Financial Distress

1. Financial Distress

2. 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.

3. Outline What is Financial Distress? What Happens in Financial Distress? Bankruptcy Liquidation and Reorganization Private Workout or Bankruptcy: Which is Best? Prepackaged Bankruptcy Summary and Conclusions

4. 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.

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

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

7. Why firms suffer financial distress? • Firms with too high leverage ratio • Firms with inferior operating results • Firms in a declining industry

8. Largest U.S. Bankruptcies

9. 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.

10. No financialrestructuring 49% Privateworkout 47% 51% Financialrestructuring Reorganize and emerge 83% 53% Merge withanother firm Legal bankruptcyChapter 11 7% 10% Liquidation What Happens in Financial Distress Financialdistress

11. 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.

12. 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.

13. Bankruptcy Liquidation Straight liquidation under Chapter 7 usually involves: • 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.

14. Bankruptcy Liquidation: Priority of Claims The distribution of the proceeds of liquidation occurs according to the following priority (APR): • 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.

15. APR (Absolute Priority Rule) Example • Suppose the B.O. Drug Co. decides to liquidate under Chapter 7. • 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.

16. Type of Claim Prior Claim Cash Received Under Liquidation Mortgage Bonds $1,500,000 $1,500,000 Subordinated Debentures $2,500,000 $1,000,000 Common Stock $10,000,000 $ 0 Total $14,000,000 $2,500,000 APR (Absolute Priority Rule) Example Under APR, all creditors are paid before shareholders, and the mortgage bondholders are first in line. The trustee proposes the following distribution:

17. 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.

18. Assets $3,000,000 Liabilities: Mortgage bonds $1,500,000 Subordinated debentures $2,500,000 Equity –$1,000,000 Reorganization Example • Suppose the B.O. Drug Co. decides to reorganize under Chapter 11. • Assume that the “going concern” value is $3 million and its balance sheet is shown.

19. Old Security Old Claim New Claim Under Reorganization Mortgage bonds $1,500,000 $1,500,000 Subordinated debentures $2,500,000 $1,000,000 Reorganization Example The firm has proposed the following reorganization plan:

20. Old Security New 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 Reorganization Example And a distribution of new securities under a new claim with the reorganization plan:

21. 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 Absolute Priority Rule in Practice

22. Reasons for APR 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 don’t clog the court calendar with appeals) and pressure parties to compromise.

23. Vulture (not Venture) Capital • “Vultures” are money managers that specialize in the securities of distressed and defaulted companies. • There are between 50 and 60 institution vulture specialists, actively managing over $25 billion. • Distressed debt investors have target annual rates of return of 20–25 percent. • Although some years are better than others, the overall annual rate of return has been about 12 percent—similar to junk bonds but less than the stock market.

24. 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.

25. Private Workout or Bankruptcy: Which is Best? • Advantages of Bankruptcy • New credit is available - "debtor in possession" or "DIP" 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.

26. 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.

27. Summary and Conclusions • 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 Chapter 7 liquidation or Chapter 11 reorganization. An essential feature of the U.S. Bankruptcy code is the absolute priority rule (APR). • A hybrid of a private workout and formal bankruptcy is prepackaged bankruptcy.

28. 我國之重整制度（王之斌 1993）： • 我國在民國十八年制定公司法時並無重整制度，公司發生財務危機只能透過協商和解，否則只有破產清算一途。直到民國四十九年，唐榮鐵工廠股份有限公司發生財務危機，行政院依據國家總動員法而頒佈重要生產事業救濟令以資救助。嗣後，在民國五十五年修正公司法時，才將重整制度納入公司法第五章第十節共三十三條。

29. 聲請重整 董事、大股東、債權人 成功 徵詢主管機關、選任檢查人，保全處分 駁回 抗告 法院 選任重整人，選任監督人，申報債權與股權，重整人提重整計畫 裁定重整 失敗 表決失敗 關係人會議 表決通過 股東、債權人 重整人、公司負責人 聲請法院認可 徵詢主管機關 再審未通過 實施重整計畫 開始重整 終止重整 法院判定 失敗 成功 召開股東會 變更登記 破產清算 重整成功

30. 公司重整之要件 • 須為公開發行股票或公司債之股份有限公司 • 須公司因財務困難，暫停營業或有暫停營業之虞者 • 公司營業現況，依合理財務費用負擔標準，仍有經營價值者

