altman & hotchkiss - corporate financial distress and bankruptcy, 3e (2006)

Library of Congress Cataloging-in-Publication Data: Altman, Edward I., 1941– Corporate financial distress and bankruptcy : predict and avoid bankruptcy, analyze and invest in distressed d

Corporate Financial Distress and Bankruptcy

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Predict and Avoid Bankruptcy, Analyze and Invest in Distressed Debt

Third Edition

EDWARD I ALTMAN EDITH HOTCHKISS

Corporate Financial Distress and Bankruptcy

Copyright © 2006 by Edward I Altman and Edith Hotchkiss All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Altman, Edward I., 1941–

Corporate financial distress and bankruptcy : predict and avoid

bankruptcy, analyze and invest in distressed debt / Edward I Altman,

Edith Hotchkiss — 3rd ed.

p cm — (Wiley finance series)

Includes bibliographical references and index.

ISBN-13: 978-0-471-69189-1 (cloth)

ISBN-10: 0-471-69189-5 (cloth)

1 Bankruptcy—United States I Hotchkiss, Edith, 1961–

II Title III Series.

HG3766.A66 2006

658.15—dc22

2005017835 Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

The Legal, Economic, and Investment Dimensions of Corporate

Bankruptcy and Distressed Restructurings

Techniques for the Classification and Prediction of Corporate

Financial Distress and Their Applications

Distress Prediction Models: Catalysts for Constructive Change—

In looking back over the first two editions of Corporate Financial Distress

and Bankruptcy (1983 and 1993), we note that on both occasions of their

publication the incidence and importance of corporate bankruptcy in theUnited States had risen to ever more prominence The number of profes-sionals dealing with the uniqueness of corporate death in this country wasincreasing so much that it could have perhaps been called a “bankruptcyindustry.” There is absolutely no question now in 2005 that we can call it

an industry The field has become even more popular in the past 10 to 15years, and this has been accompanied by an increase in the number of acad-emics specializing in the corporate distress area These academics providethe serious analytical research that is warranted in this field Indeed, there isnothing more important in attracting rigorous and thoughtful researchthan data! With this increased theoretical and especially empirical interest,Edith Hotchkiss has joined the original author of the first two editions toproduce this volume

It is now quite obvious that the bankruptcy business is big-business.While no one has done an extensive analysis of the number of people whodeal with corporate distress on a regular basis, we would venture a guessthat it is at least 40,000 globally, with the vast majority in the United Statesbut a growing number abroad We include turnaround managers (mostlyconsultants); bankruptcy and restructuring lawyers; bankruptcy judges andother court personnel; accountants, bankers, and other financial adviserswho specialize in working with distressed debtors; distressed debt investors,sometimes referred to as “vultures”; and, of course, researchers Indeed, theprestigious Turnaround Management Association (www.turnaround.org)numbered more than 7,000 members in 2005

The reason for the large number of professionals working with zations in various stages of financial distress is the increasing number oflarge and complex bankruptcy cases In the United States in the three-yearperiod 2001–2003, 100 companies with liabilities greater than $1 billionfiled for protection under Chapter 11 of the Bankruptcy Code These “billion-dollar babies” are listed in the appendix to Chapter 1 Over the past 35years (1970–2005), there have been at least 228 of these large firm bank-ruptcies in the United States On the eve of the publication of this book,

organi-two of the nation’s major airlines, Delta and Northwest, have filed forbankruptcy protection Chapter 1 of this book presents some relevant defi-nitions and statistics on corporate distress and highlights the increasing re-ality that size is no longer a proxy for corporate health.

The planning for this book began long before its completion in

mid-2005, and we were unaware that the eventual passing of the new ruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA)would coincide with the timing of our completion Most observers werecommenting on the implications of the new Act for consumer (personal)bankruptcies, but as the details of the new Act became evident, it was clearthat the implications for corporations and the reorganization process arealso quite important We attempt to treat many of these new provisions inChapter 2 when we explore the evolution of the bankruptcy process in theUnited States with comparisons to many other countries

Bank-With this background in place, the remaining chapters in the first tion of the book address a number of key issues central to our understand-ing of the restructuring process In Chapter 3, we explore the success of thebankruptcy reorganization process, especially with respect to the post-bankruptcy performance of firms emerging from Chapter 11 In a disturb-ing number of instances, these emerging firms have sustained recurringoperating and financial problems, sometimes resulting in a second filing,unofficially called a “Chapter 22.” Indeed, we are aware of at least 157 ofthese two-time filers over the period 1980–2004, and seven three-time filers(Chapter 33s) If we include filings prior to the 1978 Bankruptcy ReformAct, there is even one Chapter 44 (TransTexas Gas Corporation)! Despitethe numbers of bankruptcy repeaters, many firms reduce the burden oftheir debt and go on to achieve success, especially if the core business issolid and can be managed more effectively with less debt

sec-As bankruptcy cases have become larger and more complex, there is aneed for professionals with increasingly specialized skills For example,with the sales of pieces of or entire businesses becoming more common inthe recent wave of bankruptcies, there is a need for professionals skilled inmanaging the mergers and acquisitions (M&A) process With the growth

in the number and size of cases has come increased scrutiny of bankruptcycosts Chapter 4 summarizes the extensive amount of academic researchthat has helped us to understand the nature of these costs For larger firms,the dollar magnitude of these costs may be tremendous; for smaller firms,these costs may be prohibitive and ultimately lead to liquidation

