Introduction to troubled-debt restructuring

Corporate RestructuringTim Thompson

Distressed Firm

Workout

Chapter 11(outside option)

No Chapter 11 filing

Prepackaged Ch. 11

Chapter 11 Reorganization

Chapter 7Liquidation

(outside option)

Auctionor sale

Focus of lecture Firm already in distress

defined as not able to make debt payments as they come due

Choices Renegotiate contracts with creditors out of court (workout) Renegotiate contracts with creditors in court (Chapter 11) Allow the firm to be liquidated by court appointed trustee

(Ch 7) Chapter 11 court may order the company be sold to highest

bidder Most focus will be on large firms, usually publicly

held

Insolvency

Troubled debt restructuring methods needed because firm is insolvent

I.e., it can not meet its obligations as they come due.

This is not the legal definition

Causes of insolvency

Bad luck Economic conditions Competitive position eroded Firm specific factors

Bad strategy Bad execution -- mismanagement Fraud Overlevered the company

Effect of insolvency

Have to recontract with creditors get parties to agree to reorganization

liabilities, ownership, control or liquidate

Recontracting can be settled out of court Workouts/private reorganizations

Or, in court Chapter 11 (reorg) or Chapter 7 (liquidation)

Main effect of reorganizations Restructure terms on debt

reduce interest payments/principal amounts Extend maturity Substitute equity (or equiv.) for debt

What if V is very large? Could be that have too little cash flow, but

good value, could offer BH more value, but paid later

Not the usual situation

What is optimal choice if managers are value maximizing?

Is the firm worth more as a going concern? with its own strategy bought out by another firm

Or is it worth more liquidated? What is size of the pie and how is it

to be sliced? Tough question on both counts!

Watch out for incentives on all sides!

Creditors Race to the top Don’t want firm to go into Ch. 11 In Ch. 11, want you to liquidate inefficiently

Shareholders Stay out of Ch 11 In Ch 11, want ongoing firm

Managers Depends on what their position looks like

Chapter 11 is not first choice Almost all large, publicly traded

firms attempt to workout debt before entering Chapter 11

Why do firms attempt a workout?

Workouts less expensive than Chapter 11 Gilson, John and Lang (GJL) studied

NYSE AMEX firms doing workouts and Ch. 11’s in ‘80’s Legal and professional fees higher in Ch

11 Avg length of Ch 11 is longer, especially

when workout included exchange offer In workout, only deal with claims in

default* In Ch 11, all claims

Problems with Ch. 11

Legal/professional fees have priority over other claims, so less incentive to get it done

Management by judges Major decisions: file application with court,

notify creditors -- file complaints Judges legal requirements

claimholders must receive at least what they’d get in liquidation, company not in danger of going bankrupt again (near future)

Why would bondholders or lenders agree to workout? Chapter 11 is a protection for the

debtor (called the debtor in possession, or DIP)

Chapter 11 can extract an even better (worse for the creditor) deal for the DIP than you might get in workout!

Advantages to DIP of Chapter 11 New issued debt higher priority

than pre-petition debt Interest on pre-petition unsecured

debt stops accruing Automatic stay from creditors Easier to get reorg plan accepted

because of voting rules

Why does firm go to Chapter 11? Creditor holdouts (and advantages above) In workout, have to get all participating

creditors to agree Bondholders have incentive to free ride

on the settlement Try to trap the free riders by making the

exchanged bonds higher priority, shorter maturity

Problem worse with public debt, more complex debt

LTV decision

Judge Burton Lifland Bondholders who tendered in

previous exchange offer were entitled to claim equal to market value of new bonds

Non exchanging bondholders entitled to claim equal to face value of debt

Makes holdout problem worse

Rights of management in Ch 11 DIP (debtor in possession) has

exclusive right to file first reorg plan for 120 days typically extended, sometimes for years

Large management turnover in both workouts and Ch 11’s Also, reputation issues

Tax disadvantage to voluntary restructuring Tax Reform Act of 1986

More difficult to preserve NOL carryforwards

Hard to avoid paying tax on income from forgiveness of debt

Revenue Reconciliation Act of 1990 newly exchanged bonds trading at a

discount to face value, the firm must book the difference as taxable income

Prepackaged bankruptcy

Hybrid of workouts and Chapter 11’s Firm files Chapter 11 But files reorg plan at the same time

(agreed to with secured creditors informally beforehand)

Can hurry up the Ch 11 process Not a sure thing! Why do Ch 11 at all?

