Exam 17: Alternative Exit and Restructuring Strategies:

What are the primary factors contributing to business failure? Be specific.

Dure Automotive emerged from Chapter 11 protection in mid-2008. The firm obtained exit financing consisting of $110 million revolving credit facility, a $50 million European first-lien term loan, and an $84 million U.S. second-lien loan. The reorganization plan specifies how some portion of the proceeds of these loans would be used. What do you believe might be typical stipulations in reorganization plans for using such funds? Be specific.

The leading causes of business failure include which of the following:

Speculate as to why Blockbuster filed a motion with the Court to initiate a Section 363 auction rather than to continue to negotiate a reorganization plan with its creditors to exit Chapter 11.

Photography Icon Kodak Declares Bankruptcy, A Victim of Creative Destruction Having invented the digital camera, Kodak knew that the longevity of its traditional film business was problematic. Concerned about protecting its core film business, Kodak was unable to reposition itself fast enough to stave off failure. Chapter 11 reorganization offers an opportunity to emerge as a viable business, save jobs, minimize creditor losses, and limit the impact on communities. _____________________________________________________________________________ Economic historian Joseph Schumpeter described the free market process by which new technologies and deregulation create new industries, often at the expense of existing ones, as "creative destruction." In the short run, this process can have a highly disruptive impact on current employees whose skills are made obsolete, investors and business owners whose businesses are no longer competitive, and communities that are ravaged by increasing unemployment and diminished tax revenues. However, in the long run, the process tends to raise living standards by boosting worker productivity and increasing real income and leisure time, stimulating innovation, expanding the range of products and services offered, often at a lower price, to consumers, and to increase tax revenues. Kodak is a recent illustration of this process. Founded in 1880 by George Eastman, Kodak became the latest giant to fall in the face of advancing technology, announcing that it had filed for the protection of the bankruptcy court early in 2012. Kodak had established the market for camera film and then dominated the marketplace before suffering a series of setbacks over the last 40 years. First foreign competitors, most notably Fujifilm of Japan, undercut Kodak's film prices. Then the increased popularity of digital photography eroded demand for traditional film, eventually causing the firm to cease investment in its traditional film product in 2003. Although it had invented the digital camera, Kodak had failed to develop it further, announcing on February 12, 2012, that it would discontinue its production of such cameras. Kodak's failure to move aggressively into the digital world may have reflected its concern about cannibalizing its core film business. This concern may have ultimately destined the firm for failure. Kodak closed 13 manufacturing plants and 130 processing labs and had reduced its workforce to 17,000 in 2011 from 63,000 in 2003. In recent years, the firm has undertaken a two-pronged strategy: expanding into the inkjet printer market and initiating patent lawsuits to generate royalty payments from firms allegedly violating Kodak digital patents. Kodak technologies are found in virtually all modern digital cameras, smartphones, and tablet computers. Kodak had raised $3 billion between 2003 and 2010 by reaching settlements with alleged patent infringement companies. But the revenue from litigation dried up in 2011. With only one profitable year since 2004, the firm eventually ran out of cash. Its market value on the day it announced its bankruptcy filing had slumped to $150 million, compared to $31 billion in 1995. Kodak said it had $5.1 billion in assets and $6.8 billion in debt, rendering the firm insolvent. The Chapter 11 filing was made in the U.S. bankruptcy court in lower New York City and excluded the firm's non-U.S. subsidiaries. The objectives of the bankruptcy filing were to buy time to find buyers for some of its 1,100 digital patents, to continue to shrink its current employment, to reduce significantly its healthcare and pension obligations, and to renegotiate more favorable payment terms on its outstanding debt. Kodak had put the patents up for sale in August 2011 but did not receive any bids, since potential buyers were concerned that they would be required to return the assets by creditors if Kodak filed for bankruptcy protection. While the firm's pension obligations are well funded, the firm owes health benefits to 38,000 U.S. retirees, which in 2011 cost the firm $240 million. Kodak also announced that it had obtained a $950 million loan from Citibank to keep operating during the bankruptcy process. Moreover, the firm filed new patent infringement suits in March 2012 against a number of competitors, including Fujifilm, Research in Motion (RIM), and Apple, in order to increase the value of its patent portfolios. However, a court ruled in mid-2012 that neither Apple nor RIM had infringed on Kodak patents. In early 2013, Kodak announced that it would put additional assets up for sale (including its camera film business and heavy-duty commercial scanners and software businesses) since the sale of its remaining digital imaging patents raised only $525 million, much less than the nearly $2 billion the firm had expected. The sale of these businesses would cement Kodak's departure from its roots. In late September 2012, Kodak announced that it would suspend the production and sale of consumer inkjet printers. Kodak also received permission from the bankruptcy court judge to terminate the payment of retiree medical, dental, and life insurance benefits for 56,000 retirees at the end of 2012. Kodak has to demonstrate viability to emerge from Chapter 11 as a reorganized firm or be acquired by another firm. The firm has pinned its remaining hopes for survival on selling commercial printing equipment and services, a business that generated about $2 billion in revenue in 2012 but that may lack the scale to sustain profitability. If it cannot demonstrate viability, Kodak will face liquidation. In either case, the outcome is a sad ending to a photography icon. -Why do the bankruptcy courts allow investors such as hedge funds to buy deeply discounted debt from creditors and later exchange such debt at face value for equity in the newly restructured firm?

