Chapter 30 Financial Distress 853CHAPTER 308531This definition is close to the one used by Karen Wruck, “Financial Distress: Reorganization and Organization Efficiency,” Journal of Financial Economics 27 (1990), p. 425.30.1 What Is Financial Distress?Financial distress is surprisingly hard to define precisely. This is true partly because of the variety of events befalling firms under financial distress. The list of events is almost endless, but here are some examples:Dividend reductions Plant closings Losses Layoffs CEO resignations Plummeting stock pricesFinancial distress is a situation where a firms operating cash flows are not sufficient to satisfy current obligations (such as trade credits or interest expenses) and the firm is forced to take corrective action.1 Financial distress may lead a firm to default on a contract, and it may In 2006, financial problems at General Motors and Ford were much in the news. Both automakers were saddled with large debt loads and legacy costs such as retiree health care benefits. In early 2006, Ford received more bad news when its debt was downgraded by Standard lack of means of paying ones debts. Such a condition of a womans (or mans) assets and liability that the former made immediately available would be insufficient to discharge the latter.Table 30.1 The Largest U.S. BankruptciesLiabilities Firm (in $ millions) Bankruptcy Date1 Conseco Inc. $56,639.30 December 2, 20022 WorldCom Inc. 45,984.00 July 2, 20023 Enron Corp. 31,237.00 December 2, 20014 Delta Air Lines 28,546.00 September 14, 20055 Pacific Gas it involves selling the assets of the firm for salvage value. The proceeds, net of transactions costs, are distributed to creditors in order of established priority.5However, only less than 20 percent of all firms (public or private) going through a Chapter 11 bankruptcy are successfully reorganized.ros05902_ch30.indd 856ros05902_ch30.indd 8569/26/06 3:30:31 PM9/26/06 3:30:31 PMChapter 30 Financial Distress 857Reorganization is the option of keeping the firm a going concern; it sometimes in- volves issuing new securities to replace old securities.Liquidation and formal reorganization may be done by bankruptcy. Bankruptcy is a legal proceeding and can be done voluntarily with the corporation filing the petition or involuntarily with the creditors filing the petition.Bankruptcy Liquidation Chapter 7 of the Bankruptcy Reform Act of 1978 deals with “straight” liquidation. The following sequence of events is typical:1. A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation.2. A bankruptcy trustee is elected by the creditors to take over the assets of the debtor corporation. The trustee will attempt to liquidate the assets.3. When the assets are liquidated, after payment of the costs of administration, proceeds are distributed among the creditors.4. If any assets remain, after expenses and payments to creditors, they are distributed to the shareholders.Conditions Leading to Involuntary Bankruptcy An involuntary bankruptcy petition may be filed by creditors if both the following conditions are met:1. The corporation is not paying debts as they become due.2. If there are more than 12 creditors, at least three with claims totaling $5,000 or more must join in the filing. If there are fewer than 12 creditors, then only one with a claim of $5,000 is required to file.No financialf f restructuringFinancial distressPrivate workoutFinancial restructuringReorganize and emergeLegal bankruptcy Chapter 11Merge with another firmf fLiquidation49%47%83%7%10%1%Figure 30.2What Happens in Financial DistressSOURCE: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics 27 (1990), Figure 2. See also Stuart C. Gilson, Kose John, and Larry N. P. Lang, “Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Defaults,” Journal of Financial Economics 27 (1990); and Lawrence A. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics 27 (1990).ros05902_ch30.indd 857ros05902_ch30.indd 8579/26/06 3:30:32 PM9/26/06 3:30:32 PM858 Part VIII Special TopicsPriority of Claims Once a corporation is determined to be bankrupt, liquidation takes place. The distribution of the proceeds of the liquidation occurs according to the following priority:1. Administration expenses associated with liquidating the bankrupts assets.2. Unsecured claims arising after the filing of an involuntary bankruptcy petition.3. Wages, salaries, and commissions.4. Contributions to employee benefit plans arising within 180 days before the filing date.5. Consumer claims.6. Tax claims.In Their Own WordsEDWARD I. ALTMAN* ON CORPORATE FINANCIAL DISTRESS AND BANKRUPTCYAs we entered the new millennium, corporate distress and bankruptcy were no longer a niche