The Varieties of Bankruptcy

I would like to suggest a typology of bankruptcy investing, consistent, I believe, with Graham and Dodd's approach. We will find

 that there are two types of bankruptcies, which are, in effect, three. First, there are (1) liquida, tions, which are the purest

 Graham and Dodd exercise of all, as the investor buys a security to create a workout that is entirely (or nearly entirely) cash

. It is a rate-of-return play, as the investor makes a judgment that the balance sheet will support cash distributions above those

 impliec by the current prices of the securities. What's more, these distributions wil be received soon enough to create a rate

 of return that justifies the risk involved. Second, there are reorganizations, which come in two flavors: (2) those producing a

 mélange of cash and securities and (3) those in which

CAPTURED

2 This is especially true for reorganizations, more so than for liquidations, a distinction on which I shall elaborate presently

BRIEFLY THIS PART

تلخيص المقطع 

Taking advantage of liberalized bankruptcy laws enacted in 1978, which

no longer require corporations to demonstrate that they are insolvent,6

the oil giant is immune, for the moment, from far more than the debili-

tating bond judgment. Pennzoil can no longer slap liens, as it was report-

edly preparing to do, on up to $8 billion in Texaco assets. With $3 billion

already in reserve, Texaco no longer has to pay $630 million worth of

annual interest on $7 billion in normal business debts. Nor is it required

to pay dividends on 242.3 million outstanding common shares, an esti-

mated saving this year of nearly $727 million.7

Eventually, Texaco was able to settle with Pennzoil for a massive, but

at least manageable, $3 billion, and it emerged from bankruptcy.8 Most

of the distressed investing community focused on Texaco’s senior securi-

ties, such as preferred stock and bonds. Icahn, who had owned Texaco

stock before the bankruptcy, increased his holdings dramatically after

the Chapter 11 filing, eventually raising his stake to 16.6% of the com-

pany. Obviously, he was banking that the reorganization of Texaco would

not wipe out the equity. It was a very good call. After conducting an

unsuccessful proxy fight and making a play for the entire company, Icahn

successfully negotiated for a special dividend of $8 per share to stock-

holders, for a total of $1.9 billion. In addition, Texaco announced a $500

million stock buyback. At the end, Icahn had made $1.1 billion, or a

return of over 75%.9

Introduction to Part III

6 Texaco is but one example of how the Bankruptcy Code may be used as an escape hatch. Crucially,

in NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984), the Supreme Court held that a company may use

section 365(a) of the code, which permits the bankruptcy trustee to assume or reject executory con-

tracts, to escape from the terms of a collective-bargaining agreement by which it had been bound.

7 Ibid.

8 For an overview of the Texaco bankruptcy and Icahn’s subsequent jousting with The Varieties of Bankruptcy

I would like to suggest a typology of bankruptcy investing, consistent, I

believe, with Graham and Dodd’s approach. We will find that there are two

types of bankruptcies, which are, in effect, three. First, there are (1) liquida-

tions, which are the purest Graham and Dodd exercise of all, as the

investor buys a security to create a workout that is entirely (or nearly

entirely) cash. It is a rate-of-return play, as the investor makes a judgment

that the balance sheet will support cash distributions above those implied

by the current prices of the securities. What’s more, these distributions will

be received soon enough to create a rate of return that justifies the risk

involved. Second, there are reorganizations, which come in two flavors: (2)

those producing a mélange of cash and securities and (3) those in which

Introduction to Part III

2 This is especially true for reorganizations, more so than for liquidations, a distinction on which I

shall elaborate presently. the investor’s goal is control of the reorganized company. In the second

type of bankruptcy, “cash and securities” can consist of a bewildering array

of paper: senior debt, senior subordinated debt, mezzanine debt, junior

debt, preferred stock, and equity. The third type of bankruptcy, in which

the investor seeks control, is a polar opposite of a liquidation, in that the

hope is to achieve profit from seizing control of a going concern rather

than reaping the proceeds of the sale of its parts. The first and third types

of bankruptcy are conceptually simpler to structure, unlike the cash and

securities reorganizations, which have an intermediate goal (get some

cash out of the business at the outset and then hope it will prove prof-

itable going forward) but the greatest structural complexity.

In almost all cases of distressed investing, holding periods start at a

year or two and can stretch longer—considerably longer when the

investor takes a controlling position in the company. Whereas Charles

Dickens once wrote to a friend that the character he most enjoyed por-

traying was “the rogue who transforms himself in a blink of an eye and

thereby instantly earns his eternal reward,” it is not the nature of a dis-

tressed investment to realize its goals in the blink of an eye or even in

the turn of a quarter or two. The process is necessarily drawn out, and

investors cannot easily wait till the end of the process to buy because

the product is often illiquid, all the more so when the investor wishes to

accumulate enough securities to achieve control.

In effect, the bankruptcy investor acts as the incubator, buying tad-

poles and selling frogs. In liquidations, the frogs are very green: the

investor receives cash and, sometimes, a small amount of senior debt; in

reorganizations, on the other hand, the investor may receive a mélange,

or what I like to call a “grab bag,” of cash, senior debt, junior debt, and

new equity in a reorganized company. At the extreme, where the frogs

are greenest—in a liquidation—the investor is essentially creating cash

at a discount, weighted for time and risk. As the investor moves from

liquidation to reorganization to control reorganization, he or she moves

] away from classic Graham and Dodd balance sheet analysis toward

more speculative endeavors.

Distressed investors combine a financial analysis of a company’s capi-

tal structure with a legal analysis of the rights and prerogatives of bond-

holders at each level of the capital structure. As the authors noted,

litigation can be necessary “to cut the Gordian knot” when “creditors . . .

belong to several classes with conflicting interests.” (p. 234) Blending the

financial and legal analysis is crucial. As distressed investors contemplate

an investment, their financial flexibility is defined and limited by the

legal remedies made available by specific covenants and broader con-

tract and bankruptcy law; simultaneously, their legal rights are circum-

scribed by what is financially achievable.3 In other words, distressed

investors cross-reference the legally permissible with the financially

doable. When they find the desired fit, they invest.

A few examples of recent (and not so recent) coups in distressed

investing give an idea of what takes place in the field. These examples

also suggest that, while individual investors may have success picking

stocks, it is far more difficult for them to partake in distressed investing.

Doing well in the bankruptcy process often entails expenditures of time

and resources that are beyond their capabilities.