Exam 17: Alternative Exit and Restructuring Strategies:

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. government's failure to bail out Lehman, thereby forcing the firm to file for bankruptcy, exacerbated the global credit meltdown in October 2008? Explain your answer.

All of the following represent different forms of debt restructuring except for

Why would creditors be willing to give a portion of what they are owed by the debtor firm for equity in the reorganized firm?

Comment on the fairness of the 363 auction process to Hostess shareholders, lenders, employees, communities, government, etc. Be specific.

U.S. bankruptcy laws and practices focus on maintaining shareholder value during the bankruptcy process.

Federal law prohibits trading in a bankrupt firm's securities.

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. -How does Chapter 11 bankruptcy protect Lehman's creditors? How does it potentially hurt them? Explain your answers.

The term financial distress could apply to a firm unable to meet its obligations or to a specific security on which the issuer has defaulted.

Legal insolvency occurs when a firm's liabilities exceed the book value of its assets.

What are the primary options available to a failing firm? What criteria might the firm use to select a particular option? Be specific.

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

Do you believe that a strategic bidder has an inherent advantage over a financial bidder in a 363 auction?

A firm is not bankrupt or in bankruptcy until it files or its creditors file a petition for reorganization or liquidation with the federal bankruptcy courts.

If the creditors conclude that the insolvent firm's situation cannot be resolved, liquidation may be the only acceptable course of action.

The court can ignore the objections of creditors and stockholders if it feels the reorganization is both fair and feasible.

A composition is an agreement in which creditors agree to settle for less than the full amount they are owed.

Credit ratings provided by Moody's and Standard & Poor's are highly reliable indicators of a firm's degree of financial distress.

If the selling price of the failing firm is less than the going concern and liquidation value, the firm should sell the firm to another party.

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. -To what extent do you believe the factors contributing to the airline's bankruptcy were beyond the control of management? To what extent do you believe past airline mismanagement may have contributed to the bankruptcy?

Moody's credit rating agency defines instances of default as which of the following: