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WorldCom shocked the business world when it announced in June 2002 that it had fraudulently overstated $3.9 billion of expenses as capital expendi-tures, which had allowed it to book higher profi ts during the boom years of 1998–2001. WorldCom CFO Scott Sullivan was fi red the day the fraud was disclosed, following the exit of founder and CEO Bernie Ebbers. Over the next two years, more than $7 billion in additional accounting errors and frauds were uncovered, bringing the total misstatements to $11 billion, and in a March 2004 restatement of its 2001 and 2002 fi nancial results, the company wrote off over $74 billion in previously booked profi ts and goodwill. After pleading guilty to several crimes, Sullivan testifi ed against Ebbers in his 2005 federal trial, which resulted in Ebbers being sentenced to 25 years in prison.

WorldCom’s trip through Chapter 11 bankruptcy, while painful, was also remarkably successful. With the bankruptcy court’s blessing, creditors in-stalled Michael Capellas (formerly CEO of Compaq Computer) as CEO. He submitted a reorganization plan fi ve months later that called for almost all of the company’s debt to be converted into equity, and over 90 percent of WorldCom’s creditors voted to approve this plan. Capellas also announced that the company would change its name from the tainted WorldCom to that of its principal consumer brand, MCI Inc. Therefore, when MCI fi nally emerged from Chapter 11 in April 2004, the company had a new name, a new manage-ment team, and an entirely new capital structure.

chapter.22Bankruptcy and Financial Distress

Part 1: Introduction1 The Scope of Corporate Finance 2 Financial Statement and Cash Flow

Analysis 3 The Time Value of Money

Part 2: Valuation, Risk, and Return 4 Valuing Bonds 5 Valuing Stocks 6 The Trade-off Between Risk

and Return 7 Risk, Return, and the Capital Asset

Pricing Model

Part 3: Capital Budgeting 8 Capital Budgeting Process

and Decision Criteria9 Cash Flow and Capital Budgeting 10 Risk and Capital Budgeting

Part 4: Capital Structure and Dividend Policy11 Raising Long-Term Financing 12 Capital Structure 13 Long-Term Debt and Leasing 14 Dividend Policy

Part 5: Financial Planning and Management 15 Financial Planning 16 Cash Conversion, Inventory, and

Receivables Management 17 Cash, Payables, and Liquidity

Management

Part 6: Special Topics18 International Financial Management 19 Options 20 Entrepreneurial Finance and

Venture Capital 21 Mergers, Acquisitions, and

Corporate Control22 Bankruptcy and Financial Distress 22-1 Business Failure Fundamentals22-2 Voluntary Settlements22-3 Bankruptcy Law in the

United States22-4 Reorganization in Bankruptcy22-5 Liquidation in Bankruptcy22-6 Predicting Bankruptcy23 Risk Management

WorldCom Emerges from Bankruptcy with a New Name, New Management,

and a New Capital Structure

58117_22_ch22_p887-917.indd 88758117_22_ch22_p887-917.indd 887 12/7/07 12:57:51 PM12/7/07 12:57:51 PM

888 l Part 6 Special Topics

Remarkably, within months of emerging from Chapter 11, MCI became the target of a frenzied takeover battle between Verizon Communications and Qwest Communications. Qwest initiated the contest with a $6.5 billion off er—later raised to $8 billion—in February 2005, but Verizon ultimately tri-umphed with an $8.45 billion bid. MCI’s lucky shareholders approved the Verizon acquisition in October 2005.

Source: Financial Times, multiple issues.

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After studying this chapter you should be able to:

• Describe the three major types of business failure, and discuss what each implies for the long-term prospects of the company;

• Explain what a voluntary settlement is, and discuss why these are only occasionally successful;

• Discuss the key diff erences between Chapter 7 and Chapter 11 bankruptcy fi lings;

• Explain how a reorganization plan is developed and implemented for a company that is in Chapter 11 bankruptcy;

• Understand how absolute priority rules are ap-plied when a company is liquidated under a Chap-ter 7 bankruptcy process; and

• Discuss the importance of being able to predict when a fi rm will fi le for bankruptcy and discuss how eff ectively analysts can make these predictions.

A fundamental concept in economics is that com-petition drives markets toward a state of long-term equilibrium in which surviving companies produce at minimum average cost. This transition process eliminates fi rms using obsolete technologies, inef-fi cient fi rms, and fi rms producing goods and ser-vices that are in excess supply. Consumers benefi t because, in the long run, products are manufac-tured and sold at the lowest possible price. The mechanism through which ineffi cient fi rms leave the market is frequently bankruptcy, the legal pro-cedure applied to businesses that fail.

In this chapter, we will examine fi rst how and why fi rms fail. We then look at U.S. bankruptcy law and the ways that a business that has failed can resolve its diffi culties, either voluntarily or in-voluntarily, through bankruptcy.

A business failure is an unfortunate circumstance. Although the majority of fi rms that fail do so within the fi rst year or two of life, other fi rms grow, mature, and fail much later. The failure of a business can be viewed in a number of ways and can result from one or more causes.

22-1a Types of Business FailureA fi rm can fail because its returns are negative or low. A fi rm that consistently reports operating losses will probably experience a decline in market value. If the fi rm fails to earn a return that is greater than its cost of capital, it can be viewed as having experi-enced economic failure. Negative or low returns, unless remedied, are likely to result eventually in a more serious type of failure. This happened in late 2005, with Delphi, North America’s largest auto parts maker, and both Delta and Northwest Airlines fi l-ing for bankruptcy within weeks of each other (Delta and Northwest actually fi led on the same day). Interestingly, these three fi rms also emerged from bankruptcy within a few months of each other during the spring and summer of 2007.

A second type of failure, technical insolvency, occurs when a fi rm is unable to pay its liabilities as they come due. When a fi rm is technically insolvent, its assets

22-1 Business Failure Fundamentals22-1 Business Failure Fundamentalsbusiness failure The unfortunate circumstance of a fi rm’s inability to stay in business.

business failure The unfortunate circumstance of a fi rm’s inability to stay in business.

economic failure A fi rm fails to earn a return that is greater than its cost of capital.

economic failure A fi rm fails to earn a return that is greater than its cost of capital.

technical insolvency A fi rm is unable to pay its liabilities as they come due, although its assets are still greater than its liabilities.

technical insolvency A fi rm is unable to pay its liabilities as they come due, although its assets are still greater than its liabilities.


Chapter 22 Bankruptcy and Financial Distress l 889

are still greater than its liabilities, but it is confronted with a liquidity crisis. If some of its assets can be converted into cash within a reasonable period, the com-pany may be able to escape complete failure. For example, in February 2001, Amazon.com, the online retailer, had to deny that it was facing a liquidity crisis. “The company has never been in better shape,” chief executive Jeff Bezos was quoted as saying. The company indeed survived and prospered, but at least one Amazon supplier said that it had limited the amount of business it does with Ama-zon. Limiting business with a retailer is a typical fi rst step for a creditor trying to protect itself from loss. Other techniques include shortening the terms under which a creditor will extend credit, or even asking for cash in advance.

If a company cannot convert its assets into cash quickly enough, the result is the third and most serious type of failure, insolvency bankruptcy. Insolvency occurs when a fi rm’s liabilities exceed the fair market value of its assets. Because the fi rm’s assets equal the sum of its liabilities and stockholders’ equity, the only way a fi rm that has more liabilities than assets can balance its balance sheet is to have a nega-tive stockholders’ equity. This means that the claims of creditors cannot be satis-fi ed unless the fi rm’s assets can be liquidated for more than their book value.

Although an insolvent fi rm is often said to be “bankrupt,” bankruptcy techni-cally occurs only when a company enters bankruptcy court and effectively surren-ders control of the fi rm to a bankruptcy judge. The failing fi rm may fi le for bank-ruptcy protection itself, or it may be forced into bankruptcy court (under certain conditions, discussed later in this chapter) by its creditors.

Table 22.1 shows the largest bankruptcies in U.S. history through July 22, 2007. The largest U.S. bankruptcy was that of WorldCom followed very closely on the

liquidity crisis A fi rm is unable to pay its liabilities as they come due because assets cannot be converted into cash within a reasonable period of time.

liquidity crisis A fi rm is unable to pay its liabilities as they come due because assets cannot be converted into cash within a reasonable period of time.

insolvency bankruptcy A fi rm’s liabilities exceed the fair market value of its assets.

insolvency bankruptcy A fi rm’s liabilities exceed the fair market value of its assets.

bankruptcy Occurs only when a com-pany enters bankruptcy court and eff ectively surrenders control of the fi rm to a bankruptcy judge.

bankruptcy Occurs only when a com-pany enters bankruptcy court and eff ectively surrenders control of the fi rm to a bankruptcy judge.

Total Assets,Company Bankruptcy Date Prebankruptcy

WorldCom July 21, 2002 $103,914,000,000Enron Corp. December 2, 2001 63,392,000,000Conseco December 18, 2002 61,392,000,000Texaco, Inc. April 12, 1987 35,892,000,000Financial Corp. of America September 9, 1988 33,864,000,000Refco Inc. October 5, 2005 33,333,172,000Global Crossing Ltd. January 28, 2002 30,185,000,000Pacifi c Gas and Electric Co. April 6, 2001 29,770,000,000Calpine Corporation December 20, 2005 27,216,000,000New Century Financial Corporation April 2, 2007 26,147,090,000UAL Corporation December 9, 2002 25,197,000,000Delta Air Lines, Inc. September 14, 2005 21,801,000,000Adelphia Communications June 25, 2002 21,499,000,000MCorp March 31, 1989 20,228,000,000Mirant Corporation July 14, 2003 19,415,000,000Delphi Corporation October 8, 2005 16,593,000,000First Executive Corp. May 13, 1991 15,193,000,000Gibraltar Financial Corporation February 8, 1990 15,011,000,000Kmart Corporation January 22, 2002 14,600,000,000FINOVA Group, Inc. March 7, 2001 14,050,000,000Northwest Airlines Corporation September, 2005 14,042,000,000

Table 22.1 Largest Bankruptcies in U.S. History as of July 22, 2007

Source: Bankruptcy.com, July 22, 2007 (http://www.bankruptcydata.com).



heels of Enron’s massive bankruptcy, the second largest in American history, and was followed only fi ve months later by Conseco’s bankruptcy, the third largest in U.S. history. The three largest bankruptcies in American fi nancial history oc-curred within twelve months of each other and involved over $228 billion worth of prebankruptcy assets. Globally, in December 2003, a massive scandal involv-ing forged documents and fi ctitious cash accounts in the Cayman Islands forced the Italian milk company Parmalat into bankruptcy and landed key company executives in an Italian jail. Although Parmalat’s accounts are still being un-wound, it appears that this may well become the single largest bankruptcy in world fi nancial history. In June 2007, Bank of America went on trial in Italy over the role it allegedly played in deceiving Parmalat’s investors. Clearly, the early years of the twenty-fi rst century were interesting times for bankruptcy courts around the world.

