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date: 30 September 2022

# The Costs of Bankruptcy Restructuring

• Wei WangWei WangSmith School of Business, Queen’s University

### Summary

Financially distressed and insolvent firms file for bankruptcy to either reorganize or liquidate under court supervision. Fundamentally, bankruptcy law is designed to resolve creditor coordination and holdout problems. It not only sets up rules and guidelines to allow firms to restructure their debt claims but also provides means for firms to reallocate their assets to other users. Although an efficient bankruptcy system can help mitigate bargaining frictions and maximize asset value and thus creditor recovery by avoiding inefficient liquidation or excess continuation, the bankruptcy process itself can be costly.

Understanding and quantifying the costs of bankruptcy restructuring are important not only to financially distressed firms but also to the capital structure decisions and the pricing of securities of healthy firms. More broadly, efficient bankruptcy mechanisms are important for economic growth, the productivity of firms in an economy, and the resiliency of the economy to adverse shocks. From the 1990s through the 2020s, the literature has flourished, with a growing number of empirical studies investigating the efficiency of the bankruptcy system and different aspects of bankruptcy costs.

Bankruptcy costs are typically classified as either direct or indirect costs. The former refers to out-of-pocket expenses associated with the retention of professionals, while the latter refers to opportunity costs incurred as a result of the adverse effect of a bankruptcy filing on business operations, human capital, and investments. Indirect costs are typically larger and more difficult to measure and quantify than direct costs, which studies show to be a small fraction of a bankrupt firm’s assets.

Because of significant economic frictions such as conflicts of interest, information asymmetry, and judicial biases presented in the system, bankruptcy can be a lengthy process. Since delay allows both direct and indirect costs to accumulate, a number of studies show that shortening the bargaining process can effectively help preserve firm value. Besides delay, bankruptcy costs can be manifested in inefficient liquidation, excess continuation, fire sales, loss of human capital, and managerial turnover, which impose real costs on bankrupt firms. How to mitigate frictions and minimize costs has been the central theme of bankruptcy research from the 1990s through the 2020s, a time that has also witnessed several notable changes to the U.S. bankruptcy system, including the rise of specialized distressed investors, the strengthening of secured creditor control rights, and the increasing intensity of asset sales. These changes have important implications for the restructuring landscape.

### Subjects

• Financial Economics
• Law and Economics

### The Bankruptcy System

Financially distressed firms use the bankruptcy system to restructure their assets (known as asset restructuring) and liabilities (known as financial restructuring). Although bankruptcy law is intended mostly for asset restructuring in some countries, such as those with a liquidation-based procedure (e.g., United Kingdom) or going-concern auctions (e.g., Sweden), in the United States, the goal of the bankruptcy process (i.e., Chapter 11) is to have managers, shareholders, and creditors bargain about the future of the firm under court supervision. In the process, a financially distressed firm not only restructures its financial claims but also divests assets to other users. The outcome can be a “fresh start” after reorganization or a piecemeal liquidation. Notwithstanding the different emphasis of each country’s bankruptcy law on restructuring versus liquidation, the bankruptcy process can be costly. However, despite the direct and indirect costs incurred, many financially distressed firms around the world seek the legal process for their restructuring. Hence, the first two important questions are, How does the bankruptcy system work, and what problems does it try to resolve?

#### Key Players and Constituents in Bankruptcy

The bankruptcy process is complex and involves many unique players. A bankrupt firm can be thought of as a very sick patient and the bankruptcy court as a hospital intensive care unit. In the health care system, highly skilled emergency room doctors and nurses must not only identify the nature of the illness and come up with a rescue plan but also work with anxious relatives and friends of the patient. The patient can die if the doctors and nurses do not act fast or if the wrong treatment is used. The required high level of skill and attention of the health care workers and the time pressure that everyone faces resemble the situation that a financially distressed firm faces in bankruptcy. The distressed firm and its key constituents must act fast and cooperatively before the going-concern value erodes and the firm “dies.” The important players in the bankruptcy process range from judges and lawyers, who are part of the legal system, to financial investors, nonfinancial stakeholders, and independent advisors. Their decisions, actions, and rights together shape the nature of the bankruptcy process.

The first set of key players consists of personnel who are part of the legal system, including bankruptcy judges, court clerks, legal counsels, and a U.S. Trustee, which is specific to the U.S. system. As arguably the most important decision-makers within the bankruptcy system, bankruptcy judges oversee and issue rulings on important business and legal matters, such as financing, compensation, and asset sales throughout the bankruptcy process, and confirm resolutions. The debtor’s legal counsels, who are hired before bankruptcy filing and retained throughout the whole process, are the most important legal advisors to the debtor. They are in charge of not only providing legal advice to the debtor but also representing the debtor in front of the judge throughout the reorganization process (e.g., filing motions for judicial approval of matters “outside the ordinary course of business”). The U.S. Trustee is appointed by the U.S. Department of Justice to assist in the bankruptcy process. Among other responsibilities, the U.S. Trustee organizes meetings of unsecured creditors and appoints a committee to represent them.

The second set of important stakeholders is the bankrupt firm’s financial investors, including secured lenders, unsecured debt holders, and shareholders. Different from the legal professionals, these investors hold financial claims against the debtor. Secured lenders have a security interest (i.e., a lien) on collateral, and unsecured debt holders hold a general unsecured claim. The absolute priority rule (APR) states that secured lenders should be paid in full before unsecured creditors receive any payoff. Shareholders, typically holding an “out-of-money” claim, rank lowest in priority. To increase their bargaining power in bankruptcy, equity holders can request the court to appoint an official committee of equity holders.

The third group consists of nonfinancial stakeholders such as managers, employees, suppliers, customers, and the government. Managers and employees face a high risk of turnover and termination of their labor contracts. Their interests can be strongly tied to the survival of the business because they often possess firm-specific human capital that can be easily lost if a bankrupt firm liquidates. In addition, their pension plan may be terminated, which would result in a large loss in their pension value. A firm’s suppliers and customers are also negatively affected by the bankruptcy event and are worse off if the firm liquidates, which would result in the loss of their relationship capital and the existing trade–credit claims. Government, often holding a tax claim or a litigation claim, is wary of the potential negative effect of liquidations on local unemployment and business growth.

The fourth group includes independent service providers such as turnaround consultants, restructuring advisors, accountants, tax specialists, and private trustees. These professionals perform various tasks such as managing operations, arranging financing, contract negotiation, corporate valuation, employee retention, and tax issues. They are typically retained as professionals assisting the debtor and are compensated for their services with court approval.

A large part of the bankruptcy literature examines the roles played by these constituents and shows how their actions shape the bankruptcy process.

#### The Goal of the Bankruptcy System

In his influential book, Jackson (1986) argues that bankruptcy should help resolve the “creditor run” problem. He writes,

The basic problem that bankruptcy law is designed to handle, both as a normative matter and as a positive matter, is that the system of individual creditor remedies may be bad for the creditors as a group when there are not enough assets to go around. Because creditors have conflicting rights, there is a tendency in their debt-collection efforts to make a bad situation worse. Bankruptcy law responds to this problem.