Chapters 5 and 6 explore the importance and analytics of the tressed firm valuation process from theoretical and pragmatic standpoints

dis-In essence, the most important determinants of the fate of the distressedfirm are (1) whether it is worth more dead than alive and (2) if worth morealive, what its value is relative to the claims against the assets Chapter 5

provides a careful discussion of valuation models for distressed firms, andexplains why we observe seemingly wide disagreements over the reorga-nized firm’s value between different parties in the bankruptcy negotiationprocess Chapter 6 concentrates on the highly leveraged restructuring, therelevant valuation and capital structure theories, and empirical results.Chapters 7 through 9 explore, in great depth, the two relevant capitalmarkets most important to risky and distressed firms Chapter 7 exploresthe development and risk-return aspects of the U.S high yield bond andbank loan markets Since high yield or “junk” bonds are the raw materialfor future possible distressed debt situations, it is important to investigatetheir properties Among the most relevant statistics to investors in thismarket are the default rate as well as the recovery rate once the firm de-faults The high yield corporate bond market approached $1 trillion out-standing in 2005, and topped $1 trillion when General Motors’ and Ford’sbonds were downgraded to non–investment grade status in May 2005.Chapters 8 and 9 go on to examine the size and development of thedistressed and defaulted debt market This market was actually larger thanthe high yield market in 2002 when the face value of distressed debt (pub-lic and private) was almost $950 billion—at that time greater in size thanthe gross domestic products (GDPs) of all but seven of the world’s coun-tries! As the default rate subsequently decreased from record high levels in

2002, the size receded somewhat but still was relatively large in 2005 sothat the distressed and defaulted debt market is now generally thought of

as a unique asset class itself and perhaps the fastest growing segment in thehedge fund sector As such, we explore its size, growth, risk-reward dimen-sions, and investment strategies

Rounding out the first major section of this book is Chapter 10 on porate governance in the distressed firm Virtually every aspect of a firm’sgovernance can change in some way when a firm undergoes a distressed re-structuring Management turnover rates for firms that emerge from Chap-ter 11 reach 90 percent Board size declines as firms become distressed, andthe board often changes in its entirety at reorganization Most importantly,many restructurings ultimately involve a change in control of the company.The second section of this book deals with the development and impli-cations of models built to classify and predict corporate distress The esti-mation of the probability of default in the United States (Chapter 11) andfor emerging markets (Chapter 12) and the loss given default (Chapter 15)are explored in depth Emphasis is on estimation procedures and their rele-vance to the new features of Basel II’s capital adequacy requirements forbanks and other financial institutions

cor-In an appendix to Chapter 11 of this book, we present a bibliography

explosion in interest in the corporate bankruptcy phenomenon all over theworld As illustrated earlier in Chapter 2 and further documented in Chap-ter 12, corporate distress is a global phenomenon and, as such, deservescareful analysis and constructive commentary and legislation.

Models for estimating default probabilities are discussed in Chapters

11 and 12 followed in Chapter 13 by their applications to many differentscenarios, including credit risk management, distressed debt investing,turnaround management and other advisory capacities, and legal issues.This chapter, in addition, comments on the leading practitioner firms inthese functions

With respect to the turnaround management arena, Chapter 14 furtherexplores the possibility of using distressed firm predictive models, for ex-ample our Z-Score approaches, for assisting the management of the dis-tressed firm itself in order to manage a return to financial health Weillustrate this via an actual case study discussed in Chapter 14—the GTICorporation and its rise from near extinction

New York, New York

Chestnut Hill, Massachusetts

October 2005

help-Among the practitioners, Ed Altman would like to thank Amit Arora,John Beiter, Maria Boyarzny, Brooks Brady, Bruce Buchanan, Michael Em-bler, Ken Emery, Holly Etlin, John Fenn, Jerry Foms, Martin Fridson, RichGere, Geoffrey Gold, Shelly Greenhaus, Harvey Gross, Robert Grossman,David Hamilton, Loretta Hennessey, Max Holmes, Shubin Jha, Sau-ManKam, D L Kao, David Keisman, Al Koch, Martha Kopacz, Pat LaGrange,Markus Lahrkamp, E Bruce Leonard, Bill Lutz, Judge Robert Martin,Chris McHugh, Robert Miller, Steven Miller, Wilson Miranda, David New-man, Mark Patterson, Gabriella Petrucci, Robert Raskin, Barry Ridings,Wilbur Ross, Til Scheurmann, Mark Shenkman, Dennis Smith, ChristopherStuttard, Ronald Sussman, Matt Venturi, Mariarosa Verde, Robert Wald-man, Lionel Wallace, Jeffrey Werbalofsky, Bettina Whyte, David Winters,and Steven Zelin And extra special thanks to his two ex-students, AllanBrown and Marti Murray Edie Hotchkiss would like to thank WilliamDerrough, Joseph Guzinski, Melissa Hager, Gregory Horowitz, Isaac Lee,Brett Miller, and Barry Ridings for their helpful discussions.

Ed Altman would also like to thank the many graduate assistants atthe NYU Salomon Center over the years and the wonderful staff at theCenter, including Mary Jaffier, Anita Lall, Robyn Vanterpool, and espe-cially Lourdes Tanglao The authors also thank Kimberly Thomas for herassistance with this manuscript The editorial assistance of Mary Daniello,Bill Falloon, and Laura Walsh of John Wiley & Sons is also appreciated bythe authors

Edie Hotchkiss and Ed Altman would like to acknowledge the manycontributions to the literature and field of corporate distress by academics,especially the more than 20 scholars who make up the Academic AdvisoryCouncil to the Turnaround Management Association and the many coau-thors on their academic research papers

Finally, Ed Altman would like to thank his wife and longtime panion, Elaine Altman, and son Gregory, for enduring his perverse en-thusiasm for various degrees of corporate distress Edie Hotchkisswould like to thank Ed for first introducing her to this field as her Ph.D.dissertation adviser, and for inviting her to collaborate on this project.She would also like to thank her husband Steven and daughter Jenny fortheir loving support.

com-E.I.A.E.H

About the Authors

Edward I Altman is the Max L Heine Professor of Finance at the Stern

School of Business, New York University, and director of the Credit andFixed Income Research Program at the NYU Salomon Center

Dr Altman has an international reputation as an expert on corporatebankruptcy, high yield bonds, distressed debt, and credit risk analysis