22-1b Major Causes of Business FailureFinancial distress is the primary cause of business failure (as briefl y discussed in Chapter 12). This, in turn, is often the result of mismanagement, which accounts for more than 50 percent of all business failures. Numerous specifi c managerial faults can cause the fi rm to fail. Overexpansion, poor fi nancial actions, an ineffec-tive sales force, and high production costs can all singly or in combination cause the ultimate failure of the fi rm. For example, poor fi nancial actions include bad capital budgeting decisions based on unrealistic sales and cost forecasts, failure to identify all relevant cash fl ows, failure to assess risk properly, inadequate fi nancial evaluation of the fi rm’s strategic plans prior to making fi nancial commitments, inconsistent or inadequate cash fl ow planning, and failure to control receivables and inventories. Because all major corporate decisions are eventually measured in terms of dollars, the fi nancial manager may play a crucial role in avoiding or caus-ing a business failure. One of the fi nancial manager’s key duties must therefore be to monitor the fi rm’s fi nancial pulse.

Economic activity can contribute to the failure of a fi rm, especially during economic downturns. The success of some fi rms runs countercyclical to eco-nomic activity, whereas other fi rms are unaffected by economic activity. For ex-ample, sewing machine sales are likely to increase during a recession because people are more willing to make their own clothes and less willing to pay for the labor of others. The sale of boats and other luxury items may decline during a re-cession, whereas sales of staple items, such as electricity, are likely to be unaf-fected. In terms of beta, the measure of nondiversifi able risk, a stock with a nega-tive beta would be associated with a fi rm whose behavior is generally countercyclical to economic activity.

However, the fortunes of most fi rms are positively tied to the business cycle, so bankruptcy fi lings always spike upward during economic contractions. If the economy goes into a recession, sales may decrease abruptly, leaving the fi rm with high fi xed costs and insuffi cient revenues to cover them. In addition, rapid rises in interest rates just prior to a recession can further contribute to cash fl ow problems and make it more diffi cult for the fi rm to obtain and maintain needed fi nancing. If the recession is prolonged, the likelihood of survival decreases even further. A number of major business failures during 2001 and 2002, such as those of the FINOVA Group and Reliance Group Holdings, resulted from overexpan-sion and the recessionary economy. But the bankruptcy of Pacifi c Gas and Elec-tric in 2001 directly resulted from policies enacted during a fl awed deregulation



of California’s electricity market during the mid-1990s. Several other extremely large bankruptcies occurred during the 2001-02 period, including those of Adelphia, Global Crossing, Qwest Communications, and, of course, WorldCom, Enron, and Conseco. However, 3 (Refco Inc., Calpine Corporation, and Delta Air Lines) of the 12 largest bankruptcies in U.S. fi nancial history occurred during 2005, an otherwise extremely prosperous year.

A fi nal cause of business failure is corporate maturity. Firms, like individuals, do not have infi nite lives. Like a product, a fi rm goes through the stages of birth, growth, maturity, and eventual decline. The fi rm’s management should attempt to prolong the growth stage through research, the development of new products, and mergers. Once the fi rm has matured and has begun to decline, it should seek to be acquired by another fi rm or liquidate before it fails. Effective management planning should help the fi rm postpone decline and ultimate failure.

Polaroid is an example of a company that has failed because of corporate maturity. Almost a decade ago, digital photography brought with it distant warnings of the demise of instant photography. Before long, computer chips would capture and store images and instant, self-developing fi lm would disappear. That prediction came true most recently in the form of Pola-roid’s insolvency. The company, which dominated the instant photography business for years, fi led for Chapter 11 bankruptcy protection (discussed later) on October 12, 2001. The stock price had fallen from nearly $50 per share in 1998 to 28 cents on October 11. Polaroid, it turns out, was unable to change with the times.

The company’s troubles date back to the late 1980s when it went deeply into debt to fi ght off a hostile takeover bid. A string of strategic errors followed, including its failure to anticipate how much digital photography would cut into its instant fi lm business. The company’s latest generation of instant cameras has fallen fl at because digital cameras for consumers are just as instant and much more versatile. Although the company tried to reorganize its debts and con-tinue operating, this strategy failed and the fi rm’s remaining assets were purchased by an in-vestment group associated with Bank One of Ohio in an auction conducted by the bankruptcy court in July 2002. As often occurs in bankruptcies, Polaroid’s shareholders (including employ-ees) were eff ectively wiped out by the failed reorganization, and litigation by unsecured credi-tors against the investment group that acquired the renamed Primary PDC, Inc. was not settled until April 2004. Polaroid’s unfunded pension liabilities were taken over by the federal government.

Sometimes the cause of a business failure is diffi cult to anticipate and can hap-pen quite suddenly in response to an economic or political event. For example, ANC Rental Corp., the owner of the Alamo and National car rental chains, fi led for Chapter 11 bankruptcy protection on November 13, 2001, as the downturn in the travel sector worsened the company’s troubles. ANC claims to have been the hardest-hit car rental company after the September 11 terrorist attacks, mainly be-cause most of its rental offi ces were at airports. “The drastic decline in travel after September 11 has taken a tremendous toll on our business, and our current capital and expense structure cannot absorb the shortfall,” CEO Michael Egan was quoted as saying. ANC, which listed assets of nearly $6.5 billion, estimated it had more than 1,000 creditors at the time of its fi ling.



As it happens, ANC’s trip through Chapter 11 bankruptcy was quite successful. The company was auctioned to a private investment group in June 2003 and exited the bankruptcy court’s protection shortly thereafter. Renamed Vanguard Car Rental, the company announced plans to expand its operations in an effort to dou-ble its share of the car rental market back to the 4.5 percent level achieved in mid-2001. The company was so successful that it was acquired by the North American market leader, Enterprise Rent-A-Car, in April 2007.

22-1

Are the occurrence of operating losses, technical in-solvency, and bankruptcy independent, or are they likely to be related?

Why do the managers of a business allow its condi-tion to deteriorate to the point where bankruptcy occurs? Why don’t the shareholders intervene?

1.

2.

Explain how business failures help the economy overall.

3.

When a fi rm becomes technically insolvent or bankrupt, it may arrange a voluntary settlement or workout with its creditors, which enables it to bypass many of the costs involved in legal bankruptcy proceedings. The debtor fi rm usu-ally initiates the settlement, because such an arrangement may enable it to con-tinue to exist or to be liquidated in a manner that gives the owners the greatest chance of recovering part of their investment. The debtor, possibly with the aid of a key creditor, arranges a meeting between itself and all its creditors. At the meet-ing, a committee of creditors is selected to investigate and analyze the debtor’s sit-uation and recommend a plan of action. The committee discusses its recommenda-tions with both the debtor and the creditors and draws up a plan for sustaining or liquidating the fi rm.

22-2a Voluntary ReorganizationGenerally, the rationale for sustaining a fi rm is that it is reasonable to believe that the fi rm’s recovery is feasible. By sustaining the fi rm, the creditor can continue to receive business from it. A number of strategies are commonly used to imple-ment a voluntary reorganization. An extension is an arrangement wherein the fi rm’s creditors are promised payment in full, although not immediately. Usually, when creditors grant an extension, they require the fi rm to make cash payments for purchases until all past debts have been paid. By now, you will probably rec-ognize this as another example where the “marginal benefi ts equal or exceed marginal costs” decision rule will apply to managerial decision-making. Creditors

22-2 Voluntary Settlements22-2 Voluntary Settlements

voluntary settlement A fi rm that becomes technically insolvent or bankrupt may make an arrangement with its creditors that enables it to bypass many of the costs involved in legal bankruptcy proceedings.

voluntary settlement A fi rm that becomes technically insolvent or bankrupt may make an arrangement with its creditors that enables it to bypass many of the costs involved in legal bankruptcy proceedings.

workout A fi rm that becomes technically insolvent or bankrupt may make an arrangement with its creditors that enables it to bypass many of the costs involved in legal bankruptcy proceedings.

workout A fi rm that becomes technically insolvent or bankrupt may make an arrangement with its creditors that enables it to bypass many of the costs involved in legal bankruptcy proceedings.

voluntary reorganization A strategy that sustains a fi rm so that the creditor can continue to receive business from it.

voluntary reorganization A strategy that sustains a fi rm so that the creditor can continue to receive business from it.

extension An arrangement wherein a fi rm’s creditors are promised payment in full, although not immediately.

extension An arrangement wherein a fi rm’s creditors are promised payment in full, although not immediately.



will agree to a voluntary reorganization, rather than pushing for a formal bankruptcy fi ling, if the expected payoff (net of transactions costs) from volun-tary negotiations is higher than the expected payoff after legal bankruptcy proceedings.

A second arrangement, called a composition, is a pro rata cash settlement of creditor claims. Instead of receiving full payment for their claims, as in the case of an extension, creditors receive only a partial payment. A uniform percentage of each dollar owed is paid in satisfaction of each creditor’s claim.

A third arrangement is creditor control. In this case, the creditor committee may decide that replacing the operating management is the only feasible way to maintain the fi rm. The committee may then take control of the fi rm and op-erate it until all claims have been settled. Sometimes, a plan involving some combination of extension, composition, and creditor control will result. An ex-ample of this would be a settlement whereby the debtor agrees to pay a total of 75 cents on the dollar in three annual installments of 25 cents on the dollar. The creditors also agree to sell additional merchandise to the fi rm on thirty-day terms, if a new management team that is acceptable to them replaces the existing managers.

22-2b Voluntary LiquidationAfter the creditor committee has investigated the fi rm’s situation, made recom-mendations, and held talks with the creditors and the debtor, the only acceptable course of action may be to liquidate the fi rm. Liquidation involves winding up the fi rm’s operations, selling off its assets, and distributing the proceeds to creditors. Liquidation can be carried out in two ways, privately or through the legal proce-dures provided by bankruptcy law. If the debtor fi rm is willing to accept liquida-tion, legal procedures may not be required. Generally, avoiding litigation enables the creditors to obtain quicker and higher settlements. However, all the creditors must agree to a private liquidation for it to be feasible.

The objective of the voluntary liquidation process is to recover as much per dollar owed as possible. Under voluntary liquidation, common stockholders, who are the fi rm’s true owners, cannot receive any funds until the claims of all other parties have been satisfi ed. A common procedure is a creditors meeting at which they make an assignment by passing the power to liquidate the fi rm’s as-sets to an adjustment bureau, a trade association, or a third party that is desig-nated the assignee. The assignee’s job is to liquidate the assets, obtaining the best price possible. The assignee is sometimes referred to as trustee, because it is en-trusted with the title to the company’s assets and the responsibility to liquidate them effi ciently. Once the trustee has liquidated the assets, it distributes the re-covered funds to the creditors and owners (if any funds remain for the owners). The fi nal action in a private liquidation is for the creditors to sign a release attest-ing to the satisfactory settlement of their claims. If a voluntary settlement for a failed fi rm cannot be agreed upon, the creditors can force the fi rm into bank-ruptcy. Because of bankruptcy proceedings, the fi rm may be either reorganized or liquidated.

