The “Creditory” Instinct: Using Chapter-11 to Hijack Ownership of Corporate Assets from Shareholders

I NTRODUCTION After the high-tech bubble burst in 2000, large enterprises filing for protection from creditors under Chapter XI of the United States bankruptcy code (“Chapter-11”) dominated the hit-parade of the ten largest insolvencies ever. The rush for Chapter-11 sanctuary to courts in Delaware and other sympathetic venues migrated beyond tech and telecom companies like Global Crossing and Worldcom to include financial institutions (e.g., Conseco), airlines (e.g., United & USAir) and retailers (e.g., K-mart). Tales of mismanagement and outright malfeasance lay behind many of these spectacular insolvencies. Less noticed in other cases was the manipulation of the Chapter-11 process at the expense of the firm’s owners (i.e., the shareholders), resting on intentionally misleading information designed to create an illusion of insolvency. This essay discusses how such disguised acquisitions evolved; examines a case of possible abuse; and, proposes initial remedies.

H ISTORICAL R EVIEW of U.S. B ANKRUPTCY L AWS Modern U.S. bankruptcy statutes – biased toward financial rehabilitation – originated from the turn of the last century with added impetus during the New Deal to culminate in the Bankruptcy Reform Act of 1978, as amended periodically. This preference toward debtors written into the code combined with a significant shift in policy in favor of business interests unleashed a wave of bankruptcies in the 1980s and 90s. Chapter-11 filings changed not only in frequency and severity but also in rationale. Continental Airlines (1983), Johns Manville (1984) and Texaco (1987) led this new breed of preemptive Chapter-11 filings, seeking protection from looming liabilities – frequently undetermined – stemming from previously negotiated collective bargaining agreements; litigation involving product liabilities; and, damages awarded by juries in take-over battles.

The multiplicity of cases taxed the judicial system, leading to efforts to curtail the work-load. The invention of pre-packaged Chapter-11 filings enhanced the efficiency of the bankruptcy process by presenting a previously negotiated restructuring, conditioned upon judicial confirmation, to the bankruptcy court as a fait accompli. In jurisdictions known to favor corporate interests, this new practice eviscerated the role of the U.S. Trustee as a source of independent due-diligence mandated under the 1978 law. In allocating the limited value of the post-Chapter-11 enterprise among classes of creditors and owners, bankruptcy law and court precedent instituted the “absolute priority” of senior to junior claims. Thus secured lenders recovered 100% prior to any recovery by senior unsecured creditors and so on, usually leaving little or nothing for preferred and common shareholders.

More recent Chapter-11 plans modified the absolute priority rule to facilitate compromise acceptable to a majority of creditors and owners. “Cram-down” provisions legislated into bankruptcy statutes allowed for such compromises to proceed notwithstanding the unanimous dissent by whole classes of creditors or owners. These cram-down provisions and the absolute priority rule enabled corporations to emerge from Chapter-11 using newly issued debt and equity allocated among senior creditors at the expense of owners. The premise underlying the willingness of senior creditors to sacrifice value to more junior claimants lay in documented experience that the ultimate recoveries of going concerns had exceeded the proceeds realized during liquidations. Accordingly, questions of enterprise value became paramount in negotiating the Chapter-11 process. Pre-packaged bankruptcies engineered the transfer of ownership to creditors through reliance upon the cram-down provisions. Yet, underlying valuations were subjective since they remained sensitive to changes in initial operating and financial assumptions.

A REAS for A BUSE under C URRENT B ANKRUPTCY S TATUTES The sensitivity to subjective assumptions underlying enterprise values and the negotiating leverage conferred upon senior lenders under the absolute priority regimen leave the current pre-packaged Chapter-11 process open to abuse by unscrupulous lenders. The lenders advance funds against the assets controlled by debtors-in-possession under the terms of a “D.I.P. financings”. In most cases these lenders are investors specializing in D.I.P. financings (“vulture funds”) that have already purchased a significant portion of defaulted debt at deep discounts. Since the D.I.P. financiers then control the assets, they become de facto owners. Pre-packaged Chapter-11 filings can become finished products based on questionable accounting assumptions. Neither the Trustee nor committees of aggrieved creditors and owners are privy to the intricacies of the valuation. This lack of transparency, often aggravated by plan deadlines, render adequate due-diligence impossible.

