Once a firm begins encountering these difficulties, the firm’s owners and management have to consider the alternatives available to failing businesses. In general, a failing company has two alternatives:
A company’s creditors may also petition the courts, and this may result in the company’s being involuntarily declared bankrupt. Regardless of whether a business chooses informal or formal methods to deal with its difficulties, eventually the decision has to be made whether to reorganize or liquidate the business. Before this decision can be made, both the business’s liquidation value and its going-concern value have to be determined. Liquidation value equals the proceeds that would be received from the sale of the business assets minus liabilities. Going-concern value equals the capitalized value of the company’s operating earnings minus its liabilities.
Basically, if the going -concern value exceeds the liquidation value, the business should be reorganized; otherwise, it should be liquidated. However, in practice, the determination of the going -concern and liquidation values is not an easy matter. For example, problems may exist in estimating the price the company’s assets will bring at auction. In addition, the company’s future operating earnings and the appropriate discount rate at which to capitalize the earnings may be difficult to determine. Also, management understandably is not in a position to be completely objective about these values.
Informal Alternatives for Failing Businesses
Regardless of the exact reasons why a business begins to experience difficulties, the result is often the same: namely, cash flow problems. Frequently, the first steps taken by the troubled company involve stretching its payables.
Causes of Business Failures
In some cases, this action can buy the troubled company up to several weeks of needed time before creditors take action. If the difficulties are more than just minor and temporary, the company may next turn to its bankers and request additional working capital loans. In some situations, the bankers may make the additional loans, especially if they perceive the situation to be temporary. Another possible action the company’s bankers and creditors may take is to restructure the company’s debt. Debt restructuring by bankers and other creditors can be quite complex. However, debt restructuring basically involves either extension, composition, or a combination of the two.
In an extension, the failing company tries to reach an agreement with its creditors that will permit it to lengthen the time it has to meet its obligations. In a composition, the firm’s creditors accept some percentage amount less than their actual original claims, and the company is permitted to discharge its debt obligations by paying less than the full amounts owed. The percentage a company’s creditors will agree to in the event of a composition is usually greater than the percentage they could net if the company had to sell its assets to satisfy their claims. If a company’s creditors feel that the company can overcome its financial difficulties and become a valuable customer over the long run, they may be willing to accept some form of composition.
Debt restructuring by lenders can involve deferment of both interest and principal payments for a time. Before lenders will agree to these deferments, they often require the troubled company’s suppliers to make various concessions as well. In addition, the lenders frequently demand and receive warrants in return for making their deferment concessions. Large companies that experience cash flow difficulties often sell off real estate, various operating divisions, or both to raise needed cash. For example, Pan American Airlines, which incurred over $1 billion in losses during the 1980s, sold its New York headquarters building, Intercontinental Hotels subsidiary, Pacific route system, and various aircraft during this period to raise the cash needed to stay in business. These asset sales continued into 1991 when the company essentially liquidated itself.
Another method often used by failing companies to raise needed cash involves the sale and leaseback of its land and buildings. Some companies also resort to more unusual methods of conserving cash, such as offering preferred stock to certain employees in exchange for a portion of their salary.
Frequently, failing companies voluntarily form a creditors’ committee that meets regularly and attempts to help the company out of its predicament. The creditors are usually requested to accept deferred payments, and in return, the creditors usually request that the company cut various expenditures. If the company and its creditors are able to reach an agreement on the appropriate actions to take, the legal and administrative expenses associated with formal bankruptcy procedures are not incurred. Accordingly, both the company and creditors may be better off as a result.
Liquidation can also occur outside the bankruptcy courts. The process is called an assignment. Usually a trustee, who is probably one of the major creditors, is assigned the assets. The trustee then has the responsibility of selling the assets and distributing the proceeds in the best interest of the creditors.
Formal Alternatives for Failing Businesses Under the Bankruptcy Laws
The Bankruptcy Reform Act of 1978 states the basic mechanics of the bankruptcy procedure. Either the failing company or its unsecured creditors may initiate bankruptcy procedures by filing a claim in bankruptcy court.When the debtor company files for bankruptcy, it is termed a voluntary petition. A bankruptcy proceeding may also be initiated by a group of three or more of the company’s unsecured creditors that have aggregate claims of at least $500. The unsecured creditors filing the claim must assert that the debtor company is not paying its present debts as they come due. Such a claim is termed an involuntary petition.
Reform Act of 1978
After the initial bankruptcy petition has been filed, both the failing company and its creditors receive protection from the courts. The company itself is protected from any further actions on the part of the creditors while it attempts to work out a plan of reorganization. The debtor company has 120 days to work out a plan of reorganization. After that, the creditors may file a plan of their own. The court has considerable latitude in a bankruptcy case. For example, depending on the nature of the case, it may decide to appoint a trustee who will be responsible for running the business and protecting the creditors’ interests.Normally, the troubled company is allowed to continue operations. If there is reason to believe that continuing operations will result in further deterioration of the creditors’ position, however, the court can order the firm to cease operating. A new development and alternative for firms considering bankruptcy is the prepackaged bankruptcy.
