Photography Icon Kodak Declares Bankruptcy, A Victim of Creative Destruction
Key Points
Having invented the digital camera, Kodak knew that the longevity of its traditional film business was
problematic.
Concerned about protecting its core film business, Kodak was unable to reposition itself fast enough to
stave off failure.
Chapter 11 reorganization offers an opportunity to emerge as a viable business, save jobs, minimize
creditor losses, and limit the impact on communities.
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Economic historian Joseph Schumpeter described the free market process by which new technologies and
deregulation create new industries, often at the expense of existing ones, as “creative destruction.” In the
short run, this process can have a highly disruptive impact on current employees whose skills are made
obsolete, investors and business owners whose businesses are no longer competitive, and communities that
are ravaged by increasing unemployment and diminished tax revenues. However, in the long run, the
process tends to raise living standards by boosting worker productivity and increasing real income and
leisure time, stimulating innovation, expanding the range of products and services offered, often at a lower
price, to consumers, and to increase tax revenues. Kodak is a recent illustration of this process.
Founded in 1880 by George Eastman, Kodak became the latest giant to fall in the face of advancing
technology, announcing that it had filed for the protection of the bankruptcy court early in 2012. Kodak had
established the market for camera film and then dominated the marketplace before suffering a series of
setbacks over the last 40 years. First foreign competitors, most notably Fujifilm of Japan, undercut Kodak’s
film prices. Then the increased popularity of digital photography eroded demand for traditional film,
eventually causing the firm to cease investment in its traditional film product in 2003. Although it had
invented the digital camera, Kodak had failed to develop it further, announcing on February 12, 2012, that
it would discontinue its production of such cameras. Kodak’s failure to move aggressively into the digital
world may have reflected its concern about cannibalizing its core film business. This concern may have
ultimately destined the firm for failure.
Kodak closed 13 manufacturing plants and 130 processing labs and had reduced its workforce to 17,000
in 2011 from 63,000 in 2003. In recent years, the firm has undertaken a two-pronged strategy: expanding
into the inkjet printer market and initiating patent lawsuits to generate royalty payments from firms
allegedly violating Kodak digital patents. Kodak technologies are found in virtually all modern digital
cameras, smartphones, and tablet computers. Kodak had raised $3 billion between 2003 and 2010 by
reaching settlements with alleged patent infringement companies. But the revenue from litigation dried up
in 2011.
With only one profitable year since 2004, the firm eventually ran out of cash. Its market value on the
day it announced its bankruptcy filing had slumped to $150 million, compared to $31 billion in 1995.
Kodak said it had $5.1 billion in assets and $6.8 billion in debt, rendering the firm insolvent. The Chapter
11 filing was made in the U.S. bankruptcy court in lower New York City and excluded the firm’s non-U.S.
subsidiaries. The objectives of the bankruptcy filing were to buy time to find buyers for some of its 1,100
digital patents, to continue to shrink its current employment, to reduce significantly its healthcare and
pension obligations, and to renegotiate more favorable payment terms on its outstanding debt. Kodak had
put the patents up for sale in August 2011 but did not receive any bids, since potential buyers were
concerned that they would be required to return the assets by creditors if Kodak filed for bankruptcy
protection. While the firm’s pension obligations are well funded, the firm owes health benefits to 38,000
U.S. retirees, which in 2011 cost the firm $240 million.
Kodak also announced that it had obtained a $950 million loan from Citibank to keep operating during
the bankruptcy process. Moreover, the firm filed new patent infringement suits in March 2012 against a
number of competitors, including Fujifilm, Research in Motion (RIM), and Apple, in order to increase the
value of its patent portfolios. However, a court ruled in mid-2012 that neither Apple nor RIM had infringed
on Kodak patents. In early 2013, Kodak announced that it would put additional assets up for sale (including
its camera film business and heavy-duty commercial scanners and software businesses) since the sale of its
remaining digital imaging patents raised only $525 million, much less than the nearly $2 billion the firm
had expected. The sale of these businesses would cement Kodak’s departure from its roots. In late
September 2012, Kodak announced that it would suspend the production and sale of consumer inkjet
printers. Kodak also received permission from the bankruptcy court judge to terminate the payment of
retiree medical, dental, and life insurance benefits for 56,000 retirees at the end of 2012.