An alternative to liquidation of the fi rm is for it to be acquired. Merger with a fi -nancially sound company may allow the fi rm suffering from fi nancial distress to return to profi tability and continue as a going concern.

composition A pro rata cash settle-ment of creditor claims.

composition A pro rata cash settle-ment of creditor claims.

creditor control The creditor committee takes control of the fi rm and operates it until all claims have been settled.

creditor control The creditor committee takes control of the fi rm and operates it until all claims have been settled.

liquidation Winding up a fi rm’s operations, selling off its assets, and distributing the proceeds to creditors.

liquidation Winding up a fi rm’s operations, selling off its assets, and distributing the proceeds to creditors.

assignment An agreement of the creditors by which they pass the power to liquidate the fi rm’s assets to an adjustment bureau, a trade associa-tion, or a third party.

assignment An agreement of the creditors by which they pass the power to liquidate the fi rm’s assets to an adjustment bureau, a trade associa-tion, or a third party.

trustee In bankruptcy, someone appointed by a judge to replace a fi rm’s current management team and to oversee liquidation or reorganization.

trustee In bankruptcy, someone appointed by a judge to replace a fi rm’s current management team and to oversee liquidation or reorganization.



As already stated, bankruptcy in the legal sense occurs when the fi rm cannot pay its bills or when its liabilities exceed the fair market value of its assets and the fi rm is forced into bankruptcy court. In either of these situations, a fi rm may be declared legally bankrupt. However, creditors generally attempt to avoid forcing a fi rm into bankruptcy if it appears to have opportunities for future success.

The governing bankruptcy legislation in the United States today is the Bank-ruptcy Reform Act of 1978, which signifi cantly modifi ed earlier bankruptcy legislation. This law contains eight odd-numbered (1 through 15) and one even-numbered (12) chapters. Several of these chapters would apply in the instance of failure; the two key ones are Chapters 7 and 11.

Chapter 7 of the Bankruptcy Reform Act of 1978 details the procedures for liqui-dating a failed fi rm. This chapter typically comes into play once it has been deter-mined that a fair, equitable, and feasible basis for the reorganization of a failed fi rm does not exist (although a fi rm may of its own accord choose not to reorganize and may instead go directly into liquidation). Chapter 7 includes the rules, known as absolute priority rules (APR), that determine the order in which creditor claims are to be paid. As described in detail in Section 22.5, the APR specify which claimants are to be paid fi rst, and in full, before any payments can be made to more junior claimants.

Chapter 11 outlines the procedures for reorganizing a failed or failing fi rm, whether its petition is fi led voluntarily or involuntarily. If a workable reorganiza-tion plan cannot be developed, the fi rm will be liquidated under Chapter 7. Table 22.2 shows how the total number of U.S. corporate bankruptcies was di-vided between Chapter 7 and Chapter 11 fi lings for the period from 1980 to March 2007. The table shows that there were a total of 1,112,542 bankruptcy fi lings in the United States during fi scal year 2006 (ending September 30, 2006) and an annual-ized total of 742,480 based on the fi rst half of fi scal year 2007. Both totals are down very sharply from 2005’s record 1,782,643 fi lings. The 2006 fi lings consisted of 27,333 business failures and 1,085,209 nonbusiness (mostly personal) bankrupt-cies. Keep in mind that the total population of the United States was about 300 million in 2006, so roughly one-half percent of all American adults fi led for bank-ruptcy in that year alone! Still, this is a massive reduction from the number of per-sonal bankruptcies during 2005, which was infl ated by a huge surge in fi lings

Bankruptcy Reform Act of 1978 The governing bank-ruptcy legislation in the United States today.

Bankruptcy Reform Act of 1978 The governing bank-ruptcy legislation in the United States today.

Chapter 7 Section of the Bank-ruptcy Reform Act of 1978 that details the pro-cedures to be followed when liquidating a failed fi rm.

Chapter 7 Section of the Bank-ruptcy Reform Act of 1978 that details the pro-cedures to be followed when liquidating a failed fi rm.

absolute priority rules (APR) Rules contained in Chapter 7 of the Bankruptcy Reform Act of 1978 that specify the procedure by which secured creditors are paid fi rst, then unse-cured creditors, then preferred shareholders, and fi nally common stockholders.

absolute priority rules (APR) Rules contained in Chapter 7 of the Bankruptcy Reform Act of 1978 that specify the procedure by which secured creditors are paid fi rst, then unse-cured creditors, then preferred shareholders, and fi nally common stockholders.

Chapter 11 Section of the Bank-ruptcy Reform Act of 1978 that outlines the procedures for reorgan-izing a failed or failing fi rm, whether its petition is fi led voluntarily or involuntarily.

Chapter 11 Section of the Bank-ruptcy Reform Act of 1978 that outlines the procedures for reorgan-izing a failed or failing fi rm, whether its petition is fi led voluntarily or involuntarily.

22-3 Bankruptcy Law in the United States

22-2

If you were a supplier and creditor to a company that had undergone a voluntary reorganization, would you continue to do business with the com-pany?If you were a creditor of a company that was un-dergoing a voluntary reorganization, what would

4.

5.

be the advantages and disadvantages from your perspective of handling it as an extension, com-position, or creditor control?Why would a firm’s shareholders agree to a volun-tary liquidation if the business had a negative net worth, and they could expect to receive nothing?

6.



Table 22.2 Business and Non-business Bankruptcy Cases Filed in U.S. Bankruptcy Courts, by Chapter of the Bankruptcy Code, 1980–2007

Fiscal YearaTotal

FilingsBusiness Filings Non-business Filings

Chapter 7 Chapter 11 Total Chapter 7

1980 298,492 30,402 5,333 259,160 194,4911981 362,233 34,356 7,795 315,250 230,1391982 373,853 41,863 14,696 310,330 219,9301983 362,051 39,573 17,608 297,835 203,0961984 346,500 38,649 17,396 283,618 196,5411985 383,510 41,838 19,864 314,378 216,0901986 507,557 48,976 21,110 429,334 307,9721987 568,430 49,471 18,333 482,300 353,0871988 604,759 39,803 16,025 538,636 391,4281989 656,980 27,228 15,703 595,511 427,1471990 749,981 36,687 17,789 685,429 484,6711991 918,988 38,705 20,394 848,812 599,7991992 977,478 38,467 20,070 905,753 646,3991993 897,231 35,807 17,068 832,374 585,2641994 837,797 30,781 13,379 783,372 541,1901995 883,457 28,800 11,168 832,415 569,4501996 1,111,964 30,289 11,358 1,058,444 731,3631997 1,367,364 31,862 10,092 1,313,112 926,1831998 1,436,964 29,229 7,884 1,389,839 996,9051999 1,354,376 23,499 8,238 1,315,751 935,7922000 1,262,102 20,687 9,135 1,226,037 850,1182001 1,437,354 22,800 9,787 1,398,860 991,3372002 1,547,669 22,574 10,702 1,508,578 1,061,7622003 1,661,996 21,008 9,185 1,625,813 1,156,2842004 1,618,987 20,243 9,436 1,584,170 1,133,6222005 1,782,643 23,313 5,776 1,748,421 1,322,8882006 1,112,542 18,258 5,345 1,085,209 814,8892007b 742,480 15,276 4,906 718,748 424,966

a The fi scal year end runs through September 30.b Annualized, based on fi rst two quarters of FY 2007 (October 1, 2006 through March 31, 2007).

Chapter 7: “Straight Bankruptcy”—LiquidationChapter 11: Reorganization

Source: United States Bankruptcy Courts (http://www.uscourts.gov/bnkrpctystats/statistics.htm)

during early September. This surge was prompted by a desire to fi le before the more stringent terms of the Bankruptcy Abuse Prevention and Consumer Protec-tion Act of 2005 came into effect. While this law did not fundamentally change bankruptcy procedures and has had a minimal effect on business fi lings, it did make personal bankruptcy signifi cantly more punitive.

When a company fi les either to reorganize or liquidate in bankruptcy, a col-lective legal procedure begins by which all claims against the company are



resolved. When a fi rm declares bankruptcy, individual creditors are prevented (stayed) from beginning or continuing with lawsuits against the debtor. Thus, bankruptcy law is substituted for the commercial and tax laws that normally govern fi rms.

Without a collective procedure, individual creditors would engage in a costly and unproductive race to be fi rst to sue the company for repayment of their own claims. Creditors that sued fi rst would be paid in full until the fi rm’s resources were exhausted, after which other creditors would receive nothing. Both the creditors’ duplicative expenses and the costs of the lawsuits themselves would consume assets. Bankruptcy eliminates the benefi t of being the fi rst to sue because all claims against the fi rm are settled simultaneously, and all creditors having

Like many students, you may well graduate from col-lege and begin your working career heavily bur-dened with personal debt. You may also then add to the existing burdens of student loans and credit card debts by purchasing a new wardrobe, a new car, and perhaps even a new home on credit as you settle into a new job. But what happens if you lose your job, are struck by a major illness that runs up large uninsured medical bills, or become responsible for caring for an invalid parent (three of the most common causes of fi nancial distress)? Would fi ling for personal bankruptcy be a possible solution for your debt problems?

Yes and no. As Table 22.2 shows, roughly three-quarters of a million Americans will likely fi le for per-sonal bankruptcy during 2007 alone, with about 425,000 fi ling under Chapter 7 of the Bankruptcy Code (liquidation of assets) and most of the remain-der fi ling under Chapter 13 (rehabilitation with a pay-ment plan). As implied, if a Chapter 7 fi ling is accepted, the bankruptcy judge will order that all the applicant’s assets be converted into cash and distributed to his or her creditors, after which the judge will issue a dis-charge of debt order. In a Chapter 13 fi ling, the appli-cant’s debts are reorganized and (usually) partially expunged, but a plan of repayment is then set up for the borrower to repay his or her creditors the remain-ing debt. After this order is issued, creditors cannot demand more complete, speedier, or preferential re-payment of the debtor’s liabilities to them. Perhaps

surprisingly, employers are not allowed to discrimi-nate against workers based upon their personal in-debtedness or even if they have fi led for bankruptcy, though as a practical matter, employers often do dis-criminate against bankrupts when making new hires.

The actual eff ect of bankruptcy on any specifi c debtor depends to a large extent upon where he or she lives. While the U.S constitution explicitly gives the federal government responsibility for establish-ing bankruptcy laws, the implementation of these laws gives the states wide discretion over the ad-ministration of personal bankruptcy and rules vary widely. In all states, the debtor is allowed to keep certain essential or “exempt” assets—such as work tools, vehicles, and, under certain conditions, equity in his or her primary residence—but some states are more generous to debtors than are others. In all cases, however, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) made it far more diffi cult for individuals who fi le after October 17, 2005 to use a personal bankruptcy fi ling to completely expunge their debts. And, since late 1998, student loans have been “non dischargea-ble,” regardless of the age of the loan, so bankruptcy cannot eliminate these debts. These loans can, how-ever, be discharged outside of bankruptcy if the bor-rower becomes disabled. The bad news, therefore, is that you are probably stuck with paying off your stu-dent loans in full whether you ever fi le for bank-ruptcy or not.

