Bankruptcy and Restructuring

Causes of Financial Distress

Lack of access to capital markets
JP Morgan buys Bear Stearns after Merrill Lynch creates
impression of liquidity crisis by ceasing collateral in a Bear
Stearns fund.

Deterioration of operating performance

General economic downturn

Foreign competition
Failed growth strategies
Bad capital structure

Large off balance sheet contingent liabilities

Tort claims (US Gypsum, Merck)
Liability for fraud
Liabilities concealed in SPEs
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Definition of Financial Distress

FMV assets less than FMV liabilities
AIGs of the world
Mark-to-Market

Inability to meet obligations as they become

due (liquidity crisis)
Many current firms: profit and nonprofit
Yale as an example

Universities: Endowment Size

Universities: Endowment per

Student 2006

Why do Universities have

Endowments?

Intergenerational Equity
Buffer against Financial Adversity
Protect Reputational Capital in Long-run
Protect Intellectual Freedom
Pass Values across Generations
Wishes of Donors, Trustees, etc
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Spending Rules
Protect Endowment Value in Real Terms
Should be Independent of the Investment
Policies
Should Provide a Smooth Spending Pattern to
facilitate Financial Planning

Liquidity (most important focus in

nonprofits)

Truths of Distress Investing

No one can take away a Corporate Creditors Right to a money payment

outside of Chapter 11
E.g. $5 billion bailout by congress of airlines: more than $2 billion given to
creditors for principal and interest (therefore it is a creditor bailout!)

Chapter 11 rules influence all reorganizations

Voluntary exchanges
Conventional Chapter 11
Prepackaged Chapter 11
rule of absolute priority, period of exclusivity, etc.

Creditors of a distressed company will get ripped off by the reorganization

professionals
Creditors have only contractual rights
Solvent Companies
Contractual rights in covenant
No residual claims
Other legal rights, e.g. fraudulent conveyance

Insolvent Companies
Zone of insolvency
Insolvent: Board of Directors works for the creditors
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Deal Expenses/Costs of Bankruptcy

Administrative expenses of a bankruptcy
are paid by the estate (DIP)
Committees (DIP, creditor committees, equity
holder committees)
Attorneys, financial advisors, CPAs, I Bankers,
Appraisers, etc.each committee hires these
people
Superpriority in payment over other unsecured
claims Paid in cash on an on-going basis)
Contributes to infeasibility
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Deal Expenses/Costs of Bankruptcy

Examples

Ongoing fees (examples)

UAL

Saybrook Restructuring Advisors LLC: $250,000/month

for first 6 months and $200,000/month thereafter

Loral Space and Communications

Conway, Del Genio Gries and Co.: $250K/month
Jeffries & Co.: $150K/month

Bonus Potential (examples)

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Deal Expenses/Costs of Bankruptcy

Examples

Bonus Potential (UAL/Saybrook)

If either a plan is confirmed and becomes effective in the companys
bankruptcy case or a sale transaction (as defined in the agreement)
closes, the firm will be entitled to an incentive fee. The fee will be
measured based on the percent, if any, by which the value of
consideration issued to bondholders under a restructuring increased
over the median value of the bonds on Dec. 30 (based on a median
trading price of 9.83 cents for every dollar of principal amount
outstanding). The incentive fee is capped at $7.5 million. The firm will
be entitled to an incentive fee of $7.5 million for a 50% increase above
the baseline trading price. To the extent that the increase is between
0% and 50%, the firm will be entitled to a prorated fee calculated to
the nearest $10,000. If the firm doesnt earn an incentive fee under this
formula, the panel may elect to pay a discretionary incentive fee not to
exceed $3.5 million. The amount of the earned incentive fee (not the
discretionary incentive fee) will be reduced by the total amount of all
monthly advisory fees paid to the firm after the sixth month.
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Deal Expenses/Costs of Bankruptcy

Examples
Bonus Potential (Loral/Jeffries)
The firm will be entitled to a completion fee
equal to the greater of $1 million or 1% of
the total consideration received by
unsecured creditors between $500 million
and $700 million plus 1.75% of total
consideration over $700 million.

