Introduction to troubled-debt restructuring

1. Introduction to troubled-debt restructuring Corporate Restructuring Tim Thompson

2. No Chapter 11 filing Workout Prepackaged Ch. 11 Distressed Firm Chapter 11 Reorganization Chapter 11 (outside option) Auction or sale Chapter 7 Liquidation (outside option)

3. Focus of lecture • Firm already in distress • defined as not able to make debt payments as they come due • Choices • Renegotiate contracts with creditors out of court (workout) • Renegotiate contracts with creditors in court (Chapter 11) • Allow the firm to be liquidated by court appointed trustee (Ch 7) • Chapter 11 court may order the company be sold to highest bidder • Most focus will be on large firms, usually publicly held

4. Insolvency • Troubled debt restructuring methods needed because firm is insolvent • I.e., it can not meet its obligations as they come due. • This is not the legal definition

5. Causes of insolvency • Bad luck • Economic conditions • Competitive position eroded • Firm specific factors • Bad strategy • Bad execution -- mismanagement • Fraud • Overlevered the company

6. Effect of insolvency • Have to recontract with creditors • get parties to agree to reorganization • liabilities, ownership, control • or liquidate • Recontracting can be settled out of court • Workouts/private reorganizations • Or, in court • Chapter 11 (reorg) or Chapter 7 (liquidation)

7. Main effect of reorganizations • Restructure terms on debt • reduce interest payments/principal amounts • Extend maturity • Substitute equity (or equiv.) for debt • What if V is very large? • Could be that have too little cash flow, but good value, could offer BH more value, but paid later • Not the usual situation

8. What is optimal choice if managers are value maximizing? • Is the firm worth more as a going concern? • with its own strategy • bought out by another firm • Or is it worth more liquidated? • What is size of the pie and how is it to be sliced? Tough question on both counts!

9. Watch out for incentives on all sides! • Creditors • Race to the top • Don’t want firm to go into Ch. 11 • In Ch. 11, want you to liquidate inefficiently • Shareholders • Stay out of Ch 11 • In Ch 11, want ongoing firm • Managers • Depends on what their position looks like

10. Chapter 11 is not first choice • Almost all large, publicly traded firms attempt to workout debt before entering Chapter 11 • Why do firms attempt a workout?

11. Workouts less expensive than Chapter 11 • Gilson, John and Lang (GJL) studied NYSE AMEX firms doing workouts and Ch. 11’s in ‘80’s • Legal and professional fees higher in Ch 11 • Avg length of Ch 11 is longer, especially when workout included exchange offer • In workout, only deal with claims in default* • In Ch 11, all claims

12. Problems with Ch. 11 • Legal/professional fees have priority over other claims, so less incentive to get it done • Management by judges • Major decisions: file application with court, notify creditors -- file complaints • Judges legal requirements • claimholders must receive at least what they’d get in liquidation, company not in danger of going bankrupt again (near future)

13. Why would bondholders or lenders agree to workout? • Chapter 11 is a protection for the debtor (called the debtor in possession, or DIP) • Chapter 11 can extract an even better (worse for the creditor) deal for the DIP than you might get in workout!

14. Advantages to DIP of Chapter 11 • New issued debt higher priority than pre-petition debt • Interest on pre-petition unsecured debt stops accruing • Automatic stay from creditors • Easier to get reorg plan accepted because of voting rules

15. Why does firm go to Chapter 11? Creditor holdouts (and advantages above) • In workout, have to get all participating creditors to agree • Bondholders have incentive to free ride on the settlement • Try to trap the free riders by making the exchanged bonds higher priority, shorter maturity • Problem worse with public debt, more complex debt

16. LTV decision • Judge Burton Lifland • Bondholders who tendered in previous exchange offer were entitled to claim equal to market value of new bonds • Non exchanging bondholders entitled to claim equal to face value of debt • Makes holdout problem worse

17. Rights of management in Ch 11 • DIP (debtor in possession) has exclusive right to file first reorg plan • for 120 days • typically extended, sometimes for years • Large management turnover in both workouts and Ch 11’s • Also, reputation issues

18. Tax disadvantage to voluntary restructuring • Tax Reform Act of 1986 • More difficult to preserve NOL carryforwards • Hard to avoid paying tax on income from forgiveness of debt • Revenue Reconciliation Act of 1990 • newly exchanged bonds trading at a discount to face value, the firm must book the difference as taxable income

19. Prepackaged bankruptcy • Hybrid of workouts and Chapter 11’s • Firm files Chapter 11 • But files reorg plan at the same time (agreed to with secured creditors informally beforehand) • Can hurry up the Ch 11 process • Not a sure thing! • Why do Ch 11 at all?

