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An empirical examination of prepackaged bankruptcy.

Prepackaged bankruptcy is an increasingly popular means of restructuring financially distressed firms. A prepackaged bankruptcy (a "prepack") calls for a firm to negotiate a reorganization plan with its creditors, and possibly solicit acceptances of the plan, prior to filing for bankruptcy.(1) The firm then files for Chapter 11 and simultaneously files a plan of reorganization. Given the advance negotiation with creditors, a confirmation hearing can be scheduled quickly, leading to a quick exit from bankruptcy. In the fastest such case to date, In-Store Advertising filed for Chapter 11 on July 8, 1993 and had its reorganization plan confirmed just 29 days later. Table 1 compares "traditional" Chapter 11 filings by public firms, distressed exchange offers, and prepackaged bankruptcies between 1986 and 1993. More firms completed prepacks than exchange offers in both 1992 and 1993; prepacks constituted 19% of distressed restructurings in 1993.

Prepackaged bankruptcy has been described as a hybrid of two methods of reorganizing troubled firms: workouts and bankruptcy. Prepacks are said to combine the low direct and indirect costs of a workout with the benefits of formal reorganization. McConnell and Servaes (1991) note three reasons that firms might file a prepackaged Chapter 11 instead of completing an out-of-court workout: binding holdout claimants, avoiding cancellation of indebtedness income, and preserving the firm's net operating loss carry forwards.

Despite the increasing frequency of prepacks, existing evidence on the costs and benefits of prepackaged bankruptcy is anecdotal (Hansen and Salerno (1991), McConnell and Servaes (1991), Altman (1992)). McConnell and Servaes (1991, p. 94) ask if prepacks "are motivated by real economic gains, and if so, what are the sources of such gain?" In an effort to identify the sources of the economic gains associated with this form of restructuring, I study 49 prepackaged bankruptcies filed between 1986 and 1993

I first examine the direct costs of financial distress and the actions that the sample firms take to minimize the indirect costs of financial distress. I find that the direct costs of prepackaged bankruptcies are comparable to those previously reported for "traditional" Chapter 11 filings. Firms routinely pay the pre-bankruptcy expenses of informal bondholder committees and bank creditors. Thus, most of the direct expenses are incurred during the often lengthy negotiations that take place prior to filing.

Sample firms spend less time in financial distress than firms in traditional Chapter 11, suggesting that the indirect costs of prepacks are relatively low. Sample firms also attempt to reduce indirect financial distress costs by [TABULAR DATA FOR TABLE 1 OMITTED] minimizing the disruption in normal business activities that can accompany a traditional Chapter 11 filing. Firms often get bankruptcy court permission, for example, to pay trade creditors in the ordinary course of business, even though by law the firm has the right to suspend payments until it emerges from bankruptcy. By leaving trade creditors unimpaired, firms also avoid bargaining with a diverse (and likely hostile) creditor group.

Tax planning plays an important role in debt restructurings, but its effect on the workout or bankruptcy decision has not been investigated empirically.(2) The two most widely cited tax benefits of Chapter 11 are avoiding cancellation of indebtedness (COD) income and preserving the firm's net operating loss carryforwards (NOLs).(3) I estimate nevertheless that not a single sample firm would have had to pay taxes on COD income had its prepack been completed as a workout instead.

Prepacks do, however, offer advantageous treatment of net operating loss carryforwards. The main benefit is not in preserving the NOLs per se; few firms would have lost any more NOLs in a workout than they did in their prepack. Rather, the main benefit of Chapter 11 is that it puts a less restrictive limitation on annual use of NOLs relative to a workout. I estimate that the present value of future taxes saved by restructuring through a prepack instead of a workout averages around $9 million, or 3% of total assets.

Sample firms fall into two categories: those that attempt exchange offers and at the same time solicit votes for a prepack in case the exchange offer fails and those that file prepacks directly. Firms that file prepacks directly realize significantly larger tax savings from bankruptcy than firms that first attempt exchange offers, suggesting that tax considerations play an important role in firms' debt restructuring decisions.

I include two case studies that provide additional insight into the decision to restructure in or out of Chapter 11. These cases also highlight factors common to other sample reorganizations: the role that distressed-security or "vulture" investors play in aligning the incentives of potentially conflicting claimholder classes and the way the voting mechanism in Chapter 11 allows firms to bind non-voting claim holders.

Two recent articles also investigate prepackaged bankruptcy. Tashjian, Lease, and McConnell (1994) examine the terms of prepackaged bankruptcy plans, including creditor writedowns and deviations from absolute priority, and conclude that on most dimensions prepacks provide benefits somewhere between what previous authors have reported for workouts and traditional bankruptcies. Chatterjee, Dhillon, and Ramirez (1994) compare firm characteristics and restructuring outcomes for a sample of exchange offers, prepacks, and traditional Chapter 11 filings. Analysis of security price reactions leads them to conclude that workouts preserve more value than prepacks, which in turn are less expensive than traditional Chapter 11 filings.

I. Data and Descriptive Statistics

Prepackaged bankruptcies are identified from The Bankruptcy Yearbook and Almanac (1993), The Bankruptcy DataSource, and from the Nexis database (search words include bankruptcy, prepackaged, prearranged, and prenegotiated). These sources yield 57 prepacks, and prospectuses and disclosure statements were obtained for 49 of these firms.(4) I define a prepackaged bankruptcy as one in which the firm files a bankruptcy petition and simultaneously files a plan of reorganization that had either been accepted or that major creditor groups have agreed in principle to support.(5)

Table 2 identifies the sample firms and provides information on their bankruptcy cases. Twenty of the 49 firms (41%) are LBOs, which is consistent with Hansen and Salerno's (1991) observation that prepacks are more likely to succeed when the number of creditor groups is small and these groups do not have widely divergent interests. Median prefiling total assets are $213 million. The sample firms are thus comparable in size to those in Gilson (1989) and Franks and Torous (1994). Six of the sample firms have assets of over $1 billion.

In eleven cases, firms solicited two votes prior to filing: one for an exchange offer and one for a prepack in case the exchange offer failed to draw an acceptable number of votes. Twenty-seven firms solicited votes only for a prepack. Eleven firms did not hold a prepetition vote but, instead, filed the bankruptcy petition and plan of reorganization with only an agreement in principle with major creditors (Tashjian et al. (1994) refer to these cases as "post-voted" prepacks). In some cases, the firm was forced to renegotiate some terms of the plan once in Chapter 11.