He was named Laureate 1984 by the Hautes Etudes Commerciales Foundation in Paris for his accumulated works on corporate distress pre-diction models and procedures for firm financial rehabilitation, and

he was awarded the Graham and Dodd Scroll for 1985 by the FinancialAnalysts Federation for his work on default rates and high yield corpo-rate debt

He was inducted into the Fixed Income Analysts Society Hall of Fame

in 2001 and elected president of the Financial Management Association

(2003) and a Fellow of the FMA in 2004 He was honored by Treasury and

Risk Management magazine as one of the 100 most influential people in

fi-nance (June 2005)

Dr Altman is an adviser to many financial institutions, including group, Concordia Advisors, Droege & Company, Investcorp, Miller-Mathis,the New York State Common Retirement Fund, and SERASA, S.A.; he is

Citi-on the boards of the Franklin Mutual Series Funds, Automated TradingDesk L.L.C., and the Ascend Group, and is chairman of the Academic Ad-visory Council to the Turnaround Management Association; and he hastestified before federal and state legislative bodies

Edith Hotchkiss is an Associate Professor of Finance at the Carroll

School of Management at Boston College She received her Ph.D in nance from the Stern School of Business at New York University and herB.A from Dartmouth College Prior to entering academics, she worked

Fi-in consultFi-ing and for the FFi-inancial Institutions Group of Standard &Poor’s Corporation

Dr Hotchkiss’s research covers such topics as corporate financial tress and restructuring, the efficiency of Chapter 11 bankruptcy, and

dis-trading in corporate debt markets Her work has been published in

jour-nals including the Journal of Finance, Journal of Financial Economics,

Journal of Financial Intermediation, and Review of Financial Studies.

She has served on the national board of the Turnaround ManagementAssociation, and as a consultant to the National Association of Securi-ties Dealers (NASD) on trading in corporate bond markets

Distressed Restructurings

Corporate Financial Distress and Bankruptcy: Predict and Avoid Bankruptcy, Analyze and Invest in Distressed Debt, Third Edition

by Edward I Altman and Edith Hotchkiss Copyright © 2006 Edward I Altman and Edith Hotchkiss

CHAPTER 1

Corporate Distress: Introduction

and Statistical Background

Corporate distress, including the legal processes of corporate ruptcy reorganization (Chapter 11 of the Bankruptcy Code) and liqui-dation (Chapter 7), is a sobering economic reality reflecting theuniqueness of the American way of corporate “death.” The business fail-ure phenomenon received some exposure during the 1970s, more duringthe recession years of 1980 to 1982, heightened attention during the ex-plosion of defaults and large firm bankruptcies in the 1989–1991 period,and an unprecedented interest in the 2001–2002 corporate debacle anddistressed years In the 1989–1991 period, 34 corporations with liabili-ties greater than $1 billion filed for protection under Chapter 11 of theBankruptcy Code, and in the three-year period 2001–2003 as many as

bank-100 so-called billion-dollar babies, including the top five, filed for tection under the Code (see Appendix 1.1)

pro-The lineup of major corporate bankruptcies was capped by the moth filings of Conseco ($56.6 billion in liabilities), WorldCom ($46.0 bil-lion), and Enron ($31.2 billion—actually almost double this amount onceyou add in the enormous amount of off-balance liabilities, making it thelargest bankruptcy in the United States) Two of these three largest bank-ruptcies were fraud-related (see our discussion of corporate governance is-sues in distressed companies in Chapter 10) Incidentally, we believe that it ismore relevant to list and discuss the size of bankruptcies in terms of liabili-ties at the time of filing rather than assets For example, WorldCom hadabout $104 billion in book value of assets but its market value at the time offiling was probably less than one-fifth of that number It is the claims againstthe bankruptcy estate, as well as the going-concern value of the assets, thatare most relevant in a bankrupt company We list the largest corporatebankruptcies in the United States over the period 1970–2005 (Q1) in Ap-pendix 1.1—the so-called billion-dollar babies Actually, only two of the

228 entries in this list were from the 1970–1979 decade—Penn Central(1970) and W T Grant (1975)—and only 21 occurred in the 1980s Themajority of the largest bankruptcies in the 1970–2004 period were from thefirst four years of the new millennium Even adjusting for inflation, it isclear that size is no longer a proxy for corporate health, and there is littleevidence, except in very rare circumstances, of the old adage “too big tofail.” Lately, that question has been asked about General Motors and Ford.The unsuccessful business enterprise has been defined in numerousways in attempts to depict the formal process confronting the firm and/or

to categorize the economic problems involved Four generic terms that are

commonly found in the literature are failure, insolvency, default, and

bankruptcy Although these terms are sometimes used interchangeably,

they are distinctly different in their formal usage

Failure, by economic criteria, means that the realized rate of return on

invested capital, with allowances for risk consideration, is significantly andcontinually lower than prevailing rates on similar investments Somewhatdifferent economic criteria have also been utilized, including insufficientrevenues to cover costs and where the average return on investment is con-tinually below the firm’s cost of capital These economic situations make

no statements about the existence or discontinuance of the entity tive decisions to discontinue operations are based on expected returns andthe ability of the firm to cover its variable costs It should be noted that acompany may be an economic failure for many years, yet never fail to meetits current obligations because of the absence or near absence of legally en-forceable debt When the company can no longer meet the legally enforce-able demands of its creditors, it is sometimes called a legal failure The

