edward j. altaman costs of bankruptcy

CHAPTER 4The Costs of Bankruptcy

The costs of financial distress and legal proceedings under the BankruptcyCode are important for obvious practical reasons. For small firms, the

costs involved in a reorganization can often exceed any remaining firmvalue, explaining why so many smaller cases end with the firm being dis-solved. For larger firms, the dollar magnitude of professional fees has be-come a concern, particularly in many of the recent multibillion-dollarChapter 11 cases. For example, fees paid to advisers in the Enron bank-ruptcy case are ultimately expected to exceed $1 billion.

Distress costs have also been recognized as an important determinantof the pricing of a firm’s debt and of its capital structure. There has beensome debate, however, as to how significant their impact might be. Haugenand Senbet (1978) were among the first to argue that bankruptcy costsshould not be significant because claimants in financial distress should beable to negotiate outside of court without affecting the value of the under-lying firm. More recent scholars, however, such as Jensen (1991) note thatnot only the conflicts between creditor groups, but also the influence of cer-tain bankruptcy court decisions have had a negative impact on firms’ abil-ity to renegotiate their claims out of court. When a firm is unable tocomplete an out-of-court reorganization, it may be unable to avoid a morecostly court-supervised bankruptcy proceeding. Regardless, it is clear that ifdistress costs are in fact significant, the optimal leverage for a companymay be lower. A number of researchers discuss the bankruptcy cost issuewithin the framework of capital structure and cost of capital assessment(see Chapter 6).

The costs of financial distress are typically classified as either director indirect. Direct costs include out-of-pocket expenses for lawyers, ac-countants, restructuring advisers, turnaround specialists, expert wit-nesses, and other professionals. Indirect costs include a wide range ofunobservable opportunity costs. For example, many firms suffer fromlost sales and profits caused by customers choosing not to deal with a

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firm that may enter bankruptcy. They may also suffer from increasedcosts of doing business, such as higher debt costs or poorer terms withsuppliers while in a financially vulnerable position. Indirect costs also in-clude the loss of key employees, or lost opportunities due to manage-ment’s diversion from running the business.

While direct costs are relatively easy to identify, it has not been easyfor researchers to obtain the information needed to study these costs in asystematic way. The various estimates that have been constructed over timeare described in this chapter. Indirect costs are not directly observable, butthere have also been several recent studies that provide useful estimates oftheir potential magnitude and determinants. (See Table 4.1.)

DIRECT COSTS

The difficulty in measuring direct costs is that there is no centralized sourcelisting all firms filing for bankruptcy (with the notable exception of the Ad-ministrative Office of the U.S. Courts and Executive Office for the U.S.Trustees, which does not make information publicly available), let aloneinformation on costs in bankruptcy cases. The only way to compile this in-formation has been to obtain documents from individual federal bank-ruptcy courts scattered throughout the country. Studies of direct coststherefore have been based on samplings of cases, often for larger firms,filed in one or more jurisdictions. A listing of these studies and summariesof their findings are presented in Table 4.1.

One of the earliest attempts to measure direct costs is by Warner(1977). He examines payments for legal fees, professional services,trustees’ fees, and filing fees for 11 bankrupt railroads filing under Section77 of the Bankruptcy Act between 1933 and 1955. These cases took on av-erage 13 years to settle, and the direct costs are estimated to average 4 per-cent of the market value of the firm one year prior to default.

More recently, Weiss (1990) obtained documents from seven bank-ruptcy courts, including the Southern District of New York. Based on hisexamination of 37 cases between 1980 and 1986, all of which were NYSEor AMEX firms, he estimates that direct costs of bankruptcy average 3.1percent of the book value of debt plus the market value of equity at the fis-cal year-end prior to the bankruptcy filing, with a range from 1 percent to6.6 percent. Weiss interprets these figures as relatively low direct costs,which would be expected to have little or no impact on the pricing ofclaims prior to bankruptcy.