Of the eight firms that filed two bankruptcy plans, six did not conduct a prepetition vote. As for the other two firms, Southland was forced to resolicit votes because of alleged irregularities in the timing and method of the prepetition voting. Before the new vote, Southland renegotiated some terms of the plan with bondholders and preferred stockholders. Sunshine Precious Metals increased its distribution to bondholders after they threatened to challenge the results of the prepetition vote.

As expected, time in bankruptcy is substantially less in a prepack than in a traditional Chapter 11. Sample firms spent an average of 2.5 months from bankruptcy filing to plan confirmation (median 1.7 months). In contrast, Eberhart, Moore, and Roenfeldt (1990) report that an average firm spends around 25 months in a "traditional" Chapter 11 case.

The total time spent in financial distress can be protracted, however. The time from the first default on any debt contract until plan confirmation averages 16 months, with a maximum of 39 months. This compares with 29 months for the traditional Chapter 11 filing in Betker (1994). Measured from the first debt restructuring attempt, time in financial distress averages 20 months. This compares with 15.4 months for the successful workouts in Gilson, John, and Lang (1990). Firms that renegotiate their plans once in Chapter 11 spend an average of 5.1 months in bankruptcy, compared to 2.1 months for firms that confirm their original plan.

II. Financial Distress Costs

Financial distress costs are both direct and indirect. Workouts are subject as well to pressures created by holdout creditors. Prepackaged bankruptcy may offer a means of reducing the holdout problem inherent in workouts, while holding financial distress costs below levels associated with traditional Chapter 11.

A. Direct Financial Distress Costs

Direct costs of financial distress include fees for lawyers, accountants, and other professionals. McConnell and Servaes (1991, p. 93) note that in a prepack, the "time (and presumably the money) actually spent in Chapter 11 has been significantly reduced." Altman (1992, p. 412) states that a prepack "attempts to combine the time and cost savings of an out-of-court distressed restructuring with the more lenient voting conditions of a formal Chapter 11 proceeding." The claim that prepacks are cheaper than traditional bankruptcies appears elsewhere as well, e.g., Gorney and Furness (1992), Berner and Rahl (1991), Morris and Dobbs (1991), Retkwa (1991), and "Leveraged Debtors Opt for New Out: Prepackaged Chapter 11" (1990). (In contrast, Hansen and Salerno (1991) note that a prepack is not necessarily cheaper than a traditional Chapter 11.)

Table 3 reports the direct costs of reorganization for the sample firms. These costs are the reported "professionals' fees" taken from the firms' postbankruptcy financial statements or from estimates in the firms' bankruptcy plans.(6) [TABULAR DATA FOR TABLE 2 OMITTED] [TABULAR DATA FOR TABLE 3 OMITTED] Also shown in Table 3 are estimates of the direct costs of bankruptcy as reported by Weiss (1990) and McMillan, Nachtmann, and Philips-Patrick (1991) and the direct costs of exchange offers from Gilson et al. (1990).

The mean value of direct costs/total prefiling assets is 2.9%, which lies between the estimates of Weiss (1990) and McMillan et al. (1991). Expressed as a percentage of the postbankruptcy market value of equity, direct costs average 22.2%. These figures are much higher than those in Gilson et al. (1990), who estimate the average direct costs of an exchange offer as 0.65% of total assets.

The relatively high direct cost of a prepack compared to an exchange offer may arise because firms routinely pay the pre-bankruptcy expenses of informal bondholder committees that form in response to the firm's initial reorganization attempts. For example, Gaylord Container "agreed to pay the fees and reasonable expenses of the advisors of the Unofficial Bondholder Committee in connection with the Restructuring. Payment of such fees was required by the Unofficial Bondholder Committee before it would enter into discussions with the Corporation" (p. C-12 of July 24, 1992 prospectus).

Forty-one of the 49 firms state in their prospectus that they paid prepetition creditor fees and expenses. Sunshine Precious Metals is the only firm for which I can confirm that these fees were not paid. Sunshine's attorney stated that the issue was discussed, but the firm declined to pay creditors' pre-bankruptcy expenses. (Sunshine's creditors later threatened to challenge prepetition voting procedures after the firm filed for Chapter 11.) For the other seven firms, I am unable to confirm or deny that these fees were paid. Direct costs average 4% of total assets for these firms, however, so it seems likely that prepetition fees were paid in some of these cases as well.

This evidence belies the notion that a prepackaged bankruptcy is substantially cheaper than traditional Chapter 11. Of course, there is no way to tell what direct costs would have been had the sample firms filed traditional Chapter 11 cases, but the nature of the bargaining prior to filing a prepack is quite similar to the bargaining that takes place after filing a traditional Chapter 11. In either case, creditor committees hire professionals at the firm's expense. It is not clear why professional fees would be higher once the firm files for bankruptcy, and given a bankruptcy judges authority to limit professional fees, they may even be lower.

B. Indirect Financial Distress Costs

Indirect costs are the costs of losing customers, employees, and suppliers as a result of financial distress, and the sample firms' bankruptcy plans generally discussed these in detail. One oft-cited reason for filing a prepack instead of a traditional Chapter 11 is that it reduces these disruptions of normal business that may occur in a traditional Chapter 11.

The sample firms routinely took actions designed to reduce these disruptions. Forty-one of the 49 sample firms, for example, paid trade creditors in full. Of course, by leaving trade creditors unimpaired, the firm also avoids negotiating with a diverse and potentially fractious creditor group (and thereby avoids a serious holdout problem). Twenty-two of the 41 firms got bankruptcy court permission to pay trade creditors in the ordinary course of business, however, despite the legal right to defer payment until emerging from bankruptcy. If the only reason to pay trade creditors in full were to avoid negotiating with them, the firm would wait until it emerged from bankruptcy.

Charter Medical describes its reasoning in this way:

The company believes that the continued availability of trade credit in amounts and on terms consistent with those currently in place is of great importance in preserving the value of the company. Notwithstanding provisions of the Code which would otherwise require payment of such prepetition claims to be deferred until consummation of the Plan, the company intends to seek the approval of the Bankruptcy Court ... to make payments in the ordinary course of business on general unsecured claims of trade creditors ... (p. 186 of April 24, 1992 prospectus).

The sample firms typically filed a series of requests ("first-day orders") with the bankruptcy court on the day they filed for Chapter 11. Gaylord Container filed a typical set of first-day orders: payment of trade creditors in the ordinary course of business; payment of certain undisputed claims in the ordinary course of business; payment of employees in the ordinary course of business; maintenance of employee benefits; continuation of workers' compensation programs; continuation of employee retention programs; maintenance of cash management system; continuation of existing bank accounts; continuation of existing cash investment program; continuation of existing customer programs; and the making of limited capital expenditures without bankruptcy court approval. According to bankruptcy attorneys I talked to, judges will almost always agree to these orders as long as it appears that the firm's plan will be confirmed in under 90 days.