Norma-term legal is somewhat misleading because the condition, as just described,

may exist without formal court involvement

The term business failure was adopted by Dun & Bradstreet (D&B),

which for many years until recently supplied relevant statistics on nesses to describe various unsatisfactory business conditions According toD&B, business failures included “businesses that cease operation followingassignment or bankruptcy; those that cease with loss to creditors after suchactions or execution, foreclosure, or attachment; those that voluntarilywithdraw, leaving unpaid obligations, or those that have been involved incourt actions such as receivership, bankruptcy reorganization, or arrange-ment; and those that voluntarily compromise with creditors.”1

busi-4 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

1 In the prior editions of this book (Altman 1983 and 1993) we used the D&B “failure

Insolvency is another term depicting negative firm performance and is

generally used in a more technical fashion Technical insolvency exists

when a firm cannot meet its current obligations, signifying a lack of ity Walter (1957) discussed the measurement of technical insolvency andadvanced the theory that net cash flows relative to current liabilities should

liquid-be the primary criterion used to descriliquid-be technical insolvency, not the ditional working capital measurement Technical insolvency may be a tem-porary condition, although it often is the immediate cause of formalbankruptcy declaration

tra-Insolvency in a bankruptcy sense is more critical and usually indicates a

chronic rather than temporary condition A firm finds itself in this situationwhen its total liabilities exceed a fair valuation of its total assets The realnet worth of the firm is, therefore, negative Technical insolvency is easilydetectable, whereas the more serious bankruptcy insolvency condition re-quires a comprehensive valuation analysis, which is usually not undertakenuntil asset liquidation is contemplated Finally, a relatively recent concept

that has appeared in judicial courts concerns the condition known as

deep-ening insolvency This involves an eventually bankrupt company that is

al-leged to be kept alive unnecessarily and to the detriment of the estate,especially the creditors This concept is explored in Chapter 13 of this book.Another corporate condition that is inescapably associated with dis-

tress is default Defaults can be technical and/or legal and always involve the relationship between the debtor firm and a creditor class Technical de-

fault takes place when the debtor violates a condition of an agreement with

a creditor and can be the grounds for legal action For example, the tion of a loan covenant, such as the current ratio or debt ratio of thedebtor, is the basis for a technical default In reality, such defaults are usu-ally renegotiated and are used to signal deteriorating firm performance.Rarely are these violations the catalyst for a more formal default or bank-ruptcy proceeding

viola-When a firm misses a scheduled loan or bond payment, usually the riodic interest obligation, a legal default is more likely, although it is not al-ways the result in the case of a loan Interest payments can be missed andaccrue to the lender in a private transaction, such as a bank loan, without aformal default being declared For publicly held bonds, however, when afirm misses an interest payment or principal repayment, and the problem isnot cured within the grace period, usually 30 days, the security is then indefault The firm may continue to operate while it attempts to work out a

pe-distressed restructuring with creditors and avoid a formal bankruptcy

dec-laration and filing It is even possible to agree upon a restructuring with asufficient number and amount of claimants and then legally file for bank-

ruptcy This is called a prepackaged Chapter 11 (discussed in Chapter 2) Corporate Distress: Introduction and Statistical Background 5

Defaults on publicly held indebtedness have become a commonplaceevent, especially in the two major default periods, 1989–1991 and2001–2002 Indeed, in 1990 and again in 1991, over $18 billion of pub-licly held corporate bonds defaulted each year involving about 150 differ-ent entities And in 2002, defaults soared to an almost unbelievable level ofclose to $100 billion! Table 1.1 shows the history of U.S public bond de-

6 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

TABLE 1.1 Historical Default Rates—Straight Bonds Only Excluding Defaulted Issues from Par Value Outstanding, 1971–2004 ($Millions)

faults from 1971 to 2004, including the dollar amounts and the amounts

as a percentage of total high yield bonds outstanding—the so-called junkbond default rate Default rates are also calculated on leveraged loans,which are the private debt market’s equivalent to speculative grade bonddefaults (see Chapter 7 of this book)

Finally, we come to bankruptcy itself One type of bankruptcy was

de-scribed earlier and refers to the net worth position of an enterprise A ond, more observable type is a firm’s formal declaration of bankruptcy in afederal district court, accompanied by a petition either to liquidate its as-sets (filing Chapter 7) or attempt a recovery program (filing Chapter 11)

sec-The latter procedure is legally referred to as a bankruptcy reorganization.

The judicial reorganization is a formal procedure that is usually the lastmeasure in a series of attempted remedies We will study the bankruptcyprocess in depth and the evolution of bankruptcy laws in the United States

in the next chapter

BANKRUPTCY AND REORGANIZATION THEORY

In an economic system, the continuous entrance and exit of productive tities are natural components Since there are costs to society inherent inthe failure of these entities, laws and procedures have been established (1)

en-to protect the contractual rights of interested parties, (2) en-to provide forthe orderly liquidation of unproductive assets, and (3) when deemed desir-able, to provide for a moratorium on certain claims in order to give thedebtor time to become rehabilitated and to emerge from the process as a

Corporate Distress: Introduction and Statistical Background 7

TABLE 1.1 (Continued)

Standard Deviation

b Weighted by par value of amount outstanding for each year.

Source: Authors’ compilations.

continuing entity Both liquidation and reorganization are availablecourses of action in most countries of the world and are based on the fol-lowing premise: If an entity’s intrinsic or economic value is greater than itscurrent liquidation value, then from both a public policy and the entityownership viewpoints, the firm should be permitted to attempt to reorga-nize and continue If, however, the firm’s assets are “worth more deadthan alive”—that is, if liquidation value exceeds the economic going-concernvalue—liquidation is the preferable alternative.