Since pre-packaged bankruptcy filings maintain the debtors as going-concerns to exist in perpetuity, slight changes of initial assumptions create widely divergent values. Fabrication of value resting upon accounting legerdemains can escape the notice of sophisticated observers. For example, Advanta Corp. nearly slid into insolvency in 1997 due to burgeoning losses in its credit card portfolio; to re-structure, the company sold two of its three principal operating divisions to Chase Manhattan Bank (now part of JPMorgan / Chase) and Fleet Bank (currently being merged into Bank of America). Within a year of the respective asset sales, both acquirors filed law-suits seeking punitive damages against Advanta by alleging misrepresentations of asset values based upon unsustainable performance assumptions. Advanta admitted as much by establishing in excess of $100 million of loss reserves for large portions of the amounts being sought.

What these reserves do not obscure is the fact that two highly sophisticated buyers with ample time and resources, including independent valuation opinions by professionals privy to the raw data, were unable to detect the over-valuations ahead of time. Thus, it should come as no surprise that unscrupulous D.I.P. financiers can mislead bankruptcy judges and court-required trustees as well as subordinate classes of creditors and shareholders with unsupportable values emerging from the far less transparent Chapter-11 process. Often, the management that created the problems remains in place, violating its fiduciary duty to the shareholders (i.e., the passive owners). Thus the emerging pattern is one of management buy-outs at large discounts to book value.

C ASE -S TUDY : a ‘ R EAL - T IME ’ E XAMPLE (in process) As an example of a coerced transfer of ownership ratified by the bankruptcy code, we refer to a current Chapter-11 proceeding involving a small, publicly traded textile mill with facilities in South Carolina and, through joint ventures with host-country enterprises, in Mexico and Turkey. This company filed for protection in September 2003 with a planned transfer of ownership already in place through a $46 million investment plus the assumption of D.I.P. financing already in place by a vulture fund already intimately familiar with the inner-most workings of the enterprise. Management announced that preferred and common shareholders would recover nothing. Please refer to the Appendix for summary spreadsheets of the financials.

Management argued in its petition that a “flood” of cheap imported fabrics had undermined its solvency and that this pre-arranged Chapter-11 restructuring was necessary to save American jobs. Close scrutiny of management’s statements to the public, to shareholders and in its filings with the Securities and Exchange Commission (“S.E.C.”) belies these assertions. In fact, an alternative review of the same data argues in favor of a management buy-out at less than half the book value and at the expense of the owners. With the aid of a ‘strategic’ communications firm in New York, management carefully laid out its case, occasionally resorting to ad hominem attacks against shareholders who questioned it. The rationale for the seizure of assets from the owners under the guise of a Chapter-11 filing relied upon the following premises: Industry conditions had changed permanently with a “flood” of inexpensive imports. The textile mill’s principal customer of almost ninety years was shutting down its last operations in the U.S.,

hinting at a material dislocation in the company’s revenue base. Incumbent management would continue to run the company while being compensated at “present levels”. Dissident shareholders were neither qualified to argue nor credible in view of perceived character

deficiencies. The fixed asset base had become worthless and the enterprise unable to meet its fixed obligations. The pre-arranged Chapter-11 re-structuring would preserve thousands of jobs in the U.S.

Ironically, what management was not saying proved to be as interesting to a critical observer, familiar with the company’s recent fortunes, as its many precise statements. By carefully examining the S.E.C. filings, one could adduce evidence to argue that this Chapter-11 filing had been unnecessary; that the pre-packaged bankruptcy had served the interests of management and a D.I.P. financier in acquiring a viable enterprise facing a cyclical working capital constraint instead of insolvency.

R ATIONALE What management did not say…1. Permanent change in

textile industry pricing dynamics with relaxed tariffs against developing societies.

Management decision based on one meeting with the Department of Commerce.

Prices had stabilized over the preceding months. Sales volume had declined to a cyclical nadir though inventories remained

consistent with stable order back-logs.

2. Expected loss of sales to largest buyer of principal product due to its taking all manufacturing off-shore.

Quality of the company’s material remained the key differentiating strength of buyer’s finished product.

The company’s manufacturing activity had already followed the buyer to lower-cost markets twice in recent years.

The company remained the most reliable supplier to the vendor of high-quality not easily replicated material for the latter’s sewing and stitching into a finished product for re-sale in the U.S. and E.U.

3. Incumbent management equipped with expertise to run the company at current compensation levels.

Management gave itself a two-year contract. While compensation levels remained “unchanged” under the ‘new’

contracts of September 2003, management had previously increased overall compensation by 71% at year-end 2002.

Management then voted an increase in base-pay of 22% earlier in 2003, as little as a week prior to the announcement of new contracts, after amassing operating losses in the first two quarters of 2003.

4. Dissident shareholders lacking the expertise and, in one case, having questionable credentials; citing the resignation of one Director (sponsored by the dissident group) after being indicted for violations of securities laws.