Kodak has to demonstrate viability to emerge from Chapter 11 as a reorganized firm or be acquired by
another firm. The firm has pinned its remaining hopes for survival on selling commercial printing
equipment and services, a business that generated about $2 billion in revenue in 2012 but that may lack the
scale to sustain profitability. If it cannot demonstrate viability, Kodak will face liquidation. In either case,
the outcome is a sad ending to a photography icon.
Discussion Questions
1. To what extent do you believe the factors contributing to Tribune’s bankruptcy were beyond the
control of management? To what extent do you believe past 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. Describe the firm’s strategy to finance the transaction?
4. Comment on the fairness of this transaction to the various stakeholders involved. How
would you apportion the responsibility for the eventual bankruptcy of Tribune among
Sam Zell and his advisors, the Tribune board, and the largely unforeseen collapse of the
credit markets in late 2008? Be specific.
5. Why do the bankruptcy courts allow investors such as hedge funds to buy deeply discounted debt
from creditors and later exchange such debt at face value for equity in the newly restructured 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
under Section 363 of the U.S. Bankruptcy Code. Historically, firms used this tactic to sell failing plants and
redundant equipment. In recent years, so-called 363 sales have been used to completely restructure
businesses, including the 363 sales of entire companies. A 363 sale requires only the approval of the
bankruptcy judge, while a plan of reorganization in Chapter 11 must be approved by a substantial number
of creditors and meet certain other requirements to be approved. A plan of reorganization is much more
comprehensive than a 363 sale in addressing the overall financial situation of the debtor and how its exit
strategy from bankruptcy will affect creditors. Once a 363 sale has been consummated and the purchase
price paid, the bankruptcy court decides how the proceeds of sale are allocated among secured creditors
with liens on the assets sold.
Total financing provided by the U.S. and Canadian (including the province of Ontario) governments
amounted to $69.5 billion. U.S. taxpayer-provided financing totaled $60 billion, which consisted of $10
billion in loans and the remainder in equity. The government decided to contribute $50 billion in the form
of equity to reduce the burden on GM of paying interest and principal on its outstanding debt. Nearly $20
billion was provided prior to the bankruptcy, $11 billion to finance the firm during the bankruptcy
proceedings, and an additional $19 billion in late 2009. In exchange for these funds, the U.S. government
owns 60.8 percent of the “new GM’s common shares, while the Canadian and Ontario governments own
11.7 percent in exchange for their investment of $9.5 billion. The United Auto Workers’ new voluntary
employee beneficiary association (VEBA) received a 17.5 percent stake in exchange for assuming
responsibility for retiree medical and pension obligations. Bondholders and other unsecured creditors
received a 10 percent ownership position. The U.S. Treasury and the VEBA also received $2.1 billion and
$6.5 billion in preferred shares, respectively.
The new firm, which employs 244,000 workers in 34 countries, intends to further reduce its head count
of salaried employees to 27,200 by 2012. The firm will also have shed 21,000 union workers from the
54,000 UAW workers it employed prior to declaring bankruptcy in the United States and close 12 to 20
plants. GM did not include its foreign operations in Europe, Latin America, Africa, the Middle East, or
Asia Pacific in the Chapter 11 filing. Annual vehicle production capacity for the firm will decline to 10
million vehicles in 2012, compared with 15 to 17 million in 1995. The firm exited bankruptcy with
consolidated debt at $17 billion and $9 billion in 9 percent preferred stock, which is payable on a quarterly
basis. GM has a new board, with Canada and the UAW healthcare trust each having a seat on the board.
Following bankruptcy, GM has four core brands—Chevrolet, Cadillac, Buick, and GMC—that are sold
through 3,600 dealerships, down from its existing 5,969-dealer network. The business plan calls for an IPO
whose timing will depend on the firm’s return to sufficient profitability and stock market conditions.
By offloading worker healthcare liabilities to the VEBA trust and seeding it mostly with stock instead of
cash, GM has eliminated the need to pay more than $4 billion annually in medical costs. Concessions made
by the UAW before GM entered bankruptcy have made GM more competitive in terms of labor costs with
Toyota.
