Corporate Financial Distress, Restructuring, and Bankruptcy: Analyze Leveraged Finance, Distressed Debt, and Bankruptcy

About the Authors

Edward Altman is the Max L. Heine Professor of Finance Emeritus at New York University, Stern School of Business, and Director of the Credit and Fixed Income Research Program at the NYU Salomon Center.

Dr. Altman has an international reputation as an expert on corporate bankruptcy, high‐yield bonds, distressed debt, and credit risk analysis. He is the creator of the world‐famous Altman Z‐Score models for bankruptcy prediction of firms globally. He was named Laureate 1984 by the Hautes Études Commerciales Foundation in Paris for his accumulated works on corporate distress prediction models and procedures for firm financial rehabilitation and awarded the Graham & Dodd Scroll for 1985 by the Financial Analysts Federation for his work on Default Rates and High Yield Corporate Debt. He was a Founding Executive Editor of the Journal of Banking & Finance and serves on the editorial boards of several other scholarly finance journals.

Professor Altman was inducted into the Fixed Income Analysts Society Hall of Fame in 2001 and elected President of the Financial Management Association (2003) and a Fellow of the FMA in 2004, and was among the inaugural inductees into the Turnaround Management Association's Hall of Fame in 2008.

In 2005, Dr. Altman was named one of the 100 Most Influential People in Finance by Treasury & Risk Management magazine and is frequently quoted in the popular press and on network TV.

Dr. Altman has been an advisor to many financial institutions including Merrill Lynch, Salomon Brothers, Citigroup, Concordia Advisors, Investcorp, Paulson & Co., S&P Global Market Intelligence and the RiskMetrics Group (MSCI, Inc.). He is currently (2018) Advisor to Golub Capital, Classis Capital (Italy), Wiserfunding in London, Clearing Bid, Inc., S‐Cube Capital (Singapore), ESG Portfolio Management (Frankfurt) and AlphaFixe (Montreal). He serves on the Board of Franklin Mutual Series and Alternative Investments Funds. He is also Chairman of the Academic Advisory Council of the Turnaround Management Association. Dr. Altman was a Founding Trustee of the Museum of American Finance and was Chairman of the Board of the International Schools Orchestras of New York.

Edith S. Hotchkiss is a Professor of Finance at the Carroll School of Management at Boston College, where she teaches courses in corporate finance, valuation, and restructuring. She received her AB in engineering and economics summa cum laude from Dartmouth College and her PhD in finance from NYU's Stern School of Business. Prior to entering academics, she worked in consulting and for the Financial Institutions Group of Standard & Poor's Corporation.

Professor Hotchkiss's research covers topics including: corporate financial distress and restructuring; the efficiency of Chapter 11 bankruptcy; and trading in corporate debt markets. Her work has been published in leading finance journals including the Journal of Finance, Journal of Financial Economics, and Review of Financial Studies. She has served on the national board of the Turnaround Management Association, and as a consultant to FINRA on fixed income markets. She has also served as a consultant for several recent Chapter 11 cases.

Wei Wang is an Associate Professor and RBC Fellow of Finance and Director of Master of Finance–Beijing program at the Smith School of Business at Queen's University, Canada. His research interests are in bankruptcy restructuring, distressed investing, and corporate governance. His work has been published in leading academic journals including the Journal of Finance and Journal of Financial Economics, and featured in the Wall Street Journal and other media. He has published a number of Harvard Business School finance cases. He worked in commodities derivative trading and financial engineering prior to entering academics.

Dr. Wang has taught corporate restructuring and distressed investing at the Wharton School's undergraduate, MBA, and EMBA programs as a visiting professor. He is in active collaboration with the Aresty Institute for Executive Education at the Wharton School to deliver lectures and workshops on bankruptcy restructuring, leveraged loans, and distressed M&A to banking executives. Dr. Wang has also taught corporate restructuring and fixed income securities with an Asian market perspective at Hong Kong University of Science and Technology Business School. He is retained as a foreign expert at the Mingde Center for Corporate Acquisition and Restructuring Research at Shanghai University of Finance and Economics in China.