These shareholders owned roughly 20% of the company’s common stock. Management failed to sell two secondary operations with modern plants. Management postponed the annual shareholders’ meeting until the time

of the Chapter-11 filing to reduce accountability. Institutional Shareholders Services group, which provides corporate

governance advice to shareholders, endorsed this dissident group’s demand for three Board seats.

Management turned aside without open discussion a shareholder rights offering and other strategic options proposed by the dissident shareholders.

5. A worthless fixed asset base, requiring a write-down of substantially all fixed assets to eliminate shareholder value.

The U.S. fixed asset base had been installed within the last decade. Liquidation of excess inventory temporarily aggravated price competition. Renewed lending agreements, executed in conjunction with the Chapter-

11 filing, allowed for $6-12 million of maintenance capital expenditures. Such permitted capital expenditures implied an ongoing value of the

existing plant of (at least) 60-80% of that presented in the historical financials.

Operating cash flows proved to be consistent throughout the last twelve months at 3x the level of interest paid for that period.

Despite strained earnings before interest and non-cash charges, free cash flow remained positive, implying operating continuity and solvency.

6. The current plan’s re-structuring designed to keep jobs in the U.S.

Management had reduced head-count by 50% since 1999 and planned another 25% cut over the next few months.

The preferred stock being crammed down to zero-value represented the ownership interest of employees in a twenty year old E.S.O.P.

Management re-calculated the pension obligation to make the pension fund appear to be 25% under-funded.

Company management, in collaboration with the vulture fund, implemented the re-structuring. To deter resistance to court-ratification of the plan, a costly break-up fee would be payable to the vulture fund if the confirmation were not forthcoming within a few months. Though break-up analyses indicated a negative net worth, a conclusion of insolvency from such worst-case scenarios would have been pre-mature. Instead, as detailed in the appendix, a discounted cash flow valuation indicated the following:

enterprise value in excess of higher than net worth exclusive of the write-down of fixed assets; and, re-payment of company debt within seven years with ample interest and debt service coverages.

The assumptions underlying the discounted cash flows were deliberately conservative to illustrate this alternate view. Specifically the valuation assumed: a slow migration of manufacturing to lower cost platforms (i.e., a gradual trend of non-U.S. sales as a

percentage of total revenues from 14-33% over the next ten years); annual revenue increases of 2.2%, tracking the real growth rate over time of U.S. gross domestic product; no realization of cost economies in non-U.S. facilities; no improvement in the profitability of U.S. manufacturing efforts from currently depressed levels; and, a required rate of return set at 25% to account for risks facing the textile industry in general and this heavily

indebted company in particular.

The two alternative valuations – on worst case and one normalized – presented in the Appendix suggest that a large portion of shareholder value could be preserved by re-scheduling debt payments or, if pricing and the economic outlook improve modestly from their currently poor levels, the company has shareholder value well in excess of book value.

C ONCLUSIONS and R ECOMMENDATIONS Summary. Since the passage of the modern Chapter-11 protections in 1978, bankruptcies have evolved from worst-case scenarios to preventive measures to finesse unforeseen liabilities. With the invention of pre-packaged bankruptcies, such filings have become a method of covertly buying the operating assets of struggling firms on the cheap and at the expense of shareholders. A recent ‘ fast-track’ bankruptcy arguably involved the collusion of senior management and a vulture investor to usurp the ownership of a publicly traded textile company from its common shareholders and employees participating in an E.S.O.P. Through questionable accounting maneuvers, management potentially distorted its financials to create a misleading impression of the company being unable to continue operations.

The Absence of Regulatory Oversight. While critics may tend to blame regulatory failures for the presence of potential abuse, the bankruptcy laws actually prevent the S.E.C. from appealing plans confirmed by the courts. Further, the S.E.C. has other issues with which it must presently contend including the ongoing enforcement of a myriad of rules already in place. Nevertheless, if proven, collaboration between senior managers and unscrupulous creditors may rise to the level of a criminal conspiracy to defraud shareholders and employees. Such a contention requires investigation beyond the scope of this essay.

Recommendations. In the interim, the following policy suggestions would begin to redress the abuse of ownership rights carried out under the guise of Chapter-11 filings: an economic impact statement filed in the bankruptcy court’s records by an outside party, perhaps the

S.E.C. or a private advisory group specifically selected and deputized by the S.E.C.; testimony on the necessity of the Chapter-11 filing by the experts conducting the study, including losses

sustained by stakeholders (e.g., local communities, employees and pensioners) other than shareholders; repeal of Section 1109 of the bankruptcy code prohibiting the S.E.C. from contesting any judgement, order

or decree in a specific case; placement of the U.S. Trustee under the S.E.C.; detailed testimony on re-structuring actions already implemented by the parties sponsoring the Chapter-11

plan, including a detailed comparison with subsequent actions contemplated under the plan; comparison of the amount and terms of new cash being invested under the plan versus the sales price in

an arms-length transaction assuming the re-scheduling of debt maturities; and, use of the R.I.C.O. law – with treble paid by the plan’s sponsoring investor – upon proof of a conspiracy to

commit fraud through the transfer of assets at little or value to the current owners.

