Chapter 17 Alternative Exit and Restructuring Strategies:
Bankruptcy Reorganization and Liquidation
Chapter Discussion Questions
17.1 Why would creditors make concessions to a debtor firm? Give examples of common types of
concessions made?
17.2 Although most companies that file for bankruptcy do so because of their deteriorating financial
position, companies increasingly are seeking bankruptcy protection to avoid litigation and hostile
takeovers. Give examples of how bankruptcy can be used to avoid litigation.
17.3 What are the primary options available to a failing firm? What criteria might the firm use to select
a particular option? Be specific.
17.4 Describe the probable trend in financial returns to shareholders of firms that emerge from
bankruptcy. To what do you attribute these trends? Explain your answer.
17.5 Identify at least two financial or non-financial variables that have been shown to affect firm
defaults and bankruptcies? Explain how each might affect the likelihood the firm will default or
seek Chapter 11 protection?
17.6 On June 25, 2008, JHT Holdings, Inc., a Kenosha Wisconsin–based package delivery service, filed
for bankruptcy. The firm had annual revenues of $500 million. What would the firm have to
demonstrate for its petition to file for bankruptcy to be accepted by the bankruptcy court?
17.7 Dura Automotive emerged from Chapter 11 protection in mid-2008. The firm obtained exit
financing consisting of $110 million revolving credit facility, a $50 million European first-lien
term loan, and an $84 million U.S. second-lien loan. The reorganization plan specifies how some
portion of the proceeds of these loans would be used. What do you believe might be typical
stipulations in reorganization plans for using such funds? Be specific.
17.8 What are the primary factors contributing to business failure? Be specific.
17.9 In recent years, hedge funds have engaged in so–called “loan–to–own” pre-bankruptcy investments
in which they acquire debt from distressed firms at a fraction of face value. Subsequently, they
move the company into Chapter 11 intent upon converting the acquired debt to equity in a firm
with sharply reduced liabilities. The hedge fund also provides DIP financing to further secure its
interest in the business. The emergence from Chapter 11 is typically accomplished under section
363 (k) of the bankruptcy code which gives debtors the right to bid on the firm in a public auction
sale. During the auction, the firm’s debt is valued at face rather than market value, effectively
discouraging any other bidders other than the hedge fund which acquired the debt prior to
bankruptcy at distressed levels. Without competitive bidding, there is little chance of generating
additional cash for the general creditors. How might this be viewed as an abuse of the Chapter 11
bankruptcy process?
17.10 American Home Mortgage Investments, a major U.S. mortgage lender, filed for Chapter 11
bankruptcy in late 2008. The company indicated that it chose this course of action because it
represented the best means of preserving the firm’s assets. W.L. Ross and Company agreed to
provide the firm $50 million in debtor in possession financing to meet its anticipated cash needs
while in Chapter 11. Comment on the statement that bankruptcy provides the best means of asset
preservation. Why would W.L. Ross and Company lend money to a firm that had just filed for
bankruptcy?
Solutions to Chapter Case Stud Questions
Hostess Brands Liquidates in Bankruptcy
Discussion Questions and Solutions:
1. How might the way in which Hostess Brands Inc. grew have contributed to its eventual financial
distress?
2. What are the primary objectives of the bankruptcy process? Speculate as to why this process may
have failed in reorganizing Hostess Brands?
3. What types of businesses are most appropriate for Chapter 11 reorganization, Chapter 7
liquidation, or a Section 363 sale? What factor(s) drove Hostess into a Section 363 sale?
4. The Hostess Brands Inc. case study illustrates options available to the creditors and owners of a
failing firm. Describe the available options. How do you believe creditors and owners might
choose from among the range of available options?
5. Financial buyers (both hedge funds and private equity investors) clearly are motivated by the
potential profit they can make by buying distressed debt. Their actions may have both a positive
and negative impact on parties to the bankruptcy process. Identify how parties to Hostess
bankruptcy may have been helped or hurt by the actions of the hedge funds and private equity
investors.
