Chapter 16 Alternative Exit and

Restructuring Strategies:Reorganization and

Liquidation

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Learning Objectives

• Primary Learning Objective: To provide students with an understanding of alternative strategies for failing businesses

• Secondary Learning Objectives: To provide students with an understanding of– Criteria for choosing strategy for failing firms– Process for filing for bankruptcy, voluntary

and involuntary settlements inside and outside of court, and voluntary and involuntary liquidation

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Rule of Law and Corporate Asset Allocation

• The smooth functioning of capital markets requires rapid and fair resolution of disputes involving the legal rights of borrowers and lenders

• Studies show that borrowing costs are lower and access to credit easier in countries which enforce credit rights.

• Total cost of financial distress (i.e., inability to meet financial obligations) includes the following:--Employee layoffs--Firm under-investment--Eroding community tax base and blight--Customer dissatisfaction with declining product quality and increasing

delivery times--Delayed payments to suppliers (including lenders)--Higher borrowing costs --Declining shareholder value

• Bankruptcy plays key role in minimizing these costs by providing a process for resolving these issues in a timely manner.

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Bankruptcy• Applicable to failing firms

– A firm is technically insolvent if it is unable to pay its liabilities as they come due

– A firm is legally insolvent if a firm’s liabilities exceed the fair market value of its assets

• Designed to protect failing firms from lawsuits by its creditors until decision made to shut-down or to continue operating the firm

• A firm not considered bankrupt until it or its creditors petition the federal bankruptcy court

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Signs and Risks of Distress¹• Ratings downgrades• Near scheduled expiration of credit lines• Complex capital structures• Pending regulatory investigations• Auditor discord or qualified opinion• Change of lender representatives• Debt reduction programs• Cost reduction initiatives – layoffs, concessions• Unexpected changes in management¹ Ball and Kane, A Practical Guide to Distress M&A, The M&A Lawyer

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Examples

• Los Angeles Dodgers

• Prince Sports

• Kodak

• Hostess

• MF Global

• Lehman

• General Motors

• Delphi – formerly GM supplier. 7

Voluntary Reorganization Outside of Bankruptcy Court

• Generally offers best chance for owners to recover a portion of their investment

• Usually, initiated by debtor firm by requesting relief from creditors• Such relief often consists of the following:

– An extension: Creditors agree to lengthen period during which debtor firm can repay its debt. May also include a temporary suspension of both interest and principal repayments

– A composition: Creditors agree to settle for less than the full amount they are owed

– Debt for equity swap: Creditors surrender a portion of their claims in exchange for an ownership position in the firm

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Voluntary Liquidation Outside of Bankruptcy Court

• If creditors conclude insolvent firm’s situation cannot be reorganized, liquidation may be only course of action

• If insolvent firm is willing to accept liquidation and all creditors agree, legal proceedings not necessary

• Creditors normally prefer liquidations to avoid lengthy and costly litigation

• Significant issue: liquidation vs. going concern

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Reorganization and Liquidation in Bankruptcy

• In absence of out-of-court voluntary settlement, debtor firm may – seek protection from creditors by petitioning the bankruptcy

court or – be forced into bankruptcy by its creditors

• Bankruptcy allows creditor firm to stop all principal and interest payments and prevents secured creditors from taking possession of their collateral Stay

• U.S. Bankruptcy Code:– Chapter 11 deals with reorganization and provides for the

debtor to remain in possession, unless court rules otherwise– Chapter 7 deals with liquidation and defines priority in which

creditors will be paid– Chapter 15 addresses insolvency issues involving assets,

lenders, and other parties in various countries

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Chart 16-1. U.S. Chapter 11 FilingsBy Fiscal Year (Public and Private Companies)

Source: Administrative Office of the United States Courts11

Chapter 11 Filings

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Chapter 11 – Statistics

• Public record but difficult to identify

• Approximately 1% of total filings –

• September 2011 and September 2010– Filings 1,596,355 1,467,732– Terminations 1,496,732 1,461,896– Pending 1,659,086 1,664,393

• Conclusion: Increase 2.75 X 2008

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Procedures for Reorganizing in Bankruptcy

Filing with the Bankruptcy Court

Appointment of Debtor in Possession or Court Trustee

Develop and Present Reorganization Plan

Acceptance

of

Reorganization Plan by All Parties

Payment of Court Approved Expenses

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Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

(BAPCPA)• Pre-BAPCPA:

– Debtor in possession (DIP) had exclusive right for first 120 days to file a reorganization plan before creditors could submit their own plan

