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University of Utah Study Finds U.S. Bankruptcy Process Works, Weeds out Weak

January 8, 2009 –With high-profile company bankruptcies becoming a distressingly common occurrence, many would be hard-pressed to find an upside in the situation.

According to a new study by three finance researchers at the University of Utah’s David Eccles School of Business, however, there might be a silver lining of sorts: the effectiveness of the U.S. bankruptcy system.

They found that 80% of fundamentally sound companies – those with good business models but too much debt – reorganized and emerged from Chapter 11 with only 7% fewer assets.

On the other hand, just 37% of economically distressed companies – those with severe business problems such as poor management, outdated technology or flawed business models – reorganized with less than 50% of their original assets. The remainder were liquidated or purchased by other firms.

In addition, all reorganized firms had reduced debt by 50% by the time they emerged from Chapter 11.

“We found that the bankruptcy system is largely successful at helping fundamentally strong companies recover from financial problems, while dismantling weaker companies whose troubles are more severe, says Elizabeth Tashjian, one of the authors of “Financial and Economic Distress and Restructuring Heterogeneity in Chapter 11.”

The study reviews data from 530 companies that entered bankruptcy between 1991 and 2004, making it much more comprehensive than previous research on bankruptcy policy, says Tashjian, associate professor of finance and a member of the Academic Advisory Council of the Turnaround Management Association.

“There’s no question that the process isn’t perfect, but it seems that Chapter 11 is doing what it’s supposed to do,” she says. “It seems to take the assets away from those firms that are destroying the value of assets and retain them in firms that have a good chance of surviving and creating value.”

The U.S. bankruptcy process is markedly different from that in countries such as Sweden, where companies are sold without getting a chance to restructure, says University of Utah professor of finance Michael Lemmon, who co-authored the study.

“The study doesn’t say that the U.S. has the best bankruptcy procedure,” he says. “It does say that some of the criticisms that have been levied against U.S. bankruptcy procedure don’t appear to be that important.”

While previous research has focused on the average outcomes of firms going into Chapter 11, Tashjian says she, Lemmon and Ph.D. student Yung-Yu Ma tried to approach the subject in a more nuanced fashion, recognizing that firms file for bankruptcy for different reasons.

Companies in the study were divided into two separate groups: “financially distressed,” which were fundamentally sound firms with good business models, but too much debt, and “economically distressed,” which had poor operating performance for a number of factors, including bad management, outdated technology or a flawed business model.

“The fundamentally sound companies create value, so ideally, the bankruptcy process would reduce their debt and let them continue,” Tashjian says. “You don’t want to shut down those companies completely.”

Because economically distressed companies are potentially harming the value of their assets, Tashjian says an ideal bankruptcy policy would favor selling off unprofitable pieces to return them to financial health or liquidating them all together.

Tashjian says she and her colleagues used two simple accounting variables to arrive at their conclusions: operating earnings to assets, with profit margins adjusted by industry, and debt to value: basically, the amount of leverage a company has.

Financially distressed firms tended to have bad debt ratios but good operating performance, Tashjian says; with economically distressed firms, it was the other way around.

Lemmon says Chapter 11 might be a better option in the long run for U.S. automakers than receiving federal funds.

“My opinion is that most of those firms are experiencing more than just financial difficulties,” he says, pointing out that overseas automakers who have factories in the United States don’t appear to be suffering. “There seem to be fundamental operating problems in the U.S. auto industry.”

If U.S. automakers do end up declaring bankruptcy and undergoing that process, Lemmon says those firms would likely only continue as much smaller entities.

“If it really is just financial difficulties, bankruptcy would allow them to restructure,” he says.

The researchers are part of the finance department in the University of Utah’s David Eccles School of Business. The department has been ranked 20th for its research productivity from 2003 to 2007 by the Finance Management Association and Arizona State University, which annually evaluate finance departments in colleges and universities worldwide according to the number of articles published in the field’s premier academic journals.