Exam 17: Alternative Exit and Restructuring Strategies:

A workout is an arrangement conducted inside of bankruptcy court by a debtor and its creditors for payment or re-scheduling of payment of the debtor's obligations.

Automatic stays are granted by the court only when the debtor files for bankruptcy.

Lehman Brothers Files for Chapter 11 in the Biggest Bankruptcy in U.S. History A casualty of the 2008 credit crisis that shook Wall Street to its core, Lehman Brothers Holdings, Inc., a holding company, announced on September 15, 2008, that it had filed a petition under Chapter 11 of the U.S. Bankruptcy Code. Lehman's board of directors decided to opt for court protection after attempts to find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and Enron with $126 billion and $81 billion in assets, respectively. None of the holding company's subsidiaries was included in the filing, enabling customers of Lehman's brokerage, Neuberger Berman Holdings, to continue to use their accounts to trade. Furthermore, by excluding its units from the bankruptcy filing, customers of its broker–dealer operations would not be subject to claims by LBHI's more than 100,000 creditors in the bankruptcy case. Prior to the Dodd-Frank Act of 2010 (see Chapter 2) limiting such rights, counterparties could cancel contracts when a financial services firm went bankrupt. Lehman would normally hedge or protect its investments by taking opposite positions to minimize potential losses in its derivatives portfolios. Derivatives are financial instruments whose value changes in response to the value of the underlying assets over a specific period. For example, if the firm purchased a contract to buy oil at a specific price at some point in the future, it would also sell a contract at a somewhat lower price to another party (called a counterparty) to minimize losses if the price of oil dropped. Thus, the bankruptcy filing left Lehman's investment positions unprotected. On September 20, 2008, Barclays PLC., a major U.K. bank, acquired Lehman's broker–dealer operations for $250 million and paid an additional $1.5 billion for the firm's New York headquarters building and two New Jersey–based data centers. Coming just five days after Lehman filed for bankruptcy, the deal reflected the urgency to find buyers for those businesses whose value consisted primarily of their employees. Barclays did not buy any of Lehman's commercial real estate assets or private equity and hedge fund investments. However, Barclays did agree to take $47.4 billion in securities and assume $45.5 billion in trading liabilities. On September 24, 2008, Japanese brokerage Nomura Securities acquired Lehman's Japanese and Australian operation for $250 million. Lehman's investment management group, Neuberger Berman, was sold in late December 2008 to a Neuberger management group for $922 million. Under the deal, Neuberger's management would own 51 percent of the firm, and Lehman's creditors would control the remainder. Other Lehman assets, consisting primarily of complex derivatives ranging from oil price futures to credit default swaps (i.e., debt insurance) to options on stock indices, with more than 8,000 counterparties, were expected to take years to identify, value, and liquidate. The firm also could expect to face numerous lawsuits. The October 18, 2008, auction of $400 billion of Lehman's debt issues was valued at 8.5 cents on the dollar. Because such debt was backed by only the firm's creditworthiness, the buyers of the Lehman debt had purchased insurance from other financial institutions to mitigate the risk of a Lehman default. The existence of these credit default swap arrangements meant that the insurers were required to pay Lehman bondholders $366 billion (i.e., 0.915 × $400 billion). Purchasers of this debt were betting that, following Lehman's liquidation, holders of this debt would receive more than 8.5 cents on the dollar and the insurers would be able to satisfy their obligations. Hedge funds also were affected by the Lehman bankruptcy. Hedge funds borrowed heavily from Lehman, putting up certain assets as collateral for the loans. While legal, Lehman was using this collateral to borrow from other firms. By using its customers' collateral as its own collateral, Lehman and other firms could borrow more money, using the proceeds to make additional investments. When Lehman filed for bankruptcy, the court took control of such assets until who was entitled to the assets could be determined. Moreover, while derivative agreements were designed to terminate whenever a party declares bankruptcy and be settled outside of court, Lehman's general creditors may lay claim to any collateral whose value exceeds the value of the derivative agreements. Disentangling these claims will take years. In early 2010, a report compiled by bank examiners described how Lehman manipulated its financial statements, leaving the investing public, credit rating agencies, government regulators, and Lehman’s board of directors totally unaware of the accounting tricks. By departing from common accounting practices, Lehman appeared to be less levered than it actually was. It was pressure from speculators, sensing that the firm was in disarray, which uncovered the scam by selling Lehman’s stock short and accomplishing what the regulators and credit rating agencies could not. See the Inside M&A case study at the beginning of Chapter 2 for more details on Lehman’s accounting practices. -Do you believe the U.S. bankruptcy process was appropriate in this instance? Explain your answer.