(Jackson, 1986, p. 10)

He proposes that the bankruptcy system should provide a framework within which claimants can negotiate about the future of the firm and how to divide the firm value. However, determining the firm value and the value of payment to claims is often difficult. The collective bargaining process can fail and thus entail large costs, resulting in outcomes that destroy firm value due to significant economic frictions and challenges.

Bebchuk (1988) proposes a framework that helps resolve the valuation and thus the division problem. In his framework, all debts are eliminated, and new shares are allocated to senior creditors; junior creditors and old shareholders have the option of buying shares from senior creditors by paying what they are owed. That is, if junior creditors believe they are underpaid, they can simply pay cash to senior creditors to buy out their claims at face value. Despite its theoretical appeal, some argue that this procedure may run into problems if junior claimants are financially constrained, although an active trading market for distressed securities may help mitigate this problem.

Other legal scholars (e.g., Baird, 1986) argue that the bankruptcy code should serve as a mechanism for auctioning off a firm’s assets as a going-concern or piecemeal, and thus, collective bargaining is not necessary. If a firm is worth more alive than dead, a bid for the whole firm should dominate a set of independent bids for the pieces. However, in a world with trading frictions and imperfect competition, this proposal can meet real challenges. For example, the lack of bidding competition is likely to be exacerbated to the extent that firms in the same industry—the natural bidders for a bankrupt firm and its assets—are also in financial distress (Shleifer & Vishny, 1992). Potential buyers can face severe financial constraints themselves, as evidenced during the 2008–2009 financial crisis. As a result, a bankrupt firm can be sold, as a whole or in pieces, at a price below its best-use value. Notwithstanding the challenges and obstacles, the mandatory auction procedure seems to work efficiently in Sweden in maintaining bankrupt firms’ value and maximizing creditor recoveries (Eckbo & Thorburn, 2009; Strömberg, 2000; Thorburn, 2000). In fact, the United States has seen an increasing use of sales and auction processes in Chapter 11 since 2000 (Baird & Rasmussen, 2002; Gilson et al., 2016).

Regardless of the approach, collective bargaining or auctioning of assets, the bankruptcy system should help a viable firm remain in business when its “going-concern” value is higher than the proceeds that can be derived from a piecemeal liquidation. However, a firm should be sold piecemeal, and its assets are reallocated to better users when the firm is worth more “dead” than alive. Bankruptcy claimants must reach timely consensus on the future of the firm to minimize costs and thus preserve value. Whether bankruptcy can help mitigate bargaining frictions and maximize asset value by avoiding excess continuation or premature liquidation in a timely manner plays a pivotal role in academic discussions on the goal of the bankruptcy system (Smith & Strömberg, 2005; White, 1994). Aghion et al. (1992) and Hart (1999) succinctly summarized the main goals of an efficient bankruptcy procedure:

(1)

maximize the ex post value of the firm (with an appropriate distribution of this value across claimants);

(2)

preserve the (ex ante) bonding role of debt by penalizing management adequately in bankruptcy states; and

(3)

preserve the absolute priority of claims, except that some portion of value should possibly be reserved for shareholders.

That is, an efficient system should help maximize creditor recovery and reinforce creditor rights ex post and thus allow firms to finance at lower costs ex ante. Since the enactment of the modern U.S. Bankruptcy Code in 1978 and the seminal theoretical work developed by economists and legal scholars on the logic and limits of the bankruptcy procedure, many studies have investigated the efficiency and costs of the bankruptcy system in the United States and other countries. Much of the scholarly work pays close attention to major economic frictions present in the bankruptcy system and how these frictions may result in a costly process.

#### Major Economic Frictions

As the bankruptcy process is typically complex and costly, achieving a successful out-of-court restructuring is less costly and often in the best interests of the firm’s claimants as a whole. However, significant economic frictions impede the success of an out-of-court restructuring. Because economic frictions are important determinants of bankruptcy costs, this section provides a brief summary of the most important economic frictions documented in the literature.

Creditor coordination and holdout. A number of studies find that the complexity of a firm’s capital structure has a direct effect on the likelihood of a successful out-of-court restructuring and investment efficiency. Specifically, firms with multiple classes of debt or public debt find it more difficult to achieve out-of-court restructuring, pushing these firms into bankruptcy and even inefficient liquidations (Asquith et al., 1994; Bolton & Scharfstein, 1996; Demiroglu & James, 2015; Gilson et al., 1990; James, 1995, 1996). The culprit for the less desirable outcomes lies in creditors’ difficulty in coordinating and (un)willingness to participate in private negotiations. Because negotiations are costly, no creditor has an incentive to incur the costs and allow all other creditors to “free ride” a successful negotiation.

A related problem is creditor “holdout” (Brown, 1989; Gertner & Scharfstein, 1991; Haugen & Senbet, 1978), a situation in which creditors that hold small blocks of a claim have the intention of not participating in a private negotiation to offer debt relief. The Trust Indenture Act of 1939 requires unanimous consent of all public debt holders of a given class before a firm can alter the pricing terms, such as principal, interest, and maturity of its public debt. Because tender offers effectively modify these terms, non-tendering public debtholders benefit from the full contractual payment if the exchange offer is successful.

Gertner and Scharfstein (1991) suggest that an effective approach to mitigating the holdout problem is for a firm to offer a more senior security with short maturity in exchange for the public debt such that the holdout debt will become junior to the new securities. A bankruptcy filing can be a credible threat to holdout creditors because they will gain little or even lose the value of their holding if a firm cannot successfully restructure out of court and has to file for bankruptcy as a result (Brown, 1989). It is important to note that instead of requiring a unanimous vote, a reorganization plan requires approval by one half in number and a two-thirds majority in value of each debt class for it to be binding on all creditors.

Conflicts of interest. A major challenge that financially distressed firms face is how to align the interests of financial claim holders. The diverging interests among different classes of claimants make it difficult for firms to negotiate out of court, leading to inefficient liquidations (Bernardo & Talley, 1996; Bulow & Shoven, 1978).

One such conflict is the incentive misalignment between senior lenders and shareholders. Secured lenders such as bank lenders rarely make concessions in out-of-court negotiations, perhaps because their claims are well protected by the collateral in bankruptcy (Asquith et al., 1994; James, 1995). In contrast, shareholders stand to lose the most in bankruptcy when deadweight costs are high. As a result, the continuation bias of shareholders and the liquidation bias of over-secured lenders produce a direct conflict of interest regarding the timing and outcome of out-of-court negotiations. Mitigating these conflicts should help firms achieve more efficient restructuring outcomes (Chu et al., 2021).

