Financial Distress

Group 5 ACT 4611 Seminar in Accountings

Financial Distress
A situation where a firms operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action. Insolvency is a term which generally means an inability to repay debts.
Stock-based insolvency Flow-based insolvency

Insolvency
Solvent firm
Debt

Insolvent firm
Assets

Stock-based insolvency
Occurs when the value of assets < value of promised payments to debt $

Assets

Debt

Equity

Negative equity

Flow-based Insolvency
Occurs when operating cash flows are insufficient to cover contractually required payments.
Cash flow shortfall

Contractual obligation Firm cash flow

Insolvency

Definition of Terms
Financial Distress
Includes default and bankruptcy, but also Threat of default or bankruptcy and its effect on the company Defined to capture the costs and benefits of using large amounts of debt finance

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

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

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

Dividend reduction

Plant closing

Losses

Indicators of financially distressed firms

Lay offs CEO resignations

Plummeting stock prices

General Options in Time of Financial Distress

Disposing of real property

Merging with other firms

Reducing capital spending on research and development

General Options in Time of Financial Distress

Issuing new shares

Negotiating with creditors

Liquidation Lay offs

Main causes of Financial Distress

REASON
Lousy management

COMMENT
 Inexperienced/unqualified senior

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

Main causes of Financial Distress

REASON COMMENT
 WITHIN control of management

Capital structure

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

Unavoidable industry or economywide shock(s)

 OUTSIDE control of management  Your bad luck airlines & 9/11 attacks  Someone elses good luck (unpredictable new

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

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

Asset restructuring
49%

Financial distress
51% 47%

Private workout

Financial restructuring
83% 53%

Reorganize and emerge

7% 10%

Legal bankruptcy

Merge with another firm Liquidation

Informal Bankruptcy Terminology

Workout: Voluntary informal reorganization plan. Restructuring: Current debt terms are revised to facilitate the firms 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 firms assets. Title to the debtors assets is transferred to a third party, called a trustee or assignee, and then the assets are sold off.

Bankruptcy Reorganization
Reorganization is the option of keeping the firm as a going concern
sometimes involves issuing new securities to replace old ones

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

Bankruptcy Reorganization: A Typical Sequence

1
A voluntary petition can be filed in court by the firm or an involuntary petition can be filed by the creditors

A federal judge either approves or denies the petition

In most cases, the debtor continues to run the business

Bankruptcy Reorganization: A Typical Sequence

4

The firm is required to submit a reorganization plan Creditors and shareholders are divided into classes After acceptance by creditors, the plan is confirmed by the court Payments in cash, property, and securities are made to the creditors and shareholders
Note that (i) a class of creditors accepts the plan if a majority of the class agrees; (ii) secured creditors vote before unsecured creditors; and (iii) courts have the power to force uncooperative creditors to accept proposals

Cramdown
Cramdown procedure permits confirmation of a plan over the objections of one or more classes of creditors provided that: The plan provides the holders with property whose value is at least equal to the allowed amount of their claims, or else No junior class receives anything.

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 firms management. Involuntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firms creditors.

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

Informal Reorganization:
Less costly Relatively simple to create Typically allows creditors to recover more money and sooner.

What are the major differences between an informal reorganization and reorganization in bankruptcy? Reorganization in Bankruptcy Avoids holdout problems. Due to automatic stay provision, avoids common pool problem. Interest and principal payments may be delayed without penalty until reorganization plan is approved.

What are the major differences between an informal reorganization and reorganization in bankruptcy? Reorganization in Bankruptcy
Permits the firm to issue debtor in possession (DIP) financing. Gives debtor exclusive right to submit a proposed reorganization plan for agreement from the parties involved. Reduces fraudulent conveyance problem. Cramdown if majority in each creditor class approve plan.

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

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

1. Administrative expenses associated with liquidation

2. Other expenses arising after the filing of an involuntary bankruptcy petition but prior to the appointment of a trustee

3. Wages, salaries, and commissions

4. Municipal tax claims

Priority of Claims in Liquidation

5. Rent

6. Claims from employee injuries not covered by workers compensation

7. Unsecured creditors

8. Preferred shareholders

9. Common shareholders

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

Private Workout
Liquidation or reorganization are two formal bankruptcy procedures An alternative is a private workout, which is a reorganization involving direct negotiations between creditors and debtors In a private workout, usually senior debt is replaced by junior debt and debt is replaced with equity

Private Workout
When they work, private workouts are better than a formal bankruptcy (direct costs are only about 10% of a bankruptcy) A firm with a more complicated capital structure will have more trouble arranging a private workout Bankruptcy is usually better for equity investors because they can typically hold out for a better deal (courts violate strict priority)

Prepackaged Bankruptcy
A prepackaged bankruptcy is a combination of a private workout and a formal bankruptcy
The firm and most creditors agree to a private reorganization The firm then files a formal bankruptcy Idea is to use the courts to force holdouts to agree to a reorganization

Prepackaged 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-ofcourt 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 classes1/2 by number and 2/3 by dollar value of claim

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

No Disclosure Statement requiredbut information must be disseminated in accordance with securities laws

Advantages of Bankruptcy
Automatic stay of all creditor collection efforts. Debtor can negotiate with a single forum - the bankruptcy court. Court can allow debtor to reject unfavorable contracts. All claims can be dealt with at one time. Interest stops accruing on unsecured claims.

Advantages of Bankruptcy
Bankruptcy court can affirm plan over the objections of dissenting creditors. Cram down rules apply. Upon confirmation, all creditors and stockholders are bound by the plan. Avoid taxes on income that results when debt is retired at less than face value.

Disadvantages of Bankruptcy
Business is disrupted. Debtor in possession must meet stringent reporting requirements. Bankruptcy court must approve all transactions outside the ordinary course of business. Bankruptcy filing can trigger other claims. Legal and administrative expenses paid by debtor.

Thank You For Your Attention

Group 5