The theory of reorganization in bankruptcy is basically sound and haspotential economic and social benefits The process is designed to enable thefinancially troubled firm to continue in existence and maintain whatevergoodwill it still possesses, rather than to liquidate its assets for the benefit ofits creditors Justification of this attempt is found in the belief that contin-ued existence will result in a healthy going concern worth more than thevalue of its assets sold in the marketplace Since this rehabilitation processoften requires several years, the time value of money should be consideredexplicitly through a discounted cash flow procedure If, in fact, economi-cally productive assets continue to contribute to society’s supply of goodsand services above and beyond their opportunity costs, the process of reor-ganization has been of benefit, to say nothing of the continued employment

of the firm’s employees, revenues for its suppliers, and taxes paid on profits.These benefits should be weighed against the costs of bankruptcy to the firmand to society We will explore further those costs in Chapters 4 and 6.The primary groups of interested parties are the firm’s creditors andowners The experience of these parties is of paramount importance in theevaluation of the bankruptcy reorganization process, although the lawsgoverning reorganization reflect the legislators’ concern for overall societalwelfare The primary immediate responsibility of the reorganizationprocess is to relieve the burden of the debtor’s liabilities and restructure thefirm’s assets and capital structure so that financial and operating problemswill not recur in the foreseeable future

8 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

Corporate Distress: Introduction and Statistical Background 9

TABLE 1.2a Bankruptcy Filings by Type, 1980–2004

Source: Bankruptcydata.com, www.abiworld.org/stats.

TABLE 1.2b Bankruptcy Filings by Bankruptcy Chapter, 2000–2004

Source: Bankruptcydata.com, www.abiworld.org/stats.

FIGURE 1.1 Business Bankruptcy Filings, 1980–2004

bers of business filings have receded to between 35,000 and 40,000 peryear in 2000–2004, the size in terms of total liabilities at the time of filingrose to record levels, especially in 2002 when more than $330 billion of li-abilities were impacted Certainly, the massive fraud-related bankruptcieshad an important influence on the 2001–2002 numbers, but it is also fair

to say that no longer does the term bankruptcy have the same ultranegative

connotation that it once did for larger companies

Some observations are worth mentioning First, the incredible increase

in nonbusiness (consumer) bankruptcies is apparent, reflecting the huge crease in personal indebtedness in the United States These personal bank-ruptcies have increased almost fivefold over the past 25 years With thetougher conditions for consumers under the Bankruptcy Abuse Preventionand Consumer Protection Act of 2005 (see Chapter 2), most observers areexpecting a significant decrease after the new Act goes into effect on Octo-ber 17, 2005 Second, the number of business filings has actually decreasedsince the peak period of 1991–1992 (see Figure 1.1) Third, despite the de-crease in the number of filings since the early 1990s, total liabilities of thelarger business bankruptcies have swollen to record levels in the2000–2004 period, especially in 2001 and 2002 (see Figure 1.2).2 Thesetrends have fed the distressed debt investment sector and have given un-precedented importance to this new alternative asset class (see our discus-sion in Chapters 8 and 9)

in-10 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

FIGURE 1.2 Filings for Chapter 11: Number of Filings and Prepetition Liabilities

of Public Companies, 1989–2004

Note: Minimum $100 million in liabilities.

Source: New York University Salomon Center Bankruptcy Filings Database.

0 40 80 120 160 200

Prepetition Liabilities, in $Billions (Left Axis) Number of Filings (Right Axis)

THE BANKRUPTCY INDUSTRY PLAYERS

The fact that corporate bankruptcy in the United States is a major industrycan be documented by the size and scope of activities that are associated withbankruptcy and distress While the sheer volume of corporate bankruptcy fil-ings peaked in the early 1990s, bankruptcies now (2005) attract a recordnumber of practitioners and researchers Perhaps the main reason is the size

of the entities in recent years that have found it necessary to file for ruptcy As noted earlier, firms with liabilities and assets of at least $1 billionare now fairly commonplace And, just as important to strategists and re-searchers, is the availability of data on distressed firms from many sources.The major players in the bankruptcy and related distressed firm industry are:

bank-■ Bankrupt and failed firms—the debtors

■ Bankruptcy legal system (judges, trustees, etc.)

■ Bankruptcy law specialists

■ Bankruptcy-insolvency accountants and tax specialists

■ Bankrupt firm creditors and committees

■ Distressed firm securities traders and analysts

■ Distressed firm turnaround specialists

■ Financial restructuring advisers

■ Public relations firms specializing in troubled firms

■ Bankruptcy and workout publications

Most of these bankruptcy and distressed firm players are discussed inChapter 13 of this book

THE DEBTORS

As we discussed in prior versions of this book, during the 1970s, about29,000 to 35,000 business entities filed for protection to either liquidate orreorganize under the bankruptcy laws of the United States each year Asshown earlier in Table 1.2a and b and Figures 1.1 and 1.2, under the Bank-ruptcy Code that went into effect in October 1979 and was recentlyamended in 2005, the number of business bankruptcy filings increased tonearly 44,000 in 1980, were well over 60,000 per year from 1982 to 1993,then receded to between 35,000 and 55,000 from 1993 to 2004

Although the amendments to the Bankruptcy Code in 2005, the ruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA),dramatically changed the provisions dealing with individuals, we do not focus

Bank-on cBank-onsumer bankruptcies in this book The new Act in 2005 also did changesome important corporate provisions, which we review in the next chapter

Corporate Distress: Introduction and Statistical Background 11

CHAPTER 22 DEBTORS AND BANKRUPTCY SUCCESS

The bankruptcy reorganization process is, unfortunately, not always cessful even if the firm emerges as a continuing entity It is certainly possi-ble for the emerged firm to fail again and file a second time (or even athird time and so on) for protection under the code We first coined the

suc-term Chapter 22 (Altman 1983) to illustrate those companies that have

filed twice These Chapter 22s were saddled with too much debt and/orthe business outlook was overly optimistic at the time of emergence thefirst time We will explore the postbankruptcy performance of firms inChapter 3 of this volume in much greater depth Table 1.3 lists the esti-

12 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

TABLE 1.3 Chapter 22s and 33s in the United

mated number of Chapter 22s and 33s each year since 1984 As one canobserve, the totals are nontrivial and indicate some problems in our dis-tressed restructuring process We argue later in Chapter 13 for some fur-ther tests to increase the probability of a firm’s successful emergence fromChapter 11.

