Chapter 17 CORPORATE LIQUIDATIONS and REORGANIZATIONS Answers to Questions Equity insolvency occurs when a debtor is unable to pay its debts as they come due Bankruptcy insolvency occurs when a debtor’s liabilities exceed the fair value of all assets A bankruptcy proceeding is designated voluntary if the debtor corporation files the petition to place itself under the protection of the bankruptcy court and involuntary if creditors file the petition to bring the debtor into bankruptcy court An involuntary petition may be filed by a single creditor with an unsecured claim of $12,300 or more if there are fewer than twelve unsecured creditors Otherwise, three or more entities with unsecured claims totaling at least $12,300 must file in order to commence an involuntary case The requirements are the same for Chapter and Chapter 11 cases The duties of the U.S trustee are to maintain and supervise a panel of private trustees eligible to serve in Chapter cases, to serve as trustee or interim trustee in some bankruptcy cases, to supervise the administration of bankruptcy cases, and to preside over creditor meetings Bankruptcy judges still supervise cases in districts without U.S trustees The debtor corporation in a bankruptcy case has the following duties: (1) to file a list of creditors, a schedule of assets and liabilities, and a statement of the debtor’s financial affairs; (2) to cooperate with the trustee so that the trustee may perform his duties; (3) To surrender all property, including books, documents, records, and so on, to the trustee; and (4) to appear at hearings of the bankruptcy court as required A trustee is not appointed in all Title 11 cases In Chapter cases a trustee will be elected by unsecured creditors if a majority vote in amount of holders with at least 20 percent of the claims is obtained Otherwise, an appointed interim trustee serves as trustee In Chapter 11 cases a trustee is appointed only if deemed necessary by the court, but otherwise, the debtor remains in possession of the estate and performs the duties of a trustee Within 30 days from the time the court orders the appointment of a trustee in a Chapter 11 case, a party in interest may request the election of a trustee © 2009 Pearson Education, Inc publishing as Prentice Hall 17-2 Corporate Liquidations and Reorganizations The trustee in a liquidation case takes possession of the debtor’s estate, converts estate assets into cash, and distributes the proceeds as directed by the court He also performs other duties such as investigating the financial affairs of the debtor, providing information about the estate to parties of interest, examining creditor claims and objecting to those that appear improper, operating the debtor’s business if authorized to so by the court, providing financial reports and summaries about the estate to the court, and filing reports on trusteeship as directed by the court The priority rankings in a Chapter liquidation case are summarized in Exhibit 17–2 of the text The priorities recognized for unsecured claims (Rank II) are: (1) administrative expenses, (2) claims incurred between an involuntary filing and appointment of a trustee, (3) salary claims up to $10,000 per individual earned within 90 days of filing, (4) employee benefit plan contribution claims up to $10,000 per individual earned within 180 days of filing, (5) individual claims up to $1,800 for goods and services purchased from, but not provided by the debtor, and (6) claims of governmental units for taxes owed by the debtor (subject to time restrictions), including taxes collected and withheld for which the debtor is liable Four ranks within the unsecured nonpriority claim category (general unsecured claims) are: (1) claims allowed that were timely filed, (2) claims allowed where proof was filed late, (3) claims allowed for fines, penalties or forfeitures, or damages, and arising before the court order for relief or appointment of a trustee, and (4) claims for interest on unsecured claims The accountant’s statement of affairs is a financial statement that is designed to provide information about liquidation values and priority rankings for use by the trustee, the court, creditors, and other interested parties in the debtor’s estate Assets are measured at expected net realizable values in the statement, but book values are also included for reference purposes (The Bankruptcy Act refers to a statement of affairs, but that statement is a questionnaire that includes various financial and nonfinancial and legal section 10 A debtor corporation’s estate may be liquidated even though the filing is under Chapter 11 This can occur when the case is transferred to Chapter