In the absence of a voluntary settlement out of court, the debtor firm may seek protection from its creditors by initiating bankruptcy. However, creditors cannot force the debtor firm into bankruptcy.

How might the way in which Hostess Brands Inc. grew have contributed to its eventual financial distress?

In recent years, hedge funds have engaged in so-called "loan-to-own" pre-bankruptcy investments in which they acquire debt from distressed firms at a fraction of face value. Subsequently, they move the company into Chapter 11 intent upon converting the acquired debt to equity in a firm with sharply reduced liabilities. The hedge fund also provides DIP financing to further secure its interest in the business. The emergence from Chapter 11 is typically accomplished under section 363 (k) of the bankruptcy code which gives debtors the right to bid on the firm in a public auction sale. During the auction, the firm's debt is valued at face rather than market value, effectively discouraging any other bidders other than the hedge fund which acquired the debt prior to bankruptcy at distressed levels. Without competitive bidding, there is little chance of generating additional cash for the general creditors. How might this be viewed as an abuse of the Chapter 11 bankruptcy process?

Which of the following are commonly used strategic alternatives for failing firms?

Identify at least two financial or non-financial variables that have been shown to affect firm defaults and bankruptcies? Explain how each might affect the likelihood the firm will default or seek Chapter 11 protection?

Companies may not seek the protection of bankruptcy court to avoid liquidation.

