Chapter 25
Bankruptcy, Reorganization, and Liquidation
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
25-1
Bankruptcies occur in firms of all sizes. Small firms, with fewer creditors, are often able
to work out informal settlements and thus avoid the time and expense of formal
bankruptcy. Ross Corporation, described in Question 3, is probably too large, and it has
too many creditors, to work out an informal settlement. If Ross attempted to resolve its
problems informally, the attempt would probably fail, and then it would have to resort to
the federal bankruptcy court. Note that if there had been fewer creditors, and particularly
if most of the debt were owed to a few banks, then the chances of an informal resolution
would be better. But with many holders of the publicly traded bonds, 15 banks, and 250
unsecured creditors, there would probably be too many holdouts to reach an informal
resolution.
25-2
The judge in a federal bankruptcy proceeding can abrogate all contracts, including labor
contracts. If a contract requires payments greater than the company’s cash flows can
support, then the judge can order that payments be scaled back to a level the company
can afford. Labor contracts were abrogated for a number of firms that were hit with
asbestos suits, notably Johns Manville, and currently several airlines are in bankruptcy
proceedings under which labor contracts will likely be changed.
25-3
a. As noted above, is probably too large, and it has too many creditors, to work out an
informal settlement. For a company this large and complex, the federal bankruptcy
system will almost certainly have to be used.
b. The two key chapters are Chapter 11, which spells out how a company can be
reorganized and thus allowed to continue in existence, and Chapter 7, which spells
out the procedures for liquidation.
c. Management generally initiates bankruptcy proceedings. One of its creditors whose
debt is in default might be threatening to get a court order attaching the company’s
bank account or foreclosing on a piece of property, and this action might put the
company out of business. However, the company could head this off by filing for
protection under the Bankruptcy Code. That filing would stop the creditors from
taking action to seize the company’s property, and the bankruptcy court would hold
hearings designed to determine the best course of action.
d. The company could file for liquidation under Chapter 7, but managements generally
try to save the company, and that means reorganizing under Chapter 11. If
management cannot come up with a feasible reorganization plan as judged by the
Court, then it will be ordered to liquidate under Chapter 7. Managers have 120 days
in which to file a plan of reorganization. They can take longer than 120 days, but
after that time other parties, especially creditors, can also file plans, and creditors
Answers and Solutions: 25 - 1
e.
f.
g.
h.
might file a plan that called for a liquidation or a reorganization under a new
management.
If creditors filed first, or in reply to the company’s request for a reorganization,
there is a good chance that creditors would request a liquidation. In particular,
secured creditors whose collateral is worth more than the amount they are owed
might well prefer a speedy liquidation to a long, drawn out bankruptcy proceeding
during which time they would receive no cash payments and at the end of which they
might receive new securities rather than cash.
The “common pool problem” refers to a situation where creditors are owed more than
the value of the firm’s assets. Here each individual creditor might try to collect what
was owed to him or her quickly, knowing that there was not enough to satisfy all
creditors. It might be that the company would be worth more, hence creditors in total
would receive more, if the firm were reorganized, but if one creditor seized some vital
property, the company might be put out of business and forced to liquidate. In this
situation, all the creditors would, in self-defense if for no other reason, be quick to try
to get their money out, which would shut down the debtor firm. The Bankruptcy Act
recognized this situation and has provisions that mitigate it.
The “automatic stay” is one of the provisions that mitigates the common pool
problem by forcing all creditors to cease and desist attempts to collect money from
the bankrupt firm until after a bankruptcy court has decided on the best course of
action. The automatic stay would certainly be applied in the hypothetical situation
described in the question.
A “pre-pack” is a pre-packaged bankruptcy reorganization plan. Here a plan is
worked out between management and the major creditors prior to filing for Chapter
11 protection. Pre-packs are most feasible under either of two conditions: (1) The
firm is fundamentally sound and is merely experiencing a temporary liquidity
problem, or (2) there are relatively few creditors, as that makes it easier to conduct
negotiations. In a pre-pack (and also in other reorganization plans), smaller claims
are generally paid off in full to avoid administrative hassles. The judge could, of
course, cram down a pre-pack.
The term “cramdown” refers to the situation where the bankruptcy judge forces
various claimants to accept terms that they do not like and vote against, i.e., the judge
crams the plan down the throats of the various parties. Bankruptcies are typically
contentious affairs, and at least some parties end up being unhappy. Therefore, most
plans end up being crammed down on at least some claimants.
As a part of the bankruptcy proceedings, after a plan (or plans) has been filed with
the court and disseminated to the various claimants, the claimants vote to accept or
reject the plan (or choose among competing plans). The firm’s “fair market value”
(the higher of its value as a going concern after reorganization or else its liquidating
value) is generally less than the amount of the claims. Generally, a plan to reorganize
the company will result in a higher predicted value than competing plans that call for
liquidation. However, the reorganization plan (probably supported by management
and stockholders) is based on assumptions about sales, costs, and so forth, and those
predictions are far from certain. Moreover, the reorganization plan probably requires
Answers and Solutions: 25 - 2
debtholders to accept securities in the reorganized firm, and perhaps some creditors
will be required to accept common stock rather than debt.
In such a situation, some creditors (especially secured creditors) will probably
vote against the plan, and they may file a competing plan that calls for a liquidation.
They will argue that the assumptions used in management’s reorganization plan are
unrealistic and hence that the plan is not feasible. In liquidation, stockholders
generally get nothing, and unsecured creditors typically receive only a small fraction
of their claim. Therefore, stockholders and unsecured creditors might vote in favor of
reorganization.
The bankruptcy judge--who has tremendous power as judge, jury, and
executioner—will decide among the various plans, and he or she will decide exactly
how much each creditor will receive. Then, the judge will cram down the plan he or
she finally approves. In other words, the approved plan does not require 100%
support from all parties.
i. The following is the specified priority ranking of claimants to a company’s assets in
the event of bankruptcy:










