Prepared by Professor Wei Wang Queen’s University © 2011 McGraw–Hill Ryerson Limited Financial Distress Chapter Thirty One

2-1 © 2011 McGraw–Hill Ryerson Limited 31-1 Executive Summary This chapter discusses financial distress, private workouts, and bankruptcy. A firm that defaults on a required payment may be forced to liquidate its assets. More often, a defaulting firm will reorganize. Financial restructuring involves replacing old financial claims with new ones and takes place with private workouts or legal bankruptcy.

2-2 © 2011 McGraw–Hill Ryerson Limited 31-2 Chapter Outline 31.1 What is Financial Distress? 31.2 What Happens in Financial Distress? 31.3 Bankruptcy Liquidation and Reorganization 31.4 Current Issues in Financial Distress 31.5 The Decision to Seek Court Protection: The Case of Canwest Global Communications Corporation 31.6 Summary and Conclusions

2-3 © 2011 McGraw–Hill Ryerson Limited 31-3 What is Financial Distress? LO31.1 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. Usually the firm is forced to take actions that it would not have taken if it had sufficient cash flow.

2-4 © 2011 McGraw–Hill Ryerson Limited 31-4 Insolvency LO31.1 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

2-5 © 2011 McGraw–Hill Ryerson Limited 31-5 Insolvency LO31.1 Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments. Contractual obligations Insolvency $ Firm cash flow Cash flow shortfall time

2-6 © 2011 McGraw–Hill Ryerson Limited 31-6 The Largest U.S. Bankruptcies LO31.1 FirmAssets (in $ billions) Date Lehman Brothers Holdings$ September 15, 2008 Washington Mutual$ September 26, 2008 Worldcom Inc.$ July 21, 2002 General Motors$82.300June 1, 2009 CIT Group$71.019November 11, 2009

2-7 © 2011 McGraw–Hill Ryerson Limited 31-7 What Happens in Financial Distress? LO31.2 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.

2-8 © 2011 McGraw–Hill Ryerson Limited 31-8 Reorganize and emerge Merge with another firm Liquidation 83% 10% 7% What Happens in Financial Distress: The U.S. Experience LO31.2 Financial distress Financial restructuring No financial restructuring 49% 51% Legal bankruptcy Chapter 11 Private workout 47% 53% 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).

2-9 © 2011 McGraw–Hill Ryerson Limited 31-9 Responses to Financial Distress LO31.2 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.

2-10 © 2011 McGraw–Hill Ryerson Limited Bankruptcy Liquidation and Reorganization LO31.3a Firms that cannot meet their obligations have two choices: liquidation or reorganization. Liquidation 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 is the option of keeping the firm a going concern. –Reorganization sometimes involves issuing new securities to replace old ones.

2-11 © 2011 McGraw–Hill Ryerson Limited Bankruptcy Liquidation LO31.3b Straight liquidation usually involves: 1.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. 2.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. 3.After the assets are sold, after payment of the costs of administration, money is distributed to the creditors. 4.If any money is left over, the shareholders get it.

2-12 © 2011 McGraw–Hill Ryerson Limited Bankruptcy Liquidation: Priority of Claims LO31.3b The distribution of the proceeds of liquidation occurs according to the following priority : 1.Administration expenses associated with liquidation. 2.Other expenses arising after the filing of an involuntary bankruptcy petition. 3.Wages, salaries and commissions. 4.Municipal tax claims. 5.Rent. 6.Claims resulting from employee injuries. 7.Unsecured creditors. 8.Preferred shareholders. 9.Common shareholders.

2-13 © 2011 McGraw–Hill Ryerson Limited Example LO31.3b Suppose the B.O. Drug Co. decides to liquidate. Assume that the liquidation value is $2.7 million. Bonds worth $1.5 million are secured by a mortgage on the corporate headquarters building, which is sold for $1 million. $200,000 is used to cover administrative costs and other claims—after paying this, $2.5 million is available to pay creditors. The only problem is that the unpaid debt is $4 million.

2-14 © 2011 McGraw–Hill Ryerson Limited Example (continued) LO31.3b Following our list of priorities, all creditors are paid before shareholders, and the mortgage bondholders are first in line. The trustee proposes the following distribution: Type of ClaimPrior ClaimCash Received Under Liquidation Mortgage Bonds$1,500,000 Subordinated Debentures $2,500,000$1,000,000 Common Stock$10,000,000$ 0 Total$14,000,000$2,500,000

2-15 © 2011 McGraw–Hill Ryerson Limited Bankruptcy Reorganization LO31.3b A typical sequence: 1.A voluntary petition can be filed by the corporation or an involuntary petition can be filed by creditors. 2.A federal judge either approves or denies the petition. 3.In most cases the debtor continues to run the business. 4.The firm is required to submit a reorganization plan. 5.Creditors and shareholders are divided into classes. 6.After acceptance by the creditors, the plan is confirmed by the court. 7.Payments in cash, property, and securities are made to creditors and shareholders.

