Financial Distress

What is Financial Distress? 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.

Definition of Terms Default –Failure to meet an interest payment, or –Violation of debt agreement Bankruptcy –Formal procedure for working out default –Does not automatically follow from default. Financial Distress –Includes default and bankruptcy, but also –Threat of default or bankruptcy and its effect on the company –Defined to capture the costs and benefits of using large amounts of debt finance

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

Insolvency 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

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.

Reorganize and emerge Merge with another firm Liquidation 83% 10% 7% What Happens in Financial Distress Financial distress Financial restructuring No financial restructuring 49% 51% Legal bankruptcy Chapter 11 Private workout 47% 53%

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.

Bankruptcy Liquidation and Reorganization Malaysia’s Bankruptcy Act 1967 is based on the English Bankruptcy Act of A debtor is defined in Section 3(3) BA ’67 to include those personally present in Malaysia, ordinarily resident or had a place of residence in Malaysia, was carrying on business in Malaysia either personally or by means of an agent, or was a member of a firm or partnership which carried on business in Malaysia.

Corporate Insolvency in Malaysia General Liquidation Receivership Schemes of Arrangement Special Administration under Pengurusan Danaharta Nasional Berhad Act 1998

General Liquidation Under S217 and 218 Companies Act 1965, a company may be wound-up upon presentation of a Winding-Up Petition if it is unable to pay its debt Once the winding-up order is made, a court- appointed liquidator will be entrusted with the job of overseeing the liquidation process, including the handling of the wound-up Company’s assets and the repayment of debts

Receivership If a foreign creditor has a debenture over the assets of a Malaysian Company, he may appoint a receiver to run the business for a limited period with a view to realising it as a going concern

Schemes of Arrangement S 176 CA 1965 allows companies that are in financial difficulty to apply to the Courts for court-approved schemes of arrangements. During the 1997 crisis, this device was used by numerous debtor companies in order to buy time to restructure their finances. The typical modus operandi was to file an application to Court for Court approval of a proposed scheme of arrangement, pending that hearing, applying ex-parte to the High Court to stay all proceedings against the Company until the Court makes a decision on the proposed scheme. The Company may continue to operate pending the outcome of the scheme.

.. continue Section 176’s provision was checked by a new Section 176 (10)(A) CA 1965 which was enacted to restrict any period of stay to merely 90 days or such longer period as the Court may for good reason allow if and only if certain conditions are met. Even then, the schemes would only be approved if a majority (3/4) of creditors agrees to any compromise.

Pengurusan Danaharta Nasional Berhad Act 1998 The Act empowers Danaharta Corporation to acquire non-performing loans from banks and other financial institutions and manage these assets pending their sale by public tenders or auction. The main objective was to restructure the loans where possible, and only resort to foreclosure and sale of collateral as a last resort.