Smaller creditors have little incentive to attempt to hold up the agreement unless they receive special treatment.

By law, corporate liquidation can only be conducted outside of the U.S. bankruptcy court.

The Blockbuster case study illustrates options available to the creditors and owners of a failing firm. How do you believe creditors and owners might choose from among the range of available options?

The Bankruptcy Abuse Prevention and Creditor Protection Act of 2005 is intended to achieve all of the following except:

Financial buyers such as hedge funds clearly are motivated by the potential profit they can make by buying distressed debt. Their actions may have both a positive and a negative impact on parties to the bankruptcy process. Identify how parties to a bankruptcy may be helped or hurt by the actions of the hedge funds.

Empirical studies show that company size (measured by assets), case duration (measured in days), and the number of parties involved in the proceedings (measured in terms of the numbers of professional firms working) explain most of the case-to-case variation in professional fees.

Financial buyers clearly are motivated by the potential profit they can make by buying distressed debt. Their actions may have both a positive and negative impact on parties to the bankruptcy process. Identify how parties to a bankruptcy may be helped or hurt by the actions of the hedge funds.

For capital markets to function smoothly, disputes involving the legal rights of all participants (both debtors and creditors) need to be resolved quickly and equitably by the courts.

Hostess's assets were sold in a 363 auction. Such auctions attract both strategic and financial bidders. Which party tends to have the greater advantage: the strategic or financial bidder? Explain your answer.

Chapter 11 of the U.S. bankruptcy code deals with liquidation while Chapter 7 addresses reorganization.

Delta Airlines Rises from the Ashes -Once in Chapter 11, a firm may be able to negotiate significant contract concessions with unions as well as its creditors. -A restructured firm emerging from Chapter 11 often is a much smaller but more efficient operation than prior to its entry into bankruptcy. ______________________________________________________________________________________ On April 30, 2007, Delta Airlines emerged from bankruptcy leaner but still an independent carrier after a 19-month reorganization during which it successfully fought off a $10 billion hostile takeover attempt by US Airways. The challenge facing Delta's management was to convince creditors that it would become more valuable as an independent carrier than it would be as part of US Airways. Ravaged by escalating jet fuel prices and intensified competition from low-fare, low-cost carriers, Delta had lost $6.1 billion since the September 11, 2001, terrorist attack on the World Trade Center. The final crisis occurred in early August 2005 when the bank that was processing the airline's Visa and MasterCard ticket purchases started holding back money until passengers had completed their trips as protection in case of a bankruptcy filing. The bank was concerned that it would have to refund the passengers' ticket prices if the airline curtailed flights and the bank had to be reimbursed by the airline. This move by the bank cost the airline $650 million, further straining the carrier's already limited cash reserves. Delta's creditors were becoming increasingly concerned about the airline's ability to meet its financial obligations. Running out of cash and unable to borrow to satisfy current working capital requirements, the airline felt compelled to seek the protection of the bankruptcy court in late August 2005. Delta's decision to declare bankruptcy occurred about the same time as a similar decision by Northwest Airlines. United Airlines and US Airways were already in bankruptcy. United had been in bankruptcy almost three years at the time Delta entered Chapter 11, and US Airways had been in bankruptcy court twice since the 9/11 terrorist attacks shook the airline industry. At the time Delta declared bankruptcy, about one-half of the domestic carrier capacity was operating under bankruptcy court oversight. Delta underwent substantial restructuring of its operations. An important component of the restructuring effort involved turning over its underfunded pilot's pension plans to the Pension Benefit Guaranty Corporation (PBGC), a federal pension insurance agency, while winning concessions on wages and work rules from its pilots. The agreement with the pilot's union would save the airline $280 million annually, and the pilots would be paid 14 percent less than they were before the airline declared bankruptcy. To achieve an agreement with its pilots to transfer control of their pension plan to the PBGC, Delta agreed to give the union a $650 million interest-bearing note upon terminating and transferring the pension plans to the PBGC. The union would then use the airline's payments on the note to provide supplemental payments to members who would lose retirement benefits due to the PBGC limits on the amount of Delta's pension obligations it would be willing to pay. The pact covers more than 6,000 pilots. The overhaul of Delta, the nation's third largest airline, left it a much smaller carrier than the one that sought protection of the bankruptcy court. Delta shed about one jet in six used by its mainline operations at the time of the bankruptcy filing, and it cut more than 20 percent of the 60,000 employees it had just prior to entering Chapter 11. Delta's domestic carrying capacity fell by about 10 percent since it petitioned for Chapter 11 reorganization, allowing it to fill about 84 percent of its seats on U.S. routes. This compared to only 72 percent when it filed for bankruptcy. The much higher utilization of its planes boosted revenue per mile flown by 15 percent since it entered bankruptcy, enabling the airline to better cover its fixed expenses. Delta also sold one of its "feeder" airlines, Atlantic Southeast Airlines, for $425 million. Delta would have $2.5 billion in exit financing to fund operations and a cost structure of about $3 billion a year less than when it went into bankruptcy. The purpose of the exit financing facility is to repay the company's $2.1 billion debtor-in-possession credit facilities provided by GE Capital and American Express, make other payments required on exiting bankruptcy, and increase its liquidity position. With ten financial institutions providing the loans, the exit facility consisted of a $1.6 billion first-lien revolving credit line, secured by virtually all of the airline's unencumbered assets, and a $900 million second-lien term loan. As required by the Plan of Reorganization approved by the Bankruptcy Court, Delta cancelled its preplan common stock on April 30, 2007. Holders of preplan common stock did not receive a distribution of any kind under the Plan of Reorganization. The company issued new shares of Delta common stock as payment of bankruptcy claims and as part of a postbankruptcy compensation program for Delta employees. Issued in May 2007, the new shares were listed on the New York Stock Exchange. -Why would lenders be willing to lend to a firm emerging from Chapter 11? How did the lenders attempt to manage their risks? Be specific.

