Introduction to troubled-debt restructuring
Corporate RestructuringTim Thompson
Distressed Firm
Workout
Chapter 11(outside option)
No Chapter 11 filing
Prepackaged Ch. 11
Chapter 11 Reorganization
Chapter 7Liquidation
(outside option)
Auctionor sale
Focus of lecture Firm already in distress
defined as not able to make debt payments as they come due
Choices Renegotiate contracts with creditors out of court (workout) Renegotiate contracts with creditors in court (Chapter 11) Allow the firm to be liquidated by court appointed trustee
(Ch 7) Chapter 11 court may order the company be sold to highest
bidder Most focus will be on large firms, usually publicly
held
Insolvency
Troubled debt restructuring methods needed because firm is insolvent
I.e., it can not meet its obligations as they come due.
This is not the legal definition
Causes of insolvency
Bad luck Economic conditions Competitive position eroded Firm specific factors
Bad strategy Bad execution -- mismanagement Fraud Overlevered the company
Effect of insolvency
Have to recontract with creditors get parties to agree to reorganization
liabilities, ownership, control or liquidate
Recontracting can be settled out of court Workouts/private reorganizations
Or, in court Chapter 11 (reorg) or Chapter 7 (liquidation)
Main effect of reorganizations Restructure terms on debt
reduce interest payments/principal amounts Extend maturity Substitute equity (or equiv.) for debt
What if V is very large? Could be that have too little cash flow, but
good value, could offer BH more value, but paid later
Not the usual situation
What is optimal choice if managers are value maximizing?
Is the firm worth more as a going concern? with its own strategy bought out by another firm
Or is it worth more liquidated? What is size of the pie and how is it
to be sliced? Tough question on both counts!
Watch out for incentives on all sides!
Creditors Race to the top Don’t want firm to go into Ch. 11 In Ch. 11, want you to liquidate inefficiently
Shareholders Stay out of Ch 11 In Ch 11, want ongoing firm
Managers Depends on what their position looks like
Chapter 11 is not first choice Almost all large, publicly traded
firms attempt to workout debt before entering Chapter 11
Why do firms attempt a workout?
Workouts less expensive than Chapter 11 Gilson, John and Lang (GJL) studied
NYSE AMEX firms doing workouts and Ch. 11’s in ‘80’s Legal and professional fees higher in Ch
11 Avg length of Ch 11 is longer, especially
when workout included exchange offer In workout, only deal with claims in
default* In Ch 11, all claims
Problems with Ch. 11
Legal/professional fees have priority over other claims, so less incentive to get it done
Management by judges Major decisions: file application with court,
notify creditors -- file complaints Judges legal requirements
claimholders must receive at least what they’d get in liquidation, company not in danger of going bankrupt again (near future)
Why would bondholders or lenders agree to workout? Chapter 11 is a protection for the
debtor (called the debtor in possession, or DIP)
Chapter 11 can extract an even better (worse for the creditor) deal for the DIP than you might get in workout!
Advantages to DIP of Chapter 11 New issued debt higher priority
than pre-petition debt Interest on pre-petition unsecured
debt stops accruing Automatic stay from creditors Easier to get reorg plan accepted
because of voting rules
Why does firm go to Chapter 11? Creditor holdouts (and advantages above) In workout, have to get all participating
creditors to agree Bondholders have incentive to free ride
on the settlement Try to trap the free riders by making the
exchanged bonds higher priority, shorter maturity
Problem worse with public debt, more complex debt
LTV decision
Judge Burton Lifland Bondholders who tendered in
previous exchange offer were entitled to claim equal to market value of new bonds
Non exchanging bondholders entitled to claim equal to face value of debt
Makes holdout problem worse
Rights of management in Ch 11 DIP (debtor in possession) has
exclusive right to file first reorg plan for 120 days typically extended, sometimes for years
Large management turnover in both workouts and Ch 11’s Also, reputation issues
Tax disadvantage to voluntary restructuring Tax Reform Act of 1986
More difficult to preserve NOL carryforwards
Hard to avoid paying tax on income from forgiveness of debt
Revenue Reconciliation Act of 1990 newly exchanged bonds trading at a
discount to face value, the firm must book the difference as taxable income
Prepackaged bankruptcy
Hybrid of workouts and Chapter 11’s Firm files Chapter 11 But files reorg plan at the same time
(agreed to with secured creditors informally beforehand)
Can hurry up the Ch 11 process Not a sure thing! Why do Ch 11 at all?