In general, firms structure their prepacks to look as much like a workout as possible. In a workout, trade creditors would generally not even be involved, nor for example, would the firm be required to close its existing bank accounts as required in a traditional Chapter 11. Thus if indirect distress costs are a function of time in distress and disruption of ordinary business operations, firms try to keep the indirect costs of a prepack as low as the indirect costs of a workout.

C. The Holdout Problem

The holdout problem in a workout occurs when an individual creditor has an incentive to reject a deal that collectively benefits all creditors (Roe (1987)). If all other creditors accept a lower-priority claim (like equity) while one holds out, then the value of the now-senior claim is increased at the expense of the tendering creditors. Under Chapter 11, as long as one-half of the creditors in each class by number, and two-thirds by value, vote to accept the plan, all claimholders are bound by the terms of the plan.(7)

Assessing the extent of the holdout problem in the sample firms is difficult. For the 11 firms that attempted exchange offers and solicited votes on a prepack as a backup, it seems clear that the holdout problem was an important reason for filing for bankruptcy. Had the minimum tender condition been met, these firms were willing to complete their reorganizations out of court.

For the other 38 sample firms, it is not so clear. Even if 100% of a firm's creditors vote for a prepackaged bankruptcy plan, this is no assurance that 100% would have voted for a workout, for in a workout the incentive to hold out is much stronger.

Firms do not routinely report the results of the voting on their prepackaged plans. I could find this information in financial statements or press reports for only 22 sample firms. Furthermore, those that do report only the percentage of voting claimholders that voted "yes." They do not report the number of creditors who effectively voted "no" by not voting at all. This distinction is important and makes it difficult to assess what the results of a vote for a workout would have been.

Two firms, Calton and Charter Medical, specifically noted that a major creditor would not go along with any restructuring unless it was accomplished as a prepack. Thirteen firms initiated exchange offer negotiations but abandoned the idea after it was clear that an acceptable level of bonds would not be tendered.(8)

There is only one sample firm for which it is clear that there was no holdout problem. The reorganization plan of TIE/Communications was voted on by only one senior creditor, who had agreed to the plan prior to filing. Since there was no holdout problem, securing the tax benefits of Chapter 11 was apparently the main reason to file for bankruptcy.(9)

Hansen and Salerno (1991, p. 39) note that, when the number of claims is large, prepacks are "not a realistic alternative." McConnell and Servaes (1991) argue that prepacks are unlikely to succeed when the firm has extensive trade debt, since trade creditors may be a diverse group with differing interests. The sample firms almost all avoided this problem by paying trade creditors cash in full. Forty-one of the 49 firms left trade creditors unimpaired, i.e., claims were paid in full. An unimpaired creditor class does not vote on the reorganization plan; they are deemed to accept it since they are paid in full. The firm thus avoids negotiating with this group of creditors. (As noted earlier, paying trade creditors in full may also be an attempt to minimize indirect bankruptcy costs.)

III. Taxes

Although the importance of tax planning in debt restructurings has been widely discussed, its effect on the workout or bankruptcy decision has not been examined empirically. I first review the tax effects of a debt restructuring and how they differ for workouts and bankruptcies. I then estimate what the tax effects of the sample restructurings would have been had they been achieved as workouts instead of prepacks. By comparing these figures to the actual tax effects of the prepackaged bankruptcy, I can get an estimate of the firm value preserved as a result of the tax benefits of Chapter 11.

A distressed restructuring, whether in a workout or a bankruptcy, has two potential tax consequences. The first involves cancellation of indebtedness (COD) income, and the second involves preservation of the firm's net operating loss carryforwards (NOLs). These two effects are not independent: that is, if a firm uses up NOLs to avoid paying taxes on current COD income, there are fewer NOLs available to shelter future income. See Solomon and Saret (1992) for a complete discussion of the tax effects of a debt restructuring.

A. Cancellation of Indebtedness Income

A debtor generally realizes COD income when its debt is exchanged for securities worth less than the issue price of the debt.(10) Under Internal Revenue Code [section]108, however, income is not recognized as a result of COD (a) if the cancellation occurs in a bankruptcy or (b) to the extent the amount of debt canceled does not exceed the debtor's insolvency. Insolvency is defined as the face value of liabilities minus the fair market value of assets. If a debtor avoids COD income because it is insolvent or in bankruptcy, the debtor must reduce its NOLs by the amount of COD income avoided. Despite these general rules, a bankrupt or insolvent debtor will not have to recognize COD income or reduce NOLs if the exchange involves swapping old debt for new equity (the "stock-for-debt exception").(11)

A firm deciding between a prepack and a workout must consider the COD income generated by either alternative. The effects of a restructuring on COD income depend on whether the exchange involves swapping old debt for new equity.(12) To see this in an example, consider a firm with debt of 100 and assets with a fair market value of 90, so that insolvency is 10. The firm exchanges its debt for new debt with a market value of 75, generating 25 of COD income. If the exchange occurs in a workout, the firm would have to reduce its NOLs by 10 (the COD income avoided by the firm's insolvency) and pay taxes on 15 of COD income. These current taxes could be avoided, however, by using up NOLs of 15. The net effect is a reduction in NOLs of 25.

In a prepack, all current taxes would be avoided but the firm would have to reduce NOLs by 25, the amount of COD income avoided. Thus, as long as the firm has sufficient NOLs, the effect of a debt-for-debt exchange is the same in either a workout or a prepack.(13)

In a stock-for-debt restructuring, a prepack may have advantages over a workout. Suppose in the example, that the firm exchanges old debt for new stock with a market value of 75. In a workout, the firm can exclude 10 of the COD income (the amount of its insolvency) and avoid NOL reduction by claiming the stock-for-debt exception. In this case, the firm must either pay current taxes or use NOLs to avoid taxation on the other 15 of COD income. In a prepack, the firm can apply the stock-for-debt exception to all 25 of COD income and avoid both current taxes and NOL reduction entirely. If the firm's insolvency exceeds the COD income generated by the stock-for-debt exchange, there would be no taxes or NOL reduction in either a workout or a prepack. (Note that a firm may still prefer a prepack to avoid having to prove insolvency to the Internal Revenue Service.)

B. Preservation of Net Operating Loss Carryforwards

Section 382 of the Internal Revenue Code generally limits a corporation's use of its NOLs if it undergoes an "ownership change." An ownership change occurs if the percentage of the corporation's stock held by 5% shareholders increases by more than 50% over a three-year testing period.(14) A workout or bankruptcy usually involves swapping a majority of the firm's equity for old debt claims, i.e., a group of shareholders goes from owning 0% to more than half of the firm's stock. Thus, an ownership change is to be expected as a result of distressed restructuring.

