The costs of

bankruptcy
 Introduction
Altman (1984) found that the total (direct and indirect) costs of bankruptcy amount to about 15% of
predistress firm value for industrial firms and around 7% for retailers. Franks and Torous (1994)
concluded that the average incremental cost of a formal proceeding (i.e., bankruptcy) exceeds that of
an informal workout by at least 4.5%. In a study of one major case (Federated), Kaplan (1994) found
the estimated gains from the bankruptcy-induced financial restructuring process exceeded the cost.
Kaplan wonders whether the bankruptcy process typically produces a net gain. Clearly we have a
wide range of estimates for financial distress costs. Financial distress costs may be classified into four
subcategories.

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 1. Real (i.e., not transfer) costs borne directly by the bankrupt firm.
2. Real costs, borne directly by the claimants (but not by the bankrupt firm itself).
3. Losses to the bankrupt firm that are offset by gains to other entities.
4. Real costs borne by parties other than the bankrupt firm and/or its claimants. 

Categories 1, 2, and 3 are relevant for determining of bankruptcy costs’ impact on the optimal
capital structure, as well as for determining the size and composition of the risk premium. To assess
the legal system’s efficiency in dealing with bankruptcy, Cost categories 1, 2, and 4 are relevant.
The present analysis focuses upon Cost categories 1, 2, and 3. Cost category 4 is beyond the scope
of this review

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 Estimating the costs of bankruptcy
The cost of dealing with financial distress is, in the present analysis, related to the market value of the firm just before it
became financially distressed.
PDV of the bankrupt firm = LCD + CDD + GVR
where PDV = predistress value, LCD = loss causing distress, CDD = firm’s cost of dealing with distress, GVR = gross value
recovered. The gross value recovered by claimholders (GVR) may itself be divided into the claimholders cost of obtaining
that recovery (CRC) and the net value recovered by claimholders (NVR).
GVR = NVR + CRC
In this framework the total bankruptcy-related costs borne by claimholders in dealing with the bankruptcy (TDC) is the
sum of the firm’s (CDD) and the claimholders (CRC) direct costs of dealing with the bankruptcy. Thus:
TDC = CDD + CRC
Substituting Eqs. (2) and (3) into Eq. (1) yields Eq. (4),

PDV = LCD + TDC + NVR

where TDC = total firm and claimholders cost of dealing with bankruptcy (CDD + CRC), NVR = net value recovered by
claimholders equal to total value recovered (GVR) less the claimholders cost of obtaining the recovery (CRC).

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 This analysis seeks to estimate the average magnitudes of these components of a bankrupt firm’s PDV. We
begin with a benchmark value (PDV) for the firm just before it became distressed. PDV is frequently
measured as the total book value of the bankrupt firm’s assets as of its last prebankruptcy financial report.
The bankrupt firm will usually report equity value is close to zero (liabilities approximately equal to assets)
just before it files. The balance sheet reported just prior to the bankruptcy filing will, however, usually
include some overstated asset values and fail to reflect the impact of continuing operating losses. Once the
bankruptcy proceeding begins, the true magnitude of these as-yet-unrecognized (on the books) losses will
emerge.

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 Recovery rates

An idea of the relative magnitudes of PDV and GVR may be determined from Altman and Kishore’s study
(1993) of recoveries on defaulted bonds. They computed the average recovery (defined as the market price
immediately after default) for a set of 594 bonds over the 1985–1994 period to be 40.95% of par. The authors
update and expand their analysis to 747 bonds for the 1971–1997 period finding an averaged recovery rate of
41.66% (unweighted) and 40.32% (weighted by market value) (Altman & Kishore, 1998).

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 Real bankruptcy costs
borne by the firm

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 Professional fees

Bankrupt firms almost always employ outside professionals. Specifically, lawyers, accountants, investment
bankers, appraisers, auctioneers, and actuaries as well as those with experience in selling distressed assets are
all likely to be employed in larger bankruptcies. Such professionals generally charge out at substantial (hourly)
fees. Similar professionals may well be used in more normal times. Their use, however, is virtually certain to
increase when a firm gets into serious financial difficulty.
Weiss (1990) studied direct bankruptcy costs for 37 New York and American Stock Exchange bankruptcy filings
for the November 1979–December 1986 period. He found direct costs equaled 3.1% of the book value of debt
plus the market value of equity (as measured for the fiscal year end immediately prior to the bankruptcy filing).

