16 - Bankruptcy resolution: Direct costs and violation of priority of claims

Summary

Introduction

This chapter examines the resolution of bankruptcy for thirty-seven New York Stock Exchange (NYSE) and American Stock Exchange (Amex) firms that filed petitions under the 1979 Bankruptcy Code (hereafter “the Code”) between November 1979 and December 1986. New evidence is provided on the direct costs of bankruptcy and the violation of priority of claims.

The costs of bankruptcy have long been viewed as a potential determinant of the pricing of a firm's debt and of its capital structure. Bankruptcy costs are direct and indirect. Direct costs encompass the legal and administrative fees, including the costs of lawyers, accountants, and other professionals involved in the bankruptcy filing. Indirect costs include a wide range of unobservable opportunity costs.

Prior studies report direct costs of bankruptcy ranging from 4 percent to 25 percent. This study is the first to examine direct costs under the new Code and to cover a broad range of industrial firms. For the firms examined, direct costs average 3.1 percent of the book value of debt plus the market value of equity at the end of the fiscal year preceding bankruptcy. As Warner (1977a) demonstrates, such small direct costs have virtually no impact on the pricing of claims and capital structure prior to bankruptcy.

The firm's cost of capital and its capital structure may also be affected if priority of claims is not maintained in bankruptcy. Priority of claims is violated when senior claimants' are not fully satisfied before junior claimants receive any payment.