Bankruptcy and Reorganization

Bankruptcy and Reorganization (Canada and the U.S.) Questions to ask Insolvency: temporary or permanent? Firm value: is it worth more dead than alive? Definitions Economic Failure Refers to a firm that does not have the prospect of earnings revenues sufficient to match or exceed all of its costs, including its cost of capital. Business Failure Include any business that has terminated with a resultant loss to creditors. Technical Insolvency (flow-based insolvency) The firm cannot meet its maturing financial obligations as they become due. It implies a lack of liquidity. Insolvency in Bankruptcy (stock-based insolvency) A firm is insolvent in bankruptcy when its total liabilities exceed the value of its assets. This often leads to liquidation of the firm Acts of Bankruptcy The Bankruptcy and Insolvency Act contains several provisions defining what constitutes an act of bankruptcy:  ceasing to meet liabilities as they come due  giving notice to suspend payment of debts  failing to meet maturing obligations, or  committing an act of fraud toward a creditor Reorganization in Canada (chapter 11 in the U.S.):  A petition is filed (by the company or by the creditors)  The petition is submitted to a federal judge  If approved, the debtor in possession continues to run the corporation  The company submits a reorganization plan  Secured creditors followed by unsecured creditors vote to accept/reject the plan  The plan is confirmed by the court  Payments are made and reorganization begins Under the reorganization plan the firm:  Negotiates with the creditors  Scales down (up) the operations  Sales some assets  Modernizes the technology  Changes the management Liquidation in Canada (chapter 7 in the U.S.):  A petition is filed  The creditors appoint a trustee-in-bankruptcy  The assets are liquidated and the proceeds are distributed to creditors and shareholders Absolute priority (can be modified by the court):  Secured creditors  Ad-tive expenses associated with the bankruptcy  Other expenses associated with the bankruptcy, before the appointment of a trustee  Wages, salaries and commissions  Contribution to employee benefit plans  Consumer claims  Municipal tax claims  Unsecured creditors  Preferred stockholders  Common stockholders Bankruptcy: Workouts vs. going to court Workouts:  Legal and professional fees amount to 0.6-0.9% of firm's total assets  Can be settled relatively fast  Voting rules are very restrictive: consensus is needed  Strip financing reduces the conflict of interests among classes of claimants  Exchange offers and holdouts Going to court:    Legal and professional fees amount to 5-6% of firm's total assets Cross-default provisions Can take years before the case is settled  Bankruptcy judges are required to ensure that claim-holders are paid and future financial distress is avoided; many times judges lack relevant management experience (ex: violations of absolute priority) Judge can rule to overcome holdout situations (sometimes in the detriment of some creditors)      DIP financing allows the firm to borrow on relatively cheaper terms Protection from creditor harassment Voting rules on restructuring plans less restrictive Advantageous for retailers: the firm can deal with hundred of suppliers as a single class Other issues: Bankruptcy proceedings, labor disputes, and product liability claims: Companies might try to use bankruptcy in order to solve labor disputes and avoid product liability claims. Cases in point: Continental Airlines Dow Corning Bankruptcy and accounting fraud: Bankruptcy should not allow anyone to get away with fraud. Cases in point: Enron WorldCom Who bears the costs of bankruptcy? Eventually, bankruptcy leads to a more efficient re-allocation of resources. Past experience reveals that business failures were a consequence and not a cause of economic downturns. Determinants of bankruptcy costs: •   Type of process: private workouts cost less Speed of the process: the faster a firm is reorganized or liquidated the lower the cost Claimholders' structure and concentration: it is easier to negotiate with a bank than with several thousands bondholders  The complexity of bankruptcy legislation and procedure Question Should we allow any firm to fail, regardless of its size?