Chapter 7 vs. Chapter 11: Which Bankruptcy System Is Better?
Skip to content
Finance & Accounting Economics Jul 5, 2016

Chapter 7 vs. Chapter 11: Which Bankruptcy System Is Better?

In certain markets, forcing companies to liquidate could cause offices and factories to sit empty.

Chapter 7 bankruptcy causing business real estate to sit empty.

Yevgenia Nayberg

Based on the research of

Shai Bernstein

Emanuele Colonnelli

Benjamin Iverson

For a failing company, declaring bankruptcy is painful. And it can be painful for the economy as well. After all, bankrupt companies occupy a substantial amount of real estate, not to mention employ local workers, so it is vital that the bankruptcy process put those assets to good use.

U.S. courts have two options in deciding how to adjudicate bankruptcies. Under Chapter 7, a firm must liquidate and sell all of its assets in an auction. Under Chapter 11, managers can negotiate with creditors to decide whether to reorganize the firm or liquidate some or all of its assets.

While this dual bankruptcy system has been available since the late 1970s—and most bankruptcy systems around the world mimic one of the two processes—“we’ve never really known which system works better or under what conditions,” says Ben Iverson, an assistant professor of finance at the Kellogg School of Management.

So he and his collaborators compared the two. They found that putting a firm into Chapter 7 increases the chances that its real estate assets will sit vacant and employ fewer workers. However, these patterns mainly occur in markets with relatively few potential buyers in the same industry. “The optimal bankruptcy system depends a lot on the kind of market you’re in,” Iverson says.

The results suggest that forcing a company into liquidation could sometimes harm the economy. In those situations, a better strategy might be to give the company time to form a plan and potentially reorganize rather than trying to sell all its assets right away.

That does not mean all Chapter 11 companies will bounce back. Many in Iverson’s study did, in fact, shutter. But the key difference was that these companies did not have to fold immediately, which allowed them to stay in business while looking for buyers—and thus reduced the chances that offices and factories would go unused. “A lot of them still shut down,” Iverson says. “But we don’t force it to happen.”

Locations, Locations, Locations

“In any dynamic economy that’s evolving, you’re always going to have companies that fail,” Iverson says.

If a firm is not the most productive user of a particular asset, a shutdown could even be desirable, as office buildings, employees, or other resources transition to other uses. For example, if an auto-parts company shuts down, and its factory is better suited to producing sewing machines, then handing over the factory to a sewing-machine company will boost the economy.

In their study, Iverson and his collaborators Shai Bernstein and Emanuele Colonnelli, who are both at Stanford University, analyzed Chapter 11 bankruptcy filings for roughly 28,000 companies nationwide from 1992 to 2005. In about 40 percent of the cases, a judge converted the firm to Chapter 7; the other 60 percent remained in Chapter 11.

In thin markets, “forcing firms into liquidation is very costly.”

By identifying each bankrupt company’s locations in U.S. Census data, they could track what happened to each piece of property—roughly 129,000 in total—over the next five years. If the same address showed up under another firm’s name, that meant a new company had moved in.

Empty Buildings

Despite the fact that Chapter 11 does not force companies to liquidate, the researchers found that, “in reality, the vast majority shut down,” Iverson says. When a company stayed in Chapter 11, three-quarters of its locations were no longer occupied by that firm five years after filing.

The researchers also found that time is of the essence. If a location did not find a new owner within two years, it was likely to sit vacant for the rest of the study period. In some cases, an office or factory might simply be in an undesirable location. But the extended vacancy could occur because the building gets run-down or customers drift to another business district.

When a location did transition to another company, the new owner was often in the same industry—for instance, a failed restaurant location was taken over by another restaurant. But this was less likely if the company had been converted to Chapter 7.

“The firms that are liquidated are typically the worst firms,” Iverson says. “If they’re not performing well, it’s pretty unlikely that another firm that does the exact same thing will perform well in that location.”

Through Thick and Thin

This reality created a challenge for the researchers. They could not simply compare Chapter 7 with Chapter 11 companies because the liquidated firms tend to be worse. Any differences in the fate of their assets might be due to the companies’ quality and not to the bankruptcy system. So how could the team figure out whether the Chapter 7 or 11 system is better for the economy?

The researchers solved this by taking advantage of a quirk of the legal process. Bankruptcy cases are randomly assigned to judges. And when a firm files for Chapter 11, the judge has some discretion over leaving it in Chapter 11 or converting it to Chapter 7.

It turns out that different judges have different interpretations of the law and tend toward either Chapter 7 or 11. This means that similar companies could be assigned to Chapter 7 or 11 depending on which judge oversaw their case, creating something close to a randomized experiment. So Iverson’s team was able to compare the outcomes of cases assigned to judges who favor Chapter 7 with the outcomes of otherwise-identical cases assigned to judges who favor Chapter 11.

They found substantial differences. If a company was converted to Chapter 7, its locations were 17 percent more likely to remain vacant than if the company had stayed in Chapter 11. “You literally can’t find a buyer,” Iverson says. And there were on average 34 percent fewer employees at these firms’ locations, because locations stood empty or remaining locations employed fewer people.

But the type of bankruptcy only really mattered in “thin markets”—which have fewer potential buyers in the same industry—than “thick markets.” (For example, an urban area might be a thick market for restaurants but a thin market for grain silos.) If a Chapter 7 company was in an area with a lot of potential buyers, the location was just as likely to get snapped up, and the employment rate was just as high, as if the company had stayed in Chapter 11.

A Costly Strategy

The results suggest that in thin markets, “forcing firms into liquidation is very costly,” Iverson says. “It dramatically reduces utilization of the asset.”

While some companies are undoubtedly so bad that they should be liquidated immediately, the firms that could reasonably fall into either Chapter 7 or 11 might be better off with the latter approach so that they can take time to formulate a plan or find a buyer, Iverson says. And the bankruptcy code could do a better job of considering what local market conditions are like when determining how a firm should go through the bankruptcy process.

The study comes with some caveats. First, it is possible that employees of a shuttered company ended up with good jobs at another firm post-bankruptcy, even if the real estate assets went unused. Additionally, a painful Chapter 7 bankruptcy process might be better for the economy in some ways because managers are more motivated to stay out of bankruptcy in the first place.

It may seem obvious, but the research bolsters the idea that the best course of action is to avoid the bankruptcy process altogether. If a company in a thin market is forced into Chapter 7, they might not be able to find a buyer on short notice. Instead, Iverson suggests, the firm should take intermediate steps such as selling assets or renegotiating with creditors.

“It’s not good to wait until it’s an emergency situation,” he says.

Featured Faculty

Member of the Department of Finance faculty until 2017

About the Writer
Roberta Kwok is a freelance science writer based near Seattle.
About the Research

Bernstein, Shai, Emanuele Colonnelli, and Benjamin Iverson. 2016. “Asset Allocation in Bankruptcy.” US Census Bureau Center for Economic Studies Paper No. CES-WP-16-13.

Read the original

Most Popular This Week
  1. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  2. Don’t Wait to Be Asked: Lead
    A roadmap for increasing your influence at work.
    An employee leads by jumping from the bleachers and joining the action.
  3. How (Not) to Change Someone’s Mind
    Psychologists have found two persuasion tactics that work. But put them together and the magic is lost.
    A woman on a street talks through a large megaphone.
  4. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  5. How Autocracies Unravel
    Over time, leaders grow more repressive and cling to yes-men—a cycle that’s playing out today in Putin’s Russia.
    autocrat leaning over battle map surrounded by yes-men.
  6. Knowing Your Boss’s Salary Can Make You Work Harder—or Slack Off
    Your level of motivation depends on whether you have a fair shot at getting promoted yourself.
    person climbin ladder with missing rungs toward rich boss surrounded by money bags on platform
  7. Will AI Eventually Replace Doctors?
    Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
    doctors offices in small nodules
  8. Sitting Near a High-Performer Can Make You Better at Your Job
    “Spillover” from certain coworkers can boost our productivity—or jeopardize our employment.
    The spillover effect in offices impacts workers in close physical proximity.
  9. It’s Performance Review Time. Which Ranking System Is Best for Your Team?
    A look at the benefits and downsides of two different approaches.
    An employee builds a staircase for his boss.
  10. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  11. Four Strategies for Cultivating Strong Leaders Internally
    A retired brigadier general explains how companies can prioritize talent development.
    Companies should adopt intentional leadership strategies since developing leaders internally is critical to success.
  12. Entrepreneurship Through Acquisition Is Still Entrepreneurship
    ETA is one of the fastest-growing paths to entrepreneurship. Here's how to think about it.
    An entrepreneur strides toward a business for sale.
  13. Take 5: Not So Fast!
    A little patience can lead to better ideas, stronger organizations, and more-ethical conduct at work.
  14. Too Much Cross Talk. Too Little Creativity. How to Fix the Worst Parts of a Virtual Meeting.
    Six tools from an unlikely place—improv comedy—to use on your next Zoom call.
    meeting participants improv
  15. Take 5: How to Be Prepared for Important Career Moments
    Expert advice on getting ready to network, negotiate, or make your case to the CEO.
    How to be prepared
  16. Why Do Long Wars Happen?
    War is a highly inefficient way of dividing contested resources—yet conflicts endure when there are powerful incentives to feign strength.
    long line of soldiers marching single file through a field
  17. 2 Factors Will Determine How Much AI Transforms Our Economy
    They’ll also dictate how workers stand to fare.
    robot waiter serves couple in restaurant
  18. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  19. 5 Tips for Growing as a Leader without Burning Yourself Out
    A leadership coach and former CEO on how to take a holistic approach to your career.
    father picking up kids from school
More in Leadership & Careers Leadership