What are the primary objectives of the bankruptcy process? Speculate as to why this process may have failed in reorganizing Hostess Brands?

On June 25, 2008, JHT Holdings, Inc., a Kenosha Wisconsin-based package delivery service, filed for bankruptcy. The firm had annual revenues of $500 million. What would the firm have to demonstrate for its petition to file for bankruptcy to be accepted by the bankruptcy court?

Calpine Emerges from the Protection of Bankruptcy Court Following approval of its sixth Plan of Reorganization by the U.S. Bankruptcy Court for the Southern District of New York, Calpine Corporation was able to emerge from Chapter 11 bankruptcy on January 31, 2008. Burdened by excessive debt and court battles with creditors on how to use its cash, the electric utility had sought Chapter 11 protection by petitioning the bankruptcy court in December 2005. After settlements with certain stakeholders, all classes of creditors voted to approve the Plan of Reorganization, which provided for the discharge of claims through the issuance of reorganized Calpine Corporation common stock, cash, or a combination of cash and stock to its creditors. Shortly after exiting bankruptcy, Calpine cancelled all of its then outstanding common stock and authorized the issuance of 485 million shares of reorganized Calpine Corporation common stock for distribution to holders of unsecured claims. In addition, the firm issued warrants (i.e., securities) to purchase 48.5 million shares of reorganized Calpine Corporation common stock to the holders of the cancelled (i.e., previously outstanding) common stock. The warrants were issued on a pro rata basis reflecting the number of shares of “old common stock” held at the time of cancellation. These warrants carried an exercise price of $23.88 per share and expired on August 25, 2008. Relisted on the New York Stock Exchange, the reorganized Calpine Corporation common stock began trading under the symbol CPN on February 7, 2008, at about $18 per share. The firm had improved its capital structure while in bankruptcy. On entering bankruptcy, Calpine carried $17.4 billion of debt with an average interest rate of 10.3 percent. By retiring unsecured debt with reorganized Calpine Corporation common stock and selling certain assets, Calpine was able to repay or refinance certain project debt, thereby reducing the prebankruptcy petition debt by approximately $7 billion. On exiting bankruptcy, Calpine negotiated approximately $7.3 billion of secured “exit facilities” (i.e., credit lines) from Goldman Sachs, Credit Suisse, Deutsche Bank, and Morgan Stanley. About $6.4 billion of these funds were used to satisfy cash payment obligations under the Plan of Reorganization. These obligations included the repayment of a portion of unsecured creditor claims and administrative claims, such as legal and consulting fees, as well as expenses incurred in connection with the “exit facilities” and immediate working capital requirements. On emerging from Chapter 11, the firm carried $10.4 billion of debt with an average interest rate of 8.1 percent. The Enron Shuffle—A Scandal to Remember What started in the mid-1980s as essentially a staid "old-economy" business became the poster child in the late 1990s for companies wanting to remake themselves into "new-economy" powerhouses. Unfortunately, what may have started with the best of intentions emerged as one of the biggest business scandals in U.S. history. Enron was created in 1985 as a result of a merger between Houston Natural Gas and Internorth Natural Gas. In 1989, Enron started trading natural gas commodities and eventually became the world's largest buyer and seller of natural gas. In the early 1990s, Enron became the nation's premier electricity marketer and pioneered the development of trading in such commodities as weather derivatives, bandwidth, pulp, paper, and plastics. Enron invested billions in its broadband unit and water and wastewater system management unit and in hard assets overseas. In 2000, Enron reported $101 billion in revenue and a market capitalization of $63 billion. The Virtual Company Enron was essentially a company whose trading and risk management business strategy was built on assets largely owned by others. The complex financial maneuvering and off-balance-sheet partnerships that former CEO Jeffrey K. Skilling and chief financial officer Andrew S. Fastow implemented were intended to remove everything from telecommunications fiber to water companies from the firm's balance sheet and into