6 We suggest the existence of a substantial chargeholder will be important to the reorganisation decision, due to the ability of these creditors to avoid the moratorium that is imposed on other classes of creditors. Coalitions involving the substantial chargeholder are only likely to arise where it can be demonstrated that their security position will be protected in reorganisation. In addition, charge holders are likely to be large lending institutions which will have a greater amount of information about the viability of firms attempting reorganisation. Clearly, the support of a substantial chargeholder will have to be obtained for the reorganisation plan to proceed, and will be actively sought by potential coalition parties that prefer reorganisation to liquidation. As suggested by Fisher and Martel (1995) support of this senior creditor will send a positive signal to other creditors regarding reorganisation. The following proposition is, therefore, suggested: Proposition 4: Companies that have a substantial chargeholder are more likely to reorganise. 6 See s 441A of The Corporations Law (Cth). # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 244 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 3.3. Control variables Based on a review of relevant literature, we expect that company size and the economic environment in which a financially distressed company operates will have an effect on the company's reorganisation prospects and performance. Therefore, we control for both industry and company size in the models studied here. Hotchkiss (1995), in her study of firms reorganising under Chapter 11, reports that poor industry performance in the post bankruptcy period had a significant relation to the incidence of a second bankruptcy or the requirement for a further reorganisation. Campbell (1996) reported that the type of business was a significant predictor of a successful reorganisation outcome: arguably, this finding may relate, inter alia, to industry conditions for similar business types in his sample. D'Aveni (1989) provides evidence that an inefficient firm is more likely to `linger' if it is in an industry with a higher growth rate of demand. The firm, although inefficient, can survive because of its improving environment. Based on evidence that industry classification will have some effect on reorganisation prospects and performance for individual companies, this variable will be controlled for by (1) using industry matched samples of reorganised and liquidated companies in the reorganisation decision model, and (2) by including industry classification as a control variable in the model for successful=unsuccessful reorganisations. Studies that have examined the effect of company size on reorganisation prospects indicate that larger companies are more likely to reorganise. White (1983) suggests larger firms are more likely to have previously raised unsecured capital, and assets generated by such borrowing provides collateral for additional borrowing when faced with financial distress. Previous research by Warner (1977), Altman (1984) and Campbell (1996) indicate the existence of an economy of scale with respect to bankruptcy costs for larger firms. Larger firms' bankruptcy costs are less significant when measured as a ratio of size. The above discussion suggests that larger firms are more likely to secure additional funding in reorganisation and are less likely to be further distressed by costs associated with bankruptcy. Company size is also included as a control in the analyses by using matched samples of reorganised and liquidated companies in the first model developed, including size as a control variable in the analysis for successful=unsuccessful reorganised companies. 4. Model development Based on the results of the prior studies and the coalition behaviour model, selected variables are considered in two logistic regression analyses. The first model tests the propositions developed in the preceding section. The second model is developed as a comparative model that examines whether the same variables can distinguish `successful' reorganised companies from `unsuccess# AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 245 ful' reorganised companies. Success is determined by examining performance (profitability) after reorganisation. It should be noted that the coalition behaviour model specifically deals with the reorganisation decision, providing a basis for discussion leading to formulation of propositions relating to whether a company is likely to reorganise or liquidate. However, coalition theory remains relevant to the development of the second comparative model, as efficient decision making by the various coalitions that exist in voluntary administration will mean that companies likely to perform poorly in reorganisation will not attempt to reorganise. The dependent variable in the second model developed separates companies on an `efficiency' criterion, that is, whether or not the companies are successful in reorganisation. The model's dimensions