Chapter 17 Alternative Exit and Restructuring Strategies:
Bankruptcy Reorganization and Liquidation
Examination Questions and Answers
True/False: Answer True or False to the following questions: (50 T/Fs)
1. For capital markets to function smoothly, disputes involving the legal rights of all participants
(both debtors and creditors) need to be resolved quickly and equitably by the courts. True or False
2. Reforms in creditor rights tend to increase the availability and reduce the cost of credit in countries
where court enforcement is quick and fair. True or False
3. Financially distressed firms also affect communities in which they are located in terms of increasing
unemployment and eroding the tax base. True or False
4. The term financial distress could apply to a firm unable to meet its obligations or to a specific
security on which the issuer has defaulted. True or False
5. Credit ratings provided by Moody’s and Standard & Poor’s are highly reliable indicators of a
firm’s degree of financial distress. True or False
6. A firm is said to be technically solvent when it is unable to pay its liabilities as they come due.
True or False
7. Legal insolvency occurs when a firm’s liabilities exceed the book value of its assets. True or False
8. Bankruptcy is a state-level legal proceeding designed to protect the technically or legally insolvent
firm from lawsuits by its creditors until a decision can be made to shut down or to continue to
operate the firm. True or False
9. A firm is said to be bankrupt once it defaults on a bond payment. True or False
10. A firm is not bankrupt or in bankruptcy until it files or its creditors file a petition for
reorganization or liquidation with the federal bankruptcy courts. True or False
11. The debtor firm often initiates the voluntary settlement process, because it generally offers the best
chance for the current owners to recover a portion of their investments either by continuing to
operate the firm or through a planned liquidation of the firm. True or False
12. Increasingly, distressed companies are choosing to restructure inside of bankruptcy court, rather
than reaching a general agreement with creditors before seeking Chapter 11 protection. True or
False
13. Large companies often have a difficult time achieving out–of-court settlements because they
usually have hundreds of creditors. True or False
14. A workout is an arrangement conducted inside of bankruptcy court by a debtor and its creditors for
payment or re-scheduling of payment of the debtor’s obligations. True or False
15. A debt extension occurs when creditors agree to lengthen the period during which the debtor firm
can repay its debt. True or False
16. A composition is an agreement in which creditors agree to settle for less than the full amount they
are owed. True or False
17. A debt-for-equity swap occurs when the distressed firm’s shareholders are willing to surrender a
portion of their ownership for debt in the firm. True or False
18. A debt-for-equity swap occurs when creditors surrender a portion of their claims on the firm in
exchange for an ownership position in the firm. True or False
19. If a creditor is owed a large amount of money, it could become a major or even the controlling
shareholder in the reorganized firm. True or False
20. If the creditors conclude that the insolvent firm’s situation cannot be resolved, liquidation may be
the only acceptable course of action.
21. By law, corporate liquidation can only be conducted outside of the U.S. bankruptcy court.
True or False
22. If the insolvent firm is willing to accept liquidation,, legal proceedings are not necessary,
regardless of what the creditors think. True or False
23. Through a process called an assignment, a committee representing creditors grants the power to
liquidate the firm’s assets to a third party called an assignee or trustee. True or False
24. In the absence of a voluntary settlement out of court, the debtor firm may seek protection from its
creditors by initiating bankruptcy. However, creditors cannot force the debtor firm into
bankruptcy. True or False
.
25. In the absence of a voluntary settlement out of court, the debtor firm may seek protection from its
creditors by initiating bankruptcy or may be forced into bankruptcy by its creditors. True or False
26. The filing of a petition triggers an automatic stay once the court accepts the request, which
provides a period suspending all judgments, collection activities, foreclosures, and repossessions
of property by the creditors on any debt or claim that arose before the filing of the bankruptcy
petition. True or False
27. Automatic stays are granted by the court only when the debtor files for bankruptcy. True or False
28. U.S. bankruptcy laws and practices focus on maintaining shareholder value during the bankruptcy
process. True or False
29. Chapter 11 of the U.S. bankruptcy code deals with liquidation while Chapter 7 addresses
reorganization. True or False
30. Prior to the Bankruptcy Abuse Protection and Consumer Protection Act of 2005 (BAPCPA),
commercial enterprises used Chapter 11 Reorganization to continue operating a business and to
repay creditors through a court-approved plan of reorganization. True or False
31. Prior to the Bankruptcy Abuse Protection and Consumer Protection Act of 2005, the debtor had
the exclusive right to file a plan of reorganization for the first 120 days after it filed the case.
