Chapter 16

Alternative Exit and Restructuring Strategies

Reorganization and Liquidation

What matters is not the size of the dog in the fight but the size of the fight in the dog.

—Vince Lombardi

Inside M&A: calpine emerges from the protection of bankruptcy court

Following approval of its sixth Plan of Reorganization by the U.S. Bankruptcy Court for the Southern District of New York, Calpine Corporation was able to emerge from Chapter 11 bankruptcy on January 31, 2008. Burdened by excessive debt and court battles with creditors on how to use its cash, the electric utility had sought Chapter 11 protection by petitioning the bankruptcy court in December 2005. After settlements with certain stakeholders, all classes of creditors voted to approve the Plan of Reorganization, which provided for the discharge of claims through the issuance of reorganized Calpine Corporation common stock, cash, or a combination of cash and stock to its creditors.

Shortly after exiting bankruptcy, Calpine canceled all of its then outstanding common stock and authorized the issuance of 485 million shares of reorganized Calpine Corporation common stock for distribution to holders of unsecured claims. In addition, the firm issued warrants (i.e., securities) to purchase 48.5 million shares of reorganized Calpine Corporation common stock from the holders of the canceled (i.e., previously outstanding) common stock. The warrants were issued on a pro rata basis reflecting the number of shares of “old common stock” held at the time of cancellation. These warrants carried an exercise price of $23.88 per share and expired on August 25, 2008. Relisted on the New York Stock Exchange, the reorganized Calpine Corporation common stock began trading under the symbol CPN on February 7, 2008, at about $18 per share.

The firm had improved its capital structure while in bankruptcy. On entering bankruptcy, Calpine carried $17.4 billion of debt with an average interest rate of 10.3%. By retiring unsecured debt with reorganized Calpine Corporation common stock and selling certain assets, Calpine was able to repay or refinance certain project debt, thereby reducing the prebankruptcy petition debt by approximately $7 billion. On exiting bankruptcy, Calpine negotiated approximately $7.3 billion of secured “exit facilities” (i.e., credit lines) from Goldman Sachs, Credit Suisse, Deutsche Bank, and Morgan Stanley. About $6.4 billion of these funds were used to satisfy cash payment obligations under the Plan of Reorganization. These obligations included the repayment of a portion of unsecured creditor claims and administrative claims, such as legal and consulting fees, as well as expenses incurred in connection with the “exit facilities” and immediate working capital requirements. On emerging from Chapter 11, the firm carried $10.4 billion of debt with an average interest rate of 8.1%.

Chapter overview

The focus of this chapter is on bankruptcy and liquidation as alternative restructuring or exit strategies for failing firms. Bankruptcy enables a failing firm to reorganize, while protected from its creditors, or to cease operation by selling its assets to satisfy all or a portion of the firm's outstanding debt. How reorganization and liquidation take place both inside and outside the protection of the bankruptcy court are examined in detail. This chapter also discusses common strategic options for failing firms and how to value such firms, the current state of bankruptcy prediction models, and empirical studies of the performance of firms experiencing financial distress.

A review of this chapter (including practice questions with answers) is available in the file folder entitled “Student Study Guide” on the companion site to this book (www.elsevierdirect.com/companions/9780123854858). The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.

Business failure

Failing firms may be subject to financial distress as measured by declining asset values, liquidity, and cash flow. The term financial distress does not have a strict technical or legal definition. The term applies to a firm that is unable to meet its obligations or a specific security on which the issuer has defaulted. Firms whose debt yields more than 10 percentage points above the risk-free rate often are considered financially distressed. Moody's credit rating agency defines default as any missed or delayed disbursement of interest or principal, bankruptcy, receivership, or an exchange diminishing the value of what is owed to bondholders. For example, the issuer might offer bondholders a new security or package of securities (such as preferred or common stock or debt with a lower coupon or par value) that are worth less than what they are owed.¹

Technical insolvency arises when a firm is unable to pay its liabilities as they come due. Legal insolvency occurs when a firm's liabilities exceed the fair market value of its assets. Creditors' claims cannot be satisfied unless the firm's assets can be liquidated for more than the book value of the firm's liabilities. A federal legal proceeding designed to protect the technically or legally insolvent firm from lawsuits by its creditors until a decision can be made to shut down or to continue to operate the firm is called bankruptcy. A firm is not bankrupt or in bankruptcy until it files, or its creditors file, a petition for reorganization or liquidation with the federal bankruptcy courts.

The terms liquidity and solvency often are used inappropriately. Liquidity is the ability of a business to have sufficient cash on hand (as opposed to tied up in receivables and inventory) to meet its immediate obligations without having to incur significant losses in selling assets. Insolvency means that a firm cannot pay its bills under any circumstances. A liquid business is more likely to be solvent (i.e., able to pay its bills); however, not all businesses that are liquid are solvent, and not all solvent businesses have adequate liquidity.

Receivership can be an alternative to bankruptcy in which a court- or government-appointed individual (i.e., a receiver) takes control of the assets and affairs of a business to administer them according to the court's or government's directives. The purpose of a receiver may be to serve as a custodian while disputes between officers, directors, or stockholders are settled or to liquidate the firm's assets. Under no circumstances can the firm's debt be discharged without the approval of the bankruptcy court. In most states, receivership cannot take effect unless a lawsuit is under way and the court has determined that receivership is appropriate. Conservatorship represents a less restrictive alternative to receivership. While the receiver is expected to terminate the rights of shareholders and managers, a conservator is expected to merely assume these rights temporarily.

For example, in July 2008, the failing IndyMac Bank was taken into administrative receivership by the Federal Deposit Insurance Corporation, and the bank's assets and secured liabilities were transferred into a “bridge bank” called IndyMac Federal Bank until the assets could be liquidated. Also, in September 2008, the CEO and the boards of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation were dismissed, and the firms were put under the conservatorship of the Federal Housing Finance Agency while their asset portfolios were reduced.

A debtor firm and its creditors may choose to reach a negotiated settlement outside of bankruptcy, within the protection of the court, or through a prepackaged bankruptcy, which represents a blend of the first two options. The following sections discuss each of these options.

Voluntary settlements with creditors outside of bankruptcy

An insolvent firm may reach an agreement with its creditors to restructure its obligations out of court to avoid the costs of bankruptcy proceedings. The debtor firm usually initiates the voluntary settlement process because it generally offers the best chance for the current owners to recover a portion of their investments either by continuing to operate the firm or through a planned liquidation of the firm. This process normally involves the debtor firm requesting a meeting with its creditors. At this meeting, a committee of creditors is selected to analyze the debtor firm's financial position and recommend a course of action: whether the firm continues to operate or is liquidated.

Increasingly, distressed companies are choosing to restructure outside of bankruptcy court.² Smaller firms are inclined to use out-of-court settlements because of the excessive expenses associated with reorganizing in bankruptcy courts. Small business bankruptcy filings cost $50,000 to $100,000 in legal expenses and court filing fees. Legal and fee expenses well in excess of $100,000 are common.³ More midsized companies moving into international markets also contribute to the growth in out-of-court restructurings. Such firms may not be able to restructure through U.S. bankruptcy courts if the ruling is not recognized overseas. Large companies often have a difficult time achieving out-of-court settlements because they usually have hundreds of creditors.

Voluntary Settlements Resulting in Continued Operation

Plans to restructure the debtor firm developed cooperatively with creditors commonly are called workouts. A workout is an arrangement outside of bankruptcy by a debtor and its creditors for payment or rescheduling of payment of the debtor's obligations. Because of the firm's weak financial position, the creditors must be willing to restructure the insolvent firm's debts to enable it to sustain its operations. Debt restructuring involves concessions by creditors that lower an insolvent firm's payments so that it may remain in business. Restructuring normally is accomplished in three ways: an extension, a composition, or a debt-for-equity swap.

An extension occurs when creditors agree to lengthen the period during which the debtor firm can repay its debt. Creditors often agree to temporarily suspend both interest and principal repayments. A composition is an agreement in which creditors agree to receive less than the full amount they are owed. A debt-for-equity swap occurs when creditors surrender a portion of their claims on the firm in exchange for an ownership position in the firm. If the reduced debt service payments enable the firm to prosper, the value of the stock in the long run may far exceed the amount of debt the creditors were willing to forgive.

Exhibit 16.1 depicts a debt restructure of a bankrupt company that would enable the firm to continue operation by converting debt to equity. Although the firm, Survivor Incorporated, has positive earnings before interest and taxes, these is not enough to meet its interest payments. When principal payments are considered, cash flow becomes negative, rendering the firm technically insolvent. As a result of the restructuring of the firm's debt, Survivor Inc. is able to continue to operate; however, the firm's lenders now have a controlling interest in the firm. Note that the same type of restructuring could take place either voluntarily outside the courts or as a result of reorganizing under the protection of the bankruptcy court. The latter scenario is discussed later in this chapter.

Exhibit 16.1 Survivor Inc. Restructures Its Debt

Survivor Inc. currently has 400,000 shares of common equity outstanding at a par value of $10 per share. The current rate of interest on its debt is 8%, and the debt is amortized over 20 years. The combined federal, state, and local tax rate is 40%. The firm's cash flow and capital position are shown in Table 16.1.

Table 16.1. Cash Flow and Capital Position

Assume that bondholders are willing to convert $5 million of debt to equity at the current par value of $10 per share. This necessitates that Survivor Inc. issue 500,000 new shares. These actions result in a positive cash flow, a substantial reduction in the firm's debt–to–total capital ratio, and a transfer of control to the bondholders. The former stockholders now own only 44.4% (4 million/9 million) of the company. The revised cash flow and capital position are shown in Table 16.2.

Table 16.2. Revised Cash Flow and Capital Position

Voluntary Settlement Resulting in Liquidation

If the creditors conclude that the insolvent firm's situation cannot be resolved, liquidation may be the only acceptable course of action. Liquidation can be conducted outside the court in a private liquidation or through the U.S. bankruptcy court. If the insolvent firm is willing to accept liquidation and all creditors agree, legal proceedings are not necessary. Creditors normally prefer private liquidations to avoid lengthy and costly litigation. Through a process called an assignment, a committee representing creditors grants the power to liquidate the firm's assets to a third party, called an assignee or trustee. The responsibility of the assignee is to sell the assets as quickly as possible while obtaining the best possible price. The assignee distributes the proceeds of the asset sales to the creditors and the firm's owners if any monies remain.