– Court could at its discretion provide extensions

– Leases could be extended indefinitely as long as payments made

• Post-BAPCPA: “Stop the foot dragging”– Caps DIP exclusivity period at 18 months with an additional 2 months to

win creditors’ acceptance of reorganization plan, effectively giving DIP a maximum of 20 months before creditors’ can submit their plan

– “Good cause” lease extensions limited to 90 days

– Payments to management employees cannot be more than 10 times amount paid to non-management employees

• Chapter 11 Success ? ¹ Warren & Westbrook, The Success of Chapter 11: A Challenge to The Critics, Michigan Law Review Vol. 107:603

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Liquidation in Bankruptcy• If the bankruptcy court determines reorganization not feasible, failing firm

may be forced to liquidate

• Priority in which claims are paid (per Chapter 7 of U.S. Bankruptcy Code)

– Past due property taxes

– Secured creditors up to proceeds of the sale of pledged assets

– Legal fees

– Expenses incurred after involuntary case begun but before trustee appointed

– Wages not to exceed $2000 per worker

– Unpaid employee benefit plan contributions up to $2000

– Unsecured customer deposits of $900 or less

– Income taxes owed federal, state, or local governments

– Under-funded pension liabilities up to 30% of the firm’s book value

– Unsecured creditors

– Preferred shareholders, up to par value of their stock

– Common shareholders, paid out of remaining funds

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Prepackaged Bankruptcies

• Debtor negotiates reorganization plan with major creditors well in advance of filing for Chapter 11

• Subsequent Chapter 11 reorganization averages a few months as court only has to approve the plan

• Minority creditors may be required to accept the plan by the court “Cram Down”

• Debtor may lose NOLs if out of court settlement reached in which creditors exchange their debt for equity and original shareholders own less than 50 percent of firm. In bankruptcy, debtor may claim NOLs. Unless GM

• Beechcraft – 5/3/12 – swap debt for equity

¹ Fitzgerald & Beaudette, Hawker Beechcraft Files for Chapter 11, WSJ, May 3, 2012

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Choosing Appropriate Restructuring Strategy: Failing Firms

• Choice heavily influenced by the following:– Going concern value of debtor firm– Sale value of debtor firm– Liquidation value of debtor firm

• Implications:– If sale value > going concern or liquidation value, sell

firm– If going concern value > sale or liquidation value,

reach out of court settlement with creditors or seek bankruptcy protection under Chapter 11

– If liquidation value > sale or going concern value, reach out of court settlement with creditors and liquidate or liquidate under Chapter 7

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Examples – 2011-2012

• Borders – February 2011– Assets $1.28B; Liabilities $1.2b– GE Capital provided DIP financing $550M– Sales down double digit each quarter from

2008– 6,100 staff, 508 stores including Waldenbooks– Liquidation sale $700M in July

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A123 Bankruptcy

• October 2012 Bankruptcy

• Presidential election issue -$249M/$120M

• Awaiting court approval – 12/11/12 – 2PM– Other suitors – Johnson Controls & NEC

• Also CFIUS approval – Treasury may stop

• Original deal – Wanxiang – 80% -$450M– Now gets 100% (less US govt. deal) $260M

• Military/industry – businesses too similar20

Examples – 2011-2013

• MF Global – November 2011 – 8th largest

– Firm began 1783 by James Man

– 12/8/11 – Corzine – Sgt. Schultz defense.

– Ongoing hearings today as CH 11 proceeds

– Former FBI head Louis Freeh, Trustee

– October 30 – “material shortfall”; $7B in August

– October 31 – accounts frozen; petition filed

– Invested $6B in European sovereign bonds

– Mixed customer and firm assets; loss > $1B

– Cannot be primary dealer

– Assets: $41B; liabilities $40B21

Examples – 2013

• Atari – cleared Ch 11. No game buyers

• Building 19

• Gallup NM Catholic Diocese

• City of Detroit (Chapter 9)

• Blockbuster

• Cengage – PUBLISHER

• Bebo – Former AOL subsidiary

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Things to Remember…

• Bankruptcy process supports smooth functioning of capital markets by protecting creditor and debtor rights

• Generally offers best chance for owners to recover a portion of their investment

• Bankruptcy allows creditor firm to stop all principal and interest payments and prevents secured creditors from taking possession of their collateral

• A failing firm’s options are to merge with another firm, reach an out-of-court voluntary settlement with creditors, or file for Chapter 11 bankruptcy protection

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