Sources: U.S. Bankruptcy Courts, “Bankruptcy Basics” (http://uscourts.gov/bankrutcycourts/bankruptcybasics.html); the Morgan Law Group, “Bankruptcy in Brief: Student Loans in Bankruptcy,” (http://www.moranlaw.net/studentloans.htm); and “Bankruptcy in the United States,” Wikipedia, the Free Encyclopedia (www.wikipedia.org/wiki/Bankruptcy_in_the_United States).

Is Personal Bankruptcy an Option for Reducing Debt?



On January 6, 2002, Argentina abandoned the decade-old parity between its currency and the U.S. dollar by devaluing the peso. “We are bankrupt,” ad-mitted Economy Minister Jorge Remes Lenicov when he announced the devaluation. The govern-ment also confi rmed that Argentina could not con-tinue servicing its $155 billion of foreign currency debt, and it declared a moratorium on payments. Because of the default, the price of Argentine bonds fell to about 25 percent of their par value.

Argentina’s creditors braced themselves for a long fi ght for their money. The Argentine bondhold-ers formed a committee in November 2001 to com-municate some of the large investors’ views to the Argentine government. The committee included in-vestment banks that began to pay out on credit- default swaps, derivative securities that guarantee payment should a borrower default. The default swaps total almost $4 billion, and the investment banks soon owned the bonds returned to them under the terms of the swaps.

The questions for bondholders were how vigor-ously should they react and how quickly should they call their lawyers? The announcement of a default meant that bondholders could “accelerate” their claims by demanding immediate payment of all principal and interest from the debtor. However, ac-celeration was unlikely to result in prompt payment because, as the bondholders realized, Argentina hadserious problems. Most creditors fi gured they could receive more money by negotiation than by confrontation.

The repayment moratorium turned out to be very good for Argentina. Initially, the newly-elected government negotiated very aggressively with cred-itors and refused to make net payments to bond-holders (pay more in interest and principal than it receives in new loans). Within two years of declaring this moratorium, however, the world economy began growing very rapidly and Argentina began to enjoy export-fueled economic growth of more than 8 percent per year. By early 2005, the country had re-structured its debt to private bondholders, and one year later fully repaid its debt to the International Monetary Fund (IMF). By the summer of 2007, Argentina appeared ready to settle the last of its

outstanding claims—those with offi cial (govern-ment) creditors. Furthermore, while the fallout from its chaotic 2002 default still prevented Argentina from borrowing on international capital markets in 2007, the country was able to sell large amounts of new debt to international investors on its domestic capital markets.

Although Argentina was ultimately able to work its way out of economic distress, many other coun-tries will surely face payments diffi culties once the world economy slows. Thus the question remains: How should excessively indebted sovereign borrow-ers be dealt with when they cannot continue servic-ing their debts? Whereas companies can declare bankruptcy and seek protection from their creditors, countries have no such option. They are faced with the bleak choice between bailouts and chaotic defaults. However, that could change. The IMF has suggested that a country whose debts are “truly un-sustainable” should have a mechanism for restruc-turing them, in the same way that companies can fi le for bankruptcy protection and reorganize their obligations.

The idea is that a country in fi nancial distress would get temporary legal protection when it stopped making payments on its debt. In return, it would have to promise to negotiate with its credi-tors in good faith. Lenders would get an incentive to provide new “working capital” by giving new debt seniority over old. Also, small creditors would have to go along with the reorganization plan if enough creditors agreed.

Sovereign bankruptcy is appealing because it might eliminate the need for IMF bailouts while avoiding the legal quagmire of unilateral default. Both creditors and debtors would benefi t from clear rules about the procedure for debt restructuring, if the rules balanced the rights of debtors and creditors.

Previous proposals on sovereign bankruptcy have failed, in part, because the details are diffi cult to work out. Who, for instance, will act as the impar-tial judge? Also, how do you force a debtor country to negotiate in good faith? After all, countries can-not be threatened with liquidation or a forcible change in “management.”

If Companies Can Declare Bankruptcy; Why Not Countries?

the same type of claim receive the same settlement. Although there is still an incentive for creditors to attempt to sue the fi rm fi rst, the incentive is diminished because a large number of suits will cause the fi rm to enter bankruptcy voluntarily.



A company’s managers typically make the initial decision to attempt to reorganize their fi rm under the protection of Chapter 11 of the bankruptcy laws. The reorga-nization process in bankruptcy is designed to allow businesses that are in tempo-rary fi nancial distress, but are worth saving, to continue operating while the claims of creditors are settled using a collective procedure. A disadvantage of this proce-dure is that the managers of the company, and not an outside party, make the deci-sion to fi le under Chapter 11. Thus, managers have an incentive to choose the bankruptcy procedure that is best for themselves and for equity holders and not the fi rm’s creditors. This sometimes results in fi rms being reorganized that are not worth saving because of a lack of economic effi ciency. Thus, a problem with reorganization is that even though it may allow some effi cient fi rms to continue operating that would otherwise be liquidated, it is also likely to allow some eco-nomically ineffi cient fi rms to be saved.

22-4a Reorganization ProceduresThe procedures for initiation and execution of corporate reorganization under Chapter 11 entail fi ve separate steps: fi ling, appointment, development and ap-proval of a reorganization plan, acceptance of the plan, and payment of expenses.

Filing. A fi rm must fi le a reorganization petition under Chapter 11 in a federal bankruptcy court. There are two basic types of bankruptcy reorganization peti-tions: voluntary and involuntary. Any fi rm that is not a municipal or fi nancial in-stitution can voluntarily fi le a petition for reorganization on its own behalf. Firms sometimes fi le a voluntary petition to obtain temporary legal protection from cred-itors or from prolonged litigation. Once they have straightened out their legal or fi nancial affairs, prior to further reorganization or liquidation actions, they will have the petition dismissed. Although such actions are not the intent of the bank-ruptcy laws, diffi culty in enforcing the law has allowed this abuse to occur.

An outside party, usually a creditor, initiates involuntary reorganization. An involuntary petition against a fi rm can be fi led if one of three conditions is met:

1. The fi rm has past-due debts of $5,000 or more.2. Three or more creditors can prove that they have aggregate unpaid claims of

$5,000 against the fi rm. If the fi rm has fewer than twelve creditors, any creditor that is owed more than $5,000 can fi le the petition.

3. The fi rm is insolvent, which means that (a) it is not paying its debts as they come due, (b) within the immediately preceding 120 days a custodian

22-4 Reorganization in Bankruptcy22-4 Reorganization in Bankruptcy

reorganization The process in bank-ruptcy designed to allow businesses that are in temporary fi nancial distress but are worth saving to continue operating while the claims of creditors are settled using a collective procedure.

reorganization The process in bank-ruptcy designed to allow businesses that are in temporary fi nancial distress but are worth saving to continue operating while the claims of creditors are settled using a collective procedure.

involuntary reorganization A reorganization initiated by an outside party, usually a creditor.

involuntary reorganization A reorganization initiated by an outside party, usually a creditor.

insolvent A fi rm is insolvent when (a) it is not paying its debts as they come due; (b) within the immedi-ately preceding 120 days a custodian (a third party) was appointed or took possession of the debtor’s property; or (c) the fair market value of its assets is less than the stated value of its liabilities.

insolvent A fi rm is insolvent when (a) it is not paying its debts as they come due; (b) within the immedi-ately preceding 120 days a custodian (a third party) was appointed or took possession of the debtor’s property; or (c) the fair market value of its assets is less than the stated value of its liabilities.

22-3

Why are bankruptcy laws necessary? Why is normal contracting under commercial law insuffi cient?

How does society benefi t by allowing fi rms to declare bankruptcy?

7.

8.

Why is it important that bankruptcy law eliminate the incentive for creditors to be the fi rst to sue for repayment of claims?

9.



(a third party) was appointed or took possession of the debtor’s property, or (c) the fair market value of the fi rm’s assets is less than the stated value of its liabilities.

If the debtor challenges an involuntary petition, a hearing must be held to de-termine whether the fi rm is insolvent. If it is, the court enters an “Order for Relief” that formally initiates the process.

Appointment. Upon the fi ling of a reorganization petition, the fi ling fi rm be-comes the debtor in possession (DIP) of the assets, and its existing management usually remains in control. However, one or more creditors’ committees are ap-pointed to represent the interests of creditors.

If the creditors object to the fi ling fi rm being the debtor in possession, they can petition the bankruptcy court to appoint a trustee to replace management. How-ever, the incompetence of the existing management, which is strongly suggested by the fact that the fi rm is in bankruptcy, is not considered a suffi cient reason for replacing management. To replace existing management, the creditors usually must present evidence that the management is making preferential transfers to favored creditors or stealing the company’s assets.

Because reorganization activities are largely in the hands of the DIP, it is useful to understand the DIP’s responsibilities. The DIP’s fi rst responsibility is the valua-tion of the fi rm to determine whether reorganization is appropriate. To do this, the DIP must estimate both the liquidation value of the business and its value as a going concern. If the DIP fi nds that its value as a going concern is less than its liq-uidation value, it will recommend liquidation. If the opposite is true, the DIP will recommend reorganization. If the DIP recommends reorganization of the fi rm, a plan of reorganization must be drawn up.

Perhaps surprisingly, many companies are able to arrange debtor-in-possession fi nancing from commercial banks and other lenders immediately after fi ling for reorganization. They are able to do this because the bankruptcy judge grants these loans super-priority status, and the economic justifi cation for allowing this type of fi nancing is that the fi rm must have ongoing access to business credit to continue operating while it tries to reorganize. Delphi arranged this type of funding soon after fi ling for Chapter 11, when a group of lenders led by Citigroup (a leading DIP fi nancier) and JP Morgan Chase committed up to $2 billion in secured DIP fi nancing.

Reorganization Plan. After reviewing its situation, the debtor in possession submits a plan of reorganization to the court and fi les the plan and a disclosure statement summarizing the plan. A hearing is held to determine whether the plan is fair, equitable, and feasible, and whether the disclosure statement contains adequate information. The court’s approval or disapproval is based on its evaluation of the plan in light of these standards. A plan is considered fair and equitable if it main-tains the priorities of the contractual claims of the creditors, preferred stockholders, and common stockholders. The court must also fi nd the reorganization plan feasible, meaning that it must be workable. The reorganized corporation must have suffi -cient working capital, suffi cient funds to cover fi xed charges, suffi cient credit pros-pects, and suffi cient ability to retire or refund debts as proposed by the plan.

The key portion of the reorganization plan generally concerns the fi rm’s capital structure. Because most fi rms’ fi nancial diffi culties result from high fi xed charges, the company’s capital structure is generally recapitalized, or altered, to reduce these charges. Under recapitalization, debts are generally exchanged for equity or the maturities of existing debts are extended. The DIP, when recapitalizing

debtor in possession (DIP) The fi rm fi ling a reorganization petition.

debtor in possession (DIP) The fi rm fi ling a reorganization petition.

recapitalization Alteration of a compa-ny’s capital structure to reduce high fi xed charges.

recapitalization Alteration of a compa-ny’s capital structure to reduce high fi xed charges.



the fi rm, places a great deal of emphasis on building a mix of debt and equity that will allow the fi rm to meet its debts and provide a reasonable level of earnings for its owners.