The General Motors’ Bankruptcy—The Largest Government-Sponsored Bailout in U.S. History Rarely has a firm fallen as far and as fast as General Motors. Founded in 1908, GM dominated the car industry through the early 1950s with its share of the U.S. car market reaching 54 percent in 1954, which proved to be the firm’s high water mark. Efforts in the 1980s to cut costs by building brands on common platforms blurred their distinctiveness. Following increasing healthcare and pension benefits paid to employees, concessions made to unions in the early 1990s to pay workers even when their plants were shut down reduced the ability of the firm to adjust to changes in the cyclical car market. GM was increasingly burdened by so-called legacy costs (i.e., healthcare and pension obligations to a growing retiree population). Over time, GM’s labor costs soared compared to the firm’s major competitors. To cover these costs, GM continued to make higher margin medium to full-size cars and trucks, which in the wake of higher gas prices could only be sold with the help of highly attractive incentive programs. Forced to support an escalating array of brands, the firm was unable to provide sufficient marketing funds for any one of its brands. With the onset of one of the worst global recessions in the post–World War II years, auto sales worldwide collapsed by the end of 2008. All automakers’ sales and cash flows plummeted. Unlike Ford, GM and Chrysler were unable to satisfy their financial obligations. The U.S. government, in an unprecedented move, agreed to lend GM and Chrysler $13 billion and $4 billion, respectively. The intent was to buy time to develop an appropriate restructuring plan. Having essentially ruled out liquidation of GM and Chrysler, continued government financing was contingent on gaining major concessions from all major stakeholders such as lenders, suppliers, and labor unions. With car sales continuing to show harrowing double-digit year over year declines during the first half of 2009, the threat of bankruptcy was used to motivate the disparate parties to come to an agreement. With available cash running perilously low, Chrysler entered bankruptcy in early May and GM on June 1, with the government providing debtor in possession financing during their time in bankruptcy. In its bankruptcy filing for its U.S. and Canadian operations only, GM listed $82.3 billion in assets and $172.8 billion in liabilities. In less than 45 days each, both GM and Chrysler emerged from government-sponsored sales in bankruptcy court, a feat that many thought impossible. Judge Robert E. Gerber of the U.S. Bankruptcy Court of New York approved the sale in view of the absence of alternatives considered more favorable to the government’s option. GM emerged from the protection of the court on July 10, 2009, in an economic environment characterized by escalating unemployment and eroding consumer income and confidence. Even with less debt and liabilities, fewer employees, the elimination of most “legacy costs,” and a reduced number of dealerships and brands, GM found itself operating in an environment in 2009 in which U.S. vehicle sales totaled an anemic 10.4 million units. This compared to more than 16 million in 2008. GM’s 2009 market share slipped to a post–World War II low of about 19 percent. While the bankruptcy option had been under consideration for several months, its attraction grew as it became increasingly apparent that time was running out for the cash-strapped firm. Having determined from the outset that liquidation of GM either inside or outside of the protection of bankruptcy would not be considered, the government initially considered a prepackaged bankruptcy in which agreement is obtained among major stakeholders prior to filing for bankruptcy. The presumption is that since agreement with many parties had already been obtained, developing a plan of reorganization to emerge from Chapter 11 would move more quickly. However, this option was not pursued because of the concern that the public would simply view the post–Chapter 11 GM as simply a smaller version of its former self. The government in particular was seeking to position GM as an entirely new firm capable of profitably designing and building cars that the public wanted. Time was of the essence. The concern was that consumers would not buy GM vehicles while the firm was in bankruptcy. Consequently, a strategy was devised in which GM would be divided into two firms: “old GM,” which would contain the firm’s unwanted assets, and “new GM,” which would own the most attractive assets. “New GM” would then emerge from bankruptcy in a sale to a new company owned by various stakeholder groups, including the U.S. and Canadian governments, a union trust fund, and bondholders. Only GM’s U.S. and Canadian operations were included in the bankruptcy filing. Figure 16.2 illustrates the GM bankruptcy process. Buying distressed assets can be accomplished through a Chapter 11 plan of reorganization or a post-confirmation trustee. Alternatively, a 363 sale transfers the acquired assets free and clear of any liens, claims, and encumbrances. The sale of GM’s attractive assets to the “new GM” was ultimately completed under Section 363 of the U.S. Bankruptcy Code. Historically, firms used this tactic to sell failing plants and redundant equipment. In recent years, so-called 363 sales have been used to completely restructure businesses, including the 363 sales of entire companies. A 363 sale requires only the approval of the bankruptcy judge, while a plan of reorganization in Chapter 11 must be approved by a substantial number of creditors