Lessons can be learned from bankruptcy

By DAVID MOON, Moon Capital Management, LLC
May 18, 2008

OK, class. For some strange reason, I feel inspired to review some of basics of Chapter 11 bankruptcy. Maybe I've read or heard something about it recently in the Knoxville business news; I don't remember. Perhaps some people would like to be reminded how it works.

Chapter 11 bankruptcy is typically used to reorganize a business by reducing or eliminating some of the company's outstanding debt.

The company will file a report listing its assets and liabilities. Often the total amount of assets will include items that have limited value to an outside, nonstrategic purchaser.

If a company has a lot of inventory, perhaps that can be sold and the proceeds used to pay debts. Alternatively, if a company's assets include millions of dollars of'oh, let's say'truck electrification systems or big ole yellow hoses, those can't easily be turned into cash.

Rather than being repaid in cash, the creditors of the company end up with the assets of the company, including the desks, computers, telephones and the big ole yellow hoses.

If the debts exceed the value of the assets, the stockholders' rights in the company are terminated; they get nothing. Creditors end up owning the newly reorganized company.

Secured creditors are the first to get paid. These are people with 'perfected' collateral interest in certain assets of the company. It's like the mortgage holder on your house. That bank has a perfected lien on your home.

Unsecured creditors are people who simply loaned money to the company with the expectation of receiving interest and, presumably, their principal when the debt matured.

Whoops.

The employees are best described as insecure creditors.

The stockholders are the last people to get their money, in the unlikely event there is any left. Often the only things remaining are the marketing brochures and souvenir stock certificates, not so subtle reminders that 'these securities involve a high degree of risk.' That phrase was probably on the original offering documents when the shares of stock were originally sold, but somehow that boring, black-and-white, legal-looking item wasn't nearly as exciting or interesting as the glossy brochure with the pictures.

Stockholders do get to keep those pictures, however.

There are all sorts of lessons to learn from a bankruptcy ' whether you're watching it as a curious outsider or from inside the sausage factory. Many of the lessons are obvious: Investments have risk. Speculation is fine, as long as you know you're speculating and can afford the risk. Earnings are good. Cash earnings are better. Earned cash is usually better than borrowed cash. Cash from grants can dry up on a moment's notice. Financial statements matter.

But the best lesson may be that there is not always an EmeraldCity at the end of the Yellow Hose Road.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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