Assets to be liquidated by Motors Liquidation Company (i.e., “old GM) were split into four trusts,
including one financed by $536 million in existing loans from the federal government. These funds were
set aside to clean up 50 million square feet of industrial manufacturing space at 127 locations spread across
14 states. Another $300 million was set aside for property taxes, plant security, and other shutdown
expenses. A second trust will handle claims of the owners of GM’s prebankruptcy debt, who are expected
to get 10 percent of the equity in General Motors when the firm goes public and warrants to buy additional
shares at a later date. The remaining two trusts are intended to process litigation such as asbestos-related
claims. The eventual sale of the remaining assets could take four years, with most of the environmental
cleanup activities completed within a decade. 1
Reflecting the overall improvement in the U.S. economy and in its operating performance, GM repaid
$10 billion in loans to the U.S. government in April 2010. Seventeen months after emerging from
bankruptcy, the firm completed successfully the largest IPO in history on November 17, 2010, raising
$23.1 billion. The IPO was intended to raise cash for the firm and to reduce the government’s ownership in
the firm, reflecting the firm’s concern that ongoing government ownership hurt sales. Following
completion of the IPO, government ownership of GM remained at 33 percent, with the government
continuing to have three board representatives.
GM is likely to continue to receive government support for years to come. In an unusual move, GM was
allowed to retain $45 billion in tax loss carryforwards, which will eliminate the firm’s tax payments for
years to come. Normally, tax losses are preserved following bankruptcy only if the equity in the
reorganized company goes to creditors who have been in place for at least 18 months. Despite not meeting
this criterion, the Treasury simply overlooked these regulatory requirements in allowing these tax benefits
to accrue to GM. Having repaid its outstanding debt to the government, GM continued to owe the U.S.
government $36.4 billion ($50 billion less $13.6 billion received from the IPO) at the end of 2010.
Assuming a corporate marginal tax rate of 35 percent, the government would lose another $15.75 in future
tax payments as a result of the loss carryforward. The government also is providing $7,500 tax credits to
buyers of GM’s new all-electric car, the Chevrolet Volt.
Discussion Questions
1. Do you agree or disagree that the taxpayer financed bankruptcy represented the best way to save
jobs. Explain your answer.
Consolidat
ed GM
U.S. &
Canadian
Operations
All Other
Internation
al
Ope ti
Attractive
Assets
“Old GM”
Unattractiv
e Assets
“New GM”
U.S. &
Canadian
Ope ti
All Other
Internation
al
Ope ti
Consolidat
ed GM
Pre-Bankruptcy Bankruptcy Post-Bankruptcy
Figure 16.2 General Motors Bankruptcy
2. Discuss the relative fairness to the various stakeholders in a bankruptcy of a
more traditional Chapter 11 bankruptcy in which a firm emerges from the protection of the
bankruptcy court following the development of a plan of reorganization versus an expedited
sale under Section 363 of the federal bankruptcy law. Be specific.
3. Identify what you believe to be the real benefits and costs of the bailout of General Motors?
Be specific.
4. The first round of government loans to GM occurred in December 2008. The
firm did not file for bankruptcy until June 1, 2009. Discuss the advantages and disadvantages
of the firm having filed for bankruptcy much earlier in 2009. Be specific.
5. What alternative restructuring strategies do you believe may have been
considered for GM? Of these, do you believe that the 363 sale in bankruptcy
represented the best course of action? Explain your answers.
Lehman Brothers Files for Chapter 11 in the Biggest Bankruptcy in U.S. History
A casualty of the 2008 credit crisis that shook Wall Street to its core, Lehman Brothers Holdings, Inc., a
holding company, announced on September 15, 2008, that it had filed a petition under Chapter 11 of the
U.S. Bankruptcy Code. Lehman’s board of directors decided to opt for court protection after attempts to
find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman
is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and
Enron with $126 billion and $81 billion in assets, respectively.
None of the holding company’s subsidiaries was included in the filing, enabling customers of Lehman’s
brokerage, Neuberger Berman Holdings, to continue to use their accounts to trade. Furthermore, by
excluding its units from the bankruptcy filing, customers of its broker–dealer operations would not be
subject to claims by LBHI’s more than 100,000 creditors in the bankruptcy case.
