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12 Bankruptcy and Reorganization VISHWANATH S.R. AND CHANDRASHEKAR KRISHNAMURTI CHAPTER OBJECTIVES • Highlights the causes of fi nancial distress • Surveys the bankruptcy code in the US, the UK and such others. • Suggests a methodology for valuation of bankrupt fi rms • Summarizes the results of academic studies on various aspects of bankruptcy When a fi rm’s condition deteriorates to the extent where it cannot meet its fi nancial obligations, the fi rm is said to be in fi nancial distress. Usually, the fi rst signals of distress are violation of debt covenants and suspension of dividends. Bankruptcy includes fi nancial reorganization and liquidation. Financial reorganization involves rearranging a fi rm’s cash fl ow (for example, converting debt into equity), whereas liquidation ends the fi rm’s operations. It involves selling off tangible assets and paying off claimants to the extent possible. Recent examples of distressed fi rms are L A Gear, Enron, Iridium, Chrysler, Massey Ferguson and Marvel Entertainment. Some of these companies, once considered the darling of the investment community, have left million of investors with worthless paper. Why We thank Professor P. V. Viswanath, Lubin School of Business, Pace University, New York for useful comments and inputs. 334 VISHWANATH S.R. AND CHANDRASHEKAR KRISHNAMURTI do some apparently well-run companies get into fi nancial distress? The causes of distress can be inferred from the ex-ante characteristics of the companies that became distressed. We attack the issue of distress by using ex-ante and ex-post information on the characteristics of some high profi le distressed fi rms and try to make some generalizations. Causes of Distress Although companies may go bankrupt due to numerous reasons, there are some generic reasons like failure of control systems, loss aversion and overconfi dence, changes in the macroecono