Chapter 25

Bankruptcy, Reorganization, and Liquidation
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

25-1 Bankruptcies occur in firms of all sizes. Small firms, with fewer creditors, are often able to work out informal settlements and thus avoid the time and expense of formal bankruptcy. Ross Corporation, described in Question 3, is probably too large, and it has too many creditors, to work out an informal settlement. If Ross attempted to resolve its problems informally, the attempt would probably fail, and then it would have to resort to the federal bankruptcy court. Note that if there had been fewer creditors, and particularly if most of the debt were owed to a few banks, then the chances of an informal resolution would be better. But with many holders of the publicly traded bonds, 15 banks, and 250 unsecured creditors, there would probably be too many holdouts to reach an informal resolution.

25-2 The judge in a federal bankruptcy proceeding can abrogate all contracts, including labor contracts. If a contract requires payments greater than the company’s cash flows can support, then the judge can order that payments be scaled back to a level the company can afford. Labor contracts were abrogated for a number of firms that were hit with asbestos suits, notably Johns Manville, and currently several airlines are in bankruptcy proceedings under which labor contracts will likely be changed.

25-3 a. As noted above, is probably too large, and it has too many creditors, to work out an informal settlement. For a company this large and complex, the federal bankruptcy system will almost certainly have to be used. b. The two key chapters are Chapter 11, which spells out how a company can be reorganized and thus allowed to continue in existence, and Chapter 7, which spells out the procedures for liquidation. c. Management generally initiates bankruptcy proceedings. One of its creditors whose debt is in default might be threatening to get a court order attaching the company’s bank account or foreclosing on a piece of property, and this action might put the company out of business. However, the company could head this off by filing for protection under the Bankruptcy Code. That filing would stop the creditors from taking action to seize the company’s property, and the bankruptcy court would hold hearings designed to determine the best course of action. d. The company could file for liquidation under Chapter 7, but managements generally try to save the company, and that means reorganizing under Chapter 11. If management cannot come up with a feasible reorganization plan as judged by the Court, then it will be ordered to liquidate under Chapter 7. Managers have 120 days in which to file a plan of reorganization. They can take longer than 120 days, but after that time other parties, especially creditors, can also file plans, and creditors might file a plan that called for a liquidation or a reorganization under a new management. If creditors filed first, or in reply to the company’s request for a reorganization, there is a good chance that creditors would request a liquidation. In particular, secured creditors whose collateral is worth more than the amount they are owed might well prefer a speedy liquidation to a long, drawn out bankruptcy proceeding during which time they would receive no cash payments and at the end of which they might receive new securities rather than cash. e. The “common pool problem” refers to a situation where creditors are owed more than the value of the firm’s assets. Here each individual creditor might try to collect what was owed to him or her quickly, knowing that there was not enough to satisfy all creditors. It might be that the company would be worth more, hence creditors in total would receive more, if the firm were reorganized, but if one creditor seized some vital property, the company might be put out of business and forced to liquidate. In this situation, all the creditors would, in self-defense if for no other reason, be quick to try to get their money out, which would shut down the debtor firm. The Bankruptcy Act recognized this situation and has provisions that mitigate it. f. The “automatic stay” is one of the provisions that mitigates the common pool problem by forcing all creditors to cease and desist attempts to collect money from the bankrupt firm until after a bankruptcy court has decided on the best course of action. The automatic stay would certainly be applied in the hypothetical situation described in the question. g. A “pre-pack” is a pre-packaged bankruptcy reorganization plan. Here a plan is worked out between management and the major creditors prior to filing for Chapter 11 protection. Pre-packs are most feasible under either of two conditions: (1) The firm is fundamentally sound and is merely experiencing a temporary liquidity problem, or (2) there are relatively few creditors, as that makes it easier to conduct negotiations. In a pre-pack (and also in other reorganization plans), smaller claims are generally paid off in full to avoid administrative hassles. The judge could, of course, cram down a pre-pack. h. The term “cramdown” refers to the situation where the bankruptcy judge forces various claimants to accept terms that they do not like and vote against, i.e., the judge crams the plan down the throats of the various parties. Bankruptcies are typically contentious affairs, and at least some parties end up being unhappy. Therefore, most plans end up being crammed down on at least some claimants. As a part of the bankruptcy proceedings, after a plan (or plans) has been filed with the court and disseminated to the various claimants, the claimants vote to accept or reject the plan (or choose among competing plans). The firm’s “fair market value” (the higher of its value as a going concern after reorganization or else its liquidating value) is generally less than the amount of the claims. Generally, a plan to reorganize the company will result in a higher predicted value than competing plans that call for liquidation. However, the reorganization plan (probably supported by management and stockholders) is based on assumptions about sales, costs, and so forth, and those predictions are far from certain. Moreover, the reorganization plan probably requires debtholders to accept securities in the reorganized firm, and perhaps some creditors will be required to accept common stock rather than debt. In such a situation, some creditors (especially secured creditors) will probably vote against the plan, and they may file a competing plan that calls for a liquidation. They will argue that the assumptions used in management’s reorganization plan are unrealistic and hence that the plan is not feasible. In liquidation, stockholders generally get nothing, and unsecured creditors typically receive only a small fraction of their claim. Therefore, stockholders and unsecured creditors might vote in favor of reorganization. The bankruptcy judge--who has tremendous power as judge, jury, and executioner—will decide among the various plans, and he or she will decide exactly how much each creditor will receive. Then, the judge will cram down the plan he or she finally approves. In other words, the approved plan does not require 100% support from all parties.

