Bankruptcy and restructuring

Why Bankruptcy? Every economic system needs mechanisms to ensure the optimal utilisation of resources. Bankruptcy is the primary instrument for reallocating means of production from inefficient to efficient firms Without efficient bankruptcy procedures, financial crises are longer and deeper The bankruptcy process can allow a company to reorganise, often requiring asset sales, a change in ownership and partial debt forgiveness on the part of creditors

When and Why? Causes of bankruptcy In other cases, bankruptcy leads to liquidation, the death of the company. Generally speaking, bankruptcy is triggered when a company can no longer meet its short-term commitments and thus faces a liquidity crisis The problems generally stem from a ill-conceived strategy, or because that strategy is not implemented properly for its sector. As a result, profitability falls If the company does not have a heavy debt burden, it can limp along for a certain period of time. Otherwise, financial difficulties rapidly start appearing.

Generally speaking, financial difficulties result either from a market problem, a cost problem or a combination of the two. The company may have been caught unaware by market changes and its products might not suit market demands Alternatively, the market may be too small for the number of companies competing in it

Nevertheless, a profitable company can encounter financial difficulties, too. For example, if a company’s debt is primarily short-term, it may have trouble rolling it over if liquidity is lacking on the financial markets. In this case, the most rational solution is to restructure the company’s debt.

WHAT IS FINANCIAL DISTRESS? Financial distress is surprisingly hard to define precisely. This is true partly because of the variety of events befalling firms under financial distress. The list of events is almost endless but here are some examples: Dividend reductions Plant closings Losses Layoffs CEO resignations Plummeting stock prices

Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy current obligations (such as trade credits or interest expenses) 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. What is insolvency? Inability to pay one’s debts; lack of means of paying one’s debts. Such a condition of a woman’s (or man’s) assets and liability that the former made immediately available would be insufficient to discharge the latter (Black’s Law Dictionary)

There are two ways of thinking about insolvency There are two ways of thinking about insolvency. The stock-based insolvency occurs when a firm has negative net worth, and so the value of assets is less than the value of its debts. Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations. Flow-based insolvency refers to the inability to pay one’s debts.

WHAT HAPPENS IN FINANCIAL DISTRESS? In the early 1990s Trans World Airline, Inc. (TWA) experienced financial distress. It lost money in 1989, 1990, and 1991 and steadily lost its market share to rivals United, American, and Delta. Having seen Eastern and Pan Am disappear, airline travelers had good reason to be nervous about buying tickets from TWA. In the summer of 1991,TWA General Counsel Mark A. Buckstein bet Carl Icahn,TWA owner and CEO, $1,000 that the airline would be forced to involuntary bankruptcy by September 1991.4 Icahn argued that he could arrange a private restructuring and avoid formal bankruptcy. Icahn won the bet, but TWA eventually filed for bankruptcy on January 31, 1992. Icahn was quoted as saying the bankruptcy reorganization would give TWA the time it needed to turn the firm around. The odds favored Icahn because financial distress does not usually result in a firm’s death. TWA was reorganized in 1993. Icahn resigned as CEO

and gave up all ownership claims and gave up all ownership claims. However, TWA continued to struggle and for the second time, on July 3, 1995, filed for bankruptcy. Several months later, it emerged from bankruptcy after exchanging $500 million of debt for equity. Remarkably, on January 9, 2001, the board of TWA again approved a plan to file for bankruptcy. The plan included the purchase of TWA by American Airlines for $500 million. Firms deal with financial distress in several ways, such as 1. Selling major assets. 2. Merging with another firm. 3. Reducing capital spending and research and development. 4. Issuing new securities.

5. Negotiating with banks and other creditors. 6. Exchanging debt for equity. 7. Filing for bankruptcy. Items (1), (2), and (3) concern the firm’s assets. Items (4), (5), (6), and (7) involve the righthand side of the firm’s balance sheet and are examples of financial restructuring. Financial distress may involve both asset restructuring and financial restructuring (i.e., changes on both sides of the balance sheet).