When an ownership change occurs, a firm's annual use of its NOLs is limited to the value of the firm's equity immediately before the ownership change times the long-term tax-exempt rate (which was between 6% and 7% for most of the sample period). Since NOLs expire in 15 years if not used, this annual limit on their use severely reduces their value to the firm. Furthermore, if the firm does not continue its historic business for the two-year period following the ownership change, NOLs are reduced to zero.

Bankrupt firms are allowed to make a special election regarding postbankruptcy treatment of their NOLs. The bankruptcy exception of [section]382(1)(5) may be used, if old shareholders and historic creditors of the firm before the ownership change own at least 50% of the firm's stock after the ownership change.(15) When the bankruptcy exception applies, annual future use of NOLs is unlimited, although NOLs must be reduced according to a statutory formula.(16)

Bankrupt firms may "elect out" of [section]382(1)(5) treatment. If the firm elects out, the general rules of [section]382 apply, i.e., annual use of NOLs is restricted. In determining the limitation on annual use of NOLs, [section]382(1)(6) provides that the equity of the firm immediately before the ownership change includes the equity resulting from any cancellation of creditors' claims in the bankruptcy proceeding. In essence, [section]382(1)(6) allows a bankrupt firm to use the value of equity after the ownership change, rather than the preownership change value, when computing the annual limitation on NOLs.

The effect of electing out of the [section]382 (1)(5) bankruptcy exception is illustrated by estimates from Gaylord Container's August 30, 1992 10K. Gaylord had pre-bankruptcy NOLs of $430 million. If it took the bankruptcy exception, it would lose $170 million of NOLs, but annual use after bankruptcy would be unlimited. If it elected out of [section]382(1)(5), there would be no reduction in NOLs, but annual use of NOLs would be restricted to $8 million, or a total of $120 million over 15 years. Not surprisingly, Gaylord took the bankruptcy exception.

Assuming there is an ownership change as a result of a restructuring, a firm deciding between a prepack and a workout must consider the effect that each alternative would have on its NOLs. In a workout, annual use of NOLs would be limited to the pre-exchange value of equity times the long-term tax-exempt rate. Since this equity value is often minimal, pre-bankruptcy NOLs would be of little value to the firm. In a prepack, annual use of NOLs would be unlimited if the firm takes the bankruptcy exception of [section]382(1)(5) or would be limited to the postbankruptcy value of equity times the long-term tax-exempt rate. This favorable treatment may offer firms with large NOLs an incentive to choose a prepack over a workout.

C. Comparing the Tax Effects of Workouts and Prepacks

To compare the tax effects of bankruptcies and workouts, for each firm I calculate what the tax effects of restructuring would have been, if the firm had done a workout instead of a prepack. By comparing these figures to the actual tax effects of the prepackaged bankruptcy, I can get an estimate of the firm value preserved as a result of the tax benefits of Chapter 11. By examining firms that first tried exchange offers compared to firms that filed prepacks directly, I can also determine whether taxes were an important motivation for the decision to file a prepack. Five firms - Arizona Biltmore, Petrolane Gas, Trump's Castle, Trump Plaza, and Trump Taj Mahal - were organized as partnerships and had no corporate tax attributes. They are excluded from the analysis of this section.

1. Cancellation of Indebtedness Income

COD income from a workout is excludable to the extent of the firm's insolvency, defined as the face value of the firm's liabilities minus the fair market value of its assets. Under "fresh start" accounting, firms are required to record all assets and liabilities at their fair market value.(17) The appraised value of total assets is then reported on a pro-forma balance sheet published in the firm's prospectus.(18) Twenty-five firms adopted fresh start accounting. Of the other 19 firms, 15 estimated the going concern value of their assets elsewhere in their prospectus. For the other four firms, I use book value of assets. Since book value is likely to exceed the market value of the assets, as it did for the 40 firms that reported both, this understates the insolvency of these four firms and biases against finding significant tax savings from the prepack filing (since highly insolvent firms are unlikely to owe taxes in any debt restructuring).

I first compare the tax effects from COD income in the prepackaged bankruptcy to the estimated tax effects that a firm would have faced had its restructuring been done out of court. As an example, suppose the reorganization of Barry's Jewelers had been completed as a workout instead of a prepack. Estimated COD income from Barry's debt exchange is $50.02 (all dollar figures in millions), and estimated insolvency is $41.43. Thus, $41.43 of the COD income would have been excluded from current taxes, and since the stock-for-debt exception applies to the exchange, no NOL reduction was required either.

The exchange would generate $8.60 of taxable income ($50.02 - $41.43). Because Barry's has $39.91 of NOLs, however, no current taxes would be paid; rather, the firm would use up $8.60 of NOLs. Thus, in terms of current taxes owed, Barry's Jewelers would be indifferent to a workout or a prepack. (Of course, the $8.60 million in NOLs would be unavailable to shelter future income, which might provide an incentive to file a prepack.)

The results of this analysis for the entire sample appear in Table 4. The main conclusion is that prepacks do not appear to help firms avoid current taxes on cancellation of indebtedness income. If all the sample restructurings had been completed out of court, no firm would have paid any current taxes on COD income.

Recall that COD income is recognized only to the extent that it exceeds the firm's insolvency. In 27 cases, COD income was less than the firm's estimated insolvency, so that no taxes would have been paid had the restructuring been done as a workout. The median value of insolvency/COD income for these firms is about 1.5, meaning that the typical firm could have realized 50% more in COD income and still not have paid taxes.

Table 4 also reports the ratio of (NOLs + insolvency)/COD income. If this ratio exceeds 1.0, then the firm would have sufficient tax attributes to avoid current taxation on COD income. The minimum value of this ratio for any firm is 1.19, which means that COD income could have been about 20% larger than reported before any firm would have paid current taxes as a result of a workout.

In the other 17 cases, COD income in excess of the firm's insolvency was generated, but in every case, the firm had sufficient NOLs to offset this excess COD income. For these firms, the minimum value of (NOLs + insolvency)/COD income is also 1.19; thus, each of these firms also had at least a 20% "cushion" before it would have paid any current taxes on COD income in a workout.

In summary, no sample firm would have paid any current taxes had it completed its reorganization out of court. This conclusion is strengthened when one considers that the definition of insolvency that I use probably understates the firms' insolvency for tax purposes. Firms estimate the market value of their assets as the going concern value of the [TABULAR DATA FOR TABLE 4 OMITTED] firm for fresh start accounting purposes; for tax purposes, they are allowed to use an asset-by-asset valuation, which would normally result in a lower value of assets and hence a greater value for insolvency.