Conclusion. These initial measures would begin to re-align regulatory authority with prosecutorial accountability. Such a re-alignment could prevent Chapter-11 filings from degenerating into the means by which cagey creditors and unscrupulous managers fraudulently transfer ownership of publicly-traded companies to themselves at the expense of dispersed, passive and unprotected shareholders.

Primary Source Materials and Suggested Readings

Inter-net: Retrieved on February 13, 2004

Continental Airlines History 1978 to 1990http://www.continental.com/company/history/1978-1990.asp

The Handbook of Texas On-line: Continental Airlineshttp://www.tsha.utexas.edu/handbook/online/articles/view/CC/epc3.html

WebBRD: Lynn M. LoPucki’s Bankruptcy Research Databasehttp://lopucki.law.ucla.edu

Bankruptcy Dictionary (updated: September 14, 2002)http://www.bankruptcyaction.com/bankruptcydictionary.htm#D

Wiley Rein & Fielding LLP: The Art Of Defending Against Cram Downhttp://www.wrf.com/publications/publication.asp?id=654114262002

Case Study: Texaco vs Pennzoil (R.E. Marks; 2001)http://www.agsm.edu.au/~bobm/teaching/MDM/pennzoil.pdf

Inter-net: Retrieved on February 8, 2004

Form 10-K; Advanta Corporation (Dec-02; filed with the United States Securities & Exchange Commission)

A Brief History of Bankruptcy in the U.S. (The 2001 Bankruptcy Yearbook & Almanac)http://www.bankruptcydata.com/Ch11History.htm

Naval Academy Research: James W. Kinnearhttp://www.usna.edu/AcResearch/Kinnear.html

In the Matter of the Stay of Proceedings Against Defendants Johns-Manville Corporation, et al. (State of Washington Supreme Court)http://www.mrsc.org/mc/courts/supreme/099wn2d/099wn2d0193.htm

Glossary of Common Bankruptcy Termshttp://www.bankruptcydata.com/Glossary.htm

The Financial Journalist: Bankruptcy Need Not Be the Final Chapter AND V aluing Firms in Distress (Sep-02)http://www.aimr.com/pressroom/fjnews/fjSept02.html

Chapter 11 Timelineshttp://www.lanepowell.com/pressroom/publications/pdf/travisc_001.pdf

United States Securities & Exchange Commission Documents filed by Company in Case Study

8-K: 13 filings between January 17, 2003 and February 11, 2004

10-K: 4 filings for calendar years 1999 (Mar-2000) through 2002 (Mar-2003)

10-Q: 3 filings for the first three quarters of F.Y.E. Dec-03

14-A: 11 proxy solicitation filings by dissident shareholders; March 3, 2003 and September 19, 2003 10 proxy solicitation filings by management between August 11, 2003 and September 19, 2003

S.E.C. Documents filed by Company in Case Study (continued)

14-C: 2 definitive solicitation by dissident shareholders for contested proxy votes on September 3, 2003

Asset Purchase Agreement dated November 2003

2000 Credit Agreement; amendment dated May 2003

1999 Securitization Agreement; amendment & waiver dated September 2003

1999 Yarn Purchase Agreement; amendment dated November 2003

1992 Note Agreement; amendment dated May 2003

SUGGESTED READINGS

11 USC TITLE 11 – BANKRUPTCY; Jan-02 // http://uscode.house.gov/DOWNLOAD/Title_11.ZIP

“Bankruptcy: A Debtor's Perspective” (Howard H. Stevenson & Michael J. Roberts; Harvard Business School Press; Jun-98)

“Braniff International: The Ethics of Bankruptcy” (Kenneth E. Goodpaster and David E. Whiteside; Harvard Business School Press; Jul-84)

New York Bankruptcy Conference: 1st Day Orders in Chapter 11 Cases (May-02)http://www.abiworld.org/abidata/online/conference/02nybc/Sprayregen.html

Strategic Bankruptcy: How Corporations and Creditors Use Chapter 11 to Their Advantage (Kevin J. Delaney; 3rd Edition; University of California Press; 1998)

Valuation (McKinsey & Co.; 3rd Edition; John Wiley & Sons; 2000); please note that author read an earlier edition of this text in 1996.