Acknowledgments

We would like to acknowledge an impressive group of practitioners and academics who have assisted us in the researching and writing of this book. We are enormously grateful to all of these persons for helping us to shape our analysis and commentary in our writings and in our classes at the New York University Stern School of Business, Boston College, Queens University Smith School of Business, and the Wharton School.

Among the many practitioners who have helped out over the many years in the writing of this volume, Ed Altman would like to single out Robert Benhenni, Allan Brown, Martin Fridson, Michael Gordy, Tony Kao, Stuart Kovensky, and James Peck. Edie Hotchkiss and Wei Wang further thank Brian Benvenisty, Michael Epstein, Elliot Ganz, Joseph Guzinski, David Keisman, Bridget Marsh, Abid Qureshi, Ted Osborn, and Robert Stark for the many hours of conversations and comments on our work.

We also would like to sincerely thank the many academic colleagues who helped to enrich the content of this book. Our academic colleagues include Yakov Amihud, Alessandro Danovi, Sanjiv Das, Jarred Elias, Malgorzata Iwanicz‐Drozdowski, Erkki Laitinen, Frederik Lundtote, Herbert Rijken, and Arto Suvas. Ed would also like to sincerely acknowledge the great assistance of the staff at the NYU Salomon Center, including Brenda Kuehne, Mary Jaffier, Robyn Vanterpool and last, but not least, Lourdes Tanglao.

To his family, especially his wife Elaine and son Gregory, Professor Altman has only sincere words of gratitude for their endless support. To his colleagues and co authors Edith Hotchkiss and Wei Wang, for their amazing collegiality and great efforts in making this volume a reality. Edie Hotchkiss would like to thank Ed for first introducing her to this field as her PhD dissertation adviser, and for his guidance and friendship through many years of research in this area. Wei Wang sincerely thanks Ed and Edie for inviting him to work on this volume. He would also like to thank his students at both the Smith School of Business and the Wharton School, including Aneesh Chona and Xiaobing Ma, for spending many hours reading the manuscript and providing valuable feedback.

Preface

In looking back over the first three editions of Corporate Financial Distress and Bankruptcy (1983, 1993, 2006), we note that with each publication, the incidence and importance of corporate bankruptcy in the United States had risen to ever more prominence. The number of professionals dealing with the uniqueness of corporate death in this country was increasing so much that it could have perhaps been called a bankruptcy industry. There is absolutely no question in 2019 that we can now call it an industry. The field has become even more significant in the past 15 years, accompanied by an increase of academics specializing in the area of corporate financial distress. Indeed, there is nothing more important in attracting rigorous and thoughtful research than data! With this increased theoretical and especially empirical interest, Wei Wang, has joined the original author (Altman) of the first three editions and Edith Hotchkiss (from the third edition) to produce this volume.

It is now quite obvious that the bankruptcy business is big‐business. While no one has done an extensive analysis of the number of people who deal with corporate distress on a regular basis, we would venture a guess that it is at least 45,000 globally, with the vast majority in the United States but a growing number abroad. We include turnaround managers (mostly consultants); bankruptcy and restructuring lawyers; bankruptcy judges and other court personnel; accountants, bankers, and other financial advisers who specialize in working with distressed debtors; distressed debt investors, sometimes referred to as vultures; and, of course, researchers. Indeed, the prestigious Turnaround Management Association (www.tumaround.org) total members numbered more than 9,000 in 2018.

The reason for the large number of professionals working with organizations in various stages of financial distress is the increasing number of large and complex bankruptcy cases. Despite the fact that the United States has been in a benign credit cycle since 2010, during the six‐year period of 2012–2018, 130 companies with liabilities greater than $1 billion filed for protection under Chapter 11 of the Bankruptcy Code. Over the past 47 years (1971–2018), there have been at least 450 of these large, mega‐bankruptcies in the United States. Just before finishing our first draft of this book, one of the nation's largest retailers, Sears, Roebuck and Company, filed for Chapter 11 with over $11 billion of liabilities! And the number of mega‐bankruptcies, as well as the total of all filings, will spike dramatically when the next financial crisis hits, especially due to the enormous build‐up of corporate debt in recent years.