Reorganization and liquidation in bankruptcy

In the absence of a voluntary settlement out of court, the debtor firm may seek protection from its creditors by initiating bankruptcy or may be forced into bankruptcy by its creditors. When the debtor firm files the petition with the bankruptcy court, the bankruptcy is said to be voluntary. When creditors do the filing, the action is said to be involuntary. Once either a voluntary or an involuntary bankruptcy petition is filed, the debtor firm is protected from any further legal action related to its debts until the bankruptcy proceedings have been completed. The filing of a petition triggers an automatic stay once the court accepts the request, which provides a period that suspends all judgments, collection activities, foreclosures, and repossessions of property by the creditors on any debt or claim that arose before the filing of the bankruptcy petition.

The Evolution of U.S. Bankruptcy Laws and Practices

U.S. bankruptcy laws focus on rehabilitating and reorganizing debtors in distress. Except for Chapter 12, all the chapters of the present Bankruptcy Code are odd-numbered. Chapters 1, 3, and 5 cover matters of general application, while Chapters 7, 9, 11, 12, and 13 concern liquidation (business or nonbusiness), municipality bankruptcy, business reorganization, family farm debt adjustment, and wage-earner or personal reorganization, respectively. Chapter 15 applies to international cases.

The Bankruptcy Reform Act of 1978

The Bankruptcy Reform Act of 1978 substantially changed the bankruptcy laws by adding a strong business reorganization mechanism, referred to as Chapter 11 of the U.S. Bankruptcy Code. Chapter 11 replaced the old Chapters 10 through 12 of the U.S. Bankruptcy Code. Similarly, a more powerful personal bankruptcy, Chapter 13, replaced the old laws. In general, the Reform Act of 1978 made it easier for both businesses and individuals to file a bankruptcy and reorganize. The 1978 law also broadened the conditions under which companies could file so that a firm could declare bankruptcy without having to wait until it was virtually insolvent. The intent of making the Bankruptcy Code less rigid was to increase the likelihood that creditors and owners would reach agreement on plans to reorganize rather than liquidate insolvent firms, which offered the prospect of saving jobs, government tax revenue, and enabling creditors to recover a larger portion of their claims.

The Bankruptcy Reform Act of 1994

During the 1980s and early 1990s, the number of bankruptcy filings reached record levels. Most of the filings were for Chapter 11 reorganization. As the frequency and complexity of cases grew, concerns about the level of professional fees and the perceived loss of value of assets in a number of bankruptcy cases increased the demand for new legislation. In response, the U.S. Congress passed the Bankruptcy Reform Act of 1994, which contained provisions to expedite bankruptcy proceedings and encourage individual debtors to use Chapter 13 to reschedule their debts rather than use Chapter 7 to liquidate.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

On April 19, 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) became law. The new legislation primarily affects consumer filings, making it more difficult for a person or estate to file for Chapter 7 bankruptcy. The BAPCPA affects business filers as well, with the heaviest influence on smaller businesses (i.e., those with less than $2 million in debt).

Prior to BAPCPA, commercial enterprises used Chapter 11 reorganization to continue operating a business and repay creditors through a court-approved plan of reorganization. The debtor had the exclusive right to file a plan of reorganization for the first 120 days after it filed the case. The court ultimately approved or disapproved the reorganization plan. If approved, the plan enabled the debtor to reduce its debts by repaying a portion of its obligations and discharging other obligations. The debtor could also terminate onerous contracts and leases, recover assets, and restructure its operations.

BAPCPA changed this process by (1) reducing the maximum length of time during which debtors have an exclusive right to submit a plan; (2) shortening the time that debtors have to accept or reject leases; and (3) limiting compensation under key employee retention programs. Prior to BAPCPA, a debtor corporation had the opportunity to request a bankruptcy judge to extend the period for submission of the plan of reorganization as long as it could justify its request. Once the judge ruled that the debtor has been given sufficient time, any creditor could submit a reorganization plan. The new law caps the exclusivity period at 18 months from the day of the bankruptcy filing. The debtor then has an additional two months to win the creditors' acceptance of the plan, thereby providing a debtor-in-position a maximum of 20 months before creditors can submit their reorganization plans.⁴

Before BAPCPA, Chapter 11 litigation often took several years before the reorganized firm emerged from bankruptcy. United Airlines exited from bankruptcy in February 2006 after 38 months in Chapter 11, the longest period under court protection in U.S. bankruptcy history. UAL used the time to radically restructure the company and trim $7 billion in annual costs, including two rounds of employee pay cuts and the elimination of 25,000 jobs. The firm also transferred successfully its defined benefit pension plans to the U.S Pension Benefit Guaranty Corporation and further reduced its cost structure by shedding more than 100 planes from its fleet, cutting some U.S. flights, and expanding internationally.

Finally, Chapter 15 was added to the U.S. Bankruptcy Code by BAPCPA of 2005 to reflect the adoption of the Model Law on Cross-Border Insolvency passed by the United Nations Commission on International Trade Law (UNCITRAL) in 1997. The purpose of UNCITRAL is to provide for better coordination among legal systems for cross-border bankruptcy cases. Chapter 15 is discussed in more detail later in this chapter.

Filing for Chapter 11 Reorganization

Chapter 11 reorganization may involve a corporation, sole proprietorship, or partnership. Since a corporation is viewed as separate from its owners (i.e., the shareholders), the Chapter 11 bankruptcy of a corporation does not put the personal assets of the stockholders at risk, other than the value of their investment in the firm's stock. In contrast, sole proprietorships and owners are not separate; a bankruptcy case involving a sole proprietorship includes both the business and personal assets of the owner–debtor. Like a corporation, a partnership exists as a separate entity apart from its partners. In a partnership bankruptcy case, the partners may be sued such that their personal assets are used to pay creditors. The partners themselves may have to file for bankruptcy.

Figure 16.1 summarizes the process for filing for reorganization under Chapter 11. The process begins by filing in a federal bankruptcy court. In the case of an involuntary petition, a hearing must be held to determine whether the firm is insolvent. If the firm is found to be insolvent, the court enters an order for relief, which initiates the bankruptcy proceedings. On the filing of a reorganization petition, the filing firm becomes the debtor-in-possession of all the assets and has a maximum of 20 months to convince creditors to accept its reorganization plan, after which the creditors can submit their own proposal. In the case of fraud, creditors may request that the court appoint a trustee instead of the debtor to manage the firm during the reorganization period.

Figure 16.1 Procedures for reorganizing during bankruptcy.

The U.S. Trustee (the bankruptcy department of the U.S. Justice Department) appoints one or more committees to represent the interests of creditors and shareholders. The purpose of these committees is to work with the debtor-in-possession to develop a reorganization plan for exiting Chapter 11. Creditors and shareholders are grouped according to the similarity of claims. In the case of creditors, the plan must be approved by holders of at least two-thirds of the dollar value of the claims, as well as a simple majority of the creditors in each group. In the case of shareholders, two-thirds of those in each group (e.g., common and preferred shareholders) must approve the plan. Following acceptance by creditors, bondholders, and stockholders, the bankruptcy court also must approve the reorganization plan. Even if creditors or shareholders vote to reject the plan, the court is empowered to ignore the vote and approve the plan if it finds the plan fair to creditors and shareholders as well as feasible. Finally, the debtor-in-possession is responsible for paying the expenses approved by the court of all parties whose services contributed to the approval or disapproval of the plan.

Although intended to give firms time to restructure, whether a business is likely to be successful in Chapter 11 in part depends on the type of business and the circumstances under which it seeks the protection of the bankruptcy court. The credit crisis of 2008, which saw global banks write down more than $300 billion in assets and caused the hurried sales of Bear Stearns, Merrill Lynch, Wachovia, and Washington Mutual, also forced investment banking behemoth Lehman Brothers to seek protection from its creditors.

Case Study 16.1 illustrates the race against time to salvage as much of the firm's franchise as possible and how circumstances overcame Lehman's plans to restructure the business. Lehman Brothers had a plan in place to restructure operations, reduce the overall cost structure, and improve performance. Top executives intended to sell a majority of the firm's investment management business, which included money manager Neuberger Berman, and spin off its troubled real estate loans into a publicly traded unit. The firm also had explored the sale of its broker–dealer operations (i.e., a broker network and securities trading business). However, plans take time to implement, and, with the loss of confidence in the capital markets in general and Lehman in particular, the firm simply ran out of time and options.

Case Study 16.1 : Lehman Brothers Files for Chapter 11 in the Biggest Bankruptcy in U.S. History

A casualty of the 2008 credit crisis that shook Wall Street to its core, Lehman Brothers Holdings, Inc., a holding company, announced on September 15, 2008, that it had filed a petition under Chapter 11 of the U.S. Bankruptcy Code. Lehman's board of directors decided to opt for court protection after attempts to find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and Enron with $126 billion and $81 billion in assets, respectively.

None of the holding company's subsidiaries was included in the filing, enabling customers of Lehman's brokerage, Neuberger Berman Holdings, to continue to use their accounts to trade. Furthermore, by excluding its units from the bankruptcy filing, the customers of its broker–dealer operations would not be subject to claims by LBHI's more than 100,000 creditors in the bankruptcy case.

Prior to the Dodd-Frank Act of 2010 (see Chapter 2) limiting such rights, counterparties could cancel contracts when a financial services firm went bankrupt. Lehman would normally hedge or protect its investments by taking opposite positions to minimize potential losses in its derivatives portfolios. Derivatives are financial instruments whose value changes in response to the value of the underlying assets over a specific period. For example, if the firm purchased a contract to buy oil at a specific price at some point in the future, it would also sell a contract at a somewhat lower price to another party (called a counterparty) to minimize losses if the price of oil dropped. Thus, the bankruptcy filing left Lehman's investment positions unprotected.

On September 20, 2008, Barclays PLC, a major U.K. bank, acquired Lehman's broker–dealer operations for $250 million and paid an additional $1.5 billion for the firm's New York headquarters building and two New Jersey–based data centers. Coming just five days after Lehman filed for bankruptcy, the deal reflected the urgency to find buyers for those businesses whose value consisted primarily of their employees. Barclays did not buy any of Lehman's commercial real estate assets or private equity and hedge fund investments. However, Barclays did agree to take $47.4 billion in securities and assume $45.5 billion in trading liabilities.

On September 24, 2008, Japanese brokerage Nomura Securities acquired Lehman's Japanese and Australian operation for $250 million. Lehman's investment management group, Neuberger Berman, was sold in late December 2008 to a Neuberger management group for $922 million. Under the deal, Neuberger's management would own 51 percent of the firm, and Lehman's creditors would control the remainder. Other Lehman assets, consisting primarily of complex derivatives ranging from oil price futures to credit default swaps (i.e., debt insurance) to options on stock indices, with more than 8,000 counterparties, were expected to take years to identify, value, and liquidate. The firm also could expect to face numerous lawsuits.

