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CHAPTER 30

Financial Distress
In late 2008, financial problems at General Motors (GM) and Ford were much in the news. Both automaers were
saddled with lar!e debt loads and le!ac" costs such as retiree health care benefits. #he o$erall econom" also
presented problems for both companies. In %eptember, Ford announced that its sales from the pre$ious "ear had
dropped about &' percent. Because of a!!ressi$e pricin! such as (emplo"ee discount) promotions, GM*s sales
dropped onl" about +, percent. Both companies fou!ht a!ainst filin! for banruptc", e$en !oin! to the -.%. .on!ress
to re/uest a bailout. In testimon" before .on!ress, 0ic 1a!oner, the .23 of GM, stated that independent research
showed that 80 percent of customers would not consider bu"in! a car from GM if the compan" was in banruptc".
GM and Ford are e4amples of companies e4periencin! si!nificant financial distress, the sub5ect of this chapter.
6 firm with insufficient cash flow to mae contractuall" re/uired financial obli!ations, such as interest pa"ments, is
in financial distress. 6 firm that defaults on a re/uired pa"ment ma" be forced to li/uidate its assets, but, more often,
a defaultin! firm will reor!ani7e its financial structure. Financial restructurin! in$ol$es replacin! old financial claims
with new ones and taes place with pri$ate worouts or le!al banruptc". 8ri$ate worouts are $oluntar"
arran!ements to restructure a compan"*s debt, such as postponin! a pa"ment or reducin! the si7e of the pa"ment. If a
pri$ate worout is not possible, formal banruptc" is usuall" re/uired.
30.1 What Is Financial Distress?
Financial distress is surprisin!l" hard to define precisel". #his is true partl" because of the $ariet" of e$ents
befallin! firms under financial distress. #he list of e$ents is almost endless, but here are some e4amples9
:i$idend reductions
8lant closin!s ;osses
;a"offs
.23 resi!nations
8lummetin! stoc prices
Financial distress is a situation where a firm*s operatin! cash flows are not sufficient to satisf" current
obli!ations (such as trade credits or interest e4penses) and the firm is forced to tae correcti$e
action.
+
Financial distress ma" lead a firm to default on a contract, and it ma" in$ol$e financial restructurin! between
the firm, its creditors, and its e/uit" in$estors. -suall" the firm is forced to tae actions that it would not ha$e taen
if it had sufficient cash flow.
Table 30.1 The Largest .!. "an#r$%tcies
3ur definition of financial
distress can be e4panded somewhat b" linin! it to insol$enc". Insol$enc" is defined in Blacks Law Dictionary as9
2
Inabilit" to pa" one*s debts< lac of means of pa"in! one*s debts. %uch a condition of a woman*s (or man*s)
assets and liabilities that the former made immediatel" a$ailable would be insufficient to dischar!e the latter.
#his definition has two !eneral themes9 stocs and flows.
&
#hese two wa"s of thinin! about insol$enc" are
depicted in Fi!ure &0.+. %toc=based insol$enc" occurs when a firm has ne!ati$e net worth, so the $alue of assets is
less than the $alue of its debts. Flow=based insol$enc" occurs when operatin! cash flow is insufficient to meet
current obli!ations. Flow =based insol$enc" refers to the inabilit" to pa" one*s debts. Insol$enc" ma" lead to
banruptc". %ome of the lar!est -.%. banruptcies are in #able &0.+.
Fig$re 30.1 Ins&l'enc(
30.) What Ha%%ens
in Financial Distress?
In >une 2008, General Motors (GM) reported second /uarter net income of ne!ati$e ?+@ million. It also lost
mone" in 200@ and 200A and steadil" lost its maret share to ri$als such as #o"ota, BM1, and Bonda. Its accountin!
shareholder e/uit" turned ne!ati$e in 200, and its stoc price decreased from ?@0 in late 200& to about ?+ in 200C.
6utomobile customers had !ood reason to worr" about bu"in! cars from GM. GM stru!!led to increase sales, cut
costs, attempted to sell assets (e.!., the Bummer line), drew down ban debt, and arran!ed for more lon! =term
financin!. GM was clearl" a firm e4periencin! financial distress. GM filed for banruptc" on >une +, 200C.
Firms deal with financial distress in se$eral wa"s, such as these9
+. %ellin! ma5or assets.
2. Mer!in! with another firm.
&. 0educin! capital spendin! and research and de$elopment.
'. Issuin! new securities.
@. De!otiatin! with bans and other creditors.
,. 24chan!in! debt for e/uit".
A. Filin! for banruptc".
Items (+), (2), and (&) concern the firm*s assets. Items ('), (@), (,), and (A) in$ol$e the ri!ht side of
the firm*s balance sheet and are e4amples of financial restructurin!. Financial distress ma" in$ol$e both asset
restructurin! and financial restructurin! (i.e., chan!es on both sides of the balance sheet).
%ome firms ma" actuall" benefit from financial distress b" restructurin! their assets. For e4ample, a le$ered
recapitali7ation can chan!e a firm*s beha$ior and force a firm to dispose of unrelated businesses. 6 firm !oin!
throu!h a le$ered recapitali7ation will add a !reat deal of debt and, as a conse/uence, its cash flow ma" not be
sufficient to co$er re/uired pa"ments, and it ma" be forced to sell its noncore businesses. For some firms, financial
distress ma" brin! about new or!ani7ational forms and new operatin! strate!ies. Bowe$er, in this chapter we focus
on financial restructurin!.
Financial restructurin! ma" occur in a pri$ate worout or a banruptc" reor!ani7ation under .hapter ++ of the
-.%. banruptc" code. Fi!ure &0.2 shows how lar!e public firms mo$e throu!h financial distress. 6ppro4imatel" half
of the financial restructurin!s ha$e been done $ia pri$ate worouts. Most lar!e public firms (appro4imatel" 8&
percent) that file for .hapter ++ banruptc" are able to reor!ani7e
and continue to do business.
'
Fig$re 30.) What Ha%%ens in Financial Distress
Financial distress can ser$e as a firm*s (earl" warnin!) s"stem for trouble. Firms with more debt will e4perience
financial distress earlier than firms with less debt. Bowe$er, firms that e4perience financial distress earlier will ha$e
more time for pri$ate worouts and reor!ani7ation. Firms with low le$era!e will e4perience financial distress later
and, in man" instances, be forced to li/uidate.
30.3 "an#r$%tc( Li*$idati&n and Re&rgani+ati&n
Firms that cannot or choose not to mae contractuall" re/uired pa"ments to creditors ha$e two basic options9
;i/uidation or reor!ani7ation. #his section discusses banruptc" li/uidation and reor!ani7ation.
@
Eer" small firms (i.e., with assets less than ?+00,000), are more liel" to li/uidate than reor!ani7e compared to
lar!e firms.
Firms with a lar!e number of secured creditors are more liel" to tr" to reor!ani7e.
Firms with an unsecured creditor, especiall" a ban, are more liel" to choose li/uidation.
Firms that ha$e lar!e ne!ati$e e/uit" are more liel" to tr" to reor!ani7e.
Li*$idati&n means termination of the firm as a !oin! concern< it in$ol$es sellin! the assets of the firm for
sal$a!e $alue. #he proceeds, net of transactions costs, are distributed to creditors in order of established priorit".
Re&rgani+ati&n is the option of eepin! the firm a !oin! concern< it sometimes in$ol$es issuin! new securities
to replace old securities.
;i/uidation and formal reor!ani7ation ma" be done b" banruptc". Bankruptcy is a le!al proceedin! and can be
done $oluntaril" with the corporation filin! the petition or in$oluntaril" with the creditors filin! the petition.
Bankruptcy Liquidation
.hapter A of the Banruptc" 0eform 6ct of +CA8 deals with (strai!ht) li/uidation. #he followin! se/uence of
e$ents is t"pical9
+. 6 petition is filed in a federal court. 6 corporation ma" file a $oluntar" petition, or in$oluntar" petitions ma"
be filed a!ainst the corporation.
2. 6 banruptc" trustee is elected b" the creditors to tae o$er the assets of the debtor corporation. #he trustee
will attempt to li/uidate the assets.
&. 1hen the assets are li/uidated, after pa"ment of the costs of administration, proceeds are distributed amon! the
creditors.
'. If an" assets remain after e4penses and pa"ments to creditors, the" are distributed to the shareholders.
