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Bankruptcy

We have reviewed some of the techniques that firms use to evaluate the creditworthiness of their customers and to decide whether to issue credit. It would be helpful if these techniques were refined to perfectly distinguish among customers that will pay their bills and those that will go belly up, but this is not a realistic goal. In any event, we have seen that granting credit to a financially shaky customer may pay off if there is a chance that the offer will lead to a profitable future relationship. Therefore, it is not uncommon for firms to have to deal with an insolvent customer.

Our focus here is on business bankruptcy. Such bankruptcies account for only about 15 percent of the total number of bankruptcies, but because they are larger than individual bankruptcies, they involve about half of all claims by value. There are also more complications when a business declares bankruptcy than when an individual does so.

BANKRUPTCY PROCEDURES

A corporation that cannot pay its debts will often try to come to an informal agreement with its creditors. This is known as a workout. A workout may take several forms. For example, the firm may negotiate an extension, that is, an agreement with its creditors to delay payments. Or the firm may negotiate a composition, in which the firm makes partial payments to its creditors in exchange for relief of its debts.

The advantage of a negotiated agreement is that the costs and delays of formal bankruptcy are avoided. However, the larger the firm, and the more complicated its capital structure, the less likely it is that a negotiated settlement can be reached. (For example, Wickes Corp. tried and failed to reach a negotiated settlement with its 250,000 creditors.)

If the firm cannot get an agreement, then it may have no alternative but to file for bankruptcy.9 Under the federal bankruptcy system the firm has a choice of procedures. In about two-thirds of the cases a firm will file for, or be forced into, bankruptcy under Chapter 7 of the 1978 Bankruptcy Reform Act. Then the firm`s assets are liquidated that is, sold and the proceeds are used to pay creditors.

There is a pecking order of unsecured creditors.10 First come claims for expenses that arise after bankruptcy is filed, such as attorneys` fees or employee compensation earned after the filing. If such postfiling claims did not receive priority, no firm in bankruptcy proceedings could continue to operate. Next come claims for wages and employee benefits earned in the period immediately prior to the filing. Taxes are next in line, together with debts to some government agencies such as the Small Business Administration or the Pension Benefit Guarantee Corporation. Finally come general unsecured claims such as bonds or unsecured trade debt.

The alternative to a liquidation is to seek a reorganization, which keeps the firm as a going concern and usually compensates creditors with new securities in the reorganized firm. Such reorganizations are generally in the shareholders` interests they have little to lose if things deteriorate further and everything to gain if the firm recovers.

Firms attempting reorganization seek refuge under Chapter 11 of the Bankruptcy Reform Act. Chapter 11 is designed to keep the firm alive and operating and to protect the value of its assets while a plan of reorganization is worked out. During this period, other proceedings against the firm are halted and the company is operated by existing management or by a court-appointed trustee.

The responsibility for developing a plan of reorganization may fall on the debtor firm. If no trustee is appointed, the firm has 120 days to present a plan to creditors. If these deadlines are not met, or if a trustee is appointed, anyone can submit a plan the trustee, for example, or a committee of creditors.

The reorganization plan is basically a statement of who gets what; each class of creditors gives up its claim in exchange for new securities. (Sometimes creditors receive cash as well.) The problem is to design a new capital structure for the firm that will (1) satisfy the creditors and (2) allow the firm to solve the business problems that got the firm into trouble in the first place. Sometimes only a plan of baroque complexity can satisfy these two requirements. When the Penn Central Corporation was finally reorganized in 1978 (7 years after it became the largest railroad bankruptcy ever), more than a dozen new securities were created and parceled out among 15 classes of creditors.

The reorganization plan goes into effect if it is accepted by creditors and confirmed by the court. Acceptance requires approval by a majority of each class of creditor. Once a plan is accepted, the court normally approves it, provided that each class of creditors has approved it and that the creditors will be better off under the plan than if the firm`s assets were liquidated and distributed. The court may, under certain conditions, confirm a plan even if one or more classes of creditors vote against it. This is known as a cram-down.

The terms of a cram-down are open to negotiation among all parties. For example, unsecured creditors may threaten to slow the process as a way of extracting concessions from secured creditors. The secured creditors may take less than 100 cents on the dollar and give something to unsecured creditors in order to expedite the process and reach an agreement.

Chapter 11 proceedings are often successful, and the patient emerges fit and healthy. But in other cases cure proves impossible and the assets are liquidated. Sometimes the firm may emerge from Chapter 11 for a brief period before it is once again submerged by disaster and back in bankruptcy. For example, TWA came out of bankruptcy at the end of 1993 and was back again less than 2 years later, prompting jokes about

¬Chapter 22. ­

BANKRUPTCY The reorganization or liquidation of a firm that cannot pay its debts.

WORKOUT Agreement between a company and its creditors establishing the steps the company must take to avoid bankruptcy

LIQUIDATION Sale of bankrupt firm`s assets.

REORGANIZATION Restructuring of financial claims on failing firm to allow it to keep operating.