Past due property taxes
Secured creditors up to the value of their collateral. Different secured creditors
may be secured by different assets.
Legal fees and administrative costs
Wages due, with limitations
Unpaid contributions that to pension plans within the last 6 months
Customer deposits, up to $900 per customer
Taxes due to federal, state, and local government units
General (unsecured) creditors.
Preferred stockholders
Common stockholders
In a liquidation, the assets are sold off and the available funds are then distributed.
If they are distributed in strict accordance with the above priority rankings, then this
is in accordance with absolute priority doctrine.
The relative priority doctrine refers to the situation where the bankruptcy judge
determines that a company’s value would be greater if it were reorganized and
continued in business versus being liquidated. Here some claimants, especially well
secured creditors, might prefer to see the firm be liquidated, as that might get them
cash relatively soon, but the judge deems it would be most fair to most parties to have
the firm reorganized, because then unsecured creditors and perhaps even stockholders
would end up receiving something of value. Adoption of the relative priority doctrine
makes it much easier to reorganize companies, because if the absolute priority
doctrine were followed, liquidations would occur more often.
Answers and Solutions: 25 - 3
j. If the assets were sold at auction and the company was liquidated, the proceeds would
in all likelihood be distributed in accordance with the absolute priority doctrine as
discussed above, using the previously indicated rankings. Well-secured debtholders
would perhaps be paid in full, and lower ranking claimants would get something only
if funds were available.
k. From a finance perspective the most interesting aspect of a bankruptcy proceeding is
determining the value of the company if it were reorganized rather than liquidated,
and then deciding on the allocation of the estimated value among the various
claimants.
If the liquidating value is higher, then the allocation is simple—just follow the
absolute priority rankings, paying off the most senior creditors and then giving junior
creditors anything that’s left. Generally, common stockholders get nothing.
Estimating the firm’s value as a reorganized entity generally involves forecasting
sales, costs, required investments, and eventually free cash flow. Then, the
appropriate capital structure must be determined and a WACC must be estimated.
With the projected FCF and the WACC, the value of the firm can be determined as
the PV of the FCFs. The estimated value must then be apportioned among the
claimants. Generally, each secured creditor would be left whole, provided the
appraised value of their specific collateral is equal to or greater than the face amount
of the secured debt. However, some or all secured creditors might have to take debt
in the reorganized company. The other claimants would probably have to “take a
haircut” of some magnitude, i.e., have to accept cash or securities worth less than the
value of their claims.
Note too that in a reorganization creditors are often forced to accept common
stock so as to put the capital structure in a balance and make the business plan of the
reorganized firm feasible. Also, some new cash is generally required to pay taxes, to
cover administrative costs and legal fees, and probably to pay off small creditors.
Generally, new cash comes in the form of common stock, and those who put up the
cash (who may or may not include old stockholders), along with creditors forced to
accept common stock, get the bulk of the common stock.
Valuation in bankruptcy is conceptually the same as any other business valuation.
When we have worked on bankruptcy cases, we use the same corporate valuation
model that we use for merger analysis and other types of valuations.
Answers and Solutions: 25 - 4
ANSWERS TO END-OF-CHAPTER QUESTIONS
25-1
a. Informal debt restructuring is the agreement between the creditors and troubled firm
to change the existing debt terms. An extension postpones the required payment date,
while a composition is a reduction in creditor claims. Extension provides payment in