The October 18, 2008, auction of $400 billion of Lehman's debt issues was valued at 8.5 cents on the dollar. Because such debt was backed by only the firm's creditworthiness, the buyers of the Lehman debt had purchased insurance from other financial institutions to mitigate the risk of a Lehman default. The existence of these credit default swap arrangements meant that the insurers were required to pay Lehman bondholders $366 billion (i.e., 0.915 × $400 billion). Purchasers of this debt were betting that, following Lehman's liquidation, holders of this debt would receive more than 8.5 cents on the dollar and the insurers would be able to satisfy their obligations.

Hedge funds also were affected by the Lehman bankruptcy. Hedge funds borrowed heavily from Lehman, putting up certain assets as collateral for the loans. While legal, Lehman was using this collateral to borrow from other firms. By using its customers' collateral as its own collateral, Lehman and other firms could borrow more money, using the proceeds to make additional investments. When Lehman filed for bankruptcy, the court took control of such assets until who was entitled to the assets could be determined. Moreover, while derivative agreements were designed to terminate whenever a party declares bankruptcy and be settled outside of court, Lehman's general creditors may lay claim to any collateral whose value exceeds the value of the derivative agreements. Disentangling these claims will take years.

In early 2010, a report compiled by bank examiners described how Lehman manipulated its financial statements, leaving the investing public, the credit rating agencies, government regulators, and Lehman's board of directors totally unaware of the accounting tricks. By departing from common accounting practices, Lehman appeared to be less levered than it actually was. It was pressure from speculators, sensing that the firm was in disarray, that uncovered the scam by selling Lehman's stock short and accomplishing what the regulators and credit rating agencies could not. See the Inside M&A case study at the beginning of Chapter 2 for more details on Lehman's accounting practices.

Discussion Questions

1. Why did Lehman choose not to seek Chapter 11 protection for its subsidiaries?

2. How does Chapter 11 bankruptcy protect Lehman's creditors? How does it potentially hurt them? Explain your answers.

3. Do you believe the U.S. bankruptcy process was appropriate in this instance? Explain your answer.

4. Do you believe the U.S. government's failure to bail out Lehman, thereby forcing the firm to file for bankruptcy, exacerbated the global credit meltdown in October 2008? Explain your answer.

U.S. automotive parts manufacturer Dana Corporation used Chapter 11 bankruptcy in 2008 to achieve substantial cost savings from employees and suppliers, price increases from customers, and concessions from its creditors. These actions enabled the firm to avoid liquidation, which may have resulted in a much larger loss of jobs and tax revenue in the communities in which the firm had operations, while enabling creditors to recover a larger portion of their claims.

Implementing Chapter 7 Liquidation

If the bankruptcy court determines that reorganization is infeasible, the failing firm may be forced to liquidate. A trustee is given the responsibility to liquidate the firm's assets, keep records, examine creditors' claims, disburse the proceeds, and submit a final report on the liquidation. The priority in which the claims are paid is stipulated in Chapter 7 of the Bankruptcy Reform Act, which must be followed by the trustee when the firm is liquidated.⁵ All secured creditors are paid when the firm's assets that were pledged as collateral are liquidated. If the proceeds of the sale of these assets are inadequate to satisfy all of the secured creditors' claims, they become unsecured or general creditors for the amount that was not recovered. If the proceeds of the sale of pledged assets exceed secured creditors' claims, the excess proceeds are used to pay general creditors.

Liquidation under Chapter 7 does not mean that all employees lose their jobs. When a large firm enters Chapter 7 bankruptcy, a division of the company may be sold intact to other companies during the liquidation. For example, the sale of several Lehman Brothers operating units in 2008, while the firm was in bankruptcy, preserved the jobs of as many as 10,000 of the firm's 25,000 employees in place before the bankruptcy.

Fully secured creditors, such as bondholders or mortgage lenders, have a legally enforceable right to the collateral securing their loans or the equivalent value. A creditor is fully secured if the value of the collateral for its loan to the debtor equals or exceeds the amount of the debt. For this reason, fully secured creditors are not entitled to participate in any distribution of liquidated assets that the bankruptcy trustee might make.

Exhibit 16.2 describes how a legally bankrupt company could be liquidated. In this illustration, the bankruptcy court, owners, and creditors could not agree on an appropriate reorganization plan for DOA Inc. Consequently, the court ordered that the firm be liquidated in accordance with Chapter 7. Note that this illustration would differ from a private or voluntary out-of-court liquidation in two important respects. First, the expenses associated with conducting the liquidation would be lower because the liquidation would not involve extended legal proceedings. Second, the distribution of proceeds could reflect a priority of claims negotiated between the creditors and the owners that differs from those set forth in Chapter 7 of the Bankruptcy Reform Act.

“Section 363 Sales” from Chapter 11

So-called 363 sales have become increasingly popular in recent years when time is critical. Section 363 bankruptcies allow a firm to enter a court-supervised sale of assets—usually an auction—as the best means of protecting the value of such assets. Unlike typical bankruptcies, firms may emerge in as little as 30 to 60 days.

The auction process starts with a prospective buyer setting the initial purchase price and terms, as well as negotiating a topping fee to be paid if it is not successful in buying the assets. Often referred to as a stalking horse, the identity of the initial bidder may be concealed. Credit bids occur when secured creditors propose to buy the assets. Such bidders can bid up to the amount of the debt owed before offering any cash. In 2010, creditors outbid an investor group to acquire the Philadelphia Inquirer for an amount equal to $318 million, about one-half of what they were owed by the newspaper.

Creditors opposing the sale have only 10 to 20 days to file written objections to the court, although the period may be shortened to as little as a few days by the bankruptcy judge. The bankruptcy judge decides how the proceeds of the auction are distributed among secured creditors.

Exhibit 16.2 Liquidation of DOA Inc. Under Chapter 7

DOA has the balance sheet shown in Table 16.3. The only liability that is not shown on the balance sheet is the cost of the bankruptcy proceedings, which are treated as expenses and are not capitalized. The sale of DOA's assets generates $5.4 million in cash. The distribution of the proceeds is displayed in Table 16.4. Note that the proceeds are distributed in accordance with the priorities stipulated in the current commercial bankruptcy law and that the cost of administering the bankruptcy totals 18% (i.e., $972,000 ÷ $5,400,000) of the proceeds from liquidation.

Table 16.3. DOA Balance Sheet

Table 16.4. Distribution of Liquidation Proceeds

	Amount
Proceeds from Liquidation	$5,400,000
Expenses of Administering Bankruptcy	972,000
Salaries Owed Employees	720,000
Unpaid Employee Benefits	140,000
Unsecured Customer Deposits	300,000
Taxes	400,000
Funds Available for Creditors	$2,868,000
First Mortgage (From sale of fixed assets)	1,500,000
Funds Available for Unsecured Creditors	$1,368,000

Once all prior claims have been satisfied, the remaining proceeds are distributed to the unsecured creditors. The pro rata or proportional settlement percentage of 27.64% is calculated by dividing funds available for unsecured creditors by the amount of unsecured creditor claims (i.e., $1,368 ÷ $4,950). The shareholders receive nothing because not all unsecured creditor claims have been satisfied (Table 16.5).

Table 16.5. Pro Rata Distribution of Funds among Unsecured Creditors

Unsecured Creditor Claims	Amount	Settlement at 27.64%
Unpaid Balance from First Mortgage	$1,000,000	$ 276,400
Accounts Payable	750,000	207,300
Notes Payable	3,000,000	829,200
Unsecured Debt	200,000	55,280
Total	$4,950,000	$1,368,000

The Chapter 11 bankruptcy proceedings of automakers General Motors and the Chrysler in 2009 are among the most visible 363 sales. Chrysler LLC was sold to a new company managed by Italian carmaker Fiat that would operate as Chrysler Group LLC and consist of the Chrysler, Jeep, Dodge, and Mopar brands. The ownership distribution of the new company emerging from Chapter 11 was United Auto Workers (55%), Fiat (20%, growing to 35% once certain milestones had been reached), the U.S. government (8%), and the Canadian government (2%). The outcome of this proceeding was particularly controversial in that the absolute priority rule appears to have been violated. Under this federal bankruptcy code rule, no unsecured creditor can receive an interest in a reorganized firm before secured creditors are paid in full or are provided a fair distribution. However, in this instance, the UAW received for its pension obligations—an unsecured claim—a much higher ownership stake than the value of the cash received by secured creditors.

The resolution of the GM 363 sale involved splitting the firm into two companies. The U.S. and Canadian operations only were included in the GM bankruptcy filing. “New GM” contained the “good assets,” while all the other assets were retained in “Old GM.” “New GM” represented a new corporation containing only the attractive assets held by the U.S. and Canadian operations and is primarily owned by the U.S. and Canadian governments, a UAW healthcare trust, and the creditors of “Old GM.” Following approval of the Chapter 11 plan of reorganization, a postliquidating trust directed by a court-appointed trustee was established to dispose of “Old GM” assets, with the proceeds going to the creditors. For a more detailed discussion, see Case Study 16.2 at the end of the chapter.

Chapter 15: Dealing with Cross-Border Bankruptcy

As noted previously in this chapter, the purpose of Chapter 15 of the U.S. Bankruptcy Code is to provide mechanisms for resolving insolvency cases involving assets, lenders, and other parties in various countries. In general, a Chapter 15 case is ancillary or secondary to the primary proceeding brought in another country, which is typically the debtor's home country. As an alternative to Chapter 15, the debtor may proceed with a Chapter 7 or Chapter 11 case in the United States. As part of a Chapter 15 proceeding, the U.S. Bankruptcy Court may authorize a trustee to act in a foreign country on its behalf.