Conflicts of interest also exist between secured creditors and unsecured creditors. Each class of creditors tries to maximizes its “piece of the pie” rather than the firm’s value as a whole. Several empirical studies suggest that such conflicts can result in inefficient asset sales and excess delay that results in high bankruptcy costs. For example, Ayotte and Morrison (2009) showed that a bankrupt firm is more likely to be sold, even at fire-sale prices, when secured lenders’ claims are overcollateralized. Brown et al. (1994) found that senior bank lenders have a direct influence on the asset sale decisions of financially distressed firms. Moreover, their conflicts of interest can result in distorted firm valuations in bankruptcy (Ayotte & Morrison, 2018; Gilson et al., 2000). Senior creditors of firms in Chapter 11 typically argue for low values, while junior creditors argue for higher values because a higher (lower) value means a larger (smaller) payout to junior claims.

Agency problems can arise as a result of management’s heightened risk-shifting incentives in financial distress and bankruptcy (Jensen & Meckling, 1976). The Eastern Airlines bankruptcy case provides an interesting illustration of how asset stripping by existing management in bankruptcy destroyed firm value and creditor recoveries from the late 1980s to the early 1990s (Weiss & Wruck, 1998). Since the mid-1990s, there has been a shift of managers’ fiduciary duties from shareholders to all investors of the firm after bankruptcy (Becker & Stromberg, 2012). Moreover, with the strengthening of creditor rights both inside and outside of bankruptcy, the past two decades witnessed a near elimination of bankruptcy outcomes that favor managers and shareholders (Ayotte et al., 2013; Bharath et al., 2010, Eckbo et al., 2016; Hotchkiss et al., 2008). It seems that management now has minimal control over the restructuring process, and risk shifting may no longer be a major concern (Gilje, 2016). However, strong senior creditor rights may have helped produce a different type of agency problem: Managers’ actions are plausibly more aligned with the interests of senior secured lenders. Specifically, managers’ compensation contracts that directly tie pay with asset sales and creditor recoveries and strict financing contracts with senior lenders may incentivize self-interested agents to undertake actions at the expense of junior creditors (Ayotte & Elias, 2021; Goyal & Wang, 2017).

Information asymmetry. Different players can be asymmetrically informed about the state and value of a distressed firm and their controlling skills. First, there is information asymmetry between the firm and investors: The firm (or management) is better informed about its prospects than debt holders and shareholders. Due to such information asymmetry, sometimes bankruptcy cannot be avoided, even if it entails large deadweight costs (Giammarino, 1989). Private information can also interfere with the efficiency of ex post re-contracting between management and debtholders, as they do not trust management and shareholders and instead seek a costly court process. Brown et al. (1993) showed that firms can issue new equity to private lenders to convey favorable private information to outside investors in distressed debt exchanges.

Second, there can exist “double-sided” information asymmetry among different classes of creditors about their skills and the private valuation of the company (Dou et al., 2021). Such information asymmetry produces frictions in creditors’ bargaining in bankruptcy, leading creditors to make tough, lowball offers, resulting in firms having to go through a lengthy bankruptcy process and/or an inefficient liquidation. Similarly, creditors in the same class can be asymmetrically informed about the value of the firm and have diverging opinions about whether to liquidate or reorganize the firm.

Judicial biases. A growing body of research demonstrates that judges’ discretion, specialization, behavioral mistakes, political ideology, and personal biases affect their rulings and case outcomes (Gennaioli & Rossi, 2010; Gennaioli & Shleifer, 2008; Posner, 2008; Rachlinski et al., 2006; Sharfman, 2005). Examining individual judges’ past rulings, Chang and Schoar (2013) identify pro-debtor and pro-creditor bankruptcy judges. Bernstein, Colonnelli, and Iverson (2019) and Iverson et al. (2021) have shown that judicial bias and inexperience can lead to more liquidations and delays in bankruptcy. All these studies suggest that judicial discretion and biases can be a major source of inefficiency. Similarly, Waldock (2017) found that the individual skills of the U.S. Trustee attorneys determine the formation of an official unsecured creditors’ committee (UCC) in a bankruptcy case.

Market illiquidity. Market illiquidity as a trading friction has real effects on how assets are priced and allocated (Gavazza, 2011). When a firm sells assets in bankruptcy, its industry peers, perhaps first-best buyers, are also likely in financial distress, leading to assets sold below their best-use value. This is essentially the implication of the model of Shleifer and Vishny (1992) on how market illiquidity results in fire sales of assets by firms in bankruptcy. Market illiquidity can have strong effects on how firms reallocate their assets in bankruptcy and their liquidation values.

### The Costs Associated With the U.S. Bankruptcy System

Because of the complexity of the restructuring process, bankruptcy can impose real costs on financially distressed firms. The costs of bankruptcy are typically classified as either direct or indirect costs. Direct costs refer to those out-of-pocket expenses associated with the retention of professionals and related court fees. In addition to these costs, reorganizing firms in Chapter 11 also incur economic losses that are attributable to the adverse effect of bankruptcy on business operations, human capital, and investments. These opportunity costs are referred to as the indirect costs of bankruptcy. Although studies suggest that such indirect costs can be much larger than direct costs, compared to direct costs, indirect costs are harder to measure and quantify empirically. Despite empirical challenges, many studies try to measure ex post indirect costs of bankruptcy by zooming in on specific aspects or stakeholders of the process. For example, earlier studies, such as Altman (1984) and Opler and Titman (1994), attempt to measure such costs using the decline in firms’ profits and sales. More recent studies estimate specific elements of indirect costs such as delay, loss of employees, fire sales, and financing costs. This section provides a brief review of the notable empirical studies that were published since 1990 on quantifying various costs associated with the U.S. bankruptcy system, with each subsection focusing on a specific aspect of the bankruptcy costs.

#### Direct Costs

Direct costs range from fees paid to courts and the law firms representing the firm and the creditors, to fees paid to financial advisors, consultants, special examiners, and private trustees. Prior studies have documented that direct costs are relatively small for large firms after adjusting for their size. General estimates of direct costs for large firms in Chapter 11 are about 1% to 3% of their pre-petition book assets (Goyal et al., 2021; LoPucki & Doherty, 2004, 2008; Weiss, 1990). They are significantly lower in prepackaged cases (Tashjian et al., 1996).

