1. Ronald F. Singer FINA 4330 Financial Distress Lecture 28

2. Key Concepts and Skills
Be able to define financial distress and understand what happens to a firm in distress
Understand the difference between liquidation and reorganization
Understand the absolute priority rule
Understand the potential benefits of a private workout versus formal bankruptcy

3. Outline
1 What Is Financial Distress? 2 What Happens in Financial Distress? 3 Bankruptcy Liquidation and Reorganization 4 Private Workout or Bankruptcy: Which is Best? 5 Prepackaged Bankruptcy

4. 1 What Is Financial Distress?
Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy current obligations, and the firm is forced to take corrective action.
Financial distress may lead a firm to default on a contract, and it may involve financial restructuring between the firm, its creditors, and its equity investors.

5. Insolvency
Stock-base insolvency: the value of the firm’s assets is less than the value of the debt.
Assets
Debt
Equity
Solvent firm
Debt
Assets
Equity
Insolvent firm
Debt
Note the negative equity

6. Insolvency
Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments. $
Cash flow shortfall
Contractual obligations
Insolvency
Firm cash flow
time

7. Largest U.S. Bankruptcies
Firm
Liabilities (in $ millions)
Date
Conseco Inc.
$56,639.30
December 2002
Worldcom Inc.
45,984.00
July 2002
Enron Corp.
31,237.00
December 2001
Delta Air Lines
28,546.00
September 2005
Pacific Gas & Electric Co.
25,717.00
April 2001

8. 2 What Happens in Financial Distress?
Financial distress does not usually result in the firm’s death.
Firms deal with distress by:
Selling major assets.
Merging with another firm.
Reducing capital spending and research and development.
Issuing new securities.
Negotiating with banks and other creditors.
Exchanging debt for equity.
Filing for bankruptcy.

9. What Happens in Financial Distress?
Financial restructuring
No financial restructuring
49%
51%
Financial distress
Legal bankruptcy Chapter 11
Private workout
47%
53%
Reorganize and emerge
Merge with another firm
Liquidation
83%
10% 7%
Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics 27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, “Troubled Debt Restructurings: An Empirical Study of Private Reorganization in Firms in Defaults,” Journal of Financial Economics 27 (1990); and Lawrence A. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority Claims,” Journal of Financial Economics 27 (1990).

10. Responses to Financial Distress
Think of the two sides of the balance sheet.
Asset Restructuring:
Selling major assets
Merging with another firm
Reducing capital spending and R&D spending
Financial Restructuring:
Issuing new securities
Negotiating with banks and other creditors
Exchanging debt for equity
Filing for bankruptcy

11. 3 Bankruptcy Liquidation and Reorganization
Firms that cannot meet their obligations have two choices: liquidation or reorganization.
Liquidation (Chapter 7) means termination of the firm as a going concern.
It involves selling the assets of the firm for salvage value.
The proceeds, net of transactions costs, are distributed to creditors in order of priority.
Reorganization (Chapter 11) is the option of keeping the firm a going concern.
Reorganization sometimes involves issuing new securities to replace old ones.

12. Bankruptcy Liquidation
Straight liquidation under Chapter 7:
A petition is filed in a federal court. The debtor firm could file a voluntary petition or the creditors could file an involuntary petition against the firm.
A trustee-in-bankruptcy is elected by the creditors to take over the assets of the debtor firm. The trustee will attempt to liquidate the firm’s assets.
After the assets are sold, after payment of the costs of administration, money is distributed to the creditors.
If any money is left over, the shareholders get it.

13. Bankruptcy Liquidation: Priority of Claims
Liquidation proceeds are distributed in order of priority:
Administration expenses associated with liquidation
Unsecured claims arising after the filing of an involuntary bankruptcy petition
Wages earned within 90 days before the filing date, not to exceed $2,000 per claimant
Contributions to employee benefit plans arising with 180 days before the filing date
Consumer claims, not exceeding $900
Tax claims
Secured and unsecured creditors’ claims
Preferred stockholders’ claims
Common stockholders’ claims

14. Absolute Priority Rule in Practice
The APR states that senior claims are fully satisfied before junior claims receive anything.
Deviations from APR
Equityholders
Expectation: No payout
Reality: Payout in 81% of cases
Unsecured creditors
Expectation: Full payout after secured creditors
Reality: Violation in 78% of cases
Secured creditors
Expectation: Full payout
Reality: Full payout in 92% of cases

15. Reasons for Absolute Priority Rule Violations
Creditors want to avoid the expense of litigation. Debtors are given a 120-day window of opportunity to cause delay and harm value.
Managers often own equity and demand to be compensated. They are in charge for at least the next 120 days.
Bankruptcy judges like consensual plans (they do not clog the court calendar with appeals) and pressure parties to compromise.

16. Bankruptcy Reorganization: Chapter 11
A typical sequence:
A voluntary petition or an involuntary petition is filed.
A federal judge either approves or denies the petition.
In most cases the debtor continues to run the business.
The firm is given 120 days to submit a reorganization plan.
Creditors and shareholders are divided into classes. Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt.
After acceptance by the creditors, the plan is confirmed by the court.
Payments in cash, property, and securities are made to creditors and shareholders.

17. 4 Private Workout or Bankruptcy: Which Is Best?
Both formal bankruptcy and private workouts involve exchanging new financial claims for old financial claims.
Usually, senior debt is replaced with junior debt, and debt is replaced with equity.
When they work, private workouts are better than a formal bankruptcy.
Complex capital structures and lack of information make private workouts less likely.

18. Private Workout or Bankruptcy: Which Is Best?
Advantages of Bankruptcy
New credit is available - "debtor in possession" debt
Discontinued accrual of interest on pre-bankruptcy unsecured debt
An automatic stay provision
Tax advantages
Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt
Disadvantages of Bankruptcy
A long and expensive process
Judges are required to approve major business decisions
Distraction to management
“Hold out” by stockholders

19. 5 Prepackaged Bankruptcy
Prepackaged Bankruptcy is a combination of a private workout and legal bankruptcy.
The firm and most of its creditors agree to private reorganization outside the formal bankruptcy.
After the private reorganization is put together (prepackaged) the firm files a formal bankruptcy (under Chapter 11).
The main benefit is that it forces holdouts to accept a bankruptcy reorganization.
Offers many of the advantages of a formal bankruptcy, but is more efficient.