Prior to the Dodd-Frank Act of 2010 (see Chapter 2) limiting such rights, counterparties could cancel
contracts when a financial services firm went bankrupt. Lehman would normally hedge or protect its
investments by taking opposite positions to minimize potential losses in its derivatives portfolios.
Derivatives are financial instruments whose value changes in response to the value of the underlying assets
over a specific period. For example, if the firm purchased a contract to buy oil at a specific price at some
point in the future, it would also sell a contract at a somewhat lower price to another party (called a
counterparty) to minimize losses if the price of oil dropped. Thus, the bankruptcy filing left Lehman‘s
investment positions unprotected.
On September 20, 2008, Barclays PLC., a major U.K. bank, acquired Lehman’s broker–dealer
operations for $250 million and paid an additional $1.5 billion for the firm’s New York headquarters
building and two New Jersey–based data centers. Coming just five days after Lehman filed for bankruptcy,
the deal reflected the urgency to find buyers for those businesses whose value consisted primarily of their
employees. Barclays did not buy any of Lehman’s commercial real estate assets or private equity and hedge
fund investments. However, Barclays did agree to take $47.4 billion in securities and assume $45.5 billion
in trading liabilities. On September 24, 2008, Japanese brokerage Nomura Securities acquired Lehman‘s
Japanese and Australian operation for $250 million. Lehman’s investment management group, Neuberger
Berman, was sold in late December 2008 to a Neuberger management group for $922 million. Under the
deal, Neuberger‘s management would own 51 percent of the firm, and Lehman’s creditors would control the
remainder. Other Lehman assets, consisting primarily of complex derivatives ranging from oil price futures
to credit default swaps (i.e., debt insurance) to options on stock indices, with more than 8,000
counterparties, were expected to take years to identify, value, and liquidate. The firm also could expect to
face numerous lawsuits.
The October 18, 2008, auction of $400 billion of Lehman’s debt issues was valued at 8.5 cents on the
dollar. Because such debt was backed by only the firm’s creditworthiness, the buyers of the Lehman debt
had purchased insurance from other financial institutions to mitigate the risk of a Lehman default. The
existence of these credit default swap arrangements meant that the insurers were required to pay Lehman
bondholders $366 billion (i.e., 0.915 × $400 billion). Purchasers of this debt were betting that, following
Lehman’s liquidation, holders of this debt would receive more than 8.5 cents on the dollar and the insurers
would be able to satisfy their obligations.
Hedge funds also were affected by the Lehman bankruptcy. Hedge funds borrowed heavily from
Lehman, putting up certain assets as collateral for the loans. While legal, Lehman was using this collateral
to borrow from other firms. By using its customers’ collateral as its own collateral, Lehman and other firms
could borrow more money, using the proceeds to make additional investments. When Lehman filed for
bankruptcy, the court took control of such assets until who was entitled to the assets could be determined.
Moreover, while derivative agreements were designed to terminate whenever a party declares bankruptcy
and be settled outside of court, Lehman‘s general creditors may lay claim to any collateral whose value
exceeds the value of the derivative agreements. Disentangling these claims will take years.
In early 2010, a report compiled by bank examiners described how Lehman manipulated its financial
statements, leaving the investing public, credit rating agencies, government regulators, and Lehman’s board
of directors totally unaware of the accounting tricks. By departing from common accounting practices,
Lehman appeared to be less levered than it actually was. It was pressure from speculators, sensing that the
firm was in disarray, which uncovered the scam by selling Lehman’s stock short and accomplishing what
the regulators and credit rating agencies could not. See the Inside M&A case study at the beginning of
Chapter 2 for more details on Lehman’s accounting practices.
Discussion Questions
1. Why did Lehman choose not to seek Chapter 11 protection for its subsidiaries?
2. How does Chapter 11 bankruptcy protect Lehman’s creditors? How does it potentially hurt them?
3. Do you believe the U.S. bankruptcy process was appropriate in this instance? Explain your answer.
4. Do you believe the U.S. government’s failure to bail out Lehman, thereby forcing the firm to file for
bankruptcy, exacerbated the global credit meltdown in October 2008? Explain your answer.