32. The court must approve any plan accepted by the debtor’s shareholders and creditors. True of
False
33. The court can ignore the objections of creditors and stockholders if it feels the reorganization is
both fair and feasible. True or False
34. The purpose of Chapter 15 of the U.S. Bankruptcy Code is to prioritize the payment of creditors.
True or False
35. As part of a Chapter 15 proceeding, the U.S. bankruptcy court may authorize a trustee to act in a
foreign country on behalf of the U.S. Bankruptcy Court. True or False
36. Companies may not seek the protection of bankruptcy court to avoid liquidation. True of False
37. Chapter 11 reorganization often enables creditors to recover relatively more of their claims than
under liquidation. True or False
38. In liquidation, bankruptcy professionals, including attorneys, accountants, and trustees, often end
up with the majority of the proceeds generated by selling the assets of the failing firm. True or
False
39. Empirical studies show that company size (measured by assets), case duration (measured in days),
and the number of parties involved in the proceedings (measured in terms of the numbers of
professional firms working) explain most of the case–to-case variation in professional fees. True or
False
40. Under a prepackaged bankruptcy, the debtor negotiates with creditors well in advance of filing for
a Chapter 7 bankruptcy. True or False
41. Prepackaged bankruptcies are less common today than in years past. True or False
42. If a firm enters into a workout in which a voluntary negotiated agreement with debtors is achieved,
the firm may lose its right to claim NOLs in its tax filing. True or False
43. Federal law prohibits trading in a bankrupt firm’s securities. True or False
44. While bankrupt firms generally are unable to meet the listing requirements of the major stock
exchanges, their shares may trade in the over-the-counter market. True or False
45. If the selling price of the failing firm is less than the going concern and liquidation value, the firm
should sell the firm to another party.
46. If the going concern value is less than the selling or liquidation price, the firm should seek the
protection of the bankruptcy court.
47. Sales within the protection of Chapter 11 reorganization may be accomplished either by a
negotiated private sale to a particular purchaser or through a public auction. True or False
48. Smaller creditors have little incentive to attempt to hold up the agreement unless they receive
special treatment.
49. Economic distress arises when a firm’s growth and investment prospects deteriorate, causing a
reduction in the value of the business due to the deteriorating outlook for the firm’s cash flow.
50. Chapter 11 reorganization may involve a corporation, sole proprietorship, or partnership. True or
False
Multiple Choice: Circle only one. (15)
1. Debt restructuring of a bankrupt firm is usually accomplished in which of the following ways:
a. An extension
b. A composition
c. A debt for equity swap
d. Some combination of a, b, or c
e. All of the above
2. Why would creditors be willing to give a portion of what they are owed by the debtor firm for
equity in the reorganized firm?
a. They are legally obligated to do so under U.S. bankruptcy law.
b. Ownership in a firm is inherently more valuable than being a creditor.
c. The value of the stock may in the long run far exceed the amount of debt the creditors
were willing to forgive.
d. Creditors understand that they can sue the firm at a later date for what they are owed.
e. None of the above.
3. All of the following are true of the bankruptcy process except for
a. The debtor firm may seek protection from its creditors by initiating bankruptcy or may be
forced into bankruptcy by its creditors.
b. When creditors file for bankruptcy on behalf of the debtor firm, the action is said to be
involuntary bankruptcy.
c. Once either a voluntary or involuntary petition is filed, the debtor firm is protected from
any further legal action related to its debts until the bankruptcy proceedings are
completed.
d. The filing of a petition triggers an automatic stay even before the court accepts the
request.
e. An automatic stay suspends all judgments, collection activities, foreclosures, and
repossessions of property by the creditors on any debt or claim that arose before the filing
of the bankruptcy petition
4. All of the following are true except for
a. Chapter 15 deals with international or cross-border bankruptcies.
b. Chapter 11 deals with reorganizing the firm.
c. Chapter 7 defines the process and priorities of the liquidation process for commercial
businesses.
d. Chapter 11 also addresses issues pertaining to personal bankruptcy.
