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Introduction to troubled-debtrestructuring

Corporate Restructuring

Tim Thompson

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Distressed Firm

Workout

Chapter 11(outside option)

No Chapter 11 filing

Prepackaged Ch. 11

Chapter 11

Reorganization

Chapter 7

Liquidation

(outside option)

Auction

or sale

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Focus of lecture Firm already in distress

defined as not able to make debt payments

as they come due

Choices Renegotiate contracts with creditors out of court (workout)

Renegotiate contracts with creditors in court (Chapter 11)

Allow the firm to be liquidated by court appointed trustee(Ch 7)

Chapter 11 court may order the company be sold to highestbidder

Most focus will be on large firms, usually publicly held

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Insolvency Troubled debt restructuring methods

needed because firm is insolvent

I.e., it can not meet its obligations asthey come due.

This is not the legal definition

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Causes of insolvency Bad luck

Economic conditions

Competitive position eroded

Firm specific factors

Bad strategy

Bad execution -- mismanagement Fraud

Overlevered the company

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Effect of insolvency Have to recontract with creditors

get parties to agree to reorganization liabilities, ownership, control

or liquidate

Recontracting can be settled out of court

Workouts/private reorganizations

Or, in court

Chapter 11 (reorg) or Chapter 7 (liquidation)

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Main effect of reorganizations Restructure terms on debt

reduce interest payments/principal amounts

Extend maturity

Substitute equity (or equiv.) for debt

What if V is very large?

Could be that have too little cash flow, but goodvalue, could offer BH more value, but paid later

Not the usual situation

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What is optimal choice if managers are

value maximizing?

Is the firm worth more as a goingconcern? with its own strategy bought out by another firm

Or is it worth more liquidated?

What is size of the pie and how is it tobe sliced? Tough question on bothcounts!

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Watch out for incentives on all sides!

Creditors Race to the top

Dont want firm to go into Ch. 11 In Ch. 11, want you to liquidate inefficiently

Shareholders Stay out of Ch 11

In Ch 11, want ongoing firm

Managers Depends on what their position looks like

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Chapter 11 is not first choiceAlmost all large, publicly traded firms

attempt to workout debt beforeentering Chapter 11

Why do firms attempt a workout?

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Workouts less expensive than

Chapter 11 Gilson, John and Lang (GJL) studied

NYSE AMEX firms doing workouts and

Ch. 11s in 80s Legal and professional fees higher in Ch 11

Avg length of Ch 11 is longer, especiallywhen workout included exchange offer

In workout, only deal with claims indefault*

In Ch 11, all claims

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Problems with Ch. 11

Legal/professional fees have priority overother claims, so less incentive to get it done

Management by judges Major decisions: file application with court, notify

creditors -- file complaints

Judges legal requirements

claimholders must receive at least what theyd get inliquidation, company not in danger of going bankruptagain (near future)

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Advantages to DIP of Chapter

11 New issued debt higher priority than

pre-petition debt

Interest on pre-petition unsecured debtstops accruing

Automatic stay from creditors

Easier to get reorg plan acceptedbecause of voting rules

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Why does firm go to Chapter 11?

Creditor holdouts (and advantages above)

In workout, have to get all participatingcreditors to agree

Bondholders have incentive to free ride onthe settlement

Try to trap the free riders by making theexchanged bonds higher priority, shorter maturity

Problem worse with public debt, morecomplex debt

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LTV decision Judge Burton Lifland

Bondholders who tendered in previousexchange offer were entitled to claim equalto market value of new bonds

Non exchanging bondholders entitled to

claim equal to face value of debt Makes holdout problem worse

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Rights of management in Ch

11 DIP (debtor in possession) has

exclusive right to file first reorg plan

for 120 days

typically extended, sometimes for years

Large management turnover in both

workouts and Ch 11sAlso, reputation issues

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Tax disadvantage to voluntary

restructuring Tax Reform Act of 1986

More difficult to preserve NOL

carryforwards Hard to avoid paying tax on income from

forgiveness of debt

Revenue Reconciliation Act of 1990 newly exchanged bonds trading at a

discount to face value, the firm must bookthe difference as taxable income

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Prepackaged bankruptcy

Hybrid of workouts and Chapter 11s Firm files Chapter 11

But files reorg plan at the same time(agreed to with secured creditorsinformally beforehand)

Can hurry up the Ch 11 process

Not a sure thing!

