Financial Restructuring - Series 79 Exam

Financial Distress Overview

Financial restructuring is the process of reorganizing a company's financial obligations when it faces financial distress, meaning it can no longer meet its debt obligations or its liabilities exceed its assets. Restructuring is a critical area of investment banking, and understanding the legal frameworks, strategic options, and advisory roles involved is important for the Series 79 exam.

Companies may experience financial distress for various reasons: excessive leverage, declining revenues, loss of key customers, industry disruption, litigation, regulatory changes, or macroeconomic downturns. The severity of the distress determines the range of options available and the urgency of action required.

Signs of Financial Distress

Liquidity crisis: Inability to meet payroll, pay suppliers, or service debt obligations as they come due
Covenant violations: Breaching financial maintenance covenants in loan agreements (leverage ratios, interest coverage ratios, minimum EBITDA levels)
Declining financial performance: Persistent revenue declines, margin compression, and negative free cash flow
Going concern qualification: Auditors express doubt about the company's ability to continue as a going concern
Credit rating downgrades: Successive downgrades by rating agencies signal deteriorating creditworthiness
Vendor tightening: Suppliers reduce credit terms or require cash on delivery

Financial Restructuring: The process of reorganizing a company's capital structure, typically involving the modification of debt terms, conversion of debt to equity, asset sales, or other measures designed to restore the company's financial viability. Restructuring may occur out of court (consensual) or through bankruptcy proceedings (judicial).

Out-of-Court Restructuring

Companies in financial distress will typically first attempt an out-of-court restructuring (also called a "workout") because it is generally faster, less expensive, and less disruptive than formal bankruptcy proceedings. An out-of-court restructuring involves negotiating directly with creditors to modify the terms of existing obligations.

Common Out-of-Court Strategies

Debt Extension (Amend and Extend): Extending the maturity dates of existing debt to give the company more time to improve its financial position. Creditors may agree if they believe the company can eventually repay if given additional time.
Debt-for-Equity Swap: Creditors exchange their debt claims for equity ownership in the company. This reduces the company's debt burden and interest obligations but dilutes existing equity holders. Creditors become owners and may influence the company's future direction.
Covenant Relief/Modification: Negotiating with lenders to waive covenant violations or modify covenants to provide more operational flexibility. This often requires additional consideration (fees, higher interest rates, or additional collateral).
Asset Sales: Selling non-core assets to generate cash for debt repayment. This can reduce leverage while allowing the company to focus on its core operations.
Exchange Offers: Offering creditors new securities (typically with different terms) in exchange for their existing claims. For example, offering new secured notes in exchange for existing unsecured bonds at a discount to face value.
Rights Offerings: Issuing new equity to existing shareholders, often at a significant discount, to raise capital for debt reduction.

The key advantage of out-of-court restructuring is that it requires unanimous creditor consent for changes to debt terms. The key disadvantage is that a single holdout creditor can block the restructuring. This "holdout problem" is the primary reason companies sometimes must resort to Chapter 11 bankruptcy, which allows a court to impose a plan on dissenting creditors (a "cramdown").

Chapter 11 Reorganization

Chapter 11 of the U.S. Bankruptcy Code provides a framework for companies to reorganize their financial affairs under court supervision while continuing to operate their business. Chapter 11 is designed to preserve the going-concern value of the business while providing a structured process for addressing creditor claims. Understanding Chapter 11 is essential for the Series 79 exam.

Key Features of Chapter 11

Automatic Stay: Upon filing, an automatic stay immediately halts all collection efforts, lawsuits, foreclosures, and enforcement actions against the debtor. This gives the company breathing room to develop a reorganization plan without the pressure of creditor actions.
Debtor-in-Possession (DIP): In most cases, existing management continues to operate the business as a "debtor-in-possession" under court supervision. The DIP has the powers of a bankruptcy trustee and can continue ordinary business operations.
DIP Financing: The company can obtain new financing (DIP financing) with court approval. DIP loans receive priority over existing claims, making them attractive to lenders despite the company's distressed state. DIP financing provides the liquidity needed to continue operations during the bankruptcy process.
Exclusivity Period: The debtor has an exclusive right to propose a reorganization plan during the first 120 days (extendable to 18 months). After exclusivity expires, any party in interest can file a competing plan.
Plan of Reorganization: The plan specifies how each class of creditors will be treated, typically involving a combination of cash payments, new debt, new equity, or a combination. The plan must be accepted by each impaired class of creditors (two-thirds in amount and more than half in number of claims voting).
Cramdown: If one or more impaired classes reject the plan, the court can still confirm it under the "cramdown" provisions if the plan does not discriminate unfairly and is "fair and equitable" to the dissenting class.

The Absolute Priority Rule

The Absolute Priority Rule (APR) is a fundamental principle of bankruptcy law that governs the distribution of value in a Chapter 11 reorganization. Under the APR, each class of claims must be paid in full before any junior class receives any distribution. The priority order is:

Secured creditors: Paid first, up to the value of their collateral
Administrative claims: Professional fees, DIP financing, and post-petition obligations
Priority claims: Employee wages (up to limits), tax obligations, and customer deposits
Unsecured creditors: Bondholders, trade creditors, and other unsecured claimants
Subordinated creditors: Junior or subordinated debt holders
Preferred stockholders: Preferred equity holders
Common stockholders: Last in line; typically receive nothing in most Chapter 11 cases

In most Chapter 11 cases, existing common equity holders receive nothing. The absolute priority rule requires that all senior claims be satisfied in full before equity holders receive any distribution. This is a frequently tested concept on the Series 79 exam. The exception is where the plan is consensual (all classes accept) and the parties agree to deviate from absolute priority, which sometimes occurs in practice.

