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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?
Answer: Creditors may decide to allow the insolvent firm to continue to operate, because they
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.
Answer: A failing firm’s strategic options are to merge with another firm, reach an out-of-court
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.
Answer: Empirical studies show that financial returns to investors often are highest immediately
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.
Answer: The leading causes of business failure in order of priority include economic factors such
as recession, financial factors such as excess operating expenses and excessive leverage, and lack
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?
Answer: Under the protection of the court, American Home Mortgage Investments will have the
time and opportunity to reorganize the firm while working with its creditors, without having the
Solutions to Chapter Case Stud Questions
Airbag Manufacturer Takata Files for Bankruptcy
Discussion Questions and Solutions:
Discussion Questions:
1. Speculate as to the culture that prevailed at Takata. To what extent, do you believe that the firm's
corporate culture contributed to the firm's eventual bankruptcy?
Answer: Takata had a history of quality problems dating back to 1995 with major seatbelt recalls.
2. What is the purpose of a Chapter 11 bankruptcy filing? How would you describe the Takata
proposed reorganization plan?
Answer: Chapter 11 is a type of filing that gives a debtor firm time to develop a viable
reorganization plan acceptable to a majority of creditors and the bankruptcy court judge. The plan
3. Who were Takata's largest unsecured creditors? Why were they classified as such?
Answer: The mechanics of the recall process require automakers to recall cars they have produced
4. Why wasn't the bankruptcy filing for Takata's U.S. operations filed under Chapter 7 rather than
Chapter 11?
Answer: Chapter 7 deals with the liquidation of a debtor firm in accordance with certain statutory
5. Why would Key Safety Systems want to buy Takata's factories?
Answer: Takata's problems were centered in its airbag inflator production operations. Its other
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.
Case Study Short-Essay Questions
HERCULES OFFSHORE INC. EMERGES FROM COURT PROTECTION THROUGH A
PREPACKAGED BANKRUPTCY
KEY POINTS:
• Chapter 11 provides an opportunity for debtor firms to reorganize, restructure their liabilities, and
to emerge as financially viable firms
• Debt-for-equity swaps are often used by creditors to recover all or a portion of what they are owed
• “Prepackaged” bankruptcy offers the potential for expediting the bankruptcy process saving
millions of dollars in legal expenses.
With crude prices plunging to a seven year low, energy exploration and production companies reduced
dramatically spending on costly off shore drilling projects given narrowing profit margins. Consequently,
offshore oil and gas exploration came to a virtual standstill in 2015. Moreover, with the global economy
showing few signs of economic growth, OPEC members continuing to pump at capacity, and oil
inventories worldwide brimming, there was little prospect that oil prices would improve significantly in the
foreseeable future.
Cash strapped offshore drillers were running out of options. Seeking protection from their creditors by
It is against this backdrop that Hercules Offshore Drilling Inc. (Hercules) announced that it was filing a
“prepackaged” Chapter 11 bankruptcy in August 2015. Chapter 11 reorganizations often are lengthy and
very expensive in terms of legal and consulting fees and in no way guarantee that the firm will in fact
achieve financial health. The length of time in bankruptcy protection can often undermine the capability of
the firm because key employees, customers and suppliers leave.
dollars in bankruptcy related expenses.
For Hercules, this strategy proved successful as it was able to emerge from Chapter 11 two months after
filing. At the time of filing the firm had $546 million in assets and $1.32 million in total liabilities, of which
$1.2 billion was long-term debt. The firm had $81 million in cash on hand. During the several months
preceding filing, the firm had terminated more than 40% of its employees and cut the number of drilling
rigs it operates by half. The firm also sold four of its Gulf of Mexico rigs and “moth-balled” several more.
Revenue tumbled by two-thirds during the first six months of 2015 over the same period the prior year.
In a so-called debt for equity swap negotiated before filing, Hercules was able to get nearly all of its
senior bondholders to agree to exchange $1.2 billion in debt for equity in the new Hercules that would
existing common shareholders are recover much of the their investment.
END OF CHAPTER CASE STUDY: ARCH COAL FILES FOR CHAPTER 11
BANKRUPTCY PROTECTION
Key Points
• Chapter 11 provides an opportunity for debtor firms to reorganize into financially viable firms and
for creditors to recover a portion of what they are owed.
• Distressed industries such as the U.S. coal industry often become prime targets for private equity
investors to acquire deeply discounted assets (e.g., coal reserves and profitable mines).
_______________________________________________________________________
_OOOOCREDIT: AP PHOTO/MATTHEW BROWN, FILESLUG
To paraphrase the American humourist Mark Twain, reports of the coal industry’s death have been greatly
exaggerated. The coal industry is clearly in decline but appears to be far from dead. Globally, coal is used
to fuel more than 40% of power generation. In addition, metallurgical coal is used to produce about 70% of
the world’s steel production (the remainder comes from recycled scrap). Despite concerns about pollution,
coal is abundant, making it affordable. It is also easy to transport, store, and use. Equally important is that it
is not subject to geopolitical tensions.