Under Chapter 15, an ancillary case is initiated by a “foreign representative” filing a petition for recognition of a “foreign proceeding.” As such, Chapter 15 gives the foreign representative the right to petition the U.S. court system for resolving insolvency issues. Once processed by the U.S. court, the petition gives the court the authority to issue an order recognizing the foreign proceeding as either a “foreign main proceeding” or a “foreign nonmain proceeding.” A foreign main proceeding is a proceeding in a country where the debtor's main interests are located. A foreign nonmain proceeding is a proceeding in a country where the debtor has an establishment not representing its primary holdings. If recognized as a foreign main proceeding, the court imposes an automatic stay on assets in dispute in the United States and authorizes the foreign representative to operate the debtor's business.⁶

In late 2008, judges in Canada and the United States approved key elements of an agreement enabling Hollinger Inc., a Canadian-based newspaper holding company, to emerge from the protection of bankruptcy court. Bondholders sent Hollinger into insolvency protection in Canada and Chapter 15 in the United States. A key component of the agreement with Davidson Kempner, holder of about 40 percent of the more than $100 million owed by Hollinger, involved the elimination of the supervoting control shares held by a major stockholder. The shareholder agreed to convert supervoting shares in Hollinger's largest investment (i.e., Sun-Times Media Group) for one-vote, one-share common stock. Hollinger's creditors would receive the new shares as part of an agreement to dispense with the debt they are owed.

Motivations for Filing for Bankruptcy

Although most companies that file for bankruptcy do so because of their deteriorating financial position, companies increasingly are seeking bankruptcy protection to enhance negotiating leverage, avoid litigation, and minimize exposure to potentially onerous future liabilities. In the mid-1980s, Johns Manville Corporation used bankruptcy to negotiate a reduction in huge liability awards granted in the wake of asbestos-related lawsuits. Similarly, Texaco used the threat of bankruptcy in the early 1990s as a negotiating ploy to reduce the amount of court-ordered payments to Occidental Petroleum resulting from the court's determination that Texaco had improperly intervened in a pending merger transaction. More recently, a bankruptcy judge in late 2004 approved a settlement enabling two subsidiaries of the energy giant Halliburton to emerge from bankruptcy and to limit their exposure to potential future asbestos claims by establishing a $4.2 billion trust fund to pay such claims.

In 2001, LTV sold its plants while in bankruptcy to W.L. Ross and Company, which restarted the plants in 2002 in a new company, the International Steel Group. By simply buying assets, ISI eliminated its obligation to pay pension, healthcare, or insurance liabilities, which remained with LTV. Delphi, the ailing auto parts manufacturer, used its bankrupt status to threaten to abrogate union contracts to gain substantial wage and benefit concessions from its employees in 2007.

Effectiveness of Chapter 11 Reorganization versus Chapter 7 Liquidation

Chapter 7 liquidations appear to be as costly as Chapter 11 reorganization, in terms of legal expenses and related fees, as well as the time required to complete the proceedings. However, Chapter 11 reorganization allows creditors to recover relatively more of their claims than under liquidation. In liquidation, bankruptcy professionals, including attorneys, accountants, and trustees, often end up with the majority of the proceeds generated by selling the assets of the failing firm.⁷

Professional Fees Associated with the Bankruptcy Process

Factors explaining most of the variation in professional fees from one bankruptcy to another include company size, duration, complexity, and the number of parties involved. These factors measure not only the need for professional services but also the opportunity to bill.⁸ Efforts to contain costs have prompted a greater use of auctions and other market-based techniques to privatize bankruptcy. These techniques include prepackaged bankruptcies with a reorganization plan in place at the time of the bankruptcy filing, acquisition of distressed debt by vulture investors willing to support the proposed plan of reorganization, and voluntary auction-based sales while a firm is under the protection of Chapter 11. Despite the increasing use of innovative ways of expediting the bankruptcy process, the cost of professional services remains high. While large and complex, estimated fees paid to bankruptcy advisors, such as appraisers and investment bankers, and legal fees since the Lehman Brothers liquidation began in September 2008, exceeded $800 million by the end of 2010.

Prepackaged Bankruptcies

Under a prepackaged bankruptcy, the debtor negotiates with creditors well in advance of filing for a Chapter 11 bankruptcy. Because there is general approval of the plan before the filing, the formal Chapter 11 reorganization that follows generally averages only a few months and results in substantially lower legal and administrative expenses.⁹ More than one-fifth of major bankruptcy cases between 2001 and 2005 were prepackaged deals.¹⁰ Prepackaged bankruptcies are often a result of major creditors anticipating a potential liquidation in bankruptcy as occurring at “fire sale” prices.¹¹ Prepackaged bankruptcies work best when a limited number of sophisticated secured creditors are involved, enabling the negotiations to proceed rapidly.

In a true prepackaged bankruptcy, creditors approve a reorganization plan before filing for bankruptcy. The bankruptcy court then approves the plan and the company emerges from bankruptcy quickly. Minority creditors are often required by the court to accept a plan of reorganization. The confirmation of a plan of reorganization over the objections of one or more classes of creditors sometimes is referred to as a cram down.

Prepackaged bankruptcy provides tax benefits not found in workouts. If a firm enters into a workout in which a voluntary negotiated agreement with debtors is achieved, the firm may lose its right to claim net operating losses in its tax filing.¹² In bankruptcy, the firm may claim the right to NOLs if the court rules the firm insolvent (i.e., negative net worth). In addition, if a debtor company reaches a voluntary agreement outside of bankruptcy court whereby creditors agree to cancel a certain percentage of debt, the amount is treated as income for tax purposes. A similar debt restructuring in bankruptcy does not create such a tax liability.

On November 4, 2010, U.S. movie studio Metro-Goldwyn-Mayer filed a prepackaged Chapter 11 bankruptcy in New York that had the approval of nearly all of its creditors. The week before, creditors had approved a plan to forgive more than $4 billion in debt for ownership stakes in the restructured studio and to replace existing management. The bankruptcy was approved the following month, with the reorganized firm emerging from court protection having raised $600 million in new financing.

Analyzing strategic options for failing firms

A failing firm's strategic options are to merge with another firm, reach an out-of-court voluntary settlement with creditors, or file for Chapter 11 bankruptcy. Note that the prepackaged bankruptcy discussed earlier in this chapter constitutes a blend of the second and third options. The firm may voluntarily liquidate as part of an out-of-court settlement or be forced to liquidate under Chapter 7 of the Bankruptcy Code. Table 16.6 summarizes the implications of each option. The choice of which option to pursue is critically dependent on which provides the greatest present value for creditors and shareholders. To evaluate these options, the firm's management needs to estimate the going concern, selling price, and liquidation values of the firm.

Table 16.6. Alternative Strategies for Failing Firms

Assumptions	Options: Failing Firm	Outcome: Failing Firm
Selling Price > Going Concern or Liquidation Value	1. Is acquired by another firm 2. Merges with another firm	1. Continues as subsidiary of acquirer 2. Merged into acquirer and ceases to exist
Going Concern Value > Sale or Liquidation Value	1. Reaches out-of-court settlement with creditors 2. Seeks bankruptcy protection under Chapter 11 3. Seeks prepackaged settlement with primary creditors before entering Chapter 11	1. Continues with debt for equity swap, extension, and composition 2. Continues in reorganization
Liquidation Value > Sale or Going Concern Value	1. Reaches out-of-court settlement with creditors 2. Liquidates under Chapter 7	1. Ceases to exist; assignee liquidates assets and distributes proceeds reflecting terms of negotiated settlement with creditors 2. Ceases to exist; trustee supervises liquidation and distributes proceeds according to statutory priorities

Merging with Another Firm

If the failing firm's management estimates that the sale price of the firm is greater than the going concern or liquidation value, management should seek to be acquired by or to merge with another firm. If there is a strategic buyer, management must convince the firm's creditors that they will be more likely to receive what they are owed and shareholders are more likely to preserve share value if the firm is acquired rather than liquidated or allowed to remain independent. In some instances, buyers are willing to acquire failing firms only if their liabilities are reduced through the bankruptcy process. Hence, it may make sense to force the firm into bankruptcy to have some portion of its liabilities discharged during the process of Chapter 11 reorganization.¹³ Alternatively, the potential buyer could reach agreement in advance of bankruptcy reorganization with the primary creditors (i.e., a prepackaged bankruptcy) and employ the bankruptcy process to achieve compliance from the minority creditors.

Sales within the protection of Chapter 11 reorganization may be accomplished either by a negotiated private sale to a particular purchaser or through a public auction. The latter is often favored by the court, since the purchase price is more likely to reflect the true market value of the assets. Generally, a public auction can withstand any court challenge by creditors questioning whether the purchaser has paid fair market value for the failing firm's assets. International Steel Group's acquisition of LTV Steel's assets in 2002 and the bankrupt Bethlehem Steel in early 2003, and U.S. Steel's purchase of bankrupt National Steel shortly thereafter, are examples of such transactions. In 2005, Time Warner Inc. and Comcast Corp. reached an agreement to buy bankrupt cable operator Adelphia Communications Corporation while it was in Chapter 11 for nearly $18 billion. Time Warner and Comcast paid Adelphia bondholders and other creditors in cash and warrants for stock in a new company formed by combining Time Warner's cable business and Adelphia.

Bidders tend to overpay for firms purchased out of Chapter 11, with such strategies benefiting target firm but not acquirer shareholders. In most cases, the acquirers fail to successfully restructure the target firms.¹⁴

Reaching an Out-of-Court Voluntary Settlement with Creditors

Alternatively, the going concern value of the firm may exceed the sale or liquidation value. Management must be able to demonstrate to creditors that a restructured or downsized firm would be able to repay its debts if creditors were willing to accept less, extend the maturity of the debt, or exchange debt for equity.

A voluntary settlement may be difficult to achieve because the debtor often needs the approval of all its creditors. Known as the holdout problem, smaller creditors have an incentive to attempt to hold up the agreement unless they receive special treatment. Consensus may be accomplished by paying all small creditors 100 percent of what they are owed and the larger creditors an agreed-on percentage. Other factors limiting voluntary settlements, such as a debt-for-equity swap, include a preference by some creditors for debt rather than equity and the lack of the necessary information to enable proper valuation of the equity offered to the creditors. Because of these factors, there is some evidence that firms attempting to restructure outside of Chapter 11 bankruptcy have more difficulty in reducing their indebtedness than those that negotiate with creditors while under the protection of Chapter 11.¹⁵ If management cannot reach agreement with the firm's creditors, it may seek protection under Chapter 11.

Voluntary and Involuntary Liquidations

The failing firm's management, shareholders, and creditors may agree that the firm is worth more in liquidation than in sale or as a continuing operation. If management cannot reach agreement with its creditors on a private liquidation, the firm may seek Chapter 7 liquidation. The proceeds of a private liquidation are distributed in accordance with the agreement negotiated with creditors, while the order in which claimants are paid under Chapter 7 is set by statute.

Failing firms and systemic risk

In response to the meltdown in global financial markets in 2008 and 2009, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protections Act of 2010 (Dodd-Frank). Among other things, the Act created a new government mechanism to dismantle financial services firms whose imminent demise would endanger the U.S. financial system and economy.

