Chapter 18 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.
Answer: Firms facing potentially financially devastating lawsuits from such items as asbestos or
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
voluntary settlement with creditors, or file for Chapter 11 bankruptcy. The firm may voluntarily
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
following the emergence from Chapter 11. However, over time a substantial percentage of these
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?
Answer: Declining net worth, liquidity, and financial returns are all factors affecting a firm’s cost
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?
Answer: The firm would have to be able to demonstrate that it was it was currently unable to pay
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 End of Chapter Case Study Questions
American Icon Survives Chapter 11 Filing
Discussion Questions and Solutions:
1. What is the purpose of a Chapter 11 bankruptcy filing?
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
2. What is the purpose of Chapter 7 of the US bankruptcy code?
3. What factors do you believe the federal judge considered in approving Edward Lampert’s takeover
of Sears?
4. Do you believe Edward Lampert abused the bankruptcy process? Explain your answer.
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
AIRBAG MANUFACTURER TAKATA
FILES FOR CHAPTER 11 BANKRUPTCY PROTECTION
CASE STUDY OBJECTIVES: To illustrate how Chapter 11
• Provides an opportunity for debtor firms to reorganize in an orderly fashion free of the burdens of
certain financial obligations,
• Can result in the planned liquidation of the debtor firm, and
• Can in some instances exacerbate a firm’s financial deterioration.
_______________________________________________________________________OOOCREDIT
: AP PHOTO/MATTHEW BROWN, FILESLUG
Bankruptcy protection allows debtor firms time to either reorganize into a viable firm for eventual exit
from bankruptcy or to undertake an orderly liquidation of the firm. When a workable reorganization plan is
not possible, liquidation usually follows within a comparatively short period of time. In the case of Takata,
the besieged Japanese airbag manufacturer, filing for bankruptcy could delay the eventual liquidation of the
firm by as much as five years. As with many bankruptcies, this filing was a long time in the making.
The firm was founded in 1933 by Takezo Takada. Its original products included textiles and parachute
lifelines. The firm entered the seatbelt business in 1966 and airbags in 1988. The firm’s first experience
with large scale recalls was in 1995 when 8.5 million Japanese built cars using Takata seatbelts were
recalled due to faulty belt buckles. This constituted the second largest recall in the history of the U.S.
Department of Transportation and led the U.S. National Highway Traffic and Safety Agency (NHTSA) to
levy fines of $50,000 against Honda and Takata. They were penalized for failing to notify the agency about
the seatbelt defect on a timely basis.
years of claiming that the problems with the airbags did not lie with their design, Takata admitted that its
products were defective prompting regulators to expand recalls by 35 million additional airbags. Faulty
inflators, when triggered sometimes exploded sending fragments throughout a vehicle‘s passenger
compartment, had contributed to at least 17 deaths and more than one hundred injuries globally. In January
2017, Takata agreed to pay $1 billion in penalties and pled guilty to charges of wire fraud in the U.S. for
providing false data to safety regulators. The penalties consisted of a $25 million fine, $125 million for
victim compensation, and $850 million to compensate auto makers.
Filing for bankruptcy means that the firm can suspend payment to creditors and prevents creditors from
liquidating the firm’s supplies of airbags and airbag components, including millions of replacement
inflators that still needed to be installed in cars subject to recall. As part of the agreement with KSS, Takata
will continue to produce replacement inflators to satisfy recall efforts so that KSS does not have to be
involved in the recall process and is absolved of any recall-related liability. A court appointed trustee will
manage the distribution of the proceeds of the sale to KSS to Takata creditors including banks and
automakers to reimburse them for replacing millions of potentially dangerous airbag inflators.
By some estimates, the cumulative cost of the recalls range from $5 billion to $10 billion and could take
as long as five years to complete. Takata also faces numerous lawsuits in the U.S., Canada, and other
countries. Given the size of the cost of the recall program, Takata shareholders and most of the creditors are
not likely to recover anything from the bankruptcy proceedings. Takata shares were delisted on the Tokyo
Stock exchange the day following the bankruptcy filing. Car makers are shifting to other suppliers for
inflators and integrating them into their supply chain by including them in new models. Efforts to get
Japanese firms to invest in Takata failed because of the difficulty in determining the size of the total future
cost of recalling and replacing airbags.