This book is a completely updated volume that includes updated key statistics and surveys the most recent academic studies. Newly added chapters include those on leveraged finance, out‐of‐court restructurings, and international insolvency codes, as well as a review of the Altman Z‐Score family of models and their applications to celebrate the 50th birthday of the original Z‐Score model. The 16 chapters in this new edition cover the most important aspects of leveraged finance, high‐yield markets, corporate restructuring, bankruptcy, and credit risk modeling.

Starting with Chapter 1, we define corporate distress and present the statistical background for corporate defaults and bankruptcies over the past few decades. The chapter also discusses the common reasons for corporate failures and presents the organization theory that guides practice. In addition, the chapter introduces the key industry players in distressed restructuring and investing.

The leveraged finance market experienced an unprecedented boom in the past two decades, the total issuance of leveraged loans and high yield bonds reaching close to $1 trillion in 2017. The markets have been quite creative at producing new financial instruments (e.g. second‐lien, covenant‐lite) as the markets have grown. These instruments are attractive to not only traditional commercial lenders but also alternative investors due to their high yield and high fee structure. Chapter 2 provides an overview of the two major categories of debt instruments in this space and discusses typical features of these instruments, lender protections, default and remedies, as well as debt subordination issues. This material is particularly necessary to understanding the priority of debt claims and their relative bargaining position in distressed restructuring.

Chapter 3 provides an overview of the U.S. bankruptcy system. We begin by briefly illustrating the evolution of the U.S. bankruptcy law since the equity receiverships of 1898. We provide a primer on Chapter 11 by introducing the key provisions of the U.S. Bankruptcy Code after the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Our summary and interpretation of important sections of the Code is written to be accessible to students and practitioners in finance as well as a legal audience. We review the many relevant academic studies, and also provide examples from recent cases to help readers gain an in‐depth understanding of the bankruptcy process. The conclusion to this chapter summarizes the ABI Commission Report of 2014 advocating revisions to the existing code.

Firms suffer large costs of financial distress, and bankruptcy restructuring can be even costlier. These costs include not only direct costs such as out‐of‐pocket expenses for lawyers and finance professionals, but also a wide range of opportunity costs known as indirect costs. Firms generally have strong incentives to avoid these costs by conducting private negotiations and restructuring out‐of‐court. When and how can firms successfully restructuring out of court? Why do others restructure in court? Chapter 4 attempts to answer these questions.

Chapter 5 explores the analytics and process for distressed firm valuation. We provide a careful discussion of valuation models, and consider why we observe wide disagreements over firm value between different stakeholders in the negotiation process. We describe in depth best practices in valuation methods, using the example of Cumulus Media which filed for Chapter 11 in November 2017.

Virtually every aspect of a firm's governance can change in some way when a firm becomes financially distressed. Management turnover increases, board size declines, and boards often change in their entirety at reorganization. A substantial number of restructurings lead to a change in control of the company. Chapter 6 discusses key corporate governance issues for distressed firms, including fiduciary duties of managers and boards, complexities in providing compensation, and the value of creditor control rights. We wrap up the chapter by discussing managerial labor markets and labor issues.

In Chapter 7, we explore the success of the bankruptcy reorganization process, especially with respect to the postbankruptcy performance of firms emerging from Chapter 11. In numerous instances, emerging firms suffer from continued operating and financial problems, sometimes resulting in a second filing, unofficially called a Chapter 22. Indeed, we are aware of at least 290 of these two‐time filers over the period 1984‐2017 (see Chapter 1), and 18 three‐time filers (Chapter 33s). There are even three Chapter 44s and at least one Chapter 55! Despite the numbers of bankruptcy repeaters, there are also some spectacular success stories upon emergence from bankruptcy, at least from the perspective of equity holders in the reorganized company.