full, though delayed. Conversely, composition involves a reduced cash settlement.
Restructuring often involves both extension and composition. A reorganization in
bankruptcy is a court-approved attempt to keep a company alive by changing its
capital structure. A reorganization must adhere to the standards of fairness and
feasibility.
b. Assignment is an informal procedure for liquidating debts which transfers title to a
debtor's assets to a third person, known as an assignee or trustee. Assignment
normally yields creditors a larger amount than they would receive in a formal
bankruptcy. However, an assignment does not automatically result in a full and legal
discharge of all the debtor's liabilities, nor does it protect the creditors against fraud.
Liquidation is the sale of the assets of a firm and the distribution of the proceeds to
the creditors and owners in a specific priority. The decision whether to reorganize or
liquidate should be based on the value of the firm if it is rehabilitated versus the value
of the assets if they are sold off individually. The procedure that promises higher
returns to the creditors and owners would be adopted. The standard of fairness states
that claims must be recognized in the order of their legal and contractual priority. In
simpler terms, the reorganization must be fair to all parties. The standard of
feasibility states that there must be a reasonably high probability of successful
rehabilitation and profitable future operations.
c. The absolute priority doctrine states that claims must be paid in strict accordance with
the priority of each claim, regardless of the consequence to other claimants. The
relative priority doctrine is more flexible and gives a more balanced consideration to
all claimants than does the absolute priority doctrine.
d. The Bankruptcy Reform Act of 1978 was enacted to speed up and streamline
bankruptcy proceedings. This law represents a shift to a relative priority doctrine of
creditors' claims. Chapter 11 of the Bankruptcy Act is the business reorganization
chapter. Under this chapter, a case is started when a firm's management or its
creditors file a petition with the bankruptcy court. A committee of unsecured
creditors is then appointed by the court to negotiate with the firm's management.
Existing management may stay in office unless a trustee is appointed by the court. If
no fair and feasible reorganization can be worked out, the firm will be liquidated
under the procedures spelled out in Chapter 7 of the act. Chapter 7 of the Federal
Bankruptcy Reform Act accomplishes three important tasks during a liquidation: (1)
it provides safeguards against fraud by the debtor, (2) it provides for an equitable
Answers and Solutions: 25 - 5
distribution of the debtor's assets among the creditors, and (3) it allows insolvent
debtors to discharge all their obligations and to start new businesses unhampered by
a burden of prior debt.
e. The priority of claims in liquidation is established in Chapter 7 of the Bankruptcy Act
to provide an equitable distribution of the debtor's assets among the creditors.
f. Extension and composition are both characteristics of debt restructuring. In an
extension, creditors postpone the dates of required interest or principal payments, or
both. In a composition, creditors voluntarily reduce their fixed claims on the debtor
by accepting a lower principal amount, reducing the interest rate on the debt,
accepting equity in place of debt, or some combination of these changes. Workouts
are voluntary reorganization plans arranged between creditors and generally sound
companies experiencing temporary financial difficulties. Workouts typically require
some restructuring of the old firm's debt. Cramdowns are bankruptcy court-mandated
reorganization plans which are binding on all parties. Prepackaged bankruptcy is a
new type of reorganization which combines the advantages of informal workouts and
formal Chapter 11 reorganization. Holdout is a problematic characteristic of informal
reorganizations where all of the involved parties do not agree to the voluntary plan.
Holdouts are usually made by creditors in an effort to receive full payment on claims.
25-2
25-3
The rehabilitation plan may be accepted because of the following:

Expenses of liquidation may consume a large proportion of the assets.

The going-concern value of a firm is always substantially greater than its liquidating
value. Hence, to preserve the life of the firm is to preserve a substantial portion of its
value.

They may retain a stable customer for the future.

On balance, the creditors will accept a plan for financial rehabilitation because it
appears that the funds they will receive will be much larger under this procedure.
Not necessarily. The going-concern value of a firm is a function of its outlook--it might
be improved by changing the management or otherwise improving operations. The firm
may be temporarily distressed.
Answers and Solutions: 25 - 6
25-4
Liquidations usually result in losses for the following reasons:

Assets typically have characteristics which make their value in existing uses greater
than when resold.

The organizational value of a company is lost when liquidation takes place.

Because the claims of numerous parties must be adjudicated, considerable
administrative, accounting, and legal costs may be incurred.
Partial liquidation over a period would have the following results:
25-5

Probably would not decrease losses.

Failure to institute the necessary operating and management changes might cause
losses to continue and might cause further deterioration in the value of the company.
It is often said that a swift major "surgery" for a business firm is preferred to an
extended illness.
Because public utilities and railroads often involve essential services, reorganizations and
mergers rather than liquidations are likely to take place. This is less true for industrial
companies.
Answers and Solutions: 25 - 7
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
25-1
a. The pro forma balance sheet follows (in millions of dollars):
Current assets
Net fixed assets
Goodwill
Total assets
$159a
153
15
$327
Current liabilities
Advance payments
Reserves
Subordinated debentures
$2.40 preferred stock,
$37.50 par value
(1,200,000 shares)
Common stock, $1.50
par value
(6,000,000 shares)
Retained earnings
Total claims
$ 42
78
6
90b
45c
9
57
$327
Notes:
a
$168 less $9 used to retire the $10.50 preferred stock.
b
(1.2 million shares)($75 par value) = $90.
c
(1.2 million shares)($37.50 par value) = $45.
b. The pro forma income statement (in millions of dollars) follows:
Net sales
Operating expense
Net operating income
Other income
EBIT $ 27.0
Interest expense
EBT
Taxes (50%)
Net income
Dividends on $2.40 preferred
Income available to common stockholders
$540.0
516.0
$ 24.0
3.0
7.2a
$ 19.8
9.9
$ 9.9
2.9b
$ 7.0
Notes:
a
0.08($90 million par value) = $7.2.
b
$2.40(1.2 million shares) = $2.9.
Thus, the increase in income available to common shareholders is $7.0 - $5.7 = $1.3
million.
Answers and Solutions: 25 - 8
c. The earnings required before the recapitalization is $7.8 million/(1 - 0.5) = $15.6
million. We divide the preferred dividends by (1 - T) since $15.6 million must be
earned to provide the $7.8 million needed after-tax. After recapitalization, the firm
requires $2.9 million/0.5 = $5.8 million to cover the preferred dividend payment, and
$7.2 million to cover the interest expense for a total of $13.0 million. Since interest
expense is tax deductible, only $7.2 million in pre-tax earnings are required to cover
the interest expense. Thus, required earnings will decrease by $15.6 million - $13.0
million = $2.6 million if the reorganization takes place.
d. The debt ratio before reorganization is $120 million/$336 million = 0.357 = 35.7%.
After reorganization the debt ratio is $210 million/$327 million = 0.642 = 64.2%.
Note that advance payments by customers are counted as debt while reserves are not.
If preferred stock is treated as debt, the debt ratio actually declines slightly from 78.6
percent to 78.0 percent. The reorganization is in the best interests of the shareholders