Although 17 firms would have used up NOLs in a workout to avoid current taxes, only one firm would have been able to use the lost NOLs anyway. Since annual use of NOLs was limited by an ownership change in nearly every case, these lost NOLs would have expired before being used.

2. Preservation of Net Operating Loss Carryforwards

Net operating loss carryforwards (NOLs) are a valuable asset of the sample firms. The mean (median) value of NOLs, expressed as a percentage of prefiling total assets, is 62.8% (37.4%). Two sample firms, In-Store Advertising and Specialty Equipment, did not report NOLs in their prospectus, leaving 42 firms available for analysis.

Thirty-six of these forty-two firms experienced an ownership change as defined in [section]382 of the Internal Revenue Code. All but six of these firms elected out of the bankruptcy exception of [section]382(1)(5), choosing instead to accept an annual limitation on use of NOLs. In most of these cases, the reduction in NOLs required by [section]382(1)(5) would have eliminated all the firms' NOLs. The firms naturally preferred an annual limitation to the loss of all NOLs.

To analyze the choice between a prepack and a workout with respect to NOL preservation, I estimate the present value of future taxes avoided as a result of the prepack and compare this to the present value of taxes avoided had a firm's reorganization instead been done out of court. In order to estimate the incremental tax savings, I need estimates of earnings before taxes for the next 15 years (since that is how long the NOLs will last), the size of NOLs, and the annual limit on NOL usage.

Future earnings are taken from the firms' forecasts in their disclosure statements. Most firms forecast earnings before taxes for the next five years.(19) I assume that earnings for the remainder of the 15-year horizon will be the same as in the last year of the forecast and use a 10% discount rate and a 34% tax rate. (Results in this section do not differ materially under different assumptions regarding discount rates, tax rates, and the growth rate of year 6 through 15 earnings; nor do they differ if I take the present value of tax savings for only five rather than fifteen years.)

The annual limitation on NOL use in a workout (prepack) is the preexchange (postexchange) market value of the firm's equity times the federal long-term tax-exempt rate in effect for the month of the exchange. Stock prices are obtained from the Center for Research in Security Prices tapes, the Bankruptcy DataSource, and the Capital Changes Reporter. In three cases, the preemergence stock value is inferred from the postemergence value. For example, if the old shareholders held 100 shares and, in the exchange, receive 10 shares with a market value of $1, the old shares must have been worth $0.10 each just prior to the exchange. In nine cases, the value of the old stock is set to zero, because old shareholders received no consideration under the plan.

Table 5 gives an example of this estimation process for Charter Medical. Note that if the firm forecasts a loss, the next year's annual limit on NOL use is increased by the NOLs unused from the prior year. The estimated present value of tax savings for Charter Medical is $32.18 million (15% of the market value of equity), which certainly would provide a strong incentive to file a prepack.

The results of the analysis for the full sample appear in Table 6, Panel A. The mean incremental tax savings from filing a prepack is $8.97 million (median $3.71). These mean tax savings represent about 3% of total assets and over 19% of the market value of the reorganized firm's equity. If these tax savings are economically meaningful, then we should see differences between firms that tried to complete exchange offers and those that did not.

Firms that tried exchange offers presumably did so because the incremental tax savings from a prepack would not exceed the marginal direct and indirect costs of the prepack. Firms that filed prepacks directly may have done so to avoid a holdout problem, but many presumably could realize significant tax savings as well.

Panel B of Table 6 compares the mean and median estimated tax savings between firms that attempted exchange offers and firms that instead went directly to Chapter 11. Whether the savings is measured in dollars, as a percentage of assets, or as a percentage of equity, firms that did not attempt exchange offers realized significantly larger tax savings from their prepacks. The median tax savings is $0.66 million (3.3% of the market value of equity) for firms that tried exchange offers but $4.57 million (14.6% of the market value of equity) for firms that filed prepacks. McConnell and Servaes (1991, p. 96) note that they are "unable to identify firms that have undergone a prepackaged bankruptcy simply for the reason of retaining tax loss carryforwards." The evidence presented here supports the contention that taxes play an important role in debt restructuring decisions.

Rymer Foods provides an interesting example of how tax considerations can affect the form of a restructuring. The firm had prebankruptcy NOLs of $55.85 million (59% of assets). Rymer attempted an exchange offer but also solicited prepack votes in case the exchange offer failed. The terms of Rymer's reorganization plan indicated that an ownership change would be avoided in a workout but would occur in a bankruptcy.

In the exchange offer, 50.81% of the new equity in the firm would go to old shareholders, while old debenture holders and the firm's financial advisors received the rest. In the prepack, the firm planned to issue additional shares to its lawyers and financial advisors, as well as options for 10% of the equity to employees. Since options are treated as exercised for purposes of the ownership change test, the prepack would result in an ownership change.

The firm then planned to use the [section]382(1)(5) bankruptcy exception to avoid an annual limitation on NOL use. Rymer noted that the main purpose of this scheme was to "preserve to the greatest extent possible the Company's net operating loss carryforwards" (p. 6 of December 15, 1992 prospectus).

IV. Case Studies of Two Prepackaged Bankruptcies

Analysis of two prepacks in detail - LIVE Entertainment and Kinder-Care Learning Centers - offers additional insight into the decision to effect a restructuring through an exchange offer or a prepack, as well as the holdout problems that firms face when attempting a debt restructuring. LIVE Entertainment is a failed exchange offer, while Kinder-Care did not attempt an exchange offer.

The cases also illustrate how the voting mechanism in Chapter 11 can bind non-voting claim holders (LIVE Entertainment), and the role that distressed-security, or [TABULAR DATA FOR TABLE 5 OMITTED] "vulture," investors play in aligning the incentives of claim holders (Kinder-Care). Information on the cases comes from the firms' prospectuses, press reports, and discussions with attorneys who worked on the case.

A. LIVE Entertainment

LIVE Entertainment distributes films on videocassette and sells records, tapes, and compact discs through its retail outlets. The firm issued $110 million of 14.5% notes in May 1989 to fund the operations of a subsidiary. In July 1991, the firm issued 1.05 million shares of 10% preferred stock to acquire Vestron Inc. Later that year, the company sold the subsidiary at a loss of $89 million, leaving it unable to service the notes. The firm's stock was 49.9% owned by Carolco, which was itself financially distressed. The stock owned by Carolco was pledged to Pioneer LDCA, Inc. as security for a loan.