partnerships. What distinguished Enron's partnerships from those commonly used to share risks were their lack of independence from Enron and the use of Enron's stock as collateral to leverage the partnerships. If Enron's stock fell in value, the firm was obligated to issue more shares to the partnership to restore the value of the collateral underlying the debt or immediately repay the debt. Lenders in effect had direct recourse to Enron stock if at any time the partnerships could not repay their loans in full. Rather than limiting risk, Enron was assuming total risk by guaranteeing the loans with its stock. Enron also engaged in transactions that inflated its earnings, such as selling time on its broadband system to a partnership at inflated prices at a time when the demand for broadband was plummeting. Enron then recorded a substantial profit on such transactions. The partnerships agreed to such transactions because Enron management seems to have exerted disproportionate influence in some instances over partnership decisions, although its ownership interests were very small, often less than 3 percent. Curiously, Enron's outside auditor, Arthur Andersen, had a dual role in these partnerships, collecting fees for helping to set them up and auditing them. Time to Pay the Piper At the time the firm filed for bankruptcy on December 2, 2001, it had $13.1 billion in debt on the books of the parent company and another $18.1 billion on the balance sheets of affiliated companies and partnerships. In addition to the partnerships created by Enron, a number of bad investments both in the United States and abroad contributed to the firm's malaise. Meanwhile, Enron's core energy distribution business was deteriorating. Enron was attempting to gain share in a maturing market by paring selling prices. Margins also suffered from poor cost containment. Dynegy Corp. agreed to buy Enron for $10 billion on November 2, 2001. On November 8, Enron announced that its net income would have to be restated back to 1997, resulting in a $586 million reduction in reported profits. On November 15, chairman Kenneth Lay admitted that the firm had made billions of dollars in bad investments. Four days later, Enron said it would have to repay a $690 million note by mid-December and it might have to take an additional $700 million pretax charge. At the end of the month, Dynegy withdrew its offer and Enron's credit rating was reduced to junk bond status. Enron was responsible for another $3.9 billion owed by its partnerships. Enron had less than $2 billion in cash on hand. The end came quickly as investors and customers completely lost faith in the energy behemoth as a result of its secrecy and complex financial maneuvers, forcing the firm into bankruptcy in early December. Enron's stock, which had reached a high of $90 per share on August 17, 2001, was trading at less than $1 by December 5, 2001. In addition to its angry creditors, Enron faced class-action lawsuits by shareholders and employees, whose pensions were invested heavily in Enron stock. Enron also faced intense scrutiny from congressional committees and the U.S. Department of Justice. By the end of 2001, shareholders had lost more than $63 billion from its previous 52-week high, bondholders lost $2.6 billion in the face value of their debt, and banks appeared to be at risk on at least $15 billion of credit they had extended to Enron. In addition, potential losses on uncollateralized derivative contracts totaled $4 billion. Such contracts involved Enron commitments to buy various types of commodities at some point in the future. Questions remain as to why Wall Street analysts, Arthur Andersen, federal or state regulatory authorities, the credit rating agencies, and the firm's board of directors did not sound the alarm sooner. It is surprising that the audit committee of the Enron board seems to have somehow been unaware of the firm's highly questionable financial maneuvers. Inquiries following the bankruptcy declaration seem to suggest that the audit committee followed all the rules stipulated by federal regulators and stock exchanges regarding director pay, independence, disclosure, and financial expertise. Enron seems to have collapsed in part because such rules did not do what they were supposed to do. For example, paying directors with stock may have aligned their interests with shareholders, but it also is possible to have been a disincentive to question aggressively senior management about their financial dealings. The Lessons of Enron Enron may