Small firms incur much higher direct costs relative to their assets than large firms. For example, examining a sample of more than 300 small firms that filed bankruptcies in Arizona and the Southern District of New York from 1995 to 2001, Bris et al. (2006) found that the mean direct costs as a percentage of book assets before bankruptcy are 16.9% and 8.1% for Chapter 11 and Chapter 7 cases, respectively. The findings suggest that there may be substantial fixed costs associated with the bankruptcy process. Using a more recent sample of all public firms, large and small, that filed for Chapter 11 (regardless of their size) between 2002 and 2012, Iverson et al. (2021) showed that legal fees alone on average account for about 4% (median 2%) of pre-petition assets. Studying trustee fees in Chapter 7 liquidations, Antill (2021a) found that commissions charged by trustees are excessive, jeopardizing creditor recoveries.1

#### Excess Delay

Legal costs accumulate over the course of bankruptcy. Hence, it is not surprising that a longer duration is associated with higher fees (LoPucki & Doherty, 2004). In addition, the longer a firm stays in bankruptcy, the more reputation damage and higher the indirect costs. Perhaps for these reasons, firms often try to negotiate with security holders before filing for bankruptcy (i.e., pre-negotiated or prepackaged filings) or to avoid bankruptcy altogether (i.e., through out-of-court restructuring). Studies show that costly bankruptcy negotiations and restructuring can be avoided if creditor coordination and holdout problems are mitigated. For example, Gilson et al. (1990) found that prepackaged filings are more likely to occur, and thus, court duration is shorter and costs are lower when senior bank lenders make up a significant part of the firm’s debt (i.e., low creditor coordination frictions). A few subsequent studies also document similar findings (e.g., Asquith et al., 1994; Demiroglu & James, 2015; James, 1996). Dou et al. (2021) is one of the very few studies that use a structural estimation approach to show that excess delay is one of the most important bankruptcy inefficiencies. Specifically, the authors highlight the presence of two specific economic frictions that cause delay: the conflict of interest between senior and junior creditors and asymmetric information between the two classes of creditors. They first develop an economic model that features dynamic bargaining between a senior and junior creditor with two-sided incomplete information. In the model, the two creditors bargain over the firm’s business plan, which determines the reorganization value and the restructuring outcome (i.e., reorganization vs. liquidation), and the financial plan, which specifies how the creditors split the “pie” with the goal of maximizing their own recovery rates. Each creditor gains reorganization skills (i.e., skills to maximize the reorganization value) and privately observes the quality of their own reorganization plan over time.

Their model features three types of bankruptcy costs. The first is the net cost of going to court, which can be thought of as the cost triggered by going to court (e.g., legal fees and indirect costs associated with bankruptcy filing) minus the sum of the cost of coordinating creditors and achieving a private settlement and other residual benefits of going to court. The second is the time-varying cost representing professional fees that increase linearly with case duration. The third represents a decay of reorganization value as the case prolongs. As a result, creditors face a trade-off between resolving the case early, which reduces bankruptcy costs, and delaying, which offers an opportunity for learning and developing a better reorganization plan. Due to uncertainty about the counterpart’s type, each creditor has incentives to make lowball offers to avoid overpaying. Such lowball offers are often rejected, leading to delays. Their model is able to produce a negative slope coefficient of total debt recovery on case duration, similar to the one observed in the data.

The authors estimate their model using a comprehensive sample of large Chapter 11 filings that feature a senior debt class and a junior debt class between 1996 and 2014 and then quantify the counterfactual debt recovery rates by turning off the two economic frictions. They find that the average payout to both creditors increases by 4% if asymmetric information is removed and increases by an additional 18% if a social planner is appointed to maximize the firm value while perfectly observing both creditors’ reorganization skills (i.e., shutting down both information asymmetry and creditor conflicts). They conclude that the U.S. bankruptcy process is quite inefficient. Importantly, they find that excess delay is the primary source of inefficiency. Asymmetric information and especially conflicts of interest result in too many cases going to court without a prepackaged agreement and make cases going to court stay there too long. Removing these two economic frictions helps shorten the duration of court cases from 16.7 months to 4.5 months, a 73% reduction.

Iverson (2018) documented judge caseload as a potential source of excess delay. His sample consists of 3,282 business Chapter 11 filings between 2004 and 2007, a 5-year period surrounding the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). Using the BAPCPA as an exogenous shock to nonbusiness bankruptcy filings and thus judges’ caseloads in courts that handle more of these filings, he finds that when judges’ caseloads decline (i.e., judges become less busy), large firms spend less time in court and firms that are dismissed from court are less likely to refile for bankruptcy. Müller (2022) further showed that a reduction in bankruptcy court congestion reduces bankruptcy delay and increases debt recovery. Such improvement translates to lower ex ante costs of financing. Moreover, Goyal et al. (2021) showed that lawyers’ familiarity with judges’ preferences through their past interactions with judges helps shorten bankruptcy duration, and the shorter duration is associated with lower legal fees and higher debt recoveries.

