Financial Distress Resume

30.1 What Is Financial Distress?
Financial distress is surprisingly hard to define precisely. This is true partly because of the variety of events
befalling firms under financial distress. The list of events is almost endless, but here are some examples:
Dividend reductions
Plant closings
Losses
Layoffs
CEO resignations
Plummeting stock prices
Financial distress is a situation where a firms operating cash flows are not sufficient to satisfy current obligations
(such as trade credits or interest expenses) and the firm is forced to take corrective action. Financial distress may
lead a firm to default on a contract, and it may involve financial restructuring between the firm, its creditors, and its
equity the firm is forced to take actions that it would not have taken if it had stOur definition of financial distress can
be expanded some insolvency. Insolvency is defined in Black s Law Dictionary as
This definition has two general themes: stocks and flows.3 These two ways of thinking about insolvency are
depicted in Figure 30.1. Stock-based insolvency occurs when a firm has negative net worth, so the value of assets is
less than the value of its debts. Flow-based insolvency occurs when operating cash flow is insufficient to meet
current obligations. Flow-based insolvency refers to the inability to pay ones debts.
30.2 What Happens in Financial Distress?
In the early I 990s, Trans World Airline, Inc. (TWA), experienced financial distress. It lost money in 1989, 1990, and
1991 and steadily lost its market share to rivals United, American, and Delta. Having seen Eastern and Pan Am
disappear, airline travelers had good reason to be nervous about buying tickets from TWA.
In the summer of 1991, TWA General Counsel Mark A. l3uckstejn bet Carl Icahn, TWA owner and CEO, $1,000 that
the airline would be forced to file involuntary bankruptcy by September 199 I.4 Icahn argued that he could arrange a
private restructuring and avoid formal bankruptcy. Tcahn won the bet, but TWA eventually filed for bankruptcy on
January31, 1992.
Reorganization is the Option of keeping the firm a going Concern; it sometimes involves iSsuing new securities to
replace old securities
Liquidation and formal reorganization may be done by bankruptcy Bankruptcy is alegal Proceeding and
can be done Voluntarily with the corporation filing the petition orinvoluntarily with the creditors filing the petition.
Bankruptcy Liquidation
Chapter 7 of the Bankruptcy Reform Act of 1978 deals with straight liquidation Thefollowing sequence of events
is typical:
1. A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary petitions
may be filed against the corporation
2. A banptcy trustee is elected by the creditors to take over the assets of the debtor corporation The trustee
will attempt to liquidate the assets.
3. When the assets are liquidated, after payment of the costs of administration, proceeds are distributed
among the creditors.
4. If any assets remain, after expenses and payments to creditors they are distributed to the shareholders
Conditions Leading to involuntary Bankruptcy An involuntary bankruptcy petitionmay be filed by creditors if both
the following conditions are met:
1. The corporation is not paying debts as they become due.
2. If there are more than 12 creditors, at least three with claims totaling $5,000 or more must join in the filing.
If there are fewer than 12 creditors, then only one with a claim of $5,000 S required to file.
3. In most cases, the corporation
4. The corporation is given 120 days to submit a reorganization plan
5.
6.
7.
Creditors and shareholders are divided into classes. A class of creditors accepts the plan if two-thirds of the
class (in dollar amount) and one-half of the class (in number) have indicated approval.
After acceptance by creditors, the plan is confirmed by the court.
Payments in cash, property, and securities are made to creditors and shareholders.
30.4 Private Workout or Bankruptcy: Which Is Best?

A firm that defaults on its debt payments will need to restructure its financial claims. Thefirm will have two choices:
formal bankruptcy or private workout. The previous sectiondescribed two types of formal bankruptcies: bankruptcy
liquidation and bankruptcy
One. Its reorganization plan was confirmed by the U.S Bankruptcy Court on November 2004, six weeks after the
date of filing!
Firms typically file bankruptcy to seek protection from their creditors,admitting that they cannot meet their financial
obligations as they are presently structured. Once in bankruptcy, the firm attempts to reorganize its financial picture
it can survive. A key to this process is that the creditors must ultimately give the approval to the restructuring plan.
The time a firm spends in Chapter 11 depends onthings, but it usually depends most on the time it takes to get
creditors to agree to areorganization.
Prepackaged bankruptcy is a combination of a private workout and legal bankruptcy Prior to filing bankruptcy, the
firm approaches its creditors with a plan for reorganization The two sides negotiate a settlement and agree on the
details of how the firmsbe restructured in bankruptcy. Then, the firm puts together the necessary paperwork the
bankruptcy court before filing for bankruptcy. A filing is a prepack if the essentially walks into court and, at the
same time, files a reorganization plan completedocumentation of the approval of its creditors, which is exactly what
Choice One did.
The key to the prepackaged reorganization process is that both sides have sogain and something to lose. If
bankruptcy is imminent, it may make sense forthto expedite the process even though they are likely to take a
financial loss in the restructuring. Choice Ones bankruptcy was relatively painless for most creditors. Interest
payment were made on its debt while in bankruptcy, and all vendors were paid. TheChoice One was approved by
100 percent of creditors. Two sets of bondholders . The senior bondholders exchanged $404 million worth of longterm dmillion in new notes and 90 percent of the new stock in the company. The bondholders had their $252 million
worth of bonds converted to 10 percentstock and the ability to purchase more common stock in the future. Of
course,received
nothing
and,
in
fact,
had
their
shares
canceled.
Prepackaged bankruptcy arrangements require that most creditors reach agreement privately. Prepackaged
bankruptcy doesnt seem to work when there are of reluctant trade creditors, such as in the case of a retail trading
firm likeRevco D. S.
The main benefit of prepackaged bankruptcy is that it forces holdoutsbankruptcy reorganization. If a large fraction
of a firms creditors can agreereorganization plan, the holdout problem may be avoided. It makes a reorganization
formal bankruptcy easier to put together.A study by McConnell, Lease, and Tashjian reports that prepackaged
offer many of the advantages of a formal bankruptcy, but they are also more efficient. Their results suggest that the
time spent and the direct costs of resolving financial distress in a prepackaged bankruptcy than in a formal
bankruptcy.2

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30.1 What Is Financial Distress?

30.4 Private Workout or Bankruptcy: Which Is Best?

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