represent the underlying constructs that would likely exist if coalitions made decisions based on securing the most efficient administration outcomes. Comparison of the second `efficiency' model with the reorganisation decision model will provide useful insight into the efficiency of the VA decision process. Each of the financial dimensions is operationalised by financial ratios or proxy variables. While a number of financial ratios could be used to represent the selected financial dimensions, the final choice was restricted to those ratios that could be calculated from the available data. The approach suggested by Chen and Shimerda (1981) is followed, in that each financial dimension is generally represented by one selected ratio. This approach avoids analysis problems associated with correlation between ratios. Independent variables are summarised in Table 2. Measures for each independent variable were from the company's most recent annual report prior to the appointment of the administrator. 7 The profit measure excluded abnormal and extraordinary items, so that the measure more reliably represented the company's underlying performance. Reorganisation and liquidation samples were matched for size and industrial classification in the first model. 8 For the second comparative model, matching was not possible due to sample size constraints, therefore size and industry classification were included in the analysis as control variables. 7 Therefore, the only available asset and liability measures were generally at book value (cost less depreciation expense). However, it is possible that some items could have been re-valued either subsequent or prior to balance date, which may have been prompted by audit recommendations. Due to non-public disclosure of these items, they could not be controlled for in the analysis. 8 Matching to control for variables was undertaken to neutralise effects of industry and size. This allowed the development of a parsimonious model, which included only those variables related to the propositions developed. Re-testing of the model on the complete sample with industry and size included as control variables showed little difference from the reported model. # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 246 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 Table 2 Variables used in logistic regression analyses Category Ratio or Measure Earnings Prospects Liquidity (pay-off rate) Leverage (free assets) Equity Commitment Debt Structure operating profit= total assets current assets= current liabilities total assets= total liabilities positive owners' equity (0 ve, 1 ve) existence of chargeholder (0 no charge, 1 charge) Natural log of total assets Company Size Variable Descriptor ROA CA=CL TA=TL Shareholders' Equity Charge Size The dependent variable for the first model was determined by whether the company reorganised (coded as 1), or liquidated (coded as 0). A company was considered a liquidation if 1) the administration ended in liquidation, or 2) the administration ended with a deed of company arrangement that provided for winding-up (a `liquidating deed'). For the second regression, the dependent variable was based on return on assets after administration. To develop a logistic regression model that could be compared with the reorganisation decision model it was necessary for the dependent variable to be dichotomous. The dichotomous dependent variable was assigned a value of 1 (successful) where return on assets was positive based on the average for the administration year (the year in which the administrator was appointed) and the two years subsequent to administration year. Therefore, companies deemed to be `unsuccessful' (coded as 0) were those that consistently failed to achieve a positive return on assets even after implementing a reorganisation plan. 9 5. Data Data availability is a considerable restriction for research in this area, as there are no special reporting requirements for a company under administration. Problems for empirical research relating to voluntary administration arise due to the lack of consistent financial data for many companies. Moreover, the costly process of identifying companies that are likely to have 9 The sensitivity of the cut-off criteria was examined. For one company ROA was marginally positive at 2 per cent. Accordingly, ROA was examined for each year. The company had performed poorly in the year of administration, however, it had achieved an average ROA of 4.9 per cent over the subsequent two years. The dependent variable for this case was assigned a value of 1 (successful). The next lowest value of ROA for companies in the sample was 7 per cent; the classification was therefore not sensitive to the cut-off chosen. # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 247 some available data, and subsequent collection of that data are major obstacles. Annual returns lodged with the ASIC provided data for analysis. These returns were characterised by missing information, and for many smaller companies, the reported accounting data were limited to key financial data required to be provided on the annual return. In this study, data for 40 companies were obtained for the matched sample analysis. The sample included 20 reorganised and 20 liquidated companies. Matching was based on size, measured by total assets, and industrial classification. 