© 2007 Thomson South-Western

Chapter 25Bankruptcy and Financial

Distress

Professor XXXXXCourse Name / Number

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Types of Business Failure

Economic failure

Return earned by the company is lower than its cost of capital.

Technical insolvenc

y

Firm is unable to pay its liabilities as they come due.

Company assets are still greater than its liabilities, but company is confronted with a

liquidity crisis.

Insolvency

bankruptcy

Firm's liabilities exceed the market value of its assets.

Courts treat technical insolvency and bankruptcy in the same way.

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Largest Bankruptcies in U.S. History as of December 14, 2005

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Major Causes of Business Failure

Financial distress: the primary cause of business failure

Over-expansion, poor financial actions, ineffective sales force, and high production costs

Economic activity, especially economic downturns

– Sales may decrease, leaving the firm with high fixed costs and insufficient revenues to cover them.

– Rapid rises in interest rates prior to a recession can further cause cash flow problems.

Corporate maturity: failure to promote R&D or mergers

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Voluntary Reorganization

Extension Firm’s creditors receive payment in full, although not immediately.

Composition

Pro rata cash settlement of creditor claims

Creditor control

Committee of creditors decides that operating management be replaced.

Firm may arrange with its creditors a voluntary settlement:

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Voluntary Liquidation

Credit committee could recommend liquidation of the firm:

Liquidation: privately or through the legal procedures provided by bankruptcy law

ObjectiveRecover as much per dollar owed as

possible

Alternative to liquidation - the firm is acquired

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Bankruptcy Law in U.S.

Bankruptcy Reform Act of 1978: contains eight odd-numbered (1 through 15) chapters and chapter

12.

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.

Individual creditors are prevented from beginning lawsuits against the debtor.

Eliminates the benefit of being the first to sue because all claims against the firm are settled simultaneously.

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Reorganization

Approval

Filing

Appointment

Acceptance of plan

Payment of expenses

Five steps

Allow businesses in temporary financial distress to continue operating:

Disadvantage: managers can file for chapter 11 and choose the bankruptcy procedure that is best for themselves.

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Filing

Reorganization petition must be filed in a federal bankruptcy court by the firm or an

outside party.,

Outside party can file for reorganization if:

firm has past-due debts of $5,000 or more,

three or more creditors with aggregate unpaid claims of $5,000 or more, or

the firm is insolvent.

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Appointment

DIP is responsible for the valuation of the firm.

The filing firm becomes the debtor in possession (DIP) of the assets:

Creditor committee appointed to represent the interest of creditors.

If DIP evaluates the value as a going concern of the firm lower than liquidation value, recommend liquidation.

Otherwise, DIP recommends reorganization.

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Reorganization Plan

DIP submits a reorganization plan to the court:

Recapitalization

Key part of reorganization plan

Debt is exchanged for equity or its maturity is extended.

Claims on the new securities issued are distributed based on the seniority of the

existing claims.

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Acceptance of the Reorganization Plan

Court approved plan is submitted for approval to the firm’s creditors and

shareholders.

Under unanimous consent procedure (UCP), creditors and equity classes must agree with the

reorganization plan.

When a reorganization plan fails to meet approval by all classes under the UCP, use cramdown

procedure.

The bankruptcy court can approve the plan without the consent of the other classes in cramdown. What is the

procedure?

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Acceptance of the Reorganization Plan

One class of creditors has to vote for reorganization plan in this case.

Secured creditors retain their prebankruptcy liens on assets.

What if no reorganization plan is adopted under either the UCP or cramdown?

– Managers sometimes voluntarily sell the firm as a going concern.

– The proceeds of the sale are paid to creditors.

– Creditors could petition for the shift of bankruptcy filing to Chapter 7 liquidation.

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Payment of Expenses

After the reorganization plan has been approved or disapproved A statement of expenses is filed; if approved, the debtor must

pay the expenses within a reasonable period

An example....

Current capital structure for Campbell Technologies

Debentures (unsecured debt) $22,000,000

Subordinated debentures $28,000,000

Common stock (100,000 shares) $20,000,000

Total $70,000,000

Debt/Equity of the company is 2.5 ($50 million/$20 million)

Campbell Technologies is worth $45 million as a going concern

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Payment of Expenses

The company could be reorganized as follows

Debentures (unsecured debt) $11,000,000Subordinated debentures $14,000,000Common stock (200,000 shares) $20,000,000

Total $45,000,000

Debt holders receive 100,000 shares in exchange for cutting their debt claims in half

Debt/Equity ratio is reduced to 1.25 ($25 million/$20 million)

The financial condition of the company is improved by reducing the debt!

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Subsidies to Firms that Reorganize

1. When reorganizing firms settle liabilities for less than their face value, the amount of debt forgiveness is deducted as a loss by the creditor but is not immediately treated as taxable income to the reorganizing firm.

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Subsidies to Firms that Reorganize

2. Firms reorganizing under Chapter 11 have the right to terminate underfunded pension plans, and the U.S. government’s Pension Benefit Guaranty Corporation (PBGC) picks up the uncovered pension costs.

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Subsidies to Firms that Reorganize

3. Firms that reorganize retain most of their accrued tax loss carryforwards, which would be lost if they liquidated.

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Subsidies to Firms that Reorganize

4. When firms file for bankruptcy, their obligation to pay interest to pre-bankruptcy creditors, both secured and unsecured, ceases.

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Subsidies to Firms that Reorganize

5. Firms in reorganization can reject any of their contracts that are not substantially completed.

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Subsidies to Firms that Reorganize

6. Firms in reorganization can reject their collective bargaining labor agreements, on approval of the bankruptcy judge.

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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.

This prepackaged bankruptcy shortens and simplifies the process and saves money.

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Liquidation in Bankruptcy

Final accounting

Procedures

Priority of claims

Three important aspects

Chapter 7 of Code addresses the order of priority of claims:

1. The expenses of administering the bankruptcy

2. Any unpaid interim expenses incurred in the ordinary course of business between filing the bankruptcy petition and the entry of an Order of Relief in an involuntary proceeding

3. Wages of not more than $2,000 per worker that have been earned by workers in the 90-day period immediately preceding the bankruptcy

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Liquidation in Bankruptcy

4. Unpaid employee benefit plan contributions5. Unsecured customer deposits, not to exceed

$900, resulting from purchasing or leasing a good or service from the failed firm

6. Taxes owed by the bankrupt firm7. Claims of secured creditors, who receive the

proceeds from the sale of collateral held, regardless of the proceeding priorities

8. Claims of unsecured creditors9. Preferred stockholders, who receive an amount

up to the par value of their preferred stock10. Common stockholders, who receive any

remaining funds, which are distributed on an equal per share basis

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Example: Liquidation of Oxford Company – Balance Sheet

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Distribution of Liquidation Proceeds of Oxford Company

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Pro Rata Distribution of Funds among the Unsecured Creditors of Oxford Co.

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Predicting Bankruptcy

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

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

futureAbout 80% accurate in forecasting bankruptcy two years in the

future

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Balance Sheet for Poff Industries

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Income Statement for Poff Industries

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Z scores

Using Z score, businesses are classified in:Companies with high probability

of failure, Z is less than 1.8.Companies with unsure

probability of failure, Z is between 1.81 and 2.99.

Companies with low probability of failure, Z is higher than 3.