Not Paying the Piper
Corporate Bankruptcy Facts
• In March 2003, PWC forecasted that around 10,000
companies would file for Chapter 11 protection that year,
down from a record 11,000 in 2002.
• In June 2004 PricewaterhouseCoopers forecasted that
approximately 110 public companies will file for
bankruptcy in 2004. Substantially fewer than in any of
the past six years.
• Recovering Industries: Pharmaceuticals, Computers,
– PWC Source: PR Newswire Association, Inc., June 15, 2004.
Source: Administrative Office of the U.S. Courts.
Bankruptcy Recent Events
• The previous graph shows the total number of filings (Chapter 7 and
• In 2002 about 38,000 firms filed for bankruptcy.
– (11,000 filed a Chapter 11, 27,000 filed a Chapter 7).
– Out of the 11,000 companies that filed for Chapter 11 in 2002, 189 were publicly
– About 100 of the 187 public firms that filed for Chapter 11 in 2001 have already
emerged from bankruptcy.
• In the last three years:
– Midway Airlines
– Global Crossing
– Mirant Corporation
The Largest Bankruptcies 1980 – Present
Bankruptcy Total Assets Filing Court
Date Pre-Bankruptcy District
(click for more info)
Worldcom, Inc. 07/21/02 $103,914,000,000 NY-S
Enron Corp.* 12/2/01 $63,392,000,000 NY-S
Conseco, Inc. 12/18/02 $61,392,000,000 IL-N
Texaco, Inc. 4/12/1987 $35,892,000,000 NY-S
Financial Corp. of America 9/9/1988 $33,864,000,000 CA-C
Global Crossing Ltd. 1/28/2002 $30,185,000,000 NY-S
Pacific Gas and Electric Co. 4/6/2001 $29,770,000,000 CA-N
UAL Corp. 12/9/2002 $25,197,000,000 IL-N
Adelphia Communications 6/25/2002 $21,499,000,000 NY-S
MCorp 3/31/1989 $20,228,000,000 TX-S
Mirant Corporation 7/14/2003 $19,415,000,000 TX-N
The Largest Public Company Bankruptcies - 2003
Company Ch. 11 Assets
Mirant Corporation 14-Jul-03 $19,415,000,000
NRG Energy, Inc. 14-May-03 $10,883,688,000
Trenwick Group, Ltd. 20-Aug-03 $5,277,982,000
Petroleum Geo-Services ASA 29-Jul-03 $4,302,806,000
Amerco 20-Jun-03 $3,773,455,000
Fleming Companies, Inc. 01-Apr-03 $3,654,690,000
Solutia, Inc. 17-Dec-03 $3,342,000,000
Touch America Holdings, Inc. 19-Jun-03 $3,059,480,000
Loral Space & Communications Ltd. 15-Jul-03 $2,692,802,000
* Assets are taken from most recent annual report prior to bankruptcy. Source:
U.S. Bankruptcy System
• Firms that are unable to make required
payments to their creditors can file:
– Chapter 7: which leads to the liquidation of
the firm’s assets in the settlement of the
creditors’ claims, or
– Chapter 11 which allows the firm to
restructure its debt and equity claims and
continue to operate.
• In reality, it is often the creditors who file
for Chapter 7 bankruptcy.
Chapter 7: Liquidation
• In a Chapter 7 bankruptcy, the bankruptcy court selects
a trustee from outside the company who liquidates the
assets of the firm and distributes the proceeds to the
• Any proceeds from the liquidation that remain after
settling the debt holders’ claims are then distributed to
the company’s shareholders.
• Under Chapter 7, these proceeds are divided among the
claim holders according to the Absolute Priority Rule
(APR), which states that debt holders must be paid in full
before equity holders receive any proceeds of the
• APR also states that secured debt holders must be paid
before unsecured debt holders and that the more senior
of the unsecured debt holders must be paid in full before
the more junior debt holders.
Chapter 7 Rules and Restrictions
• Virtually any individual or business entity may be
a voluntary debtor in a Chapter 7 proceedings.
– Railroads (Special subchapter in Chapter 11)
– Most domestic financial institutions (FDIC)
– Most foreign financial institutions
– Government units (Chapter 9)
• No lawyer is required to file
• Most bankruptcy are filed under Chapter 7.
– Mostly small firms.
• Under Chapter 11, debt and equity claims
cannot be settled with cash realized from the
liquidation of assets.
– Instead debt and equity holders receive new financial
claims in exchange for their existing claims.
• Almost all bankruptcies of large corporations
start out as Chapter 11 Bankruptcies and
become Chapter 7 bankruptcies only when the
various claimants fail to agree on a
Reorganization under Chapter 11
• After filing for a Chapter 11, the corporation has
120 days to submit a reorganization plan, which
creditors can either accept or reject.
• Judges frequently extend this 120-day period.
This happens if creditors reject the offer, or the
corporation fails to submit a reorganization plan.
• In most cases, at least one extension is granted.
Accepting or Rejecting the Plan
• To determine the acceptability of the plan, each
class of impaired creditors – the creditors that
will not be paid in full – as well as the equity
holders must vote on it.
