An operating business emerging from chapter 11 is expected to operate successfully and is not anticipated to re-file for bankruptcy in the near future. Indeed, a business debt must satisfy certain "feasibility" conditions designed to reduce the risk of re-entry into chapter 11. To satisfy those conditions, the debtor must provide financial projections demonstrating that it will be able to successfully operate in the "real world" without the protection of the Bankruptcy Code.

Unfortunately, lawyers analyzing the performance of business debts operating in chapter 11 are often ill-equipped to determine whether a debtor will be able to emerge from bankruptcy and continue operating successfully without filing a second ("chapter 22") bankruptcy case. While many methodologies are available to evaluate the performance of healthy businesses, relatively few methods exist for effectively evaluating future performance of distressed or bankrupt businesses.

This article demonstrates that the financial projections of business debtors emerging from bankruptcy are frequently overstated, and that the overstatements are significantly larger for debtors that end up filing bankruptcy for a second time, even in the first year following emergence from the first bankruptcy.

Ames Department Stores Inc. is typical of companies emerging successfully from bankruptcy. Its bankruptcy was caused by a major debt-financed acquisition in 1988, just prior to the 1990-1991 recession. While in chapter 11, it underwent a comprehensive reorganization, recruiting new management, closing 221 unprofitable stores and turning around operations in its remaining 659 stores. Ames differed significantly from many of its peers by reducing its size and cutting its debt level.

While many companies such as Ames emerge successfully from bankruptcy, numerous others re-enter chapter 11 and become known as chapter 22s. One such company is TWA. It emerged from its first bankruptcy in November 1993 but filed again less than two years later in June 1995. TWA ascribes the cause of the second filing to a "too highly leveraged position" and continued "significant operating losses." Yet both Ames and TWA emerged from chapter 11 (the first chapter 11 for TWA) with projections suggesting satisfactory performance.

In order to better understand the characteristics of businesses filing twice for chapter 11, we compared 30 companies filing once with 23 companies that filed twice. The first chapter 11 for all of the companies occurred between January 1989 and December 1991. The second filings occurred prior to December 1997. During this period, between July 1990 and February 1991, the United States officially experienced a recession. With the exception of one firm (Ramtek Corp.), all of the companies in the sample emerged from bankruptcy following the beginning of the recession. In other words, each of these companies was either aware of the weakness in the economy or was operating in the post-recession economy at the time of its confirmation out of bankruptcy.

The analysis focuses on the difference between projected and actual results for both one- and two-time filers. The actual results are classified as either "good" or "bad" news. "Good" news occurs when actual results are greater than projected for net sales, net income, cash flow from operations, current assets, total assets and stockholders' equity. "Good" news also occurs when actual results are lower than projected for current liabilities and long-term debt.

However, given the nature of several of the variables, good news may be interpreted as "bad" news, and vice-versa. For example, having actual total assets greater than projected may be good news if sales are also greater then projected, but bad news if the company has deteriorating and obsolete equipment.

The results in Panels A, B and C indicate that bad news dominates good news for both one-time and two-time filers. Panel A demonstrates that the percentage of one-time filers experiencing bad news in the first year following emergence from bankruptcy is dominated by the percentage of two-time filers experiencing bad news. For example, in the first year following bankruptcy, actual results for variables such as sales, net income and cash flow from operations are already dramatically less than projections for two-time filers.

Panel B suggests similar results for the second year following emergence from bankruptcy for virtually all variables examined. It is interesting to note that the percentage of one-time filers exhibiting bad news does not dramatically change between years one and two (see Panel A). For instance, the percentage increases in only three variables and declines in five. For two-time filers, the results do differ (by comparing Panel A with Panel B). Six out of the eight variables for two-time filers in year two exhibit an increase in the percentage of firms reporting bad news. Moreover, comparing Panel A with Panel B for both years, two-time filers consistently report worse news than one-time filers. The only exception is current liabilities in year two.

The dominance of bad news for companies filing twice did not increase in year three compared to year two. This was primarily due to the degree of bad news experienced in year two. Only three of the eight variables exhibited worse news in year three than in year two. However, for one-time filers, six of the eight variables exhibited a higher percentage of bad news in year three. Note that long-term debt declined dramatically in year three for two-time filers. This is particularly noteworthy given the noticeable increase in bad news for one-time filers in year three. This decrease for two-time filers may well reflect the contraction of credit available to them three years following their emergence from the first bankruptcy.

The study also reveals that the median deviation of actual values from projected values deteriorated for virtually all of the variables in each successive year. Moreover, the results for two-time filers were drastically worse than for one-time filers. For example, median actual net income for one-time filers was worse than projected by 38.3 percent, 52.2 percent and 74.5 percent for years one through three, respectively. The results for two-time filers were worse by 18.0 percent, 227.5 percent and 349.2 percent. In other words, the results deteriorated dramatically between years one and three for both one- and two-time filers. Actual results for virtually all variables were worse than projected in each of the years. Only in year one were the results worse for one-time filers than for those that filed twice. Interestingly, this occurred for five of the eight variables analyzed. Yet, by year three, each of the results was worse for two-time filers.

In sum, the results demonstrate that the projections provided to the court prior to a company's emergence from chapter 11 are typically overstated. The overstatements for those companies filing twice are generally sizeable and observable in even the first year following the first bankruptcy filing. The overstatements are large for one-time filers, but dramatic for two-time filers, particularly in years two and three.

Footnotes

¹ Professors at Boston University's School of Management. Return to article

² Director of Research. The authors thank Alex Kohl of Goldman Sachs for his able assistance. For further analysis of the issues, see Michel, Alan, Shaked, Israel and McHugh, Christopher, "Chapter 22s: Lessons of Two-time Bankruptcies," The Financier, Summer/Autumn 1999. Return to article