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Corporations in Financial Distress
Bankruptcy, Liquidation and Reorganization
FINC 5880 MBA - week 6-7
Managing Reorganizations
Failures that trigger reorganization Economic failure: LT
Revenue<Total Costs Business failure: terminated
businesses that still owe to creditors
Technical insolvency: the firm can not meet its current obligations
Insolvency in bankruptcy: book value of liabilities> market value of the assets
Legal bankruptcy: firm has filed for bankruptcy with the court
Dun & Bradstreet NYSE: DNB is a Fortune 500 public company headquartered in Short Hills, New Jersey, USA that licenses information on businesses and corporations for use in credit decisions, B2B marketing and supply chain management. Often referred to as D&B, the company maintains information about more than 204 million companies worldwide.[1]
The largest bankruptcies
Enron Worldcom MF Global Tyco Texaco Airlines… GM Lehman Brothers MF Global Eastman Kodak
The down fall of companies often tricker the downfall of some of their customers and suppliers….
(bonus) Homework Assignment: ENRON versus GM What were the main reasons behind GM’s
filing for bankruptcy in early 2009 What were the main reasons behind
ENRON’s bankruptcy in 2001 Why are they different? What could GM have done to prevent this? What could ENRON have done?
Class Assignment: GM’s back to the future
Just before the trading of GM stocks halts in anticipation of a major announcement concerning the financial situation you walk in to the Corporate HQ to meet Rick Wagoner Chairman and CEO of GM.
On the agenda is a restructuring that should take place the following months
You are a top level consultant and you are asked to come up with a plan to be negotiated with all major stakeholders
Will you file for chapter 11 or seek for an out of court work out? What are your ideas about the reorganization ?
The Problem… Car industry is faced with the worst economic downturn in decades US Financial service sector is under pressure and even some investment banks are in
default (Lehmann, Freddie Mac and Fenny Mae) Consumers are facing rising unemployment, declined house prices, illiquid credit markets GMAC the finance arm of GM is in problems and it now only provides financing for 6% of
car sales of GM Sales has dropped to a level 40% under last year sales… Post retirement healthcare and pensions are absorbing all cash and the company is fast
burning its cash.. GM foresees it will begin to default on debt in the periods to come GM considers taking loans from the government and let an Oversight Body take over
control to lead the restructuring Fuel prices are rising, labor cost are rising, every car sold carries a retirement cost of
$1,500 for people who worked at GM now retired (to compare the cost of steel per car is less!)
The US Government has offered $19 billion in cheap financing and another $30 billion for restructuring
GM is no longer in a position to acquire funds from the capital markets
GM warns it may be forced into bankruptcy Thu Mar 5, 2009 7:39am ESTDETROIT (Reuters) - General Motors Corp on Thursday said its auditors had raised "substantial doubt" about its ability to survive outside bankruptcy if it fails to stem its losses and stop burning cash.
The "going concern" warning from the struggling U.S. automaker had been expected, but underscored the stakes for GM as it seeks up to $30 billion in U.S. government aid to restructure outside a court-supervised bankruptcy process.GM had warned late last month that it expected its auditors would question its viability at the same time that it reported a loss of nearly $31 billion for 2008.
Current cases of potential bankruptcy The car industry in the US The airline industry Rover…Roewe… Investment Banks
Company
Bankruptcy Date
Total Assets Filing Court
District(click for more info) Pre-Bankruptcy
Worldcom, Inc. 07/21/02 $103,914,000,000 NY-S
Enron Corp.* 12/02/2001 $63,392,000,000 NY-S
Conseco, Inc. 12/18/02 $61,392,000,000 IL-N
Texaco, Inc. 04/12/1987 $35,892,000,000 NY-S
Financial Corp. of America
09/09/1988 $33,864,000,000 CA-C
Global Crossing Ltd. 1/28/2002 $30,185,000,000 NY-S
UAL Corp. 12/09/2002 $25,197,000,000 IL-N
Adelphia Communications
6/25/2002 $21,499,000,000 NY-S
Pacific Gas and Electric Co.
04/06/2001 $21,470,000,000 CA-N
MCorp 3/31/1989 $20,228,000,000 TX-S
Mirant Corporation 7/14/2003 $19,415,000,000 TX-N
First Executive Corp. 5/13/1991 $15,193,000,000 CA-C
Gibraltar Financial Corp.
02/08/1990 $15,011,000,000 CA-C
Kmart Corp. 1/22/2002 $14,600,000,000 IL-N
Who is next ?
GM (as forecasted) Ford (not yet) Daimler Chrysler (as forecasted) North West Airlines (as forecasted) Altria (not yet) Eastman Kodak (as forecasted) Your company?
The firm in distress; first signs
The firm can not meet its scheduled payments due to cash flow problems
The firm starts to wonder if this is temporary or a more structural issue
The firm starts to think if its worth more dead or alive
The firm considers filing under chapter 11 protection against creditors who will chase the firm’s assets
The firm starts to think of the new management that should take care of the turnaround…
Informal reorganization
Creditors work with the firm to find a solution for its problems
These problems are temporarily The debtor is perceived as a good
moral risk The debtor must present a
reasonable plan to solve its problems
General business conditions must be favourable for recovery
Informal liquidation The firm is seen to be of more
value if it liquidates The firm may still agree to partly
repay its creditors Since this is not a formal
procedure a lot of costs and interests are saved…to benefit the remaining creditors
The debtors assets are assigned to a trustee who sells the assets in a private sale or public auction
The proceeds are distributed among the creditors
Federal Laws on bankruptcy
Chapters 1,3,5,7,9, and 11 US Bankruptcy Laws
Chapters 1,3,5: general provisions Chapter 7: procedures of liquidation Chapter 9: financially distressed public
bodies Chapter 11: protection under law avoiding
creditors to chase assets of the firm
Filing under chapter 11
The company seeks protection against creditors
The company works on a reorganization plan or regulation for creditors
The company has the flexibility to negotiate with its creditors and stockholders
Reorganization Bankruptcy
Informal procedures are less costly and offer most chances of quick solutions
Two problems arise: 1) common pool problem: if a creditor
waits for the other creditors the firm has to share between the creditors if the firm forecloses on the debtor it can get priority and hold the chance of getting all what is owed back!