APPENDIX; Table 1: Mystery Mills Balance Sheet Summary

MEXICAN Operation Mystery Mills Audited by Regional CPA Unaudited 10-q; 9 months 12 months

BALANCE SHEET; FYE 12 / 31 Dec-01 Dec-02 Dec-2000 Dec-01 Dec-02 Sep-02 Sep-03 Sep-03Total Owned Assets (on balance sheet) 110.0 111.2 #### 423.2 334.4 318.3 325.8 168.2 168.2Return on Total Owned Assets (%) 0.82% 5.40% -5.65% -9.64% 3.49% 3.44% -94.41% -47.00%Total Stockholders' Equity: UnauditedNet Worth (includes minority interest) 73.4 79.8 #### 126.4 86.6 93.5 91.8 (86.3) (86.3)

Tangible Net Worth 73.4 79.8 83.0 67.7 34.9 39.9 38.8 (136.3) (136.6)

Tangible Net Worth Ratio 66.7% 71.8% 18.5% 12.3% 15.1% 14.2% -115.3% -115.6%Extended Tangible Net Worth 73.9 80.5 72.8 40.6 43.3 44.5 (50.1) (50.4)

BALANCE SHEET; FYE 12 / 31 MEXICAN Operation Mystery Mills Audited by Regional CPA nine months

Assets: Dec-01 Dec-02 Dec-2000 Dec-01 Dec-02 Sep-02 Sep-03 12 monthsNet P.P.&E. 80.2 75.6 #### 192.9 164.5 149.1 152.2 17.8 17.8

Cash 3.4 9.8 1.3 2.9 0.0 1.6 1.6 7.5 7.5

Net Receivables 9.2 8.9 47.5 40.1 28.4 33.0 43.3 30.6 30.6

Inventories 9.9 8.3 #### 106.3 62.1 48.9 48.3 61.0 61.0Total hard assets 121.3 125.6 #### 441.1 348.1 332.0 153.8 25.3 25.3Current Ratio 2.45x 1.00x 1.04x 1.72x 0.86x 0.86x 0.77x 0.77x

Quick Ratio 0.55x 0.84x 0.48x 0.35x 0.40x 0.36x 0.33x 0.34x

Defensive-interval (days) 91 139 32 26 33 28 42 53Cash released at 12x A/R & Inv. t/o 0.4 1.2 8.4 5.9 0.0 0.0 3.6 5.2

Liabilities:

Short-term Debt 5.9 17.3 79.7 73.5 3.1 46.2 56.3 76.4 76.4

Senior Long-term Debt 22.4 0.0 #### 108.6 170.7 99.0 98.9 100.0 100.0

Debt-to-Net Worth (x) 38.6% 21.7% 144% 201% 155% 169% N.M. N.M.

APPENDIX; Table 2: Mystery Mills Income StatementUSD millions MEXICAN Operation Mystery Mills Audited by Regional CPA nine months 12 months

INCOME STATEMENT Dec-01 Dec-02 Dec-2000 Dec-01 Dec-02 Sep-02 Sep-03 Sep-03

Net Sales in Denim 58.5 64.0 434.6 352.1 365.4 277.4 230.2 318.2

Cost of Goods Sold / Denim 43.4 41.9 363.8 301.9 296.1 223.6 189.5 262.0

GROSS MARGIN 25.8% 34.5% 16.5% 17.3% 19.2% 18.7% 15.9% 17.2%Gross Margin / Denim 25.8% 34.5% 16.3% 14.3% 19.0% 19.4% 17.7% 14.7%