REASONS FOR CORPORATE FAILURES

Without question, the most pervasive reason for a firm’s distress and ble failure is some type of managerial incompetence In its earlier annual

possi-publication of The Failure Record (no longer published), D&B itemized the

many reasons for failure, and those related to management invariably taled about 90 percent Of course, most firms fail for multiple reasons, butmanagement inadequacies are usually at the core of the problems The ulti-mate cause of failure is usually simply running out of cash, but there are avariety of means-related reasons that contribute to the high number ofbankruptcies and other distressed conditions in which firms find themselves.These reasons include:

to-■ Chronically sick industries (e.g., agriculture, textiles, department stores)

■ Deregulation of key industries (i.e., airlines, financial services, healthcare, energy)

■ High real interest rates in certain periods

■ International competition

■ Overcapacity within an industry

■ Increased leveraging of corporate America

■ Relatively high new business formation rates in certain periods.Several of these reasons are obvious (e.g., high interest rates, overleverag-ing, and competition)

Deregulation removes the protective cover of a regulated industry andfosters larger numbers of entering and exiting firms Competition is fargreater in a deregulated environment, such as the airline industry Hence,airline failures multiplied in the 1980s following deregulation at the end ofthe 1970s and have continued virtually unabated since New business for-mation is usually based on optimism about the future But new businessesfail with far greater frequency than do more seasoned entities, and the fail-ure rate can be expected to increase in the years immediately following asurge in new business activity The aggregate new business formation de-terminant of business failures, as well as other macroeconomic factors, was

Corporate Distress: Introduction and Statistical Background 13

modeled in an earlier edition of this book (Altman 1983) in a lag econometric framework.

distributed-THE JUDICIAL SYSTEM

The legal structure whereby businesses of all sizes and in most economicsectors settle their financial difficulties and in many cases attempt to reor-ganize is our nation’s federal bankruptcy courts The intricate and some-times complex evolution of the bankruptcy laws and the courts thatadminister them is discussed in detail in Chapter 2 The bankruptcy lawsare designed either to rehabilitate a distressed debtor or to liquidate its as-sets for distribution to claimants

At the end of 2004, there were about 360 bankruptcy judge positions tionwide authorized to guide the debtors and their various creditors throughthe bankruptcy process These are federal judges who serve in 90 judicial dis-tricts encompassing the 50 states, Puerto Rico, and the District of Columbia

na-No district includes more than one state, although several districts can befound in the same state Bankruptcy statistics, gathered by the AdministrativeOffice of the U.S Courts, Bankruptcy Division, in Washington, D.C., are as-sembled by district and then aggregated Bankruptcy judges are assisted byU.S trustees who play a major role in the scheduling of hearings and recordkeeping of the huge flow of cases in the system Trustees are appointed by theU.S attorney general’s office This trusteeship function should not be con-fused with either the old bankruptcy trustees under Chapter X of the previousbankruptcy law (1938), whereby individuals were appointed by bankruptcyjudges to both manage the bankrupt debtor and propose a plan of reorganiz-ing, or the new (2005) law’s stipulation that a Chapter 11 trustee may be ap-pointed by the court if incompetence, gross mismanagement, fraud, ordishonesty by current management is found (not just suspected)

Finally, the nation’s large core of bankruptcy lawyers make up an portant constituency in the bankruptcy process These lawyer-consultantsrepresent the many stakeholders in the process, including the debtor, credi-tors, equity holders, employees, and even tax authorities An educatedguess as to the number of practicing bankruptcy lawyers in recent years(e.g., 2002–2005) is at least 5,000, especially during periods when thenumber of large firm failures is at a peak Martinsdale.com lists 4,991bankruptcy lawyers in 2005 (see www.martinsdale.com) Some of thelarger firms with specialization in the bankruptcy area are Weil Gotshal,Stroock, Stroock and Lavan; Kirkland & Ellis; Skadden, Arps, Slate,Meagher & Flom; Davis Polk & Wardell; and Wilkie-Farr, among others

im-14 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

Corporate Distress: Introduction and Statistical Background 15

APPENDIX 1.1 Bankrupt Companies—$1 Billion in Liabilities or More,

1970–2005 (Q1)

(Continued)

16 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

APPENDIX 1.1 (Continued)

Corporate Distress: Introduction and Statistical Background 17

APPENDIX 1.1 (Continued)

(Continued)

18 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

APPENDIX 1.1 (Continued)

142 Metropolitan Mortgage & Securities Co., Inc 1,713.84 Feb-04

157 Republic Technologies International Holdings, LLC 1,578.75 Apr-01

Corporate Distress: Introduction and Statistical Background 19

APPENDIX 1.1 (Continued)

(Continued)

20 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

APPENDIX 1.1 (Continued)

Source: E Altman and the New York University Salomon Center Bankruptcy

Filings Database.

rel-in corporate governance and capital structure issues rel-in the United Statesand Europe since Numerous texts and articles are constantly being writtenextolling the virtues of value-enhancing techniques.

The purpose of this chapter is to examine valuation from the tive of the firm’s capital structure We analyze capital structure issueswithin the context of massive changes brought about by leveraged re-structurings, particularly leveraged buyouts (LBOs) In doing so, we alsoaddress the question, Does debt matter and is there an optimal capitalstructure?

perspec-Our inquiry follows a decade of extraordinary activity in mergers andacquisitions (M&A) in the United States in the 1980s and the renewed in-terest in LBOs in 2004–2005 The transaction values of these restructur-ings rose in the earlier period as exceptionally high acquisition prices wereoffered due to the competitive interaction of numerous buyout funds Inturn, the debt amounts and proportions of the merged firms’ capital struc-tures also rose to levels never before seen in corporate America Hence,both values and bankruptcy risks escalated in the mid and especially in thelate 1980s

121

This chapter is derived and updated from an article by E Altman and R Smith

published in part in Corporate Bankruptcy and Distressed Restructuring, E

Alt-man, editor, Dow Jones–Irwin, Homewood, IL (1991a) Also see Altman and Smith (1991b).

