Corporate Liquidations and Reorganizations Chapter 18 Corporate Liquidations and Reorganizations Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1

Corporate Liquidations and Reorganizations: Objectives Understand differences among types of bankruptcy filing. Comprehend trustee responsibilities and accounting during liquidation. Understand financial reporting during reorganization. Understand financial reporting after emerging from reorganization, including fresh-start accounting. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

1: types of bankruptcies Corporate Liquidations and Reorganizations 1: types of bankruptcies Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Insolvency Equity insolvency Inability to pay debts on time May avoid bankruptcy proceedings Negotiate directly with creditors Bankruptcy insolvency Having total debts in excess of the fair value of assets May be liquidated, or Reorganized Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Types of Bankruptcies Chapter 7: Liquidation Trustee appointed to sell assets of business Chapter 9: Adjustment of Debt of a Municipality Chapter 11: Reorganization Debtor is expected to be rehabilitated Chapter 12: Farmers Chapter 13: Adjustment of Debts of an Individual Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Characteristics Voluntary bankruptcy proceedings Filed by debtor Involuntary bankruptcy proceedings Filed by creditor or group of creditors Court action Dismiss a case Accept the petition Change form Chapter 11 reorganization Chapter 7 liquidation Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

2: trustee responsibilities and accounting Corporate Liquidations and Reorganizations 2: trustee responsibilities and accounting Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Duties of Debtor Corporation In both liquidation and reorganization cases, the debtor corporation must File a list of creditors, a schedule of assets and liabilities, and a statement of financial affairs Cooperate with trustee Surrender property to the trustee, including records Appear at court hearings Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Duties of Trustee Trustee serves in liquidation cases Investigate debtor's financial affairs Provide information Examine, perhaps object to, creditor claims File report on trusteeship If authorized to operate debtor's business, other period reports are required In reorganization cases, in addition to above Filing reorganization plan or statement why one cannot be filed Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Ranking of Claims: Liquidation Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Statement of Affairs Legal document prepared for bankruptcy court Assets at expected net realizable values Classified on basis of availability for classes of creditors Liabilities are classified Priority, fully secured, partially secured, unsecured Historical values included for reference Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Trustee Accounting At start of case, trustee creates a new set of books. During the case, Records transactions Statement of cash receipts and disbursements Statement of changes in estate equity Balance sheet Statement of realization and liquidation At close of case, Final settlement of claims Trustee is dismissed Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Debtor in Possession Unless there is a reason to appoint a trustee, the debtor corporation’s management is permitted to continue to run the company while in bankruptcy. The Debtor in Possession has the same responsibilities as a trustee in a reorganization case. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Creditors’ Committee The Creditors’ Committee is elected in a liquidation case, and is appointed in a reorganization case from the largest unsecured creditors. Makes decisions on behalf of all creditors Reviews ongoing transactions of the debtor in possession and can object Handles negotiations with any creditor regarding settlement or continued business. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Benefits of Chapter 11 Benefits of being the Debtor in Possession include: Rejecting executory contracts Cancelling unexpired leases Legal protection from creditor action, such as lawsuits or repossession of property However, day-to-day operations may become more difficult as lenders, suppliers, customers, and employees are aware of the bankruptcy filing. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Reorganization Plan A plan may be filed at the time of the bankruptcy filing (“prepackaged bankruptcy”) or by the debtor corporation within 120 days of filing. Other interested parties may file proposed plans after 120 days. Identify classes of claims Specify the expected payout of each class Claims within a given class must be treated alike Define the expected requirements for execution of the plan Must be fair and equitable Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

3: financial reporting during REORGANIZATION Corporate Liquidations and Reorganizations 3: financial reporting during REORGANIZATION Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 11: Balance Sheet Prepetition liabilities subject to compromise are reported as a separate line item in liabilities Arose before filing Include unsecured and under-secured liabilities Likely to be paid at an amount less than face value Prepetition secured liabilities and post petition liabilities reported in normal fashion Prepetition claims discovered after filing Included at court-allowed amounts Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 11: Other Statements Reorganization costs shown separately Interest to be paid or probable amount Differences from contractual amounts should be noted Expected stock or stock equivalent issuances should be disclosed Cash flow items related to reorganization shown separately Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Combined Financial Statements Condensed combined financial statements are prepared for all entities in reorganization proceedings as supplementary information Intercompany receivables and payables Write-down if necessary Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

