Bankruptcy

Not Paying the Piper

Corporate Bankruptcy Facts

• In March 2003, PWC forecasted that around 10,000 companies would file for Chapter 11 protection that year, down from a record 11,000 in 2002.

• In June 2004 PricewaterhouseCoopers forecasted that approximately 110 public companies will file for bankruptcy in 2004. Substantially fewer than in any of the past six years.

• Recovering Industries: Pharmaceuticals, Computers, Airlines.– PWC Source: PR Newswire Association, Inc., June 15, 2004.

http://www.usdoj.gov/ust/statistics/stats-new/national/03national.htm

Bankruptcies

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

Year

Co

rpo

rate

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

Per

son

al

Corporate Personal

Source: Administrative Office of the U.S. Courts.

Bankruptcy Recent Events• The previous graph shows the total number of filings (Chapter 7 and

Chapter 11).• In 2002 about 38,000 firms filed for bankruptcy.

– (11,000 filed a Chapter 11, 27,000 filed a Chapter 7).– Out of the 11,000 companies that filed for Chapter 11 in 2002, 189 were publicly

traded companies.– About 100 of the 187 public firms that filed for Chapter 11 in 2001 have already

emerged from bankruptcy.• In the last three years:

– Worldcom– TWA– Enron– Kmart– Excite@home– Swissair– Midway Airlines– Global Crossing– Mirant Corporation

The Largest Bankruptcies 1980 – PresentSource: BankruptcyData.com

Company(click for more info)

Bankruptcy Date

Total Assets Pre-Bankruptcy

Filing Court District

Worldcom, Inc. 07/21/02 $103,914,000,000 NY-S

Enron Corp.* 12/2/01 $63,392,000,000 NY-S

Conseco, Inc. 12/18/02 $61,392,000,000 IL-N

Texaco, Inc. 4/12/1987 $35,892,000,000 NY-S

Financial Corp. of America 9/9/1988 $33,864,000,000 CA-C

Global Crossing Ltd. 1/28/2002 $30,185,000,000 NY-S

Pacific Gas and Electric Co. 4/6/2001 $29,770,000,000 CA-N

UAL Corp. 12/9/2002 $25,197,000,000 IL-N

Adelphia Communications 6/25/2002 $21,499,000,000 NY-S

MCorp 3/31/1989 $20,228,000,000 TX-S

Mirant Corporation 7/14/2003 $19,415,000,000 TX-N

 The Largest Public Company Bankruptcies - 2003

* Assets are taken from most recent annual report prior to bankruptcy. Source: BankruptcyData.com

Company Ch. 11 Assets

Mirant Corporation 14-Jul-03 $19,415,000,000

NRG Energy, Inc. 14-May-03 $10,883,688,000

Trenwick Group, Ltd. 20-Aug-03 $5,277,982,000

Petroleum Geo-Services ASA 29-Jul-03 $4,302,806,000

Amerco 20-Jun-03 $3,773,455,000

Fleming Companies, Inc. 01-Apr-03 $3,654,690,000

Solutia, Inc. 17-Dec-03 $3,342,000,000

Touch America Holdings, Inc. 19-Jun-03 $3,059,480,000

Loral Space & Communications Ltd. 15-Jul-03 $2,692,802,000

U.S. Bankruptcy System

• Firms that are unable to make required payments to their creditors can file:– Chapter 7: which leads to the liquidation of

the firm’s assets in the settlement of the creditors’ claims, or

– Chapter 11 which allows the firm to restructure its debt and equity claims and continue to operate.

• In reality, it is often the creditors who file for Chapter 7 bankruptcy.

Chapter 7: Liquidation• In a Chapter 7 bankruptcy, the bankruptcy court selects

a trustee from outside the company who liquidates the assets of the firm and distributes the proceeds to the debt holders.

• Any proceeds from the liquidation that remain after settling the debt holders’ claims are then distributed to the company’s shareholders.

• Under Chapter 7, these proceeds are divided among the claim holders according to the Absolute Priority Rule (APR), which states that debt holders must be paid in full before equity holders receive any proceeds of the bankruptcy.

• APR also states that secured debt holders must be paid before unsecured debt holders and that the more senior of the unsecured debt holders must be paid in full before the more junior debt holders.

Chapter 7 Rules and Restrictions

• Virtually any individual or business entity may be a voluntary debtor in a Chapter 7 proceedings.

• Exceptions:– Railroads (Special subchapter in Chapter 11)– Most domestic financial institutions (FDIC)– Most foreign financial institutions– Government units (Chapter 9)

• No lawyer is required to file• Most bankruptcy are filed under Chapter 7.

– Mostly small firms.

Chapter 11

• Under Chapter 11, debt and equity claims cannot be settled with cash realized from the liquidation of assets. – Instead debt and equity holders receive new financial

claims in exchange for their existing claims.

• Almost all bankruptcies of large corporations start out as Chapter 11 Bankruptcies and become Chapter 7 bankruptcies only when the various claimants fail to agree on a reorganization plan.

Reorganization under Chapter 11

• After filing for a Chapter 11, the corporation has 120 days to submit a reorganization plan, which creditors can either accept or reject.

• Judges frequently extend this 120-day period. This happens if creditors reject the offer, or the corporation fails to submit a reorganization plan.

