I got it all wrong. Despite a perfect British accent, our Corporate Finance teacher is Dutch. Humble apologies to everyone who was constructing a geographical mapping of my P2 professors. After correction, please note: Dutch, American, Indian, Romanian and Spanish.

Today's Finance class was very interesting. We talked about some of the possible conflicts that arise between bond holders and shareholders, especially under increasing default risk.

This is exemplified by Chapter 11 in the US. If a company defaults on its debt, in the US, management can decide to file for Chapter 7 (liquidation) or Chapter 11 (restructuring). In the event of liquidation, shareholders have only a residual claim on the assets of the firm. After huge payments made to lawyers, government in the form of tax payment, employees, suppliers and debt holders, not much is left for shareholders...If management acts in the interest of shareholders, whom they represent, chances are that they opt for Chapter 11 – if the restructuring does not work, well, it will always be time to file for Chapter 7. People argue that Chapter 11 keeps afloat firms that would otherwise continue to be insolvent and should be closed down. Such filing helps firm re-organize as firms typically benefit from a reduction of their debt load and delays in interest payments. These mechanisms distort the financial picture facing the company.

The example of Eastern Airlines in the US is quite telling.
At the time the company filed for bankruptcy, it faced claims against its assets worth some $3.1bn. It was valued at around $3.7bn. In the event of liquidation, it could fulfill its obligation in full but the shareholders would get close to nothing. So the company filed for Chapter 11. Its first proposal of a turnaround plan was turned down. The second proposal faced the same fate. Ditto for the third proposal until enough cash was spent to bring the value of the firm down to $0.3bn. Each time, management had a choice to liquidate or restructure. By the time, the firm finally filed for Chapter 7, so much value had been destroyed that the original obligations could not be met.

In contrast, in Germany, when a company files for bankruptcy, management is ousted and replaced by trustees. Since everyone is getting very nervous about the ability to turnaround a firm under the burden of heavy labor laws, 99% of the firms filing will opt for liquidation.

On this happy note, I wish you a fantastic evening!

Sayonara!