Bankruptcy as an Auction Process: Lessons from Sweden

by B. Espen Eckbo, Tuck School of Business at Dartmouth College and

Karin S. Thorburn, Norwegian School of Economics and Business Administration

The U.S. bankruptcy system seems to be fundamentally flawed. It is expensive, it exacerbates

conflicts among different classes of creditors, and it often takes years to resolve individual cases...
[The] value of viable businesses is destroyed…in providing life support for terminal cases.
— Michael C. Jensen (1991)

When firms can be sold as going concerns, the need for the traditional negotiated plan
of reorganization disappears…Today the Chapter 11 of a large firm is an auction of the assets,
followed by litigation over the proceeds…[The era of] the law of corporate reorganizations…
has come to an end. — Douglas G. Baird and Robert K. Rasmussen (2002)

C
ompanies facing the prospect of defaulting on a
loan or debt instrument have two basic options:
(1) attempt a private workout (which, if success-
ful, results in a change in debt terms and/or an
exchange of equity for debt) or (2) file for a court-super-
vised “one size fits all” bankruptcy. The optimal design of
formal bankruptcy procedures is a controversial issue. From
an economic standpoint, the main goal of bankruptcy is to
reallocate control rights over corporate assets to their most
efficient users. That is accomplished by deciding which
distressed companies should continue as going concerns, and
which should be liquidated piecemeal. And having made that
decision, the system should then aim to ensure the largest
possible recoveries for creditors.
To accomplish this goal, bankruptcy procedures are designed
to prevent a creditor race to claim collateral assets, to set rules
for bargaining between claimholders, and to reduce some of the
information problems inherent in private workout attempts. But
the devil is in the details, and the specific design of a bankruptcy
code can have major effects—negative as well as positive—on the
future operating performance and value of the filing company.
1. Until 2003, secured creditors in the U.K. could appoint a receiver who looked after
their interests and decided whether to restructure the firm or sell its assets. Changes in
2003 moved the U.K. code closer to the U.S. system.
A poorly designed code can create costly conflicts among
security holders and destroy firm value by putting control over
corporate resources into the wrong hands.
For reasons that are poorly understood, different
countries have developed substantially different approaches to
bankruptcy. For example, the U.S. and U.K. systems occupy
the opposite poles of a continuum in terms of their allocation
of rights between creditors and their corporate debtors. In
the U.S., a filing under Chapter 11 of the U.S. Bankruptcy
Code substantially restricts creditor rights through its “stay”
of debt claims. The aim of this provision is to allow compa-
nies to continue to operate in bankruptcy while their capital
structures get reworked. At the other extreme is the U.K.
receivership procedure, which is largely a contract-oriented
system in which creditors have the upper hand. In the
U.K., assets pledged as collateral may be seized by creditors
even if they are vital for the filing companies, effectively
reducing the chance that they emerge from bankruptcy as
going concerns.1
Between these two poles is a third type of system—a
mandatory auction procedure—that has been developed in