i. The following is the specified priority ranking of claimants to a company’s assets in the event of bankruptcy:

• Past due property taxes • Secured creditors up to the value of their collateral. Different secured creditors may be secured by different assets. • Legal fees and administrative costs • Wages due, with limitations • Unpaid contributions that to pension plans within the last 6 months • Customer deposits, up to $900 per customer • Taxes due to federal, state, and local government units • General (unsecured) creditors. • Preferred stockholders • Common stockholders

In a liquidation, the assets are sold off and the available funds are then distributed. If they are distributed in strict accordance with the above priority rankings, then this is in accordance with absolute priority doctrine. The relative priority doctrine refers to the situation where the bankruptcy judge determines that a company’s value would be greater if it were reorganized and continued in business versus being liquidated. Here some claimants, especially well secured creditors, might prefer to see the firm be liquidated, as that might get them cash relatively soon, but the judge deems it would be most fair to most parties to have the firm reorganized, because then unsecured creditors and perhaps even stockholders would end up receiving something of value. Adoption of the relative priority doctrine makes it much easier to reorganize companies, because if the absolute priority doctrine were followed, liquidations would occur more often.

j. If the assets were sold at auction and the company was liquidated, the proceeds would in all likelihood be distributed in accordance with the absolute priority doctrine as discussed above, using the previously indicated rankings. Well-secured debtholders would perhaps be paid in full, and lower ranking claimants would get something only if funds were available. k. From a finance perspective the most interesting aspect of a bankruptcy proceeding is determining the value of the company if it were reorganized rather than liquidated, and then deciding on the allocation of the estimated value among the various claimants. If the liquidating value is higher, then the allocation is simple—just follow the absolute priority rankings, paying off the most senior creditors and then giving junior creditors anything that’s left. Generally, common stockholders get nothing. Estimating the firm’s value as a reorganized entity generally involves forecasting sales, costs, required investments, and eventually free cash flow. Then, the appropriate capital structure must be determined and a WACC must be estimated. With the projected FCF and the WACC, the value of the firm can be determined as the PV of the FCFs. The estimated value must then be apportioned among the claimants. Generally, each secured creditor would be left whole, provided the appraised value of their specific collateral is equal to or greater than the face amount of the secured debt. However, some or all secured creditors might have to take debt in the reorganized company. The other claimants would probably have to “take a haircut” of some magnitude, i.e., have to accept cash or securities worth less than the value of their claims. Note too that in a reorganization creditors are often forced to accept common stock so as to put the capital structure in a balance and make the business plan of the reorganized firm feasible. Also, some new cash is generally required to pay taxes, to cover administrative costs and legal fees, and probably to pay off small creditors. Generally, new cash comes in the form of common stock, and those who put up the cash (who may or may not include old stockholders), along with creditors forced to accept common stock, get the bulk of the common stock. Valuation in bankruptcy is conceptually the same as any other business valuation. When we have worked on bankruptcy cases, we use the same corporate valuation model that we use for merger analysis and other types of valuations.

ANSWERS TO END-OF-CHAPTER QUESTIONS

25-1 a. Informal debt restructuring is the agreement between the creditors and troubled firm to change the existing debt terms. An extension postpones the required payment date, while a composition is a reduction in creditor claims. Extension provides payment in full, though delayed. Conversely, composition involves a reduced cash settlement. Restructuring often involves both extension and composition. A reorganization in bankruptcy is a court-approved attempt to keep a company alive by changing its capital structure. A reorganization must adhere to the standards of fairness and feasibility.

b. Assignment is an informal procedure for liquidating debts which transfers title to a debtor's assets to a third person, known as an assignee or trustee. Assignment normally yields creditors a larger amount than they would receive in a formal bankruptcy. However, an assignment does not automatically result in a full and legal discharge of all the debtor's liabilities, nor does it protect the creditors against fraud. Liquidation is the sale of the assets of a firm and the distribution of the proceeds to the creditors and owners in a specific priority. The decision whether to reorganize or liquidate should be based on the value of the firm if it is rehabilitated versus the value of the assets if they are sold off individually. The procedure that promises higher returns to the creditors and owners would be adopted. The standard of fairness states that claims must be recognized in the order of their legal and contractual priority. In simpler terms, the reorganization must be fair to all parties. The standard of feasibility states that there must be a reasonably high probability of successful rehabilitation and profitable future operations.

c. The absolute priority doctrine states that claims must be paid in strict accordance with the priority of each claim, regardless of the consequence to other claimants. The relative priority doctrine is more flexible and gives a more balanced consideration to all claimants than does the absolute priority doctrine.

d. The Bankruptcy Reform Act of 1978 was enacted to speed up and streamline bankruptcy proceedings. This law represents a shift to a relative priority doctrine of creditors' claims. Chapter 11 of the Bankruptcy Act is the business reorganization chapter. Under this chapter, a case is started when a firm's management or its creditors file a petition with the bankruptcy court. A committee of unsecured creditors is then appointed by the court to negotiate with the firm's management. Existing management may stay in office unless a trustee is appointed by the court. If no fair and feasible reorganization can be worked out, the firm will be liquidated under the procedures spelled out in Chapter 7 of the act. Chapter 7 of the Federal Bankruptcy Reform Act accomplishes three important tasks during a liquidation: (1) it provides safeguards against fraud by the debtor, (2) it provides for an equitable distribution of the debtor's assets among the creditors, and (3) it allows insolvent debtors to discharge all their obligations and to start new businesses unhampered by a burden of prior debt.

e. The priority of claims in liquidation is established in Chapter 7 of the Bankruptcy Act to provide an equitable distribution of the debtor's assets among the creditors.

f. Extension and composition are both characteristics of debt restructuring. In an extension, creditors postpone the dates of required interest or principal payments, or both. In a composition, creditors voluntarily reduce their fixed claims on the debtor by accepting a lower principal amount, reducing the interest rate on the debt, accepting equity in place of debt, or some combination of these changes. Workouts are voluntary reorganization plans arranged between creditors and generally sound companies experiencing temporary financial difficulties. Workouts typically require some restructuring of the old firm's debt. Cramdowns are bankruptcy court-mandated reorganization plans which are binding on all parties. Prepackaged bankruptcy is a new type of reorganization which combines the advantages of informal workouts and formal Chapter 11 reorganization. Holdout is a problematic characteristic of informal reorganizations where all of the involved parties do not agree to the voluntary plan. Holdouts are usually made by creditors in an effort to receive full payment on claims.