The firm's bank debt of $50 million matured on December 31, 1991. In the third quarter of 1991, the bank group notified the firm that it would extend the bank debt for only a short time period. LIVE negotiated two extensions, first through March 31, 1992 and then through December 2, 1992, to give the firm time to restructure the notes and preferred stock. The firm agreed as part of the second extension to reduce its bank debt to zero by December 1992. On November 27, 1992, however, the firm obtained a third extension to January 29, 1993, under which the bank debt would be reduced to $28 million.

In April 1992, the firm began to consider proposals for a debt restructuring. The firm missed the interest payment on [TABULAR DATA FOR TABLE 6 OMITTED] the notes due in May 1992 and then the dividend on the preferred due in July 1992. In May 1992, major holders of the notes and preferred formed a committee, which LIVE agreed to fund.

LIVE made its first proposal on June 16, 1992; negotiations went on until the firm and the committee agreed to the "broad outlines" of a restructuring on July 23, 1992. Old notes would be exchanged for $37 million of new 6-year increasing rate notes, $8 million cash, and 5.5 million shares of new 5% convertible preferred. The old preferred stock would be exchanged for $3 million in new notes and 469,200 shares of new preferred stock. The firm estimated that more than 75% of the old notes had been purchased at less than 70% of face value, so the proposed terms of the exchange offer would allow most holders to realize a profit.

An additional term of the plan was that LIVE receive an equity injection from a new investor. On July 29, 1992, Pioneer LDCA agreed to advance $15 million, which would convert to 33% of the firm's equity on completion of the reorganization. Pioneer also agreed to make available up to $15 million in debt financing and to arrange new bank financing to replace LIVE's old bank debt. As compensation for these efforts, Pioneer received a warrant for 1 million shares (5%) of new common stock. Thus after the restructuring, Pioneer owned 39.2% of the stock, while Carolco's holdings were diluted to 30.7%.

LIVE's exchange offer solicitation ended on January 29, 1993, with 92% of the bondholders and 87% of the preferred holders casting votes. The results for the exchange offer were: $74.8 million (68%) of bonds voted yes, $26.2 million (24%) voted no, and $9 million (8%) did not vote. Of preferred shares, 904,000 shares (86%) voted yes, 10,000 shares (1%) voted no, and 136,000 shares (13%) did not vote. The exchange offers thus failed to reach the 95% acceptance level required by LIVE.

In a prepackaged bankruptcy, however, only claim holders who cast ballots are counted; thus, the voting on the prepack was, for bonds: $99 million (98%) yes, $2 million (2%) no; for preferred: 904,000 shares (99%) yes, 10,000 shares (1%) no. Note that $24 million of bondholders who voted "no" on the exchange offer voted "yes" for the prepack.

The prepack was thus accepted by an overwhelming majority of voting claim holders, and claimants who did not vote were bound by the terms of the plan. LIVE filed the prepack on February 2, 1993, and it was confirmed on March 16, 1993.

LIVE had pre-bankruptcy NOLs of $81 million (23% of total assets). Because of an ownership change, postbankruptcy annual use was limited to $1.6 million; I estimate that had LIVE's exchange offer succeeded, postbankruptcy annual use would have been limited to $1.5 million. The present value of the estimated tax savings from the prepack is a relatively small $0.33 million.

According to LIVE's attorney, the firm made a good faith effort to complete an exchange offer because the new investor, who was going to make a large equity infusion, expressed a desire to keep the case out of court.(20) The results of LIVE's voting point out an important distinction between exchange offers and prepacks. In an exchange offer, an investor who does not vote simply keeps his or her securities. Thus a non-vote is the same as a "no" vote in an exchange offer. This is not the case in a bankruptcy.

Altman (1992, p. 413) conjectures that a "key ingredient to a successful large firm prepackaged deal reflects the debtor's ability to raise new equity capital." This conjecture is not supported by the data from this study. Despite the importance of new investors in the LIVE case, only 12 of the 49 firms (25%) raised new equity capital in their bankruptcy. Nine of the 12 firms (75%) that raised new equity capital are LBOs; only 11 of 37 firms (30%) that did not raise new equity are LBOs. Thus raising new equity seems to have more to do with restructuring failed LBOs than with prepackaged bankruptcy per se.

B. Kinder-Care Learning Centers

Kinder-Care operates over 1,200 child care centers in 39 states. Kinder-Care was formed in November 1989 when the day-care operations of the Enstar Group were spun off. Kinder-Care was 63.6% owned by Lodestar Group, the investment bank that arranged the spin-off. In the spin-off, Enstar stockholders were offered rights to acquire shares in Kinder-Care. Only a third of the new shares were purchased by the public, and Lodestar bought the rest.

The firm had bank debt of $358 million and publicly traded debt of $98.5 million. In late 1990, the collapse of the real estate market eliminated the firms' ability to complete sale and leasebacks of its properties, restricting cash flow that the firm depended on to service its debt. The firm also experienced severe investment losses on its junk bond portfolio. Enstar filed for Chapter 11, halting contractual payments to Kinder-Care under their tax-sharing agreement.

In December 1990, the firm failed to make a principal payment on its bank debt and missed an interest payment on its public debt. Under the terms of the public debt, bondholders were allowed to put the bonds back to the firm at the default, but Kinder-Care declined to repurchase the debt. The firm then missed the January 1991 interest payment on its bank debt. In February 1992, the CEO resigned and was replaced by Tull Gearreald, a co-founder of the Lodestar Group.

Kinder-Care spent over a year negotiating with lenders and used the cash saved by not paying interest to make operational improvements. Over this time period, a group of investors led by Trust Company of the West (TCW) purchased over 40% of the bank debt. By Spring 1992, it became clear that banks that had maintained their claims wanted new bank debt worth close to 100 cents on the dollar, while the new investors would be willing to forgive some principal on their bank debt claims in return for a controlling interest in the equity of the new firm.

TCW reached an agreement with the bank group in July 1992. Under this agreement, bank debt holders were offered two options: option A consisted of seven-year amortizing notes at LIBOR plus 1.5%, with a face value of 95% of the original, plus 0.5% of the new equity. Option B consisted of nine-year, 12% notes with a face value of 30% of the original claim, plus 85% of the new equity. (Ultimately, 64% of the bank note holders elected option B.)

TCW then reached an agreement in principle with the public debt holders in September 1992. TCW agreed to buy at least two-thirds of the public debt outstanding (ultimately it purchased over 91%). The plan then offered public debt holders 30% of their claim in either" option B" notes or cash. TCW agreed to pay the claims of any remaining bondholders who opted for cash.

TCW reached an agreement with Kinder-Care's board of directors on September 30, 1992. Under the plan old shareholders kept 13.5% of the new firm's equity and received warrants for an additional 16% (fully diluted) of the shares. All other creditors, including trade creditors, were paid in full. In consideration of the efforts of TCW in structuring and negotiating the plan, and purchasing the public debt, Kinder-Care awarded TCW a fee of 1% of the equity in the new firm (200,000 shares, worth $2.85 million).