The objectives of the resolution authority are to ensure a speedy liquidation of a firm through a mechanism called the Orderly Liquidation Authority (OLA), that the losses are primarily borne by the firm's shareholders and creditors, while minimizing the loss of taxpayer funds, and to penalize current management. Because the measure applies to corporations that are subject to the U.S. Bankruptcy Code, a determination by the designated government authorities that a company poses a systemic risk would enable the Federal Deposit Insurance Corporation (FDIC) to seize the firm and liquidate it under the OLA, thereby preempting any proceedings under the Bankruptcy Code. The OLA is solely a liquidation remedy and, unlike Chapter 11 of the U.S. Bankruptcy Code, does not allow for reorganization or rehabilitation as an option.

The new authority is modeled after the FDIC's resolution authority for insured depository institutions under the Federal Deposit Insurance Act. With the FDIC assuming full control as receiver, the debtor-in-position (i.e., the current management) is removed. The ability of the FDIC to seize a bank holding company allows it to conduct coordinated proceedings for the bank and its affiliates. The OLA gives the FDIC the right to terminate all contracts, including derivative contracts. The FDIC is required to resolve claims within 180 days of receivership having taken effect. Secured creditors faced with the prospect of loss of the value of their collateral may request expedited resolution of their claims within 90 days. However, as receiver, the FDIC may merge the firm with another or transfer any asset or liability without approval, consignment, or consent of creditors or other stakeholders. Officers and directors of the firm in receivership are exposed to significant financial liability. Their incentive and other compensation earned in the three years prior to receivership may be subject to “clawback” (i.e., repayment).

The order in which claimants are paid during liquidation is similar to that defined under Chapter 7, except that the government puts itself first. The cash proceeds of assets would first be used to pay the government, then to pay wages up to $11,725 per employee, and subsequently to pay senior and unsecured creditors, senior executives, and finally shareholders. If the government cannot recoup all of the taxpayer funds provided to the firm to fund the liquidation, it may enact a special assessment on other financial institutions regulated by the Federal Reserve.

The OLA applies only to U.S. companies that are bank holding companies, nonbank financial firms supervised by the Federal Reserve Board of Governors (the Fed), companies predominantly engaged in activities that the Fed determines are financial in nature, subsidiaries of such companies (other than insured depositor institutions or insurance companies), and brokers and dealers registered with the SEC and members of the Securities Investor Protection Corporation (SIPC), a fund designed to insure clients against broker/dealer fraud. The liquidation of insured depository institutions will continue to be the responsibility of the FDIC under the agency's current mandate. While insurance companies will continue to be subject to state regulation, their holding companies and unregulated affiliates are covered by the OLA.

The OLA is initiated with a request from the secretary of the Treasury that the FDIC be appointed receiver of a failing firm whose failure would jeopardize the U.S. financial system. To take effect, the request must be approved by a two-thirds vote of each of the Federal Reserve Board and the board of the FDIC, or by the SEC (in the case of a broker or dealer) or the Federal Insurance Office (in the case of an insurance company). Firms subject to the OLA must be in default or in danger of default and they must represent systemic risk.¹⁶ If the board of directors of the failing firm agrees, the approval of the Federal Reserve and a second regulator is not required, since only a decision by the Treasury secretary is needed. Furthermore, any decision by the firm's board to accept receivership will not subject the board to liability.

The advantages of the OLA are that it provides the government with both the authority and a clear process for winding down expeditiously failing firms that are deemed a risk to the financial system. However, the resolution process for dealing with failing systemically risky firms can itself destabilize the financial system, since the process could panic investors and lenders. Furthermore, the OLA is applicable only to firms whose operations are wholly domestic, since there is currently no cross-border mechanism for resolving banks operating in multiple countries. Consequently, large, multinational banks will be unaffected by the OLA.

Predicting corporate default and bankruptcy

The ability to accurately anticipate default is an important component of any lender's risk management system. While the predictive accuracy of statistical models has improved significantly over the years, the widespread defaults during the 2008 and 2009 global recession underscore the need for further research.

Alternative Models

A review of 165 bankruptcy prediction studies published from 1930 to 2006 examined how modeling trends have changed by decade. Discriminant analysis was the primary method used to develop models in the 1960s and 1970s. However, the primary modeling methods shifted by the 1980s to logit analysis and neural networks. While the number of factors used in building the models varied by decade, the average model used about ten variables. In analyzing model accuracy, multivariate discriminant analysis and neural networks seem to be the most promising, and increasing the number of variables in the model does not guarantee greater accuracy. Interestingly, two-factor models are often as accurate as models with as many as 21 factors.¹⁷

An international study analyzed the empirical findings and methodologies employed in 46% studies applied in ten countries from 1968 to 2003. The study documented that bankruptcy prediction models typically used financial ratios to forecast business failure, with about 60 of the studies reviewed using only financial ratios. The remaining studies used both financial ratios and other information. The financial ratios typically included measures of liquidity, solvency, leverage, profitability, asset composition, firm size, and growth rate. The other information included macroeconomic, industry-specific, location, and firm-specific variables. This study concluded that the predictive accuracy of the various types of models investigated was very similar, correctly identifying failing firms about 80% of the time for firms in the sample employed in estimating the models. However, accuracy dropped substantially for out-of-sample predictions.¹⁸

Documenting potential problems with bankruptcy prediction models, researchers have found that model results often vary by industry and time period. Model accuracy also tends to decline when applied to periods different from those employed to develop the models (i.e., in-sample versus out-of-sample predictions). Moreover, applying models to industries other than those used to develop the models often results in greatly diminished accuracy.¹⁹

In view of the extensive literature on the subject, the following subsections discuss categories of models that differ by methodology and choice of variables used to predict bankruptcy. The intent of these subsections is to provide an overview of the state of such models.²⁰

Models That Differ by Methodology

Bankruptcy prediction models tend to fall into three major categories: credit scoring models, structural models, and reduced form models.

Credit Scoring Models

One of the earliest (1960s) quantitative efforts to predict bankruptcy relied on discriminant analysis to distinguish between bankrupt and nonbankrupt firms.²¹ Discriminant analysis uses a combination of independent variables to assign a score (i.e., a Z score) to a particular firm. This score then is used to distinguish between bankrupt and nonbankrupt firms by using a cutoff point. The Z score model formalized the more qualitative analysis of default risk offered by credit rating agencies such as Moody's Investors Services. Five key financial ratios were used to determine a firm's Z score. The likelihood of default for firms with low Z scores is less than for firms with high Z scores. The most significant financial ratios for predicting default are earnings before income and taxes as a percent of total assets and the ratio of sales to total assets. The major shortcoming of this approach is that it is a snapshot of a firm's financial health at a moment in time, and it does not reflect changes in a company's financial ratios over time. Tests of this methodology applied to more recent samples found that the earlier models' ability to classify bankrupt companies correctly fell from 83.5 to 57.8%.²²

To compensate for the shortcomings of the discriminant model, analysts developed models to predict the probability of a firm defaulting over some future period. The model postulated that the default rate depended not only on the firm's current financial ratios but also on such forward-looking market variables as market capitalization, abnormal financial returns, and the volatility of such financial returns. The only financial ratios with significant predictive power are earnings before interest and taxes to total liabilities and the market value of equity to total liabilities.²³

Structural Models

While credit scoring models do not estimate the probability of default, structural models attempt to do so. Often employing probit analysis, structural models are debt-pricing models that link the probability of default to the structure of a firm's assets and liabilities. Structural models of credit risk assume that firms default when they violate a debt covenant, their cash flow falls short of required debt payments, their assets become more valuable in competitors' hands, or their shareholders decide that servicing the debt is no longer in their best interests. Structural models can be very difficult to develop for firms with complex debt structures.

Logistic (logit) or probit regression models provide a conditional probability of an observation belonging to a particular category. Logit and probit models do not require assumptions as restrictive as discriminant analysis. Supporters of this approach argue that logit regression fits the characteristics of the default prediction problem. The dependent variable is binary (default/nondefault). The logit model yields a score between 0 and 1, which gives the probability of the firm defaulting.²⁴

Reduced Form Models

In contrast to structural models, reduced form models use market prices of the distressed firm's debt as the only source of information about the firm's risk profile. Such prices are a proxy for the variables used in the structural models. Although easier to estimate, such models lack a specific link between credit risk and the firm's assets and liabilities and assume that the timing of default is random in that investors with incomplete data do not know how far the firm is from default. Default is triggered by some measure of distress crossing a threshold level or default boundary.²⁵

Other Modeling Methods

While statistical discriminant analysis and probit or logit methods dominate the literature, they are not the only techniques used in bankruptcy prediction. Neural networks are a type of artificial intelligence that attempts to mimic the way a human brain works. Neural networks are particularly effective when the networks have a large database of prior examples.²⁶ The cumulative sums (CUSUM) methods represent a class of models that account for serial correlation (i.e., interdependencies) in the data and incorporate information from more than one period.²⁷ The options-based approach to bankruptcy prediction builds on option-pricing theory to explain business bankruptcy, relying on such variables as firm volatility to predict default.²⁸

Models Differing in Choice of Variables Used to Predict Bankruptcy

Accounting data are sometimes used to predict credit ratings, which serve as proxies for the probability of default.²⁹ Some analysts argue that the probability of failure depends on the length of the time horizon considered³⁰ or demonstrate a correlation between default rates and loss in the event of default and the business cycle.³¹ “Shocks,” such as recession and credit crunches, contribute to default by negatively affecting firm assets or cash flow.³² Other studies use net worth as a key factor that affects a firm's ability to raise financing in a liquidity crisis³³ or equity returns and debt service ratios as measures of distress.³⁴

Valuing distressed businesses

The intent of this section is to discuss ways of incorporating the impact of potential financial distress, default, and ultimately bankruptcy on the value of the firm. Historical performance may prove a poor guide to determining the future financial performance of businesses experiencing declining revenue and profitability, since it is unclear when or if they will recover.

Standard DCF methods attempt to adjust for financial distress by increasing the discount rate. Since the bulk of the firm's total value will come from its terminal value, this adjustment implies that the firm will be able to generate cash flows in perpetuity despite its weakened state. Consequently, it is likely that the value of the firm will be overstated.

To adjust DCF estimates, it is necessary to estimate the likelihood and cost of financial distress. In practice, it is extremely difficult to estimate the probability of a specific outcome such as the event of bankruptcy. We need to estimate not only the probability of a specific outcome annually but also the cumulative probability of that outcome, since a firm experiencing distress in one year is likely to continue to experience distress in subsequent years. Thus, the effect of financial distress tends to accumulate because a firm may be less able to reinvest such that future cash flows are reduced below what they would have been had the firm not experienced financial distress.

