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.

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.

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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

Benjamin Iverson

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.

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