6. Hostess’s assets were sold in a 363 auction. Such auctions attract both strategic and financial
bidders. Which party tends to have the greater advantage: the strategic or financial bidder? Explain
your answer.
7. Comment on the fairness of the 363 auction process to Hostess shareholders, lenders, employees,
communities, government, etc. Be specific.
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.
Blockbuster Acquired by Dish Network in a Section 363 Sale
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Key Points
Section 363 auctions are an increasingly common means of preserving asset value when failing firms are
hemorrhaging cash flow.
Such sales allow buyers to purchase assets at potentially bargain prices.
While not without risk, 363 sales are often viewed as a more efficient way to exit bankruptcy than via a
more conventional reorganization plan.
______________________________________________________________________________
Despite facing challenges reminiscent of a Hollywood movie thriller, Blockbuster, the movie rental giant,
went from a mundane prepackaged bankruptcy agreement to acknowledging its own insolvency to facing
the real possibility of liquidation in the span of six months. What follows is a discussion of the sometimes–
unpredictable twists and turns of a highly contentious Section 363 bankruptcy filing.
Blockbuster had been in a downward spiral years before approaching its creditors for a negotiated
reduction in its debt burden in mid-2010. The ability to download movies via the Internet had come to
dominate the video rental business, thanks largely to DVD rental provider Netflix Inc. and video–on–
demand services from cable providers. Blockbuster was forced to file for bankruptcy for its North
American operations on September 23, 2010, with 5,600 stores, including 3,300 in the United States. The
fate of 29,000 employees and hundreds of creditors hung in the balance.
Prior to the firm’s petition for protection under Chapter 11 of the U.S. Bankruptcy Code, Blockbuster
had reached an agreement with its major creditors on a so-called prepackaged reorganization plan that
would have left the firm with $400 million in new senior debt as it emerged from bankruptcy as an ongoing
business. This amounted to about 27% of its outstanding prepetition debt of $1.46 billion.
The circumstances changed unexpectedly when famed billionaire investor Charles Icahn bought 31% of
the firm’s existing senior notes in late September, making him a major creditor and a key participant on the
creditor committee in the subsequent negotiations. Icahn and Blockbuster had had a tumultuous history
together. He had purchased shares in Blockbuster in 2004. The next year, following a bitter proxy battle, he
won three seats on the firm’s board of directors. Eventually, Icahn was able to oust then–board Chairman
John Antioco. In 2010, due to increasing demands on his time, Icahn stepped down from the board and sold
his shares in Blockbuster.
By buying such a large percentage of the outstanding debt, Icahn, as a major creditor, was able to submit
his own plan for revamping Blockbuster. His proposal was to eliminate Blockbuster’s debt when it
emerged from bankruptcy, and it represented a radically different approach from the prepackaged plan that
Blockbuster had negotiated with other creditors. His proposal involved swapping senior secured notes for
equity in a recapitalized company, with the senior subordinated note holders, preferred, and common
shareholders completely wiped out. Unsecured shareholders were to receive warrants to buy up to 3% of
the new firm’s equity. Financing to meet the firm’s immediate cash flow needs would come from a $375
million debtor-in-possession (DIP) loan from a group of the senior note holders. Such lenders’ credit claims
are given a much higher payment priority than those of other creditors in the event of the firm’s liquidation
and, as such, are often viewed as relatively low risk.
Movie studio creditors, critical suppliers to Blockbuster, supported the plan because they were promised
payments for what they were owed on a priority basis out of the operating cash flows once the firm
emerged from bankruptcy. Senior secured note holders, owning 80.1% of the firm’s debt, also were willing
to accept the Icahn proposal. With the blessing of its major creditors, Blockbuster undertook an expensive
but unsuccessful advertising campaign in late 2010 in an attempt to restore growth, with lenders providing
an additional $30 million. Despite the ad campaign, sales continued to decline. The firm waited until late
January 2011 to tell the movie studios and other creditors about its deteriorating cash position. Already
technically insolvent, the firm was fast running out of cash.