25-2 The rehabilitation plan may be accepted because of the following:

• Expenses of liquidation may consume a large proportion of the assets.

• The going-concern value of a firm is always substantially greater than its liquidating value. Hence, to preserve the life of the firm is to preserve a substantial portion of its value.

• They may retain a stable customer for the future.

• On balance, the creditors will accept a plan for financial rehabilitation because it appears that the funds they will receive will be much larger under this procedure.

25-3 Not necessarily. The going-concern value of a firm is a function of its outlook--it might be improved by changing the management or otherwise improving operations. The firm may be temporarily distressed.

25-4 Liquidations usually result in losses for the following reasons:

• Assets typically have characteristics which make their value in existing uses greater than when resold.

• The organizational value of a company is lost when liquidation takes place.

• Because the claims of numerous parties must be adjudicated, considerable administrative, accounting, and legal costs may be incurred.

Partial liquidation over a period would have the following results:

• Probably would not decrease losses.

• Failure to institute the necessary operating and management changes might cause losses to continue and might cause further deterioration in the value of the company. It is often said that a swift major "surgery" for a business firm is preferred to an extended illness.

25-5 Because public utilities and railroads often involve essential services, reorganizations and mergers rather than liquidations are likely to take place. This is less true for industrial companies.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

25-1 a. The pro forma balance sheet follows (in millions of dollars):

Current assets $159a Current liabilities $ 42 Net fixed assets 153 Advance payments 78 Goodwill 15 Reserves 6 Subordinated debentures 90b $2.40 preferred stock, $37.50 par value (1,200,000 shares) 45c Common stock, $1.50 par value (6,000,000 shares) 9 Retained earnings 57 Total assets $327 Total claims $327

Notes: a$168 less $9 used to retire the $10.50 preferred stock. b(1.2 million shares)($75 par value) = $90. c(1.2 million shares)($37.50 par value) = $45.

b. The pro forma income statement (in millions of dollars) follows:

Net sales $540.0 Operating expense 516.0 Net operating income $ 24.0 Other income 3.0 EBIT $ 27.0 Interest expense 7.2a EBT $ 19.8 Taxes (50%) 9.9 Net income $ 9.9 Dividends on $2.40 preferred 2.9b Income available to common stockholders $ 7.0

Notes: a0.08($90 million par value) = $7.2. b$2.40(1.2 million shares) = $2.9.

Thus, the increase in income available to common shareholders is $7.0 - $5.7 = $1.3 million.

c. The earnings required before the recapitalization is $7.8 million/(1 - 0.5) = $15.6 million. We divide the preferred dividends by (1 - T) since $15.6 million must be earned to provide the $7.8 million needed after-tax. After recapitalization, the firm requires $2.9 million/0.5 = $5.8 million to cover the preferred dividend payment, and $7.2 million to cover the interest expense for a total of $13.0 million. Since interest expense is tax deductible, only $7.2 million in pre-tax earnings are required to cover the interest expense. Thus, required earnings will decrease by $15.6 million - $13.0 million = $2.6 million if the reorganization takes place.

d. The debt ratio before reorganization is $120 million/$336 million = 0.357 = 35.7%. After reorganization the debt ratio is $210 million/$327 million = 0.642 = 64.2%. Note that advance payments by customers are counted as debt while reserves are not. If preferred stock is treated as debt, the debt ratio actually declines slightly from 78.6 percent to 78.0 percent. The reorganization is in the best interests of the shareholders because under reorganization (1) earnings to shareholders are increased, (2) earnings required to cover fixed charges (including preferred dividends) are decreased, and (3) income debentures are less risky to the shareholders than preferred stock.

25-2 a. Creditor claims total $1,100,000 while the trustee has an additional $50,000 in claims, yet the liquidation produced only $600,000 in proceeds. Since the proceeds are insufficient to satisfy the creditor and trustee claims, the shareholders receive nothing.

b. The mortgage bondholders have priority claim against the proceeds from the sale of pledged property. Thus, the $400,000 from the fixed assets must first be distributed to the first and second mortgage bondholders. The first mortgage holders receive their full claim of $300,000, while the second mortgage holders receive the remaining $100,000. This constitutes the total $400,000, so none of the proceeds from the sale of pledged assets are available for distribution to general creditors. Additionally, the second mortgage holders have $100,000 in unsatisfied claims which become general creditor claims.

c. The priority claimants are the mortgage bondholders, trustee, workers, and government. The remaining claimants are general creditors. There is $200,000 available after the $400,000 distribution to the mortgage bondholders. This is distributed to the remaining priority claimants as follows:

Claimant Amount Trustee's expenses $ 50,000 Workers' wages due 30,000 Governments' taxes due 40,000 Total $120,000

d. Of the total $600,000 received from the liquidation, $520,000 has been distributed to priority claimants. This leaves $80,000 to distribute to the general creditors. But the general creditor claims total $630,000:

Account Claim Accounts payable $ 50,000 Notes payable 180,000 Second mortgage bonds 100,000 Debentures 200,000 Subordinated debentures 100,000 Total $630,000

Note that the second mortgage holders' unsatisfied claim of $100,000 is included. Each claimant, before subordination adjustment, would receive $80,000/$630,000 = 0.1270 of his or her claim. Therefore, the general creditors would receive:

Account Amount Received Accounts payable $ 6,350 Notes payable 22,860 Second mortgage bonds 12,700 (plus $100,000) Debentures 25,400 Subordinated debentures 12,700 Total $ 80,000

Finally, the subordination adjustment must be made. The subordinated debentures are subordinate to notes payable. Therefore, the subordinate debenture holders must relinquish all claims until the note payable holders are fully satisfied. Since the note payable holders are $180,000 - $22,860 = $157,140 short of being fully satisfied, the full $12,700 initially allocated to the subordinated debenture holders must be relinquished to the notes payable holders resulting in $22,860 + $12,700 = $35,560 for the notes payable holders and nothing (of the general creditor portion) for the subordinate debenture holders.

25-3 a. The total amount available for distribution is $3,190,000 proceeds + $10,000 cash = $3,200,000. The total creditor and trustee claims are $6,800,000 + $200,000 = $7,000,000. Since the claims far exceed the available funds, preferred and common stockholders will receive nothing.

b. The following table shows the liquidation distribution (in thousands of dollars):

Priority Creditor Subordination Claimant Distribution Distribution Adjustment Percentage Accounts payable $ 384 $ 384 24% Notes payable 120 500 100 Wages payable $ 150 150 150 100 Taxes payable 50 50 50 100 Mortgage bonds 1,600 1,696 1,696 85 Subordinated Debentures 600 220 9 Trustee 200 200 200 100 $2,000 $3,200 $3,200

• Funds remaining after the priority distribution = $3,200 - $2,000 = $1,200.

• General creditor claims total $1,600 + $500 + $400 + $2,500 = $5,000.

• After the general creditor distribution, notes payable is $500 - $120 = $380 short. Therefore, subordinated debentures must give up $380, leaving $600 - $380 = $220.

SOLUTION TO SPREADSHEET PROBLEM

25-4 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution to IFM9 Ch 25-4 Build a Model.xls) and on the instructor’s side of the web site, http://now.swlearning.com/brigham.

MINI CASE

Note to Instructors: Some instructors choose to assign the Mini Case as homework. Therefore, the PowerPoint slides for the mini case, IFM9 Ch 25 Show.ppt, and the accompanying Excel file, IFM9 Ch 25 Mini Case.xls, are not included for the students on ThomsonNow. However, many instructors, including us, want students to have copies of class notes. Therefore, we make the PowerPoint slides and Excel worksheets available to our students by posting them to our password-protected Web site. We encourage you to do the same if you would like for your students to have these files.

Kimberly MacKenzie, president of Kim's Clothes Inc., a medium-sized manufacturer of women's casual clothing, is worried. Her firm has been selling clothes to Russ Brothers department store for more than ten years, and she has never experienced any problems in collecting payment for the merchandise sold. Currently, Russ Brothers owes Kim's Clothes $65,000 for spring sportswear that was delivered to the store just two weeks ago. Kim's concern was brought about by an article that appeared in yesterday's Wall Street Journal that indicated that Russ Brothers was having serious financial problems. Further, the article stated that Russ Brothers' management was considering filing for reorganization, or even liquidation, with a federal bankruptcy court. Kim's immediate concern was whether or not her firm would collect its receivables if Russ Brothers went bankrupt. In pondering the situation, Kim also realized that she knew nothing about the process that firms go through when they encounter severe financial distress. To learn more about bankruptcy, reorganization, and liquidation, Kim asked Ron Mitchell, the firm's chief financial officer, to prepare a briefing on the subject for the entire board of directors. In turn, Ron asked you, a newly hired financial analyst, to do the groundwork for the briefing by answering the following questions:

a. 1. What are the major causes of business failure?

Answer: The major causes of business failure consist of economic factors, such as industry weakness and poor location, and financial factors, such as too much debt and insufficient capital. However, most business failures occur because a number of factors combine to make the business unsustainable.

a. 2. Do business failures occur evenly over time?

Answer: A fairly large number of businesses fail each year, but the number in any one year has never been a large percentage of the total business population. The failure rate of businesses, however, has tended to fluctuate with the state of the economy.

a. 3. Which size of firm, large or small, is more prone to business failure? Why?

Answer: Bankruptcy is more frequent among smaller firms. While bankruptcy does occur in large firms, they tend to get more help from external sources to avoid it, given their greater impact on the economy and, in the case of large financial institutions, the financial world. The federal government's bailouts of Chrysler and Lockheed are good examples of this external assistance.

b. What key issues must managers face in the financial distress process?

Answer: As a manager begins to face financial distress, he or she must begin to consider the following key issues:

• Is this a temporary cash flow problem (technical insolvency), or is it a permanent problem caused by asset values having fallen below debt obligations (insolvency in bankruptcy)?

• Who should bear the losses if this is a permanent problem?

• Would the firm be more valuable if it continued to operate or if it were liquidated and sold off in pieces?

• Should the firm file for bankruptcy, or should it try to use informal procedures?

• Who should control the firm during liquidation or reorganization?

Obviously, answers to these questions are needed to chart the course of the firm while under financial distress.

c. What informal remedies are available to firms in financial distress? In answering this question, define the following terms: (1) workout, (2) restructuring, (3) extension, (4) composition, (5) assignment, and (6) assignee (trustee).

