Financial DistressGroup 5 ACT 4611 Seminar in Accountings

Financial Distress

• A situation where a firm’s operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action.

• Insolvency is a term which generally means an inability to repay debts.• Stock-based insolvency• Flow-based insolvency

Insolvency

Assets

Debt

EquityAssets Debt

Negative equity

Insolvency

Contractual obligation

Firm cash flow

Cash flow shortfall

$

Insolvent firmSolvent firm

Stock-based insolvency

Flow-based Insolvency

» Occurs when the value of assets < value of promised payments to debt

» Occurs when operating cash flows are insufficient to cover contractually required payments.

Definition of Terms

• Financial Distress• Includes default and bankruptcy, but also • Threat of default or bankruptcy and its effect on the

company• Defined to capture the costs and benefits of using

large amounts of debt finance

• Default• Failure to meet an interest payment, or• Violation of debt agreement

• Bankruptcy• Formal procedure for working out default• Does not automatically follow from default.

What size firm, large or small, is more prone to business failure?

•Bankruptcy is more frequent among smaller firms.

•Large firms tend to get more help from external sources to avoid bankruptcy, given their greater impact on the economy.

Four Aspects of Financial Distress

A firm is bankrupt when it has filed a petition for relief from its creditors.A firm is in default when it violates one of the terms of a loan agreement or a bond indenture.A firm is said to have failed when it ceases operations or otherwise voluntarily withdraws from obligations.A firm is insolvent when it is unable to pay its debts.

Indicators of financially distressed firms

Indicators of financially distressed firms

General Options in Time of Financial Distress

General Options in Time of Financial Distress

Main causes of Financial Distress

REASON COMMENT

Inexperienced/unqualified senior management Dumb strategy (e.g., Internet companies) Poor internal controls leading to fraud

Inexperienced/unqualified senior management Dumb strategy (e.g., Internet companies) Poor internal controls leading to fraud

Lousy managementLousy management

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Main causes of Financial Distress

REASON COMMENT

WITHIN control of management Firm gets itself overleveraged Firm gets too clever by half Unable to tap capital markets for new funds

WITHIN control of management Firm gets itself overleveraged Firm gets too clever by half Unable to tap capital markets for new funds

Capital structureCapital structure

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OUTSIDE control of management Your bad luck – airlines & 9/11 attacks Someone else’s good luck (unpredictable new

technology or discovery – e.g., oil co. & cold fusion)

OUTSIDE control of management Your bad luck – airlines & 9/11 attacks Someone else’s good luck (unpredictable new

technology or discovery – e.g., oil co. & cold fusion)

Unavoidable industry or economy-wide shock(s)

Unavoidable industry or economy-wide shock(s)

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Costs of Financial Distress

What happens in Financial Distress

• Financial distress does not always result in the termination of the firm (is the firm better alive than dead?)

• Firms deal with financial distress in a variety of ways• Asset restructuring includes actions such as:

• Selling off assets• Cutting back R&D and capital spending• Merging with another firm

• Financial restructuring may involve:• Cutting dividends• Issuing new securities• Negotiating with creditors• Exchanging debt for equity• Filing for bankruptcy

What happens in Financial Distress

Merge withanother firm

83%

10%

7%

Liquidation

Reorganize and emerge

Legal bankruptcy

Privateworkout

47%

53%

Financialdistress

Informal Bankruptcy Terminology

• Workout: Voluntary informal reorganization plan.

• Restructuring: Current debt terms are revised to facilitate the firm’s ability to pay.• Extension: Creditors postpone the dates

of required interest or principal payments, or both. Creditors prefer extension because they are promised eventual payment in full.

Informal Bankruptcy Terminology

• Composition: Creditors voluntarily reduce their fixed claims on the debtor by either accepting a lower principal amount or accepting equity in lieu of debt repayment.

• Assignment: An informal procedure for liquidating a firm’s assets. Title to the debtor’s assets is transferred to a third party, called a trustee or assignee, and then the assets are sold off.

Bankruptcy Reorganization

• Reorganization is the option of keeping the firm as a going concern• sometimes involves issuing new securities to

replace old ones

• A debtor should be given the opportunity to reorganize provided that the going concern value of the reorganized debtor’s assets exceeds its liquidation value.

Bankruptcy Reorganization: A Typical Sequence

Bankruptcy Reorganization: A Typical Sequence

Note that (i) a class of creditors accepts the plan if a majority of the class agrees; (ii) secured creditors vote before unsecured creditors; and (iii) courts have the power to force uncooperative creditors to accept proposals

Cramdown

• Cramdown procedure permits confirmation of a plan over the objections of one or more classes of creditors provided that:

• The plan provides the holders with property whose value is at least equal to the allowed amount of their claims, or else

• No junior class receives anything.

