FINA 40153 Ch 24 Bankruptcy.pdf

Chapter 24: Bankruptcy and Financial Distress © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bankruptcy and Business Failure A firm is insolvent whenever its liabilities exceed its assets. Fina...

Chapter 24: Bankruptcy and Financial Distress © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bankruptcy and Business Failure A firm is insolvent whenever its liabilities exceed its assets. Financial distress occurs when a company’s cash flows are insufficient to pay its current obligations. The term bankruptcy does not actually describe a financial condition, but instead refers to a legal process. 2 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bankruptcy Law in the U.S. Chapter 7 contains procedures to be followed when liquidating a failed firm. Chapter 11 outlines the procedures for reorganizing a firm: ❑ ❑ ❑ ❑ ❑ Collective legal procedure is begun by which all claims are resolved. An automatic stay prevents individual creditors from beginning lawsuits against the debtor. Debtor-in-possession (DIP) – Management of the firm remains in place while the case is pending Eliminates the benefit of being the first to sue because all claims against the firm are settled simultaneously. Logic behind Chapter 11 is that creditors as a whole will be better off if the firm is allowed to survive. 3 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Illiquidity In the early stages, a firm filing for chapter 11 frequently faces problems with liquidity. ❑ ❑ ❑ ❑ Cash is depleted. Lenders may threaten a declaration of default or covenant violations. Firm faces the loss of revolving credit lines. Suppliers may demand to be paid in cash up front. The Bankruptcy Code authorizes the company to offer an array of “sweeteners” to lenders who are willing to lend. Under certain conditions, the firm may offer super-priority to new lenders: the right to be paid ahead of everyone else. Called debtor-in-possession financing. Bankruptcy courts can allow ‘critical vendor’ payments for certain suppliers © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 4 Appointment The filing firm becomes the debtor in possession (DIP) of the assets: Creditor committee appointed to represent the interest of creditors. DIP is responsible for the valuation of the firm. ❑ If DIP evaluates the value as a going concern of the firm lower than liquidation value, recommend liquidation. ❑ Otherwise, DIP recommends reorganization. ❑ Stockholders usually get nothing. But not always. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 5 Reorganization Plan DIP submits a reorganization plan to the court: -Unsecured creditors may be offered stock. -Principal of debt can be reduced, interest payments can be reduced, or time to maturity can be extended. -Unsecured debt may repaid at a discount to face value Claims on the new securities issued are distributed based on the seniority of the existing claims. 6 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Acceptance of the Reorganization Plan Court approved plan is submitted for approval to the firm’s creditors and shareholders. Creditors and equity classes must agree with the reorganization plan. If creditors reject the plan, the debtor may seek a cramdown, where a judge forces creditors to accept the terms of the plan. Absolute priority rule states that stockholders and lowpriority creditors can retain no interest in the reorganized company unless all higher-priority creditors are paid in full. 7 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Sources of Aid to Firms that Reorganize ❑ Six major sources of aid come either from the government or from creditors. ❑ They give firms in reorganization advantages relative to firms that continue operating outside of bankruptcy and firms that liquidate. 8 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Sources of Aid to Firms that Reorganize ❑ 1. Debt forgiveness is taxable only when the reorganized firm becomes profitable ❑ 2. Reorganized firm can terminate underfunded pension plans and have PBGC pick up the costs ❑ 3. Reorganized firm retains tax loss carryforwards ❑ 4. Hiatus on interest payments to creditors ❑ 5. Can reject contracts not substantially completed 9 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Sources of Aid to Firms that Reorganize ❑ 6. With permission of the bankruptcy judge, reorganized firm can reject their collective bargaining agreements 10 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Section 363 Asset Sales ❑ Allows a firm under Chapter 11 reorganization to quickly sell corporate assets such that they are ‘free and clear’ of any other interests in the property. ❑ Example from book, GM sold its profitable assets to an initial bidder, a new healthy GM. (But others may bid). ❑ Remaining unhealthy assets retained in a separate company (Motors Liquidation Co) gradually liquidated. 11 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bankruptcy Act of 2005 ❑ Intended to prevent individuals and firms from shirking their obligations too easily by filing for bankruptcy ❑ Key features of the 2005 Act Limits the time incumbent management can remain in control of the firm in chapter 11 ❑ Limits bonuses that can be paid to retain key employees while in chapter 11 ❑ ❑ Overall, the chapter 11 process is now more friendly to creditors. 12 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Alternatives to Chapter 11 ❑ Out-of-Court Workouts – bankrupt firms reaches solution with creditors out of court. Must have unanimous approval from creditors. ❑ Prepackaged Bankruptcies ❑ Chapter 7 13 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Prepackaged Bankruptcies ❑ Companies can prepare a reorganization plan that is negotiated and voted on by creditors and stockholders before the company actually files for chapter 11 bankruptcy. ❑ Shortens and simplifies the process and saves money. 14 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 7: Liquidation in Bankruptcy - Appointed trustee takes total control and possession of firm and its assets - Operation usually stopped. Management out of the picture unless trustee attempts to recover from them. - Trustee often in conflict with secured creditors concerning the value of assets - Priority of claims specified in Chapter 7 of bankruptcy act. See p. 859 of textbook. 15 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Predicting Bankruptcy Altman’s Z score: Quantitative model that uses a blend of traditional financial ratios and multiple discriminant analysis: About 90% accurate in forecasting bankruptcy one year in the future About 80% accurate in forecasting bankruptcy two years in the future Z = 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5) Where X1 = Working capital / Total assets X2 = Retained earnings / Total assets X3 = Earnings before interest and taxes / Total assets X4 = Market value of equity / Book value of debt X5 = Sales / Total assets 16 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Predicting Bankruptcy ❑Z