Lecture 1: Introduction to corporate insolvency and financial distress

Question 1

What is formal insolvency governed by?

Answer 1

By law - Insolvency Act 1986

Question 2

Who oversees and manages the insolvency process?

Answer 2

An insolvency practitioner (needs to be qualified)

Question 3

What is the difference between formal and informal restructuring?

Answer 3

Formal - typically refers to a procedure governed by law (insolvency law or companies law).
Informal - typically refers to other ways to restructure - e.g. merger, refinancing, sell-off, etc.

Question 4

What are private workouts?

Answer 4

similar idea to informal restructuring, so done outside of the formal legal system (or with no court involvement)

Question 5

What is bankruptcy in the UK and the US?

Answer 5

In the UK, bankruptcy refers to individuals becoming insolvent. Elsewhere, esp. in the US, bankruptcy is used to describe corporate insolvency.

Question 6

What is Chapter 11?

Answer 6

a US insolvency procedure, used to try and rescue and rehabilitate a distressed company.

Question 7

What is liquidation?

Answer 7

another insolvency procedure (virtually all jurisdictions have a liquidation procedure).
This is used to dissolve a company, i.e. there is no attempt at rescue.
In the US, this is referred to as Chapter 7.

Question 8

When does financial distress occur?

Answer 8

When a company’s operating cash flows are insufficient to cover current financial obligations.
Not enough money to settle claims or make payments.

Question 9

When is a company legally insolvent?

Answer 9

When it is unable to pay its debts.

Question 10

What are the two main tests of insolvency?

Answer 10

Cash Flow (flow based test)
Balance sheet (stock based) test.

Question 11

What is the cash flow/flow based test?

Answer 11

A company is insolvent when it is unable to pay its debts as they fall due.
Doesn’t matter if total assets>total liabilities it is if there is enough money for the company to pay employees, suppliers, etc.

Cash flow insolvency is more easily detected. In this case creditors have more power as their claims have been breached.
May try to instigate insolvency procedure.

Question 12

What the balance sheet/stock based insolvency?

Answer 12

A company is insolvent when the company’s assets are insufficient to discharge its liabilities.
Need to also consider contingent (not yet existing) liabilities).

Creditors are still being paid .
There are sufficient short term assets to cover short term liabilities.
However there is negative equity.

Question 13

What are the causes of financial distress? (10)

Answer 13

Loss of market share - business lifecycle (maturity), competition issue e.g. retail.

• economic conditions (e.g. recession, credit crunch). E.g. impact on the property sector.
• capital structure decisions. Debt/equity ratio
• Working capital problems (e.g. bad debt, stock build up, creditor days
• Investment decisions (e.g. expansion/ acquisition strategy) - management decisions, ego
• Poor financial controls
• Management failure - agency problem
• Fraud - e.g. Enron
• Excessive costs - new legislation (health and safety, minimum wage, trade unions.
• Overdependence on one key customer/supplier

Question 14

What are the top 3 causes of failure?

Answer 14

Market share, management failure and working capital.

Question 15

Case Study: Phones 4u

Describe.

Answer 15

Entered into administration in Sept 2014 (PwC as administrators)
Had 5,596 employees, 560 stores.
Debts estimated at £635 million plus £125m revolving credit facility.

Causes of failure:

• Over reliance on one mobile network (EE)
• EE decided not to renew its contract with phones 4u.
• However, underlying cause is clearly linked to developments in the telecommunications industry and also financial crisis (new regulations and structure of market).

Question 16

What are the four procedures outlines in the Insolvency Act 1989?

Answer 16

Receivership
Administration
Liquidation/winding up
Company Voluntary Arrangements (CVAs)

In addition, there is a fifth procedure contained in s895 of the Companies Act 2006, known as a Scheme of Arrangement.

Question 17

What is receivership?

Answer 17

Purpose is for receiver (IP) to maximise returns to creditor who appointed them.
The are now abolished.
They were an unusual procedure as there was a specific and clear duty of care to the charge holder. Other creditors were at a disadvantage.

Question 18

What is administration?

Answer 18

The UK’s rescue process.

The administrator hopes to be able to sell the business.

Question 19

What is liquidation/winding up?

Answer 19

No viability.
It is insolvent.
Doesn’t have anything worth saving.
Assets are sold off and the company is liquidated.

Question 20

What is a company voluntary arrangement?

Answer 20

a rescue procedure.
Specific - it is trying to save the company (as a legal entity).
Very difficult to save the company as it stands.

Question 21

What is a Scheme of Arrangement?

Answer 21

Allows a compromise or arrangement between the company and its creditors.

Court sanctioned scheme.
(MyTravel and IMO as examples)
Used for a solvent or insolvent company.
When insolvent - debt/equity swap. A significant amount of debt is written off for shares in the insolvent company.
Creditors must be classified as to whether they have a security interest or not.
For a solvent company it is used to reorganise the company.

Need each category of creditors to agree to the terms (75% in each category).
NOT POPULAR

There is substantial court involvement. COurt must decide if the scheme is fair and reasonable.
- If sanctioned, the scheme becomes binding on all creditors

Question 22

What are the difficulties in a scheme of arrangement?

Answer 22

Not been that popular due to court expense and protection of minority interests (classification of creditors)

Substantial time/cost arrangement

There is minority interest protection - the 25% who did not agree ensure that the SoA is fair to each creditor.
No moratorium for companies - not legally protected, company is vulnerable until the court has sanctioned an agreement.

Question 23

What are the advantages of a scheme of arrangement?

Answer 23

Flexibility in arrangements - feasible arrangement in everyone’s interest.
Management stay in charge.

Question 24

Is it possible for companies to go through multiple insolvency procedures simultaneously?

Answer 24

Yes
Some companies in administration will be in liquidation as well.
Liquidations tend to be smaller firms.
Administration goes on longer so appeals more to larger firms (can afford it?).

Can be a CVA and a SoA at the same time.

Question 25

What have been the key industries affected by insolvency in 2017/18?

Answer 25

• Construction/property development
• Accomodation and food services (restaurants)
• Administrative and support services.
• Manufacturing
• Wholesale and retail trade. e.g. HoF, John Lewis and Debenhams.

Question 26

How many jobs in the UK does the insolvency sector account for?

Answer 26

11,000, only 4% of the total accounting sector employment.

Of this only about 1,600 are licensed insolvency practitioners.

Question 27

What happens when a firm is in financial distress?

Answer 27

Debt finance has tax advantages, but highly geared companies also face a higher risk of insolvency.

Financial distress may lead to a firm to default on the terms of a contract, such as a bank lending agreement.

Companies and bank may try to reschedule debt.

Question 28

What is a bank’s intensive care unit?

Answer 28

Monitors key performance indicators, (interest cover, cash cover, asset cover).
Monitor investments, trigger points (KPIs) -relationship managers contact directors to find out if it is a one off or a serious issue.

Question 29

What is rescue culture?

Answer 29

The idea that viable businesses should be rescued and given another chance.

Rescuing a company improves productivity - impact macro-variable (from a government perspective).

Question 30

What is enlightened self-interest?

Answer 30

Rescue a company if you can, but must consider if it is in your best interest.

• Do not destroy your own financial position but at the same time, try to support the rescue of the company.
• Problem is there are multiple stakeholders.
• The company may also have cross-default provisions leading to more complex negotiations with lenders.

Question 31

What actions need to be taken in these circumstances? Which firm is in a worse position?

Panel A firm is insolvent on a stock and flow basis - cash flow deteriorating consistently (stock and flow)

Panel B firm is insolvent on a flow basis only - Cash flow drops and recovers.

Answer 31

If we are at time 1, we need to estimate future cash flows.
Vitally important as the assessment of the company’s prospects will determine the best option for the company.

Panel B firms appears viable.
Panel A firm is in more serious trouble.

Creditors are pessimistic at time 0 - so you can step in and take control

When there are insufficient funds, creditors gain power over shareholders.
Panel A - maximise returns by getting in early.
Panel B - value destructive behaviour. Probably liquidated a viable company for less than it is worth.

Shareholders have an optimistic view at time 0:
Panel B - S/Hs maintain control
Panel A - value destroying behaviour.

Question 32

What are the conflicts of interest in insolvency procedures due to multiple claimants?

Answer 32

Reorganisation (both informal and formal) will redistribute wealth amongst creditors and shareholders.
Likely to lead to tensions between disparate groups.

Wruck 1990 - ‘reorganization policies are advocated both out of concern for value maximization and out of self-interest. Where the two differ, there is potential for value- destroying behaviour’.

• Self-interest manifests in different ways. Want to maintain power. But if it goes away it can lead to value destructive behaviour.

Question 33

How is there information asymmetry?

Answer 33

• Also, in assessing future cash flows, different stakeholders have different levels of expertise and access to information
  
  • Contrast banks, institutional shareholders, trade suppliers, employees, managers
  • Information asymmetry

Question 34

From Wruck 1990 how many firms entering CH 11 emerge under an accepted reorganisation plan?

Answer 34

60-95%

Question 35

Describe restructuring outside of formal insolvency (including key statistics from Wruck 1990 compared to formal).

Answer 35

• Informal restructurings between the company, its creditors and shareholders

Informal restructurings such as new arrangements with creditors or a going concern sale of the business will typically result in higher returns to creditors.

In 59% of formal insolvencies, returns of less than 10p in the £ were likely to be achieved
Returns of more than 50p in the £ were likely in only 9% of cases

In informal rescues, in 70% of cases, creditors got back 100% and
Returns of less than 25% were likely in 1% of cases

• The banks and IPs play a critical role in informal restructurings

Question 36

Why is formal restructuring avoided?

Answer 36

Want to avoid formal insolvency due to cost, damage of brand name and to give greater returns to creditors.

Question 37

Describe Wruck’s (1990) summary of prior research.