A Reorganized Dana Corporation
Emerges from Bankruptcy Court
Dana Corporation, an automotive parts manufacturer, announced on February 1, 2008, that it had emerged
from bankruptcy court with an exit financing facility of $2 billion. The firm had entered Chapter 11
reorganization on March 3, 2006. During the ensuing 21 months, the firm and its constituents identified,
agreed on, and won court approval for approximately $440 million to $475 million in annual cost savings
and the elimination of unprofitable products. These annual savings resulted from achieving better plant
utilization due to changes in union work rules, wage and benefit reductions, the reduction of ongoing
obligations for retiree health and welfare costs, and streamlining administrative expenses.
The plan of reorganization accepted by the court, creditors, and investors included a $750 million equity
investment provided by Centerbridge Capital Partners to fund a portion of the firm’s health-care and
pension obligations. Under the plan, shareholders received no payout. Bondholders of some $1.62 billion in
various maturities and holders of $1.63 billion in unsecured claims recovered about 60–90 percent of their
claims. Centerbridge would acquire $250 million of convertible preferred stock in the reorganized Dana
operation, and creditors, who had agreed to support the reorganization plan, could acquire up to $500
million of the convertible preferred shares. The preferred shares were issued as an inducement to get
creditors to support the plan of reorganization. Under the reorganization plan, Dana sold some businesses,
cut plants in the United States and Canada, reduced its hourly and salaried workforce, and sought price
increases on parts from customers.
Discussion Questions
1. Does the process outlined in this business case seem equitable for all parties to the bankruptcy
proceedings? Why? Why not? Be specific.
2 Why did Centerbridge receive convertible preferred rather than common stock?
Calpine Emerges from the Protection of Bankruptcy Court
Following approval of its sixth Plan of Reorganization by the U.S. Bankruptcy Court for the Southern
District of New York, Calpine Corporation was able to emerge from Chapter 11 bankruptcy on January 31,
2008. Burdened by excessive debt and court battles with creditors on how to use its cash, the electric utility
had sought Chapter 11 protection by petitioning the bankruptcy court in December 2005. After settlements
with certain stakeholders, all classes of creditors voted to approve the Plan of Reorganization, which
provided for the discharge of claims through the issuance of reorganized Calpine Corporation common
stock, cash, or a combination of cash and stock to its creditors.
Shortly after exiting bankruptcy, Calpine cancelled all of its then outstanding common stock and
authorized the issuance of 485 million shares of reorganized Calpine Corporation common stock for
distribution to holders of unsecured claims. In addition, the firm issued warrants (i.e., securities) to
purchase 48.5 million shares of reorganized Calpine Corporation common stock to the holders of the
cancelled (i.e., previously outstanding) common stock. The warrants were issued on a pro rata basis
reflecting the number of shares of “old common stock” held at the time of cancellation. These warrants
carried an exercise price of $23.88 per share and expired on August 25, 2008. Relisted on the New York
Stock Exchange, the reorganized Calpine Corporation common stock began trading under the symbol CPN
on February 7, 2008, at about $18 per share.
The firm had improved its capital structure while in bankruptcy. On entering bankruptcy, Calpine
carried $17.4 billion of debt with an average interest rate of 10.3 percent. By retiring unsecured debt with
reorganized Calpine Corporation common stock and selling certain assets, Calpine was able to repay or
refinance certain project debt, thereby reducing the prebankruptcy petition debt by approximately $7
billion. On exiting bankruptcy, Calpine negotiated approximately $7.3 billion of secured “exit facilities”
(i.e., credit lines) from Goldman Sachs, Credit Suisse, Deutsche Bank, and Morgan Stanley. About $6.4
billion of these funds were used to satisfy cash payment obligations under the Plan of Reorganization.
These obligations included the repayment of a portion of unsecured creditor claims and administrative
claims, such as legal and consulting fees, as well as expenses incurred in connection with the “exit
facilities” and immediate working capital requirements. On emerging from Chapter 11, the firm carried
$10.4 billion of debt with an average interest rate of 8.1 percent.