• In most cases, at least one extension is granted.

Accepting or Rejecting the Plan

• To determine the acceptability of the plan, each class of impaired creditors – the creditors that will not be paid in full – as well as the equity holders must vote on it.

• For a specific class of creditors (e.g., convertible bondholders) to accept the plan, a simple majority of the claimants, and those who hold 2/3 of the dollar amount of the claim must vote favorably.

• A class of stockholders exhibit approval for the plan when at least two thirds of the firm’s shares vote to accept it.

Accepting the Plan

• If all classes of claimants accept the plan, the court will approve it. – However, it may not be necessary to have all classes of

claimants approve the plan.

• The court may confirm the plan over the objections of the dissenting classes if it judges the plan to be nondiscriminatory, fair, and equitable.

• A plan that is forced on dissenting claimants is known as a cramdown. A necessary condition for a cramdown is that the dissenters receive at least what they would receive under a Chapter 7 liquidation.

APR and Chapter 11

• APR is often violated in a Chapter 11 settlement.– Senior debtors allow these deviations from the

APR to facilitate a timely settlement of the bankruptcy and to avoid future lawsuits.

• Junior debt holders may sue the bankrupt firm's bank for taking actions that may have caused the firm to go into bankruptcy.

• Equity holders may threaten to use legal delays if they are not given some compensation.

Absolute Priority Rule (APR)

• In bankruptcy, claims are divided into at least two categories:– A claim is secured when the claimant has collateral.

• Example: a mortgage.

– Otherwise the claim is unsecured.

• APR ranks claims in the following order:– Secured Claims– Administrative Expense claims– Wages– Unsecured claims– Equity

Administrative Expenses

• Administrative expenses are those that arise from the expenses involved in the bankruptcy proceeding itself.– Costs of Preserving the Estate.– Compensation of Trustee and others.– Reimbursement of Expenses / Compensation of Professionals.

• Under some circumstances, creditors may be reimbursed for:– Expenses for actions that benefit the state.– The attorneys or accountants they used in taking these actions

may be awarded compensation for their service as well.

About those Legal Costs

• Because creditors can seek reimbursement of their legal fees they may not always bear the cost of hiring lawyers.

• Questions:– Under what circumstances will a creditor bear

or not bear his own legal costs?– Will secured or unsecured creditors have the

greater incentive to spend money on lawyers?

Arco Example

• Arco Distributions filed for Chapter 11 in 1997. • The value of the firm’s assets at the time of the

filing was $529,000.• It owed $9 million

– $1 million to secured creditors.

• The attorneys for the creditors’ committee charged the firm $112,000 in expenses (21% of the firm’s value!) that were fully reimbursed. But APR was upheld.

• Who really paid the attorneys?

Bankruptcy Time in Process

Data from Helwege, J. (1996) "How Long do Junk Bonds Spend in Default?," working paper Federal Reserve Bank of New York.

Mo. in Default All Prepack. Other Chap. 11 Out of Court

Avg. 20.1 19.4 30.5 7.7

Median 18 18 34 6

Longest 83 34 83 25

Shortest 1 6 8 1

Definitions: A prepackaged default is actually a legal mechanism for resolving a default. All of the parties negotiate a settlement outside of court. They then bring the "prepackaged" settlement to court, and the court approves it.

Bankruptcy Direct Costs

• Direct costs of bankruptcy include legal expenses, court costs, advisory fees, management time, creditors time.

• On average, direct bankruptcy costs represent 5% of firm value at the time of the filing.

• Regarding lawyers:– In the average case, the debtor spends half a million

dollars in legal fees and the creditors $230,000.– This represents around 1.5% of firm value.

Bankruptcy Indirect Costs

• Indirect bankruptcy costs arise because of the threat of bankruptcy, and are relevant even if the firm never defaults on its obligations.

• These are:– Equity holder incentives

• Equity holders may pursue strategies that decrease the value of a firm’s debt without reducing its total value.

• Who bears these costs? Equity holders. Why? Because lenders anticipate the chance such activities will occur and incorporate them into the price of debt.

Debt and What it Encourages

• The Shortsighted Investment problem.– Highly leveraged firms prefer projects that pay off

quickly since short-term projects allow them to meet their near-term debt obligations more easily.

• Asset substitution problem.– Similar to the one above. Firms will engage in more

risky projects when financial distress is likely.

• The reluctance to liquidate problem.– Managers of firms under Chapter 11 prefer inefficient

continuations, rather than liquidations.

Debtor in Possession Financing

• By declaring Chapter 11 bankruptcy, a firm may be able to obtain additional financing that is senior to existing debt.

• The new debt obtained under Chapter 11 is called debtor-in-possession (DIP) financing.

• Chapter 11 allows a bankrupt firm to obtain permission to violate debt covenants that otherwise would keep the firm from obtaining additional financing.

• Some of the efficiency losses in bankruptcy arise because the provision to obtain DIP financing can allow a firm to continue operating when it would be better off liquidating.

Life After Chapter 11

• Only one third of firms that go through a Chapter 11 survive as independent companies.

• Another third are acquired by the end of the second year after the filing.

• The rest are usually liquidated immediately, or they file for Chapter 11 again.

• The performance for survivors long after Chapter 11 is not significantly different from the other firms in the industry.