10 The procedure for selecting the sample of companies and the matching process employed is detailed below: 1. A listing of all companies that appointed an administrator under Part 5.3A for the calendar years 1993 to 1995 was obtained from the ASIC. 11 VA began operation in July 1993, therefore companies were selected from those that commenced administration during the first two and a half years of the operation of the voluntary administration legislation (mid 1993 to 1995). Company data available from Internet search facilities provided by the ASIC (the `National Names Index', see http://www.asic.gov.au) were reviewed for each company to determine 1) if the company was still registered, 2) whether a liquidator had been appointed, and 3) the likelihood of financial data being available for a relevant company. Key financial data were available for most companies until 1996, when the ASIC reporting rules no longer required inclusion of key data in the company's annual return. Determination of whether financial information would be available for a company was based on the number of pages included in the annual report lodged with the ASIC as indicated by National Names Index data. 2. For companies selected, ASIC document numbers were obtained for annual reports from the National Names Index. Annual Returns and Annual Reports for years prior and after appointment of an administrator were obtained from the ASIC where available. 3. To facilitate analysis, data were collected for companies that concluded voluntary administration with a deed of company arrangement, and companies that were liquidated following voluntary administration. Liquidated companies were selected that had at least some financial data available for the years prior to appointment of the administrator. 10 Coverage is retail trade(10), wholesale trade(6), services(16), manufacturing(6), research and development(2). 11 ASIC records indicated that 2927 applications were lodged for appointment of an administrator over this time. # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 248 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 4. Annual reports were obtained for 110 different companies over a number of years. After perusal of annual reports it was necessary to exclude those companies from the sample if (a) they were trustee companies that had not traded, or (b) financial data were not included in their annual returns. The remaining 81 companies included 50 reorganisations and 31 liquidations. 5. For the reorganisation=liquidation decision model, it was necessary to match companies for both industry and size. First, annual returns were reviewed to determine each company's `principal activity. 12 Based on their principal activity, companies were classified according to the Australia and New Zealand Industrial Classification (ANZSIC). Second, companies were classified based on their total assets. 13 Companies were matched that had the same industry and size classification. 14 The validity of size matching was tested by performing a t-test on group means, and the mean difference was not significant (see Table 3). 6. The final sample for the reorganisation=liquidation model comprised 40 companies, consisting of 20 reorganised companies, and 20 liquidated companies. Companies in the sample included 26 proprietary companies, 12 unlisted public companies and two listed public companies. Range of size (measured by total assets) for companies in the final sample is reported in Table 3. Year of appointment for companies in the final sample was 1993± 13 companies, 1994 ±21 companies and 1995± 6 companies. 7. The final sample for the successful=unsuccessful reorganisation outcome model comprised 32 companies, consisting of 13 successful reorganised companies, and 19 unsuccessful reorganised companies. 15 Companies in this sample included 25 proprietary companies and seven unlisted public companies. Range of size (measured by total assets) for companies in the final sample is reported in Table 6. Year of appointment for companies in 12 This information is listed on all Annual Returns lodged with ASIC. 13 Classification groupings used were 1) less than $0.5 million; 2) $0.5 million ± $1 million; 3) $1 million to $5 million; 4) greater than $5 million. 14 Two large very liquidated companies fell within the `greater than $5 million' classification. Due to the restricted sample size, these could only be matched with relatively smaller companies that were just above the threshold of $5 million in assets. However, these companies would enjoy similar economies of scale. A matched-pairs ttest performed on group asset means was not significant, indicating the matching process was successful. 