By: Ian Peterkin
“Our capital position at the moment is strong.” – Former Lehman Brothers CFO Ian Lowitt, five days before Lehman’s bankruptcy filing
Financial distress is among the most important and pivotal situations that a company may find itself in. It raises important questions about the core operating nature of a business and the responsibilities of its Board and Management, while providing lucrative opportunities for debt-savvy investors. While an attempt to answer every question regarding financial distress is out of the scope of this article, we can still provide a high level of detail about the roles of each party in a bankruptcy process to remove some of the smoke and mirrors surrounding bankruptcy. With the cyclical nature of the corporate landscape, understanding who’s who in times of distress is one of the keystones to making judgements on the nature of a distressed Company.
Company players are those parties involved with the Company pre-filing for bankruptcy. This group usually consists of the Company’s Board of Directors, Management, as well as all of the Company’s creditors (in complex cases, the list of Company creditors can be quite long).
First, the Board of Directors is a group of people elected to represent Company shareholders. The Board is almost always primarily concerned with maximizing shareholder value. However, when facing insolvency (i.e. the Company can’t pay its debt), the Board must realize that its fiduciary duties extend beyond those of a Board not experiencing distress. Instead of being solely concerned with shareholders, the Board must now consider both the short and long-term effects of its actions. A Board in distress effectively operates under a microscope, with every action and reaction subject to judgement by the court.
The essential first step for a Board in distress is to prepare for this oversight by engaging experienced legal and financial professionals to advise on important decision making. Maintaining effective legal counsel helps to ensure that the Board will make effective use of the “Business Judgement Rule”, a legal protection against litigation brought about by dissatisfied shareholders and bondholders. Meanwhile, effective advisors operate as the strategists of the insolvent Board, guiding them through every potential course of action. If, after consultation with its advisors, the Board concludes that bankruptcy is the best plan of action, the advice of its advisors will prove invaluable as it navigates the bankruptcy process.
Next, Management faces similar fiduciary duties as the Board, but also has its own distinct responsibilities. Management’s compensation often relies heavily on significant equity incentives that, under distress, may have diminished value. As a result, Management might adopt a short-sighted view of embracing less than optimal deals with parties such as unsecured creditors in order to protect their own interests.
Good Management, however, understands that its fiduciary duties supersede its own interests. By colluding with unsecured creditors like bondholders, management may be starting a slippery slope to a Company sale at less than optimal prices, effectively wiping out Old Equity (more on this later). During distress, Management is concerned with operating on a tight budget, utilizing the help of financial advisors to identify areas where it had gone astray leading up to distress, hoping that through this careful analysis, it can confidently come up with meaningful ways to restructure the Company around a less burdensome capital structure.
Now onto Bondholders, who are individuals or entities that maintain ownership of outstanding bonds. Bondholders can come in two broad categories: secured and unsecured. These can each be split up into two groups as well: par holders, who purchased the bonds at face value when they were issued, and so called, vulture investors. By and large, ALL bondholders are purely financial players concerned with maximizing their returns, and NOT with keeping the firm alive (unless those bondholders maintain other interests in the firm). If both options are possible, then the bondholders can be quite amenable to a restructuring. However, if the bondholders see an opportunity for increased returns in a liquidation scenario, they will not hesitate to push for liquidation.
Typically, the “right” way to deal with bondholders is through constant communication. Generally, if the bondholders go quiet, something is up. Recently though, a new group called “vulture investors” have seen a rise. See for example the recent Puerto Rico debt crisis, in which firms like Oppenheimer, Franklin, and Aurelius Capital Management scooped up billions in distressed bonds and pension debt, hoping to profit from a rebound. These investors aim to purchase the secured debt (usually at a discount) from its original holders, seeking to maximize its internal rate of return, without giving much thought to its reputation on the street or the Company’s going concern status. The process usually goes like this: As signs of distress start to creep and the Company’s status as a going concern is brought into question, the bonds will start to lower in pricing as risk averse holders begin to fear less (or no) returns in a potential bankruptcy and start to sell off their holdings. Enter the vultures. The vultures see this lower pricing as an opportunity to bet on the Company’s status as a going concern, and purchase the bonds from their original holders.
Trade creditors are those creditors whose claims are based on goods they have sold to the Company prior to its entry into bankruptcy (this is an example of a pre-petition trade creditor, a creditor who continues to supply after filing would be considered post-petition). For example, in the recent Toys “R” Us filing, many creditors continued supplying the bankrupt retailer after its filing, hoping it would emerge from bankruptcy able to pay its debts. When the Company ended up liquidating, trade creditors collectively lost out on hundreds of millions of dollars in trade credit. In general, the trade-creditors’ claims make up the “accounts-payable” line item on a firm’s balance sheet.
