In the United States, bankruptcy is a federal court proceeding initiated voluntarily by a financially troubled debtor or involuntarily by the debtor's creditors. For most financially troubled businesses, the Federal Bankruptcy Code (Title 11 of the United States Code) provides two alternative avenues for relief. First, for the business that sees no prospect of being able to operate successfully in the future, there is the Chapter 7 liquidation procedure. In a Chapter 7 proceeding, the bankruptcy court appoints a trustee to close the business down, sell its assets, and turn the proceeds of sale over to the bankruptcy court for payment to the creditors. Alternatively, for the business that wants to continue operating, there is the Chapter 11 reorganization procedure. The goals of Chapter 11 are to give the debtor a temporary opportunity to reorganize the business and emerge from Chapter 11 as a viable business.
In a Chapter 11 proceeding, the debtor's management normally continues to operate the business while a reorganization plan is prepared. The bankruptcy judge plays only a small role in preparing the plan. Usually the reorganization plan is drafted by the debtor, ratified by one or more creditor committees, and then voted upon by the creditors after they have been divided into classes of substantially similar claims. A class of creditors is deemed to have accepted the reorganization plan if at least two-thirds in amount and more than one-half in number of the claims that are voted are cast in favor of the plan. If all classes of creditors vote to accept the debtor's reorganization plan, it is submitted to the bankruptcy court for confirmation (official approval). Conversely, if the debtor is unable obtain creditor approval within the time limits set by the bankruptcy court, then the court will order the Chapter 11 reorganization proceeding to be converted into a Chapter 7 liquidation proceeding.
In addition to the Chapter 11 procedure, the Federal Bankruptcy Code contains two other rehabilitation procedures for special types of businesses: Chapter 12 provides for the rehabilitation of family farmers, and Chapter 13 provides a streamlined reorganization procedure for individual owners of small businesses with unsecured debts of less than $100,000 and secured debts of less than $350,000.(1)
Direct bankruptcy costs are the out-of-pocket expenditures associated with the bankruptcy proceeding itself, including: filing fees, lawyer fees, accountant fees, expert witness fees, trustee fees, and other out-of-pocket administrative costs. Direct bankruptcy costs are incurred in all bankruptcy proceedings, although their magnitude varies depending on the particular bankruptcy procedure selected. In general, the direct bankruptcy costs imposed by a Chapter 11 reorganization proceeding will be substantially higher than the costs imposed by a Chapter 7 liquidation proceeding.
In addition to direct bankruptcy costs, bankruptcy also imposes certain indirect costs in lost opportunities (such as lost sales, lost profits, the inability to obtain credit, and lost investment opportunities). These indirect bankruptcy costs can occur both before bankruptcy as well as after, and are not limited to firms that actually file bankruptcy. Firms that have high probabilities of bankruptcy, whether they eventually file for bankruptcy protection or not, can incur indirect bankruptcy costs. Because indirect bankruptcy costs arise from lost business opportunities, they are virtually impossible to measure. Therefore, the present study does not attempt to estimate indirect bankruptcy costs; rather, its focus is on measuring the direct administrative costs associated with the Chapter 11 reorganization procedure.
In recent years the Chapter 11 procedure has come under sharp criticism for the high costs and time delays it imposes on bankrupt firms (Bradley and Rosenzweig 1992). These criticisms are of particular concern with respect to small closely held firms which prior research has shown to be much less likely to emerge from Chapter 11 proceedings with confirmed reorganization plans than are large publicly traded corporations (Altman 1992). …