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The second point is that creating space for a balanced assessment of the merits of reorganization versus liquidation is a good thing. It leads to a higher success rate in reorganizations, and conversely to swifter liquidation where that is the preferred conclusion; in so doing it mini mizes the negative externalities caused by bankruptcy. In Canada, as noted, about half of BIA restructurings are still in business as independ ent entities five years after emergence from the stay of proceedings. In the US the comparable figure may be as low as eight percent prima facie evidence that Chapter 11, in its lenience toward debtors, may be Skeel, op. cit., 4870.

trying too hard to save the unsalvageable at too high a price to the economy at large.

7.4. The example of Air Canada On April 1, 2003, Canadas national airline filed for creditor protec tion under CCAA while it restructured its finances. This prominent case illustrates how the Canadian bankruptcy system works under conditions of complexity, large scale, and high stress.

Factors leading to insolvency Most of the worlds best known air carriers grew up in an era of pro tectionism that privileged the various national flag carriers. Like agricul ture, air transport largely escaped the strong thrust toward international trade liberalization that has characterized most developed country in dustries since World War II. Firms enjoyed strong elements of monop oly. Regulated control over entry to markets gave airlines substantial power to set prices, with the result that no strong drive toward internal efficiency was long manifest in most firms. The result was predictable:

inefficient route systems and labour practices, high costs, and high prices.

In 1979, the US government broke the logjam. Deregulation of prices and market entry began on a large scale. The effects were re markable. Storied names like Pan Am, Braniff and Eastern went bank rupt sometimes, given the vagaries of the US Bankruptcy Codes Chapter 11, passed into law the previous year, several times. Dozens of new airlines sprang up, many only to fail after a few years. Between 1979 and 2001, 137 U.S. carriers filed for bankruptcy237. A few, notably Southwest Airlines, understood that a new model was needed for a new era of truly mass air travel.

The Southwest story is well known, but since its emulation in Canada is a large part of the Air Canada story, it is worth noting its salient fea tures. Only one type of aircraft, the Boeing 737, is used, thus simplifying maintenance and training. Labour costs are kept low by avoiding un ionization, by multi tasking, by creating unbureaucratic authority struc George F. Will, Always a bumpy ride, The Washington Post, May 9, 2002, p. A31, quoted in McArthur (note 41).

tures, and by making a share of compensation dependent on the results of the whole airline. There is great emphasis on employee enthusiasm.

Luxuries like multi class seating, fine meals and wines, and loyalty pro grams with their build up of deferred obligations, are avoided. The re sult is a cost per seat mile that is often on the order of half that of the old line companies.

Air Canada was born as Trans Canada Airlines in 1937, a Crown corporation organized by a legendary Canadian industry minister, C.D.

Howe238. For historically accidental reasons it was initially a subsidiary of the state owned Canadian National Railway. Federal regulators guaran teed its financial stability by awarding it a monopoly on transcontinental and international routes, even though rivals from the private sector were emerging and wished to be allowed to compete.

What was tolerable in Depression and war, and even in the expan sionary 1950s and 1960s, became less so as the economy matured in the period after the Canadian centennial in 1967. Deregulation began with the election of a Progressive Conservative government in 1984. In 1985 Air Canada was privatized. At that stage, Canada had two compet ing national airlines, Air Canada and Canadian Pacific Airlines (CP), a private company owned by the Canadian Pacific Railway conglomerate.

CPs difficulties led to its purchase by an upstart western airline, Pacific Western, which also acquired the highly reputed charter operator War dair. The new mainline competitor flew under the name of Canadian Airlines International Limited (CAIL), though its call letters were still the old CP. The rivalry between these two high cost national flag carriers was intense and was exacerbated by the western regional roots of CAIL and the eastern hub (Toronto) and head office (Montreal) of Air Can ada. Even after the privatization of Air Canada in 1985, Canadian was seen as the champion of free enterprise, while Air Canada carried the reputation of an arrogant, out of touch state owned enterprise.

