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CHAPTER 23: Governance Failures, Corporate Failures and Restructuring

A. EFFECTIVE CORPORATE GOVERNANCE Effective corporate governance promotes improving shareholder wealth and the wealth of other corporate stakeholders. Effective corporate governance cannot be implemented at only the top of the corporate hierarchical structure, or within a small set of company divisions; it must permeate the entire organization. Regulatory compliance is merely a starting point for an effective governance system. The system must be clearly articulated, monitored, adapted and controlled. Effective governance is essential for long-term corporate success. While there is no single model for an ideal governance structure, the many successful firms share many governance traits. This book has discussed governance mechanisms that tend to characterize more successful firms. We discussed monitoring and the role of institutional shareholders, voting and boards of directors earlier along with determinants of executive pay and board compensation. In addition, we discussed takeovers, proxy fights and going private transactions. But, what happens when these corporate governance mechanisms fail? Here, will change our orientation away from statistical analyses and focus a few individual cases of governance failure. Earlier, we viewed the corporation as a contractual structure where production is the result of coordinated activities among involved parties. A variety of stakeholders participate in these coordinated activities and the corporate governance structure is delicately balanced to specify rights and responsibilities of each stakeholder group. Nonetheless, this governance structure can fail, leading to a variety of adverse outcomes to the firm. In this chapter, we will focus on several scenarios resulting from excess concentrations of power, poor oversight of management and outright theft. We will first briefly consider several U.S. corporate governance failures and then focus on the case of Parmalat, where corruption from the very top of the hierarchical structure led to the failure of the firm. Then we will discuss Skandia where poor oversight led to misuse of corporate assets and a significant loss of confidence in the firm. B. CORPORATE KLEPTOCRACY AND COOKING THE BOOKS A number of high profile cases of governance failure led to executives being accused of activities such as stealing, improperly diverting funds and lying to investors to receive more money. In one such case, L. Dennis Kozlowski, former CEO of Tyco International and his CFO Mark H. Swartz were accused of stealing $150 million from their employer by secretly forgiving loans that they received. They were also accused of misappropriating millions more through other improper means and selling stock after lying about the companys condition. Kozlowskis case attracted substantial attention due to his lavish spending, apparently including around $11m of the companys money on furnishing his Fifth Avenue apartment, including a $6,000 goldthreaded shower curtain, a $4,000 tablecloth and a $515 toaster. He was also said to have thrown a $2m birthday party for his wife in Italy with company money. When questioned by his criminal prosecutor, Ann Donnelly during his criminal trial about compensation that was omitted on his 1999 IRS Form W-2, he testified that he did not notice that $25 million was missing. This omission, had it not been discovered, might have saved him $17.5 million on his income taxes. The prosecutor at his trial argued that the omission was evidence that he tried to conceal his employer forgiving his loan. Ultimately, both Kozlowski and Swartz were convicted.

John J. Rigas of Adelphia Communications and his two of his three sons (the third, John also served on the company board as did John Sr.s son-in-law) were arrested in 2002 on charges related to looting their company. Earlier in the year, Adelphia, once the sixth larges cable company in the U.S., had restated its earnings to include more than $1 billions in loans to John Rigas the company founder and his family and admitted having improperly guaranteed loans. The company filed for bankruptcy later in the year. John and Timothy Rigas were convicted of some of the charges filed against them, receiving lengthy prison terms. Michael Rigas pleaded guilty to lesser charges. After years of governance failure, Enron filed for bankruptcy protection in December 2001, the largest firm ($63 billion in assets) to do so until WorldCom the following year. In early 2002, Enrons auditor, Arthur Anderson admitted that it had destroyed Enron documents and was convicted of obstruction of justice and virtually shut down. Former Board Chairman and CEO Kenneth L. Lay and former CEO Jeffrey K. Skilling of Enron were indicted and prosecuted on a number of charges.1 Former CFO Andrew Fastow pleaded guilty to two felonies. Lord Conrad M. Black, former CEO and F. David Radler, former Chief Operating Officer, were accused of diverting to themselves $400 million, practically all of Hollinger International's net income over seven years. Hollinger International Inc. published a number of newspapers, including the London Daily Telegraph , the Jerusalem Post and the Chicago Sun-Times. A rather narrow 2005 indictment against Lord Black charged that he fraudulently diverted to himself $51 million from a sale of assets in 2000. In 2005, COO Radler pleaded guilty to criminal fraud for his role in the Hollinger scandal. Other officers receiving indictments included John Boultbee, former CFO and former vice presidents Peter Atkinson and Mark Kipnis. Apparently, members of the firms high profile board of directors were unable to prevent of identify the diversions of funds. Independent members of the company's Board of Directors, which included Richard N. Perle (former U.S. Secretary of Defense under Reagan), Henry Kissinger (former U.S. Secretary of State under Nixon and Ford) and James Thompson (former Governor of Illinois), were accused of being ineffective and careless in their oversight roles. Hollinger sued Perle and Kissinger and Thompson were among board members who settled to pay $50 million to shareholders of the firm. Lord Black and his wife Barbara Amiel also served on the board. Directors were paid $50,000 per year and $3,000 per meeting for their services. Members of board committees received additional compensation. Richard Breeden, former Chairman of the S.E.C., prepared the report describing accusations, which stated, Black and Radler made it their business to line their pockets at the expense of Hollinger almost every day, in almost every way that they could devise.2 Among the misappropriations was Blacks use of the corporate jet for a 10-day vacation to Bora-Bora at company cost, $24,950 for summer drinks, $40,000 for a birthday party for Lord Black's wife, two Park Avenue apartments in Manhattan and $3530 for silverware for the corporate jet. Christopher H. Browne of the money management firm Tweedy, Browne, a major investor in Hollinger, initiated the investigation into company finances. Lord Black controlled Hollinger through a pyramid structure involving a number of other firms that he controlled. The major
Their criminal trials were underway as of the time of the writing of this book. Breeden, R.C. (2004) Report of investigation by the Special Committee of the Board of Directors of Hollinger International Inc. http://www.sec.gov/Archives/edgar/data/868512/000095012304010413/y01437exv99w2.htm
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shareholder of Hollinger International was Hollinger Inc., which was controlled by the Ravelston Corporation, which was controlled by Lord Black. Joseph P. Nacchio, former CEO of Qwest Communications International and six of his executives were sued by the S.E.C. for orchestrating a $3 billion accounting fraud intended to mislead investors during the telecommunications bubble and its aftermath. The S.E.C. estimated that Nacchio's personal gain from the fraud was $216 million and profits from his coconspirators totaled $84 million. Their scheme seemed to be intended to convince U.S. West shareholders to allow their firm to be acquired by Qwest. Numerous other major firms suffered governance breakdowns, including Xerox, WorldCom, Qwest and Bristol-Myers Squibb. While these and other scandals have devastated numerous firms and hurt millions of investors, they did prompt important regulation (particularly SOX in the United States) and codes of conduct that improved corporate governance. Board directorships are no longer ceremonial posts. Surveys of large companies suggest that firms are hiring more outside directors and are staffing their audit committees with better-qualified directors. Accounting firms are less likely to seek consulting business from firms they audit. Steps are underway to establish accounting oversight boards in Europe, similar to that established by SOX in the U.S. On the other hand, public firm earnings restatements increased each year from 2001 to 2005, suggesting that the process of improving is still ongoing and probably needs to continue. In both the United States and Europe, businesses still operate under a patchwork of governance codes. C. ROTTEN TO THE CORE AND ASLEEP AT THE WHEEL As American firms found themselves embroiled in corporate governance breakdowns, some Europeans were rather smug, claiming that such scandals just could not happen in Europe. However, now it appears that the emergence of similar breakdowns in Europe may be just the tip of their own iceberg. Here, we discuss two European scandals in greater detail. Example: The Parmalat Meltdown Parmalat, Italy's giant dairy foods producer, was founded in 1961 by Calisto Tanzi, a 22 year-old college dropout and Italian food industry heir. The company was named for Parma (the food valley in Italian) and lat (an abbreviation of latte, Italian for milk). Parmalat's major innovation allowed it to produce the first shelf-stable milk through an Ultra Heat Treatment (UHT) process developed in Sweden, enabling processors to produce milk that could be stored for long periods without refrigeration. The product was a hit, benefiting from its associations with and advertising through sports, including Formula One Racing and Alpine Ski Championships. Parmalat was a European pioneer in brand advertising. Sales rapidly expanded throughout Europe, Latin America and, in total, in over 30 countries. The firm rapidly grew into a family empire, the largest food company in Italy, the fourth largest food company in Europe, with over 36,000 employees in 139 plants and branching into a variety of industries including beverages, television, tourism, cookies and football. In 1997, Parmalat initiated an aggressive campaign to acquire other firms, particularly in the Americas. One of its large purchases in 1997 was Beatrice Foods, a large U.S. producer. Many of these acquisitions were huge money losers. Most of the acquisitions were financed with debt and the firm's debt ratings gradually deteriorated.