Chapter 8 provides a brief summary on international insolvency regimes, paying particular attention to countries including France, Germany, Japan, Sweden, UK, China, and India. We focus on these representative countries because of the distinct nature in their legal procedures, significant growth in their restructuring industry in recent years, and the availability of related empirical academic research. Our brief discussions for these countries highlight the most important features of their legal systems for restructuring as well as ongoing issues and reforms.

The second part of the book provides comprehensive coverage of high yield bond markets, default prediction models and their applications, and distressed investing. We explore in depth the estimation of default probabilities for issuers in the United States (Chapter 10) and for sovereign issuers (Chapter 13) and the loss given default or recovery rates (Chapter 16). Chapters 11 and 12 demonstrate applications of these models for many different scenarios, including credit risk management, distressed debt investing, turnaround management and other advisory capacities, and legal issues. Chapters 14 and 15 go on to examine the size and development of the distressed and defaulted debt market.

Chapter 9 explores risk‐return aspects of the U.S. high‐yield bond and bank loan markets, most important to highly levered and distressed firms. Since high‐yield or junk bonds are the raw material for future possible distress situations, it is important to investigate their properties. Among the most relevant statistics to investors in this market are default rates, as well as recovery rates for firms that default. The U.S. high‐yield corporate bond market reached more than $1.6 trillion outstanding in 2017, a 60% increase since the year of publication of the previous edition of this book. Globally, the high‐yield bond market reached approximately $2.5 trillion.

It has been 50 years since the seminal work by Professor Altman developing the first family of default prediction models. With advancements in financial research such as the Black‐Scholes‐Merton framework, we have gained substantially greater understanding of methods for predicting and pricing default risk. Yet the Altman Z‐score remains one of the most popular models in this domain, due to not only its high predictive power but also its simplicity. In Chapter 10, Professor Altman provides a 50‐year retrospective on the evaluation and applications of the Z‐score family of models and other credit risk models. The three chapters that follow present applications of the Z‐score models. Chapter 11 focuses on applications performed by analysts who are external to the distressed firm in order to improve their position or to exploit profitable opportunities presented by distressed firms and their securities. With respect to the turnaround management arena, Chapter 12 further explores the possibility of using distressed firm predictive models to assist in the management of the distressed firm itself in order to manage a return to financial health. We illustrate this via an actual case study ‐ the GTI Corporation ‐and its rise from near extinction. Finally, in Chapter 13, we apply our updated distress prediction model, called Z‐Metrics, in a bottom‐up analysis of the default assessment of sovereign debt.

The distressed and defaulted debt market has grown tremendously over the past two decades. As of 2017, the publically traded and private issued market was about $747 billion (face value) and $414 billion (market value). This substantial market is poised to grow considerably when the next credit crisis hits. Debt market investors, particularly hedge funds, recognize distressed debt as an important and unique asset class. In Chapters 14 and 15, we explore the size, growth, risk‐reward dimensions, and investment strategies in distressed debt. Last, in Chapter 16, we provide a comprehensive survey of studies devoted to modeling and estimating debt recovery rates.

As the restructuring industry and the high yield and distressed markets continue to evolve, we hope readers will find this book a valuable reference to understanding the state of the market and prepare for the next downturn. We hope that the framework, methodologies, research findings, and statistics we present will be useful to practitioners who seek a deep understanding of the practice and the state‐of‐the‐art academic research, academic researchers who continue to explore and create knowledge to guide restructuring practices, policy makers who pay close attention to the design of bankruptcy law and market regulation, and students who aspire to learn about exciting opportunities in the world of distress!