and meet certain other requirements to be approved. A plan of reorganization is much more comprehensive than a 363 sale in addressing the overall financial situation of the debtor and how its exit strategy from bankruptcy will affect creditors. Once a 363 sale has been consummated and the purchase price paid, the bankruptcy court decides how the proceeds of sale are allocated among secured creditors with liens on the assets sold. Total financing provided by the U.S. and Canadian (including the province of Ontario) governments amounted to $69.5 billion. U.S. taxpayer-provided financing totaled $60 billion, which consisted of $10 billion in loans and the remainder in equity. The government decided to contribute $50 billion in the form of equity to reduce the burden on GM of paying interest and principal on its outstanding debt. Nearly $20 billion was provided prior to the bankruptcy, $11 billion to finance the firm during the bankruptcy proceedings, and an additional $19 billion in late 2009. In exchange for these funds, the U.S. government owns 60.8 percent of the “new GM’s common shares, while the Canadian and Ontario governments own 11.7 percent in exchange for their investment of $9.5 billion. The United Auto Workers’ new voluntary employee beneficiary association (VEBA) received a 17.5 percent stake in exchange for assuming responsibility for retiree medical and pension obligations. Bondholders and other unsecured creditors received a 10 percent ownership position. The U.S. Treasury and the VEBA also received $2.1 billion and $6.5 billion in preferred shares, respectively. The new firm, which employs 244,000 workers in 34 countries, intends to further reduce its head count of salaried employees to 27,200 by 2012. The firm will also have shed 21,000 union workers from the 54,000 UAW workers it employed prior to declaring bankruptcy in the United States and close 12 to 20 plants. GM did not include its foreign operations in Europe, Latin America, Africa, the Middle East, or Asia Pacific in the Chapter 11 filing. Annual vehicle production capacity for the firm will decline to 10 million vehicles in 2012, compared with 15 to 17 million in 1995. The firm exited bankruptcy with consolidated debt at $17 billion and $9 billion in 9 percent preferred stock, which is payable on a quarterly basis. GM has a new board, with Canada and the UAW healthcare trust each having a seat on the board. Following bankruptcy, GM has four core brands—Chevrolet, Cadillac, Buick, and GMC—that are sold through 3,600 dealerships, down from its existing 5,969-dealer network. The business plan calls for an IPO whose timing will depend on the firm’s return to sufficient profitability and stock market conditions. By offloading worker healthcare liabilities to the VEBA trust and seeding it mostly with stock instead of cash, GM has eliminated the need to pay more than $4 billion annually in medical costs. Concessions made by the UAW before GM entered bankruptcy have made GM more competitive in terms of labor costs with Toyota. Assets to be liquidated by Motors Liquidation Company (i.e., “old GM) were split into four trusts, including one financed by $536 million in existing loans from the federal government. These funds were set aside to clean up 50 million square feet of industrial manufacturing space at 127 locations spread across 14 states. Another $300 million was set aside for property taxes, plant security, and other shutdown expenses. A second trust will handle claims of the owners of GM’s prebankruptcy debt, who are expected to get 10 percent of the equity in General Motors when the firm goes public and warrants to buy additional shares at a later date. The remaining two trusts are intended to process litigation such as asbestos-related claims. The eventual sale of the remaining assets could take four years, with most of the environmental cleanup activities completed within a decade. Reflecting the overall improvement in the U.S. economy and in its operating performance, GM repaid $10 billion in loans to the U.S. government in April 2010. Seventeen months after emerging from bankruptcy, the firm completed successfully the largest IPO in history on November 17, 2010, raising $23.1 billion. The IPO was intended to raise cash for the firm and to reduce the government’s ownership in the firm, reflecting the firm’s concern that ongoing government ownership hurt sales. Following completion of the IPO, government ownership of GM remained at 33 percent, with the government continuing to have three board representatives. GM is likely to continue to receive government support for years to come. In an unusual move, GM was allowed to retain $45 billion in tax loss carryforwards, which will eliminate the firm’s tax payments for years to come. Normally, tax losses are preserved following bankruptcy only if the equity in the reorganized company goes to creditors who have been in place for at least 18 months. Despite not meeting this criterion, the Treasury simply overlooked these regulatory requirements in allowing these tax benefits to accrue to GM. Having repaid its outstanding debt to the government, GM continued to owe the U.S. government $36.4 billion ($50 billion less $13.6 billion received from the IPO) at the end of 2010. Assuming a corporate marginal tax rate of 35 percent, the government would lose another $15.75 in future tax payments as a result of the loss carryforward. The government also is providing $7,500 tax credits to buyers of GM’s new all-electric car, the Chevrolet Volt. -Identify what you believe to be the real benefits and costs of the bailout of General Motors? Be specific.