Answer: When faced with financial distress, it is often desirable for firms to pursue informal reorganizations or liquidations with creditors, given the costs associated with legal bankruptcy. Creditors generally prefer informal reorganization plans when dealing with economically sound companies whose financial difficulties appear to be temporary. These voluntary informal plans, commonly called workouts, tend to involve some type of restructuring, where current debt terms are revised to facilitate the firm's ability to make payments. Such restructurings typically involve extension and/or composition. In an extension, creditors postpone the dates of required interest or principal payments, or both. Creditors tend to prefer extensions when developing reorganization plans because they promise eventual payment in full. In a composition, creditors voluntarily reduce their fixed claims on the debtor by either accepting a lower principal amount or accepting equity in place of debt. This can be a desirable alternative if bankruptcy becomes a real possibility, since composition can help the creditor and debtor avoid the many costs associated with legal bankruptcy. Informal liquidations can also be used if it is decided that the firm is worth more by selling it off in pieces. Assignment is an informal procedure for liquidating a firm. It calls for title to the debtor's assets to be transferred to a third party, known as the assignee or trustee. The assignee is required to liquidate the firm's assets either through a private sale or a public auction, and then to distribute the proceeds among the firm's creditors on a pro rata basis.

d. Briefly describe U.S. Bankruptcy Law, including the following terms: (1) chapter 11, (2) chapter 7, (3) trustee, (4) voluntary bankruptcy, and (5) involuntary bankruptcy.

Answer: U. S. Bankruptcy laws were first enacted in 1898 to ensure that businesses worth more as ongoing concerns were not shut down by individual creditors desiring liquidation and full payment. The Bankruptcy Reform Act Of 1978 revised these laws to streamline and expedite bankruptcy proceedings. Current bankruptcy law consists of eight chapters, the most important of which are Chapter 7, which details the procedures to be followed when liquidating a company, and Chapter 11, the business reorganization chapter. When a petition for bankruptcy is filed in federal court, the petition can be either voluntary or involuntary. A voluntary petition is filed by the distressed firm's management; an involuntary petition is filed by its creditors. The court will appoint a committee of unsecured creditors to negotiate a reorganization, which may include restructuring. A trustee will be appointed if current management is incompetent or fraud is suspected; otherwise the existing management will retain control. If no fair and feasible reorganization can be worked out, then the firm will be liquidated under Chapter 7 procedures.

e. What are the major differences between an informal reorganization and reorganization in bankruptcy? In answering this question, be sure to discuss the following items: (1) common pool problem, (2) holdout problem, (3) automatic stay, (4) cramdown, and (5) fraudulent conveyance.

Answer: There are many differences between voluntary reorganizations and reorganizations in bankruptcy. Voluntary reorganizations are far less costly and relatively simple to create as compared to reorganizations in bankruptcy. As a result, voluntary reorganizations typically allow creditors to recover more money, and sooner, than they would under legal bankruptcy. However, reorganizations in bankruptcy have their advantages. First, they avoid holdout problems which can arise with voluntary reorganizations (which occur when all creditors do not agree to the voluntary plan). Second, because of the automatic stay provision, bankruptcy avoids the common pool problem, where efforts to foreclose on the firm by one creditor cause the remaining creditors to initiate foreclosure as well. Automatic stay, which is granted to all firms in bankruptcy, limits creditors' abilities to foreclose unilaterally on the firm to collect their claims. Third, under bankruptcy, interest and principal payments may be delayed without penalty until a reorganization plan is approved. Fourth, bankruptcy permits the firm to issue debtor in possession (dip) financing to enhance the ability of the firm to borrow funds for short-term liquidity purposes. Finally, bankruptcy gives the debtor exclusive right to submit a proposed reorganization plan for agreement from the parties affected. While bankruptcy gives the firm a chance to work out its problems without the threat of creditor foreclosure, it does not give the debtor free reign over the firm's assets. First, bankruptcy law gives creditors the right to petition the bankruptcy court to block almost any action the firm might take while in bankruptcy. Second, fraudulent conveyance statutes, which are part of debtor-creditor law in most states, protect creditors from unjustified transfers of property by a firm in financial distress. In bankruptcy, it is much easier to gain acceptance of a reorganization plan, because the bankruptcy court will lump the creditors into classes. Each class is considered to have accepted a reorganization plan if a majority of the creditors in the class (holding at least two-thirds of the amount of debt) vote for the plan, and the plan will be approved by the court if it is deemed to be "fair and equitable" to the dissenting parties. This procedure, in which the court mandates a reorganization plan in spite of dissent, is called a cramdown.
f. What is a prepackaged bankruptcy? Why have prepackaged bankruptcies become more popular in recent years?

