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Financial Distress
A situation where a firms operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action. Insolvency is a term which generally means an inability to repay debts.
Stock-based insolvency Flow-based insolvency
Insolvency
Solvent firm
Debt
Insolvent firm
Assets
Stock-based insolvency
Occurs when the value of assets < value of promised payments to debt $
Assets
Debt
Equity
Negative equity
Flow-based Insolvency
Occurs when operating cash flows are insufficient to cover contractually required payments.
Cash flow shortfall
Insolvency
Definition of Terms
Financial Distress
Includes default and bankruptcy, but also Threat of default or bankruptcy and its effect on the company Defined to capture the costs and benefits of using large amounts of debt finance
Default
Failure to meet an interest payment, or Violation of debt agreement
Bankruptcy
Formal procedure for working out default Does not automatically follow from default.
Bankruptcy is more frequent among smaller firms. Large firms tend to get more help from external sources to avoid bankruptcy, given their greater impact on the economy.
Dividend reduction
Plant closing
Losses
COMMENT
Inexperienced/unqualified senior
management Dumb strategy (e.g., Internet companies) Poor internal controls leading to fraud
Capital structure
Firm gets itself overleveraged Firm gets too clever by half Unable to tap capital markets for new funds
OUTSIDE control of management Your bad luck airlines & 9/11 attacks Someone elses good luck (unpredictable new
Financial distress
51% 47%
Private workout
Financial restructuring
83% 53%
Legal bankruptcy
Assignment: An informal procedure for liquidating a firms assets. Title to the debtors assets is transferred to a third party, called a trustee or assignee, and then the assets are sold off.
Bankruptcy Reorganization
Reorganization is the option of keeping the firm as a going concern
sometimes involves issuing new securities to replace old ones
A debtor should be given the opportunity to reorganize provided that the going concern value of the reorganized debtors assets exceeds its liquidation value.
The firm is required to submit a reorganization plan Creditors and shareholders are divided into classes After acceptance by creditors, the plan is confirmed by the court Payments in cash, property, and securities are made to the creditors and shareholders
Note that (i) a class of creditors accepts the plan if a majority of the class agrees; (ii) secured creditors vote before unsecured creditors; and (iii) courts have the power to force uncooperative creditors to accept proposals
Cramdown
Cramdown procedure permits confirmation of a plan over the objections of one or more classes of creditors provided that: The plan provides the holders with property whose value is at least equal to the allowed amount of their claims, or else No junior class receives anything.
Voluntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firms management. Involuntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firms creditors.
What are the major differences between an informal reorganization and reorganization in bankruptcy?
Informal Reorganization:
Less costly Relatively simple to create Typically allows creditors to recover more money and sooner.
What are the major differences between an informal reorganization and reorganization in bankruptcy? Reorganization in Bankruptcy Avoids holdout problems. Due to automatic stay provision, avoids common pool problem. Interest and principal payments may be delayed without penalty until reorganization plan is approved.
What are the major differences between an informal reorganization and reorganization in bankruptcy? Reorganization in Bankruptcy
Permits the firm to issue debtor in possession (DIP) financing. Gives debtor exclusive right to submit a proposed reorganization plan for agreement from the parties involved. Reduces fraudulent conveyance problem. Cramdown if majority in each creditor class approve plan.
Bankruptcy Liquidation
Liquidation means termination of the firm as a going concern
involves selling the assets of the firm for salvage value proceeds are distributed to creditors in order of priority
2. Other expenses arising after the filing of an involuntary bankruptcy petition but prior to the appointment of a trustee
7. Unsecured creditors
8. Preferred shareholders
9. Common shareholders
Note that (i) federal income tax must be paid before any of the above; (ii) secured creditors receive proceeds from sale of the securing assets (if the amount is insufficient, they join this list as unsecured creditors); and (iii) courts have considerable flexibility to deviate from this list
Private Workout
Liquidation or reorganization are two formal bankruptcy procedures An alternative is a private workout, which is a reorganization involving direct negotiations between creditors and debtors In a private workout, usually senior debt is replaced by junior debt and debt is replaced with equity
Private Workout
When they work, private workouts are better than a formal bankruptcy (direct costs are only about 10% of a bankruptcy) A firm with a more complicated capital structure will have more trouble arranging a private workout Bankruptcy is usually better for equity investors because they can typically hold out for a better deal (courts violate strict priority)
Prepackaged Bankruptcy
A prepackaged bankruptcy is a combination of a private workout and a formal bankruptcy
The firm and most creditors agree to a private reorganization The firm then files a formal bankruptcy Idea is to use the courts to force holdouts to agree to a reorganization
Prepackaged Bankruptcy
Advantages of Prepackaged Bankruptcy
Avoids costs of lengthy bankruptcy process where business decisions must be authorized by the court Saves legal fees Minimizes adverse effects on the underlying business Allows firm to implement an exchange offer without unanimous consent of bondholders Trust Indenture Act prohibits changes in coupons, maturity, principal, and other economically relevant terms outside of bankruptcy
Prepackaged Bankruptcy
Advantages of Prepackaged Bankruptcy
Instead requires acceptance by classes1/2 by number and 2/3 by dollar value of claim
Mitigates hold-up problem by forcing dissenting bondholders to accept terms similar to those received by other bondholders
No Disclosure Statement requiredbut information must be disseminated in accordance with securities laws
Advantages of Bankruptcy
Automatic stay of all creditor collection efforts. Debtor can negotiate with a single forum - the bankruptcy court. Court can allow debtor to reject unfavorable contracts. All claims can be dealt with at one time. Interest stops accruing on unsecured claims.
Advantages of Bankruptcy
Bankruptcy court can affirm plan over the objections of dissenting creditors. Cram down rules apply. Upon confirmation, all creditors and stockholders are bound by the plan. Avoid taxes on income that results when debt is retired at less than face value.
Disadvantages of Bankruptcy
Business is disrupted. Debtor in possession must meet stringent reporting requirements. Bankruptcy court must approve all transactions outside the ordinary course of business. Bankruptcy filing can trigger other claims. Legal and administrative expenses paid by debtor.