A company is considered to be in “financial distress” if its cash flow is insufficient to satisfy its obligations. In such cases, the company must either take corrective action or liquidate.
Given the state of today’s economy, many factors can lead firms into “distress,” including:
- Over-leveraged financials
- Deteriorating credit ratings
- Inadequate cash flow
- Sub-standard operating performance
- Increased competition
Corrective actions for firms in distress are conducted in one of two ways, (1) asset restructuring or (2) financial restructuring (a private workout involving the firm, its creditors and its equity investors, or a Chapter 11 filing).
Asset restructuring usually entails selling major assets, merging with another firm or reducing capital spending and R&D. Financial restructuring is typically conducted by issuing new securities, negotiating with banks and other creditors, exchanging debt for equity, filing for bankruptcy or a combination of these actions.
Firms unable to meet their obligations have two choices under the U.S. Bankruptcy Code:
1. Liquidation (Chapter 7)
2. Reorganization (Chapter 11)
Chapter 7 requires the liquidation of a company; the debtor's nonexempt property is sold and proceeds are distributed to its creditors. For more information on the priority of claims in bankruptcy liquidation, click here.
Chapter 11 is an attempt to reorganize to keep the firm alive and involves:
1. Stabilizing firm operations
2. Submitting a plan of reorganization to pay off creditors over time
3. Gaining creditor approval for the plan or reorganization
The process often involves issuing new securities to replace the firm’s existing securities. For more information about the Chapter 11 process, click here.
Distressed securities are securities issued by firms in financial distress. The distressed securities universe is comprised of a wide range of financial instruments. For more information about distressed securities, click here.