Nonetheless, Parmalat appeared to be a good citizen to many Italians, donating to Catholic causes and rebuilding a cathedral in Parma. By 2002, the firm had grown to realize 13 billion in sales. On the surface, all seemed at least reasonably well with Parmalat through 2002. In addition to many individual shareholders, Parmalat had a number of well-regarded institutional investors and creditors, a solid credit rating and even listed securities in the United States. However, as we will discuss shortly, there were important warning signals of troubles ahead. Company financial weaknesses started to surface in early 2003 when the firm experienced difficulties trying to sell 500 million in bonds. But the real implosion was towards the end of the year when, on December 8, 2003, the firm defaulted on a 150 million bond obligation, a seemingly small sum given Parmalats size and prominence. Tanzi initially attributed the default to a temporary liquidity problem, blaming it on a customer, a speculative fund named Epicurum. Parmalat claimed that Epicurum did not pay its bills. It was later revealed that Epicurum was one of Parmalat's own offshore subsidiaries. The rating agencies quickly downgraded Parmalat's bonds to junk status. On December 19, the biggest corporate scam in European history was unveiled when Bank of America announced and Parmalat confirmed that a 3.95 billion account that Parmalat claimed to have at the Bank simply did not exist. About a week later, Tanzi, who admitted to taking over 500 million for himself and his other businesses, was jailed in Milan's overcrowded San Vittore prison, albeit, reportedly, in his own cell with his own shower and a little camping stove to cook food. Two Italian-based executives of Parmalat's former auditing firm, Grant Thornton S.p.A., were also held and questioned in Italian jails. On December 24, 2003, Parmalat S.p.A. filed for bankruptcy protection with a court in Parma, Italy, the largest bankruptcy in European history. Since December 2003, Parmalat has been enmeshed in, and apparently emerging from the aftermath of the largest financial fraud in European history, with approximately 14 billion having apparently simply vanished. Much of this loss seems to be related to Parmalat's debt level being over 14 billion, almost eight times what had been reported before the firms unraveling. For years, Parmalat hid its losses, overstated its assets, recorded non-existent assets, understated its debt and diverted cash to Tanzi family members. The firm created over 260 foreign entities such as Bonlat, its Cayman Islands subsidiary to dump its non-performing and fictitious assets and to hide its debts. Interestingly, much of the fraud went undetected for as long as 13 years. Parmalat's business interests were far-flung, extending into travel and sports businesses and well beyond the areas of competence of its founder and his family. Parmalat was a publicly held Milan Stock Exchange listed firm with ADRs traded in the U.S. How could such a large international firm, with such a large following of investors and analysts be so deceptive in such a large way? When the scandal broke, Parmalat had a governance structure that was practically a recipe for a corporate meltdown. First, consider that Parmalat was Tanzi family-dominated, with Calisto Tanzi serving for many years as C.E.O. until he resigned when the scandal broke. Tanzi, his family and affiliate firms controlled the major blocks of votes in Parmalat. Tanzi founded the firm and used it and its outside suppliers of capital to build himself an empire for himself and his family. At the time of the firm's collapse, Tanzi served on Parmalat's Board of Directors, as did his son Stefano who also served as the president of the

Parmalat-owned Parma Calcio football team. The Board also included Tanzi's brother Giovanni and his niece Paola Visconti. Other board members included the company's CFO Fausto Tonna, who was deeply involved in the fraud and three other firm managers, Luciano Del Soldato, Alberto Ferraris and Francesco Giuffredi, all hired by Tanzi. The outside directors were Tanzi's attorney and two of Tanzis close friends. Tanzi's daughter Francesca apparently ran Parmatours, one of the family tourism businesses, another of Parmalat's major money-losers that owned Club Vacanze with its nine beach and four Alps resorts. She denied running the firm after her arrest. Tanzi clearly was the driving force exercising almost complete control over the company, inserting his own people in every position of power and in positions to oversee those who held power. For example, CFO Tonna, who confessed that he had forged Band of America documents for the 3.95 billion account using a scanner, scissors and glue, was also a member of the Parmalat board three-member audit committee. That is, Tonna was appointed to a position with responsibility to oversee his own operations and to ensure that he did not steal from or mislead the company's investors. He was, in effect, his own monitor. Was there warning of what was to come? Prior to the firms implosion, Parmalat had a poor rating on the Institutional Shareholder Service's Global Corporate Governance Quotient. This quotient measures corporations' governance practices against a set of 61 criteria, many of which have been discussed in this book. Parmalat was tied for last among the 69 Italian companies that were rated. Parmalat was in the bottom 3 percent of companies in the MSCI EAFE governance index, which comprises companies on major indexes in Europe, Asia, and the Far East. Why were its governance scores so low and how was the Tanzi family able to exert such control over this public firm? First, Parmalat's governance structure violated practically every major standard set forth for sound corporate governance. Parmalat's stakeholders suffered a lack of transparency on many important issues, including executive and director compensation and directors and officers stock ownership. The board failed to set and disclose adequate board guidelines for evaluations, term limits, and retirement ages, all contributing to the poor performance in the company's governance scores. The firm did have a code of conduct for internal dealings, but this did not seem to inhibit officers' theft and deception. Perhaps, more importantly, Parmalat was at the top of a complicated pyramid ownership structure controlled by Coloniale S.p.A., the Tanzi holding firm that owned 51 percent of Parmalat equity. The board chair and CEO positions were held by the same individual, Calisto Tanzi. Members of Parmalat's management team and the firms board members had many associations, outside directorships, management responsibilities and conflicts of interest involving a host of other firms. The board obviously lacked a reasonable number of independent directors; in fact, it is not clear that the firm had any really independent directors. Insiders sat on the executive, remuneration and audit committees of the board. The Tanzi family tightly controlled virtually all aspects of governance. Officers and directors clearly failed to act in shareholders' best interests or act in a professional and ethical manner. While Parmalat's auditor Grant Thornton was replaced by Deloitte after nine years as required by Italian law, Grant Thornton continued to audit Parmalat's offshore companies, the primary dumping grounds for Parmalat's losses, debts and non-performing assets. Furthermore, it is not yet clear the extent to which the firms auditors aided in the cover-up of Parmalats activities. As in Germany, banks typically play an important role in monitoring Italian firms. Parmalat's banks failed miserably in this capacity. In fact, numerous banks were targeted for investigation in

