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We employ straightforward proxies to identify firms in financial versus economic distress and show that Chapter 11 outcomes and asset restructurings vary according to these firm types. The results from our sample of large bankruptcies from 1991 to 2004 are consistent with the view that the Chapter 11 process preserves the going concern value of financially distressed firms while redeploying the assets of economically distressed firms. These results hold for asset redeployments resulting both from liquidations or acquisitions and those resulting from partial asset liquidations of firms that reorganize in Chapter 11. The empirical findings run counter to concerns that inefficiencies and conflicts of interest severely compromise the Chapter 11 process. Further, we provide the first empirical evidence that the put option inherent in lease contracts is frequently exercised in Chapter 11, that the disposition of lease contracts in bankruptcy constitutes a large portion of asset restructurings, and that the ability to put lease contracts may mitigate the indirect costs of asset fire sales. We also find that unionized firms experience smaller debt reductions in Chapter 11 than do non-unionized firms. AbstractWe employ straightforward proxies to identify firms in financial versus economic distress and show that Chapter 11 outcomes and asset restructurings vary according to these firm types. The results from our sample of large bankruptcies from 1991 to 2004 are consistent with the view that the Chapter 11 process preserves the going concern value of financially distressed firms while redeploying the assets of economically distressed firms. These results hold for asset redeployments resulting both from liquidations or acquisitions and those resulting from partial asset liquidations of firms that reorganize in Chapter 11. The empirical findings run counter to concerns that inefficiencies and conflicts of interest severely compromise the Chapter 11 process. Further, we provide the first empirical evidence that the put option inherent in lease contracts is frequently exercised in Chapter 11, that the disposition of lease contracts in bankruptcy constitutes a large portion of asset restructurings, and that the ability to put lease contracts may mitigate the indirect costs of asset fire sales. We also find that unionized firms experience smaller debt reductions in Chapter 11 than do non-unionized firms.

We document that suppliers to purely financially distressed companies that are highly likely to reorganize in bankruptcy incur little or no spillover costs. In contrast, suppliers to economically distressed firms experience large losses in market value that are linked to proxies for the cost of replacing the bankrupt customers. Suppliers experience increased selling, general, and administrative (SG&A) expenses and lower margins in the year following the bankruptcy of their trading partners, which we link to proxies for partner replacement costs. Suppliers continue to extend trade credit to firms that are healthier and in situations where the cost of replacing the partner is higher.

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