38 Journal of Applied Corporate Finance • Volume 21 Number 3 A Morgan Stanley Publication • Summer 2009
Sweden. While this code also provides the strong protection
of the filing firm (stay of debt claims) found in the U.S., it
shifts control of the firm to a court-appointed trustee that is
charged with conducting an auction of the firm’s assets. As
a result, the court-supervised renegotiation of the senior or
secured debt that is so common in the U.S. is not an option
in Sweden even when the firm is viable as a going concern.
But if the U.S. system has long been recognized to be
more friendly to corporate debtors (and their managements),
there is a distinct trend in the U.S. toward greater reliance on
the auction mechanism in Chapter 11. In the past year, for
example, auctions have been used as a way of cleaning up the
balance sheets of financially distressed banks, and of restruc-
turing large companies like GM and Chrysler. The trend
towards auctions raises a number of important questions
about the likely economic effects of a systematic use of the
auction mechanism to resolve bankruptcy:
• Are bankruptcy auctions likely to attract high-value
bidders from the same industry as the target, given that these
rival firms may also be financially distressed?
• Since the auction process virtually eliminates the
bargaining power of incumbent management, are manag-
ers likely to “hang on” to the firm too long before filing for
bankruptcy?
• Are bankrupt firms purchased as going concerns gener-
ally restructured efficiently by the buyers?
For U.S. policy makers, the larger question here is
whether a bona fide auction bankruptcy system—one where
all important constituencies expect companies to be put
up for sale quickly—is likely to be more efficient than the
current voluntary system under Chapter 11. The question
comes down to whether it makes economic sense to limit the
right of managers to choose reorganization in Chapter 11 by
requiring auctions.
There is little systematic empirical evidence on the effects
of bankruptcy auctions conducted in the U.S. Nevertheless,
some answers to the above questions can be inferred from our
recent research on the effects of the Swedish auction system.
The main findings of this research are summarized in the
pages that follow.2
The U.S. Trend Toward Auction Bankruptcy
A core tenet of economics is that, in well-functioning capi-
tal markets, auctions tend to produce efficient reallocations
of corporate resources. The winning bidder has an economic
incentive to implement the highest-valued restructuring strat-
egy, which generally includes asset dispositions as well as the
choice of capital structure and top management as the firm
continues as a going concern after bankruptcy. The buyer’s
2. The research on Swedish bankruptcy auctions appears in Thorburn (2000),
Stromberg (2000), and Eckbo and Thorburn (2003, 2008, 2009). Full citations for all
articles are provided in the Reference section.
3. For a recent review of the empirical literature on corporate takeovers, see Betton,
Journal of Applied Corporate Finance • Volume 21 Number 3
ability to implement a new higher-valued strategy, coupled
with competitive bidding, lead to high selling prices in an
auction setting. We therefore expect creditors to push for the
auction mechanism when other forms of bankruptcy proceed-
ings are perceived to be more costly and less efficient.
Consistent with this argument, a much-cited 2003 study
of U.S. bankruptcies by Douglas Baird and Robert Rasmus-
sen reported a substantial increase in the use of accelerated
sales and auction processes in Chapter 11. Specifically, they
reported that more than half of all large Chapter 11 cases
reorganized in 2002 used some kind of auction (or sales)
mechanism. The shift toward auction-like mechanisms has
been accompanied by the growing use of “pre-packaged”
bankruptcy filings (where a reorganization plan has been
worked out prior to filing), and by the rise of an active second-
ary market for publicly traded distressed debt claims (which
helps increase the efficiency of in-bankruptcy governance and
voting procedures).
These changes are clear evidence of a growing recogni-
tion that market-driven transactions executed through an
orderly acquisition process are a cost-effective alternative to
Chapter 11 reorganizations. But this development should
not come as a surprise, given the well-documented role of
the U.S. corporate takeover market in changing control of
resources and increasing efficiency outside of bankruptcy.3
While acquiring a bankrupt target may in some respects
be more complicated than acquiring a financially healthy
company (involving issues of transaction initiation, transpar-
ency and execution), it seems only natural that Chapter 11
proceedings have begun to take advantage of the methods
and experience developed in the highly sophisticated U.S.
market for corporate control.
Two studies suggest that companies acquiring targets
in bankruptcy tend to realize significant shareholder gains.4
Such gains are attributed in large part to restructuring and
governance improvements following the takeover. Consistent
with this, a third study reports that sales of plants by Chapter
11 companies in high-growth industries lead to increased
plant productivity, suggesting that the auction mechanism
used in these sales promotes an efficient reallocation of corpo-
rate resources.5
On the other hand, acquirers’ bargaining power can result
in the purchase of the targets at discounts from the targets’
full value, which may account for part of the acquirer gains.
But how does one determine whether auction sales result in
such discounts?
The traditional method is to compare recovery rates
obtained in Chapter 11 reorganizations with those in sales.
And because we know that recovery rates in the U.S. are
Eckbo and Thorburn (2008) and Eckbo (2009).
4. Hotchkiss and Mooradian (1998) and LoPucki and Doherty (2007).
5. Maksimovic and Phillips (1998).
A Morgan Stanley Publication • Summer 2009 39
typically higher in reorganizations, it is tempting to conclude
that auctions lead to “fire sale” prices.6 But this conclusion
may be premature for the following reason: because a sale
out of Chapter 11 is voluntary in the sense that it requires
approval of both managers and creditors, the U.S. evidence
on auctions is likely to reflect a disproportionate number of
sales where the eventual outcome is likely to be piecemeal
liquidation as opposed to the restructuring and preservation
of a going concern. That is, given management’s control of the
Chapter 11 restructuring process, those bankrupt companies
that end up being put up for sale are likely to be those with a
relatively low going-concern value—and therefore have low
recovery rates per se.
Why would managers be more likely to support an
in-bankruptcy sale of a firm with relatively low going-
concern value? The answer most likely has to do with the
“private control benefits”—such as prestige and power—
that top managers derive from being at the company’s helm.
The prospect of losing those benefits following an auction
where managers are replaced creates a preference for trying
to reorganize the company rather than selling it. As a result,
U.S. managers tend to choose auctions only when the cost of
forgoing private benefits of control is relatively low.
In the presence of this managerial “self-selection bias,”
the reported recovery rates in Chapter 11 auctions provide a
downward biased estimate of the recovery rates companies
actually reorganized in Chapter 11 would have obtained had
they been auctioned instead. And as a consequence, we don’t
really know the extent to which auctions organized under
Chapter 11 would result in company fire-sales.
This fundamental problem of self-selection bias does not
exist in a bankruptcy system where auctions are mandatory—
where managerial discretion over the auction decision has
been removed. We now turn to such a system and a descrip-
tion of its actual economic effects.
Anatomy of Sweden’s Auction Bankruptcy System
Sweden’s auction bankruptcy system requires an immediate
sale of the bankrupt company. After the filing, control of the
firm is transferred to an independent, court-appointed trustee
with fiduciary responsibility to all creditors. The trustee’s
main task is to conduct and oversee the sale of the firm in an
open-bid, cash-only auction.
Before the auction begins, the trustee produces an
estimate of the value of the bankrupt company if liquidated
piecemeal that is based on input from industry experts. The
auction itself then establishes whether anyone is willing to
pay a premium over the piecemeal liquidation value in order
to continue the firm as a going concern (with its core assets
intact). Buyers are free to place bids for individual assets
6. See, e.g., LoPucki and Doherty (2007).
7. Prepacks are rarely overturned (Thorburn 2000). Trustees are certified and super-
vised by a government agency (“Tillsynsmyndigheten i Konkurs” or TSM), which reviews
40 Journal of Applied Corporate Finance • Volume 21 Number 3
(piecemeal liquidation) or for the entire firm as a going
concern—and the highest bidder wins. If no bid comes up for
the company as a going concern, the assets are sold piecemeal.
And thus, in the Swedish system it is the auction bids—and
not the bankruptcy court, as in Chapter 11—that effectively
determine whether the firm is going to be liquidated piece-
meal or continued as a restructured going concern.
Companies sometimes also negotiate a sale right before
filing—which we refer to as an “auction prepack,” and which
is also subject to the trustee’s approval.7 In cases where an
insider of the bankrupt company is the only bidder (attempt-
ing to buy back the firm), the trustee is required to search for
competing bids before approving the “saleback.”
Though it has no provision for reorganizing secured debt,
Swedish insolvency law does provide a forum for renegotiating
unsecured debt that is called “composition.” In a composition,
however, secured debt and priority claims (taxes and wages)
must be offered full repayment, and junior creditors at least
25% of their claim. These high thresholds make composi-
tion uneconomic for the vast majority of distressed firms.
Because several claims tend to be impaired in bankruptcy,
composition is in fact rare. Moreover, recent reforms have
introduced other reorganization provisions (“företagsrekon-
struktion”) that, like composition, have failed to attract
much interest from distressed firms.8 Thus, for all practical
purposes, Sweden’s system has no effective option for the
court-supervised renegotiation of debt contracts.
Table 1 compares key aspects of this auction system with
that of Chapter 11. Notice first that, as in Chapter 11, a filing
triggers the automatic stay of debt payments and prevents
repossession of collateral. Moreover, the filing company may
raise debtor-in-possession (DIP) financing to pay operating
expenses while in bankruptcy. In practice, DIP financing
does not happen because the typical auction resolves the
bankruptcy quickly (within two months, on average), so there
is little need for external interim financing. In sum, while the
firm must be sold in an auction, the Swedish system provides
both debtor protection and financing opportunities for an
orderly auction process.
The buyer in the auction must pay for the target firm in
cash. Since the auction establishes the market value of the
firm, and since this market value is paid in cash, creditors are
paid in strict accordance with absolute priority (APR)—that
is, senior claims must be paid in full before any junior claims.
This again is in contrast to Chapter 11, where restructurings
often involve deviations from APR, particularly for larger
firms with complex capital structures where junior creditors
tend to form creditor committees to influence the outcome.
In Chapter 11, deviations from APR—where junior claim-
holders are given some recovery even when senior creditors
the trustees’ compensation and ability to hold a proper arms-length auction. Trustee
compensation is typically independent of the auction outcome.
8. Buttwill and Wihlborg (2004).
A Morgan Stanley Publication • Summer 2009
Table 1 Characteristics of Swedish Auction Bankruptcy and U.S. Chapter 11 Reorganization

Characteristic Swedish auction bankruptcy Chapter 11 Reorganization

Right to file The firm or any individual creditor. The firm or a joint filing of at least 3 creditors with
unsecured claims exceeding $5,000.

Control rights in Court-appointed trustee. All labor contracts with the Employees retain in principle their labor contracts
bankruptcy firm, including those of the top management, are termi- with the firm, and incumbent management (except in
nated. The trustee may choose to retain management to cases of fraud) maintain control rights. However, the
run firm during auction process. bankruptcy judge approves major decisions.

Resolution mechanism Firm is sold in an auction, either piecemeal or as a going Management has exclusive right to propose a reorga-
concern, depending on the bids. nization plan and seek creditor approval during a
six-month period.

Voting rules Redundant. Highest bidder buys the assets. One half in number of votes and two thirds in value
of claims in each debt class. Judge can force (“cram
down”) plan on dissenting class.

Settlement Claims paid in cash according to their absolute priority. Claims paid in cash and new debt and equity securi-
ties. Absolute priority may be violated.

Firm protection Stay of debt payments and assets. Debtor-in-possession Stay of debt payments and assets. Debtor-in-posses-
financing legal, but largely irrelevant due to speed of sion common for publicly traded firms.
auction.

are not paid off in full—have often been used as a “sweet-
ener” to encourage acceptance of a restructuring proposal.
In the auction system, however, the winning bid automati-
cally completes the deal with no deviations from APR
necessary. Perhaps for this reason, the U.S. trend towards
bankruptcy auctions has been accompanied by a reduction
in the incidence of priority violations under Chapter 11 (a
topic we return to later).
Requiring bidders to settle the payment for the target in
cash could conceivably prevent some cash-constrained bidders
from participating in the auction.9 If the cash constraint is
widespread, auction prices could be lower as a result. On the
other hand, there is a way for would-be buyers to effectively
relax the cash constraint. Buyers in going-concern sales may
choose to structure the acquisition either as a merger or, if
cash constrained, as a leveraged buyout (LBO). In a merger,
the buyer finances the cash payment using retained earnings
and the proceeds from securities issued by the acquiring firm.
In an LBO, by contrast, the target assets are placed in a new
company, and the cash payment is raised by issuing securi-
ties directly on this buyout firm. In the sample of Swedish
companies discussed below, two-thirds of the going-concern
sales were structured as LBOs.
In addition to mandating an auction, the Swedish system
differs fundamentally from Chapter 11 in that a bankruptcy
filing automatically terminates all labor contracts, includ-
ing those of top management. Key employees are kept on
for the duration of the auction period through their period
of notice (often up to six months) and, if necessary, with
temporary consulting-type contracts. In the Swedish system,
as noted earlier, it is the auction bids that effectively deter-
mine whether the firm is going to be liquidated piecemeal
or continued as a restructured going concern. Thus, an
employee may continue to work for the firm after filing only
if the winning bidder decides to continue the firm and rehire
the employee. The rehiring decision depends, of course, on
the quality of the employee; and as discussed further below,
the evidence suggests that only the highest-quality CEOs
tend to be rehired.
Auction versus Reorganization: Potential Inefficiencies
Table 2 summarizes some of the potential for economic distor-
tions and inefficiencies in reorganization and auction systems.
We first provide a brief discussion of these issues to set the
stage for the review of the empirical evidence that follows.
Thanks in large part to the speed of the Swedish auction
process, the evidence suggests that both the direct and indirect
bankruptcy costs associated with auctions (the out-of-pocket
legal and transaction fees as well as disruptions of investment
and operating plans) are relatively low, as compared to those
experienced by U.S. companies in Chapter 11. Also, keep
in mind that the winning bidder—and, again, not the court
or creditors, as in Chapter 11—determines the company’s
new capital structure and focuses the firm’s operations. As
the firm’s new owner and residual claimant, the buyer bears
the cost of making poor restructuring decisions. As a result,
the auction system tends to promote an efficient allocation
of control rights.

