Financial distress process Federal bankruptcy law Reorganization Liquidation BankruptcyData

1. Finance 402 1 Financial distress process Federal bankruptcy law Reorganization Liquidation BankruptcyData.com/

2. Finance 402 2 Recent U.S. Bankruptcy Filings Mirant (June 19, 2005) Collins & Aikman (May 17, 2005) Congoleum (Nov. 9, 2004) Pillowtex (Aug. 27, 2003) J P Stevens (May 2003) Conseco Inc. (Dec. 18, 2002 - $52.3 billion) United Airlines (Dec. 9, 2002) - $22.8 billion) US AIRWAYS (Summer 2002) Polaroid (June 28, 2002 - $1.86 billion) WorldCom (July 21, 2002 - $103.90 billion) Adelphia Communications (June 25, 2002 - $24.41 billion)

3. Finance 402 3 Recent U.S. Bankruptcy Filings-Continued- Global Crossing (Jan. 28, 2002 - $25.41 billion) KMART (Jan. 22, 2002 - $17.01 billion) ENRON (Dec. 2, 2001 - $63.39 billion) NTL Inc. (May 8, 2002 - $16.8 billion) Trans World Airlines Federal-Mogul (Oct. 1, 2000 - $10.15 billion) Reliance Group (June 12, 2001 - $12.60 billion) Pacific Gas & Electric (April 6, 2001 - $21.47 billion) Finova Group (March 7, 2001 - $14.05 billion) Excite@Home Burlington Industries

4. Finance 402 4 Continental Airlines In June 1993, Continental Airlines emerged from bankruptcy a second time. When it filed for bankruptcy in 1990, it had $3.96 billion in debt. When it emerged from bankruptcy in 1993, the firm had $1.8 billion in debt and $635 million in cash. Unsecured creditors received from 5 to 40 cents per dollar of claims. The existing stockholders were wiped out.

5. Finance 402 5 Economic failure: exists when a firm’s revenues are insufficient to cover its total costs. Business failure: any business which has terminated operations with a resultant loss to its creditors. Technical insolvency: when a firm cannot meet its current obligations as they fall due. Could be temporary, or the first step towards economic failure.

6. Finance 402 6 Insolvency in bankruptcy: book value of a firm’s total liabilities exceeds the true market value of its assets. Does not necessarily imply that the firm is in legal bankruptcy proceedings. Legal bankruptcy: occurs when a firm files for bankruptcy under federal law. For instance, Boston Chicken filed for bankruptcy and sold its operations to McDonald’s.

7. Finance 402 7 Lack of managerial experience in the business Financial factors Too much debt Insufficient capital Economic factors Business downturns Industry weakness Poor location/product Foreign competition Neglect, disaster and fraud Most failures occur because a number of factors combine to make the business unsustainable.

8. Finance 402 8 A large number of businesses fail each year, but the number in any one year has never been a large percentage of the total business population. The failure rate of businesses has tended to fluctuate with the state of the economy.

9. Finance 402 9 Bankruptcy is more frequent among smaller firms. Large firms tend to get more help from external sources to avoid bankruptcy, given their greater impact on the economy. Federal government bailouts of Chrysler and Lockheed Federal Reserve System’s coordination of the “bailout” of Long Term Capital Management L.P. (August, 1998)

10. Finance 402 10 Is it a temporary CF problem (technical insolvency) or a permanent problem caused by asset values below debt obligations (insolvency in bankruptcy)? Who should bear the losses? Would the firm be more valuable if it continued to operate or if it were liquidated? Would the firm be more valuable “alive or dead?”

11. Finance 402 11 Should the firm file for bankruptcy, or should it try to use informal procedures? Who would control the firm during liquidation or reorganization?

12. Finance 402 12 Informal reorganization Informal liquidation Why might informal remedies be preferable to formal bankruptcy? What types of companies are most suitable for informal remedies? When would it be preferable to file for formal reorganization under U.S. Bankruptcy laws?

13. Finance 402 13 Additional Terms Squeeze Out New money investors require that the previous investors’ interest is either eliminated or converted into common stock Down Round Equity financing rounds which are being consummated at lower valuations than prior financings

14. Finance 402 14 Bankruptcy Reform Act of 1978, as amended in 1986: Chapter 11: business reorganization chapter Chapter 7: liquidation chapter Chapter 9: municipalities Chapter 13: individuals (recently amended)

15. Finance 402 15 Workout: voluntary informal reorganization plan. Restructuring: current debt terms are revised to facilitate the firm’s ability to pay. Extension: creditors postpone the dates of required interest or principal payments, or both. Creditors prefer extension because they are promised eventual payment in full.

