Financial Distress

What is 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.
 Financial distress may lead a firm to default
on a contract, and it may involve financial
restructuring between the firm, its creditors,
and its equity investors.
Insolvency
 Stock-base insolvency; the value of the firm’s
assets is less than the value of the debt.
Solvent firm Insolvent firm

Debt Debt
Equity
Assets Assets
Equity Debt

Note the negative equity

Insolvency
 Flow-base insolvency occurs when the firms cash
flows are insufficient to cover contractually required
payments.
$

Cash flow
shortfall
Contractual
obligations
Firm cash flow

Insolvency time
Why firms suffer financial distress?

 Firms with high leverage ratio

 Firms with inferior operating results
 Firms in a declining industry
Largest U.S. Bankruptcies
Firm Liabilities Date
(in $ millions)
Conseco Inc. $56,639.30 December 2002

Worldcom Inc. 45,984.00 July 2002

Enron Corp. 31,237.00 December 2001

Pacific Gas & 25,717.00 April 2001

Electric Co.
UAL Corporation 22,164.00 December 2001
What Happens in Financial Distress?
 Financial distress does not usually result in the
firm’s death.
 Firms deal with distress by
 Selling major assets.
 Merging with another firm.
 Reducing capital spending and research and
development.
 Issuing new securities.
 Negotiating with banks and other creditors.
 Exchanging debt for equity.
 Filing for bankruptcy.
What Happens in Financial Distress
No financial
restructuring
49%

Financial Private
distress workout
47%
51%
Financial Reorganize
restructuring and emerge
83%
53%
Legal bankruptcy 7% Merge with
Chapter 11 another firm

10%
Liquidation
Responses to Financial Distress
 Think of the two sides of the balance sheet.
 Asset Restructuring:
 Selling
major assets.
 Merging with another firm.
 Reducing capital spending and R&D spending.

 Financial Restructuring:
 Issuing new securities.
 Negotiating with banks and other creditors.
 Exchanging debt for equity.
 Filing for bankruptcy.
Bankruptcy Liquidation and
Reorganization
 Firms that cannot meet their obligations have two
choices: liquidation or reorganization.
 Liquidation (Chapter 7) means termination of the firm
as a going concern.
 It involves selling the assets of the firm for salvage.
 The proceeds, net of transactions costs, are
distributed to creditors in order of priority.
 Reorganization (Chapter 11) is the option of keeping
the firm a going concern.
 Reorganization sometimes involves issuing new
securities to replace old ones.
 Bankruptcy Liquidation
Straight liquidation under Chapter 7 usually involves:
1. A petition is filed in a federal court. The debtor
firm could file a voluntary petition or the creditors
could file an involuntary petition against the firm.
2. A trustee-in-bankruptcy is elected by the creditors
to take over the assets of the debtor firm. The
trustee will attempt to liquidate the firm’s assets.
3. After the assets are sold, after payment of the
costs of administration, money is distributed to
the creditors.
4. If any money is left over, the shareholders get it.
Bankruptcy Liquidation: Priority of Claims
The distribution of the proceeds of liquidation
occurs according to the following priority (APR):
1. Administration expenses associated with liquidation.
2. Unsecured claims arising after the filing of an
involuntary bankruptcy petition.
3. Wages earned within 90 days before the filing date, not
to exceed $2,000 per claimant.
4. Contributions to employee benefit plans arising with 180
days before the filing date.
5. Consumer claims, not exceeding $900.
6. Tax claims.
7. Secured and unsecured creditors’ claims.
8. Preferred stockholders’ claims.
9. Common stockholders’ claims.
APR (Absolute Priority Rule) Example
 Suppose the B.O. Drug Co. decides to liquidate
under Chapter 7.
 Assume that the liquidation value is $2.7 million.
Bonds worth $1.5 million are secured by a
mortgage on the corporate headquarters building,
which is sold for $1 million. $200,000 is used to
cover administrative costs and other claims—after
paying this, $2.5 million is available to pay
creditors. The only problem is that the unpaid debt
is $4 million.
APR (Absolute Priority Rule) Example
Under APR, all creditors are paid before shareholders, and
the mortgage bondholders are first in line. The trustee
proposes the following distribution:
Type of Claim Prior Claim Cash Received Under
Liquidation