Once the optimal capital structure has been determined, the DIP must estab-lish a plan for exchanging outstanding obligations for new securities. The guid-ing principle is to observe priorities. Senior claims are those with higher legal priority that must be satisfi ed in full before junior claims receive any payment. To comply with this principle, senior suppliers of capital must receive a claim on new capital equal to their previous claim. The common stockholders are the last to receive any new securities, and it is not unusual for them to receive nothing. Security holders do not necessarily have to receive the same type of security they held before; often they receive a combination of securities. Once the debtor in possession has determined the new capital structure and distribution of capital, it will submit the reorganization plan and disclosure statement to the court as described.

The DIP is in a strong bargaining position in negotiations over the reorganiza-tion plan. During the fi rst four months after the bankruptcy fi ling—plus any ex-tensions, which are often granted—managers have the exclusive right to propose a plan. Then an extra two months are allowed for voting on management’s plan. Only then, and only if no further extensions have been granted, can creditors pro-pose reorganization plans.

Acceptance of the Reorganization Plan. Once approved by the bankruptcy court, the plan and the disclosure statement are given to the fi rm’s creditors and shareholders for their acceptance. Under the Bankruptcy Reform Act, creditors and owners are separated into groups with similar types of claims. Intense bar-gaining and litigation often occur concerning the construction of the classes of creditors in a reorganization. Creditors that are in substantially the same position are placed in the same class to assure that they receive the same treatment under the reorganization plan. Creditors in different positions are placed in different classes. However, managers sometimes wish to prevent a particular creditor from defeating a reorganization plan. They accomplish this by arguing that the creditor should be part of a larger class in which the creditor’s opposition to the plan will be outvoted.

There are two procedures for instituting a reorganization plan: the unanimous consent procedure and the cramdown procedure. Under the unanimous consent procedure (UCP), creditors and equity classes must consent unanimously to the reorganization plan, although not all members of each class are required to con-sent. The UCP assumes that the company’s assets will be worth more if it reorga-nizes and continues operations than if it liquidates. This difference in value, which under the absolute priority rule (APR) of Chapter 7 would belong entirely to the creditors with senior claims, must be divided up among all the creditors and equity classes by means of a negotiating process, with all classes sharing the difference in value.

A company must be solvent to use the UCP. That is, the value of creditors’ claims must be less than the value of the company as a going concern. This implies that the fi rm’s existing equity has some value. If the existing equity is worthless, then the company is considered insolvent, and the UCP cannot be used because equity holders cannot consent to a reorganization plan that eliminates their interest. To make a fi rm appear solvent, reorganization plans sometimes use infl ated valuations

unanimous consent procedure (UCP) A reorganization plan instituted by consent of all creditors and equity classes.

unanimous consent procedure (UCP) A reorganization plan instituted by consent of all creditors and equity classes.



of the fi rm’s assets to make them appear to be worth more than the liabilities under the proposed plan.

Reorganization plans using the UCP must be approved by all classes of credi-tors and by equity as a class. Each class of unsecured creditors must vote for the plan by a two-thirds margin, weighing claims by value, and also by a simple ma-jority, weighing all claims equally. Each secured creditor is a class, and each must vote for the plan if its claims are impaired. (If its claims are not impaired, a secured creditor’s consent to the plan is not needed.) Because equity holders must vote for the plan by a two-thirds margin, reorganization plans under the UCP yield a dif-ferent division of the company’s value than would occur under the APR of a Chap-ter 7 liquidation. Under the UCP, every class, even the equity holders, must receive some value. Under the APR, the equity holders and junior creditors often receive nothing.

Managers can also threaten to transfer the fi rm’s bankruptcy fi ling from Chap-ter 11 to Chapter 7 if the creditors do not agree to a plan, a threat that is often effec-tive in prodding unsecured creditors to accept the plan, as they anticipate receiv-ing little or nothing if liquidation occurs. Managers also run the fi rm during the negotiating process, so secured creditors often fear that the value of their lien as-sets will decline. Finally, even after their exclusive period for proposing a reorga-nization plan ends, managers remain in a strong bargaining position. Individual creditors typically are unrepresented except in the largest cases, and severe free-rider problems arise when creditors attempt to form groups and raise funds to take an active part in bargaining.

The cramdown procedure is used when a reorganization plan fails to meet the standard for approval by all classes under the UCP or when the fi rm is clearly in-solvent and the existing equity has no value. In a cramdown, if at least one class of creditors has voted for a reorganization plan, the bankruptcy court can approve the plan without the consent of the other classes, as long as each dissenting class is treated fairly and equitably. The fair and equitable standard closely refl ects the APR by requiring either that all unsecured creditors receive full payment of their claims over the period of the plan or that all junior classes receive nothing. The cramdown procedure also requires that secured creditors retain their prebank-ruptcy liens on assets and that they receive periodic cash payments equal to the value of their claims. Cramdowns typically involve higher transaction costs than UCP reorganization plans because the bankruptcy judge often requires asset valu-ations by outside experts and more court hearings usually occur before the plan is approved.

When no reorganization plan is adopted under either the UCP or cramdown, managers sometimes voluntarily sell the fi rm as a going concern. In that case, the proceeds of the sale are paid to creditors according to the APR. This liquidating re-organization is similar to a Chapter 7 liquidation, except that the fi rm is sold as a going concern and is not shut down. Finally, if no progress is being made toward completion of a Chapter 11 reorganization, some creditor usually petitions the bankruptcy judge to order a shift of the fi rm’s bankruptcy fi ling to a Chapter 7 liquidation.

Payment of Expenses. After the reorganization plan has been approved or disapproved, all parties to the proceedings whose services were benefi cial or con-tributed to the approval or disapproval of the plan fi le a statement of expenses. If the court fi nds these claims acceptable, the debtor must pay these expenses within a reasonable period.

cramdown procedure Used when a reorganiza-tion plan fails to meet the standard for approval by all classes, but at least one class of creditors has voted for a reorganization plan; or when the fi rm is clearly insolvent and the existing equity has no value.

cramdown procedure Used when a reorganiza-tion plan fails to meet the standard for approval by all classes, but at least one class of creditors has voted for a reorganization plan; or when the fi rm is clearly insolvent and the existing equity has no value.



22-4b Subsidies to Firms That ReorganizeReorganization is viewed as a means of providing breathing space to viable fi rms that are in temporary fi nancial distress in order to save jobs and avoid disruption to local communities. In contrast, liquidation is viewed as the process of winding up the operation of fi rms that are not viable. Therefore, in order to make reorgani-zation attractive to managers and equity holders, Congress has provided a num-ber of subsidies to fi rms in reorganization. These subsidies come either from the government or from creditors. They give fi rms in reorganization advantages relative to fi rms that continue operating outside of bankruptcy and fi rms that liq-uidate. The six major subsidies are as follows:

1. When reorganizing fi rms settle liabilities for less than their face value, the amount of debt forgiveness is deducted as a loss by the creditor but is not im-mediately treated as taxable income to the reorganizing fi rm. The debt forgive-ness amount becomes taxable when the reorganized fi rm becomes profi table by reducing either its tax loss carryforward or its depreciation allowances.

2. Firms reorganizing under Chapter 11 have the right to terminate underfunded pension plans, and the U.S. government’s Pension Benefi t Guaranty Corporation (PBGC) picks up the uncovered pension costs. Unfortunately for American tax-payers, the PBGC has been forced to absorb huge liabilities recently, and its defi cit hit $23.3 billion during 2004. That was before including a record $6.6 billion of unfunded liabilities from UAL in April 2005, and similar losses resulting from the Chapter 11 reorganizations of Delphi, Delta, and Northwest. Congress acted to minimize the incentives for companies to under-fund their pension plans by pass-ing legislation in 2006 that levied higher PBGC premiums on fi rms with such plans.

3. Firms that reorganize retain most of their accrued tax loss carryforwards, which would be lost if they liquidated. These loss carryforwards shelter the fi rm from

Campbell Technologies, a telecommunications equipment manufacturer, has fi led Chapter 11 bankruptcy and is seeking to reorganize because it cannot service its debt. The company’s current capital structure is as follows:

Debentures (unsecured debt) $4,000,000Subordinated debentures 2,000,000Common stock (100,000 shares) 2,000,000 Total $8,000,000

The company’s book-value leverage is high, with a debt/equity ratio of 3.0 ($6,000,000/ $2,000,000). It has been determined that Campbell Technologies is worth $5 million as a going concern. The company can be reorganized as follows:

Debentures (unsecured debt) $2,000,000Subordinated debentures 1,000,000Common stock (200,000 shares) 2,000,000 Total $5,000,000

The face value of the debt is cut in half, but the debt holders receive 100,000 shares, or half of the company’s equity. The debt/equity ratio of Campbell Technologies is now a more reason-able 1.5 ($3,000,000/$2,000,000), and the company’s operating profi ts should be more than suffi cient to service the reduced debt burden.



paying taxes on corporate profi ts for a period in the future, if its operations start to be profi table. They also make reorganized fi rms attractive merger partners for prof-itable fi rms, because the profi table fi rm can use the tax loss carryforward immedi-ately. This subsidy makes reorganization more attractive than liquidation for a fail-ing fi rm but has no effect on the choice between reorganization and remaining out of bankruptcy.

4. When fi rms fi le for bankruptcy, their obligation to pay interest to prebankruptcy creditors, both secured and unsecured, ceases. They do not have to start paying interest again until a reorganization plan is approved, and the unpaid interest does not become a claim against the fi rm. This subsidy clearly gives managers of failing fi rms an incentive to fi le for bankruptcy earlier and to delay proposing a reorganization plan.

5. Firms in reorganization can reject any of their contracts that are not substan-tially completed. Thus, they can get out of any unprofi table contracts. Although fi rms are still liable for damages to other parties to rejected contracts, such dam-age claims are unsecured and likely to receive a low payoff rate. Thus, the cost to the fi rm of shedding unprofi table contracts is small.

6. Firms in reorganization can reject their collective bargaining labor agreements. Since 1984, however, this step has required the approval of the bankruptcy judge. This has particularly benefi ted unionized fi rms in industries that have a mixture of unionized and non-unionized establishments by enabling them to cut all wages to non-unionized levels. A prominent example is Continental Air-lines, which, following airline deregulation, fi led to reorganize in bankruptcy in 1983. Continental was allowed to cut wages by 50 percent and cut its workforce by 65 percent.

Although companies are no longer able to unilaterally revoke collective bargaining agree-ments after they fi le for bankruptcy protection, the supervising judges allows companies this fl exibility frequently enough that the companies are often able to win concessions from their unionized employees by threatening to fi le for bankruptcy. American Airlines used this tactic very successfully in April 2003, when it secured some $1.8 billion in annual cost savings from its eight principal unions by credibly threatening to fi le for Chapter 11 protection if the wage cuts were not approved. In the previous eight months, no less than three major North American air-lines had in fact fi led for bankruptcy protection. The second largest U.S. carrier, UAL Corpora-tion, fi led for Chapter 11 in December 2002, and seventh largest, US Airways, had fi led in August—though US Airways emerged from Chapter 7 a mere seven months later. Air Canada fi led for protection from creditors, in the Canadian bankruptcy courts, in early April 2003.