• For a specific class of creditors (e.g., convertible
bondholders) to accept the plan, a simple
majority of the claimants, and those who hold
2/3 of the dollar amount of the claim must vote
• A class of stockholders exhibit approval for the
plan when at least two thirds of the firm’s shares
vote to accept it.
Accepting the Plan
• If all classes of claimants accept the plan, the court will
– However, it may not be necessary to have all classes of
claimants approve the plan.
• The court may confirm the plan over the objections of the
dissenting classes if it judges the plan to be
nondiscriminatory, fair, and equitable.
• A plan that is forced on dissenting claimants is known as
a cramdown. A necessary condition for a cramdown is
that the dissenters receive at least what they would
receive under a Chapter 7 liquidation.
APR and Chapter 11
• APR is often violated in a Chapter 11
– Senior debtors allow these deviations from
the APR to facilitate a timely settlement of the
bankruptcy and to avoid future lawsuits.
• Junior debt holders may sue the bankrupt firm's
bank for taking actions that may have caused the
firm to go into bankruptcy.
• Equity holders may threaten to use legal delays if
they are not given some compensation.
Absolute Priority Rule (APR)
• In bankruptcy, claims are divided into at least
– A claim is secured when the claimant has collateral.
• Example: a mortgage.
– Otherwise the claim is unsecured.
• APR ranks claims in the following order:
– Secured Claims
– Administrative Expense claims
– Unsecured claims
• Administrative expenses are those that arise from the
expenses involved in the bankruptcy proceeding itself.
– Costs of Preserving the Estate.
– Compensation of Trustee and others.
– Reimbursement of Expenses / Compensation of Professionals.
• Under some circumstances, creditors may be
– Expenses for actions that benefit the state.
– The attorneys or accountants they used in taking these actions
may be awarded compensation for their service as well.
About those Legal Costs
• Because creditors can seek
reimbursement of their legal fees they
may not always bear the cost of hiring
– Under what circumstances will a creditor bear
or not bear his own legal costs?
– Will secured or unsecured creditors have the
greater incentive to spend money on lawyers?
• Arco Distributions filed for Chapter 11 in 1997.
• The value of the firm’s assets at the time of the
filing was $529,000.
• It owed $9 million
– $1 million to secured creditors.
• The attorneys for the creditors’ committee
charged the firm $112,000 in expenses (21% of
the firm’s value!) that were fully reimbursed. But
APR was upheld.
• Who really paid the attorneys?
Bankruptcy Time in Process
Data from Helwege, J. (1996) "How Long do Junk Bonds Spend in
Default?," working paper Federal Reserve Bank of New York.
Mo. in Default All Prepack. Other Chap. 11 Out of Court
Avg. 20.1 19.4 30.5 7.7
Median 18 18 34 6
Longest 83 34 83 25
Shortest 1 6 8 1
Definitions: A prepackaged default is actually a legal mechanism for
resolving a default. All of the parties negotiate a settlement outside of
court. They then bring the "prepackaged" settlement to court, and the
court approves it.
Bankruptcy Direct Costs
• Direct costs of bankruptcy include legal
expenses, court costs, advisory fees,
management time, creditors time.
• On average, direct bankruptcy costs represent
5% of firm value at the time of the filing.
• Regarding lawyers:
– In the average case, the debtor spends half a million
dollars in legal fees and the creditors $230,000.
– This represents around 1.5% of firm value.
Bankruptcy Indirect Costs
• Indirect bankruptcy costs arise because of the
threat of bankruptcy, and are relevant even if the
firm never defaults on its obligations.
• These are:
– Equity holder incentives
• Equity holders may pursue strategies that decrease the value
of a firm’s debt without reducing its total value.
• Who bears these costs? Equity holders. Why? Because
lenders anticipate the chance such activities will occur and
incorporate them into the price of debt.
Debt and What it Encourages
• The Shortsighted Investment problem.
– Highly leveraged firms prefer projects that pay off
quickly since short-term projects allow them to meet
their near-term debt obligations more easily.
• Asset substitution problem.
– Similar to the one above. Firms will engage in more
risky projects when financial distress is likely.
• The reluctance to liquidate problem.
– Managers of firms under Chapter 11 prefer inefficient
continuations, rather than liquidations.
Debtor in Possession Financing
• By declaring Chapter 11 bankruptcy, a firm may be able
to obtain additional financing that is senior to existing
• The new debt obtained under Chapter 11 is called
debtor-in-possession (DIP) financing.
• Chapter 11 allows a bankrupt firm to obtain permission
to violate debt covenants that otherwise would keep the
firm from obtaining additional financing.
• Some of the efficiency losses in bankruptcy arise
because the provision to obtain DIP financing can allow
a firm to continue operating when it would be better off
Life After Chapter 11
• Only one third of firms that go through a Chapter
11 survive as independent companies.
• Another third are acquired by the end of the
second year after the filing.
• The rest are usually liquidated immediately, or
they file for Chapter 11 again.
• The performance for survivors long after
Chapter 11 is not significantly different from the
other firms in the industry.