Exam 17: Alternative Exit and Restructuring Strategies:

Economic distress arises when a firm's growth and investment prospects deteriorate, causing a reduction in the value of the business due to the deteriorating outlook for the firm's cash flow.

Which of the following statements is not true?

Through a process called an assignment, a committee representing creditors grants the power to liquidate the firm's assets to a third party called an assignee or trustee.

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. -What should (or can) be done to reduce the likelihood of this type of situation arising in the future? Be specific.

Why would creditors make concessions to a debtor firm? Give examples of common types of concessions made?

Prior to the Bankruptcy Abuse Protection and Consumer Protection Act of 2005, the debtor had the exclusive right to file a plan of reorganization for the first 120 days after it filed the case.

Financial buyers (both hedge funds and private equity investors) 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 Hostess bankruptcy may have been helped or hurt by the actions of the hedge funds and private equity investors.

A firm is said to be bankrupt once it defaults on a bond payment.

If the insolvent firm is willing to accept liquidation, legal proceedings are not necessary, regardless of what the creditors think.

What are the primary objectives of the bankruptcy process?

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. -Why did Lehman choose not to seek Chapter 11 protection for its subsidiaries?

American Home Mortgage Investments, a major U.S. mortgage lender, filed for Chapter 11 bankruptcy in late 2008. The company indicated that it chose this course of action because it represented the best means of preserving the firm's assets. W.L. Ross and Company agreed to provide the firm $50 million in debtor in possession financing to meet its anticipated cash needs while in Chapter 11. Comment on the statement that bankruptcy provides the best means of asset preservation. Why would W.L. Ross and Company lend money to a firm that had just filed for bankruptcy?

A firm is said to be technically solvent when it is unable to pay its liabilities as they come due.

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. -Comment on the fairness of the bankruptcy process to shareholders, lenders, employees, communities, government, etc. Be specific.

The court must approve any plan accepted by the debtor's shareholders and creditors. True of False

Reforms in creditor rights tend to increase the availability and reduce the cost of credit in countries where court enforcement is quick and fair.

All of the following are true except for

A debt-for-equity swap occurs when creditors surrender a portion of their claims on the firm in exchange for an ownership position in the firm.

Although most companies that file for bankruptcy do so because of their deteriorating financial position, companies increasingly are seeking bankruptcy protection to avoid litigation and hostile takeovers. Give examples of how bankruptcy can be used to avoid litigation.

Prepackaged bankruptcies are less common today than in years past.