Kinder-Care filed its prepack on November 10, 1992, without having conducted a prepetition vote. An amended bankruptcy plan was filed on January 23, 1993, which included only technical modifications to the original plan. The plan was confirmed on March 17, 1993. The new investor group (including TCW) wound up with 46% of the new equity while Lodestar retained 18%.

Kinder-Care lost almost all of its NOLs in bankruptcy. It had about $100 million of COD income that did not qualify for the stock-for-debt exception, leaving it with $15 million in NOLs after bankruptcy. Kinder-Care experienced an ownership change, but the annual limit on NOL use was $18.5 million, which was larger than its remaining NOLs. I estimate that Kinder-Care would have lost all its NOLs in a workout; the estimated present value of taxes saved by the prepack is $4.6 million (1.6% of the market value of equity).

According to Kinder-Care's attorney, the firm did not attempt an exchange offer because there were unidentified subordinated debt holders, whose claims totaled several million dollars, who could not be counted on to exchange their debt. The tax advantages of a prepack were also discussed extensively.

Several factors contributed to the success of Kinder-Care's prepack. The case was dominated by an investor group that controlled significant amounts of both the bank debt and the sub debt. This group owned over 91% of the sub debt and was willing to take a significant writedown of this claim, while using its bank claim to receive a large equity stake. There was also a controlling shareholder who wanted to get the deal done. Press reports indicated that Lodestar was under pressure to "save" Kinder-Care to preserve relations with investors in its buyout fund and avoid bad publicity for its merger-advisory business ("Can Kinder-Care Put This Puzzle Together?" (1992)).

In these respects, Kinder-Care was much like an LBO, where the number of creditors is usually small and their interests are aligned. By buying up significant amounts of bank and sub debt, TCW was able to align the incentives of these two diverse groups. Despite this, it took almost two years to settle on the terms of the plan.

Over this period, debt holders did not try to force the firm into bankruptcy, or accelerate the debt, because of the firm's strong core operations and earnings. Kinder-Care's spin-off is in this respect similar to the Allied-Federated LBO studied by Kaplan (1989). Both firms had strong operating earnings but simply too much debt to service.

"Vulture" investors played a significant role in several other sample prepacks. Trust Company of the West was also involved in the prepacks of Kendall, LIVE Entertainment, Mayflower GrOup, Resorts International, SCI TV, and USG. Other prominent distressed-security investors who were involved in sample prepacks include Leon Black's Apollo Investors (AM International, Cherokee, Memorex Telex, Price Communications, SCI TV), Fidelity Capital (Calton, LIVE Entertainment, SCI TV, USG) Goldman Sachs' Water Street Fund (Edgell Communications, USG), and Carl Icahn (Southland).

V. Conclusions

Prepacks are said to combine the low costs of a workout with the benefits of Chapter 11 - namely, binding holdouts, avoiding cancellation of indebtedness income, and preserving the firm's net operating loss carryforwards. My analysis confirms some of these assumptions about prepacks but finds evidence contrary to some others.

The direct costs of prepackaged bankruptcies in my sample are comparable to those previously reported for "traditional" Chapter 11 filings. Firms routinely pay the prepetition expenses of informal bondholder committees and bank creditors. Thus most of the expenses are incurred during negotiations that take place prior to filing. Firms that complete prepacks spend less time in financial distress than they would in the typical Chapter 11, suggesting that the indirect costs of prepacks may be more comparable to the indirect costs of a workout.

Sample firms also routinely take actions that are apparently attempts to reduce indirect bankruptcy costs. Most notably, firms often get court orders allowing them to pay trade creditors in the ordinary course of business, even though by law a firm has the right to suspend payments until it emerges from bankruptcy.

The two most widely cited tax benefits of Chapter 11 are avoiding cancellation of indebtedness (COD) income and preserving the firm's net operating losses (NOLs). In fact, I estimate that not a single sample firm would have had to pay taxes on COD income had its prepack been completed as a workout instead. Prepacks do, however, offer advantageous treatment of net operating loss carryforwards. The main benefit is not in preserving the NOLs per se; few firms would actually lose any more NOLs in a workout than they did in their prepack. Rather, the main benefit of Chapter 11 is that it allows a less restrictive limitation on annual use of NOLs than a workout does. I estimate that the present value of future taxes saved by restructuring through a prepack instead of a workout averages around $9 million, or 3% of total assets. Firms that file prepacks have significantly larger tax savings from a bankruptcy than firms that first attempt exchange offers, which suggests that the tax benefits of Chapter 11 play an important role in firms' restructuring decisions.

It remains to be seen whether prepacks are a better way to reorganize than workouts or traditional Chapter 11 filings. Hotchkiss (1995) notes the high rate of second-time-around bankruptcies, while Betker (1994) finds that over 70% of firms that complete distressed exchange offers later file for bankruptcy or complete another out-of-court exchange (or both).(21) The prepacks in this sample are too recent to examine postbankruptcy performance, but it is worth noting that Crystal Oil, Gaylord Container, Republic Health, and West Point Acquisition restructured their debt again after emerging from bankruptcy, while Memorex Telex and Resorts International filed second prepacks in early 1994. Several other sample firms are also currently reporting financial difficulties. It thus seems likely that more of these firms will need to restructure again in the years to come.

It will also be interesting to observe the effect of the repeal of the stock-for-debt exception, effective January 1, 1995, on prepackaged bankruptcy filings. Commentators agree that the repeal will have a drastic impact on the availability of net operating loss carryforwards for firms emerging from bankruptcy (see, e.g., "Time is Running Out for Stock-for-Debt Exception" (1994) and Mitchell (1994)).

For example, the firms in this study generated about $8.5 billion in COD income but, because of the stock-for-debt exception, lost only $1 billion in NOLs as a result. I estimate that, without the stock-for-debt exception, the sample firms would have lost $4.1 billion in NOLs instead. The loss of this tax benefit may cause some firms to reassess the benefits of a prepackaged bankruptcy strategy.

Helpful comments and advice were received from Mike Alderson, Jean Helwege, Tim Opler, Walt Torous, and participants in the brown-bag seminar at Ohio State. I thank the many attorneys and corporate officers who provided information on their bankruptcy cases. Discussions with Ted Maloney of Milbank, Tweed, Hadley & McCloy, Don Slome of USG Corporation, Deborah Stiles of Debevoise & Plimpton, and Kent Weitnauer of Alston & Bird were particularly helpful. Funding was received from the Dice Center for Financial Economics.