Twice, in 1992 and again in 2000, Air Canada tried to take over CAIL.

Its misfortune was winning in 2000. Both times its tactics and the poli tics of the day made it appear heavy handed and arrogant. Throughout the 1990s, CAIL was failing faster than Air Canada. Both were premium A comprehensive and readable account of Air Canadas history is provided by Keith McArthur in Air monopoly: how Robert Miltons Air Canada won and lost control of Canadas skies, McClelland & Stewart, 2004.

price airlines whose profitability depended strongly on business travel ers willing to pay high fares for comfort and convenience. When that model was threatened in the recession of 199092, both airlines lost money but CAIL nearly failed. Only government intervention in the form of a $75 million loan guarantee kept it flying. Business conditions im proved during the rest of the 1990s, but discount airlines began taking market share or forcing the majors to lower fares to compete. The problem was that fares that made WestJet and other discounters profit able were ruinous to lines with the high costs of CAIL and Air Canada.

In 2000, following a complex multi party game of bids, bluffs, threats and counter threats involving the airlines, their alliance partners, equipment suppliers, financiers, competitors239, and governments, Air Canada took over CAIL as a going concern. In so doing it took on CAILs enormous debts and a labour force that had been taught to hate its old competitors. In retrospect Air Canada probably wishes it had taken the bloody minded course of letting CAIL go bankrupt, leaving it free to cherry pick among the routes, workers and assets of a liquidated firm.

The federal government, however, did not want to see thousands of un employed CAIL employees and hundreds of trade creditors out in the cold on the eve of a federal election. While not wanting to appear to take sides in an ostensibly private sector war, the government faced serious embarrassment if liquidation were to be the result of its airline competi tion policy.

Air Canadas projections in 2000 were rosy. As a monopoly it would have considerable pricing power, and it would not have to schedule poor yielding flights just to keep market share from its rival. Rationaliza tion would offer large savings. So confident was Robert Milton, Air Can adas president, that he guaranteed all the unions concerned that there would be no layoffs before the spring of 2002 at least.

The major competing bidder was AMR, the parent of American Airlines, an alliance partner of CAIL and the provider of its vital reservation and passenger management sys tems, which teamed with Toronto based Onex Corporation, a major Canadian player in the market for corporate control and restructuring. Onex was headed by a principal finan cial contributor to the Prime Minister and his party. In the end, the Onex AMR bid was quashed by the Court, which ruled that the statutory 25 percent limit on foreign ownership would be breached by its acceptance. The implicit reliance on a political fix failed spec tacularly.

No sooner had the deal been struck, however, than things began to go seriously wrong. The tech sector bust of 200001 took large num bers of the highest yielding business class passengers out of the skies altogether, or consigned them to economy. In September 2001 the use of airliners to attack New York and Washington caused an enormous crisis for all airlines: traffic volumes fell disastrously much more rap idly than airlines could shed capacity while costs for security and in surance leapt. For Air Canada, furious actions, including the breaking of promises to unions about layoffs, turned a 2001 loss into a small profit in 2002, but then the third blow fell. The United States went to war in Iraq in March 2003, which substantially lowered traffic on the critical North Atlantic routes. And at roughly the same time, Toronto, the hub of Air Canadas worldwide operations, became the major non Asian locus for Severe Acute Respiratory Syndrome (SARS). Weakly recovering Asia Pacific volumes plummeted. By this time Air Canada had used up all its sources of financial resilience. Supplier prices and employees wages had been forced down, aircraft and their engines sold and leased back, lines of credit drawn tight. Even so, insolvency was inevi table. On April Fools Day 2003 Air Canada petitioned for protection from its creditors pending reorganization under CCAA. Mr. Justice James L. Farley, a Commercial List judge of the Superior Court of On tario, granted the protection and appointed Murray McDonald of Ernst & Young as monitor.