be the best recent example of a complete breakdown in corporate governance, a system intended to protect shareholders. Inside Enron, the board of directors, management, and the audit function failed to do the job. Similarly, the firm's outside auditors, regulators, credit rating agencies, and Wall Street analysts also failed to alert investors. What seems to be apparent is that if the auditors fail to identify incompetence or fraud, the system of safeguards is likely to break down. The cost of failure to those charged with protecting the shareholders, including outside auditors, analysts, credit-rating agencies, and regulators, was simply not high enough to ensure adequate scrutiny. What may have transpired is that company managers simply undertook aggressive interpretations of accounting principles then challenged auditors to demonstrate that such practices were not in accordance with GAAP accounting rules (Weil, 2002). This type of practice has been going on since the early 1980s and may account for the proliferation of specific accounting rules applicable only to certain transactions to insulate both the firm engaging in the transaction and the auditor reviewing the transaction from subsequent litigation. In one sense, the Enron debacle represents a failure of the free market system and its current shareholder protection mechanisms, in that it took so long for the dramatic Enron shell game to be revealed to the public. However, this incident highlights the remarkable resilience of the free market system. The free market system worked quite effectively in its rapid imposition of discipline in bringing down the Enron house of cards, without any noticeable disruption in energy distribution nationwide. Epilogue Due to the complexity of dealing with so many types of creditors, Enron filed its plan with the federal bankruptcy court to reorganize one and a half years after seeking bankruptcy protection on December 2, 2001. The resulting reorganization has been one of the most costly and complex on record, with total legal and consulting fees exceeding $500 million by the end of 2003. More than 350 classes of creditors, including banks, bondholders, and other energy companies that traded with Enron said they were owed about $67 billion. Under the reorganization plan, unsecured creditors received an estimated 14 cents for each dollar of claims against Enron Corp., while those with claims against Enron North America received an estimated 18.3 cents on the dollar. The money came in cash payments and stock in two holding companies, CrossCountry containing the firm's North American pipeline assets and Prisma Energy International containing the firm's South American operations. After losing its auditing license in 2004, Arthur Andersen, formerly among the largest auditing firms in the world, ceased operation. In 2006, Andrew Fastow, former Enron chief financial officer, and Lea Fastow plead guilty to several charges of conspiracy to commit fraud. Andrew Fastow received a sentence of 10 years in prison without the possibility of parole. His wife received a much shorter sentence. Also in 2006, Enron chairman Kenneth Lay died while awaiting sentencing, and Enron president Jeffery Skilling received a sentence of 24 years in prison. Citigroup agreed in early 2008 to pay $1.66 billion to Enron creditors who lost money following the collapse of the firm. Citigroup was the last remaining defendant in what was known as the Mega Claims lawsuit, a bankruptcy lawsuit filed in 2003 against 11 banks and brokerages. The suit alleged that, with the help of banks, Enron kept creditors in the dark about the firm's financial problems through misleading accounting practices. Because of the Mega Claims suit, creditors recovered a total of $5 billion or about 37.4 cents on each dollar owed to them. This lawsuit followed the settlement of a $40 billion class action lawsuit by shareholders, which Citicorp settled in June 2005 for $2 billion. -In what way was the Enron debacle a break down in corporate governance (oversight)? Explain your answer.

Describe the probable trend in financial returns to shareholders of firms that emerge from bankruptcy. To what do you attribute these trends? Explain your answer.

A debt-for-equity swap occurs when the distressed firm's shareholders are willing to surrender a portion of their ownership for debt in the firm.

If a firm enters into a workout in which a voluntary negotiated agreement with debtors is achieved, the firm may lose its right to claim NOLs in its tax filing.