Investment Banking (part C)
by
Charles Lamson
Financial Alternatives for Distressed Firms
A firm may be in financial distress because of technical insolvency or bankruptcy. The first term refers to a firm's inability to pay its bills as they come due. Thus, a firm may be technically insolvent, even though it has a positive net worth; there simply may not be sufficient liquid assets to meet current obligations. The second term, bankruptcy, indicates the market value of a firm's assets are less than its liabilities and the firm has a negative net worth. Under the law, either technical insolvency or bankruptcy may be adjudged as a financial failure of the business firm. Many firms do not fall into either category but are still suffering from extreme financial difficulties. Perhaps they are rapidly approaching a situation in which they cannot pay their bills or their net worth will soon be negative. Firms in the types of financial difficulty discussed in the first two paragraphs may participate in out-of-court settlements or in-court settlements through formal bankruptcy proceedings under the National Bankruptcy Act. Out-of-court settlements, where possible, allow the firm and its creditors to bypass certain lengthy and expensive legal procedures. If an agreement cannot be reached on a voluntary basis between a firm and its creditors, then court procedures will be necessary.  Out-of-court Settlement Out-of-court settlements may take many forms. Four alternatives will be examined. The first is an extension, in which creditors agree to allow the firm more time to meet it's financial obligations. A new repayment schedule will be developed, subject to the acceptance of the creditors. A second alternative is a composition, under which creditors agree to accept a fractional settlement of their original claim. They may be willing to do this because they believe the firm is unable to meet its total obligations and they wish to avoid formal bankruptcy procedures. And the case of either a proposed extension or a composition, some creditors may not agree to go along with the arrangements. If their claims are relatively small, major creditors may allow them to be paid off immediately in full to hold the agreement together. If their claims are large, no out-of-court settlement may be possible, and formal bankruptcy proceedings may be necessary. A third type of out-of-court settlement may take the form of a creditor committee established to run the business. Here the parties involved assumed management can no longer effectively conduct the affairs of the firm. Once the creditors' claims have been partially or fully settled, a new management team may be brought in to replace the creditor committee. The outgoing management may be willing to accept the imposition of a creditor committee only when formal bankruptcy proceedings appear likely and they wish to avoid that stigma. Sometimes creditors are unwilling to form such a committee because they fear lawsuits from other dissatisfied creditors or from common or preferred stockholders. A fourth type of out-of-court settlement is an assignment, in which assets are liquidated without going through formal court action. To effect an assignment, creditors must agree on liquidation values and the relative priority of claims. This is not an easy task. In actuality, there may be combinations of two or more of the above-described out-of-court procedures. For example, there may be an extension as well as a composition, or a creditor committee may help to establish one or more of the alternatives.  In-Court Settlements---Formal Bankruptcy When it is apparent an out-of-court settlement cannot be reached, the next step is formal bankruptcy. Bankruptcy proceedings may be initiated voluntarily by the company or, alternatively, by creditors. Once the firm falls under formal bankruptcy proceedings, a referee is appointed by the court to oversee the activities. The referee becomes the arbitrator of the proceedings, whose actions and decisions are final, subject only to review by the court. A trustee will also be selected to properly determine the assets and liabilities of the firm and to carry out a plan of reorganization or liquidation for the firm. Reorganization If the firm is to be reorganized (under the Bankruptcy Act's Chapter 11 restructuring), the plan must prove to be fair and feasible. An internal reorganization calls for an evaluation of current management and operating policies. If current management is shown to be incompetent, it will probably be discharged and replaced by new management. An evaluation and possible redesign of the current capital structure is also necessary. If the firm is top-heavy with debt (as is normally the case) alternate securities, such as preferred or common stock, may replace part of the debt. any restructuring must be fair to all parties involved. An external reorganization, in which a merger partner is found for the firm, may also be considered. The surviving firm must be deemed strong enough to carry out the financial and management obligations of the joint entities. Old creditors and stockholders may be asked to make concessions to ensure that a feasible arrangement is established. Their motivation is that they hope to come out further ahead then if such a reorganization were not undertaken. Ideally the firm should be merged with a strong firm in its own industry, although this is not always possible. The savings and loan banking Industries have been particularly adept at merging weaker firms with stronger firms within the industry.  Liquidation A liquidation or sale of assets may be recommended when an internal or external reorganization does not appear possible and it is determined that that the assets of the firm are worth more in liquidation than through a reorganization. Priority of claims becomes extremely important in a liquidation, because it is unlikely that all parties will be fully satisfied in their demands. The priority of claims in a bankruptcy liquidation is as follows:
Let us examine a typical situation to determine "who" should receive "what" under a liquidation in bankruptcy. Assume the Mitchell Corporation has a book value and liquidation value as shown in Table 1. Liabilities and stockholders' claims are also presented. Table 1 Financial data for the Mitchell Corporation  We see that the liquidation value of the assets is far less than the book value ($700,000 versus $1.3 million). Also, the liquidation value of the assets will not cover the total value of liabilities ($700,000 compared to $1.1 million). Since all liability claims will not be met, it is evident that lower-ranked preferred stockholders and common stockholders will receive nothing. Before a specific allocation is made to the creditors (those with liability claims) , the three highest priority levels in bankruptcy must first be covered. That would include the cost of administering the proceedings, allowable past wages due to workers, and overdue taxes. For the Mitchell Corporation, we shall assume these total $100,000. Since the liquidation value of assets was $700,000, that would leave $600,000 to cover creditor demands, as indicated in the left-hand column of Table 2. Table 2 Asset values and claims  Before we attempt to allocate the values in the left-hand column of Table 2 to the right-hand column, we must first identify any creditor claims that are secured by the pledge of a specific asset. In the present case, there is a first lien on the machinery and equipment of $200,000. Referring back to Table 1, we observe that the machinery and equipment has a liquidation value of only $100,000. The secured debt holders will receive $100,000, with the balance of their claim placed in the same category as the unsecured debt holders. In Table 3, we show asset values available for unsatisfied secured claims and unsecured debt (top portion) and the extent of the remaining claims (bottom portion). Table 3 Asset values available for unsatisfied secure claims and unsecured debt holders---and their remaining claims   In comparing the available asset values and claims in Table 3, it appears that the settlement on the remaining claims should be at a 50 percent rate ($500,000/$1,000,000). The allocation will take place in the manner presented in Table 4. Table 4 Allocation procedures for unsatisfied secured claims and unsecured debt  Each category receives 50 percent as an initial allocation. However, the subordinated debenture holders must transfer their $100,000 initial allocation to the senior debt holders and recognition of their preferential portion. The secured debt holders and those having accounts payable claims are not part of the senior subordinated arrangement and, thus, older initial allocation position. Finally, in Table 5, we show the total amounts of claims, the amount received, and the percent of the claim that was satisfied. Table 5 Payment and percent of claims  The $150,000 in column (3) for secured debt represents the $100,000 from the sale of machinery and equipment, and $50,000 from the allocation process in Table 4. The secured debt holders and Senior unsecured debt holders come out on top in terms of percent of claim satisfied (it is coincidental that they are equal). Furthermore, the stockholders received nothing. Naturally, allocations in bankruptcy will vary from circumstance to circumstance.  *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 495-500* end |
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