Gross Margin 0tro 17.5% 28.5% 20.3% 15.5% 7.3% 17.7%

Sales of 2ndary Products 0.0 0.0 118.0 97.8 80.2 63.9 49.0 65.3

Cost of Goods Sold / Otro 0.0 0.0 97.3 69.9 63.9 54.0 45.4 55.3

Interest Income; other 0.1 0.1 1.4 0.5 0.3 0.2 0.2 0.3

Total Revenues 58.6 64.1 554.0 450.4 445.9 341.5 279.4 383.8

Gross Profit 15.1 22.1 91.5 78.1 85.6 63.7 44.3 66.2

Corp/Compensation Expense 5.5 5.3 38.4 31.0 31.1 25.7 22.9 28.3

Interest Expense 2.5 1.8 18.1 18.1 15.6 12.0 11.5 15.1

Depreciation/Amortization 7.1 7.1 22.3 20.6 19.5 14.8 14.5 19.2

0tro 0.3 0.0 5.6 2.6 2.0 1.4 0.7 1.3

Pre-Tax Income (Loss) (0.2) 8.0 8.5 6.3 17.7 10.0 (5.1) 2.6

Operating Interest Coverage (x) 0.92 5.44 1.47 1.35 2.13 1.83 0.56 1.17

EBIT MARGIN 3.9% 15.3% 4.8% 5.4% 7.5% 6.4% 2.3% 4.6%

S.G.&A./Revenues 22.0% 19.3% 12.0% 12.0% 11.8% 12.3% 13.6% 12.7%

Provision for Income Taxes or (Benefits) (1.0) 1.6 (3.2) 2.4 7.1 2.9 30.4 34.6

Net Operating Income 0.8 6.4 11.7 3.9 10.6 7.1 (35.5) (32.0)

Restructuring Charges 0.0 0.0 (9.5) (13.0) 0.0 0.0 (4.9) (4.9)

Equity income 0.1 (0.4) 2.7 0.2 2.5 1.6 2.0 2.9

Goodwill write-down 0.0 0.0 (24.0) 0.0 0.0 0.0 0.0 0.0

Assets write-down 0.0 0.0 (1.2) (14.3) (1.7) (0.3) (80.7) (82.1)

Discontinued Operations 0.0 0.0 (5.0) (13.3) 0.0 0.0 0.0 0.0

Net Income (Loss) 0.9 6.0 (25.3) (36.5) 11.4 8.4 (119.1) (116.1)

APPENDIX; Table 3: Mystery Mills Cash Flow Statement

USD millions MEXICAN Operation Mystery Mills Audited by Regional CPA nine months 12 monthsCASH FLOW CALCULATION Dec-01 Dec-02 Dec-2000 Dec-01 Dec-02 Sep-02 Sep-03 Sep-03Depreciation on Leased Equipment 7.1 7.1 22.3 20.6 19.5 14.8 14.5 19.2Net Income 0.9 6.0 (25.3) (36.5) 11.4 8.4 (119.1) (116.1)All Other Operating Adjustments (5.6) 6.7 20.9 3.3 10.5 6.9 134.3 137.9Cash Flow from Operating Activities 2.4 19.8 17.9 (12.6) 41.4 30.1 29.7 41.0

Total Debt-to-E.B.I.T.D.A. (x) 3.0 1.0 5.7 5.3 4.1 4.6 11.8 8.9NOTE FOR CALCULATION: E.B.I.T.D.A. 9.4 16.9 48.9 45.0 52.8 36.8 20.9 36.9

Invt Cash Flow; Originations (4.2) (2.5) (0.7) 14.6 (3.9) (2.6) (42.4) (43.7)

Change in Deposits 0.0 0.0 1.5 (5.0) (2.8) (4.0) (2.5) (1.3)Change in Short-term Debt (4.1) 0.8 0.0 0.0 0.0 0.0 0.0 0.0Proceeds from Securitizations 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Change in Long-term Debt 7.9 (11.8) (17.2) (8.8) (29.0) (18.9) 23.7 13.6Dividend Payments 0.0 0.0 0.1 0.1 0.2 0.1 0.1 0.2Issue of Stock/Exercise of Options 0.0 0.0 0.2 0.3 0.2 0.2 0.0 0.0Repurchase/Redemption of Stock 0.0 0.0 5.0 4.0 4.6 3.6 2.5 3.5Cash Flow from Financing Activities 3.8 (11.0) (20.6) (17.6) (36.4) (26.4) 18.6 8.6Cash Flows from Discontinued Operations 0.0 0.0 5.0 13.3 0.0 0.0 0.0 0.0Net Increase (Decrease) in Cash 2.0 6.3 1.6 (2.3) 1.1 1.1 5.9 5.9

FREE CASH FLOW CALCULATIONNOTE FOR CALCULATION: Interest Paid 2.5 1.8 18.1 18.1 15.6 8.4 7.1 14.3NOTE FOR CALCULATION: Taxes Paid 0.0 1.3 0.0 0.0 0.0 0.0 0.0 0.0

CAPEX 4.2 2.5 8.0 7.0 9.8 1.9 2.5 10.4

FREE CASH FLOW 2.7 11.3 22.8 19.9 27.4 26.5 11.3 12.2

APPENDIX; Table 4: Mystery Mills Discounted Cash Flow Valuation (unadjusted / historical)Projections 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

U.S. Denim Sales% 71.1%Gross margin% 14.7%

Mexican Denim Sales% 14.3%Gross margin% 34.5%2ndary Sales% 14.6%Gross margin 7.3%

Denim Sales Growth% 2.50%2ndary Sales growth% 0.00% 2004 2005 2006 2007 2008 2009 2010 2011 2012