Corporate Financial Distress and Bankruptcy: Predict and Avoid Bankruptcy, Analyze and Invest in Distressed Debt, Third Edition

by Edward I Altman and Edith Hotchkiss Copyright © 2006 Edward I Altman and Edith Hotchkiss

We show that these high values can, in most cases, be sustained only

if the levels of debt and distress risk are reduced very quickly after theinitial restructuring If this is not achieved, similar transactions will not

be successful in attracting capital from the markets In the case of aged restructurings that prove to be unsuccessful, debt levels will still bereduced through distressed exchange arrangements, or failing that,through Chapter 11 bankruptcy reorganizations If all of these fail, thefirm’s assets will need to be liquidated In these latter distressed situa-tions, corporate values will decline sharply to levels significantly lowerthan if the firm had been able to reduce its debt as planned within a shorttime after the restructuring

lever-We first examine classical financial theories dealing with corporatevaluation in terms of debt policy These theories can help to explain notonly why leveraged restructurings can change the valuation of firms,sometimes substantially, but also why these restructurings have met withthe full spectrum of results, from great success to dismal failure Inessence, we share what we have learned, if anything, from the ill-fated andpoorly structured leveraged restructurings in the past! In so doing, wehope to provide some insights into successful capital structure changes forfuture transactions

CORPORATE RESTRUCTURINGS: DEFINITIONS

AND OBJECTIVES

A corporate restructuring is any substantial change in a firm’s asset folio or capital structure Its objectives are usually to increase value to theowners, both old and new, by improving operating efficiency, exploitingdebt capacity and tax benefits, and/or redeploying assets In some cases,the objective is less strategic, in an operating sense, and not necessarilyvalue maximizing, being directed simply to effect a change in corporatecontrol or to defend against a loss of control—that is, to preserve inde-pendence Independence of operation has long been important to boards

port-of directors or principal shareholders port-of some corporations who havebeen accustomed to rule their firm’s actions without full regard for therights of public shareholders Sometimes these actions are taken due to thefear of being taken over against management’s will In addition, seniormanagement has often professed a goal to be independent of the influencethat large lenders may exert on the operations of the firm When highlyleveraged restructurings are done in the name of corporate governance

122 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

MERGERS AND ACQUISITIONS

The United States has gone through at least four distinct cycles of M&Aactivity The latest one, in the 1980s, involved large corporate financial re-structurings, often resulting in acquisition of control by another firm.Though this cycle has been completed in the United States, the forces be-hind it have also been seen in Europe, which saw its first major M&Amovement in the 1980s This movement is primarily a result of an overdueneed for industrial restructurings and other influences European M&A ac-tivity began after the 1985 European Community (EC) initiative to inte-grate all member country trade and capital market activities Reducedbarriers to cross-national firm mergers were the result of newly found con-fidence that deregulated, private sector markets could result in improvedcorporate performance compared to previous national income and protec-tionist policies For more details on economic restructuring in Europe, seeSmith and Walter (1990) and Altman and Smith (1991b) And, in the mostrecent years, 2004–2005, we have observed a distinct increase in privateequity firm restructuring activity in Europe, specifically Germany

LEVERAGED RESTRUCTURINGS

Corporations have also tried to increase value to shareholders by massivechanges in leverage These restructurings are mainly in the form of lever-aged recapitalizations (recaps) or leveraged buyouts The former involvessome type of debt-for-equity swap, and the latter involves managementacting either alone or as a partner with a third-party investment firm, pur-chasing all of the outstanding common stock so that the firm effectivelybecomes a private entity The vehicle to buy back the equity is leverage—hence the name leveraged buyout (or leveraged buy-in when the firm re-mains public) We explore this mechanism in much greater depth andnumerically after discussing the evolution of financial theory in valuationanalysis and its relationship with a firm’s capital structure

Before we try to reconcile financial theories with corporate financialpractice, it will be beneficial to define and discuss what has come to beknown as the leveraged restructuring movement of the 1980s, particularlythe late 1980s The objectives of corporate restructurings are usually to doone or more of the following in order to increase the value of the firm—however one chooses to define value:

■ Redeploy assets to change the mix of the business

■ Exploit leverage and other financial opportunities

■ Improve operational efficiency

These objectives can be achieved by one or more of the following restructurings:

■ Acquiring other companies or businesses

■ Leveraged buyouts

■ Recapitalizations, that is, stock repurchases or swaps of debt for equity

■ Major organizational, leadership, or corporate policy changes

Leveraged Management Buyouts

A number of new techniques for increasing the value of firms were oped in the United States in the 1980s, usually involving several of thesteps outlined earlier The most visible, in many aspects, was the leveragedmanagement buyout (LMBO) or leveraged buyout (LBO), in which control

devel-of a company was acquired in the market through a takeover bid, usually

at a substantial premium over the market price of the shares (estimated atabout 46 percent by Kaplan (1989) for LBOs in the early and mid-1980sand growing to even a greater premium, perhaps double, for the LBOs ofthe late 1980s) Often, the transaction was bitterly opposed by existing di-rectors and managers if they were not part of the takeover team As thepremium grew, the new equity team had to rely more and more on bor-rowed capital from banks and the public This resulted in a number ofleverage excesses

Management buyouts (MBOs) had been around for many years both

in the United States and in Europe The early transactions in the 1970s sentially involved the senior management of a company buying out all theoutstanding shares and taking the firm private (if the firm was publiclyheld) A significant amount of the financing for the buyout was providedprimarily by commercial bank loans, with the balance coming from themanagers’ equity investments The transaction was a leveraged one but thesize of the firm and the consequent amount of financing were relativelysmall The resulting capital structure, while heavily leveraged, was quitesimple with essentially one class of debt

es-The type of firm most suitable for a management buyout was, and still

is, one with relatively stable and predictable cash flows sufficient to easilyrepay the fixed costs from the additional interest and principal on the debt.The major motivation behind the buyout is that management will now di-rectly benefit from their own efforts and reap the firm’s profits in the form

of equity returns, instead of a fixed or semifixed salary earned as managers

124 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

The LMBO or LBO differs from the MBO by the larger size andgreater complexity of the transaction and the inclusion of a significant sec-ond ownership interest Indeed, this second party, usually in the form of

an investment private-equity company or partnership, provides and quires the bulk of the equity capital, with at most 10 to 15 percent going

ac-to management The greater complexity involves several layers of debtholders (some with deferred as well as current-pay interest payments inaddition to equity participation features) and also several types of equitycapital (preferred and common stock, sometimes including equity war-rants and options)