Mortgage Bonds $1,500,000 $1,500,000

Subordinated $2,500,000 $1,000,000

Debentures

Common Stock $10,000,000 $ 0

Total $14,000,000 $2,500,000
 Bankruptcy Reorganization: Chapter 11
A typical sequence:
1. A voluntary petition or an involuntary petition is filed.
2. A federal judge either approves or denies the petition.
3. In most cases the debtor continues to run the business.
4. The firm is given 120 days to submit a reorganization plan.
5. Creditors and shareholders are divided into classes.
Requires only approval by 1/2 of creditors owning 2/3 of
outstanding debt
6. After acceptance by the creditors, the plan is confirmed by
the court.
7. Payments in cash, property, and securities are made to
creditors and shareholders.
Reorganization Example
 Suppose the B.O. Drug Co. decides to
reorganize under Chapter 11.
 Assume that the “going concern” value is $3
million and its balance sheet is shown.

Assets $3,000,000 Liabilities:

Mortgage bonds $1,500,000

Subordinated $2,500,000
debentures

Equity –$1,000,000
Reorganization Example
The firm has proposed the following
reorganization plan:
Old Security Old Claim New Claim Under
Reorganization

Mortgage bonds $1,500,000 $1,500,000

Subordinated $2,500,000 $1,000,000

debentures
Reorganization Example
And a distribution of new securities under a
new claim with the reorganization plan:
Old Security New Claim Under Reorganization

Mortgage bonds $1,000,000 in 9% subordinated

debentures
$500,000 in 11% subordinated
debentures
Subordinated debentures $1,000,000 in 8% preferred stock
$500,000 in common stock
Absolute Priority Rule in Practice
The APR states that senior claims are fully satisfied before
junior claims receive anything
Deviations from APR

Equityholders Expectation: No payout

Reality: Payout in 81% of cases

Unsecured creditors Expectation: Full payout after

secured creditors
Reality: Violation in 78% of cases

Secured creditors Expectation: Full payout

Reality: Full payout in 92% of
cases
 Reasons for APR Violations
 Creditors want to avoid the expense of litigation.
Debtors are given a 120-day window of
opportunity to cause delay and harm value.
 Managers often own equity and demand to be
compensated. They are in charge for at least the
next 120 days.
 Bankruptcy judges like consensual plans (they
don’t clog the court calendar with appeals) and
pressure parties to compromise.
Vulture (not Venture) Capital
 “Vultures” are money managers that specialize in
the securities of distressed and defaulted
companies.
 There are between 50 and 60 institution vulture
specialists, actively managing over $25 billion.
 Distressed debt investors have target annual rates
of return of 20–25 percent.
 Although some years are better than others, the
overall annual rate of return has been about 12
percent—similar to junk bonds but less than the
stock market.
Private Workout or Bankruptcy: which is Best?

 Both formal bankruptcy and private workouts

involve exchanging new financial claims for old
financial claims.
 Usually senior debt is replaced with junior debt and
debt is replaced with equity.
 When they work, private workouts are better than
a formal bankruptcy.
 Complex capital structures and lack of information
make private workouts less likely.
Private Workout or Bankruptcy: Which is Best?
 Advantages of Bankruptcy
1. New credit is available - "debtor in possession" or "DIP"
debt.
2. Discontinued accrual of interest on pre-bankruptcy
unsecured debt.
3. An automatic stay provision.
4. Tax advantages.
5. Requires only approval by 1/2 of creditors owning 2/3 of
outstanding debt.
 Disadvantages of Bankruptcy
1. A long and expensive process.
2. Judges are required to approve major business
decisions.
3. Distraction to management.
4. “Hold out” by stockholders.
Prepackaged Bankruptcy
 Prepackaged Bankruptcy is a combination of a
private workout and legal bankruptcy.
 The firm and most of its creditors agree to private
reorganization outside the formal bankruptcy.
 After the private reorganization is put together
(prepackaged) the firm files a formal bankruptcy
under Chapter 11).
 The main benefit is that it forces holdouts to accept
a bankruptcy reorganization.
 Offers many of the advantages of a formal
bankruptcy, but is more efficient.