9. Aghion, Hart and Moore (1992).

Journal of Applied Corporate Finance • Volume 21 Number 3 A Morgan Stanley Publication • Summer 2009 41
Table 2 Reorganization vs. Auction Bankruptcy: Potential Inefficiencies

Type of inefficiency Auction Reorganization

Direct and indirect costs Relatively low due to fast and simple auction process. Substantial due to large numbers of lawyers and bankers
representing the different committees, and drawn-out
proceedings.

Allocation of control Assets allocated to highest bidder in the auction. Assets allocated to the residual class of claimholders.
of assets

Excessive continuation? Unlikely that buyer would invest in continuation unless Managers may force a continuation of the operations
profitable. also when it is optimal to liquidate or to transfer control
of the firm to more efficient users of the firm’s assets.

Excessive liquidation? Viable firms could be liquidated prematurely if high- Bias toward continuation limits chance of liquidation.
value bidders are constrained from participating in the
auction.

Asset fire-sales? Price discounts may occur if high-value bidders are Court-supervised reorganization counteracts fire-sales.
liquidity constrained or it is costly to prepare a bid.

Risk shifting and Managers may take on excessively risky projects and With continued control in bankruptcy, managers may be
delayed filing? delay filing in an attempt to avoid a loss of control encouraged to file in a timely manner.
through the auction.

But this conclusion comes with two important condi-
tions:
• The auction must be sufficiently liquid to avoid fire-sales
and a premature breakup of the firm (excessive liquidation).
• The prospect of an automatic auction facing CEOs
must not cause them to distort the firm’s investment policy
in an attempt to stay out of bankruptcy and avoid being fired
(costly risk shifting).
The potential for a fire-sale is a concern when conduct-
ing any kind of auction. A fire-sale discount results when the
final auction price is lower than the fundamental value of the
assets (that is, their value in their best alternative use). This
may happen if demand for the firm’s assets is temporarily low
while the auction takes place.
For example, since financial distress tends to be “conta-
gious” within an industry, industry rivals that may be the
logical (highest-value) acquirers may themselves be finan-
cially constrained and unable to bid in the auction. Industry
debt overhang could also discourage industry rivals from
investing in the bankrupt firm. To the extent industry rivals
are unwilling to bid, the risk increases that lower-valuation
industry outsiders win the auctions—and at fire-sale prices.
The chance of this happening is greater for companies that
consist largely of unique or highly firm-specific assets, which
tend to attract fewer potential buyers.
As for the possibility of costly risk-shifting, because the
auction bankruptcy system automatically terminates all labor
(including management) contracts, there is a concern that
managers may decide to take on excessively risky investment
projects in order to delay filing or stay out of bankruptcy
altogether. The combination of shareholders’ limited liability
and the automatic labor contract termination could cause
managements facing the prospect of an auction to gamble
with creditors’ money. An example would be to liquidate
relatively safe assets and invest the proceeds in high-risk
ventures. Although this kind of risk-shifting benefits stock-
holders (and possibly managers), it comes at the expense of
creditors and in some cases lowers total firm value.10
But in a 2003 article, we pointed out that, particularly
in a context such as the Swedish auction bankruptcy system
where managers are facing automatic termination, risk-
shifting incentives are reduced and perhaps dominated by
other incentives: the private benefits associated with retain-
ing control. Since retaining control at a minimum requires
preserving the company as a going concern going into the
bankruptcy auction, it is possible—perhaps even likely—that
CEOs of troubled companies opt for a conservative investment
policy prior to filing.11 We return to this argument in light of
the empirical evidence discussed below.
In contrast to the auction system, a reorganization
procedure such as Chapter 11 leaves asset control in the
hands of the debtor (de facto the management) and requires
a voting procedure for creditors to accept restructur-
ing proposals. The essence of Chapter 11 is to provide a
legal framework for the bankrupt firm to restructure its
impaired debt claims while continuing to operate as a going
concern in bankruptcy. As mentioned earlier, to help the
firm continue its operations in bankruptcy, pressures for

10. The risk-shifting argument appears in Jensen and Meckling (1976). 11. Eckbo and Thorburn (2003).

42 Journal of Applied Corporate Finance • Volume 21 Number 3 A Morgan Stanley Publication • Summer 2009
Table 3 Description of the Swedish Bankruptcy Sample, 1988-1991

Sample characteristic All filings Going concerns Prepack sales Piecemeal liquidations

Number of cases a
263 147 53 60

A: Pre-filing firm average characteristicsb

Total assetsc ($ mill.) 3.8 3.8 4.1 3.7

Total salesc ($ mill.) 7.7 7.0 9.2 8.2

Number of employees 45 43 47 35

Operating margin (EBITDA/ -0.2 0.4 0.1 -1.8

sales, in %)

Debt to total assets (in %) 92 94 87 93

B: Firm average characteristics at bankruptcy filing

Fraction of debt that is 39 40 30 42

secured (in %)

Percent CEOs with ≥10% 74 72 77 77

of equity

C: Auction characteristics

Average auction proceedsc 1.3 1.5 1.1 1.0

($ mill.)

% of auctions with multiple n/a 75 n/a n/a

buyers expressing an inter-
est in placing a bid

% of auctions where the 49 46 57 n/a

bankrupt firm’s bank
finances the winning
bidder

Average auction premiumd 94 125 n/a 8

(in %)

Average total recovery rate 35 39 31 27

(in %)

Average bank recovery rate 70 76 77 50

(in %)

a
The outcome of the auction could not be determined for three cases.
b
The financial data is from the last public statement prior to bankruptcy, dated on average 16 months before filing.
c
The values are denominated in 2007 prices, adjusted by the consumer price index.
d
The proceeds received in the auction in excess of and as a percentage of the trustee’s pre-auction estimate of the piecemeal liquidation
value of the firm’s assets.

immediate liquidation are temporarily eliminated by staying
all debt claims and by permitting the firm to raise cash
through new, super-priority debt instruments (debtor-in-
possession or “DIP” financing).
Chapter 11 proceedings, then, are management-driven
in the sense that management has the exclusive right to
propose a restructuring plan, which is then voted up or
down by creditors.12 Proponents of this system argue that it
effectively preserves value by encouraging management to file
sooner than otherwise, when problems are presumably more
manageable. And by so doing, Chapter 11 is said to minimize
the potentially costly efforts to delay bankruptcy filing that
are thought to arise in an auction system.13
But critics of Chapter 11 see things very differently. They

12. If voted down, the Bankruptcy Court routinely allows management another try. A
proposal is approved by impaired creditors provided at least one-half in number of votes
and two-thirds in value of claims in each debt class are in favour. Judge can cram down
plan on dissenting class. The Bankruptcy Reform Act of 2005 limits the exclusivity pe-
riod (for management to propose a reorganization plan) to a maximum of 18 months.
13. When Chapter 11 was introduced in 1978, the consensus among lawmakers was
that Chapter 11 would provide sufficient time and managerial protection to avoid filing
delays and excessive liquidations.