A typical capital structure of a large LMBO in the United States inthe 1987–1988 period is shown in Figure 6.1 Note that the senior debtfrom banks and insurance companies provided about 60 percent of thetransaction value and amounted to about two-thirds of the total debt fi-nancing These creditors were not willing to provide 100 percent of thedebt financing, since the amounts were so large and the perceived risk

so great Indeed, many of these buyouts were greater than $1 billion,with the largest, by far, being the $25 billion RJR Nabisco buyout in

1989 Recently in 2005, we have seen the revival of the large LBO dealswith the $11.5 billion SunGard deal and the C= 16 billion WIND telecomdeal in Italy A recent innovation has also been the equity ownership ofthese very large deals now being shared by several large private-equitybuyout firms, that is, “club” transactions (e.g., SunGard)

Below the senior debt was the subordinated current-paying debt—that is, where interest payments commence immediately This layer pro-vided about 20 to 21 percent of the total financing The primaryinnovation here was that this debt was, in many instances, sold directly

to the public markets as part of the growing “junk bond” issuance ing a concert-hall analogy, this debt is also known as “mezzanine” fi-nancing since its priority is below the “balcony” (senior debt) and above

FIGURE 6.1 Selected Capital Structures of LMBOs in 1987–1988

Source: Credit Suisse First Boston (CSFB) and author compilation.

the “orchestra” (equity financing) After 1986, the subordinated debt inthe United States came mainly from publicly placed junk bonds About

27 to 28 percent of the transaction price was provided by this source cluding non-interest-paying subordinated debt) See our discussion ofhigh-yield junk bonds in Chapter 7

(in-DIBs, PIKs, and Resets

Several new variants of subordinated debt were introduced in the late1980s in order to reduce the initial cash interest payment burden of thetransaction These involved deferred-payment interest bonds (DIBs) andpayment-in-kind (PIK) bonds The latter paid whatever the coupon stated,not in interest but in additional bonds, so the liability and future interestpayment grew over time The former usually involved a period (e.g., threeyears) of no-coupon payments and then the start of interest coupon pay-ments (e.g., in years four to maturity)

Another innovation pioneered by U.S investment banks was resetnotes, which guaranteed that the interest rate would be reset periodically

so as to cause the bonds to sell at par value This innovation, like so many

of the others, ultimately operated adversely to the interests of the issuers asthe junk bond market became more concerned with credit quality in1989–1991 Such instruments can increase the likelihood of credit prob-lems in the future These deferred-payment debt instruments can be re-ferred to as ticking time bombs if the debt itself is not redeemed before thecash-pay period begins or reset is necessary

Role of Subordinated Debt and Equity

The subordinated debt in these restructurings played a pivotal role Usuallyincluded as debt by those interested in total firm valuation, subordinatecash-pay and non-cash-pay debt nonetheless provided an important equity-like cushion from the standpoint of potential senior creditors But, unlikethe preferred stock financed mergers of the 1960s, subordinated debt pro-vided important tax benefits

Finally, below the multilayered debt structure came the preferred andequity financing, usually over 85 percent owned by the investment com-pany with the residual owned by management Despite the small percent-age (12 to 15 percent) ownership for management, the sheer magnitude ofthe leveraged transactions could lead to extremely high returns to all of the

126 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS

Successful and Unsuccessful LBOs

A successful LBO from the standpoint of all parties concerned, includingthe old and new debt and equity holders, is one that:

■ Results in relatively quick and successful repayment to the debtholders

■ Cashes out within three to seven years so that the equity holders coup their investment and earn substantial profits

re-■ Does not cause any significant economic disruption of the acquiredcompany, for example unemployment, resulting in some political reaction

Operating efficiencies and asset sales (if necessary) should provide cient cash to the firm to repay a large portion of the senior debt within twoyears After this period, even the increasing debt burden from the deferredinterest junk bonds can be met without difficulty if the firm continues itssubstantial cash-flow generations If, however, cash flows and asset sales aredisappointing, then distress can set in and the LBO will, in many cases, fail.Failed leveraged restructurings occurred in 1989–1991 to several ofthe large LMBOs and other highly leveraged transactions that resulted incritical bankruptcies and other distressed situations These include theCampeau (Allied and Federated Stores) fiasco, Hillsborough Holdings,Southland, National Gypsum, and several others In the United Kingdom,the Isosceles PLC buyout of Gateway Corporation was a distressed situa-tion mainly due to disappointing asset sales and smaller than forecasted re-ductions in debt

suffi-To cash out means that the firm is sold or recapitalized, either in part

or as a whole, or the LBO goes public again by selling shares in the openmarket In the case of partial firm sales, proceeds are often paid out to thenew owners and debt refinanced, usually over a longer maturity period.Table 6.1 lists statistics on the average large firm LBOs that took place inthe mid to late 1980s The former period was prior to the leverage excesses

of 1987–1989 that resulted in many failures Note that the average mium paid to the original selling shareholders was 46 percent in the earlierperiod, resulting in average incremental debt of $400 million on a $524million transaction The initial debt-equity ratio was about 6:1 SuccessfulLBOs netted the new owner returns of about 250 percent over three to fiveyears, based on an average $100 million equity investment

pre-With respect to the leverage excesses and inflated prices paid in1987–1988, results in Table 6.1 show how the average premium rose to 74