The Enron Shuffle—A Scandal to Remember
What started in the mid-1980s as essentially a staid “old-economy” business became the poster child in the
late 1990s for companies wanting to remake themselves into “new-economy” powerhouses. Unfortunately,
what may have started with the best of intentions emerged as one of the biggest business scandals in U.S.
history. Enron was created in 1985 as a result of a merger between Houston Natural Gas and Internorth
Natural Gas. In 1989, Enron started trading natural gas commodities and eventually became the world’s
largest buyer and seller of natural gas. In the early 1990s, Enron became the nation’s premier electricity
marketer and pioneered the development of trading in such commodities as weather derivatives, bandwidth,
pulp, paper, and plastics. Enron invested billions in its broadband unit and water and wastewater system
management unit and in hard assets overseas. In 2000, Enron reported $101 billion in revenue and a market
capitalization of $63 billion.
The Virtual Company
Enron was essentially a company whose trading and risk management business strategy was built on assets
largely owned by others. The complex financial maneuvering and off-balance-sheet partnerships that
former CEO Jeffrey K. Skilling and chief financial officer Andrew S. Fastow implemented were intended
to remove everything from telecommunications fiber to water companies from the firm’s balance sheet and
into partnerships. What distinguished Enron’s partnerships from those commonly used to share risks were
their lack of independence from Enron and the use of Enron’s stock as collateral to leverage the
partnerships. If Enron’s stock fell in value, the firm was obligated to issue more shares to the partnership to
restore the value of the collateral underlying the debt or immediately repay the debt. Lenders in effect had
direct recourse to Enron stock if at any time the partnerships could not repay their loans in full. Rather than
limiting risk, Enron was assuming total risk by guaranteeing the loans with its stock.
Enron also engaged in transactions that inflated its earnings, such as selling time on its broadband
system to a partnership at inflated prices at a time when the demand for broadband was plummeting. Enron
then recorded a substantial profit on such transactions. The partnerships agreed to such transactions because
Enron management seems to have exerted disproportionate influence in some instances over partnership
decisions, although its ownership interests were very small, often less than 3 percent. Curiously, Enron’s
outside auditor, Arthur Andersen, had a dual role in these partnerships, collecting fees for helping to set
them up and auditing them.
Time to Pay the Piper
At the time the firm filed for bankruptcy on December 2, 2001, it had $13.1 billion in debt on the books of
the parent company and another $18.1 billion on the balance sheets of affiliated companies and
partnerships. In addition to the partnerships created by Enron, a number of bad investments both in the
United States and abroad contributed to the firm’s malaise. Meanwhile, Enron’s core energy distribution
business was deteriorating. Enron was attempting to gain share in a maturing market by paring selling
prices. Margins also suffered from poor cost containment.
Dynegy Corp. agreed to buy Enron for $10 billion on November 2, 2001. On November 8, Enron
announced that its net income would have to be restated back to 1997, resulting in a $586 million reduction
in reported profits. On November 15, chairman Kenneth Lay admitted that the firm had made billions of
dollars in bad investments. Four days later, Enron said it would have to repay a $690 million note by mid–
December and it might have to take an additional $700 million pretax charge. At the end of the month,
Dynegy withdrew its offer and Enron‘s credit rating was reduced to junk bond status. Enron was
responsible for another $3.9 billion owed by its partnerships. Enron had less than $2 billion in cash on
hand.
The end came quickly as investors and customers completely lost faith in the energy behemoth as a
result of its secrecy and complex financial maneuvers, forcing the firm into bankruptcy in early December.
Enron’s stock, which had reached a high of $90 per share on August 17, 2001, was trading at less than $1
by December 5, 2001.
In addition to its angry creditors, Enron faced class-action lawsuits by shareholders and employees,
whose pensions were invested heavily in Enron stock. Enron also faced intense scrutiny from congressional
committees and the U.S. Department of Justice. By the end of 2001, shareholders had lost more than $63
billion from its previous 52-week high, bondholders lost $2.6 billion in the face value of their debt, and
banks appeared to be at risk on at least $15 billion of credit they had extended to Enron. In addition,
potential losses on uncollateralized derivative contracts totaled $4 billion. Such contracts involved Enron
commitments to buy various types of commodities at some point in the future.
