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.
Insolvency
• Stock-base insolvency: the value of the firm’s assets
is less than the value of the debt.
Solvent firm
Insolvent firm
Debt
Assets
Assets
Debt
Equity
Debt
Equity
Note the negative equity
Insolvency
• Flow-base insolvency occurs when the firms cash
flows are insufficient to cover contractually required
payments.
$
Cash flow
shortfall
Contractual
obligations
Firm cash flow
Insolvency
time
Largest U.S. Bankruptcies
Firm
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.
What Happens in Financial Distress?
No financial
restructuring
49%
Private
workout
Financial
distress
51%
47%
Financial
restructuring
Reorganize
and emerge
83%
53%
Legal bankruptcy
Chapter 11
7%
Merge with
another firm
10%
Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics
27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, “Troubled Debt Restructurings: An Empirical
Study 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).
Liquidation
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:
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 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
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:
1.
2.
3.
4.
5.
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.
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 Bankruptcy
1. New credit is available - "debtor in possession" 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 Bankruptcy
1.
2.
3.
4.
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.