Several other studies report mean direct costs estimates in the rangeof Weiss’s study. These include Ang, Chua, and McConnell (1982) (7.5

94 DIMENSIONS OF CORPORATE BANKRUPTCY AND DISTRESSED RESTRUCTURINGS


TABLE 4.1 Estimates of Direct and Indirect Costs of Distress

Study Sample Used to Calculate Costs Time Period Estimated Costs

Direct Costs

Altman (1984) 19 Chapter 11 cases; mean assets 1974–1978 Mean 4% (median 1.7%) of firm value $110 million before filing just prior to bankruptcy for 12 retailers;

9.8% (6.4%) for 7 industrial firms

Ang, Chua, & McConnell 86 liquidations, Western District of 1963–1979 Mean 7.5% (median 1.7%) of total (1982) Oklahoma; estimated mean liquidating value of assets

prebankruptcy assets of $615,516

Betker (1997) 75 traditional Chapter 11 cases; 48 1986–1993 Prepackaged bankruptcies—mean 2.85% prepackaged Chapter 11 cases; (median 2.38%) of prebankruptcy total 29 exchange offers; mean assets; traditional Chapter 11s—mean assets FYE before restructuring 3.93% (median 3.37%); exchange $675 million offers—2.51% (1.98%)

Bris, Welch, & Zhu (2004) Over 300 Arizona and SDNY Chapter 1995–2001 Chapter 7: mean 8.1%, median 2.5% of 11 (mean prebankruptcy assets $19.8 prebankruptcy assets million) and Chapter 7 cases (mean Chapter 11: mean 9.5%, median 2%prebankruptcy assets $501,866)

Gilson, John, & Lang (1990) 18 exchange offers (from a sample of 1978–1987 0.65% average offer costs as a percentage 169 distressed firm restructurings) of book value of assets (max 3.4%)

Lawless & Ferris (1997) 98 Chapter 7 cases from 6 bankruptcy 1991–1995 Average 6.1% of total assets at filing courts; median total assets $107,603 (median 1.1%)

LoPucki & Doherty (2004) 48 Delaware & SDNY Chapter 11 1998–2002 Mean professional fees equal 1.4% of cases; mean assets at filing $480 million assets at beginning of case

(Continued)

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TABLE 4.1 (Continued)

Study Sample Used to Calculate Costs Time Period Estimated Costs

Lubben (2000) 22 Chapter 11 cases; median assets 1994 Cost of professional fees in Chapter 11 $50 million averages 1.8% (median 0.9%) of total

assets at beginning of case; 2.5% excluding prepacks

Tashjian, Lease, & 39 prepackaged Chapter 11 cases; 1986–1993 Mean 1.85%, median 1.45% of book McConnell (1996) mean book value assets FYE before value of assets at fiscal year-end

filing $570 million preceding filing

Warner (1977) 11 bankrupt railroads; 1933–1955 Mean 4% of market value of firm one estimated mean market value $50 year prior to defaultmillion at filing

Weiss (1990) 37 Chapter 11 cases from 7 bankruptcy 1980–1986 Mean 3.1% (median 2.6%) of firm value courts; average total assets before prior to filingfiling $230 million

Indirect Costs

Altman (1984) 19 Chapter 11 cases 1974–1978 10.5% of firm value measured just prior to bankruptcy

Andrade & Kaplan (1998) 31 highly leveraged transactions that 1987–1992 10% to 20% of firm valuesubsequently became distressed

Maksimovic & Phillips 302 Chapter 11 cases (owning 1,195 1978–1989(1998) plants)

Opler & Titman (1994) Distressed industries 1974–1990 Financial distress costs are positive and significant

Pulvino (1999) 27 U.S. airlines, 8 of which are in 1978–1992 Prices received for sales of used aircraft Chapter 7 or 11 by bankrupt airlines are lower than

prices received by distressed but nonbankrupt firms

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percent of total liquidating value); Altman (1984) (6.1 percent of firmvalue for his full sample); and Betker (1997) (3.93 percent of prebank-ruptcy total assets for nonprepackaged bankruptcies). Finally, two re-cent studies report professional fees for relatively large public companiesin Chapter 11. Lubben (2000) reports, for 22 firms filing in 1994, thatthe cost of professional fees in Chapter 11 is 1.8 percent of the dis-tressed firm’s total assets, with some cases reaching 5 percent. LoPuckiand Doherty (2004) find professional fees equal to 1.4 percent ofdebtor’s total assets at the beginning of the bankruptcy case for 48Delaware and New York cases. In comparison to the earlier studies,their findings suggest that there may be substantial fixed costs associatedwith the bankruptcy process, and therefore economies of scale with re-spect to bankruptcy costs.