Questions remain as to why Wall Street analysts, Arthur Andersen, federal or state regulatory
authorities, the credit rating agencies, and the firm’s board of directors did not sound the alarm sooner. It is
surprising that the audit committee of the Enron board seems to have somehow been unaware of the firm’s
highly questionable financial maneuvers. Inquiries following the bankruptcy declaration seem to suggest
that the audit committee followed all the rules stipulated by federal regulators and stock exchanges
regarding director pay, independence, disclosure, and financial expertise. Enron seems to have collapsed in
part because such rules did not do what they were supposed to do. For example, paying directors with stock
may have aligned their interests with shareholders, but it also is possible to have been a disincentive to
question aggressively senior management about their financial dealings.
The Lessons of Enron
Enron may be the best recent example of a complete breakdown in corporate governance, a system
intended to protect shareholders. Inside Enron, the board of directors, management, and the audit function
failed to do the job. Similarly, the firm’s outside auditors, regulators, credit rating agencies, and Wall Street
analysts also failed to alert investors. What seems to be apparent is that if the auditors fail to identify
incompetence or fraud, the system of safeguards is likely to break down. The cost of failure to those
charged with protecting the shareholders, including outside auditors, analysts, credit-rating agencies, and
regulators, was simply not high enough to ensure adequate scrutiny.
What may have transpired is that company managers simply undertook aggressive interpretations of
accounting principles then challenged auditors to demonstrate that such practices were not in accordance
with GAAP accounting rules (Weil, 2002). This type of practice has been going on since the early 1980s
and may account for the proliferation of specific accounting rules applicable only to certain transactions to
insulate both the firm engaging in the transaction and the auditor reviewing the transaction from subsequent
litigation. In one sense, the Enron debacle represents a failure of the free market system and its current
shareholder protection mechanisms, in that it took so long for the dramatic Enron shell game to be revealed
to the public. However, this incident highlights the remarkable resilience of the free market system. The
free market system worked quite effectively in its rapid imposition of discipline in bringing down the
Enron house of cards, without any noticeable disruption in energy distribution nationwide.
Epilogue
Due to the complexity of dealing with so many types of creditors, Enron filed its plan with the federal
bankruptcy court to reorganize one and a half years after seeking bankruptcy protection on December 2,
2001. The resulting reorganization has been one of the most costly and complex on record, with total legal
and consulting fees exceeding $500 million by the end of 2003. More than 350 classes of creditors,
including banks, bondholders, and other energy companies that traded with Enron said they were owed
about $67 billion.
Under the reorganization plan, unsecured creditors received an estimated 14 cents for each dollar of
claims against Enron Corp., while those with claims against Enron North America received an estimated
18.3 cents on the dollar. The money came in cash payments and stock in two holding companies,
CrossCountry containing the firm’s North American pipeline assets and Prisma Energy International
containing the firm’s South American operations.
After losing its auditing license in 2004, Arthur Andersen, formerly among the largest auditing firms in
the world, ceased operation. In 2006, Andrew Fastow, former Enron chief financial officer, and Lea Fastow
plead guilty to several charges of conspiracy to commit fraud. Andrew Fastow received a sentence of 10
years in prison without the possibility of parole. His wife received a much shorter sentence. Also in 2006,
Enron chairman Kenneth Lay died while awaiting sentencing, and Enron president Jeffery Skilling received
a sentence of 24 years in prison.
Citigroup agreed in early 2008 to pay $1.66 billion to Enron creditors who lost money following the
collapse of the firm. Citigroup was the last remaining defendant in what was known as the Mega Claims
lawsuit, a bankruptcy lawsuit filed in 2003 against 11 banks and brokerages. The suit alleged that, with the
help of banks, Enron kept creditors in the dark about the firm’s financial problems through misleading
accounting practices. Because of the Mega Claims suit, creditors recovered a total of $5 billion or about
37.4 cents on each dollar owed to them. This lawsuit followed the settlement of a $40 billion class action
lawsuit by shareholders, which Citicorp settled in June 2005 for $2 billion.
Case Study Discussion Questions:
1. In your judgment, what were the major factors contributing to the demise of Enron? Of these
factors, which were the most important?
2. In what way was the Enron debacle a break down in corporate governance (oversight)? Explain
your answer.
3. How were the Enron partnerships used to hide debt and inflate the firm’s earnings? Should
partnership structures be limited in the future? If so, how?
4. What should (or can) be done to reduce the likelihood of this type of situation arising in the
future? Be specific.