As it happened, all American Airlines’ stakeholders were fortunate that the company was able to avoid fi ling for bankruptcy. As the economy improved, travel picked up and American was able to return to an operating profi t by the end of 2003 (though net income was still nega-tive) without having to drastically cut employment levels. Most spectacularly, the parent com-pany’s (AMR Corporation) share price increased more than twelve-fold over the next four years, rising from a low of $3.08 in April 2003 to almost $41 in early 2007, before falling back to $29.59 per share in July 2007. By then, UAL, Delta, Northwest, and Air Canada had all emerged from bankruptcy, but American had cemented its leadership position in North American aviation.

22-4c Prepackaged BankruptciesSometimes companies prepare a reorganization plan that is negotiated and voted on by creditors and stockholders before the company actually fi les for Chapter 11



A bankrupt fi rm is usually liquidated once the courts have determined that reorganization is not feasible. The managers or creditors of the

bankrupt fi rm normally fi le a petition for reorganization. If no peti-tion is fi led, if a petition is fi led and denied, or if the reorganiza-tion plan is denied, the fi rm must be liquidated. Three important aspects of liquidation in bankruptcy are the procedures, the pri-ority of claims, and the fi nal accounting.

22-5a ProceduresWhen a fi rm is adjudged bankrupt, the judge may appoint a trustee to perform the many routine duties required in adminis-tering the bankruptcy. The trustee takes charge of the property

of the bankrupt fi rm and protects the interest of its creditors. Be-tween twenty and forty days after the fi rm has been adjudged

bankrupt, the creditors must hold a meeting. The bankruptcy court clerk presides over this meeting, during which the creditors are made

aware of the prospects for the liquidation. The trustee is then given the responsibility of liquidating the fi rm, keeping records, examining credi-

tors’ claims, disbursing money, furnishing information as required, and mak-ing fi nal reports on the liquidation. In essence, the trustee is responsible for the

22-5 Liquidation in Bankruptcy22-5 Liquidation in Bankruptcy

bankruptcy. This process, known as a prepackaged bankruptcy, shortens and sim-plifi es the process, saving the company money, and frequently generating more for the creditors as there is less spent in legal and related fees, less disruption to the company’s business, and less damage to its goodwill.

For example, Regal Cinemas, the largest U.S. movie theater chain, simultane-ously fi led a voluntary petition for Chapter 11 bankruptcy protection and a pre-packaged plan of reorganization on October 12, 2001. The reorganization plan gave effective control of the operation of 3,831 movie screens to Denver billionaire Philip Anschutz, who has used the theater industry’s misfortunes to gain control of two other chains, United Artists and Edwards. The reorganization plan gives Regal’s senior debt holders 100 percent of the reorganized company’s stock. As it turns out, Anschutz owns the majority of the senior debt, having bought it for pennies on the dollar from Regal’s bankers earlier in the year. Regal Cinemas emerged from bank-ruptcy in January 2002, an astonishingly short three months after fi ling!

prepackaged bankruptcy Companies prepare a reorganization plan that is negotiated and voted on by creditors and stockholders before the company actually fi les for Chapter 11 bankruptcy.

prepackaged bankruptcy Companies prepare a reorganization plan that is negotiated and voted on by creditors and stockholders before the company actually fi les for Chapter 11 bankruptcy.

22-4

Under what circumstances would it make sense for a company to reorganize rather than liquidate?

Why is the existing management generally allowed to remain in control when a company fi les for bankruptcy?

10.

11.

Why is a cramdown procedure sometimes neces-sary when a company reorganizes?

12.

Tom Cole, Deutsche Bank,

Leveraged Finance Group

“Obviously companies don’t want to

go bankrupt and obviously investors

don’t want to lose money.”

See the entire interview at



liquidation of the fi rm. Occasionally, the court will call subsequent creditor meet-ings, but only a fi nal meeting for closing the bankruptcy is required.

22-5b Priority of ClaimsThe trustee has the responsibility to liquidate all the fi rm’s assets and

to distribute the proceeds to the holders of provable claims. The courts have established certain procedures for determining the provability of claims, known as the absolute priority rules. The priority of claims, which is specifi ed in Chapter 7 of the Bank-ruptcy Reform Act, must be maintained by the trustee when dis-tributing the funds from liquidation. It is important to recognize that if in a liquidation any secured creditors have specifi c assets pledged as collateral, they receive the proceeds from the sale of those assets. If these proceeds are inadequate to meet their claim, the secured creditors become unsecured (or general) creditors for the unrecovered amount because specifi c collateral no longer

exists. These and all other unsecured creditors will divide up, on a pro rata basis, any funds remaining after all prior claims have

been satisfi ed. If the proceeds from the sale of secured assets are in excess of the claims against them, the excess funds become available

to meet claims of unsecured creditors. The complete order of priority of claims is as follows:

1. The expenses of administering the bankruptcy proceedings.2. Any unpaid interim expenses incurred in the ordinary course of business

between filing the bankruptcy petition and the entry of an Order of Relief in an involuntary proceeding. (This step is not applicable in a voluntary bankruptcy.)

3. Wages of not more than $2,000 per worker that have been earned by workers in the 90-day period immediately preceding the commencement of bank-ruptcy proceedings.

4. Unpaid employee benefi t plan contributions that were to be paid in the 180-day period preceding the fi ling of bankruptcy or the termination of busi-ness, whichever occurred fi rst. For any employee, the sum of this claim plus eligible unpaid wages cannot exceed $2,000.

5. Claims of farmers or fi shermen in a grain-storage or fi sh-storage facility, not to exceed $2,000 for each producer.

6. Unsecured customer deposits, not to exceed $900 each, resulting from pur-chasing or leasing a good or service from the failed fi rm.

7. Taxes legally due and owed by the bankrupt fi rm to the federal government, state government, or any other governmental subdivision.

8. Claims of secured creditors, who receive the proceeds from the sale of collateral held, regardless of priorities one through seven. If the proceeds from the liqui-dation of the collateral are insuffi cient to satisfy the secured creditors’ claims, the secured creditors become unsecured creditors for the unpaid amount.

9. Claims of unsecured creditors. The claims of unsecured, or general, creditors and unsatisfi ed portions of secured creditors’ claims are treated equally.

10. Preferred stockholders, who receive an amount up to the par, or stated, value of their preferred stock.

11. Common stockholders, who receive any remaining funds, which are distrib-uted on an equal per-share basis. If different classes of common stock are out-standing, priorities may exist.

secured creditors Creditors who have specifi c assets pledged as collateral and who receive the proceeds from the sale of those assets.

secured creditors Creditors who have specifi c assets pledged as collateral and who receive the proceeds from the sale of those assets.

unsecured creditors Creditors who have no specifi c assets pledged as collateral, or the proceeds from the sale of whose pledged assets are inadequate to cover the debt.

unsecured creditors Creditors who have no specifi c assets pledged as collateral, or the proceeds from the sale of whose pledged assets are inadequate to cover the debt.

general creditors Creditors who have no specifi c assets pledged as collateral, or the proceeds from the sale of whose pledged assets are inadequate to cover the debt.

general creditors Creditors who have no specifi c assets pledged as collateral, or the proceeds from the sale of whose pledged assets are inadequate to cover the debt.

Ed Altman, New York

University

“The average time in bankruptcy is

around 18 months to two years in

the U.S.”

See the entire interview at



In spite of the priorities listed in items one through seven, secured creditors have fi rst claim on proceeds from the sale of their collateral. The claims of unse-cured creditors, including the unpaid claims of secured creditors, are satisfi ed next, and, fi nally, the claims of preferred and common stockholders. Also, some unsecured creditors’ claims may be subordinated to those of other unsecured creditors. In the event of liquidation, the subordinated creditors do not receive any cash until the claims to which they are subordinated are paid in full. The fol-lowing Applying the Model gives a simple example of the application of these priorities by the trustee in bankruptcy liquidation proceedings.

Assets Liabilities and Stockholders’ Equity

Cash $ 100,000 Accounts payable $ 200,000Accounts receivable 1,200,000 Notes payable—bank 1,500,000Inventories 3,150,000 Accrued wagesa 100,000 Total current assets $4,450,000 Unpaid employee benefi tsb 110,000Land $2,000,000 Unsecured customer depositsc 90,000Net plant 1,500,000 Taxes payable 300,000Net equipment 1,100,000 Total current liabilities $2,300,000 Total fi xed assets $4,600,000 First mortgaged $1,400,000 Total $9,050,000 Second mortgaged 800,000 Subordinated debenturese 1,000,000 Total long-term debt $3,200,000 Preferred stock (7,000 shares) $ 700,000 Common stock (20,000 shares) 200,000 Paid-in capital in excess of par 300,000 Retained earnings 2,350,000 Total common stockholders’ equity $2,850,000 Total $9,050,000

a Represents wages of $2,000 or less per employee earned within 90 days of fi ling bankruptcy for the fi rm’s employees.

b These unpaid employee benefi ts were due in the 180-day period preceding the fi rm’s bankruptcy fi ling, which occurred simultaneously with the termination of its business.

c Unsecured customer deposits not exceeding $900 each.d The fi rst and second mortgages are on the fi rm’s total fi xed assets.e The debentures are subordinated to the bank’s note payable.

Table 22.3 Balance Sheet for Oxford Company

Table 22.3 presents the balance sheet of Oxford Company, a computer drive manufacturer. The trustee has liquidated the fi rm’s assets, obtaining the largest amounts possible. He obtained $2.1 million for the fi rm’s current assets and $1.8 million for the fi rm’s fi xed assets. The total proceeds from the liquidation, therefore, were $3.9 million. It is clear that the fi rm is legally insolvent because its liabilities of $5.5 million exceed the $3.9 million market value of its assets.

The next step is to distribute the proceeds to the various creditors. The only liability that is not shown on the balance sheet is $500,000 in expenses for administering the bank-ruptcy proceedings and satisfying unpaid bills incurred between the time of fi ling the



Proceeds from liquidation $3,900,000 Expenses of administering bankruptcy and paying bills 500,000 Wages owed workers 100,000 Unpaid employee benefi ts 110,000 Unsecured customer deposits 90,000 Taxes owed governments 300,000Funds available for creditors $2,800,000 First mortgage, paid from $2 million proceeds of fi xed asset sale 1,400,000 Second mortgage, partially paid from the remaining assets 400,000Funds available for unsecured creditors $1,000,000

Table 22.4 Distribution of the Liquidation Proceeds of Oxford Company

Settlement AfterUnsecured Creditors’ Claims Amount at 32%a Subordination

Unpaid balance on second mortgage $ 400,000b $ 129,032 $ 129,032Accounts payable 200,000 64,516 64,516Notes payable – bank 1,500,000 483,871 806,452Subordinated debentures 1,000,000 322,581 0 Totals $3,100,000 $1,000,000 $1,000,000a The 32 percent rate is calculated by dividing the $1 million available for the unsecured creditors by

the $3.1 million owed the unsecured creditors. Each is entitled to a pro rata share.b This fi gure represents the diff erence between the $800,000 second mortgage and the $400,000

payment on the second mortgage from the proceeds from the sale of the collateral remaining after satisfying the fi rst mortgage.

