Xenon, a Major Defense Contractor, Was Faced with Huge Liabilities

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The Answer is As part of the Chapter 11 reorganization, Xenon can negotiate new credit agreements. These credit agreements contain debt covenants, most likely related to the amount of debt Xenon can have. If Xenon waited until after emerging from Chapter 11, the $1 million liability along with other charges might have caused the company to violate the amount of allowable debt as specified in its debt agreements. Such a violation could have forced the company back into Chapter 11 or to renegotiate its debt agreements at less favorable terms. By recording the charges prior to negotiating its new debt agreements, the new charges would be considered by creditors in creating the debt covenants. Thus, this liability would not place Xenon into an automatic violation of its debt covenants. Reasons for taking several significant charges while under bankruptcy proceedings include:
(1) The significant charges would adversely affect Xenon's reported results of operations and financial position, and Xenon may have been trying to extract more favorable settlement terms from its creditors by demonstrating weakened performance and financial position.
(2) Xenon may have been positioning itself to show improved performance once it emerged from Chapter 11. By taking the charges now, not only does Xenon avoid having to reduce its earnings in the future, but it also reduces the company's earnings so much that its earnings can only increase next year. This latter strategy is known as "taking a bath."

Xenon, a Major Defense Contractor, Was Faced with Huge Liabilities

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