One notable study examining bankruptcy costs is Bris, Welch, andZhu (2004). They examine over 300 cases from two bankruptcy courts,Arizona and the Southern District of New York. These courts were se-lected because electronic documents are available dating back to 1995.What distinguishes their study from prior research, however, is that theylook at both Chapter 7 and Chapter 11 cases. Further, in contrast to mostof the previous studies, which look exclusively at large public companies,their study considers primarily smaller nonpublic firms. For Chapter 7cases, direct bankruptcy expenses are estimated to have a mean of 8.1percent of prebankruptcy assets (median of 2.5 percent). However, bank-ruptcy professionals (attorneys, accountants, and trustees) regularly endup with most of the postbankruptcy firm value in Chapter 7 cases. Basedon their estimates of postbankruptcy remaining value, in 68 percent ofthe Chapter 7 cases the bankruptcy fees “ate” the entire estate. This fig-ure is in line with statistics reported by the U.S. Trustee’s office, whichalso show that after paying these expenses, many Chapter 7 cases haveno remaining distributable value. The only other published study to con-sider smaller Chapter 7 cases is Lawless and Ferris (1997), who find feesin these cases average 6.1 percent of total assets. For Chapter 11 cases,Bris et al. find that direct costs have a mean of 9.5 percent of prebank-ruptcy assets (median 2 percent).

Overall, several important facts emerge from these studies. First, thereis likely to be an important scale effect. While much of the research onthis question focuses on larger public companies, smaller firms may be un-able to survive the reorganization process given the magnitude of fees rel-ative to their assets. Second, the dollar amount of fees for large publiccompanies can be tremendous, even though as a percentage of assets thesefees are not large. Still, even when the percentage direct costs are low, in-direct costs of financial distress may be significant. Third, as data becomes

The Costs of Bankruptcy 97


available in electronic form, our ability to measure and monitor thesecosts improves.

Before turning to studies of indirect costs, another important questionis how direct costs of a formal bankruptcy proceeding compare to an out-of-court restructuring. Gilson, John, and Lang (1990) provide estimates ofdirect costs for a sample of firms completing exchange offers for distressedpublic debt, and find that these expenses are quite low (0.65 percent of as-sets). Betker (1997), however, reports costs averaging 2.51 percent for ex-change offers. Interestingly, the development of prepackaged bankruptcieshas given firms the ability to negotiate a Chapter 11 plan prior to filing, al-lowing firms to exit bankruptcy within months rather than years. Aprepackaged bankruptcy calls for a firm to negotiate its reorganizationplan and possibly solicit votes on the plan prior to filing a bankruptcy peti-tion. The firm then simultaneously files its plan and its Chapter 11 petition.This allows firms to take advantage of voting rules and other provisions ofthe Bankruptcy Code, as well as tax advantages relative to an out-of-courtrestructuring, without incurring a lengthy and expensive stay in Chapter11. In many ways, a prepackaged bankruptcy can be viewed as a hybrid ofa more traditional Chapter 11 and an out-of-court restructuring. CrystalOil (1986) and Southland (1991) are among the earliest examples of thistype of bankruptcy. Betker finds that direct costs average 2.85 percent ofprebankruptcy total assets for prepackaged bankruptcies; his figure is simi-lar to traditional Chapter 11 cases, but includes restructuring expenses in-curred prior to filing. Tashjian, Lease, and McConnell (1996) find thatdirect costs average 1.85 percent of the book value of assets at the fiscalyear-end preceding Chapter 11, and 1.65 percent for the subsample ofcases that are prevoted.