possible roles aiding the frauds, including Bank of America, Citicorp, and J.P. Morgan, each of which placed Parmalat bonds, and Deutsche Bank, Banco Santander, ABN, Capitalia, S. PaoloIMI, Intesa-BCI, Unicredito and Monte dei Paschi. While most of these banks claim that they also were victimized by Parmalat, some observers argued that Parmalat's banks sought profitable deals with Parmalat that conflicted with their monitoring responsibilities. In sum, Parmalat was plagued with an excess concentration of power disproportional to residual claims, dishonest officers and directors, a willful lack of transparence, monitors and auditors who failed or simply stole and empire building. The governance structure was simply rotten to its core. We will discuss the resolution of this disaster shortly. Example: The Skandia Scandal While many Italian businesses have maintained rather sordid reputations for corporate governance, Scandinavian businesses have traditionally upheld reputations for maintaining the highest ethical standards. Scandinavian firms have generally avoided the appearance of greed and attempted to conduct their affairs by consensus. Skandia, Sweden's largest insurance company and a world leader in providing variable annuities and other savings products shook this reputation in 2003 when three of its top executives came under investigation for misusing corporate assets. However, the scope, causes and consequences of this scandal were different from those of the Parmalat disaster. First, the offending executives never exerted absolute control over their employers as Tanzi did at Parmalat. Former CEO Lars-Eric Petersson, former CFO Ulf Spng and Ola Ramstedt, the former head of Skandia Liv, Skandia's life insurance subsidiary, were all fired in 2003 before or as the scandals emerged. Later, former Chairman of the Board Lars Ramqvist and then his successor Bengt Braun resigned after accusations of having failed to provide proper oversight of their executives, though neither appeared to have participated in unethical or illegal activities themselves. The most damaging of the three scandals involved former Skandia President and CEO Lars-Eric Petersson, who, in 1999, was named by Veckans Affrer, a Swedish weekly business magazine, as the best CEO in Sweden. Petersson was charged with two counts of breach of trust against a principal for allegedly raising the company's bonus limits for the years 1998/99 without the approval of the board. This led to increases of at least 185 million kronor in extra compensation to those participating in the company's Wealthbuilder program. The top executive bonus payout pool totaled over three billion kroner (over 300 million). In addition, Peterson was accused of paying himself 37 million kronor more than the board had approved for his pension. Former CFO Ulf Spng was accused of tax fraud, based on the accusation of his having secretly moved over 20 million kronor from Skandia Leben, a Swiss subsidiary to a company he owned in Guernsey. Apparently, Spng did not declare the amount in his 2002 tax return. In addition, he rented three apartments in Stockholm, one for himself and one for each of two daughters. Skandia spent approximately 1.1 million on renovations to his apartment, primarily to move the kitchen. However, before the kitchen move was completed, Spng changed his mind about renting the apartment. Renovations to his daughters' apartments cost Skandia approximately 50,000. Ola Ramstedt was accused of breach of trust against a principal for authorizing 18 million

kronor worth of luxury renovations to apartments belonging to Skandia executives and their relatives. Apparently, rather clumsy efforts were made to disguise the expenditures as office space renovations. Unlike many Swedish firms, Skandia was not family controlled. In fact, as of year-end 1999, the company had only one 5 percent shareholder, Chase Manhattan Bank, a U.S. bank holding 7.4 percent of the firms stock. There were over 20 other shareholders owning 1 percent of the firms shares, most of which were banks and other financial institutions from the U.K., the U.S., Finland, Sweden and elsewhere. Petersson, Spng and Ramstedt held 25,000, 5,000 and 10,000 shares in the company, respectively. Chairman of the Board Ramqvist and then Board Vice Chairman Braun held 10,130 and 5,450 shares. Other than Petersson, no other board member held more than 2,000 shares. Thus, during 1999, Peterssons investment in Skandia totaled as much as $650,000, though no other board members investment totaled more than $250,000. No institutional or inside shareholder held anywhere close to a controlling interest in the firm. While both the Skandia and Parmalat scandals seem to have both been driven by executive greed, the Skandia scandal was quite different from the Parmalat debacle. As we noted above, it seems that only three Skandia executives directly benefited from funds misuse. Board members did not participate in the misuse of funds; they seemed to be asleep at the wheel, perhaps treating their directorships more like honorary appointments rather than serious positions of responsibility. They certainly did not appear to be thoroughly corrupt or under the absolute control of company managers. In fact, several board members accepted responsibility for allowing the misappropriations on their watch. Bernt Magnusson, Chairman of Skandia in March 2005, summarized governance problems at Skandia as follows: It is in the overall daily governance of an enterprise where the shareholders interests are truly at stake. And it is here that the quality of governance is determined. This is largely an issue of management culture. Codes of practice, governance tools and control instruments have little value if they are not used. For it was failures in application and follow-up, not the absence of rules and policies, that caused many of Skandias governance problems in the past. The intentions were good, and there were no major flaws in the corporate governance principles. The problem was a lack of compliance and follow-up.3 After the scandal broke, the Board was left sufficiently intact to launch appropriate investigations afterwards. Theft and absolute concentration of power were never pervasive across the top of the hierarchical structure as at Parmalat. The offending Skandia executives still reported to the board, and members of the Board were not complicit in hiding unethical activities. The scale of the Parmalat financial disaster was many times greater than that at Skandia as were the consequences. Ultimately, Skandia's losses were mainly to its reputation. As crucial as reputation and brand are to a provider of insurance products, Skandia was largely able to recover, though perhaps not entirely on its own.

2004 Skandia Annual Report, p. 60.

D. CLEANING UP THE MESS Multiple groups of stakeholders played roles in each of the governance lapses discussed above and many were involved in the company liquidations or recoveries. In some instances, the affected companies ceased operations and were simply liquidated; in others, the companies resumed full operations. How were various corporate stakeholders affected the failures in governance? What are they doing to prevent such failures in the future? Shareholders, particularly in bankrupted firms such as Enron, lost billions of dollars. Mutual funds, pension funds and other institutional shareholders and asset managers were in the uncomfortable position of having to explain to their clients why they lost so much money in these debacles, and in some cases, were sued for having done so. Despite these losses, and with more exceptions, shareholders are still almost routinely voting against fellow shareholder proposals to limit executive pay and against proposals to increase shareholder-voting power. Shareholders and their lack of participation and inability to mobilize have been and will remain at the heart of corporate governance failures. Company board members have complained about having been misled or defrauded by their managers. In many instances, boards have failed to provide proper oversight and have been negligent for failing to challenge the inappropriate activities of their managers. In too many instances, boards have behaved as though their leadership roles were merely ceremonial. However, things are starting to change. Boards are increasing the participation of outside members. Boards are now expected to place directors with appropriate skills on important committees. Directors are expected to avail themselves of independent experts should they need such assistance. After some of the scandals described above, entire boards were replaced and many other board members were forced to resign. Now, with more serious responsibilities and penalties for negligence, some board members are asking themselves whether their board positions are really worthwhile. Managers have always been at the core of the principal-agent problem. However, the key to managing this problem is for each of the firms other stakeholders to effectively monitor them and to ensure that managers monitor each other. Employees have lost hundreds of thousands of jobs and hundreds of millions of dollars in pensions and other retirement plans due to corporate governance failures. The AFL-CIO and other unions and employee groups have played a minor role in monitoring, but their power to act is extremely limited. Auditors, especially Arthur Anderson paid dearly for their participation, lack of proper oversight and other associations with governance lapses. Auditors have been prohibited from engaging in consulting and other for-profit activities for their clients. In some instances, even stock analysts, rating agencies and law firms faced adverse reputation effects or even faced civil action. Lenders, including banks and bondholders have lost large sums of money, and investors in affiliated financial institutions have lost share value as well. Lenders have unique abilities and incentives to provide for corporate monitoring. Government regulators, including the U.S. Federal Government, have strengthened legislation (e.g., SOX) to strengthen corporate governance and to provide for improved accounting oversight. The S.E.C. has successfully pursued numerous civil and criminal actions in addition to winning many settlements against violators of various laws

protecting corporate stakeholders. Some observers have regarded the S.E.C. to have been ineffective in the early part of this decade, but other offices, including that of the New York State Attorney General have also effectively pursued inappropriate behavior. Courts, civil, bankruptcy and criminal, federal and state have all been actively involved in dealing with corporate governance failures. Thousands of civil actions have been initiated and prosecutors have pressed criminal charges against offending individuals and firms, and perhaps innocent affiliates of offenders as well. Nevertheless, the court systems may well be the most important deterrents against ineffective corporate governance. While many potential defendants are protected with Director and Officer insurance policies, insurance company requirements and premiums also serve to improve corporate governance. Non-government regulators such as the New York Stock Exchange have also undertaken numerous actions to strengthen corporate governance. The New York Stock Exchange is imposing increasingly rigorous governance and reporting requirements on firms that it will list. The Financial Accounting Standards Board (FASB) is attempting to update and improve on Generally Accepted Accounting Principles (GAAP) resolve a number of questions concerning open accounting principles. Competing companies, especially in electric and communications industries saw their profits and reputations decline as a result of these meltdowns. Many of these companies are becoming particularly proactive in improving governance. Corporate activists, including the AFLCIO, CalPERS, TIAA-CREF, the Investor Responsibility Research Center and the Corporate Library are stepping up their activities to represent shareholders and other corporate constituents. These activists have been very successful in bringing governance issues to the media forefront, but have not been as successful mobilizing investors.

