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Ronald F. Singer FINA 4330 Financial Distress Lecture 28. Key Concepts and Skills. Be able to define financial distress and understand what happens to a firm in distress Understand the difference between liquidation and reorganization Understand the absolute priority rule
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Ronald F. Singer FINA 4330 Financial Distress Lecture 28
Key Concepts and Skills • Be able to define financial distress and understand what happens to a firm in distress • Understand the difference between liquidation and reorganization • Understand the absolute priority rule • Understand the potential benefits of a private workout versus formal bankruptcy
Outline 1 What Is Financial Distress? 2 What Happens in Financial Distress? 3 Bankruptcy Liquidation and Reorganization 4 Private Workout or Bankruptcy: Which is Best? 5 Prepackaged Bankruptcy
1 What Is Financial Distress? • Financial distress is 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.
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
$ 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
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.
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).
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
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.
Bankruptcy Liquidation Straight liquidation under Chapter 7: • 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.
Bankruptcy Liquidation: Priority of Claims Liquidation proceeds are distributed in order of 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
Absolute Priority Rule in Practice 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
Reasons for Absolute Priority Rule 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 do not clog the court calendar with appeals) and pressure parties to compromise.
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.
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.
Private Workout or Bankruptcy: Which Is Best? • Advantages of Bankruptcy • New credit is available - "debtor in possession" 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
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.