2) hold out problem: only if all creditors agree on getting less then what is owed they will agree not if some will hold 100% right to their credits…
Further provisions of chapter 11 Interest and principal on
delayed payments may be delayed without penalty
The firm can issue Debtor In Possession financing (DIP) this is borrowing for short term liquidity purposes
The firms managers get 120 days after filing to come up with a reorganization plan plus another 60 days to obtain agreement (the court may extend these dates)
Sharing the pie with creditors…
Absolute priority doctrine: Creditors should be compensated for their
claims in a rigid hierarchical order; Senior claims must be paid in full junior
claims may not receive a single dime
Is the reorganization viable
Future sales to be estimated Operating conditions to be
analyzed Future earnings and cash flows
to be analyzed Company value to be estimated Capital structure after chapter
11 period to be determined Firm’s securities should be
allocated to the various claimants in a fair manner
Measures taken
Debt maturity is lengthened New management team in
control Obsolete inventories to be
replaced Modernized production
equipment to improve competing strength
Stronger operations and marketing approach…
Develop and enter new markets and products…
Pre-packaged bankruptcy
Hybrid form of bankruptcy between formal and informal workout
Informal: debtor negotiates restructuring with its creditors
Formal; restructuring under chapter 11
Prepack: debtor gets creditors to agree to the reorganization plan prior to the filing for bankruptcy
Time and expense
Typical bankruptcy case takes 2 years under chapter 11 until final plan is approved by all creditors
In the meanwhile sales suffers Good employees leave the company In the meanwhile all other employees
worry about their jobs rather then work Good bankruptcy lawyers charge 650
USD+ per hour; all other costs of creditors will be imposed on the firm as well…
At some point parties may just want to settle some deal…to stop the bleeding.
Liquidation in bankruptcy
The company is worth more dead then alive: chapter 7 explains how to share the assets over the creditors:
Secured creditors (pledged/ collateral) Legal fees Expenses incurred before trustee is appointed Wages to workers up to 3 months prior to the filing Payments for contributions to pension plans Claims for customer deposits (max $900 pp.) Taxes (federal, state ) General creditors Preferred stockholders Common stockholders
Predicting the likelihood of bankruptcy
Multiple Discriminant Analysis (MDA) Discriminant function is described as:
Z= a+b1(current ratio)+b2(debt ratio)
Z=z score; multiple regression based on data of the book gives; Z= -0.3877-1.0736(current ratio)+.0579(debt ratio)
Discriminant analysis defines a boundary between current ratio and debt ratio defining high and low probabilities of bankruptcy
The lower the Z score the less likely bankruptcy Financial Institutions use their own criteria for
the value of Z
3D picture of Z score
20
Z-score
-2
0
1
40
2
debt-asset ratio
2
current ratio
60
380
3D Scatterplot of Z-score vs current ratio vs debt-asset ratio
Multiple regression Z score Regression Analysis: Z-score versus current ratio, debt-asset ratio The regression equation is Z-score = - 0.388 - 1.07 current ratio + 0.0579 debt-asset ratio
Predictor Coef SE Coef T P Constant -0.387856 0.000233 -1664.66 0.000 current ratio -1.07371 0.00009 -11572.58 0.000 debt-asset ratio 0.0578922 0.0000044 13253.17 0.000 S = 0.000282689 R-Sq = 100.0% R-Sq(adj) = 100.0%
Analysis of Variance
Source DF SS MS F P Regression 2 18.0043 9.0022 1.12649E+08 0.000 Residual Error 16 0.0000 0.0000 Total 18 18.0043 Source DF Seq SS current ratio 1 3.9679 debt-asset ratio 1 14.0364
Bond/credit ratings…
Very High Quality
High Quality Speculative Very Poor
Standard & Poors AAA AA A BBB BB B CCC D
Moody’s Aaa Aa A Baa Ba B Caa C
Homework Assignment:Altman’s Z-score model
Z= 1.2X1+1.4X2+3.3X3+0.6X4+0.99X5
Where: X1= working capital/total assets
X2=retained earnings/total assets
X3= Ebit/total assets
X4=market value of all shares/book value of liabilities
X5=sales/total assets
The lower the Z score the higher the probability of bankruptcy Altman’s model is a reasonable predictor for bankruptcy within a period of 2
years… Z score of 1.8 or less (Bankruptcy likely); between 1.8 and 3.0 (Bankruptcy
uncertain); above 3.0 (Bankruptcy unlikely) Calculate Z-scores for your companies and analyse how well z-scores
match with bond/credit ratings…
When using MDA
Collect your own data from the industry in question
Run your model/use Altman’s predictors Test for significance and fit Define critical zone… Predict future for case on hand…