Journal of Applied Corporate Finance • Volume 21 Number 3 A Morgan Stanley Publication • Summer 2009 43
question the wisdom of letting the same people who got the
company into trouble maintain control of the firm’s assets in
bankruptcy. The risk is that management continues to operate
the firm even when liquidation would be more efficient or, as
Michael Jensen puts it (in our opening quote), Chapter 11
ends up providing “life support for terminal cases.”
In sum, although Chapter 11 may provide a safeguard
against excessive corporate liquidations, it may instead cause
the opposite problem—excessive continuations. The essence
of the auction system is that it reallocates the distressed firm’s
resources based on market values to the highest bidder in the
auction. The auction process is relatively quick and straight-
forward, which lowers direct bankruptcy costs. The highest
bidder gains the right to restructure both the asset side and
the financial side of the balance sheet, improving economic
efficiency relative to a court-administered restructuring. Still
another benefit of auctions is that creditors are paid off with
cash strictly according to absolute priority, which increases
the value of priority covenants in debt contracts and hence the
value of the debt itself. The potential downsides of auctions
are the possible incentive for risk shifting prior to filing and
illiquid auctions leading to fire-sale prices and perhaps prema-
ture liquidation of the firm.
We now turn to the empirical evidence on these issues
and provide a comparison with the existing evidence on
Chapter 11.
Characteristics of the Swedish Auction Sample
The empirical results summarized below are based primar-
ily on our recent research using 263 bankruptcy auctions
by privately held Swedish companies that filed during the
period 1988-1991. The sample characteristics are described
in Table 3. The auction sample is a subset of the popula-
tion of 578 bankruptcy filings by companies with at least 20
employees that filed in one of the four most populous prov-
inces in Sweden.14 As shown in Table 3, three-quarters of
the auctioned companies ended up being purchased as going
concerns, with the remaining one-quarter sold piecemeal.
The companies preserved as going concerns were either sold
in the bankruptcy auction (147 firms) or in a prepackaged
sale (auction prepack) arranged by the firm shortly before
filing (53 cases).15
Panel A of Table 3 shows characteristics from the last
publicly filed financial statement, which was provided on
average 16 months (median 15 months) prior to filing. All
values are in 2007 dollars, adjusted with the consumer price
index (from Statistics Sweden). The average filing company
is relatively small, with total assets of $4 million, total sales
14. The four provinces are Stockholms län, Göteborg och Bohus län, Malmöhus län,
och Upplands län. Case-specific information is collected manually from the bankruptcy
records kept on file at the supervisory authority (TSM) in each province.
15. One-third of the filing firms were in manufacturing industries and one-fifth in
various trade industries, with the remaining firms relatively evenly distributed across
construction, transportation, services, and miscellaneous other industries.
44 Journal of Applied Corporate Finance • Volume 21 Number 3
of $8 million and 45 employees. Notice, however, that this
is somewhat larger than the typical firm reorganized in U.S.
bankruptcy.16
Not surprisingly, companies tend to perform poorly prior
to filing, with an average operating margin (EBITDA/sales)
of -0.2%. Those companies that end up surviving bankruptcy
as going concerns typically exhibit better pre-filing operat-
ing performance than firms that are liquidated piecemeal.
The average filing firm is highly leveraged, with a book-value
debt-to-assets ratio of 92% according to the last financial
statement before filing.
Panel B of Table 3 shows corporate characteristics at filing,
based largely on information contained in the bankruptcy
file. A substantial fraction of the debt (on average 39%) is
secured. This debt is held largely by banks and secured by real
estate and other fixed assets, as well as ”floating” assets such
as inventory and accounts receivables. Most of the compa-
nies are run by owner-managers, with three-quarters of the
CEOs owning at least 10% of the filing firm’s equity. Since
the equity is wiped out in bankruptcy, this ownership has
substantial wealth implications for the CEO.
As shown in Panel C, the proceeds generated by the
auction are substantially lower than the pre-filing book
value of the assets. The difference is attributable primarily to
various assets sales and other restructuring efforts undertaken
prior to filing. More importantly, companies sold as going
concerns in the auction generate a substantial premium over
their piecemeal liquidation value estimates announced at the
beginning of the auctions.
In what follows, we review key empirical findings on
(1) bankruptcy costs, (2) auction liquidity and bidder compe-
tition, (3) premiums and debt recovery rates, (4) fire-sales,
(5) post-bankruptcy performance, and (6) risk-shifting and
CEO income effects. The main results are summarized
in Table 4. We make comparisons to Chapter 11 evidence
when possible.17
Bankruptcy Costs
The direct costs of the bankruptcy process, such as court fees
and payments to lawyers and consultants, directly reduce the
funds available to creditors. The direct costs for the Swed-
ish companies in the sample average 4-6% of the pre-filing
book value of assets and 13-19% of the proceeds generated in
the auction. The direct costs decrease with firm size, suggest-
ing that there is a fixed component to bankruptcy costs. In
comparison, the direct costs of U.S. bankruptcy range across
different studies from 1% to 10% of the book value of assets,
with an average of 6.5% (also decreasing with firm size).
16. Chang and Schoar (2006) report average sales of $2 million and 22 employees
for a random sample of 5,000 Chapter 11 filings from 1998-2004.
17. For a comprehensive survey of empirical studies on Chapter 11, see Hotchkiss,
John, Mooradian and Thorburn (2008).
A Morgan Stanley Publication • Summer 2009
Table 4 Evidence on Swedish Bankruptcy Auctions and Chapter 11 Reorganizations*

Issue Swedish Auction Bankruptcy U.S. Chapter 11

Direct costs: 4-6% of book value of total assets; 13-19% of market 6.5% of book value of total assets; averages ranging
value. Costs decrease in firm size. from 1-10% across various samples.

Time in bankruptcy: Business sold after 2 months. 2 years.

Creditor recovery: 35% total recovery (paid in cash); 39% in going concern 60% based on face value of distributed claims, 41%
sales and 27% in piecemeal liquidations. using market values.

Firm survival: 75% of firms are sold as a going concern. 60% of firms exit as independent firms or are acquired.
Survival rates are higher for large firms.

Fire sales: Fire-sales in piecemeal liquidations but not in going Reorganization value in traditional Ch. 11 proceedings
concern sales. Banks often finances a buyer, increasing exceeds sales proceeds in 363 auctions as a fraction of
liquidity in the auction. pre-filing value of total assets.**

Post-bankruptcy perfor- Less than 20% of surviving firms show operating losses. 20-40% of emerged firms continue to show operating
mance: The performance is at par with industry rivals. losses. Two-thirds of the firms underperform industry
rivals over a five-year period.

Bankruptcy refiling: One-third of firms refile for bankruptcy within five years. One-third of emerging firms subsequently need to
restructure the debt through bankruptcy refiling or an
out-of-court workout.

CEO turnover: 61% of incumbent CEOs lose their job; 39% are rehired Three-quarters of CEOs in place two years prior to filing
by the buyer in the auction. Buyers screen CEOs on are replaced within two years of filing.
quality.

CEO compensation: CEOs experience a substantial income drop following Managers who retain their position take a substantial
bankruptcy, rehired or not. pay cut. The compensation is often tied to the success
of the debt restructuring.

* The evidence on the U.S. Chapter 11 is reviewed in Hotchkiss, John, Mooradian and Thorburn (2008) and the
evidence on Swedish auction bankruptcy is from Thorburn (2000) and Eckbo and Thorburn (2003, 2008, 2009).
** LoPucki and Doherty (2007).