Consider the two cases above that we discussed in greater detail, starting with Skandia. The firm began by launching investigations into each of the misallocations of funds to determine what was done and how far-reaching the improper activities were. After launching the investigations, Skandia sought monetary damages from its former executives Petersson, Spang and Ramstedt and criminal prosecutions were initiated against them. In addition, Skandia launched an investigation into potential liabilities for damages from its auditors and other directors for failing to prevent the misuse of corporate funds. Former Board Chairman Ramqvist reached a settlement with Skandia, agreeing to repay the SKr2,216,667 in fees he received as Skandia chairman, and for serving on its audit committee and its nominating committee. He did not admit to any wrongdoing. An announcement of the settlement indicated that Ramqvist did not benefit from the charged wrongdoings and, according to a company report:4 As far as has been learned, neither Ramqvist nor other company directors were aware of or approved the removal of the cap for the Wealthbuilder bonus program in 2000 by Lars-Eric Petersson, which resulted in higher costs for Skandia than what would have been the case if the Board's decision had been respected. However, this event took place
4

London Stock Exchange (2005) Skandia Insurance Regulatory Announcement, 1 February, 2005.

during Ramqvist's term as chairman of Skandia's board. Because of this and in the best interest of the company, Ramqvist is prepared to accept his responsibility in accordance with this agreement. The company also noted that the settlement takes into account the fact that Ramqvist did not have any participating interest in the disputed bonus programs. The company also said it was in continuing arbitration with Petersson, who is also a former director. Concerning other directors Skandia indicated that the legal investigation carried out to date indicates that the prospects for success in such processes are very small. Skandia's board has therefore chosen to not take any other action against former company directors than that pertaining to Lars Ramqvist. Thus, it appeared that Ramqvist, while not appearing to have known about, participated in or benefited from unethical or illegal activities did accept responsibility for failing to prevent them while serving as board chair. Pristine reputations are very important for insurance businesses such as Skandia. After the dust settled from the series of scandals, rumors began to surface that Skandia was offering itself for sale. In February 2006, Old Mutual P.L.C., a South African insurer listed on the London Stock Exchange successfully bid for Skandias shares at a price of SKr52.33 per share, or approximately $6.5 billion in total. Skandia had made substantial progress since its 2003 scandal building its business in the U.K., making it an attractive target for Old Mutual, which wanted to diversify out of South Africa. Old Mutual purchased 89.56 percent of Skandias stock with the bid, enabling the firm to realize substantial U.K. tax benefits. Parmalat required more intensive restructuring. After Parmalat filed for bankruptcy protection, court administrators hired turn-around specialist Enrico Bondi to reorganize the firm. Bondi had handled the break-up of Montedison, the Ferruzzi family's chemical empire, Italy's major corporate crisis in the 1990s. Bondi immediately began to trim down Parmalat to focus on its core dairy business. A number of its non-core subsidiaries such as its football teams were spun off as well as operations in Latin America, Thailand and Ireland and several poorly-performing brands were eliminated. Bondi set out to streamline the corporation's operations to 16 milk and juice-based businesses around the world and 30 of its stronger global and regional brands, including Bonlat milk, Santal juices and Kyr yogurt, a substantial reduction from its 120 brands under Tanzi. Prior to its re-emergence from bankruptcy, Parmalat creditors agreed to swap about 20 billion of the firm's debt for equity, earnings began to resurface and the firm soon relisted its shares on the Italian Stock Exchange in Milan. Parmalat remerged from bankruptcy and Bondi's appointment to remain as CEO afterwards was approved by the firm's new shareholders. Bondi also began to seek billions of euro in compensation from a number of banks that may have participated in Parmalat's meltdown, alleging they colluded to hide Parmalat's problems. Bondi charged that several banks provided assistance in creating false financial statements and profited from floating bond issues that delayed disclosures of Parmalat's financial problems. Among the banks defending themselves against these charges were Deutsche Bank for (at least 17million), UBS (290 million) and Citigroup (over 8 billion). In addition, Parmalat is suing its auditors Deloitte & Touche and Grant Thornton for approximately 20 billion, though they claimed to be victims of Parmalat's fraud.

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Separately, Italian prosecutors sought trials for 27 people. Eleven of those, including three of Parmalat's former chief financial officers, were sentenced to up to two and a half years in prison under plea bargains, while a separate trial began in January for two accountants who worked at Grant Thornton. Many of the defendants were spared prison terms by Italian sentencing guidelines protecting first-time offenders. Prosecutors in Parma, near the company's headquarters, sought to try Tanzi and dozens of others on trial for more serious charges, including fraudulent bankruptcy and criminal association. Alessandro Bassi, a 32-year-old accountant who worked under CFO Tonna, committed suicide by throwing himself off a bridge near the company's headquarters in northern Italy. To restructure its system of governance after bankruptcy, Parmalat has proposed a framework modeled on recommendations of market regulators and the Italian Stock Exchange. Changes include structuring the board of directors with a majority of independent members (6 out of 11) and creating a code of self-discipline that provides for regular reporting of obligations for all board committees. Many observers have commented that the new governance standards prepared by the restructured Parmalat could serve as a model for Italian companies. E. Financial Distress Financial distress occurs when a firm experiencing operating, economic or financial difficulties experiences difficulties maintaining sufficient cash levels to continue its operations and faces the prospect of failure. Loan default occurs when the firm fails to satisfy one or more of its obligations to one or more creditors. Loan default can lead to one or more of the following: An acceleration of obligations where all payments are immediately due when one payment is defaulted on. Foreclosure, a legal proceeding used by a creditor to force compliance with the contractual obligations. Cross-default where default on one obligation places other obligations in default as well. Firms experiencing financial distress need to establish whether their conditions are temporary or permanent. If they are permanent, and if a buyout cannot be arranged, then the firm will probably need to initiate a liquidation or bankruptcy proceedings. If the difficulties are temporary, the firm may have a turnaround opportunity, leading to several potential options for restructuring. Operations and assets may be restructured. Financial restructuring possibilities include informal private workouts where the firm attempts to renegotiate its obligations. Another is a formal bankruptcy filing, which will be discussed in the next section. Firms frequently undertake activities geared towards retrenchment when they become distressed. For example, distressed firms frequently lay off employees and stock returns often react positively to this retrenchment activity (Abowd, Milkovich, and Hannon, [1990]) and to plant relocations (Lin and Rozeff [1993]), but negatively to headquarter locations (Chan, Gau, and Wang [1995]) and to voluntary corporate divestitures (Jain [1985]).5

See Adams [2007].