e. A and B
5. Which of the following are commonly used strategic alternatives for failing firms?
a. Merge with another firm
b. Reach out of court voluntary settlement with creditors
c. File for protection from creditors from the U.S. bankruptcy court
d. A, B, and C
e. A and B only
6. To determine which strategy to pursue, the failing firm’s management needs to
estimate which of the following:
a. Going concern value
b. Liquidation value
c. Selling price of the firm
d. A and B only
e. A, B, and C
7. Financially distressed firms often are characterized by all of the following except for:
a. Underinvestment in operations
b. Employee layoffs
c. High levels of research and development spending
d. Declining product quality
e. Slower payments to suppliers
8. The leading causes of business failure include which of the following:
a. Recession
b. Excessive operating expenses
c. Excessive leverage
d. Management inexperience
e. All of the above
9. Moody’s credit rating agency defines instances of default as which of the following:
a. Missed or delayed payment of interest or principal
b. Bankruptcy
c. Receivership
d. Any exchange (equity for debt) diminishing the value of what is owed to bondholders
e. All of the above
10. Which of the following statements is not true?
a. Technical insolvency arises when a firm is unable to meet its obligations when they come
due.
b. Legal insolvency occurs when a firm’s liabilities exceed the fair market value of its
assets.
c. A firm must be legally insolvent to enter bankruptcy.
d. Bankruptcy is a legal proceeding which protects a debtor firm from its creditors.
e. A firm is not considered bankrupt until its petition for bankruptcy is accepted by the
court.
11. All of the following are conditions most favorable for reaching settlement outside of bankruptcy
court except for
a. The debtor firm is willing to share all necessary information with its creditors
b. Creditors have confidence in the debtor firm’s management.
c. The debtor firm has relatively few creditors.
d. The debtor firm has many creditors.
e. The period of economic distress afflicting the firm is expected to be short-lived.
12. All of the following represent different forms of debt restructuring except for
a. Debt extensions
b. Debt compositions
c. Share exchange ratios
d. Debt for equity swaps
e. A and D
13. All of the following are true about voluntary liquidations except for
a. They can be conducted outside of court in a private auction.
b. They can be done within the protection of the bankruptcy court.
c. Creditors normally prefer liquidations to be conducted by the bankruptcy court..
d. A trustee is assigned to sell the debtor firm’s assets as quickly as possible while obtaining
the best possible price.
e. If the insolvent firm is willing to accept liquidation and all creditors agree, legal
proceedings are not necessary.
14. The Bankruptcy Abuse Prevention and Creditor Protection Act of 2005 is intended to achieve all
of the following except:
a. To reduce the maximum length of time debtors have to submit a reorganization plan
b. To give debtors more time to accept or reject leases
c. To limit key employee compensation
d. To enable the debtor to extend the lease indefinitely as long as lease payments are made
on a timely basis
e. B and D only
15. All of the following are true of the bankruptcy process except for
a. Creditors and the debtor-in-possession have considerable flexibility in working together.
b. The purpose of creditor committees is to work with the debtor firm to develop an
acceptable reorganization plan
c. The bankruptcy judge may choose to ignore the objections of creditors and shareholders
and accept a reorganization plan.
d. The government is responsible for paying the expenses of all those who contributed to the
formulation of a reorganization plan.
e. The debtor firm may emerge from Chapter 11 as an ongoing concern or be merged with
another firm.
Delta Airlines Rises from the Ashes
Key Points:
• Once in Chapter 11, a firm may be able to negotiate significant contract concessions with unions
as well as its creditors.
• A restructured firm emerging from Chapter 11 often is a much smaller but more efficient
operation than prior to its entry into bankruptcy.
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On April 30, 2007, Delta Airlines emerged from bankruptcy leaner but still an independent carrier after a
19-month reorganization during which it successfully fought off a $10 billion hostile takeover attempt by
US Airways. The challenge facing Delta’s management was to convince creditors that it would become
more valuable as an independent carrier than it would be as part of US Airways.