Chapter 7 Liquidation

Chapter 7 of the Bankruptcy Code provides for the orderly liquidation of a company's assets. Unlike Chapter 11 (reorganization), Chapter 7 results in the cessation of business operations and the distribution of asset proceeds to creditors according to the absolute priority rule. A court-appointed trustee takes control of the company's assets, sells them, and distributes the proceeds.

Companies may be forced into Chapter 7 liquidation when the business has no viable going-concern value, reorganization is not feasible, or a Chapter 11 case is converted to Chapter 7 because the debtor cannot develop a viable reorganization plan. The liquidation value of a company is typically significantly lower than its going-concern value because assets sold in liquidation (especially under time pressure) often fetch substantial discounts.

Feature	Chapter 7 (Liquidation)	Chapter 11 (Reorganization)
Objective	Liquidate assets and distribute proceeds	Reorganize and emerge as going concern
Business Operations	Cease	Continue under DIP management
Management	Court-appointed trustee	Existing management (debtor-in-possession)
Typical Duration	3-6 months	6-24+ months
Recovery for Creditors	Lower (fire-sale values)	Higher (going-concern value preserved)
Equity Recovery	Almost never	Rare but possible

The Restructuring Advisory Role

Investment banks play a critical advisory role in restructuring situations. Restructuring advisors may represent the debtor company, secured creditors, unsecured creditors (often through an official committee), or potential acquirers of distressed assets.

Debtor-Side Advisory

When advising the distressed company, the investment bank helps assess the company's financial situation and liquidity position, evaluate strategic alternatives (out-of-court restructuring, Chapter 11, sale, or liquidation), develop financial projections and a business plan, negotiate with creditors and stakeholders, arrange DIP financing, market the company or its assets for sale (often through a Section 363 sale in bankruptcy), and develop and implement the plan of reorganization.

Creditor-Side Advisory

When advising creditors (typically the official committee of unsecured creditors or an ad hoc group of bondholders), the investment bank helps evaluate the debtor's financial condition and projections, assess the value of the company and the recoveries available to each creditor class, negotiate plan terms on behalf of the creditor group, evaluate DIP financing proposals, and assess any sale proposals.

Section 363 Sales

A Section 363 sale is a provision of the Bankruptcy Code that allows the debtor to sell assets outside the ordinary course of business with court approval. Section 363 sales are commonly used to sell businesses or divisions as going concerns during bankruptcy, often through an auction process. The key advantage is that assets are sold free and clear of liens, claims, and encumbrances, providing the buyer with "clean" title. The court must approve the sale after finding that it maximizes value for the estate.

Restructuring advisory requires a unique combination of financial analysis, legal knowledge, negotiation skills, and industry expertise. Unlike M&A advisory, where the primary goal is maximizing value for shareholders, restructuring advisory involves balancing the competing interests of multiple stakeholder groups (secured creditors, unsecured creditors, equity holders, employees, and management) within the constraints of the bankruptcy code and applicable law.

Prepackaged and Pre-Negotiated Bankruptcies

To combine the advantages of out-of-court restructuring (speed, lower cost) with the binding enforcement of Chapter 11 (ability to bind dissenting creditors), companies may pursue a prepackaged bankruptcy ("prepack"). In a prepack, the company negotiates the plan of reorganization with its major creditors before filing for Chapter 11. Creditors vote on the plan before the filing, and the company files for bankruptcy with the votes already in hand, seeking rapid court confirmation.

A pre-negotiated bankruptcy is similar but involves negotiating key terms with creditors before filing without actually soliciting votes. The formal solicitation and voting occur after the Chapter 11 filing. Pre-negotiated cases are faster than traditional Chapter 11 cases but slower than prepacks.

Both approaches significantly reduce the time and cost of the bankruptcy process. Prepackaged cases can sometimes be completed in as little as 30-45 days, compared to 12-24 months for a traditional Chapter 11 case.

Remember the creditor priority order with "SAPUSC": Secured creditors, Administrative claims, Priority claims, Unsecured creditors, Subordinated debt, Common equity. Think: "Secured Always Paid; Unsecured Sometimes Collect."

Check Your Understanding

Test your knowledge of financial restructuring. Select the best answer for each question.

1. Under the absolute priority rule in bankruptcy, which class is paid LAST?

2. The "automatic stay" in Chapter 11 bankruptcy:

3. A "cramdown" in Chapter 11 allows the court to:

4. DIP financing receives priority over existing claims because:

5. A prepackaged bankruptcy is advantageous because it:

A prepackaged bankruptcy negotiates and solicits creditor votes on the reorganization plan before filing for Chapter 11. This combines the speed and lower cost of out-of-court restructuring with the binding enforcement mechanism of Chapter 11 (including the ability to bind dissenting creditors through cramdown). Prepacks can be completed in 30-45 days versus 12-24 months for traditional Chapter 11.