for liquidation It can also be carried out in accordance with an approved Chapter 11 plan of reorganization that calls for sale and distribution of the proceeds from the debtor corporation’s estate 11 A debtor in possession reorganization case is a Chapter 11 case in which the bankruptcy court does not appoint a trustee, but instead, allows the debtor corporation to carry out the duties that otherwise would be performed by a trustee 12 A creditor committee can file a plan of reorganization under a Chapter 11 case after 120 days from the date the court order for relief is granted The order for relief occurs when the debtor or creditor’s filing petition is approved by the court 13 The approval of a plan of reorganization requires acceptance of the plan by at least two-thirds in amount and over half in number of claims in each class of claims Further, each class of claims must accept the plan or not be impaired under it A class of claims that would receive nothing if the corporation were liquidated is not impaired if it receives nothing under a plan and, accordingly, acceptance by that class of claims is not required © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-3 14 Prepetition liabilities are the liabilities of an enterprise that were incurred prior to a Chapter 11 filing They are reported at the amounts allowed by the bankruptcy court Prepetition liabilities subject to compromise are those liabilities that may be impaired by a plan and that are eligible for compromise because they are either unsecured or undersecured 15 Reorganization value is an estimate of the value of the reconstituted entity that will emerge from reorganization, plus the expected net realizable value of the assets that will be disposed of before reconstitution occurs It is also described as the fair value of the entity before considering liabilities Reorganization value approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring 16 Fresh start reporting should be used by a company emerging from Chapter 11 if the following two conditions are met: (1) the reorganization value of the assets of the emerging entity immediately before the date of confirmation is less than the total of all postpetition liabilities and allowed claims and (2) holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity 17 Entities not qualifying for fresh start reporting report liabilities compromised by a confirmed reorganization plan in a manner similar to that of a note issued in a noncash transaction under APB Opinion No 21 Forgiveness of debt should be reported as an extraordinary item © 2009 Pearson Education, Inc publishing as Prentice Hall 17-4 Corporate Liquidations and Reorganizations SOLUTIONS TO EXERCISES Solution E17-1 b d c d d c a d c 10 d 11 c 12 d 13 c Solution 17-2 a d c d Solution E17-3 Note receivable from Patriots Supply Amount secured by inventory items at expected recoverable value $100,000 (30,000) Unsecured portion of note receivable from Patriots Supply Expected recovery on the dollar for unsecured claims 70,000 35 Expected recovery on unsecured portion of note Add: Secured portion 24,500 30,000 Total expected recovery on note from Patriots Supply $ 54,500 Solution E17-4 On the basis of the reorganization value, Baxter Hardware qualifies for fresh start reporting because the estimated reorganization value of $2,000,000 is less than the postpetition liabilities and allowed claims Estimated reorganization value Liabilities: Postpetition liabilities Prepetition liabilities Fully secured debt Excess liabilities over reorganization value $2,000,000 $1,200,000 1,500,000 900,000 3,600,000 $1,600,000 Old stockholders must retain less than a 50% interest in the “new entity.” Reorganization value Less: Payment to prepetition claimants Reorganized capital structure: Postpetition liabilities Notes payable Fully secured debt $2,000,000 150,000 1,850,000 $1,200,000 300,000 900,000 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-5 New common stock to prepetition claimants New common stock to old stockholders 375,000 $ (925,000) 2,775,000 Solution E17-5 Cash available for distribution Mortgage payable (secured portion) Priority claims (administrative expenses and salaries) Available for unsecured, nonpriority claims $100,000 (50,000) 50,000 (10,000) $ 40,000 Unsecured, nonpriority claims: Balance of mortgage payable Accounts payable Unsecured, nonpriority claims $ 30,000 50,000 $ 80,000 $40,000 available cash/$80,000 claims = $.50 on the dollar Schedule of Distribution of Available Cash Mortgage payable — secured portion Unsecured, priority claims Mortgage payable — unsecured portion ($30,000 ´ $.50) Accounts payable ($50,000 ´ $.50) Total cash