According to the 2015 global energy report by the International Energy Agency, the use of coal among
the rate of one every 7-10 days, despite have horrible air pollution in its major cities. Japan plans to build
43 coal fired plants to replace its shuttered nuclear power operations.
While U.S. coal demand is expected to grow modestly long-term, the industry has been particularly hard
hit in recent years. Nationwide, coal production at 895 million tons sank to the lowest levels in three
decades in 2015. The vast majority of that drop was in Appalachia, but production in the west was down as
well according to the U.S. Energy Information Agency. Many utilities have been switching from coal to
natural gas to generate electricity. Besides being cheaper, natural gas emits less greenhouse gas, a major
consideration as utilities look to comply with tough new government regulations. The Clean Power Plan,
which takes effect in 2022, requires states to cut carbon emissions by using less coal and more solar, wind
Among the options available to failing coal firms is to downsize by selling assets to raise cash and
reduce debt, reach an out of court settlement with creditors, seek to merge with a financially stronger firm,
or to reorganize under the protection of the U.S. bankruptcy court. Apparently, many coal firms have
chosen the latter option. The most notable coal mining firms that sought such protection in 2015 were
2015 which include Wyoming, West Virginia, Kentucky, Illinois, and Pennsylvania.
2016. Having lost money since 2012, the firm had been in negotiation with its creditors seeking relief from
its bone-crushing $4.5 billion in outstanding debt. The debt consisted of $1.9 billion in senior
collateralized debt with the remaining $2.6 billion subordinated debt. In the negotiation, the firm had
sought to get debt relief through partial forgiveness, deferral of interest payments and even a debt for equity
swap.
of Arch Coal debt. GSO Special Situations Master Fund LP, a Blackstone Group LP affiliate, even filed a
lawsuit seeking to clear the way for a debt exchange rather than a debt for equity swap favoured by Arch.
Continued uncertainty about the level of acceptance of the agreement by major lenders is what ultimately
caused Arch to file for Chapter 11 bankruptcy protection from its creditors.
Following a flurry of acquisitions, Arch’s share price had declined since 2011. Much of its current debt
$275 million in “debtor in possession” (DIP) financing from lenders to help sustain the firm’s mining
operations through the bankruptcy process. Lenders made sure that a portion of their DIP financing was
secured and also that it was made by a bank syndicate consisting of multiple lenders. As of the end of 2014,
Arch estimated that its pension benefit obligations were $353 million and since they were well funded
should not be affected by the bankruptcy filing.
are profitable on an operating basis, while mines outside of Wyoming may have to be shutdown.
The Arch bankruptcy filing could jeopardize the firm’s interests on the West Coast, where there has
been some interest in building fossil fuel export terminals in recent years. Arch Coal is co-owner of the
proposed coal export terminal at the Millennium Bulk Terminals site in Longview, Washington. But the
Arch Coal bankruptcy follows financial troubles by another investor in the project, Ambre Energy, and
satisfy their obligations by self-insuring, which amounts to relying on the financial health and reputation of
the coal company to raise the monies needed to restore terrain impacted by mining operations.
1 Peabody succumbed to industry wide pressures and filed for Chapter 11 bankruptcy protection on April
13, 2016. Peabody is expected to use the bankruptcy process to reduce its debt and to restructure its
operations. Many of its mines are profitable on an operating basis. The bankruptcy filing was necessitated
by the firm's inability to pay interest and principal payments on debt incurred in the firm's recent
acquisitions.
As recently as September 2015, Wyoming allowed Arch Coal to “self-bond” to cover its reclamation
requirements. If the company cannot cover its reclamation requirements, the state will shoulder the burden
as the states in which the firm has mines requiring land reclamation will simply be considered general
includes a $75 million carve-out for environmental reclamation obligations. The balance of the reclamation
costs may ultimately be borne by taxpayers.
The coal industry survivors will be low-cost producers across the country, including most of the eleven
mines in Arch Coal's portfolio. Major U. S. mining firms have many profitable mines, but have racked up
too much debt. Their mines are now expected to fall into the hands of new owners and operators dominated
by creditors and private equity firms willing to buy deeply distressed debt. Once purchased, such debt can
be swapped at face value for coal mining assets. While the industry's future is cloudy, predictions of its
demise are likely to prove highly premature.
Discussion Questions:
1. To what extent do you believe the factors contributing to the Arch Coal’s bankruptcy were beyond
the control of management? To what extent do you believe past mismanagement may have
contributed to the bankruptcy?
