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?
Answer: Such hedge funds provide liquidity for those creditors uncertain about how much they
might recover if they wait until the final reorganization plan is approved. Often junior creditors are
concerned that they will not recover anything in the event the debtor firm is eventually liquidated.
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.
______________________________________________________________________________________
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
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
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.
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?
Answer: Factors such as escalating fuel prices, the lasting effects of terrorist’s attacks on security,
and fluctuations in the economy are largely beyond the control of airline management. However,
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
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. 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.
Answer: While it is clear that many employees suffer job losses and salary and benefit reductions
as a result of the bankruptcy process, these costs must be weighed against the benefits of
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
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
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
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
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
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
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
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
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
4 Lattman and de la Merced, 2010
Discussion Questions
1. Do you agree or disagree that the taxpayer financed bankruptcy represented the best way to save
jobs. Explain your answer.
Answer: As many as 54,000 jobs may be lost in order to restore the new GM to prosperity. It
is unclear at this point if the government will recover much of its investment and loans to the
firm. If the firm had been liquidated, others would have acquired GM brands as they did with
Hummer, Saturn, and Opel. Consequently, jobs associated with the GM brands would have
transferred to the new buyers and not have been lost. Furthermore, concern about job losses at
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.
Answers: A Chapter 11 plan of reorganization offers substantially more time to develop a
viable plan for enabling the debtor firm to emerge from bankruptcy and one which treats the
Consolidat
ed GM
U.S. &
Canadian
Operations
Attractive
Assets
“New GM”
U.S. &
Canadian
Operations
Consolidat
ed GM
Pre-Bankruptcy Bankruptcy Post-Bankruptcy
Figure 16.2 General Motors Bankruptcy
3. Identify what you believe to be the real benefits and costs of the bailout of General Motors?
Be specific.
Answer: The benefits appear to be the preservation of jobs and income at a time when the
economy was suffering from a severe recession. It is impossible to know how many jobs
would have been lost at GM and its suppliers had the firm undertaken a more conventional
The real cost of the bailout depends on if and when the government recovers the remaining
$36.4 billion of its investment owed at the end of 2010. To that figure, we should add the
probable $15.75 billion in lost tax payments and the cumulative tax credits paid to Chevrolet
Volt buyers. Less tangible costs include the contravention of the bankruptcy reorganization
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.
Answer: The major advantages of seeking Chapter 11 protection earlier in 2009 would have
been the immediate improvement in GM’s operating cash flow as it would have been able to
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.
Answer: The range of options no doubt included the renegotiation of labor contracts to
reduce GM’s labor cost disparity with its major competitors and the transfer of so-called
legacy costs including retiree healthcare and pension obligations to the UAW managed trust.
crushing debt load until the units could have been sold. The proceeds could have been used
to repay the government debt.
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
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
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
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
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.
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
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.
Answer: Without bankruptcy providing an opportunity for concessions from various stakeholders, the
firm may have been subject to liquidation. The resulting asset sale could have been far more disruptive
2 Why did Centerbridge receive convertible preferred rather than common stock?
Answer: Preferred stock has priority over common in liquidation and gave Centerbridge a senior
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
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
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
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
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.
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,
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.
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
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
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?
Answer: The major contributing to the debacle include blind ambition, greed, and arrogance.
Enron grew aggressively beyond its original gas pipeline business into a series on trading and risk
management businesses in an effort to transfer tangible assets off the balance sheet to transform
the firm from an “asset rich” to an “asset light” firm. The strategy was hailed by Enron’s
2. In what way was the Enron debacle a break down in corporate governance (oversight)? Explain
your answer.
Answer: Those charged with protecting shareholder interests, including board members, external
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?
Answer: The mechanism involved creating a series of partnerships that would buy the assets (e.g.,
power generating companies) and then sell their output through Enron’s trading operations.
Enron’s stock was often used as collateral to enable the partnerships to borrow to purchase
4. What should (or can) be done to reduce the likelihood of this type of situation arising in the
future? Be specific.
Answer: Raise the cost of non-compliance with laws and regulations. This has been partly
achieved through the passage of the Sarbanes-Oxley bill in 2002 in which gross negligence or
fraud can be subject to criminal as well as civil penalties. Other reforms include increasing the
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
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:
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.
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
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
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.
Answer: Regulators exacerbated the situation.. By not allowing the utilities to raise retail
electricity prices to pass along the increasing cost of deregulated wholesale power, the regulators
2. PG&E pursued bankruptcy protection, while Southern California Edison did not. What could
PG&E have been done differently to avoid bankruptcy?
Answer: PG&E could have sought to be acquired by another firm or to reach some