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Bankruptcy and Restructuring

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Causes of Financial Distress• Lack of access to capital markets

– JP Morgan buys Bear Stearns after Merrill Lynch creates impression of liquidity crisis by ceasing collateral in a Bear Stearns fund.

• Deterioration of operating performance– General economic downturn– Foreign competition– Failed growth strategies– Bad capital structure

• Large off balance sheet contingent liabilities– Tort claims (US Gypsum, Merck)– Liability for fraud– Liabilities concealed in SPEs

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Definition of Financial Distress• FMV assets less than FMV liabilities

– AIGs of the world– Mark-to-Market

• Inability to meet obligations as they become due (liquidity crisis)– Many current firms: profit and nonprofit

• Yale as an example

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Universities: Endowment Size

INSTITUITON ENDOWMENT VALUE (2007) (billions)

HARVARD 34.9 YALE 22.5

STANFORD 17.2 PRINCETON 15.8

TEXAS 15.0 MIT 10.0

COLUMBIA 7.2 MICHIGAN 7.1

CALIFORNIA 6.7 UPENN 6.6

NOTRE DAME 6.5 CHICAGO 6.1

WASHINGTON UNIV 5.7 UVA 4.6

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Universities: Endowment per Student 2006

INSTITUITON ENDOWMENT VALUE PER STUDENT (2006) (Millions)

PRINCETON 1.90 BRYN ATHYN COLLEGE 1.77

YALE 1.75 RICE 1.56

HARVARD 1.47 GRINNELL 1.08 STANFORD .95 POMONA .94

SWARTHMORE .84 MIT .82

AMHERST .82 WILLIAMS .78 CAL TECH .76

DARTMOUTH .71

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Why do Universities have Endowments?

• Intergenerational Equity

• Buffer against Financial Adversity

• Protect Reputational Capital in Long-run

• Protect Intellectual Freedom

• Pass Values across Generations

• Wishes of Donors, Trustees, etc

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Spending Rules

• Protect Endowment Value in Real Terms

• Should be Independent of the Investment Policies

• Should Provide a Smooth Spending Pattern to facilitate Financial Planning

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Liquidity (most important focus in nonprofits)

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“Truths” of Distress Investing• No one can take away a Corporate Creditor’s Right to a money payment

outside of Chapter 11– E.g. $5 billion bailout by congress of airlines: more than $2 billion given to

creditors for principal and interest (therefore it is a creditor bailout!)• Chapter 11 rules influence all reorganizations

– Voluntary exchanges– Conventional Chapter 11– Prepackaged Chapter 11– “rule of absolute priority”, “period of exclusivity”, etc.

• Creditors of a distressed company will get ripped off by the reorganization professionals

• Creditors have only contractual rights– Solvent Companies

• Contractual rights in covenant• No residual claims• Other legal rights, e.g. fraudulent conveyance

– Insolvent Companies• Zone of insolvency• Insolvent: Board of Directors works for the creditors

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Deal Expenses/Costs of Bankruptcy• Administrative expenses of a bankruptcy

are paid by the estate (DIP)– Committees (DIP, creditor committees, equity

holder committees)– Attorneys, financial advisors, CPAs, I Bankers,

Appraisers, etc.—each committee hires these people

– Superpriority in payment over other unsecured claims Paid in cash on an on-going basis)

– Contributes to infeasibility

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Deal Expenses/Costs of BankruptcyExamples

• Ongoing fees (examples)• UAL

– Saybrook Restructuring Advisors LLC: $250,000/month for first 6 months and $200,000/month thereafter

• Loral Space and Communications– Conway, Del Genio Gries and Co.: $250K/month

– Jeffries & Co.: $150K/month

• Bonus Potential (examples)

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Deal Expenses/Costs of BankruptcyExamples

• Bonus Potential (UAL/Saybrook)• If either a plan is confirmed and becomes effective in the company’s

bankruptcy case or a sale transaction (as defined in the agreement) closes, the firm will be entitled to an incentive fee. The fee will be measured based on the percent, if any, by which the value of consideration issued to bondholders under a restructuring increased over the median value of the bonds on Dec. 30 (based on a median trading price of 9.83 cents for every dollar of principal amount outstanding). The incentive fee is capped at $7.5 million. The firm will be entitled to an incentive fee of $7.5 million for a 50% increase above the baseline trading price. To the extent that the increase is between 0% and 50%, the firm will be entitled to a prorated fee calculated to the nearest $10,000. If the firm doesn’t earn an incentive fee under this formula, the panel may elect to pay a discretionary incentive fee not to exceed $3.5 million. The amount of the earned incentive fee (not the discretionary incentive fee) will be reduced by the total amount of all monthly advisory fees paid to the firm after the sixth month.