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F. Bankruptcy Business firms encounter uncertainty with respect to each of their investment and financing activities. Thus, each individual activity of the firm, indeed, the firm itself, is subject to the possibility of failure. What constitutes failure? There are many answers to this question from many different perspectives, including financial and legal perspectives. An individual project might be said to fail if it does not fulfill its expectations or its profitability is insufficient to sustain it. The term business failure may apply to a variety of situations including technical insolvency (the firm is unable to meet its current obligations; also called cash flow insolvency) and insolvency in bankruptcy or balance sheet insolvency where the firms liabilities exceed its assets. Although more precise definitions exist in the law literature, bankruptcy generally exists where the firm is unable to fulfill its debt obligations. Bankruptcy might be defined as a courtsupervised process of breaking and re-writing contracts entered into by the firm. Forms of Business Bankruptcy Firms make bankruptcy filings in one of over 200 federal bankruptcy courts as per the Federal Bankruptcy Reform Act of 1978. The Act is organized into chapters that describe the bankruptcy process and the different procedures for various entities and types of bankruptcy protections. The following are three of the important chapters: Chapter 7: The firm is liquidated by a court appointed trustee and funds are paid based upon the priority of claims. Chapter 11: The firm is reorganized and parties must approve a plan which may violate the original priority of claims. Typically, this filing is intended to maintain the firm as an ongoing concern. During a reorganization or liquidation period, the debtors (shareholders) remains in control of firm ("debtor in possession" (DIP)), unless management can be proven incompetent or has committed fraud, in which case the court appoints a trustee. The DIP is given 120 days to formulate a plan. The creditor is not allowed to offer an alternative plan during this period, which is routinely extended. After 180 days, if the plan is not accepted, the creditor may propose a plan. The creditor (not the debtors) must support their plan with costly appraisals. As one should expect, creditors rarely propose reorganization plans. Chapter 11 reorganizations and Chapter 7 liquidations are initiated by debtors (or creditors) filing a petition. The plan submitted must be regarded by the bankruptcy judge as being equitable and feasible. The reorganization plan resulting from this process will: 1. Designate and describe each class of creditors 2. Specify the cash and securities each class will receive and when that class will receive them 3. Indicate whether a certain class is impaired (if impaired, the percentage of the claim to be received), and whether a class will receive as much as it would in a liquidation (though, it does not necessarily state exactly what a class would receive in a liquidation). 4. States whether priority of claims is violated 5. Impartial judge confirms the values in the plan. Remember, the numbers are provided by management and it is very costly to prove otherwise. Nevertheless, lawyers claim that it is rare that impaired creditors are incorrectly classified as unimpaired.

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A firm may move from one form of bankruptcy to the other. Bankruptcy law allows junior claimant to delay the final resolution and to force the firm to incur additional costs--something junior claimants cannot do outside of formal bankruptcy proceedings. In addition to the business bankruptcies defined above, law also provides for municipal filings (Chapter 9), personal filings (Chapters 7, 11 and 13), family business filings (Chapter 12) and family farm filings (Chapter 13). Here, we will focus on business filings (Chapters 7 and 11). The number of U.S. bankruptcy filings increased significantly in the 1990s. In 1992 alone, 97,069 business failures were recorded. Bankruptcies are normally considered to be the result of financial distress, but in some cases, bankruptcy filings are made by non-distressed firms as part of a corporate strategy. For example, Continental Airlines used bankruptcy courts to nullify lease and labor contracts. Northwest Airlines obtained union concessions merely by threatening to file for Chapter 11 protection. Numerous firms, including A.H. Robins, Johns Manville and Texaco have used bankruptcy filings to obtain protection of reduce liabilities associated with lawsuits. LTV obtained Chapter 11 protection to avoid payments associated with their underfunded pension plans. Such bankruptcy filings are often referred to as strategic bankruptcies. Many of these strategic filings are the result of the Bankruptcy Reorganization Act of 1978, which enabled firms to seek protection on the basis of their contingent or potential liabilities; even pension and labor disputes may qualify the firm for bankruptcy protection. However, many observers have argued that the bankruptcy process has been abused by non-distressed firms merely following a strategy intended to abrogate their legal obligations. Even the threat of a bankruptcy filing has enabled many firms to obtain concessions from creditors, suppliers, labor unions and lessors. While bankruptcy is likely to evolve from a series of undesirable events, bankruptcy itself can be an expensive state. The costs associated with bankruptcy might be classified as direct and indirect. Direct bankruptcy costs (Legal and Administrative) include expenditures for lawyers, accountants, investment bankers (for appraisals). Statistical studies suggest that these costs range from 3% to 25% (of book value of debt plus market value of equity). Indirect bankruptcy costs tend to be operations oriented and include lost sales (Chrysler, Drexel Burnham Lambert), lost personnel, suppliers demanding unfavorable credit terms, management devoting time to bankruptcy at the expense of operations, over-investment in unprofitable projects to increase option value of stock and under-investment in profitable projects because they are not sufficiently risky. One clear indirect cost results from the end-game problem, where as bilateral relationships draw to a close, attitudes towards payment and performance are likely to create disputes. For example, many bankruptcy attorneys observe that clients are more likely to claim that they have been delivered inferior quality goods and refuse full payment as they lose their incentives to deal with the bankrupt firm as one with which they desire an ongoing relationship. Priority of Claims 1. Administrative expenses of the bankruptcy process: court costs, lawyers' fees, the trustee's expenses, and loans taken on by the firm after the bankruptcy filing (with the court's permission). 2. Claims taking statutory priority: tax claims, rent claims, consumer deposits, and unpaid wages and benefits which accrued before the bankruptcy filing.

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3.

4.

Unsecured creditors: trade creditors, utility company creditors, holders of damage claims against the firm (Dow-Corning, Manville, Texaco), and long-term bondholders. Unsecured creditors rank equally in priority ordering, unless there is a subordination agreement. To encourage granting of credit to bankrupt concerns needing loans, postfiling creditors normally have priority over pre-filing creditors. Equity holders

Note that secured creditors are considered to be outside of the priority ordering. Their liens are recorded in public records. However, if their collateral will not cover their claims, they must be regarded as unsecured creditors for the balance of their claims. Firms under bankruptcy protection have the right to terminate under-funded pension plans, which the US government guarantees. In one such example, Allis-Chambers terminated its plan. A few years before its bankruptcy filing, it made an agreement with its unions to increase pension benefits and decrease payments to its plan (its assets in the plan were only 3% of benefits). This arrangement was to the benefit of both the company and its employees, though at the expense of the government sponsored pension guarantee corporation. Creditors who notice a firm's deteriorating financial condition have an incentive to improve their priority ranking. For example, a creditor may agree to extend or to increase the size of a short-term loan when it comes due in return for becoming collateralized against specific assets such as those held in inventory. Despite the rather simple claims priority structure given above, in reality, substantial deviations from priority rules occur. One recent study suggested that priority is violated in 78% (29/37) of bankruptcy cases. This study indicated that shareholders receive nothing in only 19% (7/37) of these cases. For example, in Imperial Industries, shareholders received 100% of their claims and secured and unsecured creditors received only 60% and 37% of their claims. One lawyer involved in the proceedings said that shareholders were given crumbs off the table in order to preserve tax-loss carry forwards. Within classes of unsecured creditors (e.g. senior and subordinated debentures), strict priority rarely holds. For example, in the White Motor case, senior unsecured bondholders received 61%, senior unsecured creditors, 55%, general unsecured creditors, 51%, and subordinated unsecured bondholders, 14%. This same study indicated that priority for secured creditors was adhered to in 92% (34/37) of the filings. Consider the following sample cases of bankruptcy filings: 1. Crompton: Priority broke down because of litigation by the unsecured creditors arguing that secured creditors were not entitled to the surplus in the pension plan and holdings of export-related commercial paper. 2. Evans: First major case where creditor initiated plan won approval in court. The Victor Posner Factor (he owned a controlling interest in equity) seemed to play a role. Secured creditors made a special offer to unsecured creditors to go along with a plan that froze out equity. 3. Stevcoknit: The unsecured creditors received 33% of their claim while secured creditors accepted only 57% of their claim because market value of collateral had fallen. Why are priority claims violated? Some explanations are given above. Consider the following alternative explanations:

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1.

2.

Firm size: Larger and more complicated bankruptcies are more likely to allow opportunities for equity holders and unsecured creditors to extract concessions from more senior creditors Jurisdiction: Southern District of Florida's chief bankruptcy judge is reputedly much tougher on debtors than in some other districts (For example in New York). Firms have some leeway in where they are allowed to file for bankruptcy.