The relatively low direct costs of exchange offers, as well as the growth ofthe use of prepackaged bankruptcies, suggests that cost savings can be signifi-cant for firms that successfully restructure without entering a more traditionalChapter 11 case. Direct costs are also likely to increase with the length of timespent in bankruptcy. Franks and Torous (1989) report the time in bankruptcyfor a sample of 30 firms entering Chapter 11 or its predecessor between 1970and 1983. They find that the average time in bankruptcy is 3.7 years, but thislength is largely due to several railroad bankruptcy proceedings. More recentestimates for nonprepackaged bankruptcies are typically close to two years;Weiss (1990) reports an average of 30 months in Chapter 11; Gilson et al.(1990) report an average of 20.4 months. Tashjian, Lease, and McConnell(1996) show that the average time in Chapter 11 for prepackaged bankrupt-cies is only 3.3 months, and is even shorter (1.9 months) when the plan hasbeen voted on prior to filing. The short stay in Chapter 11 is associated withlower direct costs during the Chapter 11 period.



INDIRECT COSTS

In contrast to direct costs, indirect costs are not directly observable and aretherefore difficult to specify and empirically measure. However, researchershave developed several different approaches used to infer the likely magni-tude of these costs. The key measurement problem is that we cannot distin-guish whether the poor performance of a firm is caused by the financialdistress itself (and therefore is an indirect cost), or whether it is caused bythe same economic factors that pushed the firm into financial distress in thefirst place. These studies therefore attempt to identify whether firm perfor-mance reflects the costs of financial distress, the costs of economic distress,or an interaction of the two.

Altman (1984) was the first to provide a proxy methodology for mea-suring indirect costs of bankruptcy. For a sample of firms entering Chapter11, he compares expected profits to actual profits for the three years priorto bankruptcy (years –3 to –1); expected profits are based either on a com-parison of each firm’s sales and profit margin to industry levels prior toyear –3, or on security analyst estimates. He finds that indirect costs aver-age 10.5 percent of firm value measured just prior to bankruptcy. The com-bined direct and indirect costs average 16.7 percent of firm value,indicating that total bankruptcy costs are not trivial.

Subsequent to Altman’s initial work, several other studies have at-tempted to isolate indirect distress costs, each using quite different method-ologies and data sets. Their key insight is to recognize that it is importantto separate the effects of financial versus economic distress. For example,while Altman documents large declines in profitability, he cannot distin-guish them from negative operating shocks.

Andrade and Kaplan (1998), using methodology similar to that of Ka-plan (1989 and 1994), examine 31 firms that have become distressed sub-sequent to a management buyout or leveraged recapitalization between1980 and 1989. At the onset of distress, having recently completed ahighly leveraged transaction, the firms in their sample are largely finan-cially distressed but not economically distressed. Thus, their research de-sign provides an opportunity to isolate the costs of pure financial distress.1

Based on changes in firm value over time, they estimate the net costs of


1Cutler and Summers (1988) also attempt to isolate the effects of financial conflictfrom economic distress. They document significant wealth losses (over $3 billion)associated with the Texaco-Pennzoil litigation between 1985 and 1987. Althoughmuch of the costs they estimate are not directly related to Texaco’s bankruptcy case,they do show that financial conflict can have substantial effects on productivity.


financial distress to be 10 to 20 percent of firm value; for firms that do notalso experience an adverse economic shock, costs of financial distress arenegligible. In addition, they find that distress costs are concentrated in theperiod after the firm becomes distressed, but before it enters Chapter 11,suggesting it is not Chapter 11 itself that contributes to indirect costs. An-drade and Kaplan also examine qualitative aspects of the behavior of dis-tressed firms. A number of firms are forced to cut capital expendituressubstantially, sell assets at depressed prices, or delay restructuring or filingfor Chapter 11 in a way that appears to be costly. This evidence is consis-tent with Pulvino (1998 and 1999), who studies sales of aircraft by dis-tressed versus nondistressed airlines. Pulvino finds that financiallyconstrained airlines receive lower prices than their unconstrained rivalswhen selling used aircraft. In contrast to Andrade and Kaplan, however, hefurther finds that for airlines in either Chapter 7 or Chapter 11, the pricesthe bankrupt airlines receive for their used aircraft are generally lower thanprices received by distressed but nonbankrupt firms.

