Reorganization or Liquidation: Bankruptcy Choice and Firm Dynamics

By Dean Corbae and Pablo D’Erasmo

In this paper, we ask how bankruptcy law affects the financial decisions of corporations and its implications for firm dynamics. According to current U.S. law, firms have two bankruptcy options: Chapter 7 liquidation and Chapter 11 reorganization. Using Compustat data, we first document capital structure and investment decisions of non-bankrupt, Chapter 11, and Chapter 7 firms. Using those data moments, we then estimate parameters of a firm dynamics model with endogenous entry and exit to include both bankruptcy options in a general equilibrium environment. Finally, we evaluate a bankruptcy policy change recommended by the American Bankruptcy Institute that amounts to a “fresh start” for bankrupt firms. We find that changes to the law can have sizable consequences for borrowing costs and capital structure, which via selection affects productivity (allocative efficiency rises by 2:58%) and welfare (rises by 0:54%).

The US has a rather unique bankruptcy system that has serve it very well. For individuals, the fresh start option has been instrumental in encouraging entrepreneurship. For firms, Chapter 7 and 11 have helped many to avoid a shut down and then to flourish again. This paper shows that there is still scope to improve bankruptcy law in simple and significant ways.


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