Prepackaged bankruptcy filings must be agreed to by more than 50 percent of the creditors who hold at least two-thirds of the debt before filing for bankruptcy. Prepackaged filings can speed a firm through the process in a few months (e.g., four months for Southland, owner of the 7-Eleven chain) compared to the many years traditional filings last. For example, Revco Drugstores declared bankruptcy in 1988 and did not emerge from bankruptcy until 1992. Revco incurred over $40 million in legal and accounting fees associated with resolving its bankruptcy. An important aspect of the bankruptcy procedures involves what to do with the failing firm. Just as in the case of the informal alternatives, a decision has to be made about whether a firm’s value as a going concern is greater than its liquidation value. Generally, if this is the case and a suitable plan of reorganization can be formulated, the firm is reorganized; otherwise, it is liquidated.
The failing company presents its current financial status and its proposed plan of reorganization. This plan of reorganization is normally similar to either composition or extension.
The bankruptcy court and the Securities and Exchange Commission (SEC) review the plan of reorganization for fairness and feasibility. The term fairness means that the claims are to be settled in the order of their priority. The priority of claims is discussed in detail in the next section on liquidation. A feasible plan of reorganization is one that gives the business a good chance of reestablishing successful operations. For example, the plan must provide an adequate level of working capital, a reasonable capital structure and debt-to-equity ratio, and an earning power sufficient to reasonably cover interest and dividend requirements. Often a recapitalization may result in fewer fixed charges for the reorganized company and thereby afford it a better chance of succeeding. The reorganization may also involve an extension of the debt maturities, which would help the company’s cash flow by causing the debt’s principal retirement to occur at later dates.
After the bankruptcy court and the SEC have reviewed the reorganization plan, it is submitted to the firm’s creditors for approval. Creditors vote by class (e.g., unsecured creditors, secured creditors, common stockholders) on the reorganization plan (or plans, in the case where more than one plan is submitted for approval). The plan must be approved by a simple majority (i.e., 50 percent) of the creditors voting in each class and by creditors representing two-thirds (i.e., 66.7 percent) of the total amount of claims voting in each class. At this point, the court-appointed trustee’s task is to implement the plan.Faced with reduced revenues because of the decline in oil prices and with $1.3 billion in debt, the company filed for bankruptcy in January 1986. Over the next three years, under the supervision of the bankruptcy court, Global cut its workforce from a high of 3,047 to 1,506 employees. It reduced its yearly overhead from $59 million to $25 million. In February 1989, Global-Marine emerged from bankruptcy. Between 1984 and 1988, the company lost $874 million.Over the next five years (1989 to 1993), after it emerged from bankruptcy, its losses narrowed to $161 million.
Beginning in 1994 Global-Marine had a positive net income during each of the next seven years, before merging in 2001 with Santa Fe International to form Global Santa Fe Corporation in 2001. The reorganization plan is shown in Table 23.9. About 40 senior creditors received a combination of cash, debt securities, and 90 percent of the common stock of the reorganized company. Subordinated debt holders received 7.5 percent of the common stock. Global’s negative net worth of $116 million virtually wiped out preferred and common shareholders. They received only 2.5 percent of the common stock of the reorganized company, valued at about $3.7 million, plus warrants.
If for some reason reorganization is judged unfeasible, a legally declared bankrupt company may be liquidated. In the liquidation procedure, a referee is normally appointed to handle the administrative aspects of the bankruptcy procedure. The referee then arranges for a meeting of the creditors, and they in turn select a trustee, who liquidates the business and pays the creditors’ claims according to the priority of claims set forth.
The absolute priority rule states that, in general, secured debts are satisfied first from the sale of the secured assets and that all claims of creditors must be satisfied before any claims by stockholders. The following list specifies the order of priority in which unsecured debts must be paid:
Reorganization of Global-Marine, Inc.
To illustrate the absolute priority rule in a liquidation, consider the balance sheet prior to the liquidation of Failures Galore, Inc., shown in Suppose the total proceeds of the liquidation are $6.8 million. The distribution of these proceeds is shown in. The proceeds have been distributed in accordance with the absolute priority rule. Each general and unsecured creditor receives a settlement percentage of the funds owed after priority claims have been settled. As shown in, these priority claims are bankruptcy administration expenses, wages, and taxes owed.
In addition, mortgage bondholders receive $1.5 million from the sale of secured assets; this leaves the mortgage bondholders as general creditors for the balance of their claim ($500,000). After these priority claims have been met, there is $4.25 million in assets left to meet the remaining creditor claims of $8.5 million. Each general creditor receives 50 percent of the claim, except bank notes. Because the subordinated debentures are subordinate to bank notes, the bank notes receive the proportionate claim of the subordinated holders ($1 million in this case) in addition to the $1 million directly due the bank notes. Hence, because of the subordination provision in the debentures, the bank notes are paid off in full. The absolute priority rule is also used in bankruptcy reorganizations. However, in reorganization proceedings, deviations from the absolute priority rule by the courts have been observed.
In a detailed study of 30 bankruptcy cases filed subsequent to the effective date of the 1978 Bankruptcy Reform Act, 23 cases resulted in shareholders being awarded more than they were entitled to under strict adherence to the absolute priority rule.18 The excess amount received by the shareholders averaged 7.6 percent for the 30 cases. Two of the major reasons for the deviations are that the creditors may lack adequate information about the firm’s value or that they may be willing to compromise because of the potential cost of a lengthy reorganization.
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
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Capital Budgeting And Cash Flow Analysis
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Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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