The comparative efficiency of small-firm bankruptcies: a study of the US and Finnish bankruptcy codes

Financial Management (Financial Management Association), Winter, 1998 by S. Abraham Ravid, Stefan Sundgren

This paper compares the relative efficiency of the two major types of bankruptcy law. The first is the debtor-oriented American bankruptcy code; the second is the creditor- and liquidation-oriented legislation common in Europe. To make the comparisons and provide some insights, we analyze a combined sample of small American and Finnish firms in financial distress. Although most European firms and a significant percentage of the firms in the US are small or midsized, this class of firms has received little attention in the bankruptcy literature. Our paper contributes to filling this gap.(1)

In recent years, the efficiency aspects of the bankruptcy process have received a great deal of interest in the literature (see John, 1993, and Senbet and Seward, 1995, for reviews). One of the broad questions addressed in such studies is whether Chapter 11 results in too many inefficient firms being kept alive, or whether a bankruptcy code without Chapter 11 might result in too many liquidations.

Empirical evidence reveals that many firms that emerge from Chapter 11 are financially unstable. Hotchkiss (1995) shows that reorganized firms continue to experience difficulties later on. Gilson (1993) finds similar results.

Several theoretical models explain this tendency for inefficient firms to survive Chapter 11 proceedings. Bulow and Shoven (1978), White (1983), and most explicitly, Gertner and Scharfstein (1991) and Mooradian (1994) model inefficient firms selecting reorganization under Chapter 11.

Other studies document the incentive to continue operations of inefficient entities in which management is motivated by its advantageous position in Chapter 11 and by deviations from absolute priority (see Franks and Torous, 1989; Eberhart, Moore, and Roenfeldt, 1990; and others).

If this line of reasoning is correct, the effective elimination of Chapter 11 should provide more efficient bankruptcy proceedings. The opposing argument is that Chapter 11 allows economically viable firms to reorganize, rather than face the "common pool" problem in which creditors rush to liquidate assets in order not to lose out (see Brown, 1989, for a description of this process).

LoPucki and Whitford (1993a), White (1996), and others consider another facet of the bankruptcy code. They suggest that the lenient treatment of debtors in Chapter 11 proceedings provides incentives to file for bankruptcy at an earlier stage of financial distress, while there is some value left in the firm.

Finally, several scholars argue that a bankruptcy code that provides for sales of firms as going concerns (similar to the old Finnish code) would be more efficient than a reorganization-directed code. This view dates back to Baird (1986), who argues that the asset-deployment decision would be more correct and the administrative expenses lower if auctions were used to allocate assets to the highest-value user. (See Haugen and Senbet, 1978, on this issue.) However, Shleifer and Vishny (1992) question the efficiency of auctioning distressed firms, and they suggest that, under some circumstances, assets might be sold below their fundamental value.

Only a handful of studies compare the outcomes of different bankruptcy codes. Franks, Nyborg, and Torous (1996) provide an insightful discussion of the incentives inherent in the British, American, and German bankruptcy codes. The latter is similar to the Finnish code. Kaiser (1996) surveys several European codes. Stromberg (1998) and Thorburn (1997) investigate the Swedish code, which is similar to the old Finnish code.

The efficiency of bankruptcy procedures is not just an academic issue; it is also a matter of importance for government and corporate policy. In the US, Chapter 11 is continually questioned. In Europe and in Asia, there is an ongoing policy debate as to whether a creditor-oriented or a debtor-oriented code is best. In some industrialized countries, such as Belgium or the Netherlands, reorganization is still not possible (see Kaiser, 1996). Italy has a provision that is somewhat similar to Chapter 11, but the number of distressed firms taking advantage of it is minuscule: in 1990, about 1% of the total number of bankrupt firms filed under this provision; in 1991, this proportion was even lower (see Barontini, Belcredi, Caprio, and Floreani, 1997). In Germany, a provision for compositions exists, but in 1992 only 0.3% of bankruptcies were resolved under this provision (see Franks, Nyborg, and Torous, 1996). In addition to Finland, several other countries, notably France, Britain, and Sweden, have recently added a US-type reorganization chapter to a creditor-oriented code.(2)

Berkovitch and Israel (1995) argue that bankruptcy codes should be different for economies with different information structures. In particular, in those countries in which managers cannot predict with certainty the result of creditors' investigations into the prospects of potentially distressed firms (as is presumably the case in the us), there should be creditor and debtor chapters. In economies where managers and investors have closer ties (presumably similar to Finland), only a creditor chapter is necessary for the optimal implementation of investment and liquidation.