Why do Ch 11 at all?

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Deviations from AbsolutePriority in Troubled Debt

Restructuring

Corporate Restructuring

Tim Thompson

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AbsolutePriority

In typical corporate finance treatments ofdefault, assumed that claimants of the firm

will be paid according to absolute priority First, secured claimants

Administrative claims

Employee claims

Customer claims

Tax claims

Unsecured creditors, then equity

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Deviations from APR common

Kaiser, Chap. 11, documents manypapers describing deviations from APR Both in Chapter 11 and in workouts Typically, equity and unsecured

debtholders receive more than should,more senior claims receive less than

should Equity receives more in workouts than in

Chapter 11

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Do markets expect APR

deviations? Generally, yes.

Kaisers Chapter 11 suggests that debtmarkets do not seem to anticipate theeventual APR violations, but most of theliterature suggests that markets do, in

fact, incorporate these violations intopricing.

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Betker (1996) Show table

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If markets efficient, do

deviations from APR matter? Still matter, because the noise in how much

you would get/lose due to violations leads to

inefficient investments in time to find out how large deviations will be

in time and effort to limit/increase size ofdeviations

in increases in rates/onerous covenants when youissue debt

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LoPucki and Whitford (1990)

Managers act more in their owninterests than in equity interests, so

understanding the distinction isimportant on case by case basis.

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Recovery rates How much do bankers/bondholders get

back of their original investment in

Chapter 11 reorganizations?

What is relation between recovery ratesand seniority/security?

What is relation between recovery ratesand public/private/banks?

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Altman evidenceAverage recovery rate approx. 40%

Recovery rate defined as the price one

month after default occurred divided bypar value

1991 36.0%

1990 23.4%

1989 38.3%

1988 43.6%

1987 75.9%

1986 34.5%

1985 45.9%

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Altman: rec. rates by priority 1985-1991 Averages

Type of debt Recovery rate

Secured 60.51%

Senior 52.28%

Senior subordinated 30.70%

Subordinated (cash pay) 27.96%

Subordinated (PIK) 19.51%

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Recovery rates in Eastern Airlines Secured debt with sufficient collateral 100%

Secured debt, insufficient collateral 11.75% First equip cert 100%

12.75% Second equip cert 60% 13.75% Third equip cert 6%

Accrued interest on secured debt 57%

Capital lease obligations 100%

Unsecured debt P

BGC pension claims 15% Manufacturers sub notes 11%

Conv Sub Debs 6%

Healthcare claims 8%

Stock 0%

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Kaiser notes, Franks and

Torous Table 12.2 Percentage recovery rates

by creditor class

exchanges, Chap. 11, and prepacks

Conclusions: Recovery rates higher in workouts than Chapter

11s

Prepacks more like workouts

Pre-solicited somewhat higher than pre-negotiated

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Kaiser notes, Franks and

Torous Table 12.5, form of compensation

workouts v. Chapter 11s

Conclusions: Cash larger part of distribution in Ch. 11

Bank debt reduced in chapter 11, becomes senior debt

Junior debt and preferred receive equity, both methods

Equity is larger part of distribution in Ch. 11

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Loss in value at Eastern Weiss and Wruck

Table 2 Total recover by fixed claimants and equity at

resolution of bankruptcy, $2,005.5 million.

At filing of Chapter 11, total estimated marketvalue of equity plus different measures of debt,around $4 billion

Loss of approx. $2 billion in value in Chap 11 argue was not due to industry conditions

Direct costs were $114 million only.

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What was problem? Uncertainty about going concern v.

liquidate

Judge allowed managers to useproceeds of asset sales to fundcontinued operations (at substantial op

losses) Some venue shopping?