Ravaged by escalating jet fuel prices and intensified competition from low-fare, low-cost carriers, Delta
had lost $6.1 billion since the September 11, 2001, terrorist attack on the World Trade Center. The final
crisis occurred in early August 2005 when the bank that was processing the airline’s Visa and MasterCard
ticket purchases started holding back money until passengers had completed their trips as protection in case
of a bankruptcy filing. The bank was concerned that it would have to refund the passengers’ ticket prices if
the airline curtailed flights and the bank had to be reimbursed by the airline. This move by the bank cost the
airline $650 million, further straining the carrier’s already limited cash reserves. Delta’s creditors were
becoming increasingly concerned about the airline’s ability to meet its financial obligations. Running out of
cash and unable to borrow to satisfy current working capital requirements, the airline felt compelled to seek
the protection of the bankruptcy court in late August 2005.
Delta’s decision to declare bankruptcy occurred about the same time as a similar decision by Northwest
Airlines. United Airlines and US Airways were already in bankruptcy. United had been in bankruptcy
almost three years at the time Delta entered Chapter 11, and US Airways had been in bankruptcy court
twice since the 9/11 terrorist attacks shook the airline industry. At the time Delta declared bankruptcy,
about one-half of the domestic carrier capacity was operating under bankruptcy court oversight.
Delta underwent substantial restructuring of its operations. An important component of the restructuring
effort involved turning over its underfunded pilot’s pension plans to the Pension Benefit Guaranty
Corporation (PBGC), a federal pension insurance agency, while winning concessions on wages and work
rules from its pilots. The agreement with the pilot’s union would save the airline $280 million annually, and
the pilots would be paid 14 percent less than they were before the airline declared bankruptcy. To achieve
an agreement with its pilots to transfer control of their pension plan to the PBGC, Delta agreed to give the
union a $650 million interest-bearing note upon terminating and transferring the pension plans to the
PBGC. The union would then use the airline’s payments on the note to provide supplemental payments to
members who would lose retirement benefits due to the PBGC limits on the amount of Delta’s pension
obligations it would be willing to pay. The pact covers more than 6,000 pilots.
The overhaul of Delta, the nation’s third largest airline, left it a much smaller carrier than the one that
sought protection of the bankruptcy court. Delta shed about one jet in six used by its mainline operations at
the time of the bankruptcy filing, and it cut more than 20 percent of the 60,000 employees it had just prior
to entering Chapter 11. Delta’s domestic carrying capacity fell by about 10 percent since it petitioned for
Chapter 11 reorganization, allowing it to fill about 84 percent of its seats on U.S. routes. This compared to
only 72 percent when it filed for bankruptcy. The much higher utilization of its planes boosted revenue per
mile flown by 15 percent since it entered bankruptcy, enabling the airline to better cover its fixed expenses.
Delta also sold one of its “feeder” airlines, Atlantic Southeast Airlines, for $425 million.
Delta would have $2.5 billion in exit financing to fund operations and a cost structure of about $3 billion
a year less than when it went into bankruptcy. The purpose of the exit financing facility is to repay the
company’s $2.1 billion debtor–in-possession credit facilities provided by GE Capital and American Express,
make other payments required on exiting bankruptcy, and increase its liquidity position. With ten financial
institutions providing the loans, the exit facility consisted of a $1.6 billion first–lien revolving credit line,
secured by virtually all of the airline’s unencumbered assets, and a $900 million second-lien term loan.
As required by the Plan of Reorganization approved by the Bankruptcy Court, Delta cancelled its
preplan common stock on April 30, 2007. Holders of preplan common stock did not receive a distribution
of any kind under the Plan of Reorganization. The company issued new shares of Delta common stock as
payment of bankruptcy claims and as part of a postbankruptcy compensation program for Delta employees.
Issued in May 2007, the new shares were listed on the New York Stock Exchange.
Discussion Questions:
1. To what extent do you believe the factors contributing to the airline’s bankruptcy were beyond the
control of management? To what extent do you believe past airline mismanagement may have
contributed to the bankruptcy?
2. Comment on the fairness of the bankruptcy process to shareholders, lenders, employees,
communities, government, etc. Be specific.
3. Why would lenders be willing to lend to a firm emerging from Chapter 11? How did the lenders
attempt to manage their risks? Be specific.
4. In view of the substantial loss of jobs, as well as wage and benefit reductions, do you believe that
firms should be allowed to reorganize in bankruptcy? Explain your answer.
5. How does Chapter 11 potentially affect adversely competitors of those firms emerging from
bankruptcy? Explain your answer.