Table 22.5 Pro Rata Distribution of Funds among the Unsecured Creditors of Oxford Company

bankruptcy petition and the entry of an Order of Relief. Table 22.4 shows the distribution of the $3.9 million among the fi rm’s creditors and illustrates that once all prior claims on the proceeds to liquidation have been satisfi ed, the unsecured creditors get the remaining funds. Table 22.5 gives the pro rata distribution of the $1 million among the unsecured creditors. The disposition of funds in the Oxford Company liquidation should be clear from Tables 22.4 and 22.5. Because the claims of the unsecured creditors have not been fully satisfi ed, the preferred and common shareholders receive nothing.

22-5c Final AccountingThe trustee, after liquidating the bankrupt fi rm’s assets and distributing proceeds to satisfy all provable claims in the appropriate order of priority, makes a fi nal accounting to the bankruptcy court and creditors. Once the court approves the fi nal accounting, the liquidation is complete.



Predicting bankruptcy with some degree of accuracy is possible using Altman’s Z score, named after Professor Ed Altman of New York University. The Z score is the product of a quantitative model that uses a blend of traditional fi nancial ratios and a statistical technique known as multiple discriminant analysis. The Z score has been found to be about 90 percent accurate in forecasting bankruptcy one year in the future and about 80 percent accurate in forecasting it two years in the future. The model is as follows:

Z � 1.2 � X1 � 1.4 � X2 � 3.3 � X3 � 0.6 � X4 � 1.0 � X5

Where X1 � working capital ÷ total assets

X2 � retained earnings ÷ total assets

X3 � earnings before interest and taxes � total assets

X4 � market value of equity � book value of equity

X5 � sales � total assets

The following are guidelines for classifying businesses: Z score less than 1.8, high probability of failure; Z score between 1.81 and 2.99, unsure; and Z score above 3.0, failure unlikely.

22-6 Predicting Bankruptcy22-6 Predicting Bankruptcy

Z score The product of a quantitative model for forecasting bankruptcy that uses a blend of traditional fi nancial ratios and a statistical technique known as multiple discriminant analysis. The Z score has been found to be about 90 percent accurate in forecasting bankruptcy one year in the future and about 80 percent accurate in forecasting it two years in the future.

Z score The product of a quantitative model for forecasting bankruptcy that uses a blend of traditional fi nancial ratios and a statistical technique known as multiple discriminant analysis. The Z score has been found to be about 90 percent accurate in forecasting bankruptcy one year in the future and about 80 percent accurate in forecasting it two years in the future.

22-5

What is the purpose of the absolute priority rule? Why shouldn’t the bankruptcy judge be given more discretion?

What is the signifi cance of subordinating a claim if a fi rm is liquidated?

13.

14.

Why is the payment of the expenses of administer-ing the bankruptcy proceeding given the highest priority?

15.

Table 22.6 presents the balance sheet and Table 22.7, the income statement, for Poff Industries, a manufacturer of computer power supplies. The company’s stock price currently is $3.50 per share. The company’s Z score can be calculated as follows:

Z � 1.2(0.052) � 1.4(0.095) � 3.3(0.086) � 0.6(0.700) � 1.0(0.431) � 1.330

The Z score of 1.330 indicates that the probability that Poff Industries will fail is quite high.



Why is predicting bankruptcy a useful ability?16. How are the fi ve factors that determine a Z score related to the fi nancial health of a business?

17.

22-6

Assets Liabilities and Stockholders’ Equity

Cash $ 100,000 Accounts payable $ 2,000,000Accounts receivable 1,000,000 Notes payable—bank 1,500,000Inventories 3,000,000 Total current liabilities $ 3,500,000 Total current assets $ 4,100,000 Mortgage $ 2,000,000Land $ 2,000,000 Debentures 3,000,000Net plant 2,500,000 Total long-term debt $ 5,000,000Net equipment 3,000,000 Preferred stock (100,000 shares) 1,000,000 Total fi xed assets $ 7,500,000 Common stock (1,000,000 shares) 1,000,000 Total $11,600,000 Paid-in capital in excess of par 1,000,000 Retained earnings 1,100,000 Total stockholders’ equity $ 3,100,000 Total $11,600,000

Table 22.6 Balance Sheet for Poff Industries

Sales $5,000,000Less: Cost of goods sold 3,000,000Less: Selling and administrative expenses 1,000,000Earnings before interest and taxes $1,000,000Less: Interest 500,000Earnings before taxes $ 500,000Less: Taxes (40%) 200,000Net Income $ 300,000

Table 22.7 Income Statement for Poff Industries


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SummaryA business can fail in two ways. When it cannot pay its liabilities when they come due, the fi rm is technically insolvent due to a liquidity crisis. When its liabilities exceed the fair market value of its assets, the fi rm is insolvent. Bankruptcy occurs once a company comes under the authority of a bankruptcy court, which then exer-cises ultimate control over the fi rm.Mismanagement is the primary cause of business failure. Managerial faults include overexpansion, poor fi nancial actions, an ineffective sales force, and high production costs. Other causes are economic downturns and corporate maturity.The fi nancial distress a pending business failure places on a company and its management can have a profound effect on how the fi rm behaves and how its suppliers and customers perceive it. When a fi rm is in fi nancial distress, suppli-ers are reluctant to extend credit and customers are concerned about service and warranties.Companies facing fi nancial distress can voluntarily reorganize or liquidate. By acting voluntarily, fi rms reduce the legal and administrative expenses asso-ciated with a formal bankruptcy fi ling.The Bankruptcy Reform Act of 1978 specifi es in Chapter 7 how fi rms are liqui-dated and in Chapter 11 how fi rms are reorganized.Firms can reorganize under Chapter 11 by means of the unanimous consent procedure or the cramdown procedure. In a reorganization, the terms of the debt can be relaxed by extending the payment term or lowering the interest rate. Also, debt can be exchanged for equity in the fi rm, thus reducing the amount of cash fl ow required to service the debt.Firms are liquidated under Chapter 7 by means of the absolute priority rule, which ranks the order for paying creditors from the proceeds of the liquidation of the fi rm’s assets.The likelihood of bankruptcy can be predicted with a fair degree of accuracy (at least in the short term) using Altman’s Z score.

Key Termsabsolute priority rules

(APR) (p. 894)assignment (p. 893)bankruptcy (p. 889)Bankruptcy Reform Act

of 1978 (p. 894)business failure (p. 888)Chapter 11 (p. 894)Chapter 7 (p. 894)composition (p. 893)cramdown procedure

(p. 901)creditor control (p. 893)debtor in possession

(DIP) (p. 899)

economic failure (p. 888)extension (p. 892)general creditors (p. 905)insolvency bankruptcy

(p. 889)insolvent (p. 898)involuntary

reorganization (p. 898)liquidation (p. 893)liquidity crisis (p. 889)prepackaged

bankruptcy (p. 904)recapitalization (p. 899)reorganization (p. 898)secured creditors (p. 905)

technical insolvency (p. 889)

trustee (p. 893)unanimous consent

procedure (UCP) (p. 900)

unsecured creditors (p. 905)

voluntary reorganization (p. 892)

voluntary settlement (p. 892)

workout (p. 892)Z score (p. 908)

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Self-Test ProblemsST22-1. For a fi rm with outstanding debt of $50 million, classify each of the follow-

ing voluntary settlements as an extension, a composition, or a combina-tion of the two.

a. Paying a group of creditors in full in six periodic installments and paying the remaining creditors 75 cents on the dollar immediately

b. Paying a group of creditors 50 cents on the dollar immediately and paying the remaining creditors 70 cents on the dollar in fi ve periodic installments

c. Paying all creditors 30 cents on the dollar

ST22-2. A fi rm has $8 million in funds to distribute to its unsecured creditors. Three possible sets of unsecured creditor claims are presented. Calculate the settlement, if any, to be received by each creditor in each case shown in the following table:

Unsecured Creditors’ Claims Case I Case II Case III Unpaid balance of second mortgage $ 2,000,000 $ 2,500,000 $ 5,000,000 Accounts payable 2,500,000 3,000,000 4,000,000 Notes payable—bank 3,500,000 3,500,000 1,500,000 Unsecured bonds 4,000,000 5,000,000 5,500,000 Total $12,000,000 $14,000,000 $16,000,000

ST22-3. Oxygen Filtration Systems recently failed and will be liquidated by a court- appointed trustee who will charge $500,000 for his services. The preliquida-tion balance sheet follows. Assume that the trustee liquidates the assets for $10.2 million, with $5.8 million coming from the sale of current assets and $4.4 million coming from fi xed assets. Also assume that the unsecured bonds are subordinate to the notes payable. Prepare a table indicating the amount to be distributed to each claimant. Do the fi rm’s owners receive any funds?

Oxygen Filtration SystemsBalance Sheet

as of December 31, 2009

Assets Liabilities and Stockholder’s Equity Cash $ 600,000 Accounts payable $ 2,500,000Marketable securities 750,000 Notes payable—bank 4,000,000 Accounts receivable 1,750,000 Accrued wagesa 750,000 Inventories 2,250,000 Unpaid employee benefi tsb 500,000 Prepaid expenses 900,000 Unsecured customer depositsc 500,000 Total current assets $ 6,250,000 Taxes payable 1,000,000 Total current liabilities $ 9,250,000 Land $ 3,000,000 First mortgaged $ 3,000,000 Net plant 5,000,000 Second mortgaged 2,000,000 Net equipment 6,250,000 Unsecured bonds 3,500,000 Total fi xed assets $14,250,000 Total long-term debt $ 8,500,000 Total $20,500,000 Preferred stock (10,000 shares) $ 500,000 Common stock (20,000 shares) 2,000,000 Retained earnings 250,000 Total stockholders’ equity $ 2,750,000 Total $20,500,000

a Represents wages of $2,000 or less per employee earned within 90 days of fi ling bankruptcy for 400 of the fi rm’s employees.

b Unpaid employee benefi ts that were due in the 180-day period preceding the fi rm’s bankruptcy fi ling, which occurred simultaneously with the termination of its business.

c Unsecured customer deposits not exceeding $900 each.d First and second mortgages on the fi rm’s total fi xed assets.



ST22-4. Express Trailers has a working capital/total assets ratio of 0.3, a retained earn-ings/total assets ratio of 0.15, an earnings before interest and taxes/total asset ratio of 0.20, a market value of equity/book value of equity ratio of 0.5, and a sales/total assets ratio of 0.75. Calculate and interpret the company’s Z score.

QuestionsQ22-1. Discuss why it makes sense to offer subsidies to fi rms that reorganize

rather than liquidate.

