Survival of the Fittest? Financial and Economic Distress and Restructuring Outcomes in Chapter 11

Abstract

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.

Causes and resolution of bankruptcy: The efficiency of the law

“…To do this, some authors suggest analyzing the causes of the bankruptcy, distinguishing between financial and economic bankruptcy (White, 1994;Hotchkiss, 1995;Andrade and Kaplan, 1998;Denis and Rodgers, 2007;Lemmon et al, 2009;Balcaen et al, 2011;Fischer and Wahrenburgh, 2012). Firms that face financial bankruptcy are economically viable, but they have greater leverage and problems repaying their debts.…”

Spreading the Misery? Sources of Bankruptcy Spillover in the Supply Chain

“…Earlier work by Lemmon et al (2009) suggests that Chapter 11 does a reasonably good job of preserving the assets, reducing the leverage, and promoting the survival of firms that are purely financially distressed. We find that Chapter 11's efficacy in reorganizing financially distressed firms extends to their suppliers: bankrupt firms that are highly likely to emerge from Chapter 11 with little change in scale also transmit few or no costs to their suppliers.…”

“…We compute a measure of the degree of economic (as opposed to financial) distress following the method in Lemmon et al (2009). We sort our sample of bankrupt firms into deciles within sample and number them from 0 to 9 (0 being smallest and 9 being largest) based on the industry-adjusted EBITDA-to-assets ratio averaged over year -3 and year -2 and repeat the same process using average leverage.…”

“…The rankings are then summed, resulting in a proxy for the degree of economic (vs. financial) distress, ranging from 0 to 18. Lemmon et al (2009) label firms in categories 0 to 5 as economically distressed, label firms in categories 14 to 18 as financially distressed, and label the remaining firms as having a mixed type of distress. In our univariate tests, we use these three classifications.…”

Preference Order of Responses to Economic Distress in Italian Listed Firms

“…The study left out the time-series observations of a firm if its earnings before interest and tax were lower than its expenses on interest, so that companies in financial distress were excluded. In order to distinguish between financial and economic distress, Lemmon, Ma and Tashjian (2009) classified firms as economically distressed based on industry-adjusted EBITDA-to-assets. Andrade and Kaplan (1998) aimed to measure the cost of financial distress by selecting a sample of firms, with positive operating margins exceeding the industry median, Acque pot.…”