Under a prepackaged bankruptcy, the debtor negotiates with creditors well in advance of filing for a Chapter 7 bankruptcy.

All of the following are true of the bankruptcy process except for

The General Motors’ Bankruptcy—The Largest Government-Sponsored Bailout in U.S. History Rarely has a firm fallen as far and as fast as General Motors. Founded in 1908, GM dominated the car industry through the early 1950s with its share of the U.S. car market reaching 54 percent in 1954, which proved to be the firm’s high water mark. Efforts in the 1980s to cut costs by building brands on common platforms blurred their distinctiveness. Following increasing healthcare and pension benefits paid to employees, concessions made to unions in the early 1990s to pay workers even when their plants were shut down reduced the ability of the firm to adjust to changes in the cyclical car market. GM was increasingly burdened by so-called legacy costs (i.e., healthcare and pension obligations to a growing retiree population). Over time, GM’s labor costs soared compared to the firm’s major competitors. To cover these costs, GM continued to make higher margin medium to full-size cars and trucks, which in the wake of higher gas prices could only be sold with the help of highly attractive incentive programs. Forced to support an escalating array of brands, the firm was unable to provide sufficient marketing funds for any one of its brands. With the onset of one of the worst global recessions in the post–World War II years, auto sales worldwide collapsed by the end of 2008. All automakers’ sales and cash flows plummeted. Unlike Ford, GM and Chrysler were unable to satisfy their financial obligations. The U.S. government, in an unprecedented move, agreed to lend GM and Chrysler $13 billion and $4 billion, respectively. The intent was to buy time to develop an appropriate restructuring plan. Having essentially ruled out liquidation of GM and Chrysler, continued government financing was contingent on gaining major concessions from all major stakeholders such as lenders, suppliers, and labor unions. With car sales continuing to show harrowing double-digit year over year declines during the first half of 2009, the threat of bankruptcy was used to motivate the disparate parties to come to an agreement. With available cash running perilously low, Chrysler entered bankruptcy in early May and GM on June 1, with the government providing debtor in possession financing during their time in bankruptcy. In its bankruptcy filing for its U.S. and Canadian operations only, GM listed $82.3 billion in assets and $172.8 billion in liabilities. In less than 45 days each, both GM and Chrysler emerged from government-sponsored sales in bankruptcy court, a feat that many thought impossible. Judge Robert E. Gerber of the U.S. Bankruptcy Court of New York approved the sale in view of the absence of alternatives considered more favorable to the government’s option. GM emerged from the protection of the court on July 10, 2009, in an economic environment characterized by escalating unemployment and eroding consumer income and confidence. Even with less debt and liabilities, fewer employees, the elimination of most “legacy costs,” and a reduced number of dealerships and brands, GM found itself operating in an environment in 2009 in which U.S. vehicle sales totaled an anemic 10.4 million units. This compared to more than 16 million in 2008. GM’s 2009 market share slipped to a post–World War II low of about 19 percent. While the bankruptcy option had been under consideration for several months, its attraction grew as it became increasingly apparent that time was running out for the cash-strapped firm. Having determined from the outset that liquidation of GM either inside or outside of the protection of bankruptcy would not be considered, the government initially considered a prepackaged bankruptcy in which agreement is obtained among major stakeholders prior to filing for bankruptcy. The presumption is that since agreement with many parties had already been obtained, developing a plan of reorganization to emerge from Chapter 11 would move more quickly. However, this option was not pursued because of the concern that the public would simply view the post–Chapter 11 GM as simply a smaller version of its former self. The government in particular was seeking to position GM as an entirely new firm capable of profitably designing and building cars that the public wanted. Time was of the essence. The concern was that consumers would not buy GM vehicles while the firm was in bankruptcy. Consequently, a strategy was devised in which GM would be divided into two firms: “old GM,” which would contain the firm’s unwanted assets, and “new GM,” which would own the most attractive assets. “New GM” would then emerge from bankruptcy in a sale to a new company owned by various stakeholder groups, including the U.S. and Canadian governments, a union trust fund, and bondholders. Only GM’s U.S. and Canadian operations were included in the bankruptcy filing. Figure 16.2 illustrates the GM bankruptcy process. Buying distressed assets can be accomplished through a Chapter 11 plan of reorganization or a post-confirmation trustee. Alternatively, a 363 sale transfers the acquired assets free and clear of any liens, claims, and encumbrances. The sale of GM’s attractive assets to the “new GM” was ultimately completed under Section 363 of the U.S. Bankruptcy Code. Historically, firms used this tactic to sell failing plants and redundant equipment. In recent years, so-called 363 sales have been used to completely restructure businesses, including the 363 sales of entire companies. A 363 sale requires only the approval of the bankruptcy judge, while a plan of reorganization in Chapter 11 must be approved by a