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Deal Expenses/Costs of BankruptcyExamples

• Bonus Potential (Loral/Jeffries)

• The firm will be entitled to a completion fee equal to the greater of $1 million or 1% of the total consideration received by unsecured creditors between $500 million and $700 million plus 1.75% of total consideration over $700 million.

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Methods of Restructuring Troubled Companies

• Voluntary Exchanges

• Conventional Chapter 11

• Prepackaged Chapter 11

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Time in Bankruptcy

• Exhibit 4.5 Average and Median Duration of Chapter 11 Cases in Months, by Type of Filing, 1980–2007

Pre-2005 BAPCPA

Cases Average Median

Conventional 523 22 18

Prenegotiated 110 8 5

Prepackaged 63 2 2

Post-2005 BAPCPA

Cases Average Median

Conventional 6 13 14

Prenegotiated 4 4 5

Prepackaged 2 2 2

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Voluntary Exchanges

• Prior to Chapter 11 filing• Offer current holders to trade their equity or debt securities

for new instruments– Usually principal amount is slightly higher than current market

price but with less onerous cash service requirements or sometimes PIK

• Problems/Issues with such offers– They are voluntary

• Cannot force them to give up contractual rights– Require registration statement

• Expensive and time consuming– If bondholder holds out and others do not they will likely be better

off

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Voluntary Exchanges• Show downside

– Juniority after exchange• Nonmonetary provisions of indentures can be changed by 1

50% vote– Shorten maturity date– Threat of Chapter 11

• Other issues– Vulture investors– Taxes

• OID

• General concern (not just bankruptcy)– Worry about creating taxable events: the event causing

taxes does/doesn’t give rise to the cash to pay the taxes!

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Conventional Chapter 11• If confirmed by the bankruptcy court the

reorganization plan is binding on all claimants• Confirmation

– 2/3 in amount and 50% in number of votes for each separate class of claimants vote to accept

– 2/3 of common and preferred vote to accept– Cram down if certain classes reject plan

• Fair and equitable to all parties• Each rejecting class will receive more under the plan than

from a liquidation

• Reluctance to file 11

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Conventional Chapter 11• Reluctance to file Chapter 11

– Perceived stigma– Large administrative expenses

• Company fees for professionals– Attorneys– Investment bankers– Accountants– Other experts

• Court appointed official committees– Company pays the fees for ALL such committees

– Loss of management control• No action can be taken “outside of the normal course of business” without court approval• Must share business and strategic plans with all claimants and parties of interest• Massive reporting, discovery and testimony under oath• Oftentimes a very knowledgeable and potent set of claimants

• Emergence from Chapter 11– Virtually all claims against company disappear (unlike a voluntary settlement)

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Prepackaged Chapter 11

• Solicitation of creditors and equity holders to a Chapter 11 Plan of Reorganization before the company ever files Chapter 11– Management maintains control as this is done

out of Chapter 11– Avoid massive bankruptcy costs– Quicker than a conventional Chapter 11– No incentive for public bondholders to hold out

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Environment of the Case

• Company in trouble• Voluntary or Involuntary filing

– Involuntary• 3 petitioning creditors owed more than $10,775 (if more than 12

creditors), otherwise only 1 petitioning creditor owed $10,775 is sufficient

– Voluntary more common– Forum/Judge shopping

• Commencement of Chapter 11– Formation of Committees– Some cases-appointment of examiner or trustee

• Usually in cases of management fraudulent actions

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Claimants and Parties of Interest(Communities and Conflicts of

Interest)• Management• The company itself• Equity holders (common and preferred)• Professionals• Executory contracts• Adequately secured creditors• Subordinated debt holders• Unsecured creditors• Trade creditors• Administrative claimants

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Conventional Chapter 11• Period of Exclusivity• Automatic Stay• Consensual Plan• Adequate Protection• DIP Financing• Confirmation Hearing• Fraudulent Transfer• Voidable Preferences

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Public Policy Issues• System doesn’t work• Administratively Expensive• Doesn't fix companies• Management Entrenchment• Ideal system

– Administratively quick and inexpensive– Cause those who made incorrect investment decisions to suffer– Results of reorganizations should be fair and equitable– Should distinguish between reorganizable and liquidatable– Should contribute to making reorganized companies feasible

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Other Items• Fresh Start Accounting• “Vulture Investors”

– Fulcrum securities

• Time to reorganization• Chapter 11 as a component of corporate strategy• Substantive Consolidation• Predicting Bankruptcy

– Altman’s Z– Complex capital structure/consolidated financial

statements

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Other Issues• Management Entrenchment and

Compensation– Usually management continues in place– Need for speed in reorganization

• Key Employee Retention Plans (KERP)– 2005 bankruptcy law changes limit dollars in

KERP– Circumvent with incentive plans