15 The sample included 18 of the 20 reorganised companies used in the liquidation= reorganisation model. # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 249 the final sample was 1993 ± 7 companies, 1994± 20 companies and 1995± 5 companies. 16 6. Results 6.1. Reorganisation=liquidation model Descriptive statistics for predictor variables included in the reorganisation= liquidation model are presented in Table 3. Mean values of predictor variables for the two groups are similar with the exception of the Current Ratio and Total Assets divided by Total Liabilities (TA=TL). The mean difference for TA=TL is marginally significant ( p 0.095). Correlations among independent variables are reported in Table 4. Correlations between variables were not high enough to cause concern with multicollinearity for the subsequent logistic regression analysis (Tabachnick and Fidell, 1996). 6.1.1. Multivariate tests Logistic regression analysis was conducted to examine the discriminatory power of selected variables between reorganisations and liquidations. The results of the logistic regression analysis are presented in Table 5 below. The model was significant, and prediction success was impressive. Results confirmed the ability of selected variables to distinguish reorganised from liquidated firms. Proposition 1 suggested that highly levered companies are less likely to reorganise. Two measures of leverage were included in the analysis. Results indicate the outcome of a VA is more likely to be reorganisation where the company has positive owners' equity. However, while TA=TL is a significant 16 Data screening was performed for the final sample of companies. Examination of box-plots was undertaken to identify univariate outliers for each of the continuous independent variables. Three potential outlier cases were identified: two that had large values for the variable TA=TL, and one that had a large value for the variable CA=CL. Examination of Cook's Distance and Leverage Values was undertaken to determine the effect of these cases on the multivariate model. This examination indicated that the two cases with potential outlier values for TA=TL had little effect on the multivariate model. Diagnostics for the case with a large value for CA=CL suggested it might have had an effect on the logistic regression model. The logistic regression analyses were re-run, excluding the potential outlier case and its paired case in each analysis. The resulting models were only marginally different with and without these cases, therefore, the models are reported based on the full final sample of 40 companies. # AAANZ, 2000 Liquidation (n 20) Range Range Variable Mean S. Dev. High Low CA=CL Shareholders' Equity # ROA TA=TL Charge # Total Assets 5.51 0.65 0.11 0.75 0.75 1,976,069 17.33 n=a 0.87 0.60 n=a 1,883,780 77.18 1 2.92 2.77 1 5,771,200 0.06 0 1.07 0.09 0 41,667 significant at p < 0.05 For the nominal scale variables the last column shows Chi Square statistic CA=CL current assets=current liabilities Shareholders' Equity positive owners' equity (0 ve, 1 ve) ROA operating profit=total assets TA=TL total assets=total liabilities Charge existence of chargeholder (0 no charge, 1 charge) # 1.11 0.70 0.12 3.16 0.70 7,288,806 1.54 n=a 0.26 6.12 n=a 18,448,351 High Low t-statistic (1-tailed) Chi Square 6.89 1 0.15 24.84 1 79,691,000 0.01 0 0.86 0.05 0 67,212 1.13 n=a 0.059 1.76 n=a 1.28 n=a 0.114 n=a n=a 0.125 n=a J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 Reorganisation (n 20) {Journals}acfi/40_3/z124/makeup/z124.3d 250 # AAANZ, 2000 Table 3 Univariate statistics-Reorganisation= liquidation decision {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 251 Table 4 Correlations between predictor variables Reorganisation= liquidation decision (n 40) CA=CL CA=CL Shareholders' Equity ROA TA=TL Charge 1.00 0.14 0.09 0.14 0.11 Shareholders' Equity 1.00 0.33 0.23 0.11 ROA TA=TL 1.00 0.02 0.13 1.00 0.31 Charge 1.00 For the dichotomous variables, the Eta strength-of-association index is reported between these variables and the other interval scale variables. In all other cases within the table, Pearson correlation coefficients are reported. CA=CL current assets=current liabilities Shareholders' Equity positive owners' equity (0 ve, 1 ve) ROA operating profit=total assets TA=TL total assets=total liabilities Charge existence of chargeholder (0 no charge, 1 charge) Table 5 Results of logistic regressionÐReorganisation= liquidation decision Reorganised (1) Liquidated (0) Variable B Sig Current Ratio Positive Owners' Equity (0 ve, 1 ve) Return on Total Assets Total Assets=Total Liabilities Chargeholder (0 no charge, 1 charge) 2 Log Likelihood 2 (5, n 38) Goodness-of-fit (significance) Nagelkerke Psuedo R 2 Classification Accuracy Reorganised (n 20) Liquidated (n 20) Overall (n 40) 0.17 3.05 1.47 5.42 0.14 31.43 23.97 0.0002 0.60 0.000 0.013 0.194 0.000 0.892 75% (15) 85% (17) 80% (32) denotes significant at p < 0.05 CA=CL current assets=current liabilities Shareholders' Equity positive owners' equity (0 ve, 1 ve) ROA operating profit=total