Deviations from Absolute Priority in Troubled Debt Restructuring

Corporate RestructuringTim Thompson

Absolute Priority

In typical corporate finance treatments of default, assumed that claimants of the firm will be paid according to absolute priority

First, secured claimants Administrative claims Employee claims Customer claims Tax claims Unsecured creditors, then equity

Deviations from APR common Kaiser, Chap. 11, documents many

papers describing deviations from APR Both in Chapter 11 and in workouts Typically, equity and unsecured

debtholders receive more than “should,” more senior claims receive less than “should”

Equity receives more in workouts than in Chapter 11

Do markets expect APR deviations? Generally, yes. Kaiser’s Chapter 11 suggests that

debt markets do not seem to anticipate the eventual APR violations, but most of the literature suggests that markets do, in fact, incorporate these violations into pricing.

Betker (1996) Show table

If markets efficient, do deviations from APR matter? Still matter, because the noise in how

much you would get/lose due to violations leads to inefficient investments in time to find out how large deviations will

be in time and effort to limit/increase size of

deviations in increases in rates/onerous covenants

when you issue debt

Why are there deviations?

Management bargaining position Factors influencing amount

Larger proportion of debt, less violations higher proportion of secured debt/bank

debt, etc., less violations More equity percentage held by mgmt.

especially if same mgmt. continues employment Manager position looks like shareholder,

more!

Lo Pucki and Whitford (1990) Managers act more in their own

interests than in equity interests, so understanding the distinction is important on case by case basis.

Recovery rates How much do bankers/bondholders

get back of their original investment in Chapter 11 reorganizations? What is relation between recovery

rates and seniority/security? What is relation between recovery

rates and public/private/banks?

Altman evidence Average “recovery rate” approx. 40%

Recovery rate defined as the price one month after default occurred divided by par value

1991 36.0% 1990 23.4% 1989 38.3% 1988 43.6% 1987 75.9% 1986 34.5% 1985 45.9%

Altman: rec. rates by priority 1985-1991 Averages Type of debt Recovery rate

Secured 60.51% Senior 52.28% Senior subordinated 30.70% Subordinated (cash pay) 27.96% Subordinated (PIK) 19.51%

Recovery rates in Eastern Airlines Secured debt with sufficient collateral 100% Secured debt, insufficient collateral

11.75% First equip cert 100% 12.75% Second equip cert 60% 13.75% Third equip cert 6%

Accrued interest on secured debt 57% Capital lease obligations 100% Unsecured debt

PBGC pension claims 15% Manufacturer’s sub notes 11% Conv Sub Debs 6% Healthcare claims

8% Stock 0%

Kaiser notes, Franks and Torous Table 12.2 Percentage recovery

rates by creditor class exchanges, Chap. 11, and prepacks

Conclusions: Recovery rates higher in workouts than

Chapter 11’s Prepacks more like workouts Pre-solicited somewhat higher than pre-

negotiated

Kaiser notes, Franks and Torous Table 12.5, form of compensation

workouts v. Chapter 11’s Conclusions:

Cash larger part of distribution in Ch. 11 Bank debt reduced in chapter 11, becomes senior debt Junior debt and preferred receive equity, both methods Equity is larger part of distribution in Ch. 11

Loss in value at Eastern Weiss and Wruck

Table 2 Total recover by fixed claimants and equity

at resolution of bankruptcy, $2,005.5 million.

At filing of Chapter 11, total estimated market value of equity plus different measures of debt, around $4 billion

Loss of approx. $2 billion in value in Chap 11 argue was not due to industry conditions Direct costs were $114 million only.

What was problem? Uncertainty about going concern v.

liquidate Judge allowed managers to use

proceeds of asset sales to fund continued operations (at substantial op losses)

Some venue shopping?