20. Deviations from Absolute Priority in Troubled Debt Restructuring Corporate Restructuring Tim Thompson

21. Absolute Priority • In typical corporate finance treatments of default, assumed that claimants of the firm will be paid according to absolute priority • First, secured claimants • Administrative claims • Employee claims • Customer claims • Tax claims • Unsecured creditors, then equity

22. Deviations from APR common • Kaiser, Chap. 11, documents many papers describing deviations from APR • Both in Chapter 11 and in workouts • Typically, equity and unsecured debtholders receive more than “should,” more senior claims receive less than “should” • Equity receives more in workouts than in Chapter 11

23. Do markets expect APR deviations? • Generally, yes. • Kaiser’s Chapter 11 suggests that debt markets do not seem to anticipate the eventual APR violations, but most of the literature suggests that markets do, in fact, incorporate these violations into pricing.

24. Betker (1996) • Show table

25. If markets efficient, do deviations from APR matter? • Still matter, because the noise in how much you would get/lose due to violations leads to inefficient investments • in time to find out how large deviations will be • in time and effort to limit/increase size of deviations • in increases in rates/onerous covenants when you issue debt

26. Why are there deviations? • Management bargaining position • Factors influencing amount • Larger proportion of debt, less violations • higher proportion of secured debt/bank debt, etc., less violations • More equity percentage held by mgmt. • especially if same mgmt. continues employment • Manager position looks like shareholder, more!

27. Lo Pucki and Whitford (1990) • Managers act more in their own interests than in equity interests, so understanding the distinction is important on case by case basis.

28. Recovery rates • How much do bankers/bondholders get back of their original investment in Chapter 11 reorganizations? • What is relation between recovery rates and seniority/security? • What is relation between recovery rates and public/private/banks?

29. Altman evidence • Average “recovery rate” approx. 40% • Recovery rate defined as the price one month after default occurred divided by par value • 1991 36.0% • 1990 23.4% • 1989 38.3% • 1988 43.6% • 1987 75.9% • 1986 34.5% • 1985 45.9%

30. Altman: rec. rates by priority • 1985-1991 Averages • Type of debt Recovery rate • Secured 60.51% • Senior 52.28% • Senior subordinated 30.70% • Subordinated (cash pay) 27.96% • Subordinated (PIK) 19.51%

31. Recovery rates in Eastern Airlines • Secured debt with sufficient collateral 100% • Secured debt, insufficient collateral • 11.75% First equip cert 100% • 12.75% Second equip cert 60% • 13.75% Third equip cert 6% • Accrued interest on secured debt 57% • Capital lease obligations 100% • Unsecured debt • PBGC pension claims 15% • Manufacturer’s sub notes 11% • Conv Sub Debs 6% • Healthcare claims 8% • Stock 0%

32. Kaiser notes, Franks and Torous • Table 12.2 Percentage recovery rates • by creditor class • exchanges, Chap. 11, and prepacks • Conclusions: • Recovery rates higher in workouts than Chapter 11’s • Prepacks more like workouts • Pre-solicited somewhat higher than pre-negotiated

33. Kaiser notes, Franks and Torous • Table 12.5, form of compensation • workouts v. Chapter 11’s • Conclusions: • Cash larger part of distribution in Ch. 11 • Bank debt reduced in chapter 11, becomes senior debt • Junior debt and preferred receive equity, both methods • Equity is larger part of distribution in Ch. 11

34. Loss in value at Eastern • Weiss and Wruck • Table 2 • Total recover by fixed claimants and equity at resolution of bankruptcy, $2,005.5 million. • At filing of Chapter 11, total estimated market value of equity plus different measures of debt, around $4 billion • Loss of approx. $2 billion in value in Chap 11 • argue was not due to industry conditions • Direct costs were $114 million only.

35. What was problem? • Uncertainty about going concern v. liquidate • Judge allowed managers to use proceeds of asset sales to fund continued operations (at substantial op losses) • Some venue shopping?