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We have reviewed some of the techniques that firms use to evaluate the creditworthi-
ness of their customers and to decide whether to issue credit. It would be helpful if these
techniques were refined to perfectly distinguish among customers that will pay their
bills and those that will go belly up, but this is not a realistic goal. In any event, we have
seen that granting credit to a financially shaky customer may pay off if there is a chance
that the offer will lead to a profitable future relationship. Therefore, it is not uncommon
for firms to have to deal with an insolvent customer.
Our focus here is on business bankruptcy. Such bankruptcies account for only about
The
BANKRUPTCY
15 percent of the total number of bankruptcies, but because they are larger than indi-
reorganization or liquidation
vidual bankruptcies, they involve about half of all claims by value. There are also more
of a firm that cannot pay its
complications when a business declares bankruptcy than when an individual does so.
debts.
Credit Management and Collection 241


BANKRUPTCY PROCEDURES
A corporation that cannot pay its debts will often try to come to an informal agreement
with its creditors. This is known as a workout. A workout may take several forms. For
Agreement
WORKOUT
example, the firm may negotiate an extension, that is, an agreement with its creditors to
between a company and its
delay payments. Or the firm may negotiate a composition, in which the firm makes par-
creditors establishing the
tial payments to its creditors in exchange for relief of its debts.
steps the company must
The advantage of a negotiated agreement is that the costs and delays of formal
take to avoid bankruptcy.
bankruptcy are avoided. However, the larger the firm, and the more complicated its
capital structure, the less likely it is that a negotiated settlement can be reached. (For
example, Wickes Corp. tried”and failed”to reach a negotiated settlement with its
250,000 creditors.)
If the firm cannot get an agreement, then it may have no alternative but to file for
bankruptcy.9 Under the federal bankruptcy system the firm has a choice of procedures.
In about two-thirds of the cases a firm will file for, or be forced into, bankruptcy under
Chapter 7 of the 1978 Bankruptcy Reform Act. Then the firm™s assets are liquidated”
Sale of
LIQUIDATION
that is, sold”and the proceeds are used to pay creditors.
bankrupt firm™s assets.
There is a pecking order of unsecured creditors.10 First come claims for expenses
that arise after bankruptcy is filed, such as attorneys™ fees or employee compensation
earned after the filing. If such postfiling claims did not receive priority, no firm in
bankruptcy proceedings could continue to operate. Next come claims for wages and
employee benefits earned in the period immediately prior to the filing. Taxes are next
in line, together with debts to some government agencies such as the Small Business
Administration or the Pension Benefit Guarantee Corporation. Finally come general
unsecured claims such as bonds or unsecured trade debt.
The alternative to a liquidation is to seek a reorganization, which keeps the firm as
REORGANIZATION
a going concern and usually compensates creditors with new securities in the reorgan-
Restructuring of financial
ized firm. Such reorganizations are generally in the shareholders™ interests”they have
claims on failing firm to allow
little to lose if things deteriorate further and everything to gain if the firm recovers.
it to keep operating.
Firms attempting reorganization seek refuge under Chapter 11 of the Bankruptcy
Reform Act. Chapter 11 is designed to keep the firm alive and operating and to protect
the value of its assets while a plan of reorganization is worked out. During this period,
other proceedings against the firm are halted and the company is operated by existing
management or by a court-appointed trustee.
The responsibility for developing a plan of reorganization may fall on the debtor
firm. If no trustee is appointed, the firm has 120 days to present a plan to creditors. If
these deadlines are not met, or if a trustee is appointed, anyone can submit a plan”the
trustee, for example, or a committee of creditors.
The reorganization plan is basically a statement of who gets what; each class of cred-
itors gives up its claim in exchange for new securities. (Sometimes creditors receive
cash as well.) The problem is to design a new capital structure for the firm that will
(1) satisfy the creditors and (2) allow the firm to solve the business problems that got
the firm into trouble in the first place. Sometimes only a plan of baroque complexity
can satisfy these two requirements. When the Penn Central Corporation was finally