assets TA=TL total assets=total liabilities Charge existence of chargeholder (0 no charge, 1 charge) # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 252 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 predictor variable, the direction of its effect is opposite to that suggested in the proposition, with companies more likely to reorganise as leverage increases. Thus, only partial support for Proposition 1 is found. This result might be explained by the interaction of the two measures of leverage included in the model. While the direction of the TA=TL variable is counter-intuitive at face value, when interpreted in conjunction with the result for shareholders' equity it appears that an upper bound (of one) occurs for the leverage ratio variable for companies most likely to reorganise. The result suggests reorganisation is most likely to occur when leverage is high, and some shareholders' equity remains. This is consistent with equity holders pursuing reorganisation to preserve their claim over the company's assets, however small that claim might be. Proposition 2, that companies with higher levels of short-term liquidity are more likely to reorganise, is supported by the results. This suggests that unsecured creditors have an important role in the decision-making coalition in VA. Higher levels of short-term liquidity would allow the reorganisation plan to include an immediate pay-off to these creditors. Their acceptance of the reorganisation plan may also provide important debt forgiveness. Interestingly, past profitability is not a significant predictor, providing no support for Proposition 3. This suggests the reorganisation decision may not be based on a consideration of available indicators of the company's long term prospects. Furthermore, the results indicate major secured creditors may be indifferent to the outcome of VA (Proposition 4). The results appear to indicate that the reorganisation decision is largely a result of `coalition' behaviour involving equity (with management acting as agent) and unsecured creditors. We find that companies with positive owners' equity and higher liquidity are more likely to reorganise. Reorganisation will tend to preserve equity (and current management), and some amount of liquidity will allow a reorganisation plan that provides an immediate return to creditors. Results indicating that high leverage is associated with reorganisation also conform to the `coalition' model. For highly levered companies, liquidation would provide little or no return for unsecured creditors. For unsecured creditors, choosing reorganisation in coalition with equity would provide a marginally greater return. In addition, payment to secured creditors from liquid assets would provide some measure of debt forgiveness. Prediction success rates for the logistic model were good: overall, 80 per cent of liquidations and reorganisations were correctly classified (75 per cent for reorganisations and 85 per cent for liquidations). Cross validation of results for the model was performed by holding out individual pairs, developing a model based on the other 38 observations, and using the model to predict outcomes for the two observations held out. Classification success for the 20 holdout tests was less than for the original model at 70 per cent overall (70 per cent for reorganisations and 70 per cent for liquidations). The # AAANZ, 2000 Unsuccessful (n 20) Range Variable Mean S. Dev. High CA=CL Shareholders' Equity # ROA TA=TL Charge # Industry # Total Assets 3.89 0.38 9.68 n=a 35.72 1 0.21 1.21 0.62 6.31 10,381,041 0.92 1.33 n=a 2.29 33,586,345 2.92 4.69 1 8.00 122,000,000 Range Low Mean 0.01 0 0.83 0.09 0 2.00 139,745 0.77 0.58 0.31 1.05 0.58 5.68 12,846,898 significant at p < 0.05 For the nominal scale variables the last column shows Chi Square statistic CA=CL current assets=current liabilities Shareholders' Equity positive owners' equity (0 ve, 1 ve) ROA operating profit=total assets TA=TL total assets=total liabilities Charge existence of chargeholder (0 no charge, 1 charge) # S. Dev. High 0.63 n=a 2.42 1 0.36 0.59 n=a 2.21 41,772,198 0.09 2.53 1 8.00 184,000,000 t-statistic (1-tailed) Chi Square 0.01 0 1.16 n=a n=a 1.166 0.93 0.36 0 2.00 41,667 2.22 0.47 n=a n=a 0.19 n=a n=a 0.042 0.604 n=a Low {Journals}acfi/40_3/z124/makeup/z124.3d Successful (n 20) J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 # AAANZ, 2000 Table 6 Univariate statistics ÐSuccessful=unsuccessful reorganisation (n 32) 253 {Journals}acfi/40_3/z124/makeup/z124.3d 254 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 result of holdout testing suggests the model is reasonably stable, and problems with overfitting due to the small sample size may not be of major concern. 