Deviations from Absolute Priority in Troubled Debt Restructuring
Corporate RestructuringTim Thompson
Absolute Priority
In typical corporate finance treatments of default, assumed that claimants of the firm will be paid according to absolute priority
First, secured claimants Administrative claims Employee claims Customer claims Tax claims Unsecured creditors, then equity
Deviations from APR common Kaiser, Chap. 11, documents many
papers describing deviations from APR Both in Chapter 11 and in workouts Typically, equity and unsecured
debtholders receive more than “should,” more senior claims receive less than “should”
Equity receives more in workouts than in Chapter 11
Do markets expect APR deviations? Generally, yes. Kaiser’s Chapter 11 suggests that
debt markets do not seem to anticipate the eventual APR violations, but most of the literature suggests that markets do, in fact, incorporate these violations into pricing.
Betker (1996) Show table
If markets efficient, do deviations from APR matter? Still matter, because the noise in how
much you would get/lose due to violations leads to inefficient investments in time to find out how large deviations will
be in time and effort to limit/increase size of
deviations in increases in rates/onerous covenants
when you issue debt
Why are there deviations?
Management bargaining position Factors influencing amount
Larger proportion of debt, less violations higher proportion of secured debt/bank
debt, etc., less violations More equity percentage held by mgmt.
especially if same mgmt. continues employment Manager position looks like shareholder,
more!
Lo Pucki and Whitford (1990) Managers act more in their own
interests than in equity interests, so understanding the distinction is important on case by case basis.
Recovery rates How much do bankers/bondholders
get back of their original investment in Chapter 11 reorganizations? What is relation between recovery
rates and seniority/security? What is relation between recovery
rates and public/private/banks?
Altman evidence Average “recovery rate” approx. 40%
Recovery rate defined as the price one month after default occurred divided by par value
1991 36.0% 1990 23.4% 1989 38.3% 1988 43.6% 1987 75.9% 1986 34.5% 1985 45.9%
Altman: rec. rates by priority 1985-1991 Averages Type of debt Recovery rate
Secured 60.51% Senior 52.28% Senior subordinated 30.70% Subordinated (cash pay) 27.96% Subordinated (PIK) 19.51%
Recovery rates in Eastern Airlines Secured debt with sufficient collateral 100% Secured debt, insufficient collateral
11.75% First equip cert 100% 12.75% Second equip cert 60% 13.75% Third equip cert 6%
Accrued interest on secured debt 57% Capital lease obligations 100% Unsecured debt
PBGC pension claims 15% Manufacturer’s sub notes 11% Conv Sub Debs 6% Healthcare claims
8% Stock 0%
Kaiser notes, Franks and Torous Table 12.2 Percentage recovery
rates by creditor class exchanges, Chap. 11, and prepacks
Conclusions: Recovery rates higher in workouts than
Chapter 11’s Prepacks more like workouts Pre-solicited somewhat higher than pre-
negotiated
Kaiser notes, Franks and Torous Table 12.5, form of compensation
workouts v. Chapter 11’s Conclusions:
Cash larger part of distribution in Ch. 11 Bank debt reduced in chapter 11, becomes senior debt Junior debt and preferred receive equity, both methods Equity is larger part of distribution in Ch. 11
Loss in value at Eastern Weiss and Wruck
Table 2 Total recover by fixed claimants and equity
at resolution of bankruptcy, $2,005.5 million.
At filing of Chapter 11, total estimated market value of equity plus different measures of debt, around $4 billion
Loss of approx. $2 billion in value in Chap 11 argue was not due to industry conditions Direct costs were $114 million only.
What was problem? Uncertainty about going concern v.
liquidate Judge allowed managers to use
proceeds of asset sales to fund continued operations (at substantial op losses)
Some venue shopping?