In light of the much larger firm size in most of the U.S.
studies (which include publicly traded companies), auction
bankruptcy almost certainly involves lower direct costs than
reorganization under Chapter 11.
The fact that Chapter 11 (but not Swedish auctions)
permits deviations from APR further adds to the cost of debt
(in the form of higher effective interest rates). But, as noted
earlier, such deviations have been declining in the U.S. For
example, a recent study of over 500 large-firm Chapter 11
filings between 1991 and 2005 reports that, while over 25%
of the bankruptcies in the 1990s involve deviations from APR,
less than 10% after the year 2000 record such deviations.18
This stricter upholding of APR suggests a shift in the admin-
istration of Chapter 11 toward greater emphasis on creditor
rights, which in turn is likely to be a direct consequence of
the greater use of auction mechanisms in Chapter 11.
Indirect costs of bankruptcy, such as those associated with
declining customer demand, lack of management focus on
the business, and loss of key employees can further reduce the
total value available to creditors. Such indirect costs normally
increase with the length of time that a company spends in
bankruptcy. In Sweden, the bankrupt firm is typically sold
as a going concern after only two months—a much quicker
process than what is typically observed for Chapter 11
cases. Studies of Chapter 11 cases report an average time in
bankruptcy of about two years, with a substantially shorter
period (less than one year) for prepackaged filings.
Auction Liquidity and Bidder Competition
How competitive are the Swedish bankruptcy auctions? In
two of our own recent studies, we address this questions using
information on bidders recorded by the bankruptcy trustees.19
These records contain information on both actual and poten-
tial bidders—firms or investors who are recorded as expressing
substantial interest in submitting bids to the trustee. Poten-
tial bids create competition even in cases where a bid fails
to materialize. As shown in Panel C of Table 3, multiple
bidder interest occurs in 75% of the sample of going-concern

18. Bharath, Panchapegesan, and Werner (2007). A similar conclusion is reached by 19. Eckbo and Thorburn (2008, 2009)
Ayotte and Morrison (2007), who find that 6% or less of a sample of 153 large corporate
Chapter 11 filings in 2001 violate absolute priority rules by distributing any value to
equityholders (excluding warrants).