Q22-2. Explain why the option to delay entering bankruptcy has value for corporate managers.

Q22-3. Why do creditors usually accept a plan for fi nancial rehabilitation rather than demand liquidation of a business?

Q22-4. A certain number of bankruptcies are good for the economy. Discuss why you agree or disagree with this statement.

Q22-5. A business should always be liquidated when the liquidation value exceeds the business’s value as a going concern. Discuss why you agree or disagree with this statement.

Q22-6. What are the advantages and disadvantages of a voluntary workout to resolve fi nancial distress? What are the advantages and disadvantages of declaring bankruptcy to resolve fi nancial distress?

Q22-7. A business can be liquidated for $700,000, or it can be reorganized. Reor-ganization would require an investment of $400,000. If the company is re-organized, earnings are projected to be $150,000 per year, and the com-pany would trade at a price/earnings ratio of 8.0. Should the company be liquidated or reorganized?

Q22-8. Explain why the priorities for liquidation are determined as they are. Do you agree with the order?

Q22-9. What is the difference between economic failure and fi nancial distress? Which situation is likely to lead to liquidation, and which is likely to result in reorganization?

Q22-10. Who would use Altman’s Z score to predict bankruptcy? Why would the ability to predict bankruptcy be useful to them?

Q22-11. What is the purpose of a prepackaged bankruptcy? Would a prepackaged bankruptcy be more likely to be used for a liquidation or a reorganization?

Q22-12. Why would some creditors be willing to subordinate their claims to the claims of other creditors?

ProblemsVoluntary SettlementsP22-1. For a fi rm with outstanding debt of $2.4 million, classify each of the fol-

lowing voluntary settlements as an extension, a composition, or a combi-nation of the two.

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a. Paying all creditors 40 cents on the dollar in exchange for complete dis-charge of the debt

b. Paying all creditors in full in three periodic installmentsc. Paying a group of creditors with claims of $1 million in full over two

years and immediately paying the remaining creditors 75 cents on the dollar

P22-2. For a fi rm with outstanding debt of $125,000, classify each of the following voluntary settlements as an extension, a composition, or a combination of the two.

a. Paying a group of creditors in full in four periodic installments and pay-ing the remaining creditors in full immediately

b. Paying a group of creditors 80 cents on the dollar immediately and paying the remaining creditors 70 cents on the dollar in two periodic installments

c. Paying all creditors in full in 270 days

P22-3. For a fi rm with outstanding debt of $200 million, classify each of the following voluntary settlements as an extension, a composition, or a com-bination of the two.

a. Paying a group of creditors in full in three periodic installments and pay-ing the remaining creditors 70 cents on the dollar immediately

b. Paying a group of creditors 60 cents on the dollar immediately and pay-ing the remaining creditors 80 cents on the dollar in fi ve periodic installments

c. Paying all creditors 25 cents on the dollar

P22-4. Go to http://www.bankruptcydata.com, and pinpoint the largest public com-pany bankruptcies during the previous year. Compare the list of the largest bankruptcies in U.S. history presented in Table 22.1 with the current list at http://www.bankruptcydata.com. Have any bankruptcies that occurred after April 2004 made the list?

P22-5. Jacobi Supply Company recently ran into fi nancial diffi culties that have resulted in the initiation of voluntary settlement procedures. The fi rm cur-rently has $250,000 in outstanding debts and approximately $100,000 in marketable short-term assets. Indicate, for each of the following plans, whether the plan is an extension, a composition, or a combination of the two. Also indicate the cash payments and timing of the payments required of the fi rm under each plan.

a. Each creditor will be paid 40 cents on the dollar immediately, and the debts will be considered fully satisfi ed.

b. Each creditor will be paid 40 cents on the dollar in two quarterly installments of 20 cents and 20 cents. The fi rst installment is to be paid in ninety days.

c. Each creditor will be paid the full amount of its claims in three install-ments of 50 cents, 25 cents, and 25 cents on the dollar. The installments will be made in sixty-day intervals, beginning in sixty days.

P22-6. Heriot Manufacturing Company recently ran into certain fi nancial diffi -culties that have resulted in the initiation of voluntary settlement proce-dures. The fi rm currently has $2 million in outstanding debts and approxi-mately $1.2 million in marketable short-term assets. Indicate, for each of the following plans, whether the plan is an extension, a composition, or a


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combination of the two. Also indicate the cash payments and timing of the payments required of the fi rm under each plan.

a. Each creditor will be paid 60 cents on the dollar immediately, and the debts will be considered fully satisfi ed.

b. Each creditor will be paid 80 cents on the dollar in two quarterly install-ments of 50 cents and 30 cents. The fi rst installment is to be paid in ninety days.

c. A group of creditors with claims of $600,000 will be immediately paid in full; the rest will be paid 85 cents on the dollar, payable in ninety days.

Liquidation in BankruptcyP22-7. A fi rm has $450,000 in funds to distribute to its unsecured creditors. Three

possible sets of unsecured creditor claims are presented. Calculate the set-tlement, if any, to be received by each creditor in each case shown in the following table:

Unsecured Creditors’ Claims Case I Case II Case III

Unpaid balance of second mortgage $300,000 $200,000 $ 500,000 Accounts payable 200,000 100,000 300,000 Notes payable—bank 300,000 100,000 500,000 Unsecured bonds 100,000 200,000 500,000 Total $900,000 $600,000 $1,800,000

P22-8. A fi rm has $5 million in funds to distribute to its unsecured creditors. Three possible sets of unsecured creditor claims are presented. Calculate the settlement, if any, to be received by each creditor in each case shown in the following table:

Unsecured Creditors’ Claims Case I Case II Case III

Unpaid balance of second mortgage $1,000,000 $2,000,000 $3,000,000 Accounts payable 2,000,000 1,000,000 3,000,000 Notes payable—bank 3,000,000 2,000,000 1,000,000 Unsecured bonds 1,000,000 3,000,000 2,000,000 Total $7,000,000 $8,000,000 $9,000,000

P22-9. Keck Business Forms recently failed and will be liquidated by a court- appointed trustee who will charge $300,000 for her services. The preliqui-dation balance sheet follows. Assume that the trustee liquidates the assets for $4.8 million, with $2.6 million coming from the sale of current assets and $2.2 million coming from fi xed assets. Also assume that the unsecured bonds are subordinate to the notes payable. Prepare a table indicating the amount to be distributed to each claimant. Do the fi rm’s owners receive any funds?



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See the problem and solution explained step-by-step at

Keck Business FormsBalance Sheet


Assets Liabilities and Stockholder’s Equity

Cash $ 100,000 Accounts payable $1,200,000 Marketable securities 50,000 Notes payable—bank 1,100,000 Accounts receivable 1,100,000 Accrued wagesa 300,000 Inventories 2,400,000 Unpaid employee benefi tsb 200,000 Prepaid expenses 400,000 Unsecured customer depositsc 250,000 Total current assets $4,050,000 Taxes payable 100,000 Total current liabilities $3,150,000 Land $1,000,000 First mortgaged $1,500,000 Net plant 2,100,000 Second mortgaged 1,000,000 Net equipment 2,300,000 Unsecured bonds 2,000,000 Total fi xed assets $5,400,000 Total long-term debt $4,500,000 Total $9,450,000 Preferred stock (5,000 shares) $ 500,000 Common stock (10,000 shares) 1,000,000 Retained earnings 300,000 Total stockholders’ equity $1,800,000 Total $9,450,000

a Represents wages of $2,000 or less per employee earned within 90 days of fi ling bankruptcy for 400 of the fi rm’s employees.

b Unpaid employee benefi ts that were due in the 180-day period preceding the fi rm’s bankruptcy fi ling, which occurred simultaneously with the termination of its business.

c Unsecured customer deposits not exceeding $900 each.d First and second mortgages on the fi rm’s total fi xed assets.

Predicting BankruptcyP22-10. Sosbee Foods has a working capital/total assets ratio of 0.2, a retained earn-

ings/total assets ratio of 0.1, an earnings before interest and taxes/total asset ratio of 0.25, a market value of equity/book value of equity ratio of 0.6, and a sales/total assets ratio of 0.8. Calculate and interpret the company’s Z score.

P22-11. The following balance sheet and income statement are for Weber Indus-tries. The fi rm’s stock currently is priced at $6.00 per share. Calculate and interpret the company’s Z score.

Weber IndustriesBalance Sheet


Assets Liabilities and Stockholder’s Equity

Cash $ 400,000 Accounts payable $ 5,000,000 Accounts receivable 3,000,000 Notes payable—bank 1,000,000Inventories 4,000,000 Total current liabilities $ 6,000,000 Total current assets $ 7,400,000 Mortgage $ 4,000,000 Land $ 1,000,000 Debentures 6,000,000 Net plant 5,000,000 Total long-term debt $10,000,000 Net equipment 8,000,000 Preferred stock (100,000 shares) $ 1,000,000 Total fi xed assets $14,000,000 Common stock (500,000 shares) 1,000,000 Total $21,400,000 Paid-in capital in excess of par 2,000,000 Retained earnings 1,400,000 Total shareholders’ equity $ 5,400,000 Total $21,400,000



Weber IndustriesIncome Statement

For the Year Ending December 31, 2009

Sales: $6,000,000Less: Cost of goods sold 3,500,000Less: Selling and administrative 1,000,000Earnings before interest and taxes $1,500,000Less: Interest 1,100,000Earnings before taxes $ 400,000Less: Taxes (30%) 120,000Net Income $ 280,000

THOMSON ONE Business School Edition

For instructions on using Thomson ONE, refer to the instructions pro-vided with the Thomson ONE problems at the end of Chapters 1–6 or to “A Guide for Using Thomson ONE.”

P22-12. Calculate and interpret Altman’s Z score for Sun Microsystems Inc. (ticker: @SUNW) using the latest year’s fi nancial statements and its current mar-ket capitalization. Do you think Sun Microsystems will go bankrupt within the next year?

See the solution to Problem 22-10.

smart solutions

Ed Altman, New York University“The average time in bankruptcy is around 18 months to two years in the U.S.”

Tom Cole, Deutsche Bank, Leveraged Finance Group“Obviously companies don’t want to go bankrupt and obviously investors don’t want to lose money.”

smart ethics video

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Bankruptcy and Financial Distress

You have recently joined the fi nancial plan-ning department of American Steel Works, Incorporated. Along with much of the steel industry, this fi rm has gone through some diffi cult economic times the past few years. American Steel Works has been able to sur-vive due to comprehensive fi nancial plan-ning. Therefore, as part of the fi rm’s long-term strategic planning, the chief executive offi cer (CEO) decides to hold a discussion on bankruptcy and fi nancial distress and asks you to help prepare some background infor-mation. To assist you in this information gathering, you are asked to answer the fol-lowing questions.

Assignment

What are the types of business failure?What are the causes of business failure?Describe the types of voluntary settlement.What is reorganization? Discuss reorgani-zation procedures.How does liquidation through bankruptcy work?

1.2.3.4.

5.



bankruptcy and financial · pdf filechapter 22 bankruptcy and financial distress l 889 are...

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