The Pennsylvania State University Schreyer Honors College
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THE PENNSYLVANIA STATE UNIVERSITY SCHREYER HONORS COLLEGE DEPARTMENT OF FINANCE THE ROLE OF REAL ASSETS IN BANKRUPTCY RESOLUTION TESSA MARIE STUBLER Spring 2011 A thesis submitted in partial fulfillment of the requirements for a baccalaureate degree in Finance with honors in Finance Reviewed and approved* by the following: Brent Ambrose Smeal Professor of Real Estate Thesis Supervisor James Miles Professor of Finance Honors Adviser, Reader * Signatures are on file in the Schreyer Honors College. Abstract This paper explores the impact that real assets have on corporate bankruptcy resolutions. I use a logistic regression model to predict the probability of reorganization based on the amount of real assets a company has on its balance sheet the year prior to filing. Following a similar study conducted by Barniv, Agarwal, and Leach (2002), I collected financial data and created a prediction model. Using data collected on 236 firms that were delisted from a national exchange in the past ten years due to bankruptcy issues, my analysis classifies the bankruptcy outcome for each firm as reorganized or liquidated during bankruptcy. The classifications are based upon public documents filed with the Securities and Exchange Commission referring to the bankruptcy process and decisions reached by the court. The study also explores several case studies in which corporations filed for protection under Chapter 7 or Chapter 11 and reached either a reorganization or liquidation resolution. The regression results confirm that firms with more real assets have a higher probability of reaching a reorganization resolution. i Table of Contents Introduction .............................................................................................................................. 1 Literature Review..................................................................................................................... 2 Case Study: Circuit City .......................................................................................................... 7 Case Study: Lehman Brothers ................................................................................................. 8 Case Study: Trump Entertainment & Resorts .......................................................................... 9 Case Study: Ubrandit.com ....................................................................................................... 10 Hypothesis ............................................................................................................................... 10 Research Methodology ............................................................................................................ 12 Data Collection ........................................................................................................................ 13 Results 16 Table 1: Descriptive Statistics .................................................................................. 20 Table 2: Univariate Comparisons of Variables and Tests of Significance ............... 21 Table 3: Variable Logistic Regression Estimates Using Net Property Plant & Equipment ........................................................................................................ 22 Table 4: Variable Logistic Regression Estimates Using Property Plant & Equipment Real Estate ..................................................................................... 23 Summary .................................................................................................................................. 24 Conclusion ............................................................................................................................... 24 Appendix .................................................................................................................................. 26 Exhibit A: Sample .................................................................................................... 26 References ................................................................................................................................ 44 ii Introduction The globalization of business over the past decade has led to the emergence of impressive enterprises, although many have fallen victim to cash flow and liquidity issues, leading to bankruptcy. Corporate bankruptcy filings have greatly increased, resulting from challenging economic times, poorly managed businesses, and unnecessary risk taking. As the economy struggled through a financial meltdown between 2006 and 2007, there was a 43.8% increase in the total number of corporate bankruptcy filings. 1 At the most basic level, when a company’s liabilities exceed its assets and it can no longer continue to pay principal and interest payments on its debt, bankruptcy becomes a likely and attractive solution. When a company files for corporate bankruptcy, it can do so under Chapter 11 or Chapter 7. Chapter 11 allows the firm to submit a reorganization plan whereas Chapter 7 immediately begins the liquidation process. Several factors influence the outcome of a bankruptcy filing, such as the availability of financing, the firm’s cash position, and the strength of firms’ business model. The usual goal is to emerge from bankruptcy in a way that minimizes cost and allows the company to continue operating and return to profitability. This paper explores whether companies with real assets on their balance sheets prior to bankruptcy filing have a greater probability of emerging from bankruptcy or entering into liquidation. 2 1 See Bankruptcy Statistics (2011) 2 See Polinsky, A. Mitchell, and Steven Shavell (2007) 1 Previous studies have tried to predict bankruptcy resolution based upon several standard financial variables, but did not include property plant and equipment (a proxy for real assets) in their research. After developing variables used in previous studies, I introduced two new variables. The two new variables identify the amount of real assets, but are defined differently. Therefore, I estimate two separate logistic regressions in order to isolate the effect of real asset value. Literature Review Bankruptcy is a legal process by which financially distressed firms, individuals, and sometimes governments resolve their debts. When a firm decides to file for bankruptcy, the goal is to reduce the cost of defaulting on debts by either resolving some of the debt entirely or by reducing the debt to a manageable level. When a firm enters into corporate bankruptcy, it can do so under Chapter 11 or Chapter 7. Chapter 11 allows the firm to continue to operate and the pre-bankruptcy managers remain in control.3 When a firm chooses to file under Chapter 11, the firm continues to operate and a reorganization plan is created. Until the reorganization plan goes into effect, the firm ceases to make any principal or interest payments on unsecured debt, although it does continue to pay on secured loans. In order for the firm to successfully emerge from bankruptcy, it must submit a reorganization plan that resolves all debts of the firm. Rather than selling the firms’ assets, as is the case under Chapter 7, the company plans on future earnings of the company to resolve its debts. Firms in Chapter 11 are relieved of the 3 See Polinsky, A. Mitchell and Steven Shavell (2007) 2 obligation to pay taxes on debt forgiveness, which improves cash flow and makes debt repayment more feasible. If the firm chooses to file under Chapter 7, the company enters into a liquidation agreement whereby a trustee is appointed and all of the assets are sold with the proceeds distributed to the creditors. The process of creating a reorganization plan requires significant time and negotiation. During the first four months after the company files, managers submit a plan and creditors are given the option to “take it or leave it”. Managers carefully consider whether the plan allows them to pay creditors the least amount possible and still lead creditors to successfully accept the plan. The plan is approved via a voting procedure, which requires a two-thirds margin in amount and one-half in the number of claims. Two-thirds of equity holders must also vote in favor. The final step requires a bankruptcy judge to approve the reorganization plan. At this time, the plan becomes effective. If the judge does not approve the reorganization plan, he or she can give creditors the option to replace managers, propose an entirely new plan, or require that the firm be sold as a going concern. While a company is reorganizing, it remains in control of all assets and continues to operate. The funds from future earnings are used to repay creditors. In reality, creditors will only be paid back a portion of what they were originally owed and equity holders will be granted new equity shares. The company must make sure to repay the creditors enough in order to retain reasonable access to credit in the future. Firms attempting to reorganize often seek debtor-in-possession financing. This type of financing is specific to firms undergoing the bankruptcy process and becomes 3 senior to all other securities. Firms use debtor-in-possession financing as “seed money” to begin anew and repay existing debt obligations. 4 While most corporations initially file under Chapter 11, firms also have the option to file under Chapter 7. Chapter 7 is the legal procedure used for companies in liquidation and involves the company ceasing operations, selling all assets, and distributing the proceeds to creditors. When a company files under