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

Outline1 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.

Insolvency• Stock-base insolvency: the value of the firm’s assets

is less than the value of the debt.

Assets

Debt

Equity

Solvent firm

Debt

AssetsEquity

Insolvent firm

Debt

Note the negative equity

Insolvency• Flow-base insolvency occurs when the firms cash

flows are insufficient to cover contractually required payments.

Contractual obligations

Insolvency

$

Firm cash flow

Cash flow shortfall

time

Largest U.S. BankruptciesFirm Liabilities

(in $ millions)Date

Conseco Inc. $56,639.30 December 2002

Worldcom Inc. 45,984.00 July 2002

Enron Corp. 31,237.00 December 2001

Delta Air Lines 28,546.00 September 2005

Pacific Gas & Electric Co.

25,717.00 April 2001

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.

Reorganize and emerge

Merge withanother firm

Liquidation

83%

10%

7%

What Happens in Financial Distress?

Financialdistress

Financialrestructuring

No financialrestructuring

49%

51%

Legal bankruptcyChapter 11

Privateworkout

47%

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

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:

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 firm’s 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 Claims

Liquidation proceeds are distributed in order of priority:

1. Administration expenses associated with liquidation2. Unsecured claims arising after the filing of an involuntary

bankruptcy petition3. Wages earned within 90 days before the filing date, not to

exceed $2,000 per claimant4. Contributions to employee benefit plans arising with 180

days before the filing date5. Consumer claims, not exceeding $9006. Tax claims7. Secured and unsecured creditors’ claims8. Preferred stockholders’ claims9. Common stockholders’ claims

Absolute Priority Rule in PracticeThe APR states that senior claims are fully satisfied before junior claims receive anything.

Deviations from APR  

Equityholders Expectation: No payoutReality: Payout in 81% of cases

Unsecured creditors Expectation: Full payout after secured creditorsReality: Violation in 78% of cases

Secured creditors Expectation: Full payoutReality: 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: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.

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 Bankruptcy1. New credit is available - "debtor in possession" debt2. Discontinued accrual of interest on pre-bankruptcy

unsecured debt3. An automatic stay provision4. Tax advantages5. Requires only approval by 1/2 of creditors owning 2/3 of

outstanding debt Disadvantages of Bankruptcy

1. A long and expensive process2. Judges are required to approve major business decisions3. Distraction to management4. “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.