Reorganization or Liquidation: Bankruptcy Choice and Firm Dynamics

Abstract

In this paper, we ask how bankruptcy law affects the financial decisions of corporations and its implications for firm dynamics. According to current U.S. law, firms have two bankruptcy options: Chapter 7 liquidation and Chapter 11 reorganization. Using Compustat data, we first document capital structure and investment decisions of non-bankrupt, Chapter 11, and Chapter 7 firms. Using those data moments, we then estimate parameters of a firm dynamics model with endogenous entry and exit to include both bankruptcy options in a general equilibrium environment. Finally, we evaluate a bankruptcy policy change recommended by the American Bankruptcy Institute that amounts to a "fresh start" for bankrupt firms. We find that changes to the law can have sizable consequences for borrowing costs and capital structure, which via selection affects productivity (allocative efficiency rises by 2.58%) and welfare (rises by 0.54%).

Bankruptcy choice with endogenous financial constraints

“…From the model we compute the ratio of median leverage of reorganization firms relative to the median leverage of non-bankrupt firms. In Corbae and D'Erasmo (2016), the ratio of the means (1.45) is not too different from the ratio of the medians (1.50); see Table 1 in that paper. 22 This is very close to the 0.42% firm exit by liquidation reported in Corbae and D'Erasmo (2016).…”

“…However, from the model it is clear that their ratio determines the slope of W r (V r c ), which in turn determines the additional leverage that firms are able to obtain when under reorganization. Accordingly, we choose ρ/µ so as to approximately replicate the leverage of firms under reorganization relative to the leverage of non-bankrupt firms reported by Corbae and D'Erasmo (2016). 21 The model is reasonably successful in matching the target moments in the data.…”

“…Chapter 7 assets as reported in Corbae and D'Erasmo (2016). 24 The calibrated version of the model generates some financial selection as defined in Section 2.6 above.…”

“…This is the most relevant measure since in our model long-term debt is collateralized by ∆. The target for reorganization recovery rate can be found as the ratio of post-bankruptcy, pre-fees assets to pre-bankruptcy assets reported in Bris et al (2006)'s Table III. 24 Assets in Chapter 11 are defined in Corbae and D'Erasmo (2016) as assets in the initial period of a Chapter 11 bankruptcy. Accordingly, for the numerator of this ratio we compute the median of assets in the period of default but after renegotiation.…”

Bankruptcy Choice with Endogenous Financial Constraints

“…However, from the model it is clear that their ratio determines the slope of W r (V r c ), which in turn determines the additional leverage that firms are able to obtain when under reorganization. Accordingly, we choose ρ/µ so as to approximately replicate the leverage of firms under reorganization relative to the leverage of non-bankrupt firms reported by Corbae and D'Erasmo (2016).…”