Journal of Applied Corporate Finance • Volume 21 Number 3 A Morgan Stanley Publication • Summer 2009 45
Figure 1 Frequency of Number of Interested Bidders and Actual Bids in Automatic Bankruptcy Auctions
40
Interest Bids
35
30
Number of Bankruptcy Auctions
25
20
15
10
0
1 2 3 4 5 6
Number of Interested Bidders and Actual Bids per Auction
auctions with available data, suggesting that bankruptcy
auctions attract substantial bidder competition. 20
Figure 1 shows the frequency distribution of actual and
potential (interested) bidders in going-concern sales. The
number of actual bids ranges from one to 22, with a mean
of 3.5. The number of interested bidders (which includes the
actual bids) ranges from one to 40, with an average of 5.5
(median 3.0). There are multiple actual bids in a majority
(63%) of the going-concern auctions. Interestingly, the bid
frequency reported here for automatic bankruptcy auctions
is somewhat higher than both the number of bids per target
in U.S. tender offers and the number of bidders reportedly
involved in pre-merger talks with targets.21
The major creditor of the filing firms is almost always a
single bank, which is typical of Sweden’s small-firm environ-
ment. This same bank also frequently finances a bidder in
the auction. As shown in Panel C of Table 3, the original
bank finances the winning bidder in almost half (49%) of
the cases, including 20 of the 35 auction prepacks and 44 of
the 95 going-concern auctions where we were able to find
information on bank financing.22 Importantly, this financing
opportunity effectively increases bidder liquidity and access
to cash in the auction. 23
20. We do not track bid frequencies in prepacks (where the trustee typically approves
the prepackaged purchase agreement) or in piecemeal liquidations (where the number of
bidder depends on the number of individual assets sold in the auction).
21. See Betton and Eckbo (2000) and Boone and Mulherin (2007) for bid frequen-
cies in U.S. takeovers outside of bankruptcy.
22. When the original bank does not finance the winning bidder, it either finances a
losing bid or none of the bids. There are no public records of the bank financing commit-
ments for losers in the auction.
46 Journal of Applied Corporate Finance • Volume 21 Number 3
7 8 9 10 11 12 13+
Auction Premiums and Debt Recovery Rates
Panel C of Table 3 shows average auction premiums and debt
recovery rates. The auction premium is the price paid by the
winning bidder in excess of the trustee’s liquidation value
estimate for the assets sold in the auction.24 The premium
averages 8% for piecemeal liquidations. That is, when the
firm is liquidated piecemeal, the various buyers of the indi-
vidual assets pay a price that is very close to the trustee’s initial
piecemeal liquidation value estimate.
In contrast, the premium paid in going-concern sales
averages 125%. Thus, here the price is more than double
the trustee’s initial piecemeal liquidation value estimate.25
This substantial going-concern premium directly reflects the
market value of continuing to operate the firm with its core
assets intact, and it is generally consistent with the proposition
that the auctions tend to be competitive and liquid.
Turning to recovery rates, Panel C lists the average value
of the total debt recovery rate, as well as the recovery rate of
the main creditor (the bank). Figure 2 shows the frequency
distribution of the bank recovery rate. The total recovery rate
is calculated by dividing the proceeds distributed to all of
the firm’s creditors by the face value of total debt. It averages
35%, with 39% recovery in going concern sales and 27%
23. In Eckbo and Thorburn (2009), we show empirically that the existence of bank
(creditor) financing puts upwards pressure on auction premiums.
24. Non-core assets such as real estate holdings, accounts receivables, securities,
cash holdings, etc., are often sold or collected separately even if the firm’s core opera-
tions are auctioned as a going concern.
25. The trustee typically does not report a piecemeal liquidation value estimate for
auction prepacks, precluding a premium comparison for this subsample.
A Morgan Stanley Publication • Summer 2009
Figure 2 Frequency distribution of bank debt recovery rates in Swedish auction bankruptcy
80
70
60
50
Number of Cases
40
30
20
10
0
0–9 10–19 20–29 30–39 40–49
Recovery Rate in %
recovery in piecemeal liquidations. The bank recovery rate
averages 69% of the face value of bank debt. Bank recovery
rates are on average significantly higher in prepacks and in
going-concern auctions (77% and 76%, respectively) than in
piecemeal liquidations (50%).
It is interesting to compare these auction recovery rates to
the approximately 60% recovery rate that has been reported for
Chapter 11 reorganizations. Recall first that creditors are paid
in cash (market value) in Swedish bankruptcy while in Chapter
11 the majority of claims are paid off with new non-traded
claims on the emerging firm. The absence of market values
for these non-traded claims causes most U.S. studies to use
the face value of the new claims to estimate creditor recovery.
Using face value almost certainly leads one to overestimate
true recovery rates.26 For example, one study of large U.S.
bankruptcy reorganizations reports a median recovery rate of
41% for a subsample where all new claims were publicly traded
(thus allowing the use of market values), while the median is
51% when using face value for the total sample.27
In sum, the empirical research suggests that the auction
system succeeds in preserving substantial going-concern value.
And when using market values of assets received by creditors,
there is no evidence that auction bankruptcy lowers creditor
recovery rates relative to Chapter 11 reorganizations.
26. For example, suppose I own a debt claim on a firm in Chapter 11, and expect to
recover 10% of the debt’s face value of $100. The reorganization gives me a new debt
claim with a face value of $50. The market value of this new debt claim may be any-
where between $10 (10% of the original claim) and $50. The tradition in the literature
is to estimate the value of this new debt claim as $50, which exceeds the security’s ex-
pected recovery rate.
Journal of Applied Corporate Finance • Volume 21 Number 3
50–59 60–69 70–79 80–89 90–99 100
Do Bankruptcy Auctions Produce Fire-sales?
Creditors prefer reorganizations to auctions if the latter lead
to significant fire-sale price discounts. Critics of bankruptcy
auctions argue that auctions are likely to generate low prices
because high-valuation industry insiders themselves tend to
be financially distressed at the time of the auction and unwill-
ing to bid.28 This argument is in part supported by empirical
evidence that suggests the existence of an industry-compo-
nent to bankruptcy risk.
Our response to this argument is that the existence of such
an industry component does not guarantee fire-sales since
buyers from outside the industry may be able to overcome a
valuation disadvantage relative to an industry insider by hiring
inside managers (think of the hiring practices of private equity
firms).29 In Sweden, one obvious group of inside CEOs are
those just fired after filing for bankruptcy, and the evidence
shows that the highest-quality CEOs are in fact often rehired
by the buyers in auctions. Thus, the existence of auction fire
sales is largely an empirical issue.
We recently estimated (cross-sectionally) the fundamental
value of the auctioned firms as a function of firm-specific
characteristics, such as firm size, pre-filing profitability, and
asset tangibility and specificity. We then measured the “fire-
sale discount” as the difference between this fundamental
27. Franks and Torous (1994).
28. Shleifer and Vishny (1992).
29. See Eckbo and Thorburn (2008). Industry insiders continue to have an advantage
over outsiders when the creation of synergy gains requires the bidder to own industry-
specific assets.
A Morgan Stanley Publication • Summer 2009 47
value and the realized auction price. 30 If this difference indeed
represents fire-sales, it should (1) increase with the degree of
financial distress in the target firm’s industry and (2) should be
larger when the winning bidder is an industry outsider.
To test these fire-sale propositions, we constructed
industry distress measures from the financial statements of
a population of 12,000 non-bankrupt Swedish firms for the
period 1987-1995. The industry distress measure incorporates
the fraction of industry firms that have an interest coverage
ratio of less than one (i.e. whose cash flow is insufficient to
cover the interest expense) and the median debt ratio in the
industry. Again, the fire-sale theory suggests that these indus-
try distress factors tend to lower auction prices by preventing
high-value bidders from participating in the auction.
Interestingly, the auction evidence does not support the
fire-sale theory when the firm is sold as a going concern.
That is, the fire-sale discount in continuation sales is not
significantly different from zero on average, and is (cross-
sectionally) independent of both the degree of industry-wide
financial distress and whether or not the buyer is an indus-
try insider or outsider. Again, as discussed above, there are
several plausible reasons for this important result. First, the
auctions appear quite competitive by the standard of the
takeover literature. Second, recall that buyers often struc-
ture the acquisition as a leveraged-buyout, a type of project
financing which circumvents potential liquidity constraints.
Third, there is an active market for inside managers available
to bidders outside the industry.
There is, however, some evidence of a small fire-sale
discount in auctions that result in piecemeal liquidations. In
these cases, auction prices tend to decline in the degree of
industry-wide distress: a 1% increase in industry distress
reduces auction prices by on average 2%. We show that the
probability of piecemeal liquidation is higher for targets
with relatively tangible assets, and higher when industry-
wide leverage ratios are high and the business cycle is in a
downturn. Thus, industry-wide distress appears simultane-
ously to increase the incidence of piecemeal liquidation and
to reduce prices somewhat.
Our study also shows that premiums in auction prepacks
are lower than premiums in regular going-concern sales. This
finding is consistent with the argument that auction prepacks
help prevent excessive liquidations: if the seller is particularly
concerned that the auction may produce a premature liquida-
tion of the firm’s assets, a buyer who is willing to negotiate a
purchase of the firm as a going concern is in a strong position
30. Eckbo and Thorburn (2008).
31. Interestingly, Strömberg (2000) suggests that a saleback (in which the previous
owner/manager buys back the firm) may also help counteract excessive liquidation. Con-
sistent with this, he finds that the saleback frequency increases with industry-wide finan-
cial distress. Under the liquidation pre-emption argument, one would also expect the
additional bidder bargaining power to drive saleback prices below prices in non-saleback
going-concern sales. In contrast with prepacks, however, we show that there is no evi-
dence of a premium differential in salebacks (Eckbo and Thorburn 2008).
48 Journal of Applied Corporate Finance • Volume 21 Number 3
to bargain down the offer price.31
Do sales in Chapter 11 produce fire-sale prices? One
recent study of Chapter 11 bankruptcies found that the
reorganization values (measured as a fraction of pre-filing
total assets) in traditional proceedings exceeded the sales
proceeds in 363 auctions.32 The conclusion reached by the
authors is that auctions under Chapter 11 lead to fire-sale
prices. But, as discussed above, a simple comparison of sales
with reorganizations in Chapter 11 is likely to be misleading
due to the voluntary selection process: namely, the tendency
of managers in Chapter 11 to accept—and creditors to push
for—the auction mechanism when asset values are low. Since
this selection process by itself produces lower recovery rates
in sales than in the typical Chapter 11 reorganization, more
research is needed before one can confidently conclude that
going-concern auctions in Chapter 11 lead to fire sales.33
We next turn to another set of predictions of the “exces-
sive liquidation” hypothesis. Namely, if the auction system
is not working, we should observe a relatively high liquida-
tion rate and/or relatively poor post-bankruptcy operating
performance by the companies that do survive. Looking first
at the question of firm survival, recall from Table 3 that three-
quarters of the filing firms in Sweden survive the auction
as going concerns. By comparison, studies of U.S. Chapter
11 reorganizations suggest that a lower frequency—60%
of filing firms—either emerge as independent firms or are
acquired (though survival rates in Chapter 11 are higher than
60% for larger companies). Thus, there is no evidence of
a higher liquidation frequency in the Swedish auction
bankruptcy system.
But what about another important gauge of restructuring
efficiency: the post-bankruptcy performance of the restruc-
tured firms? Is the post-bankruptcy performance of auctioned
firms superior to that of Chapter 11 survivors?
Post-bankruptcy Performance and Refiling Probability
Starting with the Swedish experience, we have shown that
the operating profitability of companies auctioned as going
concerns is on par with that of their industry competitors for
several years, and less than 20% of the firms report operating
losses.34 In contrast, two-thirds of the companies emerging
from Chapter 11 underperform industry rivals, with 20-40%
of the emerging firms continuing to show operating losses.35
Thus, while companies emerging from Chapter 11 reorga-
nization continue to perform poorly, the auction method
appears to restructure operations efficiently.
32. LoPucki and Doherty (2007).
33. Pulvino (1999) finds that sales of individual aircrafts by airlines in Chapter 11 are
discounted from an estimate of the intrinsic aircraft value. Thus, there is some evidence
that individual asset sales (as opposed to going-concern sales) may produce fire-sale
discounts in Chapter 11.
34. Eckbo and Thorburn (2003, 2008).
35. Hotchkiss (1995). The sample proportion with operating losses is greater for
years immediately following exit from Chapter 11.
A Morgan Stanley Publication • Summer 2009
Figure 3 Evolution of a Median income Index for Chief Executive Officers (CEOs) of Bankrupt and Non-bankrupt Firms
250
Median CEO Income Index
200
150
100
50
0
-3 -2 -1 0 1
Year Relative to the Year of Bankruptcy Filing (Year 0)
The poorer post-bankruptcy operating performance for
U.S. companies does not manifest itself in a higher rate of
subsequent default or bankruptcy. By one estimate, one-third
of the companies emerging from U.S. Chapter 11 reorgani-
zation refile for bankruptcy or require another out-of-court
workout within five years of exiting Chapter 11.36 But
this refiling rate is essentially the same as the refiling rate
following Swedish auctions. Given a superior post-bank-
ruptcy operating performance of auctioned firms, one would
expect the refiling rate in Sweden to be lower. One possible
explanation for this puzzle is the relatively smaller size and
higher post-bankruptcy debt-ratios of the auctioned firms
in our sample.
Effects of Bankruptcy on CEO Behavior
In their classic 1976 paper on agency costs, Michael Jensen
and William Meckling argued that when companies are faced
with financial distress, the limited-liability feature of equity
provides an incentive for shareholders to substitute high-risk
for low-risk projects. The essence of the argument is that if
the projects pay off, the firm is saved. If the projects fail, the
losses are borne by the creditors.
But, as we pointed out earlier, managers of distressed
companies are also likely to face other incentives that work
against such risk-shifting. Specifically, CEOs of distressed
36. Ibid.
37. If this happens, the CEO has effectively become the agent of the firm’s creditors
rather than of its shareholders. This managerial-conservatism argument, first developed
in Eckbo and Thorburn (2003), complements the traditional analysis of contractual ar-
rangements designed to regulate risk-shifting incentives. As documented in Smith and
Journal of Applied Corporate Finance • Volume 21 Number 3
2 3 4 5
firms may prefer to invest conservatively not to increase share-
holder value, but mainly to extend their own job tenures and
protect their private control benefits. Because bankruptcy
filings in Sweden summarily terminate managerial employ-
ment contracts—thereby amplifying any risk-shifting
incentives that already exist—Swedish bankruptcies provide
a particularly interesting empirical “laboratory” for examin-
ing this issue.
While risk-shifting may be close to a free option for share-
holders of an insolvent firm, ”going for broke” increases the
chance that the CEO loses her job. Thus, when CEOs derive
private benefits from control and have a reasonably good
chance of surviving the reorganization process, they have an
incentive to invest conservatively to “hedge” against unfavo-
rable bankruptcy outcomes. These unfavorable outcomes
include outright company liquidation, where the CEO’s
position is eliminated, or reorganization as a going concern
with another CEO at the helm. Conversely, by investing
conservatively, CEOs increase the chance of firm survival
and, hence, of being rehired by the buyers in the auctions.37
Moreover, such behavior is effectively sanctioned by provi-
sions in the legal codes of countries such as Sweden and the
United States that encourage company directors to shift their
fiduciary responsibility towards bondholders when approach-
ing bankruptcy. 38
Warner (1979), such arrangements include debt covenants prohibiting certain forms of
asset dispositions, such as merger, sale-leaseback, and asset collateralization. Risk-
shifting incentives are also reduced by the use of convertible debt in the firm’s capital
structure (Green 1984).
A Morgan Stanley Publication • Summer 2009 49
 But let’s take a closer look at the incentives of CEOs
facing the prospect of bankruptcy. As summarized in Table
4, in Swedish bankruptcies 61% of all incumbent CEOs
leave the firm, while 39% are rehired by the buyer in the
auction. Of the companies auctioned as going concerns,
roughly half retain their CEOs. In Chapter 11, by compari-
son, three-quarters of the CEOs in place two years prior to
filing are replaced within two years of filing. Bankruptcy also
has a substantial negative effect on the wealth and income
of managers: CEOs experience a substantial income drop
following Swedish bankruptcy—rehired or not—both in
absolute terms and compared to a control group of CEOs of
non-bankrupt firms.39
Figure 3 provides a striking visual impression of the
significant income difference that develops between filing
and non-filing CEO as of the year of bankruptcy filing. The
figure plots an index of the annual taxable CEO income,
where the index value is normalized to 100 in year -3. The top
curve in the graph is the index value for the control sample of
non-bankrupt firms, while the lower curve is the index value
for the CEOs of bankrupt firms. As shown, the incomes of
filing and non-filing CEOs grow at approximately the same
rate up until bankruptcy filing. Then, over the subsequent
three years (year 0 through year 2), filing CEOs show a sharp
income decline while the income of non-filing CEOs contin-
ues to grow at about the same rate as before. After year 2,
the incomes of the two categories of CEOs again grow at
similar rates. From inspection of Figure 3, it is natural to
focus on the event period from year -2 through year 3 as
capturing the full income change differential between filing
and non-filing CEOs. Measured over this window, the
median and mean values of the abnormal income change
are -47% and -66%, respectively.
In sum, bankruptcy filing seems to produce a large and
permanent income loss for the filing CEO relative to the top
management of non-filing industry competitors.40
Given the substantial personal cost of bankruptcy, does
the typical filing CEO engage in asset substitution and
risk shifting? There is little direct evidence on this issue.
It’s important to keep in mind, however, that a success-
ful risk-shifting strategy implies that the firm does not file
for bankruptcy. Conversely, a failed risk-shifting strategy
38. In a number of U.S. states, the board of an insolvent firm owes a direct fiduciary
responsibility to creditors. Also, creditors receive greater representation on boards of firms
in Chapter 11 bankruptcy (Gilson 1990). For example, in a 1991 decision (Credit Lyon-
nais Bank Netherland N.V. v. Pathe Communications Corp. No Civ A. 12130 Del. Ch. Dec
30, 1991), the Delaware Court opined that” [a]t least where a corporation is operating in
the vicinity of insolvency, a board of directors is not merely the agent of the residu[al] risk
bearers, but owes its duty to the corporate enterprise.” In Sweden, the bankruptcy trustee
who runs the auction formally works for creditors, and creditors may reverse pre-filing
transactions designed to circumvent the debt priority structure. Such “look-back” provi-
sions notwithstanding, wealth transfers from debtholders due to asset substitution and
risk shifting may be subtle in nature and therefore difficult to detect ex post.