9 Occasionally creditors will allow the firm to petition for bankruptcy after it has reached an agreement with
the creditors. This is known as a prepackaged bankruptcy. The court simply approves the agreed workout
plan.
10 Secured creditors have the first priority to the collateral pledged for their loans.
242 SECTION TWO


reorganized in 1978 (7 years after it became the largest railroad bankruptcy ever),
more than a dozen new securities were created and parceled out among 15 classes of
creditors.
The reorganization plan goes into effect if it is accepted by creditors and confirmed
by the court. Acceptance requires approval by a majority of each class of creditor.
Once a plan is accepted, the court normally approves it, provided that each class of cred-
itors has approved it and that the creditors will be better off under the plan than if the
firm™s assets were liquidated and distributed. The court may, under certain conditions,
confirm a plan even if one or more classes of creditors vote against it. This is known as
a cram-down.
The terms of a cram-down are open to negotiation among all parties. For example,
unsecured creditors may threaten to slow the process as a way of extracting concessions
from secured creditors. The secured creditors may take less than 100 cents on the dol-
lar and give something to unsecured creditors in order to expedite the process and reach
an agreement.
Chapter 11 proceedings are often successful, and the patient emerges fit and healthy.
But in other cases cure proves impossible and the assets are liquidated. Sometimes
the firm may emerge from Chapter 11 for a brief period before it is once again sub-
merged by disaster and back in bankruptcy. For example, TWA came out of bankruptcy
at the end of 1993 and was back again less than 2 years later, prompting jokes about
“Chapter 22.”


THE CHOICE BETWEEN LIQUIDATION
AND REORGANIZATION
Here is an idealized view of the bankruptcy decision. Whenever a payment is due to
creditors, management checks the value of the firm. If the firm is worth more than the
promised payment, the firm pays up (if necessary, raising the cash by an issue of
shares). If not, the equity is worthless, and the firm defaults on its debt and petitions for
bankruptcy. If in the court™s judgment the assets of the bankrupt firm can be put to bet-
ter use elsewhere, the firm is liquidated and the proceeds are used to pay off the credi-
tors. Otherwise, the creditors simply become the new owners and the firm continues to
operate.
In practice, matters are rarely so simple. For example, we observe that firms often
petition for bankruptcy even when the equity has a positive value. And firms are often
reorganized even when the assets could be used more efficiently elsewhere. The nearby
box provides a striking example. There are several reasons.
SEE BOX
First, although the reorganized firm is legally a new entity, it is entitled to any tax-
loss carry-forwards belonging to the old firm. If the firm is liquidated rather than reor-
ganized, any tax-loss carry-forwards disappear. Thus there is an incentive to continue in
operation even if assets are better used by another firm.
Second, if the firm™s assets are sold off, it is easy to determine what is available to
pay the creditors. However, when the company is reorganized, it needs to conserve cash
as far as possible. Therefore, claimants are generally paid in a mixture of cash and se-
curities. This makes it less easy to judge whether they have received their entitlement.
For example, each bondholder may be offered $300 in cash and $700 in a new bond
which pays no interest for the first 2 years and a low rate of interest thereafter. A bond
of this kind in a company that is struggling to survive may not be worth much, but the
bankruptcy court usually looks at the face value of the new bonds and may therefore re-
gard the bondholders as paid in full.
FINANCE IN ACTION

The Grounding of Eastern Airlines
court with three different plans to reorganize the com-
Chapter 11 bankruptcy proceedings often involve a
pany, but each time it immediately became clear that
conflict between the objective of keeping the company
the plan was not viable. Eventually, the creditors™ pa-
afloat and that of protecting the interests of the lenders.
tience with management ran out, and they demanded
Seldom has that conflict been more apparent than in
the appointment of an independent trustee to run the
the case of Eastern Airlines.
company. However, the deficits continued to accumu-
Eastern Airlines operated in the very competitive
late. In less than two years the airline had piled up ad-
East Coast corridor and had services to South America
ditional losses of nearly $1.3 billion. Eventually, Eastern
and the Caribbean. For some years before it filed for
could no longer raise the cash to continue flying, and in
bankruptcy, the company had had a record of high op-
January 1991 its planes were finally grounded.
erating costs and poor labor relations. Its boss, Frank
Nearly four more years were to elapse before the
Lorenzo, had a reputation for union busting and one
court was able to settle on a plan to pay off Eastern™s
trade unionist had termed him “ the Typhoid Mary of or-
creditors and a further year passed before the last of
ganized labor.” Lorenzo™s attempts to force Eastern™s
the company™s assets were sold. A large part of the pro-
employees to take a wage cut led to a strike by ma-
ceeds from asset sales had been eaten up by the oper-
chinists in March 1989 and almost immediately Eastern
ating losses and just over $100 million had seeped
filed for bankruptcy under Chapter 11.
away in legal costs. Less than $900 million was left to
When Eastern filed for bankruptcy, it had saleable
pay off the creditors. The secured creditors received
assets, such as planes and gates, worth over $4 billion.
about 80 percent of what they were owed and unse-
This would have been more than sufficient to pay off the
cured creditors received just over 10 percent.
company™s creditors and preferred stockholders. But
the bankruptcy judge decided that it was important to
keep Eastern flying at all costs for the sake of its cus-
Source: The description of the bankruptcy of Eastern Airlines is based
tomers and employees. on L. A. Weiss and K. H. Wruck, “Information Problems, Conflicts of
Eastern did keep flying, but the more it flew, the Interest, and Asset Stripping: Chapter 11™s Failure in the Case of East-
more it lost. Management presented the bankruptcy ern Airlines,” Journal of Financial Economics 48 (1998), pp. 55“97.