because under reorganization (1) earnings to shareholders are increased, (2) earnings
required to cover fixed charges (including preferred dividends) are decreased, and (3)
income debentures are less risky to the shareholders than preferred stock.
25-2
a. Creditor claims total $1,100,000 while the trustee has an additional $50,000 in claims,
yet the liquidation produced only $600,000 in proceeds. Since the proceeds are
insufficient to satisfy the creditor and trustee claims, the shareholders receive nothing.
b. The mortgage bondholders have priority claim against the proceeds from the sale of
pledged property. Thus, the $400,000 from the fixed assets must first be distributed
to the first and second mortgage bondholders. The first mortgage holders receive their
full claim of $300,000, while the second mortgage holders receive the remaining
$100,000. This constitutes the total $400,000, so none of the proceeds from the sale
of pledged assets are available for distribution to general creditors. Additionally, the
second mortgage holders have $100,000 in unsatisfied claims which become general
creditor claims.
Answers and Solutions: 25 - 9
c. The priority claimants are the mortgage bondholders, trustee, workers, and
government. The remaining claimants are general creditors. There is $200,000
available after the $400,000 distribution to the mortgage bondholders. This is
distributed to the remaining priority claimants as follows:
Claimant
Trustee's expenses
Workers' wages due
Governments' taxes due
Total
Amount
$ 50,000
30,000
40,000
$120,000
d. Of the total $600,000 received from the liquidation, $520,000 has been distributed to
priority claimants. This leaves $80,000 to distribute to the general creditors. But the
general creditor claims total $630,000:
Account
Accounts payable
Notes payable
Second mortgage bonds
Debentures
Subordinated debentures
Total
Claim
$ 50,000
180,000
100,000
200,000
100,000
$630,000
Note that the second mortgage holders' unsatisfied claim of $100,000 is included.
Each claimant, before subordination adjustment, would receive $80,000/$630,000 =
0.1270 of his or her claim. Therefore, the general creditors would receive:
Account
Accounts payable
Notes payable
Second mortgage bonds
Debentures
Subordinated debentures
Total
Amount Received
$ 6,350
22,860
12,700 (plus $100,000)
25,400
12,700
$ 80,000
Finally, the subordination adjustment must be made. The subordinated debentures
are subordinate to notes payable. Therefore, the subordinate debenture holders must
relinquish all claims until the note payable holders are fully satisfied. Since the note
payable holders are $180,000 - $22,860 = $157,140 short of being fully satisfied, the
full $12,700 initially allocated to the subordinated debenture holders must be
relinquished to the notes payable holders resulting in $22,860 + $12,700 = $35,560
for the notes payable holders and nothing (of the general creditor portion) for the
subordinate debenture holders.
Answers and Solutions: 25 - 10
25-3
a. The total amount available for distribution is $3,190,000 proceeds + $10,000 cash =
$3,200,000. The total creditor and trustee claims are $6,800,000 + $200,000 =
$7,000,000. Since the claims far exceed the available funds, preferred and common
stockholders will receive nothing.
b. The following table shows the liquidation distribution (in thousands of dollars):
Claimant
Accounts payable
Notes payable
Wages payable
Taxes payable
Mortgage bonds
Subordinated
Debentures
Trustee
Priority
Creditor
Distribution Distribution
$ 384
120
$ 150
150
50
50
1,600
1,696
200
$2,000
600
200
$3,200
Subordination
Adjustment Percentage
$ 384
24%
500
100
150
100
50
100
1,696
85
220
200
$3,200
9
100

Funds remaining after the priority distribution = $3,200 - $2,000 = $1,200.

General creditor claims total $1,600 + $500 + $400 + $2,500 = $5,000.

