© 2007 Thomson South-Western Chapter 25 Bankruptcy and Financial Distress Professor XXXXX Course Name / Number

2 2 Types of Business Failure Economic failure Return earned by the company is lower than its cost of capital. Technical insolvency Firm is unable to pay its liabilities as they come due. Company assets are still greater than its liabilities, but company is confronted with a liquidity crisis. Insolvency bankruptc y Firm's liabilities exceed the market value of its assets. Courts treat technical insolvency and bankruptcy in the same way.

3 3 Largest Bankruptcies in U.S. History as of December 14, 2005

4 4 Major Causes of Business Failure Financial distress: the primary cause of business failure  Over-expansion, poor financial actions, ineffective sales force, and high production costs Economic activity, especially economic downturns –Sales may decrease, leaving the firm with high fixed costs and insufficient revenues to cover them. –Rapid rises in interest rates prior to a recession can further cause cash flow problems. Corporate maturity: failure to promote R&D or mergers

5 5 Voluntary Reorganization Extension Firm’s creditors receive payment in full, although not immediately. Composition Pro rata cash settlement of creditor claims Creditor control Committee of creditors decides that operating management be replaced. Firm may arrange with its creditors a voluntary settlement:

6 6 Voluntary Liquidation Credit committee could recommend liquidation of the firm: Liquidation: privately or through the legal procedures provided by bankruptcy law Objective Recover as much per dollar owed as possible Alternative to liquidation - the firm is acquired

7 7 Bankruptcy Law in U.S. Bankruptcy Reform Act of 1978: contains eight odd- numbered (1 through 15) chapters and chapter 12. Chapter 7 contains procedures to be followed when liquidating a failed firm. Chapter 11 outlines the procedures for reorganizing a firm:  Collective legal procedure is begun by which all claims are resolved.  Individual creditors are prevented from beginning lawsuits against the debtor.  Eliminates the benefit of being the first to sue because all claims against the firm are settled simultaneously.

8 8 Reorganization Approval Filing Appointment Acceptance of plan Payment of expenses Five steps Allow businesses in temporary financial distress to continue operating: Disadvantage: managers can file for chapter 11 and choose the bankruptcy procedure that is best for themselves.

9 9 Filing Reorganization petition must be filed in a federal bankruptcy court by the firm or an outside party., Outside party can file for reorganization if: firm has past-due debts of $5,000 or more, three or more creditors with aggregate unpaid claims of $5,000 or more, or the firm is insolvent.

10 Appointment DIP is responsible for the valuation of the firm. The filing firm becomes the debtor in possession (DIP) of the assets: Creditor committee appointed to represent the interest of creditors.  If DIP evaluates the value as a going concern of the firm lower than liquidation value, recommend liquidation.  Otherwise, DIP recommends reorganization.

11 Reorganization Plan DIP submits a reorganization plan to the court: Recapitalization Key part of reorganization plan Debt is exchanged for equity or its maturity is extended. Claims on the new securities issued are distributed based on the seniority of the existing claims.

12 Acceptance of the Reorganization Plan Court approved plan is submitted for approval to the firm’s creditors and shareholders. Under unanimous consent procedure (UCP), creditors and equity classes must agree with the reorganization plan. When a reorganization plan fails to meet approval by all classes under the UCP, use cramdown procedure. The bankruptcy court can approve the plan without the consent of the other classes in cramdown. What is the procedure?

13 Acceptance of the Reorganization Plan  One class of creditors has to vote for reorganization plan in this case.  Secured creditors retain their prebankruptcy liens on assets. What if no reorganization plan is adopted under either the UCP or cramdown? –Managers sometimes voluntarily sell the firm as a going concern. –The proceeds of the sale are paid to creditors. –Creditors could petition for the shift of bankruptcy filing to Chapter 7 liquidation.