Senior creditors who know they are likely to get a raw deal in a reorganization are
likely to press for a liquidation. Shareholders and junior creditors prefer a reorganiza-
tion. They hope that the court will not interpret the pecking order too strictly and that
they will receive some crumbs.
Third, although shareholder and junior creditors are at the bottom of the pecking
order, they have a secret weapon: they can play for time. Bankruptcies of large compa-
nies often take several years before a plan is presented to the court and agreed to by
each class of creditor. (The bankruptcy proceedings of the Missouri Pacific Railroad
took a total of 22 years.) When they use delaying tactics, the junior claimants are bet-
ting on a turn of fortune that will rescue their investment. On the other hand, the senior
creditors know that time is working against them, so they may be prepared to accept a
smaller payoff as part of the price for getting a plan accepted. Also, prolonged bank-
ruptcy cases are costly (the Wickes case involved $250 million in legal and administra-
tive costs). Senior claimants may see their money seeping into lawyers™ pockets and
therefore decide to settle quickly.
Fourth, while a reorganization plan is being drawn up, the company is allowed to buy
goods on credit and borrow money. Postpetition creditors (those who extend credit to a

243
244 SECTION TWO


firm already in bankruptcy proceedings) have priority over the old creditors and their
debt may even be secured by assets that are already mortgaged to existing debtholders.
This also gives the prepetition creditors an incentive to settle quickly, before their claim
on assets is diluted by the new debt.
Finally, profitable companies may file for Chapter 11 bankruptcy to protect them-
selves against “burdensome” suits. For example, in 1982 Manville Corporation was
threatened by 16,000 damage suits alleging injury from asbestos. Manville filed for
bankruptcy under Chapter 11, and the bankruptcy judge agreed to put the damage suits
on hold until the company was reorganized. This took 6 years. Of course legislators
worry that these actions are contrary to the original intent of the bankruptcy acts.




Summary
What are the usual steps in credit management?
The first step in credit management is to set normal terms of sale. This means that you
must decide the length of the payment period and the size of any cash discounts. In most
industries these conditions are standardized.
Your second step is to decide the form of the contract with your customer. Most
domestic sales are made on open account. In this case the only evidence that the
customer owes you money is the entry in your ledger and a receipt signed by the
customer. Sometimes, you may require a more formal commitment before you deliver the
goods. For example, the supplier may arrange for the customer to provide a trade
acceptance.
The third task is to assess each customer™s creditworthiness. When you have made an
assessment of the customer™s credit standing, the fourth step is to establish sensible credit
policy. Finally, once the credit policy is set, you need to establish a collection policy to
identify and pursue slow payers.

How do we measure the implicit interest rate on credit?
The effective interest rate for customers who buy goods on credit rather than taking the
discount for quicker payment is

( )
discount 365/extra days credit
1+ “1
discounted price
When does it make sense to ask the customer for a formal IOU?
When a customer places a large order, and you want to eliminate the possibility of any
subsequent disputes about the existence, amount, and scheduled payment date of the debt, a
formal IOU or promissory note may be appropriate.

How do firms assess the probability that a customer will pay?
Credit analysis is the process of deciding which customers are likely to pay their bills.
There are various sources of information: your own experience with the customer, the
experience of other creditors, the assessment of a credit agency, a check with the customer™s
bank, the market value of the customer™s securities, and an analysis of the customer™s
financial statements. Firms that handle a large volume of credit information often use a
formal system for combining the various sources into an overall credit score.
Credit Management and Collection 245


How do firms decide whether it makes sense to grant credit to a customer?
Credit policy refers to the decision to extend credit to a customer. The job of the credit
manager is not to minimize the number of bad debts; it is to maximize profits. This means
that you need to weigh the odds that the customer will pay, providing you with a profit,
against the odds that the customer will default, resulting in a loss. Remember not to be too
shortsighted when reckoning the expected profit. It is often worth accepting the marginal
applicant if there is a chance that the applicant may become a regular and reliable customer.

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