6.2. Successful=unsuccessful reorganisation model Descriptive statistics for predictor variables included in the successful= unsuccessful reorganisation model are presented in Table 6. Mean values of predictor variables for the two groups are similar with the exception of the Current Ratio and Return on Total Assets (ROA). The mean difference for Current Ratio is not significant, while ROA is significant (p < 0.05). Correlations among independent variables for this model are reported in Table 7. While some correlations are high, it is unlikely they would create statistical problems at the levels found (Tabachnick and Fidell, 1996). To confirm that multicollinearity is not at a problematical level for development of the logistic regression model, an additional analysis was performed omitting the variable Total Assets=Total Liabilities, which is reasonably highly correlated with two other variables (Current Ratio and Shareholders' Equity). The result of this analysis was substantively consistent with the full model, thereby alleviating concerns about multicollinearity. Results of the second logistic regression model (see Table 8) indicate companies that reorganise successfully are more profitable, are more highly Table 7 Correlations between predictor variablesÐSuccessful=unsuccessful reorganisation CA=CL CA=CL Shareholders' Equity ROA TA=TL Charge Log Total Assets Industry 1.00 0.21 0.18 0.72 0.14 0.05 0.11 Shareholders' equity 1.00 0.01 0.65 0.06 0.08 0.03 ROA TA=TL Charge 1.00 0.01 0.19 0.20 0.00 1.00 0.08 0.04 0.07 1.00 0.35 0.23 Log total assets Industry 1.00 0.00 1.00 For the dichotomous variables, the Eta strength-of-association index is reported between these variables and the other interval scale variables. In all other cases within the table, Pearson correlation coefficients are reported. CA=CL current assets=current liabilities Shareholders' Equity positive owners' equity (0 ve, 1 ve) ROA operating profit=total assets TA=TL total assets=total liabilities Charge existence of chargeholder (0 no charge, 1 charge) Size Natural log of total assets # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 255 Table 8 Results of logistic regressionÐSuccessful= unsuccessful reorganisation ve ROA (1) ve ROA (0) Variable Current Ratio Positive Owners' Equity (0 ve, 1 ve) Return on Total Assets Total Assets=Total Liabilities Chargeholder (0 no charge, 1 charge) Natural Log of Total Assets Industry Mining Manufacturing Wholesale Retail Service 2 Log Likelihood 2 (10, n 32) Goodness-of-fit (significance) Nagelkerke Psuedo R 2 Classification Accuracy ve ROAÐSuccessful (n 13) ve ROAÐUnsuccessful (n 19) Overall (n 32) B Sig 7.68 5.64 10.23 7.91 1.07 0.8 1.33 1.84 8.69 19.47 0.01 14.013 29.217 0.010 0.015 0.005 0.073 0.562 0.103 0.004 0.0011 0.81 85% (13) 89% (17) 87% (28) denotes significant at p < 0.05 CA=CL current assets=current liabilities Shareholders' Equity positive owners' equity (0 ve, 1 ve) ROA operating profit=total assets TA=TL total assets=total liabilities Charge existence of chargeholder (0 no charge, 1 charge) Size Natural log of total assets levered and have higher levels of short-term liquidity. In addition, industry classification has an effect on the likely success of reorganisation. Examination of raw data for industry classifications showed that a higher proportion of retail companies was unsuccessful than for other classifications. This is reflected in the large negative coefficient for this variable in the model. The existence of a chargeholder, and company size were not significant predictors of successful=unsuccessful reorganisation. As discussed previously, the second model is presented for the purpose of comparison with the actual decision model. Results relating to the effects of individual variables for the second model differ from those in the reorganisation decision model. The most striking difference between the models is the # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 256 J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 strong significance of past profitability as a predictor of successful reorganisation. This result has implications regarding the efficiency of the liquidation= reorganisation decision, as profitability was not a significant predictor in the decision model. The results of the comparative model suggest past profitability is an important variable in distinguishing, from a pool of distressed companies, suitable candidates for reorganisation. The negative sign for the TA=TL ratio, while consistent with the decision model, suggests that higher leverage at the time of reorganisation is associated with success (greater profitability) in reorganisation. In addition, the results indicate negative owner's equity at the time of reorganisation is associated with successful reorganisation. We suggest these results need to be considered in the context of restructuring that will likely take place because of the administration process. A company's capital structure and leverage position may be altered significantly because of reorganisation. For example, payment to unsecured creditors from current assets, which appears to be an important aspect to the decision to reorganise, may give rise to significant levels of debt forgiveness that will alter the company's leverage position. The nature of reorganisation plans adopted under VA, and their