PG&E SEEKS BANKRUPTCY PROTECTION
Pacific, Gas, and Electric (PG&E), the San Francisco-based utility, filed for bankruptcy on April 7, 2001,
citing nearly $9 billion in debt and un-reimbursed energy costs. The utility, one of three privately owned
utilities in California, serves northern and central California. The intention of the Chapter 11
reorganization was to make the utility solvent again by protecting the firm from lawsuits or any other action
by those who are owed money by the utility. The bankruptcy will also allow the utility to deal with all of
the firm’s debts in a single forum rather than with individual debtors in what had become a highly
politicized venue. The following time line outlines the firm’s road to bankruptcy.
P&G Bankruptcy Timeline
September 1996:
Wholesale power prices begin to rise as demand surges past supply in the buoyant
economy. However, the 1996 law prohibits the utilities from passing rising costs on
to customers until March 1, 2002.
May 2000:
California’s power restructuring efforts signed into law by then Governor Pete
Wilson.
January 4, 2001:
California Public Utility Commission (PUC) disallows PG&E’s request to recover
the full amount of their cost increases and approves an average 10% increase in retail
rates, about two-thirds of what had been requested. The PUC institutes internal
audits of the state’s private utilities.
January 5, 2000:
Credit rating agencies downgrade PG&E and Southern California Edison (SCE) to
one notch above junk bonds.
January 10, 2000:
PG&E asks then Governor Grey Davis for help to buy natural gas for customers,
saying it does not have enough cash to pay its bills.
January 12, 2000:
PG&E lays off 1000 workers.
January 17, 2000:
Rolling blackouts are ordered for the first time to avoid overloading the state’s
power grid. PG&E defaults on $76 million in commercial paper.
January 19, 2000:
President Clinton declares a natural gas supply emergency and orders out-of-state
suppliers to continue selling gas to PG&E despite concerns about getting paid.
January 23, 2000:
The Bush administration extends emergency orders through February 6.
March 27, 2000:
The PUC approves an increase in retail electricity prices by 3 cents per kilowatt-hour
to bring retail prices more in line with wholesale prices after PG&E states that its
debt has grown to more than $9 billion.
April 6, 2000:
PG&E files for bankruptcy
.
Utility industry analysts saw PG&E’s move as largely an effort to escape the political paralysis that had
befallen the state’s regulatory apparatus. The bankruptcy filing came one day after Governor Davis
dropped his opposition to raising retail rates. However, the Governor’s reversal came after five month’s of
negotiations with the state’s privately owned utilities on a rescue plan.
PG&E’s common shares fell 37 percent on the day the firm filed for reorganization. Fearing a similar
fate for San Diego Gas and Electric, the shares of Sempra Energy, SDG&E’s parent corporation, also
dropped by 35 percent
In an attempt to insulate California ratepayers from escalating wholesale electricity prices, the state
entered into a series of 5-to–10 year contracts with electricity power generators that account for more than
two-thirds of the state’s projected power needs. The last contracts were signed by the state in June 2001.
By September, a slowing economy pushed the wholesale price of electricity well below the level the state
was required to pay in the “take or pay” contracts the state had just signed. Estimates suggest that
California taxpayers will have to pay between $40 and $45 billion in power costs over the next decade
depending on what happens to future energy costs. PG&E has continued to supply its customers without
disruption or blackout while being under the protection of the bankruptcy court.
Southern California Edison, nearing bankruptcy for reasons similar to those that drove PG&E to seek
protection from its creditors, reached agreement with the Public Utility Commission to pay off $3.3 billion
in debt owed to power generators from customer revenues. Previously, the PUC had forbid the utility to
use monies generated from two previous rate increases for this purpose. The U.S. District Court judge
approved the plan on October 5, 2001. While some creditors complained that the settlement was not
reassuring because it did not include a timetable for repayment of outstanding debt, others viewed the
agreement as a voluntary reorganization plan without going through the expensive process of filing for
bankruptcy with the federal court.
Discussion Questions:
1. In your judgment, did regulators attenuate or exacerbate the situation? Explain your answer.
2. PG&E pursued bankruptcy protection, while Southern California Edison did not. What could
PG&E have been done differently to avoid bankruptcy?