As of mid-2018, car makers have recalled more than 75 million of Takata airbags installed in almost 50
million vehicles globally. And the recall could increase. The major automakers that used Takata airbags in
their cars (Honda, Toyota and GM) are expected to pay for most of the estimated $5 billion that is needed
to replace the tens of millions of Takata airbag inflators still in vehicles around the world. With only about
one-third of affected cars so far having their inflators replaced, the process of making all U.S. vehicles safe
could last until 2023.
Takata’s situation illustrates an important limitation of bankruptcy. While bankruptcy offers the
potential for an orderly reorganization of a failing firm into one that can be viable in the future, it is only a
process for achieving an outcome and not itself a solution. In fact, bankruptcy can worsen a firm’s cash
flow problems. Having filed for bankruptcy in mid-2017, the firm almost immediately found vendors
wanting to be paid in cash before they would supply needed parts. This raises the question as to whether the
firm can generate sufficient cash to sustain production of airbag inflators until those in all affected cars
have been replaced. Moreover, key employees are likely to leave during bankruptcy further limiting the
ability of the firm to meet its commitments.
Will Takata remain viable long enough to support the recall of what seems to be an ever expanding
number of affected vehicles? In mid-July 2017, less than one month after filing for bankruptcy, Takata
added a new type of air bag inflator, previously thought to be safe, to the list of those that could fail. This
new revelation will add another 2.7 million vehicles to be recalled by Ford, Nissan, and Mazda. The extent
of the future cost of the recall and the inflator replacement continues to grow.
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.
Recalls of airbag inflators started on a small scale as early as 2008. The firm also engaged in
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
and sold containing potentially faulty airbag inflators and to replace the inflators. The cost of
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
priorities. Because of the nature of the bankruptcy, Takata’s replacement airbag inflator
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
SUNEDISON EXITS BANKRUPTCY AMID ECHOES OF ENRON
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
• Common shareholders usually wiped out in bankruptcy
On July 26, 2017, global renewable energy company SunEdison emerged from Chapter 11 bankruptcy,
fourteen months after filing on April 21, 2016. From the outset, some were saying the SunEdison
bankruptcy was reminiscent of Enron in 2001, the largest bankruptcy at the time in U.S. history.
One month after SunEdison’s filing, its unsecured creditors initiated a lawsuit accusing the firm of
understating the financing package to fund the business during bankruptcy. The lawsuit stated the
following: “The debtors share a large, opaque capital structure, with complex intercompany relationships
and cash flows, poor accounting, poor controls, and allegedly fraudulent conduct at the highest levels—
characteristics that have led many commentators to draw parallels with the Enron Corporation chapter 11
case…In both cases, in a matter of months, markets and the public watched as billions of dollars vanished
into thin air.”
Both SunEdison and Enron could be described as “asset-lite” companies. Both companies operated by
pushing their assets (and associated liabilities) off the corporate books: Enron by shifting assets into
partially nonconsolidated subsidiaries and SunEdison by spinning off so-called “yield companies” or “yield
cos.”
TerrraForm Power Inc. and TerraForm Global Inc. To sustain its growth, SunEdison went on a spending
spree, purchasing billions of dollars in renewable projects in Europe, Asia, Africa,
Latin America, and North America. It also expanded through acquisition beyond solar to wind, hydro, and
storage facilities.
TerraForm Power was the first of SunEdison’s yield cos to go public in July 2014. Investors snapped up
the shares in the low interest rate environment of the period driving the firm’s share price up by 21% by the
end of the year. But as SunEdison’s growth accelerated so did its debt, which totalled $16.1 billion by
September 2015. To keep cash dividends paid to investors high, the yield cos had to continually acquire
projects which drove up valuations of renewable companies.
