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Corporate Financial Distress and Bankruptcy

CORPORATE FINANCIAL DISTRESS AND BANKRUPTCY

Financial distress of private and public entities through- out the world is a frequent occurrence with important implications for their many stakeholders. While the role of corporate bankruptcy laws is clear—either to provide a legal procedure that permits firms which have temporary liquidity problems to restructure and successfully emerge as continuing entities or to provide an orderly process to liquidate assets for the benefit of creditors before asset values are dissipated—bankruptcy laws differ markedly from country to country. It is generally agreed upon that the U.S. Chapter 11 provisions under the Bankruptcy Reform Act of 1978 provide the most protection for bankrupt firms’ assets and result in a greater likelihood of successful reorganization than is found in other countries where liquidation and sale of the assets for the benefit of creditors is more likely the result. But the U.S. code’s process is usually lengthy (averaging close to two years, except where a sufficient number of creditors agree in advance via a prepackaged Chapter 11) and expensive, and the reorganized entity is not always successful in avoiding subsequent distress. If the reorganization is not successful, then liquidation under Chapter 7 will usually ensue.

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Bankruptcy processes in the industrialized world out- side the United States strongly favor senior creditors

who obtain control of the firm and seek to enforce greater adherence to debt contracts. The U.K. process, for example, is speedy and less costly, but the reduced costs can result in undesirable liquidations, unemploy- ment, and underinvestment. The new bankruptcy code in Germany attempts to reduce the considerable power of secured creditors but it is still closer to the U.K. system. In the United States, creditors and owners can negotiate “violations” to the “absolute priority rule”—this “rule” holds that more senior creditors must be paid in full, prior to any payments to more junior creditors or to owners. (However, the so-called “violations” to absolute priority have empirically been shown to be relatively small—such as under 10 percent of firm value.) Finally, the U.S. sys- tem gives the court the right to sanction postpetition debt financing, usually with superpriority status over existing claims, thereby facilitating the continuing operation of the firm. Recently, France had a similar successful experience.

A measure of performance of the U.S. bankruptcy system is the proportion of firms that emerge successfully. The results in the United States of late are somewhat mixed, with close to 83 percent of large firms emerging but probably less than 20 percent of smaller entities. And a not insignificant number of firms suffer subsequent distress and may file again.

Regardless of the location, one of the objectives of bankruptcy and other distressed workout arrangements is

In Their Own Words

EXAMPLE 30.2 Chapter 11 Suppose B.O. Drug Co. decides to reorganize under Chapter 11. Generally senior

claims are honored in full before various other claims receive anything. Assume that the “going con- cern” value of B.O. Drug Co. is $3 million and that its balance sheet is as shown:

Assets $3,000,000 Liabilities Mortgage bonds 1,500,000 Subordinated debentures 2,500,000 Stockholders’ equity −1,000,000

The firm has proposed the following reorganization plan:

Old Security Old Claim New Claim with

Reorganization Plan

Mortgage bonds $1,500,000 $1,500,000 Subordinated debentures 2,500,000 1,500,000

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931

that creditors and other suppliers of capital clearly know their rights and expected recoveries in the event of a dis- tressed situation. When these are not transparent and/or are based on outdated processes with arbitrary and possibly corrupt outcomes, then the entire economic system suffers and growth is inhibited. Such is the case in several emerg- ing market countries. Revision of these outdated systems should be a priority.

In addition to the comparative benefits of different national restructuring systems, a number of intriguing the- oretical and empirical issues are related to the distressed firm. Among these are corporate debt capacity, manager– creditor–owner incentives, ability to predict distress, data and computations for default rate estimation, investment in securities of distressed firms, and post-reorganization performance assessment.

Corporate distress has a major impact on creditor– debtor relationships and, combined with business risk and tax considerations, affects the capital structure of com- panies. One key question is how costly are the expected distress costs compared to the expected tax benefits of using leverage—the so-called trade-off theory. Most ana- lysts agree that the sum of direct (e.g., legal fees) and indirect costs is in the range of 10–20 percent of firm value.