Answer 37

• In the US, private negotiation is more likely the higher the ratio of bank debt to total liabilities.
• The more complex the capital structure, the less likely private negotiation is to be successful.
• Therefore, more concentrated borrowings are easier to renegotiate and it is easier to negotiate with fewer groups.
  -If bulk of company debt is concentrated in one or two banks, it is less complicated and easier to negotiate so informal restructuring is easier.
• Tobin’s Q - measure of market value relative to replacement cost of assets.
  • If it is high - high intangible assets, want to avoid formal insolvency
  High TQ linked to higher value destruction and the creditors wants to avoid that. Force private reorganisation to avoid value destruction.

Question 38

Describe the MyTravel case study.

Answer 38

A companies act reconstruction agreed in 2004.

• Had been in financial difficulty for some time
  
  • Risk that civil aviation authority would revoke licences
  • If this happened, company would be unlikely to survive - no longer a going concern.
  • Would have to restructure or it is immediately no longer viable.
• Proposed a new capital structure as follows:
  
  • 88% of equity to creditors and banks
  • 8% of equity to bondholders
  • 4% to existing shareholders

Bond holders were not happy:

• their debt amounted to £216 million. They wanted more equity.
• Went to court, but are subordinate to other creditors.
• They had no economic interest, not entitled to vote in the scheme of arrangement.
• If liquidated, they would be at the same level as shareholders. so unlikely to get anything back, therefore 8% was generous.

Court approved SoA

Question 39

Describe the IMO Car Wash Case Study.

Answer 39

Companies act reconstruction.
World’s larges car wash business.

• Following a buy-out of the group, the debt consisted of:
  
  • £313m of senior credit
  • £119m of mezzanine credit - subordinated below senior creditors. They have a lower debt ranking to senior creditors.
• IMO was in breach of its financial covenants, behind with interest payments, credit insurance withdrawn and balance sheet insolvency.

STOCK BASED INSOLVENCY.

• Looking to approve a scheme of arrangement in August 2009
• Senior lenders the winners and mezzanine lenders the losers

• Key point: judge’s decision centred on the valuation of the business
• Senior lenders’ valuation suggested that group value less than senior debt
- Mezzanine lenders’ valuation suggested that group value greater than senior debt

• Mezzanine lenders were using a “monte carlo simulation” - value company based on the probability.

• Court based reliance on market approach - what is a similar company worth based on a market valuation.
• Court sanctioned scheme – mezzanine debt left in an insolvent company
• New company -> £313m - 185m in senior debt written off. Exchanged for about 100% of equity.
• Old company (liquidated)
  
  • 12m senior
  • 119m mezzanine
• Approved by 95% of senior lenders.
• Mezzanine lenders objected, said they should have a right to vote (economic interest) - group value > senior debt.

Question 40

What are the direct costs of financial distress?

Answer 40

Legal, professional, administrative and advisory fees associated with the insolvency procedure - between 3-8% of assets.

These costs are lower for private workouts compared with formal insolvency procedures.

Question 41

What are the indirect costs of financial distress?

Answer 41

Argued to be much greater than direct costs.

• Opportunity costs imposed on the firm because financial distress affects the firm’s ability to conduct business as usual.
• e.g. reduced demand for products and services; decline in stock values; increased operating costs (suppliers and employees).
• management time focused on insolvency resulting in a loss of competitiveness.
• Difficult to quantify.

Question 42

What are the benefit of financial distress? (Wruck 1990)

Answer 42

Disciplining benefits of debt:

• Linked to free cash flow theory - more debt leads to more efficient and streamlined with cash management.
• Evidence from Leveraged Buy Out transactions.

Leverage can trigger liquidation - this will benefit if liquidation is the value maximising option (liquidation value>market value)

High leverage leads to an earlier default which may lead to a quicker reorganisation.

FInancial distress may lead to changes at senior management level.
Gilson (1990) find that within 4 years after the onset of financial distress, only 47% of old directors still hold their seats.

Financial distress may force change in organisational strategy and structure.

Question 43

How is the order of debt payment to creditors decided in the UK?

Answer 43

By the order in the Insolvency Act 1986:

Question 44

What is the order of payment to creditors in the Insolvency Act 1986?

Answer 44

• 1) payment to creditors with a standard (or fixed ) security (from the proceeds of the sale of that asset)
• 2) fees and expenses for the administrator/ liquidator
• 3) Preferential debts (mainly employee claims, wages, holiday pay, unpaid contributions to state and occupational pension schemes)
• 4) Prescribed part
• 5) payment to creditors who have a floating charge over assets
• 6) payment to unsecured creditors
7) payment to ordinary shareholders

Question 45

What is a standard security

Answer 45

Debt that is secured on a particular asset (e.g. a mortgage)

Question 46

What is a floating charge?

Answer 46

Floats over assets and crystalised on date of insolvency (e.g. inventory - whatever stock exists in inventory).

Most banks have both floating charge and standard securities.