The Fed Said What about Bankruptcy

The Fed Said What about Bankruptcy

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As a general rule, the terms "Federal Reserve Board" (Fed) and "bankruptcy" are two things not heard together in the same sentence absent a discussion of interest rate policy. However, in June 2006, the Fed's Division of Research & Statistics and Monetary Affairs issued a paper entitled "Are Longer Bankruptcies Really More Costly?1 While this paper is not an official policy statement of the Fed,2 it is an important, well-written3 and fairly large study of approximately 1,000 U.S. bankruptcy proceedings that evaluates the impact of the length of time spent by corporate debtors in bankruptcy proceedings on recoveries by bondholders.

The Hypothesis: Speed Is Good

For the past several years numerous scholars have attempted to analyze the impact that the length of time a debtor is in a bankruptcy proceeding/default situation has on creditor recoveries.4 These commentators have generally focused on two separate but related issues: (1) whether time spent in bankruptcy adversely impacts overall a debtor's value,5 and (2) whether additional professional fees during longer bankruptcies have a negative impact on creditor recoveries.6

The primary issue explored is whether the widely held belief that distressed firms should be reorganized or sold as quickly as possible in bankruptcy proceedings in order to maximize creditor recoveries was, in fact, correct. Specifically, the authors of the paper wanted to study the impact a debtor's time in default on publicly issued bonds held on bondholders return.

The Study: 1,000 Defaults

In conducting their study, the authors of the paper analyzed data from approximately 1,000 U.S. companies that defaulted on publicly issued debt and filed bankruptcy cases between 1983 and 2002.7 The data for these cases came from Moody Default Risk Service and S&P's Credit Pro and Portfolio Management Data.

The paper's authors considered the time in default,8 the recovery rates on defaulted bonds,9 macroeconomic variables,10 complexity variables,11 judicial variables12 and instrumental variables13 in determining what impact the length of the bankruptcy proceedings had on creditor recoveries.

And the Answer Is?

The study found that creditor recovery rates actually increased during the first 19 months after the debtor is in default.14 The authors of the paper found that the median time in default by the debtors studied was approximately 16 months,15 although numerous firms had significantly longer (and shorter) bankruptcies.16

Second, the likelihood of a debtor having to refile bankruptcy within five years after exiting bankruptcy decreases during the time the debtor is in default until the debtors time in default reaches approximately 32 months.17

Finally, the paper concludes that cases presided over by more experienced judges had improved creditor recoveries and that having multiple judges preside over a case worsens creditor recoveries and the likelihood of a repeat filing.18 This finding recognizes the significant contribution judges make in the bankruptcy process as well as provides some interesting case management information to the courts.


In summary, this paper constitutes a valuable and well-written study that debunks the myth that faster is always better in bankruptcy and demonstrates the importance of the bankruptcy process in increasing creditor reserves. It also provides valuable empirical data on an important aspect of bankruptcy practice.

As loyal readers of this column know, the author has the honor of chairing ABI's Chapter 11 Professional Fee Study,19 which ABI has funded to obtain important data about fees in chapter 11 cases. The paper, like ABI's Fee Study, is a valuable counter to some myths concerning chapter 11 practice.


1 Covitz, Han and Wilson, Are Longer Bankruptcies Really More Costly? (June 2006 Federal Reserve Board Finance and Economic Discussion Services).

2 Id. at p. 1.

3 The author confesses that he has not engaged in any significant empirical analysis since his junior year in college and will not attempt to address any technical details of the statistical analysis.

4 See, generally, LoPucki, Courting Failure: How Competition for Big Cases Is Corrupting the Bankruptcy Courts (2005 University of Michigan Press); Smith and Strömberg, Maximizing the Value of Distressed Assets: Bankruptcy Law and Efficient Reorganization Firms (2005 Federal Reserve Board and University of Chicago).

5 See, generally, Thorburn, "Bankruptcy Auctions: Costs, Debt Recovery and Firm Survival," 58 J. of Financial Economics 337 (2000); Andrade and Kaplan, "How Costly Is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed," 53 Journal of Finance 1443 (1998).

6 See, generally, LoPucki and Doherty, "The Determinants of Professional Fees in Large Bankruptcy Reorganization Cases," 1 Journal of Empirical Legal Studies, 111 (2004); "Note, Professional Fees in Bankruptcy: Percentage of the Recovery Method—A Solvent Response for Bankruptcy Proceedings?" 1 Am. Bank Inst. L.R. 471 (1993).

7 Are Longer Bankruptcies Really More Costly? at p. 5.

8 Time in default was measured as the number of months from a firm's first default under its public debt to the resolution of its bankruptcy proceedings. Firms that defaulted but did not file bankruptcy were not included in the study. Id. at 10.

9 The recovery rate on bonds was defined as the market value of assets received by bondholders as a percentage of the par value of the bonds. Id. at 10-11.

10 Macroeconomic variables included debtors' ratio of liabilities to assets, return on assets, the debtor's industry leverage rates, T-Bill rates and other financial factors relating to the value of the debtor, the strength of the debtors' industry and general economic conditions at the time of the default and bankruptcy. Id. at 11-13.

11 The four indications of bankruptcy complexity considered in the study were (1) the number of creditor classes; (2) total assets of the debtors; (3) whether the default was triggered for nonfinancial reasons such as fraud, product or environmental liability or labor issues; and (4) unionization of the debtor. Id. at 13-14.

12 The authors tested what they termed the "Bankruptcy Process Variable" by evaluating the judicial experience of the judge presiding over a case and determining whether multiple judges oversaw a case. Id.

13 The instrumental variables considered in the paper were: (1) whether disruption of the bankruptcy courts where the cases were pending and (2) the cost of document retrieval. Id. at 15-16.

14 Id. at p. 20.

15 Id. at p. 17.

16 Id. at 20-21; 22 of the sample were in bankruptcy less than 19 months and 24 of the sample were in bankruptcy significantly longer than optimal 19-month period.

17 Id. at 26.

18 Id. at 27.

19 See Bowles and Lubben, "The ABI Chapter 11 Professional Fee Study—An Update," 25 ABI J. 106 (2006).

Journal Date: 
Wednesday, November 1, 2006