After the general creditor distribution, notes payable is $500 - $120 = $380 short.
Therefore, subordinated debentures must give up $380, leaving $600 - $380 =
$220.
Answers and Solutions: 25 - 11
SOLUTION TO SPREADSHEET PROBLEM
25-4
The detailed solution for the problem is available both on the instructor’s resource CDROM (in the file Solution to IFM9 Ch 25-4 Build a Model.xls) and on the instructor’s
side of the web site, http://now.swlearning.com/brigham.
Answers and Solutions: 25 - 12
MINI CASE
Note to Instructors:
Some instructors choose to assign the Mini Case as homework. Therefore, the
PowerPoint slides for the mini case, IFM9 Ch 25 Show.ppt, and the accompanying Excel file,
IFM9 Ch 25 Mini Case.xls, are not included for the students on ThomsonNow. However, many
instructors, including us, want students to have copies of class notes. Therefore, we make the
PowerPoint slides and Excel worksheets available to our students by posting them to our
password-protected Web site. We encourage you to do the same if you would like for your
students to have these files.
Kimberly MacKenzie, president of Kim's Clothes Inc., a medium-sized manufacturer of
women's casual clothing, is worried. Her firm has been selling clothes to Russ Brothers
department store for more than ten years, and she has never experienced any problems in
collecting payment for the merchandise sold. Currently, Russ Brothers owes Kim's Clothes
$65,000 for spring sportswear that was delivered to the store just two weeks ago. Kim's
concern was brought about by an article that appeared in yesterday's Wall Street Journal
that indicated that Russ Brothers was having serious financial problems. Further, the
article stated that Russ Brothers' management was considering filing for reorganization, or
even liquidation, with a federal bankruptcy court.
Kim's immediate concern was whether or not her firm would collect its receivables if
Russ Brothers went bankrupt. In pondering the situation, Kim also realized that she knew
nothing about the process that firms go through when they encounter severe financial
distress. To learn more about bankruptcy, reorganization, and liquidation, Kim asked Ron
Mitchell, the firm's chief financial officer, to prepare a briefing on the subject for the entire
board of directors. In turn, Ron asked you, a newly hired financial analyst, to do the
groundwork for the briefing by answering the following questions:
a.
1. What are the major causes of business failure?
Answer:
a.
The major causes of business failure consist of economic factors, such as industry
weakness and poor location, and financial factors, such as too much debt and
insufficient capital. However, most business failures occur because a number of
factors combine to make the business unsustainable.
2. Do business failures occur evenly over time?
Answer:
A fairly 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, however, has tended to fluctuate with the state of the economy.
Mini Case: 25 - 13
a.
3. Which size of firm, large or small, is more prone to business failure? Why?
Answer: Bankruptcy is more frequent among smaller firms. While bankruptcy does occur in
large firms, they tend to get more help from external sources to avoid it, given their
greater impact on the economy and, in the case of large financial institutions, the
financial world. The federal government's bailouts of Chrysler and Lockheed are
good examples of this external assistance.
b.
What key issues must managers face in the financial distress process?
Answer: As a manager begins to face financial distress, he or she must begin to consider the
following key issues:

Is this a temporary cash flow problem (technical insolvency), or is it a permanent
problem caused by asset values having fallen below debt obligations (insolvency
in bankruptcy)?

Who should bear the losses if this is a permanent problem?

Would the firm be more valuable if it continued to operate or if it were liquidated
and sold off in pieces?

Should the firm file for bankruptcy, or should it try to use informal procedures?