31. 重整之聲請：有權申請者包括 • 董事會（2/3出席，半數通過） • 持有已發行股份1/10以上達六個月以上者 • 相當於已發行股份1/10以上之債權人

32. 法院之裁定： • 形式上要件：審查法院有無管轄權？聲請人有無聲請權？公司有無破產解散等情形？ • 實質上要件：審查公司有無聲請之原因及必要： • 徵詢公司事業主管機關、證管會請其題供意見，作為准駁之參考 • 通知被聲請公司，俾使該公司提供資料或陳述意見 • 選任檢查人，以調查瞭解公司業務及財務情形 • 命公司負責人造報公司債權人及股東名冊 • 詢問利害關係人，或為其它必要之調查，法院為形式及實質審查後，始行依法斟酌准駁之裁定

33. 法院准許重整對公司股東及債權人之影響 • 重整裁定送達公司後，公司業務之經營及財產之管理處分權移屬於公司重整人。 • 重整裁定送達公司後，由重整人負責公司業務之執行，董事會、股東、及監察人之職權均依法停止。 • 公司破產、和解、強制執行及因財產關係產生的訴訟當然停止。 • 法院在重整裁定前對公司財產、業務所作之保全處分和限制，不因裁定重整而失其效力。未為處分者，於裁定重整後，仍得依利害申請人或重整監督人之聲請，或依職權裁定之。

34. 有關重整之執行機關及監督機關 • 重整人： • 重整人之指派：原則為董事，法院若覺不適當，得於債權人或股東中選任之。 • 重整人之職權：在重整程序中，由重整人以善良管理人之注意，執行業務，對外代表公司，地位相當於重整前之董事。唯重整人執行職務應受重整監督人之監督。 • 重整監督人：為監督重整人執行職務，法院須選擇對公司業務具有專門知識及經驗者為重整監督人，而重整監督人受法院監督。

35. 有關重整之利害關係人及公司重整債權 • 重整債權：在重整裁定前成立之債權為重整債權。債權人應於申報期間內，向重整監督人申報重整債權。重整債權若未經申報，不得依重整程序清償。 • 重整期間之股東權：重整期間之股東權僅能由關係人會議行使。股東權之申報、審查等程序均與重整債權同。

36. 有關重整計劃之決定與終結 • 重整計劃：調整債權人與股東之利害，重振企業之計劃。重整計劃由重整人為之，於第一次關係人會議時提出。重整計劃經關係人會議可決及法院認可，對於公司及關係人均有約束力。 • 重整程序終止：在下列狀況時（1）法院對重整計劃不予認可，（2）重整計劃經關係人會議再審查後，未予以可決，以及（3）重整計劃因情勢變遷或有正當理由致不能或無須執行時；法院可以裁定終止重整程序。 • 重整完成：重整人在期限內完成重整工作後，應即召開重整及股東會，改選董事、監察人。重整後董事、監察人就任後，應即向主管機關申請登計或變更登計，並會同重整人報請法院為重整完成之裁定。

37. 公司重整績效不彰之原因：（羅建勛 1989） • A. 人為因素： • B. 法律及結構因素：

38. 人為因素 • 1. 重整監督人未善盡監督之責 • 2. 法院未設專庭負責公司重整 • 3. 公司財務結構不健全 • 4. 金融機構態度保守 • 5. 檢查人之選任未重專門性 • 6. 法院對於重整之可能性未嚴格評估 • 7. 主管機關及法院審核時間太長

39. 法律及結構因素 • 未規定重整須有重建更生之可能：公司法282條：公開發行股票及公司債之公司，因財務困難暫停營業或有停業之虞者，法院得依聲請准予重整；未有規定重整須有重建更生之可能。若准許無可能重整之公司重整，將對債權人資產之保障造成危害。 • 原來經營者繼續擔任重整人：公司法290條第一項，原則上董事乃重整人。容易造成人謀不臧之情形，導至債權人利益受損。 • 未關於誠信聲請要件規定：重整申請之動機可能基於不正當之動機，例如爭取時間進行脫產行為，有違誠信原則。 • 法律未有以債作股之規定。 • 未規定關係人不當受讓重整債權或股份時應禁止其表決。 • 未就重整計劃各款分別訂定執行期限。