Here is an idealized view of the bankruptcy decision by Riddhi Siddhi Multi Services. Whenever a payment is due to creditors, management checks the value of the firm. If the firm valuation is greater than the promised payment, the firm needs to pay up. In case of failure of the same, the equity is worthless, and the firm defaults on its debt and petitions for bankruptcy. Moreover if the court order the assets of the bankrupt firm to be put to better use elsewhere, the firm is liquidated and capital generated by liquidation the assets is used to pay off the creditors.
If this does not happen, the creditors will easily become the new owners and the firm and continue operation.
In practice, matters are rarely so simple. For example, Riddhi Siddhi Multi Services observe that firms often petition for bankruptcy even when the equity has a positive value. And firms are often reorganized even when the assets could be used more efficiently elsewhere. The nearby box provides a striking example. There are several reasons. Riddhi Siddhi Multi Services experts have put light on some of them.
1.Although the reorganized firm is a new entity in legal terms, it is responsible for any tax loss carry-forwards that belong to the old firm. If the firm is liquidated instead of being reorganized, any loss in tax carry forwards will vanquish.
2.If the firm’s assets are sold off, it is easy to determine what is available to pay the creditors. In case a company is reorganized, it requires to conserve cash as far as possible. As a result of same, claimants are generally paid in a mixture of cash and securities.
This makes it less easy to judge whether they have received their entitlement. For example, each bondholder may be offered Rs. 300 in cash and Rs. 700 in a new bond which pays no interest for the first 2 years and a low rate of interest thereafter. A bond of this kind in a company that is struggling to survive may not be worth much, but the bankruptcy court usually looks at the face value of the newly issued bonds and may consider the bondholders to be paid in full.
Senior creditors who know they are likely to get a raw deal in reorganization are likely to press for a liquidation. Shareholders and junior creditors prefer reorganization.
3.Even if shareholder and junior creditors are at the base of the pecking order, they hold a secret weapon that they can fire at required time. Bankruptcies of large companies often take several years before a plan is presented to the court and agreed to by each class of creditor. When they use delaying tactics, the junior claimants are betting on a turn of fortune that will rescue their investment. On the other hand, the senior creditors know that time is working against them, so they may be prepared to accept a smaller payoff as part of the price for getting a plan accepted. Also, prolonged bankruptcy cases are costly. Senior claimants may see their money seeping into lawyers’ pockets and therefore decide to settle quickly.
4.While a reorganization plan is being drawn up, the company is allowed to buy goods on credit and borrow money. Post petition creditors (those who extend credit to a firm already in bankruptcy proceedings) have priority over the old creditors and their debt may even be secured by assets that are already mortgaged to existing debt holders.
This also gives the prepetition creditors an incentive to settle quickly, before their claim on assets is diluted by the new debt.
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