relationship to post-administration performance is an aspect of the operation of VA that could be considered in future research. Prediction success rates for the model were good: overall, 87 per cent of successful and unsuccessful reorganisations were correctly classified (85 per cent for successful reorganisations and 89 per cent for unsuccessful reorganisations). Cross validation of results for the model was performed by holding out individual cases, developing a model based on all other observations, and using the model to predict outcomes for the observation held out. Classification success for the 20 holdout tests was similar to the original model at 81 per cent overall (73 per cent for successful reorganisations and 88 per cent for unsuccessful reorganisations). Again, the result of holdout testing suggests the model is reasonably stable, and problems with overfitting due to the small sample size may not be of major concern in relation to the results of analysis. 7. Summary and conclusions Overall, the results of this study have the following implications. First, the analyses and results lend support to the coalition behaviour theory of reorganisation choice. Importantly, this provides a basis for further development of a parsimonious bankruptcy reorganisation prediction model based on a theoretical background. The reorganisation decision model developed in this study could be applied to data from other jurisdictions to further test the validity of analysing coalition behaviour as a means of understanding how insolvency law affects the decision making process. # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d J. Routledge, D. Gadenne / Accounting and Finance 40 (2000) 233± 260 257 Limitations of the generalisability of results concerning testing of coalition behaviour theory arise from the difficulty with obtaining data. The small sample size and missing data present limitations, although these are common problems with research in the area of financial distress. Generalisability of results could be determined more accurately by further testing of the model with an independent holdout sample. A further limitation associated with the difficulty of obtaining data is the limited choice of variables available to represent financial constructs in the models. If the chosen variables do not adequately operationalise financial constructs outlined in the propositions there may be some divide between the theory and the model tested. For policy-makers the results presented here are hardly reassuring. Arguably, the VA procedure appears to be problematic in terms of possible bias toward reorganisation of inefficient companies. The intent of the legislation was to allow viable companies the opportunity to reorganise. However, failure of the VA procedure to adequately filter inefficient companies may be adding to the overall economic cost associated with corporate insolvency. The results indicate that decision-making of parties involved in the reorganisation decision is inefficient by allowing companies with few prospects for recovery to proceed with reorganisation. Greater liquidity, which will likely mean reasonable immediate return for unsecured creditors, and positive owners' equity as distinguishing characteristics for firms that reorganise indicate the decision making `coalition' in VA is made up of equity and unsecured creditors. As discussed above, equity holders will pursue reorganisation to preserve their interest in the company, and unsecured creditors will support reorganisation if the anticipated return is greater than in liquidation. Decisions as to the company's future do not appear to be based on an assessment of its prospects to operate efficiently in the future. This is supported by underlying profitability being an important variable in the model that distinguished successful from unsuccessful reorganised companies. These findings also have implications for Australian insolvency policy, which has adopted a flexible approach to allowing companies to proceed with reorganisation. Other jurisdictions have requirements that are more stringent for distressed firms that seek to reorganise. For example, the United States Chapter 11 procedure has greater scrutiny by the courts of the validity of a reorganisation plan. German `Composition Proceedings' require composition plans to be confirmed by the courts and the reorganisation process under French law requires a `continuation plan' to be approved by the Commercial Court (Iraj, 1997, Franks et al., 1996). The results presented in this paper suggest that the trade-off between reducing costs associated with a flexible regime and the economic cost of allowing unsuitable companies to reorganise requires further consideration. Therefore, extension of the work presented here to better understand the effects of insolvency legislation on decision outcomes may be useful for constructing efficient insolvency rules. # AAANZ, 2000 {Journals}acfi/40_3/z124/makeup/z124.3d 258 J. Routledge, D. 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