Answer: Prepackaged bankruptcy is a relatively new type of reorganization which is a hybrid--combining the advantages of both the informal reorganization and formal Chapter 11 reorganization. The debtor obtains agreement from all, or almost all, creditors to a reorganization plan prior to filing for bankruptcy. The plan is then filed along with, or shortly after filing, the bankruptcy petition. This method can avoid the holdout problems of voluntary reorganizations, preserve creditors' claims, and provide favorable tax treatment.

g. Briefly describe the priority of claims in a Chapter 7 liquidation.

Answer: Chapter 7 of the federal bankruptcy reform act provides for an equitable distribution of the debtor's assets among the creditors. The distribution of assets is governed by the following priority of claims:

• Secured creditors (who are entitled to the proceeds of the sale of specific property pledged for a lien or a mortgage).

• Trustee's costs to administer and operate the bankrupt firm.

• Expenses incurred after an involuntary case has begun but before a trustee has been appointed.

• Wages due workers if earned within three months prior to filing of the petition in bankruptcy.

• Claims for unpaid contributions to employee benefit plans that should have been paid within six months prior to filing.

• Unsecured claims for customer deposits.

• Taxes due to federal, state, county, and any other government agency.

• Unfunded pension plan liabilities.

• General, or unsecured, creditors.

• Preferred stockholders.

• Common stockholders.

h. Assume that Russ Brothers did indeed fail, and that it had the following balance sheet when it was liquidated (in millions of dollars):

Current assets $40.0 Accounts payable $10.0

Net fixed assets 5.0 Notes payable (to banks) 5.0 Accrued wages 0.3 Federal taxes 0.5 State and local taxes 0.2 Current liabilities $16.0 First mortgage $ 3.0 Second mortgage 0.5 Subordinated debenturesa 4.0 Total long-term debt $ 7.5 Preferred stock 1.0 Common stock 13.0 Paid-in capital 2.0 Retained earnings 5.5 Total equity $21.5 Total assets $45.0 Total claims $45.0

Athe debentures are subordinated to the notes payable.

The liquidation sales resulted in the following proceeds:

From sale of current assets $14,000,000 From sale of fixed assets 2,500,000 Total receipts $16,500,000

For simplicity, assume that there were no trustee's fees or any other claims against the liquidation proceeds. Also, assume that the mortgage bonds are secured by the entire amount of fixed assets. What would each claimant receive from the liquidation distribution?

Answer: The following table shows the liquidation distribution (millions of dollars): Distribution to Priority Claimants (in millions)

Proceeds from the sale of assets $16.5 Less: 1. 1st mortgage (paid from sale of fixed assets) 2.5 2. Accrued wages 0.3 3. Taxes due to federal, state, and local governments 0.7 Funds available for distribution to general creditors $13.0

Distribution to General Creditors

Distribution Percentage Gen’l creditor Amt. Of pro rata after subord. Original claim claims claim distrib.1 adjustment received 1st mortgage $ 0.5 $ 0.325 $ 0.325 94% 2nd mortgage 0.5 0.325 0.325 65 Notes payable 5.0 3.250 5.000 100 Accts. Payable 10.0 6.500 6.500 65 Subord. Deben.2 4.0 2.600 0.850 21 Total $20.0 $13.000 $13.000

Notes:

1. $13 million is available for distribution to general creditors; however, there is $20 million in general creditor claims, so the pro rata distribution will be $13/$20 = 0.65, or 65 cents on the dollar.

2. The debentures are subordinated to the notes payable. The amount of the unsatisfied notes payable is $5.0-$3.25=$1.75 million. $1.75 million is reallocated from the subordinated debentures to notes payable.