Hammering out a proposal Air Canada has now been moving toward a restructuring proposal for more than a year. A reorganized Air Canada, one that would have good prospects of permanence, would have to be profitable in the new world of changed consumer demand, public policy, and competition that was emerging in the new millennium. Overwhelmingly this meant substantial cost reductions in order to reclaim market share from the upstart dis counters as well as the farther off threat of international competition cabotage in home markets. A lower cost airline might then be able to command the financial strength to be able to withstand the inevitable ups and downs of demand in an industry in which capacity (cost) was largely fixed in the short run. The strategy that has emerged so far has the following main thrusts:

Lower labour costs by about $1.3 billion a year. This is to be ac complished through lower wages, reduced pension risks and bene fits, reduced levels of passenger service, greater automation, and the contracting out of certain jobs to low wage, non unionized sup pliers.

Lower supplier costs, notably through the renegotiation of leases for aircraft and engines and through lower prices for onboard food.

While General Electric Capital Aviation Services (GECAS) was willing to make some accommodation on leases, essentially through lengthening the terms so as to lower short term cash requirements, the latter meant, for example, that CARA, the long time supplier of Air Canadas in flight meals, would have to lower the wages it paid its employees from $22 to $12 an hour, or see the work go abroad.

Commissions to travel agents would disappear entirely, and cus tomers would be required either to wrestle with the opacities of the Internet themselves or pay agents to do it for them.

Lower fares aggressively to compete with the discounters on routes where they offered competition.

Seek new equity to replace that which had vanished240.

The new corporate strategy is outlined in the plan of arrangement published on June 30241. Older aircraft with high operating costs are be ing retiured and replaced with more efficient and generally smaller air craft, thus improving load factors while maintaining flight frequencies.

Forty eight old aircraft are leaving the fleet and being replaced by a lar ger number of Embraer and Bombardier planes worth some $2 billion.

Employee headcount will decline by 6,300 and related expenses by Under the Air Canada proposal, the present common stock would become worthless.

Since the date of filing, however, they have generally traded in the range of $1.00 to $1.50, a point which may have implication for the theory of efficient markets.

Air Canada, Notice of meeting and proxy statement pertaining to a consolidated plan of reorganization, compromise and arrangement under the Companies Creditors Arrange ments Act (Canada), the Canadian Business Corporations Act, and the Business Corpo rations Act (Alberta) involving Air Canada and ACE Aviation Holdings Inc. and certain of their subsidiaries, and preliminary short form prospectus pertaining to a rights offering of ACE Aviation Holdings Inc., Montreal, 30 June 2004. A primary source of public informa tion as complex CCAA negotiations proceed is the periodic reporting of the monitor to the Court. As circumstances warrant, but on average every two weeks in the Air Canada case a detailed report, including recommendations where appropriate, is filed with the Court.

These and other documents are available at www.stikeman.com/ac.

$1.1 biullion annulally. Several business units are to be set up as quasi independent limited partnerships, including a technical services unti, Aertoplan, a groundhandling unit, an Air Canada online unit, and Jazz.

In each case, a new holding company, ACE Aviation Holdings Inc., will be the general partner and Air Canada, an ACE subsidiary, will be the initial limited partner. Financially, all of the old Air Canada equity will have vanished and more than $5 billion of its debt will have been com promised, to be replaced by $850 million of new ACE common shares, $250 million of preferred shares, and $2.3 billion in long term debt and capital leases.

An early decision under the restructuring plan was setting the re quirement for new equity at $1.1 billion. The question for management and existing creditors was how much of the firm had to be given away to a strategic investor in order to raise about 60 percent of that amount.

The smaller the proportion the higher the implicit valuation of the firm and the more equity would be available at a cut rate to creditors in trade for compromised debt. With this in mind, Air Canada and its financial advisors sought bids from qualified investors where, in essence, the winner would be the investor specifying the lowest percentage of equity it would require for its $650 million.

Air Canadas management set the qualifications for equity bidders.

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