C&nditi&ns Leading t& In'&l$ntar( "an#r$%tc(
6n in$oluntar" banruptc" petition ma" be filed b" creditors if both the followin! conditions are met9
+. #he corporation is not pa"in! debts as the" become due.
2. If there are more than +2 creditors, at least three with claims totalin! ?+&,'A@ or more must 5oin in the filin!. If
there are fewer than +2 creditors, then onl" one with a claim of ?+&,'A@ is re/uired to file.
Pri&rit( &, Clai-s
3nce a corporation is determined to be banrupt, li/uidation taes place. #he distribution of the proceeds of the
li/uidation occurs accordin! to the followin! priorit"9
+. 6dministration e4penses associated with li/uidatin! the banrupt compan"*s assets.
2. -nsecured claims arisin! after the filin! of an in$oluntar" banruptc" petition.
&. 1a!es, salaries, and commissions.
'. .ontributions to emplo"ee benefit plans arisin! within +80 da"s before the filin! date.
@. .onsumer claims.
#a4 claims.
,. %ecured and unsecured creditors* claims.
A. 8referred stocholders* claims.
8. .ommon stocholders* claims.
Bankruptcy Reorganization
.orporate reor!ani7ation taes place under .hapter ++ of the Federal Banruptc" 0eform 6ct of +CA8,
as amended b" the Banruptc" 6buse 8re$ention and .onsumer 8rotection 6ct of 200@.
,
#he !eneral ob5ecti$e of a
proceedin! under .hapter ++ is to plan to restructure the corporation with some pro$ision for repa"ment of creditors.
6 t"pical se/uence of e$ents follows9
+. 6 $oluntar" petition can be filed b" the corporation, or an in$oluntar" petition can be filed b" three or more
creditors (or one creditor if the total creditors are fewer than +2Fsee the pre$ious section). #he in$oluntar"
petition must alle!e that the corporation is not pa"in! its debts.
2. -suall", a federal 5ud!e appro$es the petition, and a time for filin! proofs of claims of creditors and of
shareholders is set.
&. In most cases, the corporation (the (debtor in possession)) continues to run the business.
A

'. For +20 da"s onl" the corporation can file a reor!ani7ation plan. If it does, the corporation is !i$en +80 da"s
from the filin! date to !ain acceptance of the plan.
@. .reditors and shareholders are di$ided into classes. 6 class of creditors accepts the plan if two=thirds of the
class (in dollar amount) and one=half of the class (in number) ha$e indicated
appro$al.
8
,. 6fter acceptance b" creditors, the plan is confirmed b" the court.
A. 8a"ments in cash, propert", and securities are made to creditors and shareholders. #he plan ma" pro$ide for the
issuance of new securities.
30.. Pri'ate W&r#&$t &r "an#r$%tc(/ Which Is "est?
6 firm that defaults on its debt pa"ments will need to restructure its financial claims. #he firm will ha$e two
choices9 Formal banruptc" or %ri'ate 0&r#&$t. #he pre$ious section described two t"pes of formal banruptcies9
Banruptc" li/uidation and banruptc" reor!ani7ation. #his section compares pri$ate worouts with banruptc"
reor!ani7ations. Both t"pes of financial restructurin! in$ol$e e4chan!in! new financial claims for old financial
claims. -suall", senior debt is replaced with 5unior debt and 5unior debt is replaced with e/uit". Much recent
academic research has described what happens in pri$ate worouts
and formal banruptcies.
C
Abs&l$te Pri&rit( R$le 1APR2
#he absolute priorit" rule states that senior claims are full" satisfied before 5unior claims recei$e an"thin!.
De'iati&n ,r&- R$le
Reas&ns ,&r 3i&lati&ns
.reditors want to a$oid the e4pense of liti!ation. :ebtors are !i$en a +20=da" opportunit" to cause dela" and
harm $alue.
Mana!ers often own e/uit" and demand to be compensated.
Banruptc" 5ud!es lie consensual plans and pressure parties to compromise.
%3-0.29 ;awrence 6. 1eiss, (Banruptc" 0esolution9 :irect .osts and Eiolation of 8riorit" of .laims,)
Journal of Financial Economics 2A (+CC0).
Bistoricall", half of financial restructurin!s ha$e been pri$ate, but recentl", formal banruptcies ha$e
dominated.
