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MINI CASE
Kimberly MacKenzie, president of Kim’s Clothes Inc., a medium-sized manufacturer of
women’s casual clothing, is worried. Her firm has been selling clothes to Russ Brothers
department store for more than ten years, and she has never experienced any problems in
collecting payment for the merchandise sold. Currently, Russ Brothers owes Kim’s Clothes
$65,000 for spring sportswear that was delivered to the store just two weeks ago. Kim’s
concern was brought about by an article that appeared in yesterday’s Wall Street Journal
that indicated that Russ Brothers was having serious financial problems. Further, the
article stated that Russ Brothers’ management was considering filing for reorganization, or
even liquidation, with a federal bankruptcy court.
Kim’s immediate concern was whether or not her firm would collect its receivables if
Russ Brothers went bankrupt. In pondering the situation, Kim also realized that she knew
nothing about the process that firms go through when they encounter severe financial
distress. To learn more about bankruptcy, reorganization, and liquidation, Kim asked Ron
Mitchell, the firm’s chief financial officer, to prepare a briefing on the subject for the entire
board of directors. In turn, Ron asked you, a newly hired financial analyst, to do the
groundwork for the briefing by answering the following questions:
a. 1. What are the major causes of business failure?
a. 2. Do business failures occur evenly over time?
a. 3. Which size of firm, large or small, is more prone to business failure? Why?
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b. What key issues must managers face in the financial distress process?
Answer: As a manager begins to face financial distress, he or she must begin to consider the
following key issues:
Is this a temporary cash flow problem (technical insolvency), or is it a permanent
problem caused by asset values having fallen below debt obligations (insolvency
in bankruptcy)?
Who should control the firm during liquidation or reorganization?
c. What informal remedies are available to firms in financial distress? In
answering this question, define the following terms: (1) workout, (2)
restructuring, (3) extension, (4) composition, (5) assignment, and (6) assignee
(trustee).
Answer: When faced with financial distress, it is often desirable for firms to pursue informal
reorganizations or liquidations with creditors, given the costs associated with legal
bankruptcy. Creditors generally prefer informal reorganization plans when dealing
with economically sound companies whose financial difficulties appear to be
temporary. These voluntary informal plans, commonly called workouts, tend to
involve some type of restructuring, where current debt terms are revised to facilitate
a desirable alternative if bankruptcy becomes a real possibility, since composition can
help the creditor and debtor avoid the many costs associated with legal bankruptcy.
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website, in whole or in part.
Informal liquidations can also be used if it is decided that the firm is worth more
by selling it off in pieces. Assignment is an informal procedure for liquidating a firm.
It calls for title to the debtor’s assets to be transferred to a third party, known as the
assignee or trustee. The assignee is required to liquidate the firm’s assets either
through a private sale or a public auction, and then to distribute the proceeds among
the firm’s creditors on a pro rata basis.
d. Briefly describe U.S. Bankruptcy Law, including the following terms:
(1) chapter 11, (2) chapter 7, (3) trustee, (4) voluntary bankruptcy, and (5)
consists of eight chapters, the most important of which are Chapter 7, which details
the procedures to be followed when liquidating a company, and Chapter 11, the
business reorganization chapter. When a petition for bankruptcy is filed in federal
court, the petition can be either voluntary or involuntary. A voluntary petition is filed
by the distressed firm’s management; an involuntary petition is filed by its creditors.
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e. What are the major differences between an informal reorganization and
reorganization in bankruptcy? In answering this question, be sure to discuss the
following items: (1) common pool problem, (2) holdout problem, (3) automatic
stay, (4) cramdown, and (5) fraudulent conveyance.
Answer: There are many differences between voluntary reorganizations and reorganizations in
bankruptcy. Voluntary reorganizations are far less costly and relatively simple to
create as compared to reorganizations in bankruptcy. As a result, voluntary
reorganizations typically allow creditors to recover more money, and sooner, than
they would under legal bankruptcy. However, reorganizations in bankruptcy have
their advantages. First, they avoid holdout problems which can arise with voluntary
delayed without penalty until a reorganization plan is approved. Fourth, bankruptcy
permits the firm to issue debtor in possession (dip) financing to enhance the ability of
the firm to borrow funds for short-term liquidity purposes. Finally, bankruptcy gives
the debtor exclusive right to submit a proposed reorganization plan for agreement
from the parties affected.
In bankruptcy, it is much easier to gain acceptance of a reorganization plan,
because the bankruptcy court will lump the creditors into classes. Each class is
considered to have accepted a reorganization plan if a majority of the creditors in the
class (holding at least two-thirds of the amount of debt) vote for the plan, and the plan
will be approved by the court if it is deemed to be “fair and equitable” to the
website, in whole or in part.
f. What is a prepackaged bankruptcy? Why have prepackaged bankruptcies
become more popular in recent years?
favorable tax treatment.
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g. Briefly describe the priority of claims in a Chapter 7 liquidation.
Answer: Chapter 7 of the federal bankruptcy reform act provides for an equitable distribution
of the debtor’s assets among the creditors. The distribution of assets is governed by
the following priority of claims:
Secured creditors (who are entitled to the proceeds of the sale of specific property
pledged for a lien or a mortgage).
bankruptcy.
Claims for unpaid contributions to employee benefit plans that should have been
paid within six months prior to filing.
General, or unsecured, creditors.
Preferred stockholders.
Common stockholders.
website, in whole or in part.
h. Assume that Russ Brothers did indeed fail, and that it had the following balance
sheet when it was liquidated (in millions of dollars):
Current assets $40.0 Accounts payable $10.0
Net fixed assets 5.0 Notes payable (to banks) 5.0
Accrued wages 0.3
Federal taxes 0.5
State and local taxes 0.2
Current liabilities $16.0
First mortgage $ 3.0
Second mortgage 0.5
Subordinated debenturesa 4.0
Total long-term debt $ 7.5
Preferred stock 1.0
Common stock 13.0
Paid-in capital 2.0
Retained earnings 5.5
Total equity $21.5
Total assets $45.0 Total claims $45.0
Athe debentures are subordinated to the notes payable.
The liquidation sales resulted in the following proceeds:
From sale of current assets $14,000,000
From sale of fixed assets 2,500,000
Total receipts $16,500,000
For simplicity, assume that there were no trustee’s fees or any other claims
against the liquidation proceeds. Also, assume that the mortgage bonds are
secured by the entire amount of fixed assets. What would each claimant receive
from the liquidation distribution?
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2. Accrued wages 0.3
3. Taxes due to federal, state, and local governments 0.7
Distribution to General Creditors
Accts. Payable 10.0 6.500 6.500 65
Subord. Deben.2 4.0 2.600 0.850 21
Notes:
1. $13 million is available for distribution to general creditors; however, there is $20