Voting Procedure Each class of impaired creditors must vote on a plan. Unimpaired creditors (those who receive payment in full with interest - all other creditors are considered impaired) do not vote on the reorganization plan. A majority of creditors in number, and at least two thirds by dollar amount owed must approve the reorganization plan. Two thirds of equity holders must also approve the plan. If a reorganization plan is approved, all security holders within the same class receive identical payoffs (in terms of securities in the reorganized firm) regardless of whether they voted to approve the plan or not. Confirmation and Cram-Down After bankruptcy plans have been acted upon by claimants, a confirmation hearing is held. If more than one plan was accepted, the court must decide which plan is best. If no plan was approved by each class of claimants, the judge may approve one anyway. A bankruptcy judge can force acceptance of a plan by use of a "cram-down". If all creditors would receive as much under the reorganization plan as they would in a liquidation, the judge can force acceptance of this plan. Before the cram-down can be implemented, the judge must order a costly evaluation of the company's assets, by the management, trustee, or an outside consultant. These dead-weight costs pressure creditors into acceptance of the plan, even though absolute priority is violated. Any claimant that disagrees with the evaluation may argue her position in court. This causes further delays. The judge rules on the fairness of the plan. If the judge determines the plan is not fair, a new plan must be submitted. Secured Creditors Secured creditors may accept a plan that violates their priority in order to avoid losing interest (if the collateral does not cover principal plus interest). The law is not clear on whether secured creditors are entitled to interest. Secured creditors may also accept a plan that violates their priority in order to avoid decay in the value of their collateral. Although the law indicates that the DIP must protect the interests of the secured creditors, the law is somewhat fuzzy about just what constitutes protecting secured creditors' interests. Tax Benefits Equity holders must cooperate in order to preserve tax-loss carry-forwards, further improving the bargaining position of equity holders. Final Notes Informal restructurings have a good chance of succeeding when the claims that need to be restructured are not diffusely held. The rules of Chapter 11 greatly reduce the holdout problem by imposing the same outcome on all creditors in a given class.

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Although formal proceedings are much more costly than are informal proceedings, the additional cost may be a "necessary evil" required to facilitate an agreement among claimants that are trying to free-ride. Because of the bargaining power of junior claimants, they often receive something in violation of priority rules and firms are sometimes restructured that should be liquidated.

Continental Airlines Case Continental Airlines has been one of the major airlines in the United States for many years. However, it experienced a period of substantial difficulties whose roots can be traced to 1978 when the U.S. airline industry was de-regulated. After deregulation, Continental experienced several years of losses due to increased operating costs and more intense competition brought on by the deregulation. In 1980, Frank Lorenzo, CEO of Texas Air, made a hostile takeover attempt for 48.5% Continental common stock at a significant premium. Texas Air had recently experienced a period of phenomenal growth through low discount fares. Lorenzo was bitterly opposed by Continental's unionized employees, who made a counter-offer through an ESOP; though this takeover attempt failed. Texas Air finally acquired 51% of the stock of Continental. A number of operating difficulties caused significant problems in the airline industry during the 1980's. First, airlines earnings are particularly volatile because: (1) output is perishable so that it cannot be adjusted to demand and supply and (2) high fixed costs, including expenditures for jets and gates. After the deregulatory activity of the 1970's, competition became based upon price; low cost carriers were causing increasing concern among full-service carriers. Computer reservation systems were dominated by American Airlines and United Airlines (Sabre and Apollo). These operations are often more profitable than basic operations. Airlines were accused of manipulating systems. Costly frequent flier programs intended to increase customer loyalty were resulting in mounting liabilities. By 1990, almost 20% of industry operations by carriers were in Chapter 11 proceedings. In 1983, Continental filed for bankruptcy under Chapter 11. This bankruptcy filing enabled Continental to abrogate union contracts. Also at this point, Continental laid off 65% of its work force and reduced its network of routes. Continental returned to profitability within a year (Note the competitive advantages that seem to have resulted from the bankruptcy filing). In the later 1980's, Texas Air experienced significant growth while making a number of successful and unsuccessful takeover bids. The airline tendered a bid for TWA in 1985, though its takeover attempt was unsuccessful as TWA was acquired by Carl Icahn. Texas Air also made an unsuccessful bid for Frontier Airlines in 1985, losing to Peoples Express. However, Texas Air acquired Peoples Express in 1986. Later in the same year, Texas Air acquired Eastern Airlines, maintaining it as a separate corporate identity. Texas Air also acquired the remaining outstanding shares in Continental. Afterwards, Continental was assigned the rest of Texas Air's airline assets and Texas Air changed its name to Continental Airlines Holdings. From 1984 to 1989, revenues increased from $1.4 billion to $6.7 2 billion, and assets increased from $1.3 billion to $7.7 billion.

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However, Continental Airlines Holdings found itself under increasing financial pressure because it relied heavily on junk bonds for acquisition financing. Its debt levels increased from $0.8 billion to $5.2 billion. By 1988, the financial leverage ratio (D/(D+E) was 80%. The industry average, reflecting general weak performance and increased borrowing to finance consolidations was 60% at this point. In 1988 and 1989, Continental experienced losses of $719 million and $889 million. In 1988, the AFL-CIO launched a campaign against the firm on behalf of Eastern Airline's employees. In March 1989, Eastern employees went on strike and a few days later, Eastern filed for Chapter 11 bankruptcy. In April 1990, the judge in the Eastern bankruptcy case appointed a trustee to run Eastern (which is a most unusual action), resulting in the removal of Eastern from Continental's span of control. Eastern ceased operations in Jan 1991. Continental Holdings responded to its difficulties in the late 1980's by divesting itself of a number of its operations. In 1988, Continental Holdings sold Eastern's profitable northeast shuttle to Trump Shuttle for $365 million. In 1989, the firm sold $471 million of its assets (including its Latin American routes) to American Airlines. During 1989 and 1990, SAS bought an 18% stake in Continental and received three board seats. However, Continental experienced additional difficulties in the early 1990's. In August 1990, Iraq's invasion of Kuwait caused airline fuel costs to double within three months. Declining passenger traffic from the worsening U.S. recession prevented airlines from raising prices to cover the increased operating costs. Restructuring debt out of court was not considered feasible because the capital structure was so complex, involving thousands of creditors and lessors and numerous inter-connected debt agreements. In December 1990, Continental filed for Chapter 11 proceedings in Wilmington, Delaware, listing assets of $4.8 billion and liabilities of $5.9 billion. Simultaneously with this filing, Continental sold the Seattle-Tokyo route to American Airlines for $150 million. The Chapter 11 filing conferred a number of benefits on Continental. First, the firm did not pay or accrue interest on its unsecured debt (saving $154 million). In fact, Continental was able to borrow $120 million more from Citibank at the prime interest rate plus 2.5%, reflecting the increased protection post-filing creditors receive when lending to a DIP. Under bankruptcy laws, Continental had 60 days to reject "executory" (obligates both parties to provide a service) contracts such as rental or lease (often sale-leaseback arrangements) agreements. This causes the loss to lessors to become general unsecured claims, protecting against repossessions. This bankruptcy convention gave the company considerable leverage in renegotiations. However, there are special rules for aircraft lessors in bankruptcy laws. After 60 days of stopped payments, planes can be repossessed. Nevertheless, Continental challenged this exception in court and was able to defer $164 million in lease payments that were due over the next year. Lessors were forced to reduce lease payments by $3.3 million and further extended $91 million in additional financing for refurbishing aircraft. By the end of 1991 operations began to turn around and Continental proposed a reorganization plan in Feb 1992. The plan provided that long-term debt would be slashed to $1.7 billion. Almost all stock would go to non-subordinated creditors. Pre-petition common and preferred