There are two types of trade creditors: critical vendors and general unsecured creditors. Critical vendors are those vendors whose functions are essential to the functions of the business. Without their continued service, the Company could no longer operate. It is these critical vendors who are often paid at the onset of the bankruptcy to ensure the going concern of the business during its stay in bankruptcy. While it may seem odd that a supplier would continue to deal with a bankrupt firm, critical vendors are usually able to strike deals on terms for their continued supply in exchange for a wide range of benefits, such as priority payment in a liquidation scenario (commonly called critical vendor claims). General unsecured creditors are those creditors who are last in the payment waterfall (there are some exceptions to this rule). The outcome of a bankruptcy for them depends on the nature of the process, but often results in little to no recoveries.
Last in the priority waterfall is old equity. We use the term “old” equity to differentiate those holders of equity pre-bankruptcy from those who hold the equity post-process (which is often composed of different groups). Generally quite passive in the process, no one really represents Old Equity in bankruptcy besides the Board. For private companies with a few high stake holding owners, Old Equity can be very active, but in public cases, Old Equity often finds itself disenfranchised.
However, just because they are disenfranchised, does not mean Old Equity will not see any recovery. In fact, there are actually many paths to meaningful recovery for Old Equity, and if possible Old Equity should attempt to maintain some sort of financial advisor of its own to evaluate these options. For example, one way is to demonstrate that the value of the enterprise is such that the equity has value in excess of the debt.
Now that we have gone through the company players, we can move onto the next group, Outside professionals. These are all of the parties brought in after the Company realizes its situation of distress, usually with the goal of ameliorating the problem(s) that the Company is facing. This group consists of legal counsel, financial advisors, and any other parties that the Company may deem necessary. This group also carries with it fees, so it is important to consider engagements economically.
Legal Counsel, along with the other professional groups, plays an essential role in the bankruptcy process. As much of the process is centered on the bankruptcy courtroom and the bankruptcy judge has the final say before giving effect to a transaction, the roles of the lawyers are of extreme importance. As a result, the Board is often not the only party to hire on legal counsel. In cases involving many claimants and uncertainty around their respective payouts, it’s not uncommon to see multiple legal firms present in the courtroom, arguing for the interests of their clients.
The responsibilities of legal counsel include maintaining meticulous records of the Company’s bankruptcy related filings; Contacting the legal counsel of other parties in order to effect a consensual sale or restructuring; Advising the Company on the legal nuances of its proceedings; Drafting legal documents; Reviewing legal documents presented by other parties; Representing the best interests of the Company in a courtroom.
The investment banker is a sort of jack of all trades when it comes to bankruptcy cases. A debtor-side investment banker may responsible for a myriad of tasks depending on the goals of her clients, including: Providing financial advisory services; Mergers and acquisition services in cases where the Company is looking (or is forced) to sell; Litigation support; Raising capital for post-filing financing; Financial opinions; Soliciting bids for assets during a sale process.
The financial advisor role may be played by the investment banker, though this is not always the case. In complex cases with multiple conflicting parties it is generally beneficial for each party to hire their own financial advisors to provide opinions and analysis on the specific situation. The financial advisor is responsible for assisting the Company in evaluating all of its potential options. In other words, the financial advisor is the Company’s guide in distress. When the Company wants to conduct sensitivity analysis, cash forecasts, or any other sort of financial diligence, they often enlist the help of their financial advisors. An experienced board may be great at running a Company under normal circumstances, but lost when distress begins to creep in. A competent financial advisor with experience aiding distressed Companies can be the saving grace of a lost management team.
Finally, the last major group is the Court. The “court” is a catch all category for the many moving parts of the legal system as defined by the U.S. Bankruptcy Code. At the head of this group is the bankruptcy judge, someone (often an ex lawyer) who is responsible for ruling on any matter connected with a bankruptcy case, such as eligibility to file or whether a debtor should receive a discharge of debts .
The bankruptcy judge is appointed by the U.S. Court of Appeals, and there are 94 federal judicial districts that handle bankruptcy cases. As of September 2012, there are 350 authorized bankruptcy judgeships, with each judge serving a term of 14 years. The defining moments of a bankruptcy take place under the supervision of the judge, and careful consideration as to which district the Company files for bankruptcy in must be made to ensure the best outcome for the Company. Legal counsel often determines jurisdiction through a careful study of past cases taken on in the district and their respective rulings.
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