Introduction to troubled-debt

restructuring

Corporate Restructuring
Tim Thompson
 No Chapter 11 filing

Workout

Prepackaged Ch. 11

Distressed Firm

Chapter 11
Reorganization

Chapter 11 Auction
(outside option) or sale
Chapter 7
Liquidation
(outside option)
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 Restructuring
Tim 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 collateral100%
 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?