U.S. Bankruptcy Process Works, Weeds Out Weak

With high-profile company bankruptcies becoming distressingly common, many would be hard-pressed to find an upside. According to a new study by three finance researchers at the University of Utah's David Eccles School of Business, however, there might be a silver lining of sorts: the effectiveness of the U.S. bankruptcy system.

They found that 80% of fundamentally sound companies, those with good business models but too much debt, reorganized and emerged from Chapter 11 with only 7% fewer assets. On the other hand, just 37% of economically distressed companies, those with severe business problems such as poor management, outdated technology or flawed business models, reorganized with less than 50% of their original assets. The remainder were liquidated or purchased by other firms. In addition, all reorganized firms had reduced debt by 50% by the time they emerged from Chapter 11.

"We found that the bankruptcy system is largely successful at helping fundamentally strong companies recover, while dismantling weaker companies whose troubles are more severe," said Elizabeth Tashjian, associate professor of finance and a member of the Academic Advisory Council of the Turnaround Management Association.

The study reviews data from 530 companies that entered bankruptcy between 1991 and 2004, making it more comprehensive than previous research, said Tashjian. "There's no question that the process isn't perfect, but it seems that Chapter 11 is doing what it's supposed to do," she said, "taking away assets from firms that are destroying their value and retaining them in firms with a good chance of surviving and creating value."

While previous research has focused on the average outcomes of firms entering Chapter 11, Tashjian said she and her co-authors, Utah professor of finance Michael Lemmon and Ph.D. student Yung-Yu Ma, recognize that firms file for bankruptcy for different reasons. The researchers used two accounting variables: operating earnings to assets, with profit margins adjusted by industry, and debt to value: the amount of leverage a company has. Financially distressed firms tended to have bad debt ratios but good operating performance. With economically distressed firms, it was the other way around.

Source: David Eccles School of Business

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