30.1 What Is Financial Distress? Financial distress is surprisingly hard to define precisely. This is true partly because of the variety of events befalling firms under financial distress. The list of events is almost endless, but here are some examples:

Dividend reductions Plant closings Losses Layoffs CEO resignations Plummeting stock prices

Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy current obligations (such as trade credits or interest expenses) 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 the firm is forced to take actions that it would not have taken if it had stOur definition of financial distress can be expanded some insolvency. Insolvency is defined in Black ‘s Law Dictionary as

This definition has two general themes: stocks and flows.3 These two ways of thinking about insolvency are depicted in Figure 30.1. Stock-based insolvency occurs when a firm has negative net worth, so the value of assets is less than the value of its debts. Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations. Flow-based insolvency refers to the inability to pay one’s debts.

30.2 What Happens in Financial Distress?

In the early I 990s, Trans World Airline, Inc. (TWA), experienced financial distress. It lost money in 1989, 1990, and 1991 and steadily lost its market share to rivals United, American, and Delta. Having seen Eastern and Pan Am disappear, airline travelers had good reason to be nervous about buying tickets from TWA.

In the summer of 1991, TWA General Counsel Mark A. l3uckstejn bet Carl Icahn, TWA owner and CEO, $1,000 that the airline would be forced to file involuntary bankruptcy by September 199 I.4 Icahn argued that he could arrange a private restructuring and avoid formal bankruptcy. Tcahn won the bet, but TWA eventually filed for bankruptcy on January31, 1992.

Reorganization is the Option of keeping the firm a going Concern; it sometimes involves iSsuing new securities to replace old securities

Liquidation and formal reorganization may be done by bankruptcy Bankruptcy is alegal Proceeding and can be done Voluntarily with the corporation filing the petition orinvoluntarily with the creditors filing the petition.

Bankruptcy Liquidation Chapter 7 of the Bankruptcy Reform Act of 1978 deals with “straight” liquidation Thefollowing sequence of events is typical:

1. A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation

2. A banptcy trustee is elected by the creditors to take over the assets of the debtor corporation The trustee will attempt to liquidate the assets.

3. When the assets are liquidated, after payment of the costs of administration, proceeds are distributed among the creditors.

4. If any assets remain, after expenses and payments to creditors they are distributed to the shareholders

Conditions Leading to involuntary Bankruptcy An involuntary bankruptcy petitionmay be filed by creditors if both the following conditions are met:

1. The corporation is not paying debts as they become due.2. If there are more than 12 creditors, at least three with claims totaling $5,000 or more must join in the filing.

If there are fewer than 12 creditors, then only one with a claim of $5,000 S required to file.3. In most cases, the corporation4. The corporation is given 120 days to submit a reorganization plan

5. Creditors and shareholders are divided into classes. A class of creditors accepts the plan if two-thirds of the class (in dollar amount) and one-half of the class (in number) have indicated approval.

6. After acceptance by creditors, the plan is confirmed by the court.7. Payments in cash, property, and securities are made to creditors and shareholders.

30.4 Private Workout or Bankruptcy: Which Is Best?A firm that defaults on its debt payments will need to restructure its financial claims. Thefirm will have two choices: formal bankruptcy or private workout. The previous sectiondescribed two types of formal bankruptcies: bankruptcy liquidation and bankruptcy

One. Its reorganization plan was confirmed by the U.S Bankruptcy Court on November 2004, six weeks after the date of filing!

Firms typically file bankruptcy to seek protection from their creditors,admitting that they cannot meet their financial obligations as they are presently structured. Once in bankruptcy, the firm attempts to reorganize its financial pictureit can survive. A key to this process is that the creditors must ultimately give the approval to the restructuring plan. The time a firm spends in Chapter 11 depends onthings, but it usually depends most on the time it takes to get creditors to agree to areorganization.

Prepackaged bankruptcy is a combination of a private workout and legal bankruptcy Prior to filing bankruptcy, the firm approaches its creditors with a plan for reorganization The two sides negotiate a settlement and agree on the details of how the firm’sbe restructured in bankruptcy. Then, the firm puts together the necessary paperwork the bankruptcy court before filing for bankruptcy. A filing is a prepack if the essentially walks into court and, at the same time, files a reorganization plan completedocumentation of the approval of its creditors, which is exactly what Choice One did.

The key to the prepackaged reorganization process is that both sides have sogain and something to lose. If bankruptcy is imminent, it may make sense forthto expedite the process even though they are likely to take a financial loss in the restructuring. Choice One’s bankruptcy was relatively painless for most creditors. Interest payment were made on its debt while in bankruptcy, and all vendors were paid. TheChoice One was approved by 100 percent of creditors. Two sets of bondholders . The senior bondholders exchanged $404 million worth of long-term dmillion in new notes and 90 percent of the new stock in the company. The bondholders had their $252 million worth of bonds converted to 10 percentstock and the ability to purchase more common stock in the future. Of course,received nothing and, in fact, had their shares canceled.

Prepackaged bankruptcy arrangements require that most creditors reach agreement privately. Prepackaged bankruptcy doesn’t seem to work when there are of reluctant trade creditors, such as in the case of a retail trading firm likeRevco D. S.’°

The main benefit of prepackaged bankruptcy is that it forces holdoutsbankruptcy reorganization. If a large fraction of a firm’s creditors can agreereorganization plan, the holdout problem may be avoided. It makes a reorganization formal bankruptcy easier to put together.”A study by McConnell, Lease, and Tashjian reports that prepackaged offer many of the advantages of a formal bankruptcy, but they are also more efficient. Their results suggest that the time spent and the direct costs of resolving financial distress in a prepackaged bankruptcy than in a formal bankruptcy.’2