39. In Sweden, personal taxable income is publicly available, allowing research to
follow the CEO income change also after she leaves the firm (which is not possible in the
U.S.). We measure the rate of income change using two methods, either of which sup-
50 Journal of Applied Corporate Finance • Volume 21 Number 3
depletes the assets of the firm that enters bankruptcy. Severe
asset depletion increases the risk of piecemeal liquidation
(which the risk-shifting strategy was designed to avoid in
the first place).
In our 2003 study, we constructed an empirical measure
of private control benefits and showed that the probability
of the CEO being rehired in the auction increases with this
measure (after controlling for the CEO’s “quality”). This is
puzzling: since greater private control benefits are associated
with managerial entrenchment, one would have expected
the measure of private benefits to lower the chance of being
rehired. But we offer the following explanation: CEOs with
greater private benefits tend to act more conservatively when
in severe financial distress, which has the effect of maximizing
firm value (rather than shareholder value) before the filing.41
And by preserving the firm as a going concern, these CEOs
also increase the probability of being rehired, assuming they
also meet the minimum “quality” standards required by the
auction buyers.
Interpreted in this way, our evidence at least indirectly
supports the hypothesis of managerial conservatism over
risk-shifting. Contrary to conventional wisdom, the “harsh”
auction system may not exacerbate costly risk-shifting incen-
tives.
Concluding Remarks
From an economic perspective, bankruptcy law should be
designed to encourage low-cost procedures for reallocating
the assets and resources of distressed or bankrupt compa-
nies to their highest-valued alternative use. A poorly designed
code exacerbates costly conflicts among security holders and
risks destroying company value by misallocating corporate
control rights.
The introduction of Chapter 11 of the U.S. Bankruptcy
Code in 1978 was motivated in large part by a concern that
the time-pressure inherent in an auction mechanism carries
an unacceptable risk of fire-sales, resulting in low sales prices
and creditor recoveries that would ultimately have the effect
of increasing the cost of debt for corporate borrowers. But
this concern was not based on—and to this day has not been
supported by—systematic empirical studies of the actual
economic effects of bankruptcy auctions.
ports the conclusion in the text. The first method uses data on the filing CEOs only and
is computed as the annual percentage change in CEOs net income before tax. (Because
capital losses are not deductible against salary income in Sweden, this reflects the full
salary loss of the CEO.) The second method uses the abnormal CEOs income change,
measured relative to the contemporaneous CEO income change in a matched non-bank-
rupt firm of similar total asset size and in the same four-digit SIC industry.
40. Managers who retain their positions after U.S. bankruptcies also take a substan-
tial pay cut (Gilson and Vetsuypens 1993). In the U.S. compensation is often tied to the
success of the debt restructuring. Overall, bankruptcy filing seems harsh on the incum-
bent CEO, irrespective of the system.
41. Under the classical assumption that risk-shifting is costly for bondholders (that is,
it involves shifting to investment projects with negative net present value), managerial
conservatism necessarily increases firm value. See Eckbo and Thorburn (2003) for fur-
ther details of the argument.
A Morgan Stanley Publication • Summer 2009
 The experience of the Swedish mandatory auction
bankruptcy system offers important clues to the economic
performance of auctions, and in particular on the issue of fire-
sale when the auctioned firm is sold as a going concern. Our
research shows that auctions are competitive when judged
by the evidence on takeovers more generally, and there is
no evidence that auction premiums tend to undercut the
bankrupt firm’s fundamental going concern value. Moreover,
three-quarters of the filing companies survive the auction with
core assets and operations intact, and these firms continue to
perform at par with non-bankrupt industry rivals after the
sale. The evidence on recovery rates, corporate survival, and
post-bankruptcy performance strongly suggests that auction
bankruptcy performs as well as—and in some respects better
than—comparable Chapter 11 restructurings.
The recent U.S. trend towards greater use of auction-
type mechanisms indicates that investors in this country
increasingly view auctions as efficient. Unlike Sweden, the
U.S. has highly developed markets for both corporate control
and corporate debt instruments, suggesting that the auction
mechanism should work well not only for smaller firms, but
for the relatively large bankrupt firms with complex capital
structures that tend to use Chapter 11.
Journal of Applied Corporate Finance • Volume 21 Number 3
Is the U.S. trend towards bankruptcy auctions likely to
persist? It is still true that, at the time of filing, Chapter 11
proceedings favor attempts to reorganize claims—extinguish-
ing old equity claims and converting some debt claims to
equity—instead of immediately promoting a sale. Though
the system is changing, powerful special interest groups that
benefit from the continuation of reorganization procedures
are resisting such change. Among these interest groups are
judges and lawyers with little experience with auctions and
selling procedures, valuation consultants that tend to be hired
during reorganizations, and last—and certainly not least—
incumbent management teams who prefer continued control
of the bankrupt firm to the risk of being fired by the buyer
in an auction.
espen eckbo is the Tuck Centennial Professor of Finance, and Found-
ing Director of Tuck’s Lindenauer Center for Corporate Governance, at the
Tuck School of Business, Dartmouth College (USA).
karin thorburn is Professor of Finance at the Norwegian School of
Economics and Business Administration (Norway).
A Morgan Stanley Publication • Summer 2009 51
References
Aghion, Philippe, Oliver Hart and John Moore, 1992,
“The Economics of Bankruptcy Reform,” Journal of Law,
Economics and Organization 8, 523-546.
Ayotte, Kenneth M., and Edward R. Morrison, 2007,
“Creditor Control and Conflict in Chapter 11,” Working
Paper, Columbia Law School.
Baird, Douglas G. and Robert K. Rasmussen, 2002, “The
End of Bankruptcy,” Stanford Law Review 55, 751-790.
Baird, Douglas G. and Robert K. Rasmussen, 2003,
“Chapter 11 at Twilight,” Stanford Law Review 55, 101-129.
Betton and Eckbo, 2000, “Toeholds, Bid-Jumps, and
Expected Payoffs in Takeovers,” Review of Financial Studies
13, 841-882.
Betton, Sandra, B. Espen Eckbo, and Karin S. Thorburn,
2008, “Corporate Takeovers”, in B. E. Eckbo (ed.), Handbook
of Corporate Finance: Empirical Corporate Finance, Volume
2, (Elsevier/North-Holland Handbook of Finance Series),
Ch. 15, 291-430.
Bharath, Sreedar T., Venky Panchapegesan, and Ingrid
Werner, 2007, “The Changing Nature of Chapter 11,”
Working Paper, University of Michigan.
Boone, Audra, and Harold Mulherin, 2007, “How Are
Firms Sold?,” Journal of Finance 62(2), pages 847-875.
Buttwill, Klas, and Clas Wihlborg, 2004, “The Efficiency
of the Bankruptcy Process. An International Comparison,”
Working paper, Copenhagen Business School.
Chang, Tom and Antoinette Schoar, 2007, “The Effect of
Judicial Bias in Chapter 11 Reorganization,” Working Paper,
Massachusetts Institute of Technology.
Eckbo, B. Espen, 2009, “Bidding Strategies and Takeover
Premiums: A Review”, Journal of Corporate Finance 15,
149-178.
Eckbo, B. Espen and Karin S. Thorburn, 2003, “Control
Benefits and CEO Discipline in Automatic Bankruptcy
Auctions,” Journal of Financial Economics 69, 227-258.
Eckbo, B. Espen and Karin S. Thorburn, 2008,
“Automatic Bankruptcy Auctions and Fire-Sales,” Journal of
Financial Economics 89, 404-422.
Eckbo, B. Espen and Karin S. Thorburn, 2009, “Credi-
tor Financing and Overbidding in Bankruptcy Auctions,”
Journal of Corporate Finance 15, 10-29.
Franks, Julian R, and Walter N. Torous, 1994, “A
Comparison of Financial Recontracting in Distressed
Exchanges and Chapter 11 Reorganizations,” Journal of
Financial Economics 35, 349-370.
Gilson, Stuart C., 1990, “Bankruptcy, Boards, Banks,
and Blockholders: Evidence on Changes in Corporate Owner-
52 Journal of Applied Corporate Finance • Volume 21 Number 3
ship and Control When Firms Default,” Journal of Financial
Economics 26, 355-387.
Gilson, Stuart C., and Michael R. Vetsuypens, 1993,
“CEO Compensation in Financially Distressed Firms: An
Empirical Analysis,” Journal of Finance 43, 425-458.
Green, Richard C., 1984, “Investment Incentives, Debt,
and Warrants,” Journal of Financial Economics 13, 115–136.
Hotchkiss, Edith S., 1995, “Post-bankruptcy Performance
and Management Turnover,” Journal of Finance 50, 3-21.
Hotchkiss, Edith S., and Robert M. Mooradian, 1998,
“Acquisitions as a Means of Restructuring Firms in Chapter
11,” Journal of Financial Intermediation 7, 240-262.
Hotchkiss, Edith S., and Robert M. Mooradian, 2003,
“Auctions in Bankruptcy,” Journal of Corporate Finance 9,
555-574.
Hotchkiss, Edith S., Kose John, Robert M. Mooradian,
and Karin S. Thorburn, 2008, “Bankruptcy and the Resolu-
tion of Financial Distress”, in B. E. Eckbo (ed.), Handbook
of Corporate Finance: Empirical Corporate Finance, Volume
2, (Elsevier/North-Holland Handbook of Finance Series),
Ch. 14, 235-287.
Jensen, Michael C., 1991, “Corporate Control and the
Politics of Finance,” Journal of Applied Corporate Finance 3,
13-33.
Jensen, M.C., and W.H. Meckling,1976, “Theory of the
firm: managerial behavior, agency costs and ownership struc-
ture,” Journal of Financial Economics 3, 305-360.
LoPucki and Doherty, 2007, “Bankruptcy Fire Sales,”
Michigan Law Review 106, 1-60.
Maksimovic, Vojislav, and Gordon Phillips, 1998, “Asset
Efficiency and Reallocation Decisions of Bankrupt Firms,”
Journal of Finance 53, 1495–1532.
Pulvino, Todd C., 1999, “Effects of Bankruptcy Court
Protection on Asset Sales,” Journal of Financial Economics
52, 151-186.
Shleifer, Andrei, and Robert W. Vishny, 1992, “Liqui-
dation Values and Debt Capacity: A Market Equilibrium
Approach,” Journal of Finance 47, 1343-1366.
Smith, Jr., Clifford W., and Jerold B. Warner, 1979, “On
Financial Contracting: An Analysis of Bond Covenants,
Journal of Financial Economics 7, 117–161.
Stromberg, Per, 2000, “Conflicts of Interests and Market
Liquidity in Bankruptcy Auctions,” Journal of Finance 55,
2641-2692.
Thorburn, Karin S., 2000, “Bankruptcy Auctions: Costs,
Debt Recover, and Firm Survival,” Journal of Financial
Economics 58, 337-368.
A Morgan Stanley Publication • Summer 2009