Iverson et al. (2021) studied judicial inexperience as a source of excess delay. Specifically, they examined whether judges who are new to the bench are less efficient in processing corporate bankruptcy cases. Exploiting the random assignment of judges to filings and using a judge fixed-effect research design, they found that small business cases assigned to a judge with twice as much time on the bench realize a 6.5% decrease in case duration. The economic effects are even larger for public firm cases. Those cases assigned to judges during their first 2 years of service take almost 20% longer to resolve than cases assigned to more experienced judges. To show that prolonged bankruptcy proceedings are costly, they found that legal fees are 30% higher and debt recoveries are 21% lower for cases assigned to inexperienced judges. Their “back-of-the-envelope” calculations show that creditors’ recoveries can be $16.8 billion higher if the 83 public firms assigned to judges with two or fewer years of experience are assigned to a more experienced judge at the same court. Campello et al. (2018) studied the effect of unionization on bankruptcy outcomes and bondholders’ wealth. They found that Chapter 11 firms that have unionized labor spend more time in bankruptcy and incur more professional fees than nonunionized cases. Particularly, senior unsecured bondholders of cases that have union representation on the UCC stand to lose the most. The evidence shows that delay as a result of the strong bargaining power of unions can be detrimental to unsecured creditors’ recoveries. #### Inefficient Liquidation and Excess Continuation Economists and legal scholars often describe the bankruptcy process as efficient if continuation, rather than liquidation, occurs when the value of the firm as a going-concern exceeds its value in liquidation, and liquidation occurs otherwise (Bulow & Shoven, 1978; White, 1980). Inefficient liquidation occurs when firms whose assets are worth more as a going-concern than if sold piecemeal are liquidated. Excess continuation refers to situations where a firm that should be liquidated is instead reorganized. Although many academic papers have studied the outcome of bankruptcy as reorganization or liquidation, determining whether a specific outcome is inefficient is empirically challenging because the counterfactual does not exist and the reorganization versus liquidation decision is often driven by unobservables. Estimating a bargaining model that features a senior creditor who can exert strong influence over whether a firm reorganizes or liquidates and a weak junior creditor, Jenkins and Smith (2014) were among the first to quantify inefficient liquidation. Their sample consists of 834 large nonfinancial firms that filed for bankruptcy from 1989 to 2011, retrieved from Moody’s Default and Recovery Database. They find that the value of losses resulting from inefficient liquidations are up to only 0.28% of the going-concern value of the firm. Bernstein, Colonnelli, and Iverson (2019), on the other hand, compared the efficiency of liquidation in Chapter 11 versus Chapter 7, using a large sample of 28,000 small-business bankruptcy filings from 1992 to 2005. They exploited the random assignment of judges to cases within a bankruptcy district that force some firms into liquidation for identification. They showed that Chapter 7 liquidation results in lower asset utilization than Chapter 11 reorganization. The effect is stronger in thin markets with few potential buyers. In a follow-up study, Bernstein, Colonnelli, Giroud, & Iverson (2019) further showed that low asset utilization resulting from inefficient bankruptcy liquidation has negative spillover effects on local economic growth. Moreover, Iverson (2018) has shown that judges are more likely to liquidate large firms in bankruptcy when their caseloads decline. The evidence suggests that excess continuation can be a direct result of judges’ hesitancy to liquidate when they are busy. A number of other studies document that judges’ biases can lead to pro-debtor outcomes, including a higher likelihood of reorganization than liquidation (e.g., Chang & Schoar, 2013; LoPucki, 2005). As a result, large firms may choose to file in a court that is not in geographic proximity to their principal place of business but has debtor-friendly judges, a controversial practice commonly known as “forum shopping.” In a similar spirit as in Bernstein, Colonnelli, et al. (2019), Antill (2021b) estimated whether U.S. firms inefficiently reorganize or liquidate in bankruptcy by exploiting a random assignment of bankruptcy judges and their liquidation preferences. His sample included 503 Chapter 11 filings by large public firms from 1987 to 2018 for which he could identify bankruptcy outcomes, including reorganization, piecemeal liquidations, §363 sales, and acquisitions. He first used a reduced-form model to show that the average judge-specific liquidation rate based on a larger sample of bankruptcies has a significant effect on the probability of reorganization and §363 sales. Using judge liquidation rates as an instrument, he then showed that the family debt recovery rates are about 50 cents on the dollar higher in reorganized cases than liquidated and acquired cases, which he referred to as the local average treatment effects of reorganization on creditor recovery rates for compliers in the sample. Because compliers may not be representative of the sample and it is hard to generalize the results to other cases, he used a Roy (selection) model to estimate the counterfactual recovery rates for all cases in the sample. He found that excess continuation has a small negative effect of two percentage points on debt recovery rates. However, inefficient liquidations, especially those cases that sell assets using §363 and then liquidate, destroy the firm’s value. He interpreted his results as that §363 “enables the sort of coordination failure that Chapter 11 is supposed to prevent.” Consistent with Jenkins and Smith (2014) but in contrast to Antill (2021b), Dou et al. (2021) showed that the inefficiencies from excess continuation and excess liquidation are small, together making up just 6.5% of the total inefficiencies. Because Antill (2021b) did not model the sources of inefficiency, the inefficiencies documented in his paper likely arise from frictions that are different from those modeled by Jenkins and Smith (2014) and Dou et al. (2021). In addition to these studies, a number of papers investigate the performance of firms emerging from bankruptcy to measure whether the bankruptcy system imposes real costs on firms. One of the first studies on post-emergence performance is Hotchkiss (1995), who examined 197 public firms that emerged from Chapter 11 by 1989. She found that more than 40% of the firms emerging from bankruptcy continued to experience operating losses in the 3 years following emergence. The performance of emerging firms is substantially lower than that for matched firms in similar industries. The firms showed some positive growth in revenue, assets, and number of employees, but little improvement in profitability, in the post-bankruptcy period. In fact, 32% of her sample firms restructured again within a few years after emergence. More important, the continued involvement of original management in the restructuring process is associated with poor post-bankruptcy performance. Several subsequent studies show evidence suggesting that Chapter 11 does not necessarily result in inefficient reorganization. Examining 108 firms that filed for bankruptcy or restructured out of court in the 1980s, Gilson (1997) found that Chapter 11 allows financially distressed firms to restructure and emerge as more viable firms than out-of-court restructuring. Studying a sample of 459 firms filing for Chapter 11 from 1991 to 1998, Kalay et al. (2007) found that firms significantly improve their operating performance throughout bankruptcy and their operating performance matches the industry median. Denis and Rodgers (2007) found that firms that significantly reduce assets and liabilities, likely through an operational restructuring, achieve positive post-emergence profitability. Examining all U.S. public firms that filed for Chapter 11 and had at least$50 million in assets at filing between 1981 and 2016, Jiang et al. (2021) showed that firms experience significant improvement in operating performance in bankruptcy and their post-emergence performance matches the industry median. Despite these findings, one must caution that operating performance is observed only for those firms that emerged from bankruptcy and filed annual reports with the Securities and Exchange Commission.

Regardless of whether the operating performance becomes better or worse after emergence, many of these studies find that firms emerging from bankruptcy maintain a high leverage ratio (Gilson, 1997). Kahl (2002) provides a theoretical explanation. Because there is asymmetric information between creditors and managers such that creditors are uncertain about the viability of distressed firms and whether the firm should be liquidated or reorganized, creditors may postpone their liquidation decision to learn more about the distressed firm’s viability. In that case, creditors may keep leverage high by refusing to swap their debt for equity.

#### Fire Sales

Firms in Chapter 11 use §363 of the Bankruptcy Code to sell assets without creditors’ formal vote. The assets sold range from equipment, real estate, and intellectual properties to the whole firm as a going-concern. The buyers in this market include not only industry competitors but also financial investors and even the creditors themselves (through a “credit bid”). Notwithstanding a number of prior studies examining the fire-sale discount of assets sold in bankruptcy, the evidence remains mixed as to whether the U.S. bankruptcy system imposes significant costs on firms selling assets in bankruptcy. Using prices of used airplanes, Pulvino (1998, 1999) was among the first to examine fire sales of real assets sold in financial distress and bankruptcy. He compared the prices of planes sold by financially distressed airlines to the prices of planes with the same characteristics sold by non-distressed airlines. He found that planes sold by distressed airlines are priced 10% to 20% lower than those sold by airlines not in distress. He further documented that prices obtained in Chapter 11 and Chapter 7 are lower than those obtained by non-distressed airlines. However, he does not find evidence that prices obtained by Chapter 11 firms are different from those obtained by Chapter 7 firms. Reexamining the fire-sale discount in aircraft transactions, Franks et al. (2021) found that such discount is muted after improving the aircraft pricing model by including additional measures for quality impairments due to low-quality maintenance performed by bankrupt airlines. They also found that buyers have higher productivity than the distressed sellers.

Examining manufacturing plant reallocations, Maksimovic and Phillips (1998) found that sales of plants by Chapter 11 firms in high-growth industries lead to increased plant productivity. The study suggests that while financial distress is costly, the bankruptcy status itself entails few real economic costs. In addition, studying the firms’ use of §363 of the bankruptcy code to sell firm assets as a whole, Gilson et al. (2016) found no difference in creditor recovery rates or post-bankruptcy survival rates between firms sold as going-concerns and those that successfully reorganize. The evidence suggests that going-concern sales can be a form of efficient restructuring in bankruptcy.

Another important finding of Gilson et al. (2016) is that §363 asset sales are attributed to greater use of secured debt. This interesting aspect of the mechanism for asset sales in bankruptcy is also documented by Ma et al. (2021), who constructed a comprehensive sample consisting of all Chapter 11 bankruptcies filed by patent-owning U.S. public firms from 1982 to 2012 and examined patent reallocation in bankruptcy. They found that innovative firms are more likely to sell core (i.e., strategically important) patents in Chapter 11 reorganization if they use more secured debt before bankruptcy. Collateralized patents are more likely to be sold in bankruptcy, and the selling of collateralized patents is more pronounced for firms that have greater use of secured debt and those that obtain debtor-in-possession (DIP) financing. They also found that patent sales lead to lower unsecured creditor recovery and lower utilization of the sold patents. The findings suggest that the pervasive patent-sale phenomenon of bankrupt innovative firms as a result of strong creditor control could be detrimental to unsecured creditors and the firm as a whole.

Among other studies, Benmelech and Bergman (2011) and Bernstein, Colonnelli, Giroud, et al. (2019) showed that trading frictions in asset markets not only affect bankrupt firms but also spill over to other firms. However, Meier and Servaes (2019) found that buyers can benefit from fire sales by bankrupt firms and thus that the externalities of fire sales are limited.

#### Costs of Financing

A major benefit of Chapter 11 is its function as a liquidity provider (Ayotte & Skeel, 2013). Financially distressed firms, which typically run out of debt capacity, can arrange a special form of secured financing—DIP financing—at the time of bankruptcy filing. It is commonly recognized that DIP financing offers a solution to firms’ temporary liquidity constraints and debt overhang problems (Myers, 1977), leading to a higher likelihood of successful reorganization and a reduction in delay (Chatterjee et al., 2004; Dahiya et al., 2003).

DIP loans often contain a large number of protective covenants and milestones tied to liquidity, performance, capital expenditures, production, asset sales, and even corporate governance. These protective covenants and milestones provide DIP lenders with the ability to react quickly if and when their borrowers’ asset quality starts to deteriorate. Several studies express the concern that these provisions grant excessive control to secured lenders, which can have mixed effects on bankrupt firms.

On one hand, strong creditor control leads to an improvement in governance and a reduction in deviations from APR (Ayotte & Morrison, 2009; Li & Wang, 2016). On the other hand, the liquidation bias of over-secured lenders can result in inefficient sales, which help protect the “super-priority” lenders’ interests at the expense of junior claimants (Ayotte & Elias, 2021).

In summary, the findings of prior papers on DIP loans suggest that while DIP loans help resolve firms’ liquidity issues and maintain their going-concern value, they can impose costs such as restrictions and high spreads and fees on the borrowing firm.

#### Employee Costs

Bankruptcy imposes significant costs on employees because, as stakeholders, they make firm-specific investments, and bankruptcy reduces the value of their human capital (Titman, 1984). The literature has not comprehensively investigated the bankruptcy costs of employees as a form of indirect cost of bankruptcy until recently, perhaps because of the availability of granular data on individuals’ employment histories.

Using employment and wage information from the Census Bureau’s Longitudinal Employer-Household Dynamics program, Graham et al. (2021) traced wages paid to 234,000 workers employed by 130 bankrupt U.S. firms from 1992 to 2005 from 1 year before bankruptcy to 6 years after. They found that compared to 154,000 workers employed by a sample of matched firms that do not file for bankruptcy, employees at the bankrupt firms earn 12% less 1 year after bankruptcy. The present value of lost earnings over 7 years after bankruptcy is 85% of pre-bankruptcy annual earnings. Earning losses are larger for workers who worked in thinner local labor markets and who leave the industry after bankruptcy, suggesting that workers’ personal losses can be exacerbated by search frictions. Examining the aviation industry in particular, Benmelech et al. (2012) provided similar evidence. They found that airlines make approximately 10% wage cuts to their employees during bankruptcy. In addition to a loss of income and job, employees face the significant risk of termination of unfunded pension plans (Duan et al., 2015). Considering the large costs of bankruptcy borne by employees, Berk et al. (2010) showed theoretically that a firm’s optimal capital structure must trade off tax benefits of debt and employee costs of bankruptcy.

Besides the significant effects of bankruptcy on employees’ wages and employment status, bankruptcy disrupts the stability and productivity of team-based inventors. Using employer–inventor matched data, Baghai et al. (2020) found that team stability is reduced by a third in the year of bankruptcy filings and the year after. Team-based inventors suffer a larger decline in their productivity (measured by citations to their patents) than solo inventors as a result of bankruptcy. More important, they show that inventors working in teams are more likely to co-locate with team members, and inventors that co-locate with their team members are more productive than inventors whose teams are dismantled. In a separate study, Ma et al. (2021) found that inventors are five percentage points more likely to leave the bankrupt firms within 3 years of bankruptcy filing. On the bright side, Babina (2020) found that financial distress results in employees’ departure to entrepreneurship and better jobs. The finding suggests that perhaps the negative effects of financial distress on employment and labor outcomes are not severe if one considers that the transfer of human capital from distressed firms to new firms reflects a reallocation of resources from less productive to more productive firms.

The combined evidence from these studies suggests that the labor market seems efficient in preserving the human capital of departed employees, although bankruptcy filing can cause significant disruptions to firms’ ability to retain valuable employees and maintain team-based human capital.

#### Managerial Costs of Turnover and Incentive Plans

Few studies have documented executive turnover and compensation around bankruptcies since the earlier work of Gilson (1989, 1990) and Gilson and Vetsuypens (1993), who examined turnover, compensation, and post-turnover employment of managers and directors of the board in a small sample of firms that either filed for bankruptcy or privately restructured their debt in the 1980s. The general finding from these earlier papers is that the turnover rate for top executives is high, managers suffer labor-income losses in corporate bankruptcies, and executive compensation contracts sometimes tie pay to creditor payoffs.

Taking advantage of the availability of a multitude of data sources, including social media, on the employment history of executives, Eckbo et al. (2016) compiled a sample of large Chapter 11 firms from the 1990s to the early 2010s to revisit the question: How costly is bankruptcy to top executives? They documented that CEOs experience high turnover from 2 years before bankruptcy to 1 year after emergence. Specifically, they found that only one third of incumbent CEOs (i.e., those in their post–2 years before bankruptcy filing) are able to maintain full-time executive employment at either the restructured company or a new company. Those CEOs experience no change in their total compensation. For the remaining two thirds of CEOs who leave the executive labor market, some become consultants or self-employed, while others retire. CEOs who leave the executive labor market experience a median compensation loss of $7 million in present value, in addition to the$11 million loss in the value of stock and option holdings. In a more recent study, Carter et al. (2020) showed that CEOs experience up to 50% turnover 5 years prior to defaults in a sample of 1,500 U.S. public firms that became distressed between 1998 and 2016. They also showed that CEOs’ compensation contracts are redesigned and that firms tie CEO pay with total firm value and creditors’ payoffs. Both studies find a larger magnitude in CEO turnover and reduction in compensation than earlier studies, perhaps as a reflection of the strengthening of creditor rights in financial distress.

One should be cautious as to the implications of high CEO turnover to the efficiency of bankruptcy reorganization. On one hand, penalizing managers in bankruptcy helps “preserve the (ex ante) bonding role of debt,” according to Aghion et al. (1992). However, when risk shifting is a concern, penalizing management harshly in bankruptcy may be counterproductive ex ante, because managers of financially distressed firms would prefer delaying bankruptcy filing, leading to value destruction (Adler et al., 2013).

Since the late 1990s, special bankruptcy bonus programs, known as key employee retention plans (KERPs) and key employee incentive plans (KEIPs), became a popular scheme for compensating man- agers in bankruptcy, until Congress imposed restrictions limiting the use of these types of plans as part of BAPCPA in 2005. Goyal and Wang (2017) examined the bonus contracts offered under these plans in a sample of 553 firms that filed for Chapter 11 between 1996 and 2013. They identified firms that adopted KERPs or KEIPs through a search of reorganization or liquidation plans, court dockets, company 8-K filings, and news. They found that 38% of their sample firms adopted such bonus plans. The plans cover 5% to 6% of total employees, most of whom are non-CEO senior executives and senior managers. Importantly, they showed that these plans were more likely to be adopted in firms with complex operations and strong creditor control and firms whose employees had more outside job options. Newly hired turnaround specialists are more likely to be covered by these plans than incumbent CEOs. The evidence suggests that the bonus plans are an efficient contracting solution to the problem of retaining and incentivizing key employees in bankruptcy when their pre-bankruptcy compensation contracts no longer provide such incentives.

### Notable Changes in the U.S. Bankruptcy System

This section briefly summarizes three notable changes in the U.S. bankruptcy system since the 1990s that have significant implications for the costs and efficiency of the bankruptcy process.

#### The Rise of Specialized Distressed Investors

One notable change to the bankruptcy restructuring landscape is the active involvement by distressed hedge funds and private-equity investors. Through trading in distressed securities markets, these investors aggressively acquire distressed debt claims and equity stakes of distressed companies. Their concentrated ownership not only helps mitigate the creditor coordination problem but also allows them to play an active role in enforcing contracts and improving governance.

Assembling a comprehensive sample of large Chapter 11 filings from 1996 to 2007, Jiang et al. (2012) investigated the active involvement of distressed investors in the bankruptcy process and its effect on bankruptcy outcomes. They first document that distressed investors are everywhere in a bankrupt firm’s capital structure: on the secured debt side through their provision of DIP financing, on the unsecured debt side, through their joining the UCC and, on the equity side, through joining the equity committee and pursuing a loan-to-own strategy, whereby an investor acquires the debt of a distressed borrower with the intention of converting the acquired position into a controlling equity stake on the firm’s emergence from Chapter 11. They find that the presence of distressed investors on the UCC has a positive effect on the debtor’s loss of exclusivity of filing a plan, CEO dismissal but retention of other key personnel, and debt recovery. Their loan-to-own strategy allows distressed investors to exert a strong influence over management. Lim (2015) provided further evidence on the role of activist funds in financially distressed firms that restructured out of court and through Chapter 11. She found that the involvement of activist investors leads to more pre-court negotiations, less delay, and a large reduction in leverage. The findings from both studies suggest that distressed investors help relax financial constraints and improve governance of distressed firms, leading to lower costs and efficiency gains.

Ivashina et al. (2016) provided an important insight into how debt ownership concentration relates to bankruptcy outcomes. They found that higher debt concentration (i.e., low creditor coordination frictions) leads to more successful pre-court negotiations, faster resolution, and higher likelihood of firm survival as a going-concern and larger debt recovery. However, they also found that the increase in concentration throughout the bankruptcy process as a result of claims trading is not associated with improvement in bankruptcy outcomes. Moreover, Ellias (2018) suggests that claims trading is not a major concern for the governance of Chapter 11 firms. Importantly, Demiroglu et al. (2022) showed that efficient market prices of debt securities, potentially as a result of trading by specialized investors, help improve participants’ in-court valuations of the bankrupt firm.

Among studies that examine the effect of distressed investors on the board of directors, Hotchkiss and Mooradian (1997) investigated the influence of “vulture” investors in firms that became financially distressed during the late 1980s to the early 1990s. They found that these investors join 27% of the boards of the 288 firms in their sample and that post-emergence performance improves as a result. Using a more recent sample of Chapter 11 filings between 1996 and 2013, Li and Wang (2016) found that 58% of emerged firms have at least one activist investor on their board. The board turnover rate and the fraction of emerged firms with activists on the board are much higher than those reported in earlier studies.

Although the financial distress of private-equity-backed firms can be a direct result of the highly leveraged transactions in the first place, private-equity investors often take an active role in restructuring their portfolio companies. Hotchkiss et al. (2021) showed that firms backed by private-equity investors are more likely to restructure their debt out of court, restructure more quickly, and liquidate less often than otherwise comparable highly leveraged distressed firms. They also showed that private-equity owners are more likely to retain control after restructuring. Studying the role of private equity in the resolution of failed banks after the 2008 financial crisis, Johnston-Ross et al. (2021) showed that private equity investors fill the gap in purchasing riskier failed banks and that the acquired banks perform better ex post.

#### Secured Creditor Control

Many empirical studies on the U.S. bankruptcy process from the early 1990s pay close attention to the creditor–shareholder bargaining frictions and document frequent APR deviations in favor of shareholders (e.g., Betker, 1995; Eberhart et al., 1990; Franks & Torous, 1989; Weiss, 1990). APR deviation occurs when shareholders receive a payoff before creditors are paid in full according to the final reorganization plan that is approved by both creditors and shareholders and confirmed by the judge. APR deviation reflects the strong bargaining position of shareholders that includes management holding significant equity ownership against creditors. Several studies show inefficiencies arising from agency problems and risk-shifting associated with management control in earlier periods (e.g., Weiss & Wruck, 1998).

The mid 1990s or so, a gradual shift in control rights in bankruptcy from shareholders and managers to (secured) creditors has been witnessed. Many attribute the changing nature of Chapter 11 to the development of an active market for control and distressed debt trading as well as contracting innovations such as DIP financing and KERPs. With the strengthening of creditor rights, several notable changes occurred that affected firms in bankruptcy.

First, APR deviation by shareholders came to an end in the early 2000s (Bharath et al., 2010; Kim, 2018). The evidence clearly reflects the diminished bargaining power of shareholders in bankruptcy. It is worth noting that APR deviations can occur between senior creditors and junior creditors as an outcome of bargaining. Badoer et al. (2020) showed that secured lenders’ payoffs are upheld in bankruptcy, while APR deviations between senior unsecured creditors and junior unsecured creditors can often occur.

Second, top executives experience higher turnover rates, and corporate governance improves in firms with strong secured creditor control (Ayotte & Morrison, 2009; Carter et al., 2020; Eckbo et al., 2016). Third, managers’ incentives are more aligned with creditors’ recovery rates rather than older shareholders’ payoffs (Goyal & Wang, 2017). The realignment of incentives effectively makes managers agents for the new principal—creditors who will be new shareholders through loan-to-own. In fact, secured lenders are involved in the restructuring process as early as immediately after covenant violations (Nini et al., 2012). Consistently, Carey and Gordy (2021) show that firm-level recovery rates increase with firms’ share of secured debt.

Despite the positive effects of enhanced creditor control on the efficiency of restructuring, a number of studies express concerns. For example, Ayotte and Morrison (2009) showed that granting too much control to senior secured lenders is detrimental to unsecured creditors’ payoffs, especially when lenders are over-secured. Ma et al. (2021) found that firms with greater use of secured debt sell core innovation in bankruptcy. Eckbo et al. (2022) expressed concerns regarding the strong blocking power of pre-petition secured lenders in limiting competition to financing bankrupt firms. Although the traditional measure of APR deviation dissipates over time, Roe and Tung (2013) raised the concern that certain classes of creditors are able to exploit the system to achieve a “priority jump” to benefit at the expense of other creditors. In fact, concerns for excessive secured creditor control led to a commissioned study by the American Bankruptcy Institute in 2015 (ABI, 2015).

#### Bankruptcy Auctions

The intensity of asset sales in Chapter 11 bankruptcy has increased dramatically in the past few decades. Although firms used to use §363 of the US Bankruptcy Code to sell portions of assets in the past, recent years witnessed the increased selling of the firm as a going-concern in bankruptcy.

Examining a sample of 350 Chapter 11 filings from 2002 to 2011, Gilson et al. (2016) showed that more than half of firms sell at least 5% of the book value of their assets in bankruptcy and 21% sell the firm as a going-concern. They also show that 84% of the cases sold as a going-concern have a stalking horse bidder, and more than half have competing offers. Both strategic buyers, such as industry competitors, and financial buyers participate in asset auctions. The evidence suggests a growing trading market with various types of participants for assets sold in bankruptcy. Notwithstanding the improved liquidity in asset trading markets and its positive effect on maintaining going-concern values, some studies suggest that the use of §363 to sell assets can be harmful to creditors (e.g., Antill, 2021b). Further studies are called for to better understand the efficiency implications of going-concern sales in bankruptcy.

### Evidence From Other Countries

The discussion in this article thus far has focused primarily on the U.S. evidence, as the majority of published studies draw inferences using U.S. firms, perhaps because of its unique institutional setting and data availability. There is, however, a large literature examining the bankruptcy process in other countries.

Among those studies, La Porta et al. (1998) and Djankov et al. (2007) constructed a country-level creditor rights index based on how secured creditors are treated in bankruptcy and whether management retains administrative power; Strömberg (2000), Thorburn (2000), Eckbo and Thorburn (2003, 2008) and Eckbo and Thorburn (2009) provided comprehensive evidence on automatic auctions in Sweden and describe how they help reduce delay and increase creditor recoveries; Helwege and Packer (2003) examined the role of keiretsu banks on the restructuring outcome of distressed Japanese firms and found no evidence that they result in excessive liquidations; Franks and Sussman (2005) examined small to medium-sized financially distressed firms in the United Kingdom and documented significant direct costs of bankruptcy; Davydenko and Franks (2008) compared the bank loan recovery rates of firms that filed for bankruptcy in France, Germany, and the United Kingdom and found that French secured creditors recover much less than U.K. banks and German banks; Djankov et al. (2008) constructed a cross-country measure of the costs and efficiency for debt enforcement in court; Ponticelli and Alencar (2016) showed that court congestion not only prolongs case duration but also reduces local firms’ access to finance and investment in Brazil; Gormley et al. (2018) showed that increases in banking competition prompt lenders to exert greater efforts to resolve bankruptcies in India more quickly; Rodano et al. (2016) found that the 2005–2006 bankruptcy reform in Italy has helped reduce the duration of liquidation procedures and has had real effects on investment; Li and Ponticelli (2021) studied bankruptcies in China and found that the introduction of specialized bankruptcy courts helps reduce case duration; Araujo et al. (2021) showed the effects of judicial biases on labor outcomes in bankruptcies in Brazil; Altman et al. (2021) suggested that modernization of a country’s bankruptcy code has helped alleviate its “zombie” problems.

The previously mentioned studies make up only a fraction of the notable papers on non-U.S. bankruptcy procedures. Future research to explore this fast-growing literature is strongly encouraged.

### Conclusion

This article has provided a brief review of the existing theoretical and empirical research on the bankruptcy system. Despite the general applications of the theoretical framework, most empirical studies discussed in the article focus on U.S. firms. The article first introduced the key players and stakeholders in the bankruptcy system and then summarized how economists and legal scholars characterize the goals of an efficient bankruptcy system. Before discussing the vast literature on the costs associated with the U.S. bankruptcy system, the major economic frictions as sources of costs and inefficiency were briefly discussed. Existing empirical findings were grouped into seven categories—legal costs, excess delay, inefficient liquidation and excess continuation, fire sales, costs of financing, employee costs, and managerial costs of turnover and incentive plans. After discussing the empirical evidence on bankruptcy costs, three notable changes that have helped reduce costs and improve efficiency were described and evidence from other countries briefly presented.

Despite the vast amount of work by prominent scholars in the field, many questions remain unanswered. For example, earlier work, such as Gertner and Scharfstein (1991), provided evidence that Chapter 11 can help overcome the debt overhang and underinvestment problems, but their evidence is indirect for measuring investment efficiency. Does the liquidity provision in bankruptcy really help firms overcome underinvestment? How do firms adjust their investments after selling major assets? How do bankrupt firms allocate resources within the organization after high employee turnover? Moreover, many aspects of the indirect costs of bankruptcy and the effects of some important stakeholders remain unexplored. For example, how costly is managers’ loss of focus and time in bankruptcy to firms? How do customers and suppliers re-contract with the bankrupt firm? How do independent advisors help mitigate frictions and improve efficiency?

As mentioned at the beginning of this article, a financially distressed firm in bankruptcy is like a sick patient seeking help in an intensive care unit. Perhaps this is not the best analogy, but what the system can and will do determines the firm’s survival and value maximization. As long as corporations use debt financing and there are cyclical economic shocks, how to most efficiently resolve financial distress and minimize costs will continue to be an important topic for future research.

### Acknowledgment

I thank B. Espen Eckbo, Winston Dou, Vidhan Goyal, Jacopo Ponticelli, Lucian Taylor, Joshua Madsen, Wenyu Wang, Yan Yang, and two anonymous reviewers for valuable comments. I also thank Yuehua Tang and the Oxford University Press for their kind invitation.

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### Notes

• 1. For a comprehensive review of the earlier literature on bankruptcy costs, interested readers can refer to Chapter 4 of Altman et al. (2019).