16. Finance 402 16 Composition: creditors voluntarily reduce their fixed claims on the debtor by either accepting a lower principal amount or accepting equity in lieu of payment. Settle for less than 100% of amount owed. Assignment: An informal procedure for liquidating a firm. Title to the debtor’s assets is transferred to a third party. Assignee (trustee): The third party to whom title has been transferred and who is required to liquidate the firm’s assets either through a private or public sale and then to distribute the proceeds among the firm’s creditors on a pro rata basis.

17. Finance 402 17 Definitions - Continued Cross-default provision: defaulting on one loan effectively places all loans in default. Common pool problem: individual investors have an incentive to foreclose on the firm even though the firm is worth more collectively as a going concern. Automatic stay: under Chapter 11, it limits the ability of creditors to foreclose unilaterally...Can foreclose collectively.

18. Finance 402 18 Definitions - Continued Fraudulent conveyance: under Chapter 11, protects creditors from unjustified transfers of property by a firm in financial distress. Holdout problem: under Chapter 11, the courts will lump creditors into classes to avoid the holdout problem. Cramdown: The court mandates a reorganization plan in spite of dissent. The plan must be “fair and feasible.”

19. Finance 402 19 Chapter 11: Business reorganization guidelines. Chapter 7: Liquidation procedures. Trustee: Appointed to control the company when current management is incompetent or fraud is suspected. Used only in unusual circumstances.

20. Finance 402 20 Voluntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm’s management. Involuntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm’s creditors.

21. Finance 402 21 Informal reorganization: Less costly Relatively simple to create Typically allow creditors to recover more money and sooner.

22. Finance 402 22 What are the advantages of a Chapter 11 Reorganization in Bankruptcy over an informal reorganization? Reorganization in bankruptcy Due to automatic stay provision, avoids common pool problem. Avoids holdout problems - permits cramdowns. Interest and principal payments may be delayed without penalty until reorganization plan is approved. Permits the firm to issue debtor in possession financing. (DIP financing)

23. Finance 402 23 Gives debtor exclusive right to submit a proposed reorganization plan for agreement from the parties involved. Reduces fraudulent conveyance problem (protects creditors from unjustified transfers of property by a firm in financial distress) Cramdown if majority in each creditor class approve plan Tax benefits - next slide

24. Finance 402 24 Tax Effects In a formal reorganization in bankruptcy, the firm keeps its loss carry-forwards (accumulated tax losses). In a formal reorganization in bankruptcy, when debt (worth, say, $1,000) is exchanged for debt (worth, say $500), the reduction in debt of $500 is not treated as taxable income.

25. Finance 402 25 Fairness and Feasibility The bankruptcy court reviews the reorganization plan on the basis of fairness and feasibility Fairness - claims are settled in order of their legal and contractual priority Absolute Priority Doctrine Relative Priority Doctrine Feasibility - there is a reasonable chance that the reorganized company will be viable. If no fair and feasible reorganization can be worked out, the firm will be liquidated under Chapter 7 procedures.

26. Finance 402 26 Relatively new type of reorganization Combines the advantages of both formal and informal reorganizations - speeds the process! Avoids common pool problem - automatic stay Avoids holdout problems - allows cramdowns Favorable tax treatment Agreement to plan obtained from creditors prior to filing for bankruptcy (51% of creditors and 2/3rds of the dollar amount of each class of debt) Plan filed with bankruptcy petition

27. Finance 402 27 Chapter 7 of the Bankruptcy Act Provides safeguards against fraud by the debtor Provides for an equitable distribution of the debtor’s assets among creditors Allows insolvent debtors to discharge all their obligations and thus be able to start new businesses

28. Finance 402 28 Past-due Property Taxes Secured creditors. Trustee administrative costs and legal fees. Expenses incurred after involuntary case begun but before trustee appointed. Wages due workers within 3 months prior to filing (up to $2,000 per person).

29. Finance 402 29 Unpaid contributions to employee benefit plans that should have been paid within 6 months prior to filing. Unsecured claims for customer deposits. Taxes due. Unfunded pension plan liabilities. General (unsecured) creditors. Preferred stockholders. Common stockholders.

