week4A - Bankruptcy and Financial Distress Thomas H Noe...

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Bankruptcy and Financial Distress Thomas H. Noe
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Lecture objectives Understand The basic legal framework for corporate financial distress and bankruptcy How the legal framework generates opportunities for strategic maneuver by the shareholders of a bankrupt firm How the bankruptcy/financial distress system affects the incentives of managers and shareholder of non- bankrupt firms.
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Basic Definitions Financial Distress : shareholders find it difficult or impossible to satisfy creditor claims. illiquidity(IL)-- firm value >> nominal debt value, but cash flow to small to cover contracted payments to creditors financial insolvency-(FI)-- firm value <= nominal debt value. economic failure-(EF) --value maximized by firm liquidation.
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Consequences of Distress In a perfect financial market economic failures will be liquidated, economically viable firms will will be able to borrow more w/o restructuring if they are illiquid but not insolvent will reorganize their capital structures and continue operations if they are insolvent .
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Consequences of Distress Unfortunately, markets are imperfect, because of Free-rider problem ---each creditor wants the other creditor to make concession Differences in information ---if shareholders feel debtholders will restructure their debt if they claim distress, the have an incentive to “cry wolf” Creditor myopia ---each creditor on see the effect of policy decisions on her own claim, not total enterprise value Therefore, distress resolution is imperfect
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Reduce inefficiency state imposed agreement Possible approaches? auctions coordinated foreclosure structured negotiations
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Two approaches: U.S/U.K. ca. 1985-1990 US: equity receivership UK: debtor asset foreclosure UK formal procedure approaches US US practice approaches UK Pro-debtor Pro-creditor time
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Financial Distress US Law Bankruptcy--Formal legal procedure for resolving financial distress. Chapter 7--liquidation Chapter 11--reorganization Workout/Reorganization--Informal procedures for resolving financial distress.
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U. S. Principles Principles underlying Chpt. 11 Bankruptcy Automatic Stay current shareholders become ‘‘debtors-in- possession,” assets protected from seizure, right to make first reorganization proposal. Automatic Approval class which is paid in full is presumed to consent to reorganization
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U. S. Principles Absolute Priority --if agreement cannot be reached, court imposed settlement (cram down) must satisfy absolute priority no payoff to any class unless all classes with higher priority are paid in full. Lifting of stay ---if a class cannot possibly receive any payment in any negotiated settlement consistent with absolute priority, that class cannot block settlement.
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U. S. Principles Transparency ---all creditor classes have a right to a full accounting of the assets and liabilities of the debtor-in-possession.
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U. S. Strategic Bankruptcy Shareholders can use the automatic stay provisions of bankruptcy law to: extract concessions from creditors maintain effective control of the firm’s assets
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U. S.
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