substantial number of creditors and meet certain other requirements to be approved. A plan of reorganization is much more comprehensive than a 363 sale in addressing the overall financial situation of the debtor and how its exit strategy from bankruptcy will affect creditors. Once a 363 sale has been consummated and the purchase price paid, the bankruptcy court decides how the proceeds of sale are allocated among secured creditors with liens on the assets sold. Total financing provided by the U.S. and Canadian (including the province of Ontario) governments amounted to $69.5 billion. U.S. taxpayer-provided financing totaled $60 billion, which consisted of $10 billion in loans and the remainder in equity. The government decided to contribute $50 billion in the form of equity to reduce the burden on GM of paying interest and principal on its outstanding debt. Nearly $20 billion was provided prior to the bankruptcy, $11 billion to finance the firm during the bankruptcy proceedings, and an additional $19 billion in late 2009. In exchange for these funds, the U.S. government owns 60.8 percent of the “new GM’s common shares, while the Canadian and Ontario governments own 11.7 percent in exchange for their investment of $9.5 billion. The United Auto Workers’ new voluntary employee beneficiary association (VEBA) received a 17.5 percent stake in exchange for assuming responsibility for retiree medical and pension obligations. Bondholders and other unsecured creditors received a 10 percent ownership position. The U.S. Treasury and the VEBA also received $2.1 billion and $6.5 billion in preferred shares, respectively. The new firm, which employs 244,000 workers in 34 countries, intends to further reduce its head count of salaried employees to 27,200 by 2012. The firm will also have shed 21,000 union workers from the 54,000 UAW workers it employed prior to declaring bankruptcy in the United States and close 12 to 20 plants. GM did not include its foreign operations in Europe, Latin America, Africa, the Middle East, or Asia Pacific in the Chapter 11 filing. Annual vehicle production capacity for the firm will decline to 10 million vehicles in 2012, compared with 15 to 17 million in 1995. The firm exited bankruptcy with consolidated debt at $17 billion and $9 billion in 9 percent preferred stock, which is payable on a quarterly basis. GM has a new board, with Canada and the UAW healthcare trust each having a seat on the board. Following bankruptcy, GM has four core brands—Chevrolet, Cadillac, Buick, and GMC—that are sold through 3,600 dealerships, down from its existing 5,969-dealer network. The business plan calls for an IPO whose timing will depend on the firm’s return to sufficient profitability and stock market conditions. By offloading worker healthcare liabilities to the VEBA trust and seeding it mostly with stock instead of cash, GM has eliminated the need to pay more than $4 billion annually in medical costs. Concessions made by the UAW before GM entered bankruptcy have made GM more competitive in terms of labor costs with Toyota. Assets to be liquidated by Motors Liquidation Company (i.e., “old GM) were split into four trusts, including one financed by $536 million in existing loans from the federal government. These funds were set aside to clean up 50 million square feet of industrial manufacturing space at 127 locations spread across 14 states. Another $300 million was set aside for property taxes, plant security, and other shutdown expenses. A second trust will handle claims of the owners of GM’s prebankruptcy debt, who are expected to get 10 percent of the equity in General Motors when the firm goes public and warrants to buy additional shares at a later date. The remaining two trusts are intended to process litigation such as asbestos-related claims. The eventual sale of the remaining assets could take four years, with most of the environmental cleanup activities completed within a decade. Reflecting the overall improvement in the U.S. economy and in its operating performance, GM repaid $10 billion in loans to the U.S. government in April 2010. Seventeen months after emerging from bankruptcy, the firm completed successfully the largest IPO in history on November 17, 2010, raising $23.1 billion. The IPO was intended to raise cash for the firm and to reduce the government’s ownership in the firm, reflecting the firm’s concern that ongoing government ownership hurt sales. Following completion of the IPO, government ownership of GM remained at 33 percent, with the government continuing to have three board representatives. GM is likely to continue to receive government support for years to come. In an unusual move, GM was allowed to retain $45 billion in tax loss carryforwards, which will eliminate the firm’s tax payments for years to come. Normally, tax losses are preserved following bankruptcy only if the equity in the reorganized company goes to creditors who have been in place for at least 18 months. Despite not meeting this criterion, the Treasury simply overlooked these regulatory requirements in allowing these tax benefits to accrue to GM. Having repaid its outstanding debt to the government, GM continued to owe the U.S. government $36.4 billion ($50 billion less $13.6 billion received from the IPO) at the end of 2010. Assuming a corporate marginal tax rate of 35 percent, the government would lose another $15.75 in future tax payments as a result of the loss carryforward. The government also is providing $7,500 tax credits to buyers of GM’s new all-electric car, the Chevrolet Volt. -The first round of government loans to GM occurred in December 2008. The firm did not file for bankruptcy until June 1, 2009. Discuss the advantages and disadvantages of the firm having filed for bankruptcy much earlier in 2009. Be specific.