Edward I. Altman

Edith Hotchkiss

Wei Wang

PART One

The Economic and Legal Framework of Corporate Restructuring and Bankruptcy

CHAPTER 1

Corporate Financial Distress: Introduction and Statistical Background

Corporate financial distress, and the legal processes of corporate bankruptcy reorganization (Chapter 11 of the Bankruptcy Code) and liquidation (Chapter 7 of the Bankruptcy Code), has become a familiar economic reality to many U.S. corporations. The business failure phenomenon received some exposure during the 1970s, more during the recession years of 1980–1982 and 1989–1991, heightened attention during the explosion of defaults and large firm bankruptcies in the 2001–2003 post‐dotcom period, and unprecedented interest in the 2008–2009 financial and economic crisis period. Between 1989 and 1991, 34 corporations with liabilities greater than $1 billion filed for protection under Chapter 11 of the Bankruptcy Code; in the three‐year period from 2001 to 2003, 102 of these billion‐dollar‐babies with liabilities totaling $580 billion filed for bankruptcy protection; and from 2008 to 2009, 74 such companies filed for bankruptcy with an unprecedented amount of liabilities totaling over $1.2 trillion.

The line‐up of major corporate bankruptcies was capped by the mammoth filings of Lehman Brothers ($613 billion in liabilities), General Motors ($173 billion in liabilities), CIT Group ($65 billion in liabilities), and Chrysler ($55 billion in liabilities) during the 2008–2009 financial crisis. In fact, the total amount of liabilities of these four mega cases accounted for 75% of the liabilities of all billion‐dollar firms filing for bankruptcy from 2008 to 2009. Three other mega cases from the 2001–2003 period also make the list of the top 10 largest filings, including Conseco ($56.6 billion in liabilities), WorldCom ($46.0 billion) and Enron ($31.2 billion—or, almost double this amount if one adds in Enron's enormous off‐balance liabilities, making it the fourth largest bankruptcy in the United States). We note that it is most relevant to discuss the size of bankruptcies in terms of liabilities at filing rather than assets. For example, WorldCom had approximately $104 billion in book value of assets, but its market value at the time of filing was probably less than one fifth of that number. General Motors had $91 billion in book value of assets, but liabilities amounting to $172 billion. It is the claims against the bankruptcy estate, as well as the going‐concern value of the assets, that are most relevant in a bankrupt company. Firm size is no longer a proxy for corporate health and safety. Figure 1.1 shows the number of Chapter 11 filings and prepetition liabilities of firms with at least $100 million in liabilities from 1989 to 2017 (the mega cases). Figure 1.2 lists the top 40 largest bankruptcy filings of all time by the total amount of liabilities. Figure 1.3 lists the top 40 largest bankruptcy filings of all time by Consumer Price Index adjusted total amount of liabilities (in constant 2017 dollars).

FIGURE 1.1 Chapter 11 Filing Statistics (1989–2017)

Source: Altman and Kuehne (2018b) and Salomon Center.

FIGURE 1.2 List of 40 Largest Bankruptcy Filings of All Time

FIGURE 1.3 List of 40 Largest Bankruptcy Filings of All Time in 2017 Dollars

A variety of terms are used in practice to depict the condition and formal process confronting the distressed firm and characterize the economic problem involved. Four generic terms commonly found in the literature are failure, insolvency, default, and bankruptcy. Although these terms are sometimes used interchangeably, they are distinctly different in their meanings and formal usage.

Failure, in an economic sense, means that the realized rate of return on invested capital, with allowances for risk consideration, is significantly lower than prevailing rates on similar investments. Somewhat different economic criteria have also been used, including insufficient revenues to cover costs, or an average return on investment that is continually below the firm's cost of capital. These definitions make no statement about whether to discontinue operations. The term business failure was adopted by Dun & Bradstreet (D&B), which for many years provided statistics on various business conditions, including exits. D&B defined business failures to include businesses that cease operation following assignment or bankruptcy; those that cease with loss to creditors after such actions or execution, foreclosure, or attachment; those that voluntarily withdraw, leaving unpaid obligations, or those that have been involved in court actions such as receivership, bankruptcy reorganization, or arrangement; and those that voluntarily compromise with creditors.