Describe the terms of Bankruptcy Reorganization

• Trustee: • Appointed to control the company when current

management is incompetent or fraud is suspected.

• Used only in unusual circumstances.

• Voluntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm’s management.

• Involuntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm’s creditors.

What are the major differences between an informal reorganization and reorganization in bankruptcy?

• Informal Reorganization:

• Less costly

• Relatively simple to create

• Typically allows creditors to recover more money and sooner.

What are the major differences between an informal reorganization and reorganization in bankruptcy?

• Reorganization in Bankruptcy

•Avoids holdout problems.

•Due to automatic stay provision, avoids common pool problem.

•Interest and principal payments may be delayed without penalty until reorganization plan is approved.

What are the major differences between an informal reorganization and reorganization in bankruptcy?

• Reorganization in Bankruptcy

• Permits the firm to issue debtor in possession (DIP) financing.

• Gives debtor exclusive right to submit a proposed reorganization plan for agreement from the parties involved.

• Reduces fraudulent conveyance problem.

• Cramdown if majority in each creditor class approve plan.

Bankruptcy Liquidation

• Liquidation means termination of the firm as a going concern• involves selling the assets of the firm for salvage value• proceeds are distributed to creditors in order of priority

• Liquidation usually involves:• a petition is filed in court (either voluntarily by the firm or the

creditors can file an involuntary petition)• a trustee-in-bankruptcy is elected by the creditors to take

over the assets of the firm and try to liquidate them• after the assets are sold, money is distributed to the creditors

(after administrative expenses are paid)• any remaining money goes to the shareholders

Priority of Claims in Liquidation

Priority of Claims in Liquidation

Note that (i) federal income tax must be paid before any of the above; (ii) secured creditors receive proceeds from sale of the securing assets (if the amount is insufficient, they join this list as unsecured creditors); and (iii) courts have considerable flexibility to deviate from this list

Private Workout

• Liquidation or reorganization are two formal bankruptcy procedures

• An alternative is a private workout, which is a reorganization involving direct negotiations between creditors and debtors

• In a private workout, usually senior debt is replaced by junior debt and debt is replaced with equity

Private Workout

• When they work, private workouts are better than a formal bankruptcy (direct costs are only about 10% of a bankruptcy)

• A firm with a more complicated capital structure will have more trouble arranging a private workout

• Bankruptcy is usually better for equity investors because they can typically hold out for a better deal (courts violate strict priority)

Prepackaged Bankruptcy

• A prepackaged bankruptcy is a combination of a private workout and a formal bankruptcy

• The firm and most creditors agree to a private reorganization

• The firm then files a formal bankruptcy• Idea is to use the courts to force holdouts

to agree to a reorganization

Prepackaged Plans of Reorganization

• In prepackaged bankruptcy , the debtor and creditors negotiate and file the plan of reorganization with the bankruptcy petition.

• Advantages:Alleviates holdout problem.Confirmed plan is binding on all debt holders.Tax advantages that are not available in out-of-

court restructuring.Allows debtor to reject burdensome leases and

contracts.

Prepackaged Bankruptcy

• Advantages of Prepackaged Bankruptcy

» Avoids costs of lengthy bankruptcy process where business decisions must be authorized by the court

– Saves legal fees– Minimizes adverse effects on the underlying business

» Allows firm to implement an “exchange offer” without unanimous consent of bondholders

– Trust Indenture Act prohibits changes in coupons, maturity, principal, and other economically relevant terms outside of bankruptcy

Prepackaged Bankruptcy

• Advantages of Prepackaged Bankruptcy

» Instead requires acceptance by classes…1/2 by number and 2/3 by dollar value of claim

» Mitigates “hold-up” problem by forcing dissenting bondholders to accept terms similar to those received by other bondholders

• No Disclosure Statement required…but information must be disseminated in accordance with securities laws

Advantages of Bankruptcy

• Automatic stay of all creditor collection efforts.

• Debtor can negotiate with a single forum - the bankruptcy court.

• Court can allow debtor to reject unfavorable contracts.

• All claims can be dealt with at one time.• Interest stops accruing on unsecured

claims.

Advantages of Bankruptcy

• Bankruptcy court can affirm plan over the objections of dissenting creditors.

• Cram down rules apply.• Upon confirmation, all creditors and

stockholders are bound by the plan.• Avoid taxes on income that results

when debt is retired at less than face value.

Disadvantages of Bankruptcy

• Business is disrupted.• Debtor in possession must meet stringent

reporting requirements.• Bankruptcy court must approve all

transactions outside the ordinary course of business.

• Bankruptcy filing can trigger other claims.• Legal and administrative expenses paid

by debtor.

Thank You For Your AttentionGroup 5