Who should control the firm during liquidation or reorganization?
Obviously, answers to these questions are needed to chart the course of the firm while
under financial distress.
Mini Case: 25 - 14
c.
What informal remedies are available to firms in financial distress? In
answering this question, define the following terms:
(1) workout, (2)
restructuring, (3) extension, (4) composition, (5) assignment, and (6) assignee
(trustee).
Answer: When faced with financial distress, it is often desirable for firms to pursue informal
reorganizations or liquidations with creditors, given the costs associated with legal
bankruptcy. Creditors generally prefer informal reorganization plans when dealing
with economically sound companies whose financial difficulties appear to be
temporary. These voluntary informal plans, commonly called workouts, tend to
involve some type of restructuring, where current debt terms are revised to facilitate
the firm's ability to make payments. Such restructurings typically involve extension
and/or composition. In an extension, creditors postpone the dates of required interest
or principal payments, or both. Creditors tend to prefer extensions when developing
reorganization plans because they promise eventual payment in full. In a
composition, creditors voluntarily reduce their fixed claims on the debtor by either
accepting a lower principal amount or accepting equity in place of debt. This can be
a desirable alternative if bankruptcy becomes a real possibility, since composition can
help the creditor and debtor avoid the many costs associated with legal bankruptcy.
Informal liquidations can also be used if it is decided that the firm is worth more
by selling it off in pieces. Assignment is an informal procedure for liquidating a firm.
It calls for title to the debtor's assets to be transferred to a third party, known as the
assignee or trustee. The assignee is required to liquidate the firm's assets either
through a private sale or a public auction, and then to distribute the proceeds among
the firm's creditors on a pro rata basis.
d.
Briefly describe U.S. Bankruptcy Law, including the following terms:
(1) chapter 11, (2) chapter 7, (3) trustee, (4) voluntary bankruptcy, and (5)
involuntary bankruptcy.
Answer: U. S. Bankruptcy laws were first enacted in 1898 to ensure that businesses worth
more as ongoing concerns were not shut down by individual creditors desiring
liquidation and full payment. The Bankruptcy Reform Act Of 1978 revised these
laws to streamline and expedite bankruptcy proceedings. Current bankruptcy law
consists of eight chapters, the most important of which are Chapter 7, which details
the procedures to be followed when liquidating a company, and Chapter 11, the
business reorganization chapter. When a petition for bankruptcy is filed in federal
court, the petition can be either voluntary or involuntary. A voluntary petition is filed
by the distressed firm's management; an involuntary petition is filed by its creditors.
The court will appoint a committee of unsecured creditors to negotiate a
reorganization, which may include restructuring. A trustee will be appointed if
current management is incompetent or fraud is suspected; otherwise the existing
Mini Case: 25 - 15
management will retain control. If no fair and feasible reorganization can be worked
out, then the firm will be liquidated under Chapter 7 procedures.
e.
What are the major differences between an informal reorganization and
reorganization in bankruptcy? In answering this question, be sure to discuss the
following items: (1) common pool problem, (2) holdout problem, (3) automatic
stay, (4) cramdown, and (5) fraudulent conveyance.
Answer: There are many differences between voluntary reorganizations and reorganizations in
bankruptcy. Voluntary reorganizations are far less costly and relatively simple to
create as compared to reorganizations in bankruptcy. As a result, voluntary
reorganizations typically allow creditors to recover more money, and sooner, than
they would under legal bankruptcy. However, reorganizations in bankruptcy have
their advantages. First, they avoid holdout problems which can arise with voluntary
reorganizations (which occur when all creditors do not agree to the voluntary plan).
Second, because of the automatic stay provision, bankruptcy avoids the common pool
problem, where efforts to foreclose on the firm by one creditor cause the remaining
creditors to initiate foreclosure as well. Automatic stay, which is granted to all firms
in bankruptcy, limits creditors' abilities to foreclose unilaterally on the firm to collect
their claims. Third, under bankruptcy, interest and principal payments may be
delayed without penalty until a reorganization plan is approved. Fourth, bankruptcy
permits the firm to issue debtor in possession (dip) financing to enhance the ability of
the firm to borrow funds for short-term liquidity purposes. Finally, bankruptcy gives
the debtor exclusive right to submit a proposed reorganization plan for agreement
from the parties affected.
While bankruptcy gives the firm a chance to work out its problems without the
threat of creditor foreclosure, it does not give the debtor free reign over the firm's
assets. First, bankruptcy law gives creditors the right to petition the bankruptcy court
to block almost any action the firm might take while in bankruptcy. Second,
fraudulent conveyance statutes, which are part of debtor-creditor law in most states,
protect creditors from unjustified transfers of property by a firm in financial distress.
In bankruptcy, it is much easier to gain acceptance of a reorganization plan,
because the bankruptcy court will lump the creditors into classes. Each class is
considered to have accepted a reorganization plan if a majority of the creditors in the
class (holding at least two-thirds of the amount of debt) vote for the plan, and the plan
will be approved by the court if it is deemed to be "fair and equitable" to the
dissenting parties. This procedure, in which the court mandates a reorganization plan
in spite of dissent, is called a cramdown.
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f.
What is a prepackaged bankruptcy?
become more popular in recent years?
Why have prepackaged bankruptcies
Answer: Prepackaged bankruptcy is a relatively new type of reorganization which is a hybrid-combining the advantages of both the informal reorganization and formal Chapter 11
reorganization. The debtor obtains agreement from all, or almost all, creditors to a
reorganization plan prior to filing for bankruptcy. The plan is then filed along with,
or shortly after filing, the bankruptcy petition. This method can avoid the holdout
problems of voluntary reorganizations, preserve creditors' claims, and provide
favorable tax treatment.
g.
Briefly describe the priority of claims in a Chapter 7 liquidation.
Answer: Chapter 7 of the federal bankruptcy reform act provides for an equitable distribution
of the debtor's assets among the creditors. The distribution of assets is governed by
the following priority of claims:

Secured creditors (who are entitled to the proceeds of the sale of specific property
pledged for a lien or a mortgage).

Trustee's costs to administer and operate the bankrupt firm.

Expenses incurred after an involuntary case has begun but before a trustee has
been appointed.

Wages due workers if earned within three months prior to filing of the petition in
bankruptcy.

Claims for unpaid contributions to employee benefit plans that should have been
paid within six months prior to filing.

Unsecured claims for customer deposits.

Taxes due to federal, state, county, and any other government agency.

Unfunded pension plan liabilities.

General, or unsecured, creditors.

Preferred stockholders.

Common stockholders.
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h.
Assume that Russ Brothers did indeed fail, and that it had the following balance
sheet when it was liquidated (in millions of dollars):
Current assets
Net fixed assets
$40.0
5.0
Total assets
$45.0
Athe
Accounts payable
Notes payable (to banks)
Accrued wages
Federal taxes
State and local taxes
Current liabilities
First mortgage
Second mortgage
Subordinated debenturesa
Total long-term debt
Preferred stock
Common stock
Paid-in capital
Retained earnings
Total equity
Total claims
$10.0
5.0
0.3
0.5
0.2
$16.0
$ 3.0
0.5
4.0
$ 7.5
1.0
13.0
2.0
5.5
$21.5
$45.0
debentures are subordinated to the notes payable.
The liquidation sales resulted in the following proceeds:
From sale of current assets
From sale of fixed assets
Total receipts
$14,000,000
2,500,000
$16,500,000
For simplicity, assume that there were no trustee's fees or any other claims
against the liquidation proceeds. Also, assume that the mortgage bonds are
secured by the entire amount of fixed assets. What would each claimant receive
from the liquidation distribution?
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Answer: The following table shows the liquidation distribution (millions of dollars):
Distribution to Priority Claimants
(in millions)
Proceeds from the sale of assets
Less:
1. 1st mortgage (paid from sale of fixed assets)
2. Accrued wages
3. Taxes due to federal, state, and local governments
Funds available for distribution to general creditors
$16.5
2.5
0.3
0.7
$13.0
Distribution to General Creditors
Gen’l creditor
claims
1st mortgage
2nd mortgage
Notes payable
Accts. Payable
Subord. Deben.2
Total
Amt. Of
claim
$ 0.5
0.5
5.0
10.0
4.0
$20.0
pro rata
distrib.1
$ 0.325
0.325
3.250
6.500
2.600
$13.000
Distribution
after subord.
adjustment
$ 0.325
0.325
5.000
6.500
0.850
$13.000
Percentage
Original claim
received
94%
65
100
65
21
Notes:
1. $13 million is available for distribution to general creditors; however, there is $20
million in general creditor claims, so the pro rata distribution will be $13/$20 =
0.65, or 65 cents on the dollar.
2. The debentures are subordinated to the notes payable. The amount of the
unsatisfied notes payable is $5.0-$3.25=$1.75 million.
$1.75 million is reallocated from the subordinated debentures to notes payable.
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