The General Motors’ Bankruptcy—The Largest Government-Sponsored Bailout in U.S. History
Rarely has a firm fallen as far and as fast as General Motors. Founded in 1908, GM dominated the car
industry through the early 1950s with its share of the U.S. car market reaching 54 percent in 1954, which
proved to be the firm’s high water mark. Efforts in the 1980s to cut costs by building brands on common
platforms blurred their distinctiveness. Following increasing healthcare and pension benefits paid to
employees, concessions made to unions in the early 1990s to pay workers even when their plants were shut
down reduced the ability of the firm to adjust to changes in the cyclical car market. GM was increasingly
burdened by so-called legacy costs (i.e., healthcare and pension obligations to a growing retiree
population). Over time, GM’s labor costs soared compared to the firm’s major competitors. To cover these
costs, GM continued to make higher margin medium to full–size cars and trucks, which in the wake of
higher gas prices could only be sold with the help of highly attractive incentive programs. Forced to
support an escalating array of brands, the firm was unable to provide sufficient marketing funds for any one
of its brands.
With the onset of one of the worst global recessions in the post–World War II years, auto sales
worldwide collapsed by the end of 2008. All automakers’ sales and cash flows plummeted. Unlike Ford,
GM and Chrysler were unable to satisfy their financial obligations. The U.S. government, in an
unprecedented move, agreed to lend GM and Chrysler $13 billion and $4 billion, respectively. The intent
was to buy time to develop an appropriate restructuring plan.
Having essentially ruled out liquidation of GM and Chrysler, continued government financing was
contingent on gaining major concessions from all major stakeholders such as lenders, suppliers, and labor
unions. With car sales continuing to show harrowing double-digit year over year declines during the first
half of 2009, the threat of bankruptcy was used to motivate the disparate parties to come to an agreement.
With available cash running perilously low, Chrysler entered bankruptcy in early May and GM on June 1,
with the government providing debtor in possession financing during their time in bankruptcy. In its
bankruptcy filing for its U.S. and Canadian operations only, GM listed $82.3 billion in assets and $172.8
billion in liabilities. In less than 45 days each, both GM and Chrysler emerged from government-sponsored
sales in bankruptcy court, a feat that many thought impossible.
Judge Robert E. Gerber of the U.S. Bankruptcy Court of New York approved the sale in view of the
absence of alternatives considered more favorable to the government’s option. GM emerged from the
protection of the court on July 10, 2009, in an economic environment characterized by escalating
unemployment and eroding consumer income and confidence. Even with less debt and liabilities, fewer
employees, the elimination of most “legacy costs,” and a reduced number of dealerships and brands, GM
found itself operating in an environment in 2009 in which U.S. vehicle sales totaled an anemic 10.4 million
units. This compared to more than 16 million in 2008. GM’s 2009 market share slipped to a post–World
War II low of about 19 percent.
While the bankruptcy option had been under consideration for several months, its attraction grew as it
became increasingly apparent that time was running out for the cash-strapped firm. Having determined
from the outset that liquidation of GM either inside or outside of the protection of bankruptcy would not be
considered, the government initially considered a prepackaged bankruptcy in which agreement is obtained
among major stakeholders prior to filing for bankruptcy. The presumption is that since agreement with
many parties had already been obtained, developing a plan of reorganization to emerge from Chapter 11
would move more quickly. However, this option was not pursued because of the concern that the public
would simply view the post–Chapter 11 GM as simply a smaller version of its former self. The government
in particular was seeking to position GM as an entirely new firm capable of profitably designing and
building cars that the public wanted.
Time was of the essence. The concern was that consumers would not buy GM vehicles while the firm
was in bankruptcy. Consequently, a strategy was devised in which GM would be divided into two firms:
“old GM,” which would contain the firm’s unwanted assets, and “new GM,” which would own the most
attractive assets. “New GM” would then emerge from bankruptcy in a sale to a new company owned by
various stakeholder groups, including the U.S. and Canadian governments, a union trust fund, and
bondholders. Only GM’s U.S. and Canadian operations were included in the bankruptcy filing. Figure 16.2
illustrates the GM bankruptcy process.
Buying distressed assets can be accomplished through a Chapter 11 plan of reorganization or a post–
confirmation trustee. Alternatively, a 363 sale transfers the acquired assets free and clear of any liens,
claims, and encumbrances. The sale of GM’s attractive assets to the “new GM” was ultimately completed