While there are many ways to value distressed firms, a common approach is the adjusted present value, or APV, method (see Chapter 13). The APV method requires the estimation of the value of the firm without debt by discounting the projected cash flows by the unlevered cost of equity; calculating the present value of interest tax savings at the unlevered cost of equity, since these tax benefits are subject to the same risk as the cash flows of an unlevered firm; and estimating the probability and cost of financial distress.

Table 16.7 illustrates the inclusion of financial distress in the valuation of the McClatchy Company using the adjusted present value method. McClatchy Company is a U.S.-based newspaper publisher owning 30 daily newspapers and 43 nondailies in 29 regional markets. The company also owns local websites offering a variety of content, engages in direct marketing and direct mail operations, and has minority interests in a series of digital businesses.

Table 16.7. Present Value of McClatchy Company Using the Adjusted Present Value Method

^a Market value of debt = Interest expense × {[1 – 1 / (1 + i)ⁿ ] / 1 + i} + Face value of debt / (1 + i)ⁿ = $107,353,000 × {[1 – 1 / (1.1065)^9.6 ] / 1.1065} + 1,796,436,000 / (1.1065)^9.6 = 60,298,095 + 679,951,810 = $740,249,905.

^b Comparable company unlevered beta = Comparable company levered beta / [(1 + (1 – marginal tax rate) × (comparable company debt / equity)] = 1.924 / (1 + (1 – 0.4) × 1.16) = 1.1344 (Based on top 10 U.S. newspapers in terms of market capitalization).

^c See Table 13.9 in Chapter 13.

^d Implied debt–to–total capital ratio = (D/E) / (1 + D/E) = 0.33 / 1.33 = 0.25.

^e Cost of debt equals the risk-free rate of 3.65 percent plus a 7 percent default spread based on McClatchy's rating of B– from S&P.

^f Unleveraged cost of equity = 0.0365 + 1.1344 (0.055) = 0.0989.

^g Terminal period WACC = 0.25 × (1 – 0.4) × 0.08 + 0.75 × 0.0989 = 0.012 + 0.0742 = 0.0862.

The entire newspaper industry has been experiencing long-term erosion in its readership base and a subsequent decline in advertising revenue. The decline in revenues was exacerbated by the 2008–2009 recession. The model assumes that the deterioration in revenues will continue through 2013 before showing a modest improvement in 2014–2015 as the firm transforms itself from primarily a print business to a digital media business. The key assumption in calculating the terminal value is an assumed 3% growth in cash flow in perpetuity.

As of March 10, 2010, the company was viewed by the major credit rating agencies as experiencing considerable financial distress and was rated below investment grade by Standard & Poor's credit rating agency. Such firms carry a B– credit rating and have an estimated cumulative probability of default of about 42% (see Table 13.9 in Chapter 13). Table 16.7 adjusts the value of the firm for the expected cost of bankruptcy ranging from 15% to 40% of the firm's APV. The cost of bankruptcy is assumed to be included in the cost of financial distress. The value of the firm's share price varies from a high of $5.85 (at 15%) to a low of $1.55 (at 40%). The firm's price per share of $5.19 at the time of the valuation suggests that investors believed the impact of financial distress was limited. See Chapter 13 for a more detailed discussion of the probability and cost of financial distress. The Excel model underlying Table 16.7 is available on the companion site in a file folder entitled “Estimating the Cost of Financial Distress.”

Empirical studies of financial distress

Many of the quantitative studies of firms in financial distress reveal an array of sometimes surprising results.

Attractive Returns to Firms Emerging from Bankruptcy Often Temporary

When firms emerge from bankruptcy, they often cancel the old stock and issue new common stock. Empirical studies show that such firms often show very attractive financial returns to holders of the new stock immediately following the announcement that the firm is emerging from bankruptcy.³⁵ However, long-term performance often deteriorates, with some studies showing that 40% of the firms studied experienced operating losses in the three years after emerging from Chapter 11. Almost one-third subsequently filed for bankruptcy or had to restructure their debt. After five years, about one-quarter of all firms that reorganized were liquidated, merged, or refiled for bankruptcy.³⁶ The most common reason for firms having to again file for bankruptcy is excessive debt, with such firms typically having 3:1 debt-to-equity ratios.

Returns to Financially Distressed Stocks Unexpectedly Low

As a class, distressed stocks offer low financial rates of return despite their high risk of business failure.³⁷ In theory, one would expect such risky assets to offer financial returns commensurate with risk. The low financial return for distressed stocks tends to be worse for stocks with low analyst coverage, institutional ownership, and price per share. Factors potentially contributing to these low returns could include unexpected events, valuation errors by uninformed investors, and the characteristics of distressed stocks. Unexpected events could include the economy being worse than expected. Valuation errors include investors not understanding the relationship between variables used to predict failure and the risk of failure and therefore not having fully discounted the value of stocks to offset this risk. The characteristics of failing firms are such that some investors may have an incentive to hold such stocks despite their low returns. For example, majority owners of distressed stocks can benefit by buying the firm's output or assets at bargain prices. Consequently, the benefits from having control could exceed the low returns associated with financially distressed stocks.

Low returns to financially distressed stocks also may be related to the future potential for asset recovery. If expected recovery rates are high, the distressed firm's shareholders may deliberately trigger default by missing payments if they believe they can recover a significant portion of the value of their shares through renegotiation of credit terms with lenders. Consequently, the lower perceived risk of such shares would result in commensurately lower financial returns.³⁸

IPOs More Likely to Experience Bankruptcy than Established Firms

Firms that have recently undergone IPOs tend to experience a much higher incidence of financial distress and bankruptcy than more established firms.³⁹ These findings are consistent with other studies showing that a portfolio of IPOs performs well below the return on the S&P 500 stock index for up to five years after the firms go public.⁴⁰ Some observers attribute this underperformance to the limited amount of information available on these firms.⁴¹

Financially Ailing Firms Can Be Contagious

A contagion in this context describes a situation in which the financial distress of one firm often spreads to other firms. For example, a declaration of bankruptcy by one firm can negatively impact rival firms and suppliers. The extent to which this may happen depends on whether the factors contributing to financial distress are impacting all firms within an industry or relate to a specific firm. The effects of financial distress may also differ depending on the degree to which an industry is concentrated. Studies show that rival stock prices react negatively to a competitor's bankruptcy in most industries; however, rival share prices may increase whenever a competitor declares bankruptcy in highly concentrated industries. The latter reflects the likelihood that the remaining competitors in concentrated industries will gain market share, enabling them to benefit from increased economies of scale and pricing power.⁴² Furthermore, firms experiencing financial distress or in Chapter 11 are likely to experience declining sales and in turn to reduce their demand for raw materials and services from suppliers. When such firms represent important customers, suppliers often experience significant declines in valuations.⁴³

There also is evidence that industry bankruptcies raise the cost of borrowing and reduce the access to credit of other industry participants by reducing the value of the collateral used to secure debt financing.⁴⁴ Specifically, firms experiencing financial distress are forced to sell assets and to reduce their purchases of similar assets, putting downward pressure on the value of such assets. Consequently, firms owning similar assets whose value has fallen will be forced to borrow less, pay more for credit, or both.

Some things to remember

Bankruptcy is a federal legal proceeding designed to protect the technically or legally insolvent firm from lawsuits by its creditors until a decision is made to liquidate or reorganize the firm. In the absence of a voluntary settlement out of court, the debtor firm may voluntarily seek protection from its creditors by initiating bankruptcy or be forced into bankruptcy by its creditors. Once a petition is filed, the debtor firm is protected from any further legal action related to its debts until the bankruptcy proceedings are completed.

Discussion Questions

16.1 Why are strong creditor rights important to an efficiently operating capital market? What is the purpose of bankruptcy in promoting capital market efficiency?

16.2 Of all the possible stakeholders in the bankruptcy process, which are likely to benefit the most? Which are likely to benefit the least? Explain your answer.

16.3 What are the advantages to the lender and the debtor firm's shareholders of reaching a negotiated settlement outside of bankruptcy court? What are the primary disadvantages?

16.4 How does the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 differ from the Bankruptcy Reform Act of 1978? In what ways do you feel that it represents an improvement? In what ways could the more recent legislation discourage reorganization in Chapter 11? Be specific.

16.5 What are prepackaged bankruptcies? In what ways do they represent streamlining of the credit recovery process?

16.6 Why would creditors make concessions to a debtor firm? Give examples of common types of concessions. Describe how these concessions affect the debtor firm.

16.7 Although most companies that file for bankruptcy do so because of their deteriorating financial position, companies increasingly are seeking bankruptcy protection to avoid litigation. Give examples of how bankruptcy can be used to avoid litigation.

16.8 What are the primary options available to a failing firm? What criteria might the firm use to select a particular option? Be specific.

16.9 Describe the probable trend in financial returns to shareholders of firms that emerge from bankruptcy. To what do you attribute these trends? Explain your answer.

16.10 Identify at least two financial or nonfinancial variables that have been shown to affect firm defaults and bankruptcies. Explain how each might affect the likelihood that the firm will default or seek Chapter 11 protection.

16.11 On June 25, 2008, JHT Holdings, Inc., a Kenosha, Wisconsin–based package delivery service company, filed for bankruptcy. The firm had annual revenues of $500 million. What would the firm have to demonstrate for its petition to be accepted by the bankruptcy court?

16.12 Dura Automotive emerged from Chapter 11 protection in mid-2008. The firm obtained exit financing consisting of a $110 million revolving credit facility, a $50 million European first-lien term loan, and an $84 million U.S. second-lien loan. The reorganization plan specified how a portion of the proceeds of these loans would be used. What do you believe might be typical stipulations in reorganization plans for using such funds? Be specific.

16.13 What are the primary factors contributing to business failure? Be specific.

16.14 In recent years, hedge funds engaged in so-called loan-to-own prebankruptcy investments, in which they acquired debt from distressed firms at a fraction of face value. Subsequently, they moved the company into Chapter 11, intent on converting the acquired debt into equity in a firm with sharply reduced liabilities. The hedge fund also provided financing to secure its interest in the business. The emergence from Chapter 11 was typically accomplished under Section 363(k) of the Bankruptcy Code, which gives debtors the right to bid on the firm in a public auction sale. During the auction, the firm's debt was valued at face rather than market value, discouraging bidders other than the hedge fund, which acquired the debt prior to bankruptcy at distressed levels. Without competitive bidding, there was little chance of generating additional cash for the general creditors. Is this an abuse of the Chapter 11 bankruptcy process? Explain your answer.