Financial distress can serve as a firm’s “early warning” system for trouble. Firms with more debt will experience financial distress earlier than firms with less debt. However, firms that experience financial distress earlier will have more time for private workouts and reorganization. Firms with low leverage will experience financial distress later and, in many instances, be forced to liquidate.

BANKRUPTCY LIQUIDATION AND REORGANIZATION Firms that cannot or choose not to make contractually required payments to creditors have two basic options: 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 established priority. Reorganization is the option of keeping the firm a going concern; it sometimes involves issuing new securities to replace old securities.

Liquidation and formal reorganization may be done by bankruptcy Liquidation and formal reorganization may be done by bankruptcy. Bankruptcy is a legal proceeding and can be done voluntarily with the corporation filing the petition or involuntarily with the creditors filing the petition

Bankruptcy Liquidation Chapter 7 of the Bankruptcy Reform Act of 1978 deals with “straight” liquidation. The following sequence of events is typical: 1. A petition is filed in a federal court. Corporations may file a voluntary petition, or involuntary petitions may be filed against the corporation. 2. A trustee-in-bankruptcy is elected by the creditors to take over the assets of the debtor corporation. The trustees will attempt to liquidate the assets. 3\

3.When the assets are liquidated, after payment of the costs of administration, assets are distributed among the creditors. 4. If any assets remain, after expenses and payments to creditors, they are distributed to the shareholders

Conditions Leading to Involuntary Bankruptcy An involuntary bankruptcy petition may be filed by creditors if both the following conditions are met: 1. The corporation is not paying debts as they become due. 2. If there are more than 12 creditors, at least three with claims totaling $5,000 or more must join in the filing. If there are fewer than 12 creditors, then only one with a claim of $5,000 is required to file.

Priority of Claims Once a corporation is determined to be bankrupt, liquidation takes place. The distribution of the proceeds of the liquidation occurs according to the following priority: 1. Administration expenses, associated with liquidating the bankrupt’s assets. 2. Unsecured claims arising after the filing of an involuntary bankruptcy petition. 3. Wages, salaries, and commissions, not to exceed $2,000 per claimant, earned within 90 days before the filing date.

Priority of Claims 4. Contributions to employee benefit plans arising within 180 days before the filing date. 5. Consumer claims, not exceeding $900. 6. Tax claims. 7. Secured and unsecured creditors’ claims. 8. Preferred stockholders’ claims. 9. Common stockholders’ claims.

Liens on property are outside the mentioned ordering. However, if the secured property is liquidated and provides cash insufficient to cover the amount owed them, the secured creditors join with unsecured creditors in dividing the remaining liquidating value. In contrast, if the secured property is liquidated for proceeds greater than the secured claim, the net proceeds are used to pay unsecured creditors and others.

Bankruptcy Reorganization Corporate reorganization takes place under Chapter 11 of the Federal Bankruptcy Reform Act of 1978 The general objective of a proceeding under Chapter 11 is to plan to restructure the corporation with some provision for repayment of creditors. A typical sequence of events follows: 1. A voluntary petition, or an involuntary petition can be filed The involuntary petition must allege that the corporation is not paying its debts.

2. A federal judge either approves or denies the petition 2. A federal judge either approves or denies the petition. If the petition is approved, a time for filing proofs of claims of creditors and of shareholders is set. 3. In most cases, the corporation continues to run the business. 4. The corporation is given 120 days to submit a reorganization plan.

5. Creditors and shareholders are divided into classes 5. Creditors and shareholders are divided into classes. A class of creditors accepts the plan if two-thirds of the class (in dollar amount) and one-half of the class (in number) have indicated approval 6. After acceptance by creditors, the plan is confirmed by the court. 7. Payments in cash, property, and securities are made to creditors and shareholders. The plan may provide for the issuance of new securities.