While these studies each indicate that financial distress is costly, theydiffer in their conclusions as to how bankruptcy status, itself, influencesthese costs. The idea that financial distress, and not Chapter 11 per se,leads to a loss in value is further supported by Maksimovic and Phillips(1998). These authors use plant-level data, obtained from the U.S. CensusBureau, to examine the productivity and plant closure decisions of bank-rupt firms. They find that Chapter 11 status is much less important than in-dustry conditions in explaining the productivity, asset sales, and closureconditions of Chapter 11 bankrupt firms. In declining industries, the pro-ductivity of plants in Chapter 11 bankruptcy and subsequent to emergingdoes not significantly differ from that of their industry counterparts, nordoes it decline during Chapter 11. This suggests that few real economiccosts are attributable to Chapter 11 itself and that bankruptcy status is notimportant to indirect costs.

Opler and Titman (1994) also recognize the causality problem instudies that attempt to relate performance declines and financial distress.Their approach is to identify depressed industries that have experiencedeconomic distress, based on negative industry sales growth and medianstock returns below –30 percent. Within those industries, they investigatewhether firms that are highly levered prior to the onset of the distressedperiod fare differently than their more conservatively financed counter-parts. Their hypothesis is that if financial distress is costly, the more highlyleveraged firms will have the greatest operating difficulties in a downturn.They find that highly leveraged firms lose market share and experiencelower operating profits than their less-leveraged competitors. Althoughthey do not provide specific estimates of the level of indirect costs, their



tests minimize the reverse causality problem which made it difficult to in-terpret some of the previous work. They interpret their findings as beingconsistent with the view that the indirect costs of financial distress are sig-nificant and positive.

IMPLICATIONS OF RESEARCH ON BANKRUPTCY COSTS

In sum, this work suggests that while direct costs of bankruptcy are only asmall percentage of firm value for large public companies, for smaller firmsthe costs may be prohibitive and lead to liquidation. Further, researchshows that even for larger firms, the indirect costs of distress can be signif-icant. It is also important to consider that indirect costs are not limited tofirms that actually default or enter Chapter 11. At the same time, studiessuch as Andrade and Kaplan (1998) are also consistent with the idea therecan be benefits to reaching financial distress, in that it can improve firmvalue by forcing managers to make difficult, value-maximizing choices thatthey would otherwise avoid (Jensen 1989).


FIGURE 4.1 Roles of Professionals in Chapter 11 CasesSource: Lazard.

Service Investment Bankers Crisis Managers AccountantsM&A

Capital Raising

Valuation

Debt Capacity/Capital Structuring

Negotiation with Creditors

Financial Modeling

Liquidation Analysis

Bankruptcy Court Testimony

Strategic Business Analysis

Analysis of Financial Controls

Day-to-Day Business Analysis

Audits

Pension Issues

Financial Reporting

SEC and Bankruptcy CourtOperate Plants or Business

Hire, Fire, or Manage EmployeesSell Company’s Goods orServices/Collect Receivables


The recent trend toward increasing size and complexity of restructur-ing companies has contributed to the growth in bankruptcy costs. In addi-tion to Enron, high-profile Chapter 11 cases in which fees have exceeded$100 million include WorldCom ($657 million), Pacific Gas & Electric($462.5 million), LTV Corporation ($237 million), Global Crossing ($174million), and Kmart ($135 million).2 As the level of complexity rises,debtors have often hired increased numbers of professionals with specificskills. To provide an understanding of the need for these professionals incomplex cases, Figure 4.1 outlines their typical roles in Chapter 11 cases.The role of financial advisers, including investment bankers in particular,has risen in recent years, especially as many large cases have involved salesof large portions of firms’ assets.

Difficulties in restructuring complicated capital structures have alsobeen evident from many recent Chapter 11 cases, and have contributed tothese rising costs. For example, a number of cases have involved firms withmultiple bank groups and bond issues at different levels in the capitalstructure, increasing the likelihood of conflicts between claimants. The sizeof creditor groups may render reaching a consensus difficult. Conflicts alsooccur between prebankruptcy and more recent entrants into the case, suchas vulture investors, who may have purchased claims at prices substantiallybelow par (see Chapter 8). When conflicts between claimants lead to in-creased difficulty in negotiating a restructuring, both direct and indirectcosts of distress are likely to increase.


2BusinessWeek, March 25, 2005.

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