Insolvency is another term depicting negative firm performance and is generally used in a more technical fashion. Technical insolvency exists when a firm is unable to meet its debts as they come due. This may, however, be a symptom of a cash flow or liquidity shortfall, which may be viewed as a temporary, rather than a chronic, condition. Balance sheet insolvency is especially critical and refers to when total liabilities exceed a fair valuation of total assets. The real net worth of the firm is, therefore, negative. This condition has implications for how and whether the firm will restructure, and requires a comprehensive analysis of both a going concern and liquidation value. In some countries (but not the United States), a determination of insolvency may be needed for a court to commence formal bankruptcy proceedings.

Default refers to a borrower violating an agreement with a creditor, as specified in the contract with the lender. Technical defaults take place when the firm violates a provision other than a scheduled payment, for example, by violating a covenant such as maintaining a specified minimum current ratio or maximum debt ratio. Violating a loan covenant frequently leads to renegotiation rather than immediate demand for repayment of the loan, and typically signals deteriorating firm performance. When a firm misses a required interest or principal payment, a more formal default occurs. If the problem is not cured within a grace period, usually 30 days, the security is declared in default. After this period, the creditor can exercise its contractually available remedies, such as declaring the full amount of the debt immediately due. Often, an impending payment default triggers a restructuring of debt payments or a formal bankruptcy filing.

Defaults on publicly held indebtedness peaked in the two most recent recession periods, 2001–2002 and 2008–2009. Indeed, in 2001 and 2002, over $160 billion of publicly held corporate bonds defaulted. In 2009, defaults soared to an unbelievable level of over $120 billion in a single year! Figure 1.4 shows the history of U.S. public bond defaults from 1971 to 2017, including the dollar amounts and the amounts as a percentage of total high‐yield bonds outstanding—the so‐called junk bond default rate. Default rates climbed to over 10% in only four years in history (1990, 2001, 2002, and 2009).

(a) As of mid‐year.

(b) Weighted by par value of amount outstanding for each year.

FIGURE 1.4 Historical Default Rates—Straight Bonds Only (Excluding Defaulted Issues from Par Value Outstanding), 1971–2017 ($ Millions)

Source: Salomon Center at New York University Stern School of Business.

Finally, a firm is sometimes referred to as bankrupt when, as described above, its liabilities exceed the going concern value of its assets. Until a firm declares bankruptcy in a federal bankruptcy court, accompanied by a petition either to liquidate its assets (Chapter 7) or to reorganize (Chapter 11), it is difficult to discern if a firm is bankrupt. In this book, we refer to firms as bankrupt when they enter court supervised proceedings. In Chapter 3 herein, we study in depth the process and evolution of bankruptcy laws for the United States.

REASONS FOR CORPORATE FAILURES

Corporate failures and bankruptcy filings are a result of financial and/or economic distress. A firm in financial distress experiences a shortfall in cash flow needed to meet its debt obligations. Its business model does not necessarily have fundamental problems and its products are often attractive. In contrast, firms in economic distress have unsustainable business models and will not be viable without asset restructuring. In practice, many distressed firms suffer from a combination of the two. Many factors contribute to the high number of corporate failures. We list the most common reasons below.

Poor operating performance and high financial leverage

A firm's poor operating performance may result from many factors, such as poorly executed acquisitions, international competition (e.g., steel, textiles), overcapacity, new channels of competition within an industry (e.g., retail), commodity price shocks (e.g., energy), and cyclical industries (e.g., airlines). High financial leverage exacerbates the effect of poor operating performance on the likelihood of corporate failure.

Lack of technological innovation

Technological innovation creates negative shocks to firms that do not innovate. The arrival of a new technology often threatens the survival of firms that possess related, yet less competitive, technologies. For example, when digital recording eventually took over dry‐film technologies in the 2000s, firms focusing on the older technologies were driven out of business.

Liquidity and funding shock

A potential funding risk known as rollover risk received heightened attention from both academics and practitioners after the 2008–2009 financial crisis. In periods of weak credit supply, some firms are unable to roll over maturing debt because of illiquidity in credit markets. This concern was particularly acute following the onset of the 2008–2009 financial crisis.