Answer: Factors such as declining natural gas prices due to a glut of natural gas, the ongoing
2. Comment on the fairness of the bankruptcy process to shareholders, lenders, employees,
communities, government, etc. Be specific.
Answer: The purpose of the bankruptcy option is to reduce the cost of borrowing by giving
creditors a mechanism for recovering their loans when the borrower defaults. The bankruptcy
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. How does Chapter 11 potentially affect adversely competitors of those firms emerging from
bankruptcy? Explain your answer.
5. Discuss whether Arch Coal’s lenders would have been better off in Chapter liquidation or from a
liquidation, or a Section 363 sale?
Answer: Although intended to give firms time to restructure, whether a business is likely to be
successful in Chapter 11 in part depends on the type of business and the circumstances under
which it seeks the protection of the bankruptcy court. For example, a firm may be technically
insolvent but still have sufficient cash flow to meet its immediate liquidity requirements;
consequently, such firms may be able to survive the length of time often required to hammer out a
6. 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?
Answer: A failing firm's strategic options are to merge with another firm, reach an out-of-court
voluntary settlement with creditors, or file for Chapter 11 bankruptcy. Note the prepackaged
Hostess Brands Liquidates in Bankruptcy
Case Study Objectives: To Illustrate
• Common characteristics of failing firms
• Options available for a failing firm and its creditors under the U.S. Bankruptcy Code
• The logic of selecting one option over other available alternatives.
Hostess Brands Inc. (Hostess), maker of the iconic Twinkies brand, filed for Chapter 11 bankruptcy on
January 11, 2012, under the weight of a shift by consumers to healthier foods and failed new product
introductions. Other contributing factors included a crushing debt burden, escalating pension and healthcare
obligations, union work rule limitations, increasing fuel and ingredients costs, and the 2008–2009 US
recession.
Hostess’s product offering included such well-known brands as Twinkies, Wonder Bread, Nature’s
Pride, Dolly Madison, Drake’s, Butternut, Home pride and Merita. While each brand had a strong
consumer following, the firm was an operational nightmare. Hostess consisted of a patchwork of disparate
operations and work rules having grown through a series of acquisitions. Beginning with its founding as the
Schulze Baking Company in 1927, acquisitions over the years resulted in 372 labor contracts, 80 separate
health and benefit plans, 5,500 delivery routes, and vastly different production processes across its
facilities.
This marked the second time in which the firm entered the protection of the U.S. Bankruptcy Court.
Notably the problems that forced the firm into bankruptcy the first time were remarkably similar to those
triggering the second business failure. Weighted down by a balance sheet laden with debt and pension
obligations and beset with costly labor rules and declining sales, Hostess Brands entered Chapter 11
bankruptcy protection in 2004. After nearly 5 years in bankruptcy, Hostess emerged in 2009 under the
control of a private equity firm called Ripplewood Holdings LLC (Ripplewood), which invested $130
million in new capital in the firm.
The emergence from bankruptcy was possible only after substantial concessions from the firm’s unions
totalling $110 million in annual labor costs and from lenders. Hedge funds Silver Point Capital LP (Silver
Point) and Monarch Alternative Capital LP (Monarch) agreed to provide a new secured loan of $360
million, forgive half of the existing debt, and to exchange the remaining debt for a payment-in-kind loan.
Silver Point and Monarch are hedge funds focused on buying so-called distressed debt (i.e., debt of
troubled firms that can be purchased at a steep discount from its face value).
Despite this substantial financial and operational restructuring, Hostess sales continued to falter.
Ripplewood injected another $60 million in the firm in 2011 consisting of new equity and subordinated
debt. Silver Point and Monarch which owned 12.28% and 8.59% of the firm, respectively, together put in
$30 million in 2011 and another $75 million after Hostess filed for Chapter 11 in early 2012 in debtor-in-
possession financing. Efforts to negotiate additional union concessions stalled with the Hostess’ CEO
leaving amidst acrimonious infighting between the unions and management.
With its equity investment worthless and subordinated debt deeply underwater, Ripplewood stopped
attending negotiating sessions with the unions, leaving only Silver Point and Monarch at the negotiating
table. The firms would not invest more in Hostess without union concessions and proposed that the unions
receive a 25% ownership stake in Hostess, board representation, and $100 million in subordinated debt in
exchange for wage, benefit, and work rule concessions.
Silverpoint and Monarch viewed such concessions as critical if a successful turnaround were to be
achieved. Work rules made it difficult to improve productivity and spend money efficiently. With sales of
$2.5 billion in 2011, Hostess lost $341 million. According to bankruptcy filings, the firm incurred $52
million in workers’ comp claims in 2011. Contractual obligations mandated a $31 million increase in
wages and health care and other benefits for 2012. Work rules required cake and bread products to be
delivered to a single retail location using separate trucks and drivers were not allowed to load the trucks
themselves; workers who loaded cakes were not allowed to load bread. Such logistical limitations added to
overall operating expenses.
