CH 24: Bankruptcy

Chapter 24: Bankruptcy

Chapter 7 vs Chapter 11 bankruptcy

• Chapter 7: contains procedures to be followed when liquidating a failed firm

  • Usually appoints a trustee to liquidate the asset

  • Takes 3-6 months

  •  You could lose valuable assets and stays in credit report for 10 years

  • You cannot get rid of certain debts

• Chapter 11: Outlines the procedures for reorganizing a firm (this is typically reorganizing a business)

  •  Primarily for business or a high debt individual (someone with a lot of assets)

  • Usually the business stays open and they usually put together a program to reorganize

  • The logic behind CH 11 is that creditors as a whole will be better off if the firm is allowed to survive

  • CH 11 frequently faces problems with liquidity

    • Cash is depleted

    • Lenders may threaten a declaration of default or covenant violations

    • The firm faces the loss of revolving credit lines

    • Suppliers may demand to be paid in cash up front

•  Once a company files for bankruptcy, it eliminates the benefit of being the first to sue because all claims against the firm are settled simultaneously

Debtor-in-Possession

•  This is the person who controls the assets when you are going through bankruptcy (CH 11) 

• (DIP)- management of the firm remains in place while the case is pending

• The debtor stays in charge but is supervised by the bankruptcy court

• They are supposed to be making sure they are running the day-to-day operations efficiently and have to file regular reports

• DIP is responsible for the valuation of the firm

• IF DIP decides that the going concern is less than the liquidation value, then the company doesn’t have any value, and you do not want to pour good money into a company that will not recover. Otherwise, DIP recommends reorganization (stockholders usually get nothing)

Super-priority to new lenders and critical vendors

• The Bankruptcy Code authorizes the company to offer an array of “sweeteners” to lenders who are willing to lend. Under certain conditions, the firm may offer super-priority to new lenders: the right to be paid ahead of everyone else. Called debtor-in-possession financing.

• Bankruptcy courts can allow ‘critical vendor’ (these are payments that are a priority, ex salaries, electricity, things that you need to make a product) payments for certain suppliers

Reorganization plans under Chapter 11

•  DIP submits a reorganization plan to the court:

  • Unsecured creditors may be offered stock (maybe you owe money to someone who is not secure, but you do not have any money, so you offer them stock that should be valuable at some point)

  •  The principal of debt can be reduced, interest payments can be reduced, or time to maturity can be extended

  • Unsecured debt may be repaid at a discount to face value

  • Claims on the new securities issued are distributed based on the seniority of the existing claims

Cramdowns

• If a company submits a CH 11 reorganization plan for approval to the firm's creditors and shareholders (which they must agree to), but if they reject the plan, the debtor may seek a cramdown, where a judge forces creditors to accept the terms of the plan

• This can happen if the creditors are not being reasonable

Absolute priority

• States that stockholders and low-priority creditors can retain no interest in the reorganized company unless all higher-priority creditors are paid in full.

Fate of underfunded pension plans and PBGC

•  Reorganized firm can terminate underfunded pension plans and have PBGC (pension benefit guarantee corporation) pick up the costs. (this is a federal government agency that protects these pension plans)

Sources of aid to firms in chapter 11

• Aid from the government or creditors (give them advantages)

1. Debt forgiveness is taxable only when the reorganized firm becomes profitable

2. The reorganized firm can terminate underfunded pension plans and have PBGC (pension benefit guarantee corporation) pick up the costs. (this is a federal government agency that protects these pension plans)

3. The reorganized firm retains tax loss carryforward (you become profitable and you have a loss that you can carry forward that offsets tax liability- you do not pay the taxes now since you have a loss but they keep track of them, this helps you reduce future taxes)

4. Hiatus on interest payments to creditors (they may stop interest payments or incurring interest payments)

5. Can reject contracts not substantially completed

6. With permission of the bankruptcy judge, reorganization firm can reject their collective bargaining agreements (this is a legally binding contract involved with a labor union, which are really strict)

Chapter 7 liquidation procedure

• The appointed trustee takes total control and possession of the firm and its assets

• Operations are usually stopped, and Management is out of the picture unless the trustee attempts to recover from them

• Trustees are  often in conflict with secured creditors concerning the value of assets

• Priority of claims specified in CH 7 of the Bankruptcy Act (LOOK AT PG 859)

  • Established in CH 7 of the Bankruptcy Act. It specifies the order in which the debtor's assets are distributed among the creditors 

Altman’s Z-score

• Quantitative model that uses a blend of traditional financial ratios and multiple discriminant analysis

•  About 90% accurate in forecasting bankruptcy one year in the future

•  About 80% accurate in forecasting bankruptcy two years in the future

• Z<= 1.8 High probability of bankruptcy

• 1.8 <Z< 3.0 Unsure

• 3.0 <= Z Bankruptcy unlikely