Capital Structure and Bankruptcy

The failure of the U.S. auto industry has been a dominant news story over the last few months. Today, GM filed for bankruptcy and it appears Chrysler will emerge reorganized soon after Judge Arthur Gonzalez rejected opposing arguments. Over a couple of articles, we will discuss some of the basic nuts and bolts of bankruptcy, a few of the key opponents of the Chrysler reorganization, and some general comments on the entire process.

Let's dive in.

One of our goals on this website is to provide education to our readers by explaining some of the background which is often glossed over in the mainstream media. In this article, we'll start by looking at the basic financial structure of a business. When a new business is started, it requires money. This money is referred to as capital and is used to fund business operations and get things going. Capital comes in two basic forms: debt and equity. The combination of debt and equity for a business is called its capital structure.

When an investor provides capital to a business, it comes in one of these two forms. Equity is a form of ownership often called stock. Equity investors become part owners (shareholders) in the firm. As shareholders, they have a claim on the earnings (profits) of the firm in the form of a dividend and have the ability to oversee the firm's operations via the board of directors. Note that if the company does not make any money, then the shareholders will probably not get paid.

Debt is the other form of capital. Debt investors are referred to as creditors - they are essentially lenders to the firm. Creditors have no claim on earnings and no say in the operations of the business. Creditors simply receive an interest payment on their loan; loans which can be traded in the market are called bonds. These creditors are then also called bondholders.

All of the above actually applies to both investors to new companies as well as existing companies. We'll create a fictitious example using a new company. Let's say that we're going to start a business and need $1M to get started. We're able to find some brave risk takers who are willing to take an equity stake in the company for a combined $400k. This will be represented by 4,000 shares at $100 each. The remaining $600k will be funded by bonds (debt). In this example, consider three classes of bond investors - each a little more risk averse than the other. The first $200k goes to the riskiest bonds. They pay a 12% interest rate are not backed by any sort of collateral. This is referred to as unsecured debt. The other $400k comes from bonds issued with a 6% interest rate and a 5% interest rate ($200k each) and are collateralized (secured) by assets the our new business is purchasing such as land and equipment. The difference between the 6% and 5% bonds are that the 5% bonds are "senior" to the 6% bonds.

After a while, our business is in trouble. If we get to the point where we cannot make interest payments to the bondholders, we may choose to file for bankruptcy protection. In some cases, a particular bondholder may force us into bankruptcy if we miss a payment. There are two key types of bankruptcies for businesses in the U.S. Chapter 11 is used for bankruptcy reorganization where the company attempts to strike deals with their creditors and emerge restructured. Chapter 7 is used to liquidate a company - i.e. sell off all the assets and cease to exist.

By the time our little business venture reaches Chapter 11, chances are most of our cash is gone. If we seek to reorganize, we must get our bondholders to agree to a deal. This deal would provide details of how we would reorganize our business to cut costs, raise cash, and/or renegotiate debt. The bankruptcy court has the authority to approve the plan, but the creditors (who invested $600k in our example) would have a major voice in the matter. In many cases, existing shareholders are "wiped out" - their shares are worthless. Also, there may be a debt-for-equity swap, where bondholders are willing to accept newly issued stock in lieu of their existing bonds which pay interest. Since the 5% yield bonds were senior and secured, those bondholders would generally be entitled to the best deal in the restructuring.

If no deal can be reached in Chapter 11, we would be liquidated in Chapter 7. You may hear of bondholders taking a "haircut" or receiving "25 cents on the dollar". If a bondholder gets paid in a restructuring or liquidation, they will not receive full value on their investment. This is called a haircut. If our unsecured bondholders took a haircut and 25 cents, that would mean they would be paid 25% of their original investment of $200k - in this example, $50k.

Ok. So, this article focused on basic education in corporate finance and bankruptcy. Sometime later this week, we'll dig deeper into the Chrysler bankruptcy and apply what we've learned here.