Relatively high new business formation rates in certain periods

New business formation is usually based on optimism about the future. But new businesses fail with far greater frequency than do more seasoned entities, and the failure rate can be expected to increase in the years immediately following a surge in new business activity.

Deregulation of key industries

Deregulation removes the protective cover of a regulated industry (e.g., airlines, financial services, healthcare, energy) and fosters larger numbers of entering and exiting firms. Competition is far greater in a deregulated environment. For example, after the airline industry was deregulated at the end of the 1970s, airline failures multiplied in the 1980s and have continued since then.

Unexpected liabilities

Firms may fail because off‐balance sheet contingent liabilities suddenly become material on‐balance sheet liabilities. For example, a number of U.S. firms failed due to litigation related to asbestos, tobacco, and silicone breast implants. Firms may also inherit uncertain liabilities through acquisitions. Energy firms and mining firms may inherit unanticipated environmental obligations via asset purchases. Financial institutions, such as Washington Mutual, inherited liabilities related to subprime mortgage related litigation in the aftermath of the 2008–2009 financial crisis.

These factors play heavily in the prediction and avoidance of financial distress and bankruptcy. Fifty years after its introduction, the Altman Z‐score remains one of the most widely used credit scoring models used by practitioners and academics to indicate the probability of default. Part Two of this book is devoted to default and bankruptcy prediction models, including the Altman Z‐score and its derivatives.

BANKRUPTCY AND REORGANIZATION THEORY

The continuous entrance and exit of productive entities are natural components of any economic system. The phrase creative destruction, referring to the ongoing process by which innovation leads new producers to replace outdated ones, was coined by Joseph Schumpeter (1942), who described it as an essential fact about capitalism.

Because of the inherent costs to society of the failure of business enterprises, laws and procedures have been established (1) to protect the contractual rights of interested parties, (2) to orderly liquidate unproductive assets, and (3) when deemed desirable, to provide for a moratorium on certain claims to give the debtor time to become rehabilitated and to emerge from the process as a continuing entity. Both liquidation and reorganization are available courses of action in many countries of the world and are based on the following premise: If an entity's intrinsic or going‐concern value is greater than its current liquidation value, then the firm should be permitted to attempt to reorganize and continue. If, however, the firm's assets are worth more dead than alive – that is, if liquidation value exceeds the economic going‐concern value – liquidation is the preferred alternative. In the end, the efficiency of any bankruptcy system can be judged by its ability to appropriately identify and provide for the restructuring of firms that arguably should be able to survive.

There are, however, challenges to reach an economically efficient outcome. These include, for example, conflicting incentives of differing priority claimants regarding the liquidation versus continuation decision; incentives of one set of claimants to accelerate its claims to the detriment of the firm value as a whole, known as the collective action problem; and inability to reach agreement among dispersed claimants. Perhaps one of the largest challenges to the process is that the going concern and liquidation values are not objective and observable. Such challenges often make a less costly out‐of‐court solution impossible and necessitate a formal legal framework for restructuring or liquidating a firm under court supervision. In Chapters 3 and 4 of this book, we explore the various options, both in and out of court, for restructuring distressed firms.

The primary benefit of a reorganization‐based system is to enable economically productive assets to continue to contribute to society's supply of goods and services, to say nothing of preserving the jobs of the firm's employees, revenues of its suppliers, and tax payments. However, these benefits need to be weighed against the costs of bankruptcy to the firm and to society.

DISTRESSED RESTRUCTURING IN A NUTSHELL

Distressed restructuring is all about fixing failed firms. The general goal is to restructure either the left‐hand side of the balance sheet, known as asset restructuring, and/or the right‐hand side of the balance sheet, known as financial restructuring. The motivation for asset restructuring is to improve operations and thus cash flows and redeploy underperforming or unexploited assets to more efficient users. One common way to achieve this is to install new managers, often with the help of turnaround specialists, with a focus on maximizing the size of the company value pie. The motivation for financial restructuring is to make the firm's cost of capital cheaper. Firms with an expensive capital structure need financial restructuring to deleverage the firm to a level that is sustainable in the long‐term.

