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Thanks to the coronavirus crisis, we are seeing more and more headlines stating that an airline has become “bankrupt” or is “insolvent”. We then hear about “restructuring”, “administration”, “liquidation” and lots more jargon. I don’t intend to call out any of my fellow miles / points bloggers, but if you aren’t a City banker or lawyer you might not know the exact definition of these terms. So what do they actually mean?
Bankruptcy is the term for the legal process that gives companies or individuals relief (temporary or permanent) from their debts.
Strictly speaking, only individuals can “go bankrupt” in the United Kingdom. Companies actually “enter administration”. In other countries, the terminology might be a bit different, but the concept is the same.
The aim of any bankruptcy proceeding, especially for companies, is for independent experts to determine whether the company remains viable or whether it is a lost cause. This is where the term “restructuring” often comes into play.
As the recent example from Norwegian shows, an airline might owe a substantial amount of money, and be unable to repay its creditors as originally agreed. Selling off aircraft for spare parts might raise some money. But if the company is more valuable as a “going concern” – i.e. continuing to operate – then it will make sense to restructure the company’s debt.
The simplest of “restructurings” involves debt holders simply exchanging their debt for some or all of the equity of the company. Instead of merely lending a company money – and having little say in how the company is run – the debt holders become the actual owners of the company (and the previous owners end up with nothing). Without the pressure of spending the company’s available cash on debt service, the company is much likelier to be profitable and survive.
Restructurings require substantial negotiation – helped by the protection offered by bankruptcy courts – but always involve converting debt that CANNOT be repaid into something that CAN be repaid (or doesn’t need to be repaid).
Sometimes you simply cannot make the case that a company is worth more alive than dead. In this case, the best approach is to sell the company’s assets piecemeal to the highest bidders, and then distribute the proceeds amongst those debt holders with the strongest claim on any available cash. This is called “liquidation”.
Flybe is an excellent example of an airline that was restructured, but ultimately was forced into liquidation. No matter what was done to reduce the burden of the airline’s debt, it simply couldn’t make a profit…
Liquidation is the only term that is a problem for YOU, the airline customer. If an airline ceases operations and is liquidated, it will owe you whatever you paid in advance for a flight you didn’t ultimately take. But you will be one of thousands of unlucky “unsecured creditors”, which basically means that you are at the end of the queue for any cash distributed to creditors. If you paid with a credit card, however, you are protected by “Section 75” – i.e. the bank will give you your money back. Alternatively, your travel insurance provider might also refund you.
Most companies find themselves in bankruptcy court because they are insolvent. Insolvency can be defined as “the inability of a debtor to repay their debt”.
There are two main types of insolvency, however.
Cash Flow Insolvency
Cash flow insolvency occurs when a company has substantial assets to its name, but simply doesn’t have enough cash to pay its debts when due. Most of the airlines going “insolvent” suffer from this problem. They own dozens of expensive planes, but cannot afford to pay for fuel. (because you pay for fuel with money, not pieces of airplanes…) But if you sell airplanes to raise cash, you cannot deliver on your promise to fly passengers from one airport to another.
The travel shutdown is causing particular problems for airlines because they are no longer receiving cash in advance for future flights. Moreover, they are forced in many cases to refund money to customers. But as long as the airline is reasonably well run in normal times – earning more from selling plane tickets than it costs to operate the airline – then this cash flow insolvency should be temporary.
Balance Sheet Insolvency
Balance sheet insolvency is often called “technical insolvency”. Instead of a short-term problem with cash flow, a balance sheet insolvency involves companies whose liabilities are far greater than the value of their assets. This problem is far more serious.
For example (although not travel related)… if you borrow £500,000 from the bank to buy a £600,000 house, your assets are worth more than your liabilities. If a housing market crash occurs and your house becomes only worth £400,000, you would be technically insolvent because your assets would be worth less than your liabilities. You might be able to continue paying your mortgage, but at some point you might wonder why you should even bother.
Companies that are technically insolvent are a real concern for lenders. Management might decide that the company is a lost cause, and spend any available cash on themselves, instead of saving the cash for future debt payments.
When Should I Worry?
When an airline appears to be in financial difficulties, only the adventurous (or naive) will pay for flights in advance. This accelerates a downward spiral where the airline approaches a cash flow insolvency and, due to the lower passenger numbers, struggles to argue that it is a viable business that merely requires debt restructuring. This situation then leads administrators to recommend liquidation, which causes financial pain for those intepid travellers who bought tickets for future flights.
Insolvent airlines can continue to operate, provided somebody is willing to make up the cash flow deficit with regular bailouts. Alitalia and Thai Airways are excellent examples.
Bankrupt airlines can also continue to operate. Several major American airlines passed through bankruptcy at some point.
But once you start hearing about liquidation, it’s too late!