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.Chapter Outline31.1 What is Financial Distress?31.2 What Happens in Financial Distress?31.3 Bankruptcy Liquidation and Reorganization31.4 Private Workout or Bankruptcy:Which is Best?31.5 Prepackaged Bankruptcy31.6 Summary and Conclusions31.1 What is Financial Distress?A situation where a firms 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.Insolvency Stock-base insolvency;the value of the firms assets is less than the value of the debt.AssetsDebtEquitySolvent firmDebtAssetsEquityInsolvent firmDebtNote the negative equityInsolvency Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments.Contractual obligationsInsolvency$Firm cash flowCash flow shortfalltimeThe Largest U.S.Bankruptcies FirmLiabilities($m)Bankruptcy DateTexaco$21,6031987Executive Life Insurance14,5771991Mutual Benefit Life13,5001991Campeau9,9471990First Capital Holdings9,2911991Baldwin United9,0001983Continental Airlines(II)6,2001990Lomas Financial6,1271989Macys5,300199231.2 What Happens in Financial Distress?Financial distress does not usually result in the firms 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.Reorganize and emergeMerge withanother firmLiquidation83%10%7%What Happens in Financial DistressFinancialdistressFinancialrestructuringNo financialrestructuring49%51%Legal bankruptcyChapter 11Privateworkout47%53%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.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.Bankruptcy LiquidationStraight liquidation under Chapter 7 usually involves:1.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.2.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 firms assets.3.After the assets are sold,after payment of the costs of administration,money is distributed to the creditors.4.If any money is left over,the shareholders get it.Bankruptcy Liquidation:Priority of ClaimsThe distribution of the proceeds of liquidation occurs according to the following priority:1.Administration expenses associated with liquidation.2.Unsecured claims arising after the filing of an involuntary bankruptcy petition.3.Wages earned within 90 days before the filing date,not to exceed$2,000 per claimant.4.Contributions to employee benefit plans arising with 180 days before the filing date.5.Consumer claims,not exceeding$900.6.Tax claims.7.Secured and unsecured creditors claims.8.Preferred stockholders claims.9.Common stockholders claims.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 claimsafter paying this,$2.5 million is available to pay creditors.The only problem is that the unpaid debt is$4 million.APR ExampleUnder APR,all creditors are paid before shareholders,and the mortgage bondholders are first in line.The trustee proposes the following distribution:Type of ClaimPrior ClaimCash Received Under LiquidationMortgage Bonds$1,500,000$1,500,000Subordinated Debentures$2,500,000$1,000,000Common Stock$10,000,000$0 Total$14,000,000$2,500,000Bankruptcy Reorganization:Chapter 11A typical sequence:1.A voluntary petition or an involuntary petition is filed.2.A federal judge either approves or denies the petition.3.In most cases the debtor continues to run the business.4.The firm is given 120 days to submit a reorganization plan.5.Creditors and shareholders are divided into classes.Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt 6.After acceptance by the creditors,the plan is confirmed by the court.7.Payments in cash,property,and securities are made to creditors and shareholders.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.Assets$3,000,000Liabilities:Mortgage bonds$1,500,000 Subordinated debentures$2,500,000 Equity-$1,000,000Reorganization ExampleThe firm has proposed the following reorganization plan:Old SecurityOld ClaimNew Claim Under ReorganizationMortgage bonds$1,500,000$1,500,000Subordinated debentures$2,500,000$1,000,000Reorganization ExampleAnd a distribution of new securities under a new claim with the reorganization plan:Old SecurityNew Claim Under ReorganizationMortgage bonds$1,000,000 in 9%subordinated debentures$500,000 in 11%subordinated debenturesSubordinated debentures$1,000,000 in 8%preferred stock$500,000 in common stockAbsolute Priority Rule in PracticeThe APR states that senior claims are fully satisfied before junior claims receive anythingDeviations from APR EquityholdersExpectation:No payoutReality:Payout in 81%of casesUnsecured creditorsExpectation:Full payout after secured creditorsReality:Violation in 78%of casesSecured creditorsExpectation:Full payoutReality:Full payout in 92%of casesReasons 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 dont clog the court calendar with appeals)and pressure parties to compromise.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 2025 percent.Although some years are better than others,the overall annual rate of return from 1978-1997 has been about 12 percentsimilar to junk bonds but less than the stock market.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.31.4 Private Workout or Bankruptcy:Which is Best?Advantages of Bankruptcy1.New credit is available-debtor in possession or DIP debt.2.Discontinued accrual of interest on pre-bankruptcy unsecured debt.3.An automatic stay provision.4.Tax advantages.5.Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt.Disadvantages of Bankruptcy1.A long and expensive process.2.Judges are required to approve major business decisions.3.Distraction to management.4.“Hold out”by stockholders.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.31.6 Summary and Conclusions Financial distress is a situation where a firms 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.