distributed $ 50,000 10,000 15,000 25,000 $100,000 © 2009 Pearson Education, Inc publishing as Prentice Hall 17-6 Corporate Liquidations and Reorganizations SOLUTIONS TO PROBLEMS Solution P17-1 Entries on trustee’s books: March 1, 2008 Cash $ 4,000 8,000 Accounts receivable — net Inventories 36,000 Land 20,000 100,000 Buildings — net Intangible assets 26,000 Accounts payable $50,000 40,000 Note payable — unsecured Revenue received in advance 1,000 Wages payable 3,000 Mortgage payable 80,000 Estate equity 20,000 To record custody of Scott Corporation in liquidation March 2008 Cash $ 7,200 Estate equity 800 $ 8,000 Accounts receivable — net To record collection of receivables and recognize loss Cash Estate equity Inventories To record sale of inventories at a loss $ 19,400 16,600 $36,000 Cash $ 90,000 Estate equity 30,000 Land Buildings — net To record sale of land and buildings at a loss Estate equity $ 26,000 Intangible assets To write off intangible assets at a loss Estate equity Administrative expenses payable — new To accrue trustee expenses $ $ 20,000 100,000 $ 26,000 8,200 $ © 2009 Pearson Education, Inc publishing as Prentice Hall 8,200 Chapter 17 17-7 Solution P17-1 (continued) Scott Corporation in Trusteeship Balance Sheet at March 31, 2008 Assets Cash $120,600 Liabilities And Deficit Accounts payable Note payable — unsecured Revenue received in advance Wages payable Mortgage payable Administrative expenses payable — new Total liabilities Less: Estate deficit $ 50,000 40,000 1,000 3,000 80,000 8,200 182,200 (61,600) Total liabilities less deficit $120,600 Statement of Cash Receipts and Disbursements from March to March 31, 2008 Cash balance, March 1, 2008 Add: Cash receipts Collections of receivables Sale of inventories Sale of land and buildings $ $ 7,200 19,400 90,000 Less: Cash disbursements (none) Cash balance, March 31, 2008 4,000 116,600 120,600 $120,600 Statement of Changes in Estate Equity from March to March 31, 2008 Estate equity, March 1, 2008 $20,000 Less: Loss on uncollectible receivables Loss on sale of inventories Loss on sale of land and buildings Loss on write-off of intangibles Administrative expenses Estate deficit, March 31, 2008 $ 800 16,600 30,000 26,000 8,200 81,600 $61,600 © 2009 Pearson Education, Inc publishing as Prentice Hall 17-8 Corporate Liquidations and Reorganizations Solution P17-1 (continued) Entries on trustee’s books: April 2008 Mortgage payable $80,000 Cash $80,000 To record payment of secured creditors from proceeds from sale of land and buildings $ 8,200 Administrative expenses payable — new Revenue received in advance 1,000 Wages payable 3,000 Cash To record payment of priority liabilities $12,200 Accounts payable $15,800 12,600 Note payable — unsecured Cash $28,400 To record payment of $.32 per dollar to unsecured creditors (available cash of $28,400 divided by unsecured claims of $90,000) Accounts payable $34,200 27,400 Note payable — unsecured Estate equity $61,600 To write off remaining liabilities and close trustee’s records © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-9 Solution P17-2 Amount expected to be available for unsecured claims: Total amount expected to be available for all claims Less: Payments to secured and priority claims Mortgage payable Note payable Priority claims $445,000 $220,000 75,000 80,000 Expected to be available for unsecured nonpriority claims 375,000 $ 70,000 Expected recovery per dollar of unsecured claims: Expected to be available (from 1) = $70,000 Unsecured claims ($550,000 - $375,000) = $175,000 Expected recovery on the dollar: $70,000/$175,000 = $.40 Expected recovery by class of creditors: $220,000 Fully secured — mortgage payable 85,000 Partially secured — note payable $75,000 + ($25,000 ´ $.40) 80,000 Priority unsecured — liabilities to priority creditors Unsecured nonpriority creditors — accounts payable ($150,000 ´ $.40) 60,000 Total $445,000 © 2009 Pearson Education, Inc publishing as Prentice Hall 17-10 Corporate Liquidations and Reorganizations Solution P17-3 Ranking of claims: Fully secured: Holders of first mortgage and related interest $228,500 Unsecured priority: Administrative expenses Wages payable up to $4,000 per employee Customer claims for merchandise paid for and not delivered (maximum $1,800 per individual) State government for gross $ 3,000 receipts taxes Local government for property taxes 4,000 Total unsecured priority claims Unsecured nonpriority: Merchandise creditors $99,000 Local bank for principal of loan 30,000 President for salary due over $4,000 1,000 Interest on unsecured bank loan Total unsecured nonpriority claims $ 12,500 47,000 1,500 7,000 68,000 130,000 4,500 134,500 $431,000 Total all