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Methods of Restructuring Troubled

Companies
Voluntary Exchanges
Conventional Chapter 11
Prepackaged Chapter 11

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Time in Bankruptcy

Pre-2005 BAPCPA

Exhibit 4.5 Average and Median

Duration of Chapter 11 Cases in
Months, by Type of Filing, 1980
2007

Cases

Average

Median

Conventional

523

22

18

Prenegotiated

110

Prepackaged

63

Post-2005 BAPCPA

Cases

Average

Median

Conventional

13

14

Prenegotiated

Prepackaged

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Voluntary Exchanges
Prior to Chapter 11 filing
Offer current holders to trade their equity or debt securities
for new instruments
Usually principal amount is slightly higher than current market
price but with less onerous cash service requirements or
sometimes PIK

Problems/Issues with such offers

They are voluntary
Cannot force them to give up contractual rights

Require registration statement

Expensive and time consuming

If bondholder holds out and others do not they will likely be better
off
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Voluntary Exchanges
Show downside
Juniority after exchange
Nonmonetary provisions of indentures can be changed by 1
50% vote

Shorten maturity date

Threat of Chapter 11

Other issues
Vulture investors
Taxes
OID

General concern (not just bankruptcy)

Worry about creating taxable events: the event causing
taxes does/doesnt give rise to the cash to pay the taxes!
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Conventional Chapter 11
If confirmed by the bankruptcy court the
reorganization plan is binding on all claimants
Confirmation
2/3 in amount and 50% in number of votes for each
separate class of claimants vote to accept
2/3 of common and preferred vote to accept
Cram down if certain classes reject plan
Fair and equitable to all parties
Each rejecting class will receive more under the plan than from
a liquidation

Reluctance to file 11
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Conventional Chapter 11

Reluctance to file Chapter 11

Perceived stigma
Large administrative expenses
Company fees for professionals

Attorneys
Investment bankers
Accountants
Other experts

Court appointed official committees

Company pays the fees for ALL such committees

Loss of management control

No action can be taken outside of the normal course of business without court approval
Must share business and strategic plans with all claimants and parties of interest
Massive reporting, discovery and testimony under oath
Oftentimes a very knowledgeable and potent set of claimants

Emergence from Chapter 11

Virtually all claims against company disappear (unlike a voluntary settlement)

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Prepackaged Chapter 11
Solicitation of creditors and equity holders
to a Chapter 11 Plan of Reorganization
before the company ever files Chapter 11
Management maintains control as this is done
out of Chapter 11
Avoid massive bankruptcy costs
Quicker than a conventional Chapter 11
No incentive for public bondholders to hold out
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Environment of the Case

Company in trouble
Voluntary or Involuntary filing
Involuntary
3 petitioning creditors owed more than $10,775 (if more than 12
creditors), otherwise only 1 petitioning creditor owed $10,775 is
sufficient

Voluntary more common

Forum/Judge shopping

Commencement of Chapter 11
Formation of Committees
Some cases-appointment of examiner or trustee
Usually in cases of management fraudulent actions
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Claimants and Parties of Interest

(Communities and Conflicts of
Interest)

Management
The company itself
Equity holders (common and preferred)
Professionals
Executory contracts
Adequately secured creditors
Subordinated debt holders
Unsecured creditors
Trade creditors
Administrative claimants

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Conventional Chapter 11

Period of Exclusivity
Automatic Stay
Consensual Plan
Adequate Protection
DIP Financing
Confirmation Hearing
Fraudulent Transfer
Voidable Preferences
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Public Policy Issues

System doesnt work

Administratively Expensive
Doesn't fix companies
Management Entrenchment
Ideal system

Administratively quick and inexpensive

Cause those who made incorrect investment decisions to suffer
Results of reorganizations should be fair and equitable
Should distinguish between reorganizable and liquidatable
Should contribute to making reorganized companies feasible

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Other Items
Fresh Start Accounting
Vulture Investors
Fulcrum securities

Time to reorganization
Chapter 11 as a component of corporate strategy
Substantive Consolidation
Predicting Bankruptcy
Altmans Z
Complex capital structure/consolidated financial
statements
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Other Issues
Management Entrenchment and
Compensation
Usually management continues in place
Need for speed in reorganization

Key Employee Retention Plans (KERP)

2005 bankruptcy law changes limit dollars in
KERP
Circumvent with incentive plans
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