14 Payment of Expenses  After the reorganization plan has been approved or disapproved  A statement of expenses is filed; if approved, the debtor must pay the expenses within a reasonable period An example.... Current capital structure for Campbell Technologies Debentures (unsecured debt) $22,000,000 Subordinated debentures $28,000,000 Common stock (100,000 shares) $20,000,000 Total $70,000,000 Debt/Equity of the company is 2.5 ($50 million/$20 million) Campbell Technologies is worth $45 million as a going concern

15 Payment of Expenses  The company could be reorganized as follows Debentures (unsecured debt) $11,000,000 Subordinated debentures $14,000,000 Common stock (200,000 shares) $20,000,000 Total $45,000,000 Debt holders receive 100,000 shares in exchange for cutting their debt claims in half Debt/Equity ratio is reduced to 1.25 ($25 million/$20 million) The financial condition of the company is improved by reducing the debt!

16 Subsidies to Firms that Reorganize 1. When reorganizing firms settle liabilities for less than their face value, the amount of debt forgiveness is deducted as a loss by the creditor but is not immediately treated as taxable income to the reorganizing firm.

17 Subsidies to Firms that Reorganize 2. Firms reorganizing under Chapter 11 have the right to terminate underfunded pension plans, and the U.S. government’s Pension Benefit Guaranty Corporation (PBGC) picks up the uncovered pension costs.

18 Subsidies to Firms that Reorganize 3. Firms that reorganize retain most of their accrued tax loss carryforwards, which would be lost if they liquidated.

19 Subsidies to Firms that Reorganize 4. When firms file for bankruptcy, their obligation to pay interest to pre- bankruptcy creditors, both secured and unsecured, ceases.

20 Subsidies to Firms that Reorganize 5. Firms in reorganization can reject any of their contracts that are not substantially completed.

21 Subsidies to Firms that Reorganize 6. Firms in reorganization can reject their collective bargaining labor agreements, on approval of the bankruptcy judge.

22 Prepackaged Bankruptcies  Companies can prepare a reorganization plan that is negotiated and voted on by creditors and stockholders before the company actually files for Chapter 11 bankruptcy.  This prepackaged bankruptcy shortens and simplifies the process and saves money.

23 Liquidation in Bankruptcy Final accounting Procedures Priority of claims Three important aspects Chapter 7 of Code addresses the order of priority of claims: 1.The expenses of administering the bankruptcy 2. Any unpaid interim expenses incurred in the ordinary course of business between filing the bankruptcy petition and the entry of an Order of Relief in an involuntary proceeding 3. Wages of not more than $2,000 per worker that have been earned by workers in the 90-day period immediately preceding the bankruptcy

24 Liquidation in Bankruptcy 4. Unpaid employee benefit plan contributions 5. Unsecured customer deposits, not to exceed $900, resulting from purchasing or leasing a good or service from the failed firm 6. Taxes owed by the bankrupt firm 7. Claims of secured creditors, who receive the proceeds from the sale of collateral held, regardless of the proceeding priorities 8. Claims of unsecured creditors 9. Preferred stockholders, who receive an amount up to the par value of their preferred stock 10. Common stockholders, who receive any remaining funds, which are distributed on an equal per share basis

25 Example: Liquidation of Oxford Company – Balance Sheet

26 Distribution of Liquidation Proceeds of Oxford Company

27 Pro Rata Distribution of Funds among the Unsecured Creditors of Oxford Co.

28 Predicting Bankruptcy Z = 1.2 * X * X * X * X * X 5 Where X 1 = working capital / total assets X 2 = retained earnings / total assets X 3 = earnings before interest and taxes / total assets X 4 = market value of equity / book value of debt X 5 = sales / total assets Altman’s Z score: quantitative model that uses a blend of traditional financial ratios and multiple discriminant analysis: About 90% accurate in forecasting bankruptcy one year in the future About 80% accurate in forecasting bankruptcy two years in the future

29 Balance Sheet for Poff Industries

30 Income Statement for Poff Industries

31 Z scores  Using Z score, businesses are classified in:  Companies with high probability of failure, Z is less than 1.8.  Companies with unsure probability of failure, Z is between 1.81 and  Companies with low probability of failure, Z is higher than 3.