2-16 © 2011 McGraw–Hill Ryerson Limited Reorganization Example LO31.3b Suppose the B.O. Drug Co. decides to reorganize under the Bankruptcy and Insolvency Act. Assume that the “going concern” value is $3 million and its balance sheet is shown. Assets$3,000,000Liabilities: Mortgage bonds$1,500,000 Subordinated debentures $2,500,000 Equity-$1,000,000

2-17 © 2011 McGraw–Hill Ryerson Limited Reorganization Example LO31.3b The firm has proposed the following reorganization plan: Old SecurityOld ClaimNew Claim Under Reorganization Mortgage bonds$1,500,000 Subordinated debentures $2,500,000$1,000,000

2-18 © 2011 McGraw–Hill Ryerson Limited Reorganization Example LO31.3b And a distribution of new securities under a new claim with the reorganization plan: Old SecurityNew Claim Under Reorganization Mortgage bonds$1,000,000 in 9% subordinated debentures $500,000 in 11% subordinated debentures Subordinated debentures$1,000,000 in 8% preferred stock $500,000 in common stock

2-19 © 2011 McGraw–Hill Ryerson Limited Current Issues in Financial Distress LO31.4 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.

2-20 © 2011 McGraw–Hill Ryerson Limited Private Workout or Bankruptcy: Which is Best? LO31.4 In Canada, the current Bankruptcy and Insolvency Act has added increased costs and time commitments to the formal bankruptcy proceedings. Direct negotiations (private workouts) between creditors and debtors can be expected to increase. Bankruptcy is better for equity investors than for creditors because equity investors can usually hold out for a better deal in bankruptcy.

2-21 © 2011 McGraw–Hill Ryerson Limited Prepackaged Bankruptcy LO31.4 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. 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.

2-22 © 2011 McGraw–Hill Ryerson Limited The Decision to Seek Court Protection: The Case of Canwest Global Communications Corp. LO31.5 Canwest, headquartered in Winnipeg, is one of Canada’s largest international media companies. The company was highly leveraged and too dependent on advertisement revenue. The financial distress was caused by issuing large amount of debt to finance various ambitious acquisitions. On October 6, 2009, Canwest filed for court protection in Canada under the Companies’ Creditors Arrangement Act. In February, 2010, Canwest found an investor, Shaw Communications, to buy a controlling stake in the company and help it reorganize. Bondholders bought out the newspaper division in June 2010 for $1.1 billion.

2-23 © 2011 McGraw–Hill Ryerson Limited The Decision to Seek Court Protection: The Case of Canwest Global Communications Corp. LO31.5 Costs of the Canwest restructuring include: 1.Direct costs of restructuring for the first six months. Fees for Canwest Media$87.7 million Fees for newspaper division $40.0 million 2.Indirect costs of restructuring: management distraction, loss of customers, and loss of reputation. 3.Costs of a complicated financial structure: conflicts between managers, shareholders, and creditors make reaching a private agreement difficult.

2-24 © 2011 McGraw–Hill Ryerson Limited Summary and Conclusions LO31.6 Financial distress is a situation where a firm’s operating cash flow is not sufficient to cover contractual obligations. Financial restructuring can be accomplished with a private workout or formal bankruptcy. Corporate bankruptcy involves liquidation or reorganization. A hybrid of a private workout and formal bankruptcy is prepackaged bankruptcy.

2-25 © 2011 McGraw–Hill Ryerson Limited Quick Quiz Define financial distress. Explain the absolute priority rule. Discuss why a private workout may be preferred to formal bankruptcy.

2-26 © 2011 McGraw–Hill Ryerson Limited Many potential lenders use credit scoring models to assess the creditworthiness of prospective borrowers. The general idea is to find factors that enable the lenders to discriminate between good and bad credit risks. Edward Altman has developed a model using financial statement ratios and multiple discriminant analyses to predict bankruptcy for publicly traded manufacturing firms Appendix 31A: Predicting Corporate Bankruptcy: The Z-score model

2-27 © 2011 McGraw–Hill Ryerson Limited Predicting Corporate Bankruptcy: The Z- score model (continued) The resultant model is of the form: Z = 3.3(EBIT/Total assets) + 1.2(Net working capital/Total assets) + 1.0(Sales/Total assets) + 0.6(Market value of equity/Book value of debt) + 1.4(Accumulated retained earnings/Total assets) where Z is an index of bankruptcy. Bankruptcy would be predicted if Z  1.81 and nonbankruptcy if Z  2.99.

2-28 © 2011 McGraw–Hill Ryerson Limited Predicting Corporate Bankruptcy: The Z- score model (continued) Altman uses a revised model to make it applicable for private firms and non-manufacturers. The resulting model is: Z = 6.56(Net working capital/Total assets) (Accumulated retained earnings/Total assets) (EBIT/Total assets) (Book value of equity/Total liabilities) where Z  1.23 indicates a bankruptcy prediction  Z  2.90 indicates a grey area, and Z  2.90 indicates no bankruptcy.