Having missed several performance milestones in the prepackaged (but never filed) reorganization plan,
Blockbuster was in default on its DIP loan, even though it had never utilized any of the funds. By
defaulting, the firm violated a covenant that allowed senior note holders to include $125 million of their
securities as part of the DIP loan. This action gave them the same high-priority position as that afforded a
DIP lender.
Blockbuster feared that it would be liquidated if it were acquired by Icahn, and it accelerated efforts to
conduct a 363(k) auction for selling the firm’s assets in the hope it could emerge from bankruptcy as a
going concern. On February 21, 2011, Blockbuster filed a motion with the U.S. Bankruptcy Court seeking
authorization to conduct an auction for selling the company’s assets, which would be conducted under the
Court’s supervision and in accordance with Section 363 of the U.S. Bankruptcy Code. Following approval
by the Court, Blockbuster initiated the bidding process. The auction allowed for a 30-day period during
which potential bidders could perform due diligence. At the end of this period, interested parties would
have one week to submit bids, with the winning bid to be announced shortly following the close of the
auction.
On April 5, five different bidding groups submitted bids. The financial buyers included the consortium
led by Icahn (which included liquidator Great American Group); a group led by Monarch Investors; and a
group consisting of liquidators Gordon Brothers and Hilco Merchant Resources. Hedge funds and investor
groups specializing in restructuring and liquidation often buy distressed debt at a deep discount, acquire the
failing firm’s assets through a credit bid (i.e., exchanging what they are owed for the firm’s assets), and
liquidate the assets at a price in excess of what they paid for the debt. The other bidders included South
Korea’s SK Telecom Co. and satellite television provider Dish Network. Both were interested in
Blockbuster because of potential synergy with their current operations.
Icahn’s, Monarch’s, and the Gordon Brothers’ strategies appeared to be similar: Close the Blockbuster
stores, liquidate the inventories, and sell the digital download business. In contrast, SK Telecom and Dish
offered the prospect of Blockbuster’s emerging from bankruptcy as a reorganized but going concern. Dish
believed the chain’s brand could be valuable for its video–on-demand services. Dish also saw an
opportunity to sell subscriptions through Blockbuster’s stores and believed the Blockbuster buyout could
give it some leverage in negotiating future business with movie studios.
Dish submitted the winning bid of $320 million. Of that figure, $125 million was to repay the senior
notes that had been “rolled up” into the DIP loan, with 75% of the rest of the proceeds paid to note holders
and 25% to the holders of administrative claims. Senior note holders were expected to receive about 26%
of their claims and unsecured lenders about 19% of their claims, with preferred and common shareholders
receiving nothing. Dish assumed $11.5 million in debt to the movie studios. The bankruptcy judge
overruled 111 objections from landlords, business partners, and other creditors about the amounts
Blockbuster proposed to pay them under contracts on which it had defaulted.
Discussion Questions
1. What are the primary objectives of the bankruptcy process?
2. What types of businesses are most appropriate for Chapter 11 reorganization, Chapter 7 liquidation, or
3. The Blockbuster case study illustrates the options available to the creditors and owners of a failing
firm. How do you believe creditors and owners might choose among the range of available options?
4. Financial buyers such as hedge funds clearly are motivated by the potential profit they can make by
buying distressed debt. Their actions may have both a positive and a negative impact on parties to the
5. Do you believe that a strategic bidder like Dish Network has an inherent advantage over a financial
6. Speculate as to why Blockbuster filed a motion with the Court to initiate a Section 363 auction rather
than to continue to negotiate a reorganization plan with its creditors to exit Chapter 11.
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The Deal from Hell: The Tribune Company Emerges from Chapter 11
___________________________________________________________
Key Points
Tribune Company’s LBO failed because it was structured without any margin for error.