claims Distribution of available cash: 1st Mortgage holders (100%) 2nd Administrative expenses (100%) 12,500 3rd Employees (up to $4,000 each) (100%) 47,000 4th Customers for merchandise not delivered (100%) 5th State government (100%) Local government (100%) $228,500 1,500 $ 3,000 4,000 7,000 [Remaining cash ($374,500 - $296,500) of $78,000/$130,000 claim of next rank = $.60 return on dollar] 6th Merchandise creditors ($99,000 ´ 60) Local bank for loan principal ($30,000 ´ 60) Company president ($1,000 ´ 60) Total distributed (equal to available cash) $59,400 18,000 600 78,000 $374,500 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-11 Solution P17-4 Hanna Corporation Statement of Affairs on June 30, 2008 Assets Realizable ValuesLiability Offsets for Secured Creditors Book Value $55,000 2,200 15,000 20,000 Pledged for partially secured creditors Equipment — net Less: Mortgage note payable and accrued interest Realizable Value Available for Unsecured Creditors $28,000 (31,000) $ Available for priority and unsecured creditors Cash Accounts receivable — net Inventories 2,200 13,500 22,500 Total available for priority and unsecured creditors Less: Priority liabilities 38,200 12,000 Total available for unsecured creditors Estimated deficiency $92,200 26,200 10,800 $37,000 Liabilities And Stockholders’ Equity Book Value $12,000 31,000 26,400 7,600 55,000 (39,800) $92,200 Secured and Unsecured NonPriority Claims priority Claims Priority liabilities Wages payable (assumed under $4,000 per employee) Partially secured creditors Note payable and accrued interest Less: Equipment pledged as security Unsecured creditors Accounts payable Rent payable $12,000 $31,000 (28,000) $ 3,000 26,400 7,600 Stockholders’ equity Capital stock Retained earnings (deficit) $37,000 © 2009 Pearson Education, Inc publishing as Prentice Hall 17-12 Corporate Liquidations and Reorganizations © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-13 Solution P17-4 (continued) Estimated payments per dollar for unsecured creditors Cash available $66,200 Distribution to partially secured and unsecured priority creditors: Note payable and interest Administrative expenses Wages payable $28,000 4,000 12,000 44,000 Available to unsecured nonpriority creditors = A $22,200 Note payable and interest (unsecured portion) Accounts payable Rent payable $ 3,000 26,400 7,600 Unsecured nonpriority claims = B $37,000 A/B = $22,200/$37,000 = $.60 per dollar Expected recovery for each class of claims Partially secured Note payable and interest Secured portion Unsecured portion ($3,000 ´ $.60) $28,000 1,800 $29,800 $ 4,000 12,000 16,000 $15,840 4,560 20,400 Unsecured priority Administrative expenses Wages payable Unsecured nonpriority Accounts payable ($26,400 ´ $.60) Rent payable ($7,600 ´ $.60) Total payments $66,200 © 2009 Pearson Education, Inc publishing as Prentice Hall 17-14 Corporate Liquidations and Reorganizations Solution P17-5 Dawn Corporation — in Chapter Statement of Affairs at July 10, 2008 Assets Book Value $210,000 250,000 80,000 200,000 150,000 10,000 Fully secured Accounts receivable — net Less: Notes payable Partially secured Land and buildings — net Less: Mortgage and interest payable Unsecured Cash Inventories Equipment — net Intangible assets Available for priority and unsecured Priority liabilities Available for nonpriority unsecured Estimated deficiency Realizable ValueLiability Offsets Realizable Value Available for Unsecured $160,000 100,000 $ 60,000 $140,000 205,000 80,000 210,000 60,000 410,000 150,000 260,000 155,000 $415,000 $900,000 Equities Secured and Priority Claims Book Value $ 50,000 24,000 76,000 Priority liabilities Accounts payable Wages payable Taxes payable 100,000 Fully secured Note payable Less: Accounts receivable — net 205,000 Partially secured Mortgage and interest payable Less: Land and buildings — net 350,000 300,000 (205,000) $900,000 Unsecured Accounts payable Capital stock Retained earnings deficit UnsecuredNonpriority Claims $ 50,000 24,000 76,000 150,000 $100,000 160,000 60,000 $205,000 140,000 65,000 $ 65,000 350,000 $415,000 © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-15 Solution P17-5 (continued) Claims by Priority Ranks Priority claims Administrative expenses Accounts payable Wages payable Taxes payable Fully secured claims Note payable Partially secured claims Mortgage and interest payable Unsecured Accounts payable Amounts to Amounts to Be Be Paid Written Off $ 11,000 50,000 24,000 76,000 $ 11,000 50,000 24,000 76,000 100,000 100,000 205,000 140,000 39,000 $ 26,000 350,000 $816,000 210,000 $650,000 140,000 $166,000 Calculation of recovery for unsecured nonpriority claims Cash available Less: Paid to