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stockholders would receive nothing (stock price of common went from $1 to $0.375 on announcement of plan). The plan was never put to a vote due to fare war. Instead, an auction process developed involving, MAXAIR, Houston Air, Air Canada/Air Partners and Lufthansa/Davis. Management considered the MAXAIR and Air Canada/Air Partners offers most seriously. The offer of Air Canada/Air Partners was eventually accepted which resulted Air Partners, a private investment group, obtaining a controlling interest in Continental. By 1996, Continental was experiencing record level profits, largely due to increased air fares. G. Restructuring The central issue in a corporate restructuring versus a liquidation is whether the distressed firm worth more "dead or alive". In a corporate restructuring, the firm is maintained as an ongoing operation. The claimants in the firm may agree to an informal restructuring or workout without the costs and delays associated with a formal Chapter 11 court process.6 Even though the firm may be worth more as an ongoing operation, it may be difficult to get a consensus among stakeholders in an informal restructuring. In fact, some stakeholders, particularly shareholders, may have strong incentives to engage in strategic Asset destruction. However, formal bankruptcy proceedings have some unique features that make it easier for the various stakeholders with conflicting incentives to reach an agreement. Consider the example of a financially distressed firm whose assets would be worth $500,000 if it were liquidated now. If it is not liquidated now, in one year it will be worth either $1,200,000 or $800,000 depending on its sales performance. The two potential asset values are regarded as having equal probability. The firm is considered to face financial distress at present because it is required to make a payment to creditors of $1,250,000 next year. This payment is the firm's only financial obligation, though, even under the best scenario, the required payment exceeds the firm's total asset level. This payment is evidenced by fifty bonds outstanding, each with a face value of $25,000. For sake of simplicity, assume that investors are risk-neutral and that the discount rate on future cash flows is zero. If the firm liquidates now, creditors will receive $500,000, or $10,000 per bond and shareholders will receive nothing. If the firm were to continue to operate, the expected future value (and current value) of the bonds would be: (50% $800,000) + (50% $1,200,000) = $1,000,000 which, of course, is less than the $1,250,000 face value of the bonds. Nonetheless, creditors will receive a payment higher than $500,000 in even the worst case scenario if the firm continues to operate. Clearly creditors here would prefer that the firm continue to operate. The firm will be insolvent in either the good or weak outcome, meaning that shareholders are assured of receiving nothing if the firm is maintained as an ongoing operation. Thus, the value of stock at present is zero regardless of whether shareholders decide to liquidate or continue operations. Shareholders (or, management), who normally initiate restructuring plans, have no incentive to continue firm operations - unless the creditors are willing to negotiate with shareholders to continue firm Kakalik et al. [1983] found that the legal costs of asbestos litigation and related bankruptcies were 1.7 times as high as the funds received by plaintiffs.
6

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operations. If the creditors are unwilling to negotiate the terms of the outstanding bonds, the shareholders have no incentive to avoid immediate liquidation. On the other hand, if priority rules are strictly followed the equity holders have no chance of receiving a cash flow next period. A restructuring agreement might be made where creditors receive more than $500,000 and shareholders have at least a chance of receiving some positive cash flow. The terms of an informal restructuring will be influenced by the relative bargaining power of the creditors and shareholders in addition to the ownership structure (distribution) of the debt claims. Consider an offer where the bondholders will surrender each of their bonds (which have a face value of $25,000 but would be worth $10,000 in liquidation) and receive a new debt security with a $15,000 face value. Shareholders agree to continue firm operations. Bondholders receive $15,000 per bond regardless of the outcome. Shareholders receive $50,000 in the poor outcome and $450,000 in the strong outcome. This would certainly leave both the bondholders and the shareholders better off than in a liquidation. Both shareholders and bondholders will certainly benefit from a restructuring as long as the offer to bondholders allows them to receive bonds with a face value between $10,000 and $16,000. Both shareholders and bondholders will receive a higher expected value if the offer to bondholders allows them to receive bonds with a face value between $10,000 and $24,000. Even with an offer allowing for higher face value bonds, shareholders have some chance of receiving a positive payoff with a restructuring. The above analysis is substantially complicated by the existence of more than one creditor. Each of the creditors realizes that other creditors will benefit from his agreeing to a restructuring agreement. Thus, each of the creditors will have an incentive to withhold agreement for an informal restructuring in an effort to extract considerations from other creditors. In this scenario (which is similar to a Prisoner's Dilemma Problem), all stakeholders may refuse to support a reorganization plan that is in their own best interests. Consider the simplest case where one creditor holds all fifty bonds. In this case the informal restructuring agreement outlined above will be successful; the creditor has no other creditors to attempt to extract considerations from. If the shareholders can credibly threaten to liquidate the firm, the single large creditor will accept any restructuring offer that gives her a face payment of $10,000 or more. Now, consider a case involving one large creditor and one small creditor. Suppose the large creditor holds 48 bonds and the small creditor holds 2 bonds. Also, suppose that all the bonds have equal priority and any new bonds offered will have the same priority. The following four scenarios will demonstrate that the large bondholder will accept the offer, while the small bondholder will holdout and free-ride on the concessions made by the large creditor. Keep in mind that the small bondholder can't be forced to reduce his claim outside of bankruptcy court. Also, the large bondholder can make concessions in a separate deal with the shareholders. 1. The large and small bondholders accept the offer. The total face value owed the next period is $750,000 = 50 $15,000

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which the bondholders are certain to get because the least the firm will be worth is $800,000 next period. The shareholders are also certain to receive a positive cash flow of at least $50,000; thus they will not liquidate the firm. 2. The large bondholder accepts the offer and the small bondholder rejects it. The total face value is (48 $15,000) + (2 $25,000) = $770,000 which the bondholders are once again certain to receive because the least the firm will be worth is $800,000 next period. The shareholders are certain to receive a cash flow of at least $30,000, so again, they won't liquidate the firm. 3. The large bondholder rejects the offer and the small bondholder accepts it. The total face value owed is (48 $25,000) + (2 $15,000) = $1,230,000 which the bondholders have no chance of receiving because it exceeds the maximum possible value of the firm. This leaves the shareholders with nothing so they would prefer to liquidate the firm, leaving all the bondholders with $10,000 per bond. Thus, this scenario seems unlikely. 4. The large and small bondholders both reject the offer. The shareholders liquidate and all the bondholders receive $10,000 per bond. Thus, the restructuring succeeds or fails solely on the basis of the large bondholder's decision. Since the small bondholder's decision has no impact on success of restructuring he has no incentive to reduce his claim from $25,000 to $10,000.

Next, consider the case with many small creditors. Suppose that there are fifty small creditors, each of whom holds one bond. First we calculate how many bonds have to be exchanged in order for the restructuring to succeed. Remember as long as there is a possibility that the shareholders receive a positive cash flow they will go along with the restructuring, which is equivalent to the face value being less than the highest value outcome next period, $1,200,000. Let N be the number of bonds exchanged. The restructuring succeeds if

N $15,000 + (50 N ) $25,000 $1,200,000 Thus, as long as at least 5 bondholders agree to exchange their bonds, the restructuring succeeds. If five bondholders agree to surrender their $25,000 face value bonds for $15,000 face value bonds, the total face value of firm debt will equal (5 15,000 + 45 $25,000) = $1,200,000. Each bondholder who agrees to surrender his $25,000 face value bonds for $15,000 face value bonds will own a fraction equal to 1.25% of this total:

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$15,000 [5 $15,000] + [45 $25,000] Thus, the expected payoff to those who exchange is $12,500: 1.25% =
$12,500 = [0.5 $15,000] + [0.5 0.0125 $800,000]

Bondholders who refuse to exchange their bonds did not reduce their claim. Thus, they receive a fraction of the value of total debt value equal to: 2.08 3 % = $25,000 [5 $15,000] + [45 $25,000]

The expected payoff to those bondholders who hold out is $20,833: $20,833. 3 = [0.5 $25,000] + 0.5 2.08 3 $800,000

Since each bondholder should prefer to hold out rather exchange, the restructuring fails and each bondholder receives $10,000 in a liquidation. Thus, creditors (and shareholders) would benefit from a court-enforced formal restructuring. There were two fundamental impediments to a successful informal restructuring in this case. Individual bondholders had an incentive to holdout and free-ride on the concessions made by participating bondholders. The ultimate outcome was not very sensitive to the actions of an individual bondholder. However, when the outstanding debt was held by one large and one small creditor, the large creditor was pivotal to the success of the restructuring. Having a restructuring succeed or fail on the basis of one investor's decision creates strong incentives for this investor to go along with the plan. Chapter 11 of the US bankruptcy code greatly reduces the free-rider problems that are present when firms try informally to restructure their debt. Without the possibility of Chapter 11, creditors will all have an incentive to free ride off other creditors by threatening to force Chapter 7 filings. Turnarounds A corporate turnaround might be defined as the process of ensuring the survival of a financially troubled company. Hoffman [1989] summarized a number of studies on this issue and synthesized from them a generic model consisting of three phases: preparatory, short-term fix and growth. The preparatory phase normally includes a change in leadership (73.2% of firms installed new CEOs according to Schendel, Patton and Riggs [1976]) and restructuring of the organization. The purpose is to install a strong leader and realize improved control over the organization. The short-term fix phase includes short-term operating strategies for reducing costs (typically including layoffs), redeploying assets (including plant relocations, capital expenditure postponement), and pruning products and markets, in many cases, with focus-increasing divestitures. The goal is to improve operating efficiencies, conserve and generate cash and increase revenues. The third phase, growth, places emphasis on repositioning the firm to ensure

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that the turnaround is permanent. Strategies here include increasing operating capacity, advertising and marketing efforts and research and development.7
H. Forecasting Financial Distress Beaver [1967] used a series of univariate tests of ratios to distinguish firms eventually filing for bankruptcy from those which did not. His tests were unable to make use of more than one ratio at a time. Altman [1968] extended this analysis, using the methodology of multi-discriminate analysis to forecast default on corporate debt issues. This paper had an enormous impact on the methods used by lending institutions and credit rating agencies in determining credit worthiness. John and John [1992] provide an extensive review of the literature in the area of financial distress and corporate restructuring. Similar bankruptcy prediction models based on logit or probit analysis including Ohlson [1980] and Zavgren [1985] have been provided in the financial literature.