16.15 American Home Mortgage Investments filed for Chapter 11 bankruptcy in late 2008. The company indicated that it chose this course of action because it represented the best means of preserving the firm's assets. W.L. Ross and Company agreed to provide the firm $50 million in debtor-in-possession financing to meet its anticipated cash needs while in Chapter 11. Comment on the statement that bankruptcy provides the best means of asset preservation. Why would W.L. Ross and Company lend money to a firm that had just filed for bankruptcy?

Answers to these Chapter Discussion Questions are found in the Online Instructor's Manual for instructors using this book.

Chapter business cases

Case Study 16.2 : The General Motors' Bankruptcy—The Largest Government-Sponsored Bailout in U.S. History

Rarely has a firm fallen as far and as fast as General Motors. Founded in 1908, GM dominated the car industry through the early 1950s, with its share of the U.S. car market reaching 54% in 1954, which proved to be the firm's high-water mark. Efforts in the 1980s to cut costs by building brands on common platforms blurred their distinctiveness. Following increasing healthcare and pension benefits paid to employees, concessions made to unions in the early 1990s to pay workers even when their plants were shut down reduced the ability of the firm to adjust to changes in the cyclical car market. GM was increasingly burdened by so-called legacy costs (i.e., healthcare and pension obligations to a growing retiree population).

Over time, GM's labor costs soared compared to the firm's major competitors. To cover these costs, GM continued to make higher-margin medium- to full-size cars and trucks, which in the wake of higher gas prices could only be sold with the help of highly attractive incentive programs. Forced to support an escalating array of brands, the firm was unable to provide sufficient marketing funds for any one of its brands.

With the onset of one of the worst global recessions in the post–World War II years, auto sales worldwide collapsed by the end of 2008. All automakers' sales and cash flows plummeted. Unlike Ford, GM and Chrysler were unable to satisfy their financial obligations. The U.S. government, in an unprecedented move, agreed to lend General Motors and Chrysler $13 billion and $4 billion, respectively. The intent was to buy time to develop an appropriate restructuring plan.

Having essentially ruled out the liquidation of GM and Chrysler, continued government financing was contingent on gaining major concessions from all of the major stakeholders such as lenders, suppliers, and labor unions. With car sales continuing to show harrowing double-digit year over year declines during the first half of 2009, the threat of bankruptcy was used to motivate the disparate parties to come to an agreement. With available cash running perilously low, Chrysler entered bankruptcy in early May; General Motors filed on June 1, with the government providing debtor-in-possession financing during their time in bankruptcy. In its bankruptcy filing for its U.S. and Canadian operations only, GM listed $82.3 billion in assets and $172.8 billion in liabilities. In less than 45 days each, both GM and Chrysler emerged from government-sponsored sale in bankruptcy court, a feat that many thought impossible.

Judge Robert E. Gerber of the U.S. Bankruptcy Court of New York approved the sale in view of the absence of alternatives considered more favorable to the government's option. GM emerged from the protection of the court on July 10, 2009, in an economic environment characterized by escalating unemployment and eroding consumer income and confidence. Even with less debt and liabilities, fewer employees, the elimination of most “legacy costs,” and a reduced number of dealerships and brands, GM found itself operating in an environment in 2009 in which U.S. vehicle sales totaled an anemic 10.4 million units. This compared to more than 16 million in 2008. GM's 2009 market share slipped to a post–World War II low of about 19%.

While the bankruptcy option had been under consideration for several months, its attraction grew as it became increasingly apparent that time was running out for the cash-strapped firm. Having determined from the outset that liquidation of General Motors either inside or outside of the protection of bankruptcy would not be considered, the government initially considered a prepackaged bankruptcy in which agreement is obtained among major stakeholders prior to filing for bankruptcy. The presumption is that since agreement with many parties had already been obtained, developing a plan of reorganization to emerge from Chapter 11 would move more quickly. However, this option was not pursued because of the concern that the public would simply view the post–Chapter 11 GM as simply a smaller version of its former self. The government in particular was seeking to position GM as an entirely new firm capable of profitably designing and building cars that the public wanted.

Time was of the essence. The concern was that consumers would not buy GM vehicles while the firm was in bankruptcy. Consequently, a strategy was devised in which General Motors would be divided into two firms: “old GM,” which would contain the firm's unwanted assets, and “new GM,” which would own the most attractive assets. “New GM” would then emerge from bankruptcy in a sale to a new company owned by various stakeholder groups, including the U.S. and Canadian governments, a union trust fund, and bondholders. Only GM's U.S. and Canadian operations were included in the bankruptcy filing. Figure 16.2 illustrates the GM bankruptcy process.

Figure 16.2 The process of bankruptcy at GM.

Buying distressed assets can be accomplished through a Chapter 11 reorganization plan or through a postconfirmation trustee. Alternatively, a 363 sale transfers the acquired assets free and clear of any liens, claims, and encumbrances. The sale of GM's attractive assets to “new GM” was ultimately completed under Section 363 of the U.S. Bankruptcy Code. Historically, firms used this tactic to sell failing plants and redundant equipment. In recent years, so-called 363 sales have been used to completely restructure businesses, including the 363 sales of entire companies. A 363 sale requires only the approval of the bankruptcy judge, while a plan of reorganization in Chapter 11 must be approved by a substantial number of creditors and meet certain other requirements to be approved. A plan of reorganization is much more comprehensive than a 363 sale in addressing the overall financial situation of the debtor and how its exit strategy from bankruptcy will affect creditors. Once a 363 sale has been consummated and the purchase price paid, the bankruptcy court decides how the proceeds of sale are allocated among secured creditors with liens on the assets sold.

Total financing provided by the U.S. and Canadian (including the province of Ontario) governments amounted to $69.5 billion. U.S. taxpayer-provided financing totaled $60 billion, which consisted of $10 billion in loans and the remainder in equity. The government decided to contribute $50 billion in the form of equity to reduce the burden on GM of paying interest and principal on its outstanding debt. Nearly $20 billion was provided prior to the bankruptcy, $11 billion to finance the firm during the bankruptcy proceedings, and an additional $19 billion in late 2009.

In exchange for these funds, the U.S. government owns 60.8% of “new GM's common shares, while the Canadian and Ontario governments own 11.7% in exchange for their investment of $9.5 billion. The United Auto Workers' new voluntary employee beneficiary association (VEBA) received a 17.5% stake in exchange for assuming responsibility for retiree medical and pension obligations. Bondholders and other unsecured creditors received a 10% ownership position. The U.S. Treasury and the VEBA also received $2.1 billion and $6.5 billion in preferred shares, respectively.

The new firm, which employs 244,000 workers in 34 countries, intends to further reduce its head count of salaried employees to 27,200 by 2012. The firm will also have shed 21,000 union workers from the 54,000 UAW workers it employed prior to declaring bankruptcy in the United States and close 12 to 20 plants. General Motors did not include its foreign operations in Europe, Latin America, Africa, the Middle East, or Asia Pacific in the Chapter 11 filing. Annual vehicle production capacity for the firm will decline to 10 million vehicles in 2012, compared with 15 to 17 million in 1995. The firm exited bankruptcy with consolidated debt at $17 billion and $9 billion in 9% preferred stock, which is payable on a quarterly basis. GM has a new board, on which Canada and the UAW healthcare trust each have a seat.

Following bankruptcy, General Motors has four core brands—Chevrolet, Cadillac, Buick, and GMC—that are sold through 3,600 dealerships, down from its existing 5,969-dealer network. The business plan calls for an IPO whose timing will depend on the firm's return to sufficient profitability and stock market conditions.

By offloading worker healthcare liabilities to the VEBA trust and seeding it mostly with stock instead of cash, GM has eliminated the need to pay more than $4 billion annually in medical costs. Concessions made by the UAW before GM entered bankruptcy have made GM more competitive in terms of labor costs with Toyota.

Assets to be liquidated by Motors Liquidation Company (i.e., “old GM”) were split into four trusts, including one financed by $536 million in existing loans from the federal government. These funds were set aside to clean up 50 million square feet of industrial manufacturing space at 127 locations spread across 14 states. Another $300 million was set aside for property taxes, plant security, and other shutdown expenses. A second trust will handle claims of the owners of GM's prebankruptcy debt, who are expected to get 10% of the equity in GM when the firm goes public and warrants to buy additional shares at a later date. The remaining two trusts are intended to process litigation (e.g., asbestos-related claims). The eventual sale of the remaining assets could take four years, with most of the environmental cleanup activities completed within a decade (Lattman and de la Merced, 2010).

Reflecting the overall improvement in the U.S. economy and in its operating performance, GM repaid $10 billion in loans to the U.S. government in April 2010. Seventeen months after emerging from bankruptcy, the firm completed successfully the largest IPO in history on November 17, 2010, raising $23.1 billion. The IPO was intended to raise cash for the firm and to reduce the government's ownership in the firm, reflecting the firm's concern that ongoing government ownership will hurt sales. Following completion of the IPO, government ownership of GM remained at 33%, with the government continuing to have three board representatives.

GM is likely to continue to receive government support for years to come. In an unusual move, GM was allowed to retain $45 billion in tax loss carryforwards, which will eliminate the firm's tax payments for years to come. Normally, tax losses are preserved following bankruptcy only if the equity in the reorganized company goes to creditors who have been in place for at least 18 months. Despite not meeting this criterion, the Treasury simply overlooked these regulatory requirements in allowing these tax benefits to accrue to GM. Having repaid its outstanding debt to the government, GM continued to owe the U.S. government $36.4 billion ($50 billion less $13.6 billion received from the IPO) at the end of 2010. Assuming a corporate marginal tax rate of 35%, the government would lose another $15.75 billion in future tax payments as a result of the loss carryforward. The government also is providing $7,500 tax credits to buyers of GM's new all-electric car, the Chevrolet Volt.

Discussion Questions

1. Do you agree or disagree that the taxpayer-financed bankruptcy represented the best way to save jobs? Explain your answer.

2. Discuss the relative fairness to the various stakeholders in a bankruptcy of a more traditional Chapter 11 bankruptcy, in which a firm emerges from the protection of the bankruptcy court following the development of a plan of reorganization versus an expedited sale under Section 363 of the federal bankruptcy law. Be specific.