The General Motors’ Bankruptcy—The Largest Government-Sponsored Bailout in U.S. History Rarely has a firm fallen as far and as fast as General Motors. Founded in 1908, GM dominated the car industry through the early 1950s with its share of the U.S. car market reaching 54 percent in 1954, which proved to be the firm’s high water mark. Efforts in the 1980s to cut costs by building brands on common platforms blurred their distinctiveness. Following increasing healthcare and pension benefits paid to employees, concessions made to unions in the early 1990s to pay workers even when their plants were shut down reduced the ability of the firm to adjust to changes in the cyclical car market. GM was increasingly burdened by so-called legacy costs (i.e., healthcare and pension obligations to a growing retiree population). Over time, GM’s labor costs soared compared to the firm’s major competitors. To cover these costs, GM continued to make higher margin medium to full-size cars and trucks, which in the wake of higher gas prices could only be sold with the help of highly attractive incentive programs. Forced to support an escalating array of brands, the firm was unable to provide sufficient marketing funds for any one of its brands. With the onset of one of the worst global recessions in the post–World War II years, auto sales worldwide collapsed by the end of 2008. All automakers’ sales and cash flows plummeted. Unlike Ford, GM and Chrysler were unable to satisfy their financial obligations. The U.S. government, in an unprecedented move, agreed to lend GM and Chrysler $13 billion and $4 billion, respectively. The intent was to buy time to develop an appropriate restructuring plan. Having essentially ruled out liquidation of GM and Chrysler, continued government financing was contingent on gaining major concessions from all major stakeholders such as lenders, suppliers, and labor unions. With car sales continuing to show harrowing double-digit year over year declines during the first half of 2009, the threat of bankruptcy was used to motivate the disparate parties to come to an agreement. With available cash running perilously low, Chrysler entered bankruptcy in early May and GM on June 1, with the government providing debtor in possession financing during their time in bankruptcy. In its bankruptcy filing for its U.S. and Canadian operations only, GM listed $82.3 billion in assets and $172.8 billion in liabilities. In less than 45 days each, both GM and Chrysler emerged from government-sponsored sales in bankruptcy court, a feat that many thought impossible. Judge Robert E. Gerber of the U.S. Bankruptcy Court of New York approved the sale in view of the absence of alternatives considered more favorable to the government’s option. GM emerged from the protection of the court on July 10, 2009, in an economic environment characterized by escalating unemployment and eroding consumer income and confidence. Even with less debt and liabilities, fewer employees, the elimination of most “legacy costs,” and a reduced number of dealerships and brands, GM found itself operating in an environment in 2009 in which U.S. vehicle sales totaled an anemic 10.4 million units. This compared to more than 16 million in 2008. GM’s 2009 market share slipped to a post–World War II low of about 19 percent. While the bankruptcy option had been under consideration for several months, its attraction grew as it became increasingly apparent that time was running out for the cash-strapped firm. Having determined from the outset that liquidation of GM either inside or outside of the protection of bankruptcy would not be considered, the government initially considered a prepackaged bankruptcy in which agreement is obtained among major stakeholders prior to filing for bankruptcy. The presumption is that since agreement with many parties had already been obtained, developing a plan of reorganization to emerge from Chapter 11 would move more quickly. However, this option was not pursued because of the concern that the public would simply view the post–Chapter 11 GM as simply a smaller version of its former self. The government in particular was seeking to position GM as an entirely new firm capable of profitably designing and building cars that the public wanted. Time was of the essence. The concern was that consumers would not buy GM vehicles while the firm was in bankruptcy. Consequently, a strategy was devised in which GM would be divided into two firms: “old GM,” which would contain the firm’s unwanted assets, and “new GM,” which would own the most attractive assets. “New GM” would then emerge from bankruptcy in a sale to a new company owned by various stakeholder groups, including the U.S. and Canadian governments, a union trust fund, and bondholders. Only GM’s U.S. and Canadian operations were included in the bankruptcy filing. Figure 16.2 illustrates the GM bankruptcy process. Buying distressed assets can be accomplished through a Chapter 11 plan of reorganization or a post-confirmation trustee. Alternatively, a 363 sale transfers the acquired assets free and clear of any liens, claims, and encumbrances. The sale of GM’s attractive assets to the “new GM” was ultimately completed under Section 363 of the U.S. Bankruptcy Code. Historically, firms used this tactic to sell failing plants and redundant equipment. In recent years, so-called 363 sales have been used to completely restructure businesses, including the 363 sales of entire companies. A 363 sale requires only the approval of the bankruptcy judge, while a plan of reorganization in Chapter 11 must be approved by a substantial number of creditors and meet certain other requirements to be approved. A plan of reorganization is much more comprehensive than a 363 sale in addressing the overall financial situation of the debtor and how its exit strategy from bankruptcy will affect creditors. Once a 363 sale has been consummated and the