U.S. Denim Sales 318.2 313.9 312.3 310.7 309.0 307.3 305.6 303.8 301.9 300.1Mexican Sales 64.0 77.9 89.2 100.9 112.9 125.1 137.7 150.5 163.7 177.3

Otro 65.3 65.3 65.3 65.3 65.3 65.3 65.3 65.3 65.3 65.3

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Gross Sales $447.5 $457.1 $466.8 $476.9 $487.2 $497.7 $508.5 $519.6 $531.0 $542.6

C.o.G.s $359.2 $379.3 $385.4 $391.6 $398.0 $404.6 $411.4 $418.3 $425.3 $432.6Gross income $88.3 $77.8 $81.5 $85.2 $89.1 $93.1 $97.2 $101.4 $105.6 $110.0

S.G.&A. $34.5 $35.2 $36.0 $36.8 $37.6 $38.4 $39.2 $40.1 $40.9 $41.8S.G.&A.% 7.7%

CAPEX $10.4 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0F.A. Turn-over 117.9%Interest Expense $16.9 $21.5 $16.6 $14.3 $12.6 $10.2 $7.4 $4.1 $1.2 $0.0

Interest rate 14.0%

Debt $176.4 $130.4 $106.9 $97.9 $81.9 $63.5 $42.2 $16.9 $0.0 $0.0Debt re-paid $46.0 $23.5 $9.0 $15.9 $18.4 $21.4 $25.3 $16.9 $0.0 $0.0

Net Depreciation $15.9 $0.1 $0.5 $0.9 $1.3 $1.7 $2.1 $2.5 $2.9 $3.3P.B.I.T. $27.5 $34.5 $37.0 $39.6 $42.3 $45.1 $47.9 $50.8 $53.8 $56.9

P.B.T. $10.6 $13.0 $20.4 $25.3 $29.7 $34.9 $40.5 $46.7 $52.7 $56.9Tax Rate 38.0%

Taxes $36.2 $4.0 $4.9 $7.8 $9.6 $11.3 $13.3 $15.4 $17.7 $20.0Net Oper. Income ($25.6) $9.0 $15.5 $17.5 $20.1 $23.6 $27.3 $31.3 $34.9 $36.9

Non-operating items ($84.5) $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0Net Income ($110.1) $9.0 $15.5 $17.5 $20.1 $23.6 $27.3 $31.3 $34.9 $36.9

break-up value (25% of net P.P.&E. of $18 million): ($100.8)Discount Rate 25.0% 13.6 15.0 13.1 11.5 10.4 9.2 8.2 7.2 6.0

Discounted Value w/o T.V. $94.2 Net Value ($19.9) terminal value of: $160.8 21.6

Disc. Value with T.V. $115.8 Net Value $1.7 Net value deducts neg. break-up value & excess of 2003 net operating loss over 2003 free cash flow

APPENDIX; Table 5: Mystery Mills Liquidation Analyses (historical & adjusted for Fixed Assets write-down)Break-up Break-up

Liquidation Aanalysis: Sep-03 Historical Valuation Adjusted Liquidation Analysis ValuationAssets: Sep-03 (100.8) Assets: Sep-03 (35.3)Property & Equipment, Net. 17.8 25% Property & Equipment, Net. 254.8 25%

Depreciation 0.0 4.5 Depreciation 237.0 63.7

Net P.P.&E. 17.8 Net P.P.&E. 17.8

Cash 7.5 7.5 Cash 7.5 7.5

Accounts Receivable 34.0 80% Accounts Receivable 34.0 80%

Loss Reserve on A/R (3.4) 27.2 Loss Reserve on A/R (3.4) 27.2

Net Receivables 30.6 Net Receivables 30.6

Inventories 61.0 overall: 57% Inventories 61.0 overall: 57%

Finished Goods 34.7 75% Finished Goods 34.7 75%

Work in Process / supplies 11.3 80% Work in Process / supplies 11.3 80%

Raw Materials & other current 15.0 0% Raw Materials & other current 15.0 0%

Total hard assets 25.3 35 Total hard assets 25.3 35

other assets other assets

Managed Charge-offs 0.0 3.3 Managed Charge-offs 0.6 3.3

Working Capital (29.2) 50% Working Capital (29.2) 50%

Current Ratio 0.77x 1.7 Current Ratio 0.77x 1.7

Quick Ratio 0.33x intangibles Quick Ratio 0.34x intangibles

Charge-off Rate; managed 0.00% 50.0 Charge-off Rate; managed 0.4% 50.0

Receivables Turnover 10.9x 50% Receivables Turnover 9.00x 63%

Inventory Turnover 9.03x 25.0 Inventory Turnover 9.1x 31.3

Defensive-interval (days) 42 Net Assets= Defensive-interval (days) 53 Net Assets=Cash released at 12x A/R & Inv. t/o 3.6 100.9 Cash released at 12x A/R & Inv. t/o 5.2 166.4