3. Identify what you believe to be the real benefits and costs of the government bailout of General Motors. Be specific.

4. The first round of government loans to GM occurred in December 2008. The firm did not file for bankruptcy until June 1, 2009. Discuss the advantages and disadvantages of the firm having filed for bankruptcy much earlier in 2009. Be specific.

5. What alternative restructuring strategies do you believe may have been considered for GM? Of these, do you believe that the 363 sale in bankruptcy represented the best course of action? Explain your answers.

Answers to these Case Study questions are found in the Online Instructor's Manual available for instructors using this book.

Case Study 16.3 : Delta Airlines Rises from the Ashes

On April 30, 2007, Delta Airlines emerged from bankruptcy leaner but still an independent carrier after a 19-month reorganization during which it successfully fought off a $10 billion hostile takeover attempt by US Airways. The challenge facing Delta's management was to convince creditors that it would become more valuable as an independent carrier than it would be as part of US Airways.

Ravaged by escalating jet fuel prices and intensified competition from low-fare, low-cost carriers, Delta had lost $6.1 billion since the September 11, 2001, terrorist attack on the World Trade Center. The final crisis occurred in early August 2005 when the bank that was processing the airline's Visa and MasterCard ticket purchases started holding back money until passengers had completed their trips as protection in case of a bankruptcy filing. The bank was concerned that it would have to refund the passengers' ticket prices if the airline curtailed flights and the bank had to be reimbursed by the airline. This move by the bank cost the airline $650 million, further straining the carrier's already limited cash reserves. Delta's creditors were becoming increasingly concerned about the airline's ability to meet its financial obligations. Running out of cash and unable to borrow to satisfy current working capital requirements, the airline felt compelled to seek the protection of the bankruptcy court in late August 2005.

Delta's decision to declare bankruptcy occurred at about the same time as a similar decision by Northwest Airlines. United Airlines and US Airways were already in bankruptcy. United had been in bankruptcy almost three years at the time Delta entered Chapter 11, and US Airways had been in bankruptcy court twice since the 9/11 terrorist attacks shook the airline industry. At the time Delta declared bankruptcy, about one-half of the domestic carrier capacity was operating under bankruptcy court oversight.

Delta underwent substantial restructuring of its operations. An important component of that restructuring effort involved turning over its underfunded pilot's pension plans to the Pension Benefit Guaranty Corporation (PBGC), a federal pension insurance agency, while winning concessions on wages and work rules from its pilots. The agreement with the pilot's union would save the airline $280 million annually, and the pilots would be paid 14% less than they were before the airline declared bankruptcy. To achieve an agreement with its pilots to transfer control of their pension plan to the PBGC, Delta agreed to give the union a $650 million interest-bearing note upon terminating and transferring the pension plans to the PBGC. The union would then use the airline's payments on the note to provide supplemental payments to members who would lose retirement benefits as a result of the PBGC limits on the amount of Delta's pension obligations it would be willing to pay. The pact covers more than 6,000 pilots.

The overhaul of Delta, the nation's third largest airline, left it a much smaller carrier than the one that sought protection of the bankruptcy court. Delta shed about one jet in six used by its mainline operations at the time of the bankruptcy filing, and it cut more than 20% of the 60,000 employees it had just prior to entering Chapter 11. Delta's domestic carrying capacity has fallen by about 10% since it petitioned for Chapter 11 reorganization, allowing it to fill about 84% of its seats on U.S. routes. This compared to only 72% when it filed for bankruptcy. The much higher utilization of its planes boosted revenue per mile flown by 15% since it entered bankruptcy, enabling the airline to better cover its fixed expenses. Delta also sold one of its “feeder” airlines, Atlantic Southeast Airlines, for $425 million.

Delta would have $2.5 billion in exit financing to fund operations and a cost structure of about $3 billion a year less than when it went into bankruptcy. The purpose of the exit financing facility is to repay the company's $2.1 billion debtor-in-possession credit facilities provided by GE Capital and American Express, make other payments required on exiting bankruptcy, and increase its liquidity position. With ten financial institutions providing the loans, the exit facility consisted of a $1.6 billion first-lien revolving credit line, secured by virtually all of the airline's unencumbered assets, and a $900 million second-lien term loan.

As required by the Plan of Reorganization approved by the bankruptcy court, Delta cancelled its preplan common stock on April 30, 2007. Holders of preplan common stock did not receive a distribution of any kind under the Plan of Reorganization. The company issued new shares of Delta common stock as payment of bankruptcy claims and as part of a postbankruptcy compensation program for Delta employees. Issued in May 2007, the new shares were listed on the New York Stock Exchange.

Discussion Questions

1. To what extent do you believe the factors contributing to the airline's bankruptcy were beyond the control of management? To what extent do you believe past airline mismanagement may have contributed to the bankruptcy?

2. Comment on the fairness of the bankruptcy process to shareholders, lenders, employees, communities, government, and so forth. Be specific.

3. Why would lenders be willing to lend to a firm emerging from Chapter 11? How did the lenders attempt to manage their risks? Be specific.

4. In view of the substantial loss of jobs, as well as wage and benefit reductions, do you believe that firms should be allowed to reorganize in bankruptcy? Explain your answer.

5. How does Chapter 11 potentially affect adversely competitors of those firms emerging from bankruptcy? Explain your answer.

Answers to these case study questions are found in the Online Instructor's Manual for instructors using this book.

¹ Keenan, Shotgrin, and Sobehart, 1999

² Lovly, 2007

³ Buljevich, 2005

⁴ In addition to increased privileges for creditors via the amended bankruptcy laws, lessors (i.e., owners of the leased asset) also benefit from BAPCPA amendments. “Good-cause” extensions are restricted to 90 days without written consent of the lessor. Under prior legislation, leases could be extended indefinitely as long as the debtor-in-position continued making payments due under the commercial lease. Under the new legislation, the trustee or debtor-in-possession no longer would be able to get endless extensions, even if the debtor is paying the rent according to the terms of the lease agreement. BAPCPA also limits pay for key employees. Payments to management employees cannot be more than ten times the amount paid to nonmanagement employees.

⁵ Chapter 7 distributes the liquidation proceeds according to the following priorities: (1) administrative claims (e.g., lawyers' fees, court costs, accountants' fees, trustees' fees, and other costs necessary to liquidate the firm's assets), (2) statutory claims (e.g., tax obligations, rent, consumer deposits, and unpaid wages and benefits owed before the filing up to some threshold), (3) secured creditors' claims, (4) unsecured creditors' claims, and (5) equity claims.

⁶ Chapter 15 also gives foreign creditors the right to participate in U.S. bankruptcy cases and prohibits discrimination against foreign creditors. The Chapter 15 proceeding attempts to promote collaboration between U.S and foreign courts, since the participants in the proceeding must cooperate fully.

⁷ Bris, Welch, and Zhu, 2006

⁸ In a study of 74 large public bankruptcies between 1998 and 2003, Lopucki and Doherty (2007) found that company size (measured by assets), case duration (measured in days), and the number of parties involved in the proceedings (measured in terms of the numbers of professional firms working) explain 87% of the case-to-case variation in professional fees. The study reviewed 74 large public company bankruptcies between 1998 and 2003. Fees and expenses increased about 9% annually during that period. The authors argue that these factors measure not only the need for professional services but also the opportunity for professionals to bill. The authors came to the same conclusion after adjusting for differences in case complexity by including such variables in their analysis as the number of employees, docket length, and the number of parties to the reorganization plan.

⁹ Altman, 1993; Betker, 1995; Tashjian, Lease, and McConnell, 1996

¹⁰ Lovly, 2007

¹¹ Eckbo and Thorburn, 2008

¹² This could occur if the original creditors exchange their debt for equity and the original equity holders own less than 50% of the company. As such, the Internal Revenue Service would view this as a loss of control by the original shareholders and a violation of the “continuity of interests” principle discussed in Chapter 12.

¹³ To protect it from litigation, Washington Construction Group required Morrison Knudsen Corporation to file for bankruptcy as a closing condition in the agreement of purchase and sale in 2000.

¹⁴ In a study of 38 takeovers of distressed firms from 1981 to 1988, Clark and Ofek (1994) found that bidders tend to overpay for these types of firms. Although this strategy may benefit the failing firm's shareholders, such takeovers do not seem to benefit the acquirer's shareholders. Clark and Ofek also found that the acquiring firms often fail successfully to restructure the target firms.

¹⁵ Gilson, 1997

¹⁶ The determination of whether a company is in default or in danger of default requires the application of certain insolvency tests to establish the likelihood that the firm will enter Chapter 11; that anticipated losses will deplete the firm's capital; and that assets will likely be less than the firm's obligations. See the section of this chapter entitled “Predicting Corporate Default and Bankruptcy” for more on the specific tests for insolvency.

¹⁷ Bellovary, Giacomino, and Akers, 2007

¹⁸ Aziz and Dar, 2006

¹⁹ Grice and Dugan, 2001

²⁰ For a more rigorous discussion of bankruptcy prediction models, see Jones and Hensher (2008).

²¹ Altman, 1968

²² Grice and Ingram, 2001

²³ Shumway, 2001

²⁴ A partial list of structural credit risk models includes the following: Kim, Ramaswamy, and Sundaresan, 1993; Leland, 1994; Longstaff and Schwartz, 1995; and Hsu, Saa-Requejo, and Santa-Clara, 2002.

²⁵ See Jarrow and Turnbull (1995) for examples of reduced form models.

²⁶ Platt et al., 1999

²⁷ Kahya and Theodosiou, 1999

²⁸ Charitou and Trigeorgis, 2000

²⁹ Blume, Lim, and MacKinlay, 1998; Molina, 2006; Avamov et al., 2006

³⁰ Duffie, Saita, and Wang, 2007

³¹ Altman et al., 2003

³² Hennessy and Whited, 2007; Anderson and Corverhill, 2007

³³ White, 1989

³⁴ Gilson, John, and Lang, 1990; Asquith, Gerthner, and Scharfstein, 1994

³⁵ Alderson and Betker, 1996; Eberhart, Altman, and Aggarwal, 1999

³⁶ Hotchkiss, 1995; France, 2002

³⁷ Campbell, Hilscher, and Szilagyi, 2008

³⁸ Garlappi and Yan, 2011

³⁹ Beneda, 2007

⁴⁰ Aggarwal and Rivoli, 1990; Ritter, 1991; and Loughran, Ritter, and Rydqvist, 1994

⁴¹ Grinblatt and Titman, 2002

⁴² Lang and Stulz, 1992

⁴³ Hertzel, Li, Officer, and Rodgers, 2008

⁴⁴ Benmelech and Bergman, 2011