Bankruptcy and Reorganization
by MaestriDuring recessions, bankruptcies normally rise, and recent recessions are no exception. The 1991–1992 casualties included Pan Am, Carter Hawley Hale Stores, Continental Airlines, R. H. Macy & Company, Zale Corporation, and McCrory Corporation. The recession beginning in 2001 has already claimed Kmart and Enron, and there will likely be more bankruptcies in 2002 if the economy continues to decline. Because of its importance, a brief discussion of bankruptcy is warranted.
When a business becomes insolvent, it does not have enough cash to meet its interest and principal payments. A decision must then be made whether to dissolve the firm through liquidation or to permit it to reorganize and thus stay alive. These issues are addressed in Chapters 7 and 11 of the federal bankruptcy statutes, and the final decision is made by a federal bankruptcy court judge.
The decision to force a firm to liquidate versus permit it to reorganize depends on whether the value of the reorganized firm is likely to be greater than the value of the firm’s assets if they are sold off piecemeal. In a reorganization, the firm’s creditors negotiate with management on the terms of a potential reorganization. The reorganization plan may call for a restructuring of the firm’s debt, in which case the interest rate may be reduced, the term to maturity lengthened, or some of the debt may be exchanged for equity. The point of the restructuring is to reduce the financial charges to a level that the firm’s cash flows can support. Of course, the common stockholders also have to give up something—they often see their position diluted as a result of additional shares being given to debtholders in exchange for accepting a reduced amount of debt principal and interest. In fact, the original common stockholders often end up with nothing. A trustee may be appointed by the court to oversee the reorganization, but generally the existing management is allowed to retain control.
Taken From : Five-Minute MBA – Corporate Finance
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