1 Under Section 1126(b) of the 1978 Bankruptcy Code, prepetition votes can be used in a bankruptcy proceeding as long as the solicitation complies with all applicable bankruptcy and non-bankruptcy disclosure laws.

2 Scholes and Wolfson (1992, p. 571) note that "a Chapter 11 bankruptcy restructuring can be used to preserve NOLs. Since Chapter 11 may be elected for a host of nontax reasons as well, it can be difficult for an outsider to determine the motivation for choosing this form of restructuring."

3 See, for example, McConnell and Servaes (1991), Altman (1992), Scholes and Wolfson (1992, Ch. 26).

4 I was unable to obtain prospectuses from Adience, ARIX, CIC-I Acquisition, First City Industries, MB Holdings, ROPS Textiles, TDII, and Webcraft Technologies.

5 Some bankruptcies that are reported as prepacks do not fit this definition. For example, Edisto Resources' October 1992 bankruptcy filing was widely reported to be a prepack, but the disclosure statement makes clear that the company did not even have an agreement in principle regarding restructuring of its bank debt at the time it filed. Edisto is thus not included in the sample. There are ten other cases where at least one source identified the case incorrectly as a prepack.

6 The figures in Table 3 exclude In-Store Advertising, LaSalle Energy, Mayflower Group, Sprouse-Reitz Stores, and Trump's Castle Funding, which did not disclose professional fees in either their prospectus or postbankruptcy financial statements.

7 The holdout problem was exacerbated by the January 1990 "LTV decision." Judge Burton Lifland ruled that, once a firm completes a debt-for-debt exchange offer, in a subsequent bankruptcy, bondholders have an allowed claim equal to the market value of the new debt, not the face value. Since the new debt in many distressed exchanges sells for less than par, bondholders, fearing a subsequent Chapter 11 filing, would be reluctant to give up their old claims. The LTV decision was confirmed on appeal in July 1991 but overturned in April 1992. In a similar case in 1991 (Pengo Industries), the Bankruptcy Court in the Northern District of Texas declined to follow the LTV decision, holding that no "original issue discount" was created by an exchange offer. This decision was affirmed on appeal in June 1992. Thus, there was substantial uncertainty about the consequences of tendering a bond in an exchange offer from January 1990 until mid-1992. Bankruptcy professionals I conferred with indicate that even after June 1992, uncertainty as to whether other court districts would follow the LTV decision still existed.

8 The firms are Calton, Charter Medical, Divi Hotels, Gaylord Container, JPS Textiles, Ladish, Munsingwear, Price Communications, Resorts International, Rymer Foods, SPI Holdings, Trump's Castle, and West Point Acquisition. These firms all filed registration statements with the SEC. In some cases the firms actually began soliciting acceptances, while in others the exchange offer never came to a vote.

9 Another benefit available to firms in bankruptcy, but not in workouts, is access to debtor-in-possession financing. This does not appear to be an important motivation for filing most prepacks. Only 14 of the 49 firms (29%) arranged for debtor-in-possession financing; the average amount borrowed was $64 million, or about 10% of total assets.

10 Prior to October 9, 1990, new debt was valued at its face value. Thus an exchange of a $1,000 face value bond for new debt with a face value of $1,000 did not result in COD income. Under the Omnibus Budget Reconciliation Act of 1990, new debt must be valued at its fair market value. In the above example, therefore, if the new debt had a market value of $700, the exchange generates $300 of COD income. If a fair market value for the new debt cannot be established, its value is assumed to be the last trading price of the old debt. If neither the old debt nor the new debt is traded on an established securities market, the value of the new debt is assumed to be its face value.

11 The stock-for-debt exception (which was repealed effective December 31, 1994) required that (a) the amount of stock transferred is not nominal or token in amount; (b) for an unsecured creditor, the ratio of the value of the stock received to the debt discharged must not be less than 50% of a similar ratio computed for all other unsecured creditors; and (c) the stock transferred does not have a fixed redemption rate and is not callable by the issuer or puttable by the holder at any time.

12 If an exchange involves swapping old debt for new equity and new debt, the stock-for-debt exception still applies. The new debt satisfies a face amount of old debt equal to the new debt's market value; thus no COD income is generated by the debt-for-debt part of the exchange. The rest of the old debt is satisfied by the stock, and the stock-for-debt exception can be applied to this part of the exchange.

13 Firms with COD income greater than the sum of their NOLs and their insolvency would prefer a prepack to a workout. In either case, all NOLs would be lost, but the firm would avoid current taxes in the prepack. None of the sample firms was in this situation.

14 A 5% shareholder owns more than 5% of the firm's stock. For purposes of the ownership change test, all less-than-5% shareholders are treated as a single 5% shareholder.

15 A historic creditor is one who incurred a claim in the ordinary course of business (e.g., trade creditors) or who has held a claim for at least 18 months prior to the filing of the bankruptcy petition.

16 A firm claiming the [section]382(1)(5) bankruptcy exception must reduce its NOLs by: (a) the amount of interest accrued on any debt exchanged for stock in the bankruptcy proceeding during the year of the bankruptcy proceeding and the three prior taxable years and (b) an amount equal to 50% of the NOL reduction that would have applied if the stock-for-debt exception was not invoked. Furthermore, if another ownership change occurs within two years, NOLs are reduced to zero.

17 See the American Institute of Certified Public Accountants Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Firms are required to adopt fresh start accounting if they are insolvent and they experience an ownership change as a result of the bankruptcy.

18 Firm value is usually estimated by consultants, who use standard techniques such as comparable firm valuation and discounted cash flow analysis. Alderson and Betker (1995) demonstrate that these valuation forecasts are unbiased predictors of the firms' postbankruptcy stock prices.

19 Hotchkiss (1995) finds that firms on average overestimate their post-Chapter 11 operating performance. If firms deliberately overestimate future performance to "sell" the plan to creditors, then it may be that managers predict positive earnings but actually expect negative (or less positive) earnings. In this case, the benefit of having NOLs is overstated.

20 The new investor was a Japanese firm. The same situation occurred in Southland's case; Ito-Yokado was to inject $430 million in new equity and reserved the right to back out if the case went into bankruptcy court. Southland's exchange offer failed. but Ito-Yokado made the new investment despite the prepack filing.

21 In this study, AM International and Anglo Energy's prepacks are second bankruptcies, while Astrex, Calton, Crystal Oil, National Environmental Group, SCI Television, Southland, and Sunshine Metals completed exchange offers prior to their Chapter 11 filings.


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Brian L. Betker is Assistant Professor of Finance at Ohio State University, Columbus, OH.
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