There are many restructuring options available to a distressed firm. In out‐of‐court restructurings, firms bargain with creditors and other stakeholders in private negotiations. Such restructurings typically result in senior debt claims being exchanged for new debt claims, either senior or junior, and junior debt claims being exchanged for equity claims, with equity holders taking significant dilution. The success of such debt‐for‐equity swaps depends largely on whether creditors can effectively coordinate their votes on the distressed exchange proposal and whether they fare better in an out‐of‐court restructuring than an in‐court restructuring. The in‐court option refers to restructuring under the supervision of the bankruptcy court. The major benefits for the formal bankruptcy proceedings are that the Bankruptcy Code equips the debtor with many valuable options for restructuring debt claims and assets and resolves the coordination problems of bargaining by debtholders. However, the disadvantage is that they are lengthier and thus more expensive than the out‐of‐court option. We explore the outcomes and costs of distressed restructurings in Chapter 4 herein.

THE DISTRESSED RESTRUCTURING INDUSTRY PLAYERS

The fact that corporate distress and bankruptcy in the United States is a major industry can be demonstrated by the size and scope of activities associated with this field. The bankruptcy space today attracts a record number of practitioners and researchers. One reason is the size of the entities that found it necessary to file for bankruptcy during and after the 2008–2009 financial crisis. A list of the major players in the bankruptcy game and the related distressed firm industry are:

Bankrupt firms (debtors)

Bankruptcy legal system (judges, trustees, etc.)

Creditors and committees

Bankruptcy law specialists

Bankruptcy insolvency accountants and tax specialists

Distressed turnaround specialists

Financial restructuring advisors

Distressed securities traders and analysts

Bankruptcy and workout publications and data providers

To a large extent, the 1978 Bankruptcy Act provides that management of the bankrupt firm, known as the debtor in possession, retains significant influence, if not control, over the process. This in turn affects, ex‐ante, the firm's ability to renegotiate claims in advance of or to avoid a filing.

As of 2016, there were 349 bankruptcy judgeships nationwide authorized to guide the debtors and their various creditors through the bankruptcy process.¹ These are federal judges who serve in 94 judicial districts encompassing the 50 states, the District of Columbia, Puerto Rico, Guam, and the Northern Mariana Islands. Bankruptcy judges are assisted by the U.S. Trustees Program, a component of the Department of Justice, which plays a major role in administering the huge flow of cases in the system. Among other responsibilities, the U.S. Trustee appoints a committee to represent unsecured creditors, and other committees as justified for a particular case. A trustee oversees the liquidation and distributions in a Chapter 7 case; in Chapter 11, a trustee is more rarely appointed, generally to replace management of the bankrupt debtor in cases of mismanagement or fraud.

The nation's large core of bankruptcy lawyers make up an important constituency in the bankruptcy process. These lawyer‐consultants represent the many stakeholders in the process, including the debtor, creditors, equity holders, employees, and even tax authorities. Martindale lists more than 110,000 bankruptcy lawyers in 2017 (see www.martindale.com). The New York area alone has more than 3,000 bankruptcy lawyers listed. Some of the large law firms with specialization in the bankruptcy area include Kirkland & Ellis, Weil Gotshal & Manges; Akin Gump Strauss Hauer & Feld; Jones Day; Skadden, Arps, Slate, Meagher & Flom; Milbank, Tweed, Hadley & McCloy; Paul, Weiss, Rifkind, Wharton & Garrison; and Davis, Polk, & Wardell, among many others.²

There are two groups of restructuring advisory firms in the industry. The first group focuses on asset restructuring, helping troubled companies improve operations, often to avoid a bankruptcy filing. These firms are known to house and provide turnaround specialists to distressed firms. Well‐known players in the field include AlixPartners, Alvarez & Marsal, and FTI. The other group focuses on financial restructuring, managing and advising a company's capital structure renegotiations.