Whether the taking of excess risk and overinvestment are examples of agency conflicts between managers and credi- tors rests upon one’s view as to who are the true residual owners of a distressed firm—the existing equityholders or

creditors who will more than likely be the new owners of a reorganized entity. Existing management has the exclusive right to file the first plan of reorganization within 120 days of filing, with exclusivity extensions possible. Their incen- tives and influence can be biased, however, and not always in accord with other stakeholders, primarily creditors. Limiting this exclusivity would appear to be desirable to speed up the process and restrict managerial abuse.

Distress prediction models have intrigued researchers and practitioners for more than 50 years. Models have evolved from univariate financial statement ratios to mul- tivariate statistical classification models, to contingent claim and market value–based approaches, and finally to using artificial intelligence techniques. Most large financial institutions have one or more of these types of models in place as more sophisticated credit risk man- agement frameworks are being introduced, sometimes combined with aggressive credit asset portfolio strategies. Increasingly, private credit assets are being treated as secu- rities with estimates of default and recovery given default the critical inputs to their valuation.

Perhaps the most intriguing by-product of corporate distress is the development of a relatively new class of investors known as vultures. These money managers spe- cialize in securities of distressed and defaulted companies.

*Edward I. Altman is Max L. Heine Professor of Finance, NYU Stern School of Business. He is widely recognized as one of the world’s experts on bankruptcy and credit analysis, as well as the distressed debt and high-yield bond markets.

The firm has also proposed a distribution of new securities under a new claim with this reorganiza- tion plan:

Old Security Received under Proposed Reorganization Plan

Mortgage bonds $1,000,000 in 9% senior debentures $500,000 in 11% subordinated debentures

Debentures $1,000,000 in 8% preferred stock $500,000 in common stock

However, it will be difficult for the firm to convince secured creditors (mortgage bonds) to accept unsecured debentures of equal face value. In addition, the corporation may wish to allow the old stockholders to retain some participation in the firm. Needless to say, this would be a violation of the absolute priority rule, and the holders of the debentures would not be happy.

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932 ■■■ PART VIII Special Topics

Private Workout or Bankruptcy: Which Is Best? A firm that defaults on its debt payments will need to restructure its financial claims. The firm will have two choices: Formal bankruptcy or private workout. The previous section described two types of formal bankruptcies: Bankruptcy liquidation and bankruptcy reorganization. This section compares private workouts with bankruptcy reorganizations. Both types of financial restructuring involve exchanging new financial claims for old financial claims. Usually, senior debt is replaced with junior debt and junior debt is replaced with equity. Much recent academic research has described what happens in private workouts and formal bankruptcies.9

● Historically, half of financial restructurings have been private, but recently, formal bankruptcies have dominated.

● Firms that emerge from private workouts experience stock price increases that are much greater than those for firms emerging from formal bankruptcies.

● The direct costs of private workouts are much less than the costs of formal bankruptcies. ● Top management usually loses pay and sometimes jobs in both private workouts and

formal bankruptcies.

These facts, when taken together, seem to suggest that a private workout is much better than a formal bankruptcy. We then ask: Why do firms ever use formal bankruptcies to restructure?

30.4

9For example, see Stuart Gilson, “Managing Default: Some Evidence on How Firms Choose between Workouts and Chapter 11,” Journal of Applied Corporate Finance (Summer 1991); and Stuart C. Gilson, Kose John, and Larry H. P. Lang, “Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default,” Journal of Financial Economics 27 (1990).

Absolute Priority Rule (APR) The absolute priority rule states that senior claims are fully satisfied before junior claims receive anything.

Deviation from Rule Equityholders Expectation: No payout

Reality: Payout in 81 percent of cases Unsecured creditors Expectation: Full payout after secured creditors

Secured creditors Expectation: Full payout Reality: Full payout in 92 percent of cases

Reasons for Violations

Creditors want to avoid the expense of litigation. Debtors are given a 120-day opportunity to cause delay and harm value.

Managers often own equity and demand to be compensated. Bankruptcy judges like consensual plans and pressure parties to compromise.

SOURCE: Lawrence A. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics 27 (1990).

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