priority claims Less: Paid to fully secured claims Less: Paid to partially secured creditors – secured portion $650,000 (161,000) (100,000) (140,000) A $249,000 Cash available for unsecured Unsecured claims: Partially secured ($205,000 - $140,000 secured) Accounts payable — nonpriority $ 65,000 350,000 B $415,000 Total unsecured claims A ¸ B = $249,000/$415,000 = $.60 recovery on the dollar © 2009 Pearson Education, Inc publishing as Prentice Hall 17-16 Corporate Liquidations and Reorganizations Solution P17-6 Everlast Window Corporation Statement of Affairs on June 30, 2008 Assets Realizable ValuesRealizable Liability Value Offsets for Available for Secured Unsecured Creditors Creditors Book Value $230,000 40,000 70,000 50,000 60,000 50,000 Pledged for fully secured creditors Land and building $170,000 Less: Mortgage payable and accrued interest (165,000) Available for priority and unsecured creditors Cash Accounts receivable — net Inventories Machinery — net Goodwill Total available for priority and unsecured creditors Less: Priority liabilities Total available for unsecured creditors Estimated deficiency $500,000 $ 5,000 40,000 63,000 42,000 20,000 170,000 70,000 100,000 65,000 $165,000 Liabilities and Stockholders’ Equity Secured and Priority Claims Book Value $ 60,000 10,000 150,000 15,000 110,000 50,000 5,000 200,000 (100,000) $500,000 Priority liabilities Wages payable Property taxes payable Fully secured creditors Mortgage payable Interest on mortgage payable Unsecured creditors Accounts payable Note payable — unsecured Interest payable — unsecured Stockholders’ equity Capital stock Retained earnings (deficit) Unsecured Non-priority Claims $ 60,000 10,000 70,000 $150,000 15,000 165,000 $110,000 50,000 5,000 $165,000 Settlement per dollar of rank unsecured creditors is $.6250 ($100,000 available for unsecured/$160,000 accounts and notes payable) No payment is made for the $5,000 unsecured interest claim © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-17 © 2009 Pearson Education, Inc publishing as Prentice Hall 17-18 Corporate Liquidations and Reorganizations Solution P17-7 The reorganization is eligible for fresh start accounting because the liabilities on June 30, 2008 of $16,500 exceed the reorganization value of $16,000 by $500 Also, the common stock of the new entity is allocated $5,000 to prepetition creditors and $2,000 to Lowstep’s old stockholders, so that the old stockholders have less than a 50 percent interest in the new entity Entries to adjust Lowstep’s accounts for the reorganization plan: Prepetition liabilities $12,500 Accounts payable (old) $ 800 Wages payable (old) 400 Note payable (new) 3,800 Common stock (new) 5,000 Gain on debt restructuring 2,500 To adjust prepetition liabilities to conform with the plan Loss on asset adjustments to fair values Inventories Land Buildings — net Patent To adjust assets to their fair values $ 4,000 400 1,000 Common stock (old) Common stock (new) Additional paid-in capital To record exchange of common stock $ 7,000 $1,400 4,000 Gain on debt discharge $ Additional paid-in capital Reorganization value in excess of fair value Loss on asset adjustments to fair values Deficit To eliminate deficit and record adoption of $2,000 5,000 2,500 5,000 1,000 $4,000 4,500 fresh start reporting © 2009 Pearson Education, Inc publishing as Prentice Hall Chapter 17 17-19 Solution P17-7 (continued) Lowstep Corporation Final Balance Sheet as of July 8, 2008 Assets Cash Trade receivables — net Inventories Land Buildings — net Equipment — net Reorganization value in excess of fair values Total assets $ 6,700 1,000 2,000 2,000 1,500 1,800 1,000 $16,000 Liabilities and Stockholders’ Equity Accounts payable Accounts payable (old) Wages payable Wages payable (old) Notes payable (new) Total liabilities Common stock (new) Total liabilities and stockholders’ equity $ 3,000 800 1,000 400 3,800 9,000 7,000 $16,000 Note: The final balance sheet of Lowstep Corporation will be the same as the beginning balance sheet of Highstep Corporation © 2009 Pearson Education, Inc publishing as Prentice Hall ... Reorganizations SOLUTIONS TO EXERCISES Solution E17-1 b d c d d c a d c 10 d 11 c 12 d 13 c Solution 17-2 a d c d Solution E17-3 Note receivable from Patriots Supply Amount secured by inventory... Reorganizations Solution P17-7 The reorganization is eligible for fresh start accounting because the liabilities on June 30, 2008 of $16,500 exceed the reorganization value of $16,000 by $500 Also,... the debtor or creditor’s filing petition is approved by the court 13 The approval of a plan of reorganization requires acceptance of the plan by at least two-thirds in amount and over half in number