Large secured creditors failing to recover what they are owed often exchange their debt for equity in the
restructured company.
The extreme length of time in Chapter 11 reflected the absence of prenegotiation with creditors due to the
firm’s rapid entry into bankruptcy, the deal structure’s complexity, and fraud allegations.
______________________________________________________________________________________
Four years after its ill-fated leveraged buyout left the media firm with an unsustainably large debt load,
Tribune Company (Tribune) emerged from Chapter 11 bankruptcy on December 31, 2012. Founded in
1847, Tribune publishes some of the best-known newspapers in the United States, such as the Los Angeles
Times, the Baltimore Sun, and the Chicago Tribune. The firm also owns WGN in Chicago and 22 other
television stations as well as the WGN radio station. Over the years the firm has spent hundreds of millions
of dollars in an attempt to become a diversified media company.
The bankruptcy court judge approved a reorganization plan that left the firm in the hands of a new
ownership group consisting largely of former creditors and hedge funds that had acquired some of the
firm’s outstanding debt. The largest owners included Oaktree Capital Management, JPMorgan Chase, and
Angelo, Gordon & Co., a firm that specializes in investing in distressed companies. Senior lenders now
own 91% of the firm’s shares in exchange for forgiving their credit claims. This group held most of
Tribune’s senior debt and worked with the company and the committee representing unsecured creditors to
create a reorganization plan acceptable to the bankruptcy court judge. Court documents indicated that the
restructured firm was valued at about 40% of its $8.2 billion valuation when it was taken private in 2007.
The firm’s broadcast business had an estimated value of $2.85 billion, and its publishing businesses were
valued at $623 million, bringing the firm’s total value to $3.47 billion.
While the reorganization plan shielded JPMorgan and other lenders from lawsuits related to the
leveraged buyout, it did allow junior creditors to file lawsuits against other parties involved in the LBO
transaction. These could include Sam Zell (a well-known real estate investor), other Tribune officers and
directors, and Tribune stockholders who sold their shares in the buyout. Junior creditors who led the
opposition to the final reorganization plan alleged that the larger creditors that financed the LBO
transaction were well aware of the Tribune’s precarious financial position in 2007 and that they were
largely escaping any punitive action stemming from their alleged fraudulent activities. The junior creditors
believed that the large lenders expected that the firm would become insolvent once the transaction was
completed, prompting some to sell loans made to the Tribune.
To understand these allegations it is necessary to recognize the extent of the financial engineering
underlying this transaction. The deal was predicated on achieving the highest leverage possible and quickly
paying down the debt through asset sales and expected tax savings. However, the timing of the transaction
could not have been worse, closing at a time when newspapers nationwide were beset by declines in their
subscriber base and advertising revenue.
Despite these considerations, Tribune seemed ripe for a takeover, with its share price having lagged well
behind that of other media companies. This also was one of the most active periods in decades for LBO
transactions. With interest rates at near-record lows, prices paid for LBO targets soared. While the firm’s
cash flows from newspapers were declining, operating cash flow from its other media operations had been
relatively stable in recent years. With profit margins on loans squeezed, lenders were trying to offset
declining interest earnings by generating additional fee income that would result from originating loans and
later selling them to other investors.
On April 2, 2007, Tribune announced that the firm’s publicly traded shares would be acquired in a
transaction valued at $8.2 billion. The deal was implemented in a two-stage transaction in which Sam Zell
acquired a controlling 51% interest in the first stage, followed by a backend merger in the second stage in
which the remaining outstanding Tribune shares were acquired. In the first stage, Tribune initiated a cash
tender offer for 51% of total shares for $34 per share, totaling $4.2 billion. The tender was financed using
$250 million of the $315 million provided by Sam Zell in the form of subordinated debt plus additional
borrowing to cover the balance. Stage 2 was triggered when the deal received regulatory approval. During
this stage, an employee stock ownership plan (ESOP) bought the rest of the shares at $34 a share (totaling
about $4 billion), with Zell providing the remaining $65 million of his pledge. Over time, the ESOP would
hold all of the remaining stock. Furthermore, Tribune was converted from a C corporation to a subchapter S
corporation, allowing the firm to avoid corporate income taxes, except on gains resulting from the sale of
assets held less than 10 years after the conversion from a C to an S corporation.
