Corporate Finance Ross  Westerfield  Jaffe

1. Chapter Thirty One 31 Financial Distress Sixth Edition Corporate Finance Ross Westerfield  Jaffe Sixth Edition

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. 31.1 What is Financial Distress? 31.2 What Happens in Financial Distress? 31.3 Bankruptcy Liquidation and Reorganization 31.4 Private Workout or Bankruptcy: Which is Best? 31.5 Prepackaged Bankruptcy 31.6 Summary and Conclusions Chapter Outline

4. 31.1 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. Firm Liabilities ($m) Bankruptcy Date Texaco $21,603 1987 Executive Life Insurance 14,577 1991 Mutual Benefit Life 13,500 1991 Campeau 9,947 1990 First Capital Holdings 9,291 1991 Baldwin United 9,000 1983 Continental Airlines (II) 6,200 1990 Lomas Financial 6,127 1989 Macy’s 5,300 1992 The Largest U.S. Bankruptcies

8. 31.2 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.

9. 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 Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, “Troubled Debt Restructurings: An EmpiricalStudy 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).

10. 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.

11. 31.3 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.

12. 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.

13. Bankruptcy Liquidation: Priority of Claims The distribution of the proceeds of liquidation occurs according to the following priority: • 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.

14. APR 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.

15. 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 Example Under APR, all creditors are paid before shareholders, and the mortgage bondholders are first in line. The trustee proposes the following distribution:

16. 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.

17. 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.

18. 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:

19. 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:

20. 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

21. 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.

22. Vultures • “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 in 1998. • 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 from 1978-1997 has been about 12 percent—similar to junk bonds but less than the stock market.

23. 31.4 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.

24. 31.4 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.

25. 31.5 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.

26. 31.6 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.