By September 2012, the Teamsters union agreed to lower pay and benefits but the Bakery Workers
union rejected the deal. With the Teamsters union having agreed to significant contract concessions, the
federal bankruptcy court gave Hostess unilateral authority to modify collective bargaining contracts. The
and 570 bakery outlet stores throughout the United States, and the phased layoff of 18,500 workers.
Hostess stressed that it had to move quickly in the sale of its brands to capitalize on the outpouring of
nostalgia and media coverage surrounding its demise. The brands still had significant value. For 2012,
Twinkies pulled in about $76 million, Hostess Donuts $385 million, and Hostess Cup Cakes $138 million.
However, the longer Hostess cakes and breads were off store shelves, the more consumers would become
auction was underway in February and March 2013. The assets that were put up for sale included a range of
Hostess brands from Twinkies to Wonder Bread to real estate and baking equipment.
Two private equity firms, C. Dean Metropoulos & Company and Apollo Global Management agreed to
pay $410 million to buy the Hostess business, including Twinkies. Flowers Foods agreed to buy Wonder
and Hostess’s other bread businesses for $360 million and to pay $30 million for Beefsteak. McKee Foods
according to Article 9 of the Uniform Commercial Code. The U.S. Bankruptcy Code allows for debt
recovery according to Chapter 11 (a court-approved plan of reorganization), Chapter 7 (trustee directed
liquidation), and under Section 363 sales (expedited court sponsored auctions) of the U.S. Bankruptcy
Code.
Article 9 determines the legal right of ownership under the Uniform Commercial Code governing
commercially reasonable method. Such sales also require lenders selling collateral to notify the debtor, any
secured parties with interests in the collateral junior to the seller (second mortgage holders), and any other
secured party with an interest in the collateral. All this adds to the cost and length of time to implement the
process. Nor does Article 9 cleanse collateral of all liens such as product liability and environmental
claims.
to continue operate the business while foregoing payments to creditors. A creditor has a better chance of
recovering accounts receivable under Chapter 11 because relationships are seen as on going. Moreover,
Chapter 11 requires the judge to disperse the proceeds of any payments to creditors according to the
absolute priority rule which places secured parties first in line for distribution under a court-approved or
confirmed reorganization plan. However, Chapter 11 is an expensive process such that any value recovered
free and clear of all liens under a court order and establishes a bidding procedure to maximize value.
Was the auction process sanctioned under Section 363 of the bankruptcy code the right one for Hostess?
Time appears to have been a critical factor. The intangible value of the Hostess brand would diminish with
time. This process allowed for a rapid sale of the firm’s operating assets, perhaps at the best prices possible
at that time. While secured lenders were able to recover much of what they were owed, unsecured creditors
were owed by Hostess as possible. However, the business as a going concern was lost. The impact on other
stakeholders varied widely from shareholders receiving nothing to workers in some cases retaining their
jobs but often with much less compensation. The Hostess saga illustrates that the bankruptcy is not a
panacea as it was never intended to meet the needs of all those involved in the process. As in most
situations, there are winners and losers.
Discussion Questions and Solutions
1. How might the way in which Hostess Brands Inc. grew have contributed to its eventual financial
distress?
Answer: Hostess grew through a series of acquisitions which it failed to fully integrate in a
consistent manner. Beginning with its founding as the Schulze Baking Company in 1927,
acquisitions over the years resulted in 372 labor contracts, 80 separate health and benefit plans,
2. What are the primary objectives of the bankruptcy process? Speculate as to why this process may
have failed in reorganizing Hostess Brands?
Answer: Bankruptcy enables a failing firm to reorganize, while protected from its creditors, or to
cease operation by selling its assets to satisfy all or a portion of the firm's outstanding debt. U.S.
bankruptcy laws focus on rehabilitating and reorganizing debtors in distress. Bankruptcy laws are
intended to enable creditors and owners to reach agreement on plans to reorganize rather than to
liquidate insolvent firms, which offers the prospect of saving jobs, government tax revenue, and
enabling creditors to recover a larger portion of their claims.
some of its better workers to competitors.
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?
Answer: Although intended to give firms time to restructure, whether a business is likely to be
successful in Chapter 11 in part depends on the type of business and the circumstances under
which it seeks the protection of the bankruptcy court. For example, a firm may be technically
insolvent but still have sufficient cash flow to meet its immediate liquidity requirements;
consequently, such firms may be able to survive the length of time often required to hammer out a
reorganization plan among the various parties to the bankruptcy. In contrast, a firm may be solvent
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?
Answer: A failing firm's strategic options are to merge with another firm, reach an out-of-court
voluntary settlement with creditors, or file for Chapter 11 bankruptcy. Note the prepackaged