purchase price paid, the bankruptcy court decides how the proceeds of sale are allocated among secured creditors with liens on the assets sold. Total financing provided by the U.S. and Canadian (including the province of Ontario) governments amounted to $69.5 billion. U.S. taxpayer-provided financing totaled $60 billion, which consisted of $10 billion in loans and the remainder in equity. The government decided to contribute $50 billion in the form of equity to reduce the burden on GM of paying interest and principal on its outstanding debt. Nearly $20 billion was provided prior to the bankruptcy, $11 billion to finance the firm during the bankruptcy proceedings, and an additional $19 billion in late 2009. In exchange for these funds, the U.S. government owns 60.8 percent of the “new GM’s common shares, while the Canadian and Ontario governments own 11.7 percent in exchange for their investment of $9.5 billion. The United Auto Workers’ new voluntary employee beneficiary association (VEBA) received a 17.5 percent stake in exchange for assuming responsibility for retiree medical and pension obligations. Bondholders and other unsecured creditors received a 10 percent ownership position. The U.S. Treasury and the VEBA also received $2.1 billion and $6.5 billion in preferred shares, respectively. The new firm, which employs 244,000 workers in 34 countries, intends to further reduce its head count of salaried employees to 27,200 by 2012. The firm will also have shed 21,000 union workers from the 54,000 UAW workers it employed prior to declaring bankruptcy in the United States and close 12 to 20 plants. GM did not include its foreign operations in Europe, Latin America, Africa, the Middle East, or Asia Pacific in the Chapter 11 filing. Annual vehicle production capacity for the firm will decline to 10 million vehicles in 2012, compared with 15 to 17 million in 1995. The firm exited bankruptcy with consolidated debt at $17 billion and $9 billion in 9 percent preferred stock, which is payable on a quarterly basis. GM has a new board, with Canada and the UAW healthcare trust each having a seat on the board. Following bankruptcy, GM has four core brands—Chevrolet, Cadillac, Buick, and GMC—that are sold through 3,600 dealerships, down from its existing 5,969-dealer network. The business plan calls for an IPO whose timing will depend on the firm’s return to sufficient profitability and stock market conditions. By offloading worker healthcare liabilities to the VEBA trust and seeding it mostly with stock instead of cash, GM has eliminated the need to pay more than $4 billion annually in medical costs. Concessions made by the UAW before GM entered bankruptcy have made GM more competitive in terms of labor costs with Toyota. Assets to be liquidated by Motors Liquidation Company (i.e., “old GM) were split into four trusts, including one financed by $536 million in existing loans from the federal government. These funds were set aside to clean up 50 million square feet of industrial manufacturing space at 127 locations spread across 14 states. Another $300 million was set aside for property taxes, plant security, and other shutdown expenses. A second trust will handle claims of the owners of GM’s prebankruptcy debt, who are expected to get 10 percent of the equity in General Motors when the firm goes public and warrants to buy additional shares at a later date. The remaining two trusts are intended to process litigation such as asbestos-related claims. The eventual sale of the remaining assets could take four years, with most of the environmental cleanup activities completed within a decade. Reflecting the overall improvement in the U.S. economy and in its operating performance, GM repaid $10 billion in loans to the U.S. government in April 2010. Seventeen months after emerging from bankruptcy, the firm completed successfully the largest IPO in history on November 17, 2010, raising $23.1 billion. The IPO was intended to raise cash for the firm and to reduce the government’s ownership in the firm, reflecting the firm’s concern that ongoing government ownership hurt sales. Following completion of the IPO, government ownership of GM remained at 33 percent, with the government continuing to have three board representatives. GM is likely to continue to receive government support for years to come. In an unusual move, GM was allowed to retain $45 billion in tax loss carryforwards, which will eliminate the firm’s tax payments for years to come. Normally, tax losses are preserved following bankruptcy only if the equity in the reorganized company goes to creditors who have been in place for at least 18 months. Despite not meeting this criterion, the Treasury simply overlooked these regulatory requirements in allowing these tax benefits to accrue to GM. Having repaid its outstanding debt to the government, GM continued to owe the U.S. government $36.4 billion ($50 billion less $13.6 billion received from the IPO) at the end of 2010. Assuming a corporate marginal tax rate of 35 percent, the government would lose another $15.75 in future tax payments as a result of the loss carryforward. The government also is providing $7,500 tax credits to buyers of GM’s new all-electric car, the Chevrolet Volt. -What alternative restructuring strategies do you believe may have been considered for GM? Of these, do you believe that the 363 sale in bankruptcy represented the best course of action? Explain your answers.

A debt extension occurs when creditors agree to lengthen the period during which the debtor firm can repay its debt.

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. -How were the Enron partnerships used to hide debt and inflate the firm's earnings? Should partnership structures be limited in the future? If so, how?

What are the primary objectives of the bankruptcy process?

Financially distressed firms often are characterized by all of the following except for: