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When people talk about companies going bankrupt, two things usually come to mind: failing companies and cutting losses.
But the bankruptcy system also plays a crucial role in the economy. It encourages risk-taking and lending, providing protections to both creditors and business owners when things go south. It can also be used to enable economic recycling, in that it reallocates a troubled company’s assets to the most productive possible uses.
Now, study coauthored by Stanford Graduate School of Business Professor Shai Bernstein and published in the Journal of Finance sheds light on a pivotal question: When is the most productive reallocation of assets likely to happen — through a simple going-out-of-business sale (liquidation under Chapter 7 of the federal bankruptcy code) or through a corporate reorganization under Chapter 11?
It’s an important issue, not just for creditors but also for overall economic productivity — especially in communities tied to declining industries.
Keeping a zombie company alive can mean throwing good money after bad. But prematurely liquidating a company could result in permanently idling factories and buildings that might still have profitable uses. Liquidation can also have spillover effects, triggering a downward spiral in the surrounding area.
“Insolvency and distressed companies are unavoidable, and the bankruptcy system is integral to any evolving economy,” says Bernstein, noting that 60,000 companies a year file for bankruptcy, even when there isn’t a recession. “Given that such a large number of firms struggle and fail, it remains a question whether the bankruptcy system effectively reallocates the assets.”
In the study, Bernstein teamed up with Emanuele Colonnelli, who received his PhD from Stanford in 2018 and is now at the University of Chicago, and Benjamin Iverson of Brigham Young University, to track what happened to real estate assets in thousands of bankruptcy cases over more than two decades.
Scrutinizing more than 28,000 cases, they compared companies that went through a Chapter 11 reorganization with those that initially filed for Chapter 11 but were later converted by a judge into a Chapter 7 liquidation. Using data from the Census Bureau, the researchers were able to see what happened to each piece of related real estate, even when it had new owners or ended up being used for different purposes.
They found that keeping a company alive often leads to a more productive use of these properties in the long run, and that judges are sometimes too quick to shut down a firm through a Chapter 7 liquidation.
That’s not an absolute verdict, of course. In fact, most insolvent companies decide on their own to file for liquidation. But in markets that don’t have many prospective buyers, such as a steel town with only one remaining steel company, business properties that went through a Chapter 11 restructuring were more likely to still be in use five years later, when compared with assets of liquidated businesses. On average, those Chapter 11 properties were also employing more people, even when the assets had been sold to new owners.
That’s an important insight for cities and towns tied to a declining local industry, such as steelmaking in the Midwest or furniture manufacturing in the South.
The findings surprised the researchers. Properties that went through a Chapter 11 reorganization were 17 percent more likely to still be in use after five years than were properties at companies forced to liquidate. In other words, a significant percentage of liquidated assets were not sold to healthy firms and thus reallocated to other uses through the market, but instead remained vacant.
Employment at the Chapter 11 properties remained higher as well. Average employment at those locations dropped initially but leveled out and remained at 70 percent of their pre-bankruptcy levels at the five-year mark. By contrast, employment only recovered to 60 percent of the original level at properties caught up in liquidations.
The big takeaway, however, was that the advantages of Chapter 11 were apparent only in “thin” markets — those with few potential buyers and less access to financing.
The researchers defined a thin market as one with only a limited number of nearby companies in the same industry that can potentially use these assets. That’s because business properties often have specific characteristics that make them attractive to just one industry, whether it’s steelmaking or retail.
In “thick” markets with lots of potential buyers, there wasn’t much difference between Chapter 11 and Chapter 7 properties. In thin markets, however, there was a whopping 30 percent difference in occupancy rates of these properties.
Bernstein says the researchers’ findings provide an important lesson for any community tied to a declining local industry. In fact, a separate 2018 study coauthored by Bernstein found that Chapter 7 liquidations also lead to a significant drop in employment at neighboring companies.
To be sure, the study also confirms that a Chapter 11 restructuring can be just as disruptive as liquidation to workers and a community. Almost a third of the properties that went through Chapter 11 were vacant and unused five years after the bankruptcy filing. And even in Chapter 11 cases, most of the real estate properties had been sold to other companies within five years of the filing.
One difference, however, is that companies in Chapter 11 have more time to look for a buyer and thus don’t have to rush through the sale process, as is the case in Chapter 7. Another difference may be that a property that’s in use has more perceived value than one that’s vacant.
Bernstein says it would be a mistake to infer that bankruptcy courts should keep all or even most troubled companies alive. The real lesson, he says, is that judges should think more carefully before ordering the seemingly simple solution of a going-out-of-business sale.
A version of this article first appeared in Insights by Stanford Business.