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The Grounding of Eastern Airlines

Chapter 11 bankruptcy proceedings often involve a conflict between the objective of keeping the company afloat and that of protecting the interests of the lenders. Seldom has that conflict been more apparent than in the case of Eastern Airlines.

Eastern Airlines operated in the very competitive East Coast corridor and had services to South America and the Caribbean. For some years before it filed for bankruptcy, the company had had a record of high operating costs and poor labor relations. Its boss, Frank Lorenzo, had a reputation for union busting and one trade unionist had termed him “ the Typhoid Mary of organized labor.” Lorenzo`s attempts to force Eastern`s employees to take a wage cut led to a strike by machinists in March 1989 and almost immediately Eastern filed for bankruptcy under Chapter 11.

When Eastern filed for bankruptcy, it had saleable assets, such as planes and gates, worth over $4 billion. This would have been more than sufficient to pay off the company`s creditors and preferred stockholders. But the bankruptcy judge decided that it was important to keep Eastern flying at all costs for the sake of its customers and employees.

Eastern did keep flying, but the more it flew, the more it lost. Management presented the bankruptcy court with three different plans to reorganize the company, but each time it immediately became clear that the plan was not viable. Eventually, the creditors` patience with management ran out, and they demanded the appointment of an independent trustee to run the company. However, the deficits continued to accumulate. In less than two years the airline had piled up additional losses of nearly $1.3 billion. Eventually, Eastern could no longer raise the cash to continue flying, and in January 1991 its planes were finally grounded.

Nearly four more years were to elapse before the court was able to settle on a plan to pay off Eastern`s creditors and a further year passed before the last of the company`s assets were sold. A large part of the proceeds from asset sales had been eaten up by the operating losses and just over $100 million had seeped away in legal costs. Less than $900 million was left to pay off the creditors. The secured creditors received about 80 percent of what they were owed and unsecured creditors received just over 10 percent.

What are the usual steps in credit management?

The first step in credit management is to set normal terms of sale. This means that you must decide the length of the payment period and the size of any cash discounts. In most industries these conditions are standardized.

Your second step is to decide the form of the contract with your customer. Most domestic sales are made on open account. In this case the only evidence that the customer owes you money is the entry in your ledger and a receipt signed by the customer. Sometimes, you may require a more formal commitment before you deliver the goods. For example, the supplier may arrange for the customer to provide a trade acceptance.

The third task is to assess each customer`s creditworthiness. When you have made an assessment of the customer`s credit standing, the fourth step is to establish sensible credit policy. Finally, once the credit policy is set, you need to establish a collection policy to identify and pursue slow payers.

How do we measure the implicit interest rate on credit?

The effective interest rate for customers who buy goods on credit rather than taking the discount for quicker payment is

(1 + discount )365/extra days credit 1 discounted price

When does it make sense to ask the customer for a formal IOU?

When a customer places a large order, and you want to eliminate the possibility of any subsequent disputes about the existence, amount, and scheduled payment date of the debt, a formal IOU or promissory note may be appropriate.

How do firms assess the probability that a customer will pay?

Credit analysis is the process of deciding which customers are likely to pay their bills. There are various sources of information: your own experience with the customer, the experience of other creditors, the assessment of a credit agency, a check with the customer`s bank, the market value of the customer`s securities, and an analysis of the customer`s financial statements. Firms that handle a large volume of credit information often use a formal system for combining the various sources into an overall credit score.

How do firms decide whether it makes sense to grant credit to a customer?

Credit policy refers to the decision to extend credit to a customer. The job of the credit manager is not to minimize the number of bad debts; it is to maximize profits. This means that you need to weigh the odds that the customer will pay, providing you with a profit, against the odds that the customer will default, resulting in a loss. Remember not to be too shortsighted when reckoning the expected profit. It is often worth accepting the marginal applicant if there is a chance that the applicant may become a regular and reliable customer. If credit is granted, the next problem is to set a collection policy. This requires tact and judgment. You want to be firm with the truly delinquent customer, but you don`t want to offend the good one by writing demanding letters just because a check has been delayed in the mail. You will find it easier to spot troublesome accounts if you keep a careful aging schedule of outstanding accounts.

What happens when firms cannot pay their creditors?

A firm that cannot meet obligations may try to arrange a workout with its creditors to enable it to settle its debts. If this is unsuccessful, the firm may file for bankruptcy, in which case the business may be liquidated or reorganized. Liquidation means that the firm`s assets are sold and the proceeds used to pay creditors. Reorganization means that the firm is maintained as an ongoing concern, and creditors are compensated with securities in the reorganized firm. Ideally, reorganization should be chosen over liquidation when the firm as a going concern is worth more than its liquidation value. However, the conflicting interests of the different parties can result in violations of this principle.