In mid-2015, SunEdison’s market value exceeded $10 billion with its shares trading at all-time highs.
However, its bone crushing debt made it increasingly difficult for the firm to service its debt, forcing it to
seek protection from its creditors by filing for bankruptcy in April 2016. The once Wall Street darling’s
stock plummeted from its mid-2015 high of $33.44 per share to $.34 per share on the day of the bankruptcy
filing announcement.
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.
agreements in place to provide dividends to investors. Yield cos include a number of projects producing
stable cash flow which lowers risk versus a single project. Once formed these yield cos are spun off in an
IPO into a separately publicly traded company. The parent is thus able to raise capital from the project
immediately and to reinvest the proceeds in new projects.
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.
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.
Accelerating the process can often increase the likelihood of saving a financially beleaguered firm. This
is where a “prepackaged” bankruptcy can be helpful as the debtor gets a consensus among its major
creditors to restructure outstanding debt before filing for Chapter 11. Prepackaged bankruptcies can shave
nine months or more off the length of time the firm remains in bankruptcy, saving tens of millions of
dollars in bankruptcy related expenses.
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
Western European countries and the U.S. and Canada, peaked about 2008 and has been flat to declining in
these countries since then. Even though the demand for coal is expected to increase at less than half of its
historical 2.4% compound annual average growth rate during the last 25 years, it is projected to still
account for more than 30% of global electricity output by 2040. Why? Because India and Asian Pacific
countries have hundreds of new coal fired electrical power generating plants under construction or on the
drawing boards to bring electricity to millions in these countries that do not currently have power. The
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
and gas power. Finally, prices of metallurgical coal remained depressed throughout 2016 amid the
slowdown in China’s economic growth. Despite these developments, the U.S. Environmental Protection
Agency predicts U.S. coal production will decline to 685 million tons in 2016 increasing to about 800
million tons in 2050, comprising about 30% of U.S. electricity output down from about 50% in 2008.
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
Alpha Natural Resources Inc., Patriot Coal Corp. and Walter Energy Inc. This has spurred asset sales and
consolidations as well as widespread employment and wage reductions at these firms and other coal
companies. States most directly impacted by these events include the five largest coal producing states in
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.
In the filing, Arch’s proposal offers senior lenders a combination of cash, new senior debt and most of
the reorganized company’s stock in a debt for equity swap. Junior creditors could choose between a
minority equity interest and the proceeds of assets that had not been pledged as collateral for senior loans if
Following a flurry of acquisitions, Arch’s share price had declined since 2011. Much of its current debt
load is attributable to its 2011 acquisition of International Coal Corporation. Those acquisitions were based
on the presumption that the coal industry would see rapid overseas growth in the coming years, which has
yet to materialize as the global economy continues its anaemic growth. In early 2011, the firm’s share price
peaked at $260 per share. On January 11, 2016, its stock traded at less than a dollar.
At the time of filing, Arch Coal had $600 million in cash and short term investments, and had negotiated
$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
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
threatens the financial feasibility of the project.
Land reclamation may be another casualty of bankruptcy. Federal law requires coal companies to
guarantee that, in the event that the company goes bankrupt, mines will be cleaned up. The law requires so
called “reclamation bonds” before any mining permit is granted. But Arch has not put in escrow any funds
by the firm’s inability to pay interest and principal payments on debt incurred in the firm’s recent
acquisitions.
creditors in the bankruptcy process. Thus, there is the danger the state will receive only a fraction of the
total reclamation cost if the firm is liquidated and the proceeds distributed.
With over ninety square miles of coal mines in Wyoming’s Powder River Basin, Arch has a $458
million reclamation liability. The firm’s court filing listed $5.8 billion in assets and $6.5 billion in debt
making it unlikely that liquidation of assets would be sufficient to cover reclamation expenses after the
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.
Answer: Lending to a reorganized firm often is relatively low risk because the old firm’s debts
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;
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
bankruptcy discussed earlier in case study constitutes a blend of the second and third options. The
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