The purchase of Tribune’s stock was financed almost entirely with debt, with Zell’s equity contribution
amounting to less than 4% of the purchase price. The Tribune ended up with $13 billion in debt (including
the $5 billion it currently held). At this level, the firm’s debt was 10 times EBITDA, more than 2.5 times
that of the average media company. Annual interest and principal repayments reached $800 million (almost
three times their preacquisition level), about 62% of the firm’s previous EBITDA cash flow of $1.3 billion.
The conversion of the Tribune into a subchapter S corporation eliminated the firm’s current annual tax
liability of $348 million. Such entities pay no corporate income tax, but must pay all profit directly to
shareholders, who then pay taxes on these distributions. Since the ESOP was the sole shareholder, the
Tribune was expected to be largely tax exempt, given that ESOPs are not taxed. In an effort to reduce the
firm’s debt burden, the Tribune tried unsuccessfully to sell certain assets. While the Tribune was able to
sell the Chicago Cubs, Wrigley Field, and the firm’s 25% stake in Comcast’s SportsNet for $845 million,
the price was about 15% less than expected.
At the closing in late December 2007, Sam Zell described the takeover of the Tribune Company as “the
transaction from hell.” His comments were prescient, in that what had appeared to be a cleverly crafted deal
from a tax standpoint was unable to withstand the credit malaise of 2008. The end came swiftly when the
161-year-old Tribune filed for bankruptcy on December 8, 2008, to conserve its rapidly dwindling cash
flow.
Those benefiting from the deal included the Tribune’s public shareholders, such as the Chandler family,
which owed 12% of the Tribune as a result of its prior sale of the Times Mirror to Tribune, and Dennis
Fitzsimons, the firm’s former CEO, who received $17.7 million in severance and $23.8 million for his
holdings of Tribune shares. Citigroup and Merrill Lynch received $35.8 million and $37 million,
respectively, in advisory fees. Morgan Stanley received $7.5 million for writing a fairness opinion letter.
Finally, Valuation Research Corporation received $1 million for an opinion indicating that Tribune could
satisfy its loan covenants.
What appeared to be one of the most complex deals of 2007, designed to reap huge tax advantages and
to use as much debt as possible, soon became a victim of the downward-spiraling economy, the credit
crunch, and its own leverage. Ironically, those who constructed what appeared on paper to be a very shrewd
deal had failed to include in their planning the potential for a slowing economy, let alone one of the worst
recessions in U.S. history. For this highly leveraged deal to have worked, everything would have had to go
according to plan, a plan that did not seem to include any contingencies.
Discussion Questions
1. What are the primary objectives of the bankruptcy process?
2. What types of businesses are most appropriate for Chapter 11 reorganization, Chapter 7
liquidation, or a Section 363 sale?
3. The Blockbuster case study illustrates options available to the creditors and owners of a failing
firm. How do you believe creditors and owners might choose from among the range of available
options?
4. Financial buyers clearly are motivated by the potential profit they can make by buying distressed
debt. Their actions may have both a positive and negative impact on parties to the bankruptcy
process. Identify how parties to a bankruptcy may be helped or hurt by the actions of the hedge
funds.
5. Do you believe that a strategic bidder has an inherent advantage over a financial bidder in a 363
auction? Explain your answer.
6. Speculate as to why Blockbuster filed a motion with the Court to initiate a Section 363 auction
rather than to continue to negotiate a reorganization plan with its creditors to exit Chapter 11.