Introduction to troubled-debt restructuring

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Introduction to troubled-debt restructuring

• Corporate Restructuring
• Tim Thompson

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No Chapter 11 filing
Workout
Prepackaged Ch. 11
Distressed Firm
Chapter 11 Reorganization
Chapter 11 (outside option)
Auction or sale
Chapter 7 Liquidation (outside option)
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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

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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

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Causes of insolvency

• Bad luck
• Economic conditions
• Competitive position eroded
• Firm specific factors
• Bad strategy
• Bad execution -- mismanagement
• Fraud
• Overlevered the company

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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)

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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

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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!

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Watch out for incentives on all sides!

• Creditors
• Race to the top
• Dont 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

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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?

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Workouts less expensive than Chapter 11

• Gilson, John and Lang (GJL) studied NYSE AMEX
  firms doing workouts and Ch. 11s in 80s
• 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

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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 theyd
  get in liquidation, company not in danger of
  going bankrupt again (near future)

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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!

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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

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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

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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

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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
  11s
• Also, reputation issues

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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

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Prepackaged bankruptcy

• Hybrid of workouts and Chapter 11s
• 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?

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Deviations from Absolute Priority in Troubled
Debt Restructuring

• Corporate Restructuring
• Tim Thompson

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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

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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

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Do markets expect APR deviations?

• Generally, yes.
• Kaisers 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.

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Betker (1996)

• Show table

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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

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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!

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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.

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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?

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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

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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

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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
• Manufacturers sub notes 11
• Conv Sub Debs 6
• Healthcare claims 8
• Stock 0

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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
  11s
• Prepacks more like workouts
• Pre-solicited somewhat higher than pre-negotiated

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Kaiser notes, Franks and Torous

• Table 12.5, form of compensation
• workouts v. Chapter 11s
• 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

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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.

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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?