Had the subordination clause not been signed both wells

Question

Michael Garber Summary:

Mark X Company manufactures farm and specialty trailers of all types. Almost more than 85 percent of the company's sales come from the west coast. A growing market for custom horse transport vans designed and produced by Mark X is developing nationally and Also, several major boat companies in California and Washington have had Mark X design and manufacture trailers for their new models, and these boat-trailer "packages" are sold through the boat companies' nationwide dealer networks. The president of Mark X, recently received a call from senior vice president of Wells Fargo Bank. The president was told that a deficiency report generated by the bank's computerized analysis system had been filed because of Mark X's deteriorating financial position. The bank requires quarterly financial statements from each of its major loan customers. Information from such statements is fed into the computer, which then calculates key ratios for each customer and charts trends in these ratios. The system also compares the statistics for each company with the average ratios of other firms in the same industry.

1) Bankruptcies occur in firms of all sizes. Small firms, with fewer creditors, are often able to work out informal settlements and thus avoid the time and expense of formal bankruptcy. If a firm is too large, it has too many creditors, and it could be difficult to work out an informal settlement.  If the firm attempted to resolve its problems informally, the attempt would probably fail, and then it would have to resort to the federal bankruptcy court.

An extension postpones the required payment date, while a composition is a reduction in creditor claims. Extension provides payment in full, though delayed. Composition, however, involves a reduced cash settlement. Usually an agreement includes both a composition and an extension.

2) The standard of fairness states that claims must be recognized in the order of their legal and contractual priority, that is, the reorganization must be fair to all parties. The standard of feasibility states that there must be a reasonably high probability of successful rehabilitation and profitable future operations.

3) A list of funds expected in case of liquidation (in thousands)

a) Land and Buildings: $5,000

b) Equipment: $3,000

c) Receivables: $29,357 X 0.75 = $22,017.75

d) Inventory: $46,659 X 0.5 = $23,329.5

e) Cash/Marketable Securities = $3,906

Total proceeds = a+b+c+d+e = $57,253.25

4)

Distribution of Proceeds (Thousands of Dollars)
Priority Claims		Claim	Payment	Percentage of Claim Received	Proceeds remaining after claim is paid
1	Mortgage	$2,340	$2,340	100%	$54,913
2	Trustee's fees	$600	$600	100%	$54,313
3	Wages due	$2,331	$2,331	100%	$51,982
4	Taxes due	$5,000	$5,000	100%	$46,982
5	Unfunded pension liability	$6,000	$6,000	100%	$40,982

The total amount of proceeds remaining after payment to the priority claimants is $40,982,000

5)

Initial General Creditor Allocation
Payment		Claim	Payment	Percentage of Claim Received	Proceeds remaining after claim is paid
6	Accounts payable	$19,998	$17,148	85.70%	$23,834
7	ST bank loans	$18,233	$15,634	85.70%	$8,200
8	Priority LT bank loans	$5,000	$4,287	85.70%	$3,913
9	Sub LT bank loans	$4,563	$3,913	85.70%	$0
10	Remaining mortgage	$0	$0	N.A.	$0
General Creditor Allocation after Subordination Adjustment
6	Accounts payable	$19,998	$17,148	85.70%	$23,834
7	ST bank loans	$18,233	$15,634	85.70%	$8,200
8	Priority LT bank loans	$5,000	$5,000	100.00%	$3,200
9	Sub LT bank loans	$4,563	$3,200	70.13%	$0
10	Remaining mortgage	$0	$0	N.A.	$0
Shareholders' Distribution
11	Common stockholders	$38,637	$0	0.00%	$0

The Senior Creditors (Priority LT bank loans) get the 100% claim amount, whereas, the general creditors get 85.7% (for ST bank loans) and 70.13% (for Sub LT bank loans).

The stockholders do not get any part of their claim, or $0.

6) Wells Fargo is repaid the entire $5 Million amount because of the subordination clause that ensures 100% repayment, however the competitor bank receives only 70.13% of its claim, which is $3.2 Million, if Mark X is liquidated.

Had the subordination clause not been signed, both Wells Fargo and the competitor bank receive 85.7% of their claim amount, which is $4.287 Million and $3.913 Million. In this case Wells Fargo would be worse off, while the competitor is relatively better off, as compared to the case where subordination clause is signed.

The value of the subordination clause for Wells Fargo would be less than (or equal to) the difference in the claim amounts they receive.

i.e. Maximum Value of the Clause for Wells Fargo = $5 Million - $4.287 Million = $713,000

7) If the proceeds from the liquidation increase, the creditors and the stockholders are definitely better off, as they receive larger percentages of their claim amounts. This is because the pro rata percentage would now be higher than it was before, (85.7%), and thus a greater proportion of the claims can be paid off.

If the proceeds are greater than the general creditor claims, the remaining amount can be distributed among the common stockholders.

If, However, the proceeds are lesser than the case above, a smaller percentage of the claims will be settled. Only if some part of proceeds is left after settling priority claims, will the general creditors' claims be settled, according to the pro rata percentage determined. The shareholders' claims in this case will not be settled at all.

8) If the company stands to earn a substantial profit, thereby giving value to common stock, the bank might decide to not demand repayment of the loan, as this would mean continued interest payments in the future and thus a greater profit for the bank.

However, if the bank does demand a repayment, the bankruptcy court would definitely look into various operating projections and the probability of these occurrences, and probability distributions can be used in this regard. These distributions help find the minimum/maximum amounts of proceeds, chance of bankruptcy in the future, possibility of recovering under a certain defined confidence interval. When used efficiently, this can be an important factor that determines the court's decision.

The financial analyst working for common stockholders would be relatively optimistic while setting assumptions. This is because the common stockholders stand to lose all their investment if the company goes bankrupt, and the proceeds are used up in repayment of claims to parties that lie above the stockholders in the repayment priority order. Thus the analyst will make optimistic assumptions, as it could lead to avoiding the bankruptcy scenario, which improves the chances of repayment in the future, if the company recovers and does well.

9) a) The Bankruptcy court should order a reorganisation as the firm is making a significant profit annually. In any case, if the reorganisation doesn't help over time, the court may order a liquidation in that case, as the assets' liquidating value doesn't decline with time.

b) The court should order liquidation as the outcome is not certain, and if the events turn out badly, the firm will not be able to pay off the bank debt, due to the declining value of the assets. The safest option is to order a liquidation, due to the risk involved.

c) The bank should order a reorganisation as the firm is making significant profits and the chance of an optimistic outcome is relatively high too. Also, the court could give the firm some time, to observe if the condition of its finances improves. If it doesn't, the court may order a liquidation later.

10) Carolyn Mayo should recommend that the bank should force the company into bankruptcy as the chance of assets declining is high, and if that happens, the bank stands to lose some part of the claim amount, if not all of it. Currently, the bank can recover the entire principle due to the subordinate clause and should not risk losing even a higher amount by being optimistic about the firm's future performance, and lending it more money.

Attachment:- Assignment.rar