30. Finance 402 30 Liquidation Illustration Data(Millions of $)

31. Finance 402 31 Proceeds from liquidation: From current assets $14.0 From fixed assets* 2.5 Total receipts $16.5 *All fixed assets are pledged as collateral to mortgage holders.

32. Finance 402 32 Priority Distribution(Millions of $)

33. Finance 402 33 Remaining Initial Final Percent Creditor GC Claim Distrib.a Amountb Received Accounts payable $10.0 $6.500 $6.500 65.0% Notes payable 5.0 3.250 5.000 100.0 Accrued wages 0.0 0.300 100.0 Federal taxes 0.0 0.500 100.0 Other taxes 0.0 0.200 100.0 First mortgage 0.5 0.325 2.825 94.2 Second mortgage 0.5 0.325 0.325 65.0 Sub. deb. 4.0 2.600 0.850 21.2 $20.0 $13.000 $16.500

34. Finance 402 34 Normally, bankruptcy is motivated by serious current financial problems. ENRON Conseco Kmart J P Stevens Bethlehem Steel However, some companies have used bankruptcy proceedings for other purposes: To break union contracts To hasten liability settlements Dow Corning

35. Finance 402 35 Critics contend that current (1978) bankruptcy laws are flawed. Too much value is siphoned off by lawyers, managers, and trustees. Companies that have no hope remain alive too long, leaving little for creditors when liquidation does occur. Companies in bankruptcy can hurt other companies in industry.

36. Finance 402 36 Reorganization Time and Expense The typical bankruptcy case takes about two years. Good bankruptcy lawyers charge more than $400 per hour. For instance, the partners in Collins & Aikman bankruptcy receive $715 and $625 per hour respectively, while the counsels receives $475 and $455 per hour respectively. Also involved are managers, investment bankers, and consultants. Before the 1978 law, 90 percent of Chapter 11 filers were liquidated, but now that percentage is less than 80 percent.

37. Finance 402 37 Cost Considerations -Continued Bankruptcy courts allow cases to drag on for years...e.g.. Eastern airlines (See Chapter Web Extension) Also, LTV was in bankruptcy from 1986 to 1993, mainly because of a pension dispute. During that time, LTV spent $162 million in legal and consulting fees. Creditors got 4 cents to 53 cents per dollar. Current law apparently benefits managers, consultants, lawyers and investment bankers. What about creditors?

38. Finance 402 38 A well-known bankruptcy prediction model is Edward Altman’s five factor model. Such models tend to work relatively well, but only for the near term. The more similar the historical sample to the firm being evaluated, the better the prediction. Typically, MDA analysis should be based on a sample with characteristics similar to those of the firm being analyzed. Multiple Discriminant Analysis

39. Finance 402 39 Multiple discriminant analysis (MDA) is a statistical technique similar to multiple regression. It identifies the characteristics of firms that went bankrupt in the past. Obtain a Z Score Then, data from any firm can be entered into the model to assess the likelihood of future bankruptcy. What is MDA, and how can it be used to predict bankruptcy?

40. Finance 402 40 Assume you have the following 2004 data for 12 companies: Current ratio Debt ratio Six of the companies (marked by Xs) went bankrupt in 2004 while six (marked by dots) remained solvent. MDA Illustration

41. Finance 402 41

42. Finance 402 42 The discriminant boundary, or Z line, statistically separates the bankrupt and solvent companies. Note that two companies have been misclassified by the MDA program: One bankrupt company falls on the solvent (left) side and one solvent company falls on the bankrupt (right) side.

43. Finance 402 43 Assume the equation for the boundary line is:

44. Finance 402 44 Suppose Firm S has CR = 4.0 and DR = 0.40. Then,

45. Finance 402 45 The most well-known bankruptcy prediction model is Edward Altman’s five factor model. Such models tend to work relatively well, but only for the near term. The more similar the historical sample to the firm being evaluated, the better the prediction. Some Final Points about MDA

46. Finance 402 46 Fair Issac & Company (FICO) “Scores” consumers’ credit “Scores” loan applicants based on financial inputs 14 billion times last year Business Intelligence Software to determine a consumer’s ability and willingness to pay back loans Uses credit reports from Experian, Trans-Union, Equifax and Dun & Bradstreet and other information

47. Finance 402 47 Bankruptcy, Reorganization and Liquidation Types of financial distress Informal procedures Formal bankruptcy Absolute vs. Relative priority Reorganization Liquidation Multiple Discriminant Analysis