Firms that emer!e from pri$ate worouts e4perience stoc price increases that are much !reater than those for
firms emer!in! from formal banruptcies.
#he direct costs of pri$ate worouts are much less than the costs of formal banruptcies.
#op mana!ement usuall" loses pa" and sometimes 5obs in both pri$ate worouts and formal banruptcies.
#hese facts, when taen to!ether, seem to su!!est that a pri$ate worout is much better than a formal
banruptc". 1e then as9 1h" do firms e$er use formal banruptcies to restructureG
Te !arginal Firm
For the a$era!e firm, a formal banruptc" is more costl" than a pri$ate worout, but for other firms formal
banruptc" is better. Formal banruptc" allows firms to issue debt that is senior to all pre$iousl" incurred debt. #his
new debt is (debtor in possession) (:I8) debt. For firms that need a temporar" in5ection of cash, :I8 debt maes
banruptc" reor!ani7ation an attracti$e alternati$e to a pri$ate worout. #here are some ta4 ad$anta!es to
banruptc". Firms do not lose ta4 carr"forwards in banruptc", and the ta4 treatment of the cancellation of
indebtedness is better in banruptc". 6lso, interest on prebanruptc" unsecured debt stops accruin! in formal
banruptc".
"oldouts
Banruptc" is usuall" better for the e/uit" in$estors than it is for the creditors. -sin! :I8 debt and stoppin!
prebanruptc" interest from accruin! on unsecured debt helps the stocholders and hurts the creditors. 6s a
conse/uence, e/uit" in$estors can usuall" hold out for a better deal in banruptc". #he absolute priorit" rule, which
fa$ors creditors o$er e/uit" in$estors, is usuall" $iolated in formal
banruptcies. 3ne recent stud" found that in 8+ percent of recent banruptcies the e/uit" in$estor
obtained some compensation.
+0
-nder .hapter ++, the creditors are often forced to !i$e up some of their seniorit"
ri!hts to !et mana!ement and the e/uit" in$estors to a!ree to a deal.
#omple$ity
6 firm with a complicated capital structure will ha$e more trouble puttin! to!ether a pri$ate worout. Firms with
secured creditors and trade creditors such as Mac"*s and .arter Bale will usuall" use formal banruptc" because it is
too hard to reach an a!reement with man" different t"pes of creditors.
Lack of %nformation
#here is an inherent conflict of interest between e/uit" in$estors and creditors, and the conflict is accentuated
when both ha$e incomplete information about the circumstances of financial distress. 1hen a firm initiall"
e4periences a cash flow shortfall, it ma" not now whether the shortfall is permanent or temporar". If the shortfall is
permanent, creditors will push for a formal reor!ani7ation or li/uidation. Bowe$er, if the cash flow shortfall is
temporar", formal reor!ani7ation or li/uidation ma" not be necessar". 2/uit" in$estors will push for this $iewpoint.
#his conflict of interest cannot easil" be resol$ed.
#hese last two points are especiall" important. #he" su!!est that financial distress will be more e4pensi$e
(cheaper) if comple4it" is hi!h (low) and information is incomplete (complete). .omple4it" and lac of information
mae cheap worouts less liel".
30.4 Pre%ac#aged "an#r$%tc(
3n 3ctober @, 200', .hoice 3ne .ommunications, a broadband data, Internet ser$ices, and phone compan", filed
for .hapter ++ reor!ani7ation under the -.%. banruptc" code. 6t the time of the filin!, the compan" had about ?+
billion in debt. 6 firm in this situation could reasonabl" be e4pected to spend a "ear or lon!er in banruptc". Dot so
with .hoice 3ne. Its reor!ani7ation plan was confirmed b" the -.% Banruptc" .ourt on Do$ember +0, 200', si4
wees after the date of filin!H
Firms t"picall" file banruptc" to see protection from their creditors, essentiall" admittin! that the" cannot
meet their financial obli!ations as the" are presentl" structured. 3nce in banruptc", the firm attempts to reor!ani7e
its financial picture so that it can sur$i$e. 6 e" to this process is that the creditors must ultimatel" !i$e their
appro$al to the restructurin! plan. #he time a firm spends in .hapter ++ depends on man" thin!s, but it usuall"
depends most on the time it taes to !et creditors to a!ree to a plan of reor!ani7ation.