Ratio analysis often involves the comparison of financial ratios one at a time, then a rather subjective evaluation of these comparisons in order to make a judgement about a firm's characteristics or problems. Statistical frameworks such as the multi-discriminate analysis model enable the analyst to aggregate various ratios in a more objective manner for analysis. One of the earliest of these models was Edward Altman's model, which was developed to forecast corporate default or bankruptcy. Altman's model is based on a series of five ratios which, when combined, seemed to distinguish in advance those firms which defaulted in the following year(s) from those firms that did not. Altman found in his statistical tests that the five ratios in the following model predicted default better than any other group of five ratios:

Z = 1.200X1 + 1.400X2 + 3.300X3 + 0.600X4 + 0.999X5 , where, Z = The multi-discriminate firm score X1 = Net Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = EBIT/Total Assets X4 = Market Value of Preferred and Common Equity/Book Value of Total Debt . X5 = Sales/Total Assets Some of these ratios taken alone, particularly the Sales to Total Assets ratio, would make very poor predictors of default. However, Altman found that these ratios combined seemed to predict default better than any other group of five or fewer ratios. Altman found that those firms with combined Z scores exceeding 2.7 were unlikely to default; firms with scores under 2.7 were likely to go default. As firm scores approached 2.7 from either direction, predictions became less certain.
7

Much of this turnarounds section has been adapted from Adams [2004].

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Consider the Madison Company, whose financial statements are given in Figures 1 and 2. Its Z score would be 1.691, based on the model given in the equation given above: Z = 1.200X1 + 1.400X2 + 3.300X3 + 0.600X4 + 0.999X5 , Z = 1.2.094 + 1.4.031 + 3.3.199 + .6.358 + .999.664 Z = .1128 + .0434 + .6567 + .2148 + .6633 Z = 1.691 where, Z is the multi-discriminate firm score X1 = Net Working Capital/Total Assets = .094 X2 = Retained Earnings/Total Assets = .031 X3 = EBIT/Total Assets = .199 X4 = Market Value of Preferred and Common Equity/Book Value of Total Debt = .358 . X5 = Sales/Total Assets = .664 The Z score of 1.691 is quite low relative to the 2.7 cut-off indicating probable default. Thus, this model indicates that the Madison Company is quite weak (Notice how highly leveraged it is and the low level of earnings that it retains) and is reasonably likely to default during the next few years. However, we must remember that the Altman Model stressed simplicity, and consequently, did not account for many of the operating differences between firms. For example, the model does not distinguish between the operating characteristics of a manufacturing company and of a retail chain. Nonetheless, the model in its simplest form seems to work fairly well in forecasting default and can be extended easily to account for a much wider variety of ratios and other firm characteristics. The model can also be easily extended to account for a variety of macroeconomic variables. Numerous lending institutions make use of extensions and variations of the multi-discriminate model to improve their lending decisions. Multiple Discriminate Analysis is a statistical technique used to classify an observation into one of several a priori groupings dependent upon the observation's individual characteristics. The steps for a typical multiple discriminate analysis may be described as follows: 1. Establish explicit group classifications; Altman uses bankrupt and solvent classifications for firms. He collects a sample of 33 firms which later defaulted on debt obligations and 33 which remained solvent. 2. Collect data on potential characteristics for classification purposes. Determine which characteristics best distinguishes groupings of firms. Altman selected ratios which seemed most likely to be relevant in forecasting bankruptcy. For example, Table 1 in his paper compared mean ratio levels for bankrupt and solvent samples. F-ratios indicated statistical significance in 4 of five univariate tests. Table 2 represents relative contributions of variables as measured by scaled vectors (standard deviations times MDA coefficients). The relevance of the fifth variable is confirmed here. 3. Determine appropriate discriminant coefficients. This could be accomplished by a probit or logit regression analysis.

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4. Test results of the MDA. Generally, with OLS Regressions with Dichotomous Dependent Variables, observations can be classified and assigned grouping numbers. These grouping numbers, for example 0 for solvent firms and 1 for bankrupt firms, may be used as dependent variables for regressions. In this case, since the dependent variable is a binary categorical variable, this model qualifies as a probit regression. Dependent variables forecast by the regression may be roughly interpreted as probabilities of falling into the (1) category. However, the probit regression does not guarantee probabilities in the {0,1} range.

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Madison Company Income Statement, 2006

Cash Sales (S) Credit Sales (CRS) Total Sales Other Revenue Total Revenue (TR) Raw Materials Cost Direct Labor Costs Cost of Goods Sold (CGS) Gross Margin (GM) Plant Operating Cost Maintenance Costs Managerial Salaries Other Fixed Costs Fixed Overhead Costs (FC) Depreciation (Depr.) Earnings Before Interest and Taxes (EBIT) Interest on Current Debt Interest on Notes Payable Interest on Bonds Payable Total Interest Charges (INT) Earnings Before Taxes (EBT)

$2,000,000 4,000,000 $6,000,000 1,000,000 $7,000,000 1,900,000 1,100,000 3,000,000 4,000,000 800,000 500,000 400,000 300,000 2,000,000 200,000 1,800,000 50,000 150,000 650,000 850,000 950,000 285,000 565,000 282,500 282,500 10,000 shs. 28.25

Taxes (30%*EBT) Net Income After Taxes (NIAT) Dividends (Div) Retained Earnings Shares Outstanding (#shs) Earnings Per Share

Figure 18.1: Madison Company Income Statement, 2006

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Madison Company Balance Sheet; Dec. 31, 2005

Assets Cash 100,000 Marketable Securities 300,000 Inventory (INV) 700,000 Accounts Receivable(AR) 400,000 Current Assets(CA) $1,500,000 Equipment(Book Value) 200,000 Plant(Book Value) 3,000,000 Land 4,000,000 Fixed Assets(FA) 7,200,000 Total Assets 8,700,000

Capital Accounts Payable(AP) $500,000 Taxes Payable 50,000 Wages Payable 50,000 Current Liabilities(CL) 600,000 Notes Payable 1,000,000 Bonds Payable 5,000,000 Long Term Debt(LTD) 6,000,000 Total Debt(D) 6,600,000 Common Equity Par 10,000 Cumulative Retained Earnings 2,090,000 Total Equity (E) 2,100,000 Liabilities and Equity (D&E) 8,700,000

Madison Company Balance Sheet; Dec. 31, 2005 Cash Marketable Securities Inventory (INV) Accounts Receivable Current Assets (CA) 100,000 300,000 500,000 600,000 $1,500,000 Accounts Payable $500,000 Taxes Payable 100,000 Wages Payable 50,000 Current Liabilities(CL) 650,000 Notes Payable 1,000,000 Bonds Payable 5,000,000 Long Term Debt 6,000,000 Total Debt (D) 6,650,000 Common Equity Par 10,000 Cumulative Retained Earnings 2,740,000 Total Equity 2,750,000 Liabilities & Equity 9,400,000

Equipment(Book Value) 900,000 Plant(Book Value) 3,500,000 Land 3,500,000 Fixed Assets(FA) 7,900,000 Total Assets 9,400,000

Figure 18.2: Madison Company Balance Sheets

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