Liabilities: Bank Debt Liabilities: Bank Debt

Short-term Debt 76.4 100% Short-term Debt 76.4 100%

Accounts Payable 51.9 76.4 Accounts Payable 51.9 76.4

Deferred Taxes 13.0 Term Debt Deferred Taxes 13.0 Term Debt

Senior Long-term Debt 100.0 100% Senior Long-term Debt 100.0 100%

Debt-to-Net Worth (x) N.M. 100.0 Debt-to-Net Worth (x) N.M. 100.0

Debt to Capital (%) #VALUE! Payables Debt to Capital (%) #VALUE! Payables

Short-term Debt-to-Total Capital (%) 53.2% 51.9 Short-term Debt-to-Total Capital (%) 53.2% 51.9

25% 25%

13.0 13.0

Dfd Taxes/Other Dfd Taxes/Other

24.5 24.5

50% 50%

12.3 12.3

APPENDIX; Table 6: Mystery Mills Discounted Cash Flow Valuation; adjusted to re-state fixed assets; normalize assumptions; and re-pay cash infusion from D.I.P. lender as debt

Projections 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012U.S. Denim Sales% 71.1%

Gross margin% 17.5%Mexican Denim Sales% 14.3%

Gross margin% 37.5%2ndary Sales% 14.6%Gross margin 15.0%

Denim Sales Growth% 5.00%2ndary Sales growth% 2.50% 2004 2005 2006 2007 2008 2009 2010 2011 2012

U.S. Denim Sales 318.2 294.7 272.9 277.1 281.6 286.2 291.1 296.2 301.6 307.2Mexican Sales 64.0 106.6 148.5 165.3 183.0 201.6 221.1 241.6 263.1 285.7

Otro 65.3 66.9 68.6 70.3 72.1 73.9 75.7 77.6 79.6 81.6

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012Gross Sales $447.5 $468.2 $490.0 $512.8 $536.6 $561.7 $587.9 $615.4 $644.2 $674.5

C.o.G.s $359.2 $366.7 $376.3 $391.7 $407.9 $424.9 $442.7 $461.3 $480.9 $501.3Gross income $88.3 $101.6 $113.7 $121.0 $128.7 $136.8 $145.2 $154.1 $163.4 $173.1

S.G.&A. $34.5 $36.1 $37.8 $39.5 $41.4 $43.3 $45.3 $47.4 $49.7 $52.0S.G.&A.% 7.7%

CAPEX $10.4 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0 $8.0F.A. Turn-over 117.9%Interest Expense $16.9 $24.5 $23.2 $20.3 $16.9 $13.1 $8.8 $3.8 $0.5 $0.0

Interest rate 11.0%

Debt $222.4 $222.4 $198.9 $169.9 $137.7 $101.3 $58.7 $9.7 $0.0 $0.0Debt re-paid $0.0 $23.5 $29.0 $32.3 $36.4 $42.5 $49.1 $9.7 $0.0 $0.0

Net Depreciation $15.9 $0.1 $0.5 $0.9 $1.3 $1.7 $2.1 $2.5 $2.9 $3.3P.B.I.T. $27.5 $57.4 $67.5 $72.6 $78.1 $83.8 $89.8 $96.2 $102.8 $109.9

P.B.T. $10.6 $33.0 $44.3 $52.4 $61.2 $70.7 $81.0 $92.4 $102.3 $109.9Tax Rate 38.0%

Taxes $36.2 $4.0 $12.5 $16.8 $19.9 $23.2 $26.8 $30.8 $35.1 $38.9Net Oper. Income ($25.6) $28.9 $31.8 $35.5 $41.3 $47.4 $54.2 $61.6 $67.2 $71.0

Non-operating items ($84.5) $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0Net Income ($110.1) $28.9 $31.8 $35.5 $41.3 $47.4 $54.2 $61.6 $67.2 $71.0

break-up value (25% of estimate P.P.&E. prior to write-downs of $255 million): ($35.3)Discount Rate 15.0% 32.1 30.1 28.6 28.2 27.6 26.9 26.2 24.6 22.5

Discounted Value w/o T.V. $246.6 Net Value $198.0 terminal value of: $495.0 140.7

Disc. Value with T.V. $387.3 Net Value $338.7 Net value deducts neg. break-up value & excess of 2003 net operating loss over 2003 free cash flow