8repaca!ed banruptc" is a combination of a pri$ate worout and le!al banruptc". 8rior to filin! banruptc",
the firm approaches its creditors with a plan for reor!ani7ation. #he two sides ne!otiate a settlement and a!ree on the
details of how the firm*s finances will be restructured in banruptc". #hen, the firm puts to!ether the necessar"
paperwor for the banruptc" court before filin! for banruptc". 6 filin! is a prepac if the firm wals into court and,
at the same time, files a reor!ani7ation plan complete with the documentation of the appro$al of its creditors, which
is e4actl" what .hoice 3ne did.
#he e" to the prepaca!ed reor!ani7ation process is that both sides ha$e somethin! to !ain and somethin! to
lose. If banruptc" is imminent, it ma" mae sense for the creditors to e4pedite the process e$en thou!h the" are
liel" to tae a financial loss in the restructurin!. .hoice 3ne*s banruptc" was relati$el" painless for most creditors.
Interest pa"ments were made on its debt while in banruptc", and all $endors were paid. #he prepac for .hoice 3ne
was appro$ed b" +00 percent of creditors. #wo sets of bondholders were in$ol$ed. #he senior bondholders
e4chan!ed ?'0' million worth of lon!=term debt for ?+A@ million in new notes and C0 percent of the new stoc in the
compan". #he subordinated bondholders had their ?2@2 million worth of bonds con$erted to +0 percent of the new
stoc and the abilit" to purchase more common stoc in the future. 3f course, stocholders recei$ed nothin! and, in
fact, had their shares canceled.
8repaca!ed banruptc" arran!ements re/uire that most creditors reach a!reement pri$atel". 8repaca!ed
banruptc" doesn*t seem to wor when there are thousands of reluctant trade creditors,
such as in the case of a retail firm lie Mac"*s or 0e$co :. %.
+2
#he main benefit of prepaca!ed banruptc" is that it forces holdouts to accept a banruptc" reor!ani7ation. If a
lar!e fraction of a firm*s creditors can a!ree pri$atel" to a reor!ani7ation plan, the holdout problem ma" be a$oided.
It maes a reor!ani7ation plan in formal banruptc" easier to put
to!ether.
+&
6 stud" b" Mc.onnell, ;ease, and #ash5ian reports that prepaca!ed banruptcies offer man" of the ad$anta!es
of a formal banruptc", but the" are also more efficient. #heir results su!!est that the time spent and the direct costs
of resol$in! financial distress are less in a prepaca!ed banruptc" than in a
formal banruptc".
+'
30.5 Predicting C&r%&rate "an#r$%tc(/ The 67!c&re 8&del
Man" potential lenders use credit scorin! models to assess the creditworthiness of prospecti$e borrowers. #he
!eneral idea is to find factors that enable the lenders to discriminate between !ood and bad credit riss. #o put it
more precisel", lenders want to identif" attributes of the borrower that can be used to predict default or banruptc".
2dward 6ltman, a professor at Dew Ior -ni$ersit", has de$eloped a model usin! financial statement ratios and
multiple discriminant anal"ses to predict banruptc" for publicl" traded manufacturin! firms. #he resultant model is
of the form9
where J is an inde4 of banruptc".
6 score of J less than 2.,A@ indicates that a firm has a C@ percent chance of becomin! banrupt within one "ear.
Bowe$er, 6ltman*s results show that in practice scores between +.8+ and 2.CC should be thou!ht of as a !ra" area. In
actual use, nonbanruptc" if J K 2.CC. 6ltman shows that ban financial profiles one "ear before banruptc". #hese
different financial ratios are the e" intuition behind the J=score model and are depicted in #able &0.2.
Table 30.) Financial !tate-ent Rati&s 9ne :ear be,&re "an#r$%tc(/ 8an$,act$ring Fir-s
6ltman*s ori!inal J= score model
re/uires a firm to ha$e publicl" traded
e/uit" and be a manufacturer. Be uses a
re$ised model to mae it applicable for
pri$ate firms and nonmanufacturers. #he
resultin! model is this9
where J L +.2& indicates a banruptc"
prediction,
+.2& K J M 2.C0
indicates a !ra"
area, and J N 2.C0
indicates no
banruptc".

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