4: emerging from reorganization Corporate Liquidations and Reorganizations 4: emerging from reorganization Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Reorganization Value Approximates fair value of entity without considering liabilities Discounted future cash flows of reorganized business Consider business and financial risk Reorganization value determines how much creditors recover Emerging business will either use Fresh start reporting Report liabilities at present value and forgiveness of debt as extraordinary item Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Fresh-Start Reporting Fresh-Start Reporting recognizes that the emerging company is a new entity. To qualify, Revaluation value immediately before the reorganization plan is confirmed must be less than post-petition liabilities and allowed claims, and Holders of existing voting shares receive less than 50% of emerging entity Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Apply Fresh Start Reporting Allocated reorganization value to identifiable assets Unallocated amount is an intangible called “Reorganization value in excess of amounts allocated to identifiable assets” Liabilities at current value at confirmation date Deferred tax benefits are first applied to reduce any intangible asset recorded Prepare final reports of old entity The effects of adjustments to asset and liability accounts are shown, so that ending balance sheet of old entity = beginning balance sheet of new entity Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Continued Reporting of Old Company If a company does not qualify for Fresh-Start Reporting, then Report liabilities at the appropriate interest rate under GAAP Report debt forgiveness as an extraordinary item Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Reorganization Example Tig files for protection under Chapter 11 on January 5, 2011. Accordingly, it reclassifies prepetition liabilities obtains short-term financing acquires additional equipment continues operations through June 30, 2012 when the plan is approved, with a reorganization value of $2,200 First, we'll look at the statements pre and post reorganization. Then we'll go through the entries and adjustments that occurred. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Balance Sheet Assets   Filed 1/5/11 FYE 12/31/11 Before 6/30/12 Re-valuation Fair value 6/30/12 AFTER 6/30/12 Cash 50 150 300 Accounts receivable 500 350 335 Inventory 370 25 375 Other current assets 30 Land 200 100 Building, net 450 425 (75) Equipment, net 330 290 (30) 260 Patent 125 (125) Reorganization value in excess of identifiable assets 250 2,100 2,050 2,055 (105) 1,950 2,200 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Changes to Assets Fair values and revaluation amounts are shown on 6/30/12 for comparison. Tig continues operations, records depreciation, and even acquires equipment from filing on 1/5/11 to reorganization on 6/30/12. The reorganization revalues the assets to their fair value on that date. Patents are completely written off. Tig records an intangible "Reorganization value in excess of identifiable assets" of $250. Not all reorganizations result in this intangible. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Balance Sheet - Liability & Equity   Filed 1/5/11 FYE 12/31/11 Before 6/30/12 AFTER 6/30/12 Short-term borrowing (post) 150 75 Accounts payable (pre/post) 600 100 125 Wages payable (post) 50 55 Taxes payable (pre) Accrued bond interest (pre) 90 Note payable (pre) 260 Subordinated debt (post) 395 12% bonds payable – current (post) 12% bonds payable (post) 500 15% bonds payable (pre) 1,200 Liabilities subject to compromise 2,300 Capital stock (old) Capital stock (new) 800 Deficit (700) (1,050) (1,000) 2,100 2,050 2,055 2,200 Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Changes to Liabilities Upon filing on 1/5/11, Tig reclassifies the unsecured and partially secured liabilities at that point as Pre-petition Liabilities Subject to Compromise. Pre-petition Liabilities Subject to Compromise are then reclassified or settled according to the plan. Accounts payable on 12/31/11 does not include any of the $600 due prior to filing. Taxes payable are still to be paid, and eventually recorded again in full. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Changes to Equity Some of the creditors receive stock in the reorganized firm. The old shareholders also receive stock, but now own only $100 of $800 of the stock at book value. Although some APIC was recorded in reorganizing, it was subsequently eliminated. If it had been sufficient to wipe out the deficit, no intangible "reorganization value in excess of identifiable assets" would be recorded. The Deficit is removed! Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Can Tig Use Fresh Start? Post-petition liabilities $255 Allowed claims 2,300 Total liabilities $2,555 Less reorganization value (2,200) Excess liabilities $355 On 6/30/12 there were $255 in post-petition liabilities. All $2,300 pre-petition liabilities were allowed by the courts. Firm value is $2,200. 1. Liabilities exceed reorganization value 2. Old shareholders retain less than 50% Yes, fresh start is appropriate. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Reorganization Plan: 6/30/12 Pre-petition Liabilities and Equity New Agreements Debt Dis-charge 15% partially secured bonds, $1200 $500 new stock, $500 senior 12% bonds, and another $100 bonds due 12/31/12 $100 Priority tax claims $150 To be paid cash once confirmed $0 Remaining unsecured claims, $950: $600 accounts payable $275 subordinated debt and $140 new stock $185 $90 accrued interest Forgiven $90 $260 note $120 subordinated debt and $60 new stock $80 Total debt discharged $455 Old stock $100 new stock Equity Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Record New Debt Agreements Liabilities subject to compromise (pre) 2,300   Taxes payable 150 12% senior debt 500 12% senior debt - current 100 Subordinated debt 395 Common stock (new) 700 Gain on debt discharge 455 settlement of prepetition claims This entry reclassifies the pre-petition debt according to the reorganization plan. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Give Shareholders New Shares Common stock (old) 500   Common stock (new) 100 Additional paid in capital 400 exchange of stock with owners They will lose control since creditors have $700 of common stock. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Revalue Assets Inventory 25   Land 100 Loss on asset revaluation 105 Buildings, net 75 Equipment, net 30 Patent 125 revalue assets to fair value A loss is recorded in revaluing the assets. Refer back to the Asset side of the balance sheet. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Calculate Balance in Retained Earnings (Deficit) (1,000) Gain on debt discharge 455 Loss on asset revaluation (105) Final measure of deficit, 6/30/12 ($650) Write-off Additional paid in capital 400 Reorganization value in excess of identifiable assets (intangible asset) ($250) If sufficient APIC had existed, there would be no intangible asset, and excess APIC would remain on the balance sheet. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Eliminate Deficit in Equity Reorganization value in excess of identifiable assets 250   Gain on debt discharge 455 Additional paid in capital 400 Loss on asset revaluation 105 Deficit 1,000 The $1,000 deficit on 6/30/12 is adjusted for the gain on debt discharge and loss on asset revaluation. The net $650 deficit eliminates all of the APIC and creates a $250 intangible. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Simplifying Assumptions All transactions are recorded on 6/30/12. Generally this takes some time. Creditors may have interest between submission and approval of plan. All pre-petition debt is approved. The $2,200 reorganization value of the firm probably used a discounted cash flow firm valuation model. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall Disclosures Adjustments to historical values Assets Liabilities Debt forgiveness Prior retained earnings or deficit eliminated Significant factors in determining the reorganization value Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall