One of the more interesting financial analyses we ever conducted was prepared for an attorney who represented a class of claimants who did not yet know they were in the class. In fact, by the time these particular claimants were to be identified as members of the class, they would likely be deceased. The case involved the bankruptcy, reorganization and later refinancing of a general aviation manufacturer. Creditors and investors were represented, but the judge in the case noticed one group conspicuously, but not surprisingly, missing—future crash victims. As long as this company's airplanes were still flying, there would be the possibility of accidents attributable to design and manufacturing flaws. If creditors and investors divvied up all available assets, to whom would the future accident victims, or their heirs, turn to for relief?

The judge appointed an attorney to represent the interests of future product liability claimants; the attorney then hired us to help. Therefore, we worked with this lawyer on behalf of clients whom we did not know. Similarly, these clients did not know us, and they probably never will.

Perhaps the reason the judge made this unusual move arises from the peculiarities of the aircraft industry. Although no one can predict which planes will crash and who will be a victim, it is nearly certain that there will be crashes and victims. Moreover, based on the historical record, it is nearly certain that heirs will bring suits for damages against the aircraft manufacturer, and that some of these suits will succeed.

In 1994 there were approximately 176,000 general aviation aircraft in service in the United States. According to Federal Aviation Administration data, between 1982 and 1994 there was an average of 2,481 general aviation accidents per year. Many of these involved relatively minor damages, but there were on average 471 fatal accidents per year. Since a single accident often resulted in multiple deaths, the number of fatalities per year averaged 885. Within this 13-year span, the lowest number of fatal accidents in a year was 433 in 1993, and the highest number was 591 in 1982. Although accidents became less frequent, the high-to-low range indicates that their rate was fairly stable and is not likely to fall to zero any time soon. On average, there were 1.7 fatal accidents per 100,000 hours of general aviation flight time, and flight time averaged more than 27 million hours per year between 1982 and 1994.

Product liability lawsuits have crippled the general aviation manufacturing industry. Annual output of single-engine airplanes dropped from 13,000 in 1977 to only 444 in 1994. There were several bankruptcies, and many companies exited the industry. By necessity, the remaining manufacturers were self-insured. The General Aviation Revitalization Act, passed by Congress in 1994, was motivated by eponymous intentions. The Act instituted an 18-year statute of repose so that, with some limited exceptions, manufacturers would be liable for the performance of their products only for the first 18 years of the product's service life; if an aircraft failed in its 19th year of service, the manufacturer could not be sued. Since the average single-engine craft was nearly 30 years old in 1994, the Act dramatically limits product liability exposure.

The history of liability claims against the company we were analyzing was similar to the average experience of the industry. Two independent actuarial firms analyzed this history and made projections for the future. One actuarial firm was hired by the attorney representing the committee of unsecured creditors, and the other firm was retained by the court-appointed attorney representing future accident victims. The actuarial reports ultimately reached similar conclusions, but due diligence required independent analyses. The actuaries estimated the likely number of future claims, the magnitude of the claims and the costs of defending against liability lawsuits. Thus, they estimated any future losses to the company from all such product liability lawsuits, successful as well as unsuccessful ones. The projections also had to incorporate assumptions regarding the extent to which the statute of repose would be sustained in court.

The actuaries discounted the future anticipated cash outflows to determine the present value of product liability exposure. This estimate, which combined the present value of future cash pay-outs to victims with the present value of the costs of defending against such claims, was a sizable proportion of the total value of the company's assets.

Several reorganization models had been considered during the years in which the company operated under bankruptcy protection. Some potential buyers were interested in the physical assets of the company, and others wished to own the company as an operating concern. The plan that was ultimately agreed upon, however, involved selling the company intact as an operating concern to a management group. Payment would be in the form of cash, debt, stock, assumption of some liabilities and call options. An irrevocable trust was constructed for future product liability claimants, and into this trust were placed cash, debt securities from the new company, stock and options. It was negotiated that the trust's debt securities would be senior to all others. The reorganization agreement further stipulated that after seven years, actuaries would recompute the present value of future claims. If the recomputation showed that the trust was underfunded, the new company would make up the difference by granting the trust an additional bond whose cash flows would cover the anticipated shortfall.

For the first three years after reorganization, the plan seemed to work well. Because of improved safety, the statue of repose and maybe luck, liability claims continued to decline. The market rebounded and profitability was restored. Competition in the business remained intense, however, and the market demanded state-of-the-art products. To remain competitive, the company had to offer new and more advanced models of aircraft, so research and development had to increase. To keep up with competitors and market demands, and to grow, the company needed additional investment funds. Investment banks were willing to underwrite new debt issues, and they entertained the notion of an eventual initial public stock offering. However, they were very concerned by the overhang of the senior debt held by the future plaintiff's trust. Wall Street demanded that any new debt be senior to the trust's securities. Such re-ranking required the approval of the attorney representing the future plaintiff class.

Our assignment was to determine whether the interests of the future plaintiffs were best served by maintaining the status quo or by accepting the refinance plan. That is, would the ability of the trust to pay claims be helped or hurt by losing seniority in exchange for allowing the company to refinance and grow and thereby become stronger and more competitive?

The refinance plan offered to the trust representatives involved buying back some of the debt securities for cash and replacing the remainder of the senior debt securities with junior debt. If status quo meant that earnings would decline because the company would be prevented from growing, the eventual outcome could be a default on the trust's debt securities, and the trust in turn would not have the cash flow to pay future plaintiff's claims. Alternatively, should the company be allowed to refinance and embark on new projects, the projects could potentially fail, jeopardizing the company's ability to service the new debt held by the trust. Even if the proposed new projects succeeded, it is possible that they would only improve profitability marginally, still jeopardizing the credit-worthiness of the trust's now-junior securities. Under more rosy projections, the refinancing could strengthen the company, making the junior debt more secure than the old senior debt. Ironically, future victims using old aircraft held the key to this company's future plans for new models.

The financial analysis was tricky. Market projections, project analyses and scenario analyses were conducted. Ultimately, we concluded that the refinancing was a good deal for the trust. The risk to the company of restricting its research and development was too great. By weighing and valuing the potential outcomes under all possible scenarios, the refinancing made sense for the trust.

What lessons could be learned from this case study? First, bankruptcy, especially in businesses with histories of successful product liability litigation, cannot be expected to shield existing assets from future claims of existing customers. In this particular case, a significant proportion of the entire company had to be escrowed to pay future claimants.

Second, if a judge requires that assets be set aside in trust to pay future claimants, it is advisable to negotiate in advance the voting and or control rights of the trust representatives. How much say will trust representatives have in deciding whether to accept or reject future refinancings and expansion plans? Debt-holders generally have a strong aversion to a company's taking on more risk, whereas equity-holders are usually more amenable. It is a novel but proven theorem of modern finance that increasing the volatility of earnings reallocates wealth from debt holders to equity holders. If future product liability claimants' assets are debt instruments, the trust representatives will generally try to thwart risky expansion projects, even if the projects are profitable for the company overall. Should the trust have veto power? How such disagreements will be worked out should be addressed in the original reorganization agreement. It is possible that such a trust, funded with debt, could potentially strangle a company trying to grow its way back to profitability while coping with changing market conditions.

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...bankruptcy, especially in businesses with histories of successful product liability litigation, cannot be expected to shield existing assets from future claims of existing customers.

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Third, there are certain facts and circumstances of this particular case that indicate how likely it is to set precedents for other bankruptcies. For example, the fact that this company and most aircraft manufacturers self-insure is relevant. If a lump-sum payment could be made to a third-party insurer, then there would be no need to construct a trust. The seniority of cash flows from the company would not be an issue, since the cash flows to future claimants would be from the insurer. Alternatively, at the time of the reorganization, insurance could be paid for with the debt or equity of the reorganized company. There may be other creative solutions to transfer risk to an insurer, and thereby free the reorganized company from the liability overhang.

The fact that this industry has had a steady rate of successful liability claims is also relevant. A judge would probably not be as likely to require representation of future product liability claimants if future claims were either unlikely, or if they could not be quantified because there had been no history of such claims. A bankruptcy of a cigarette company would more likely be treated this way than the bankruptcy of a software manufacturer. But what about a manufacturer of exercise equipment, for example? Or a manufacturer of coffee-makers? Accidents are rare, but they do happen, and one can imagine freak happenstances that could result in serious injuries. Will judges look to the product liability history for the bankrupt company in isolation, or will they aggregate within an industry? Only time will tell.

Footnotes

¹ Professors at Boston University's School of Management and managing directors of The Michel/Shaked Group. Return to article

² Professor at Babson College's Finance Division and affiliated expert of The Michel/Shaked Group. Return to article