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 Firms also incur distress-related professional fees prior to filing for bankruptcy court protection. They often
seek to avoid or at least put off the bankruptcy filing by attempting an informal workout. Gilson, John, and
Lang (1990) studied out-of-pocket costs for a sample of 26 successful financial restructurings. They found
such exchange offer costs averaged 0.65% of the book value of the distressed firm’s assets. Betker (1997),
in contrast, estimates 2.51% for his sample of exchanges. Both of the estimates relate to successful efforts
to restructure. To be conservative, the lower value (0.65%) will be used herein.
The direct cost of dealing with bankruptcy is largely in the form of fees paid to professionals (especially
lawyers and accountants)

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 Internal staff resources

Dealing with bankruptcy almost always requires a significant portion of the Board of Director’s and senior
officer’s time and energy. Similarly, substantial amounts of both human and other resources from other
departments within the firm are likely to be taken up with the process. For example, the legal, accounting,
planning, personnel, and operations staffs all tend to be involved in assessing and dealing with the implications
of bankruptcy. The firm must also be able to cooperate with and supply information to its hired outside
professionals.
The internal costs of dealing with bankruptcy are rarely reported separately. Indeed, because the tasks are
typically only part of each cost center’s total assignment, such costs are especially difficult to assess. Clearly, a
bankrupt firm must devote substantial amounts of its own resources to interacting with its hired professionals.
The more work done by professionals, the greater the amount of work to be done by the internal staffs who
interact with them.

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 A crude estimate for these costs may be derived from a couple of case studies. The internal costs reported for
liquidating firms that have already disposed of most of their operating subsidiaries are likely to be largely distress-
related. The post failure experiences of two large bank holding companies provide some information on these
costs. For the 1991– 1995 period, the Bank of New England Corporation (BNEC) incurred total professional fees
(excluding trustee fees) of US$17.7 million and internal administrative expenses (including trustee fees) of US$3.0
million. BNEC is liquidating itself in bankruptcy so all of its internal administrative expenses are associated with
dealing with that Chapter 7 liquidation (Branch, 1995). Thus BNEC’s internal costs have amounted to approximately
17% of its professional fees.

Legal and related fees are likely to be relatively large and internal staff costs relatively low for such cases

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 Real bankruptcy costs borne
directly by the firm’s interest
holders

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 In addition to the costs borne by the bankrupt firm itself, certain other costs are borne directly by its
interest holders. Thus shareholders, bondholders, bankers, trade creditors, federal, state and local revenue
departments, landlords, retirees, current employees, and others with interests in the firm (e.g., contract
holders and holders of damage claims) are likely to incur additional costs as a result of the firm’s
bankruptcy. These costs include:

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 Professional fees

The bankrupt firm pays for the creditors’ committee’s legal counsel and certain other expenses. The individual
interest holders, however, must pay any costs that they incur individually. For example, large institutional
interest holders such as banks and insurance companies frequently retain separate legal counsel to assess their
legal positions.

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 Internal staff resources

Interest holders must expend their own and their staff’s energy and other resources in assessing and
representing their interests (or risk the consequences). A portion of the work may be done by outside
professionals, but ultimately, the owner of the interest must be responsible for certain decisions.

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 HAMZA

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 Reduced marketability:

As a firm moves from a nondistressed to a distressed state, all of the stakeholders’ interests in it change their
characters. First, their interests tend to lose value because the distressed firm’s own value declines. Second,
the instruments may lose further value to the owner (who may be inclined to sell) because of their reduced
marketability.

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 Delisting and widening spreads

Listed securities are often delisted around the time the firm files for bankruptcy. Securities also become less
tradable as their prices fall closer to zero.
Once the debtor becomes financially distressed, however, the interest becomes much more difficult to sell,
even at an appropriately discounted price. Indeed, many similarly positioned interest holders may, more or less
simultaneously, seek to sell their recently downgraded interests. Accordingly, the market for such assets may
be particularly unbalanced at the very time that the interest holder is most likely to want to sell.

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 Claims for damages

Trading rejected contract and other types of damage claims against a bankrupt party are even more
problematic. Clearly, such contingent assets have potential value. Under normal circumstances they can legally
be bought and sold.
Distressed interests, particularly low-priced distressed interests, are inherently more costly to trade than
otherwise similar investment grade instruments. How large these costs may be will depend upon two principal
factors. First, what percentage of distressed instruments are sold prematurely because of the onset of distress?
Second, how much do transactions costs increase as a result of financial distress?

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 Trading bank debt

More definitive evidence on the impact of financial distress on trading costs comes from a study of traded
bank debt spreads by Harwitz and Branch (1998). A sample of 140 loans were divided into four categories: par
trading at 98 or above; stressed at 90 to 98; distresses at 65 to 90, and severely distressed below 65. The
average bid–ask spreads for these loans are shown in Table 1.

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 Table 1:

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 Losses to the bankrupt firm that
may be offset by gains to other
entities

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 Many of the costs that a bankrupt firm suffers create opportunities for others. Thus the distressed
firm’s loss may be offset, at least in part, by its competitors’ gains. These types of costs include the
following.

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 Market share loss

The disruptions caused by the bankruptcy will generally have an adverse effect on the firm’s ability to compete
in the marketplace. Its customers, suppliers, and others will be less inclined to do business with it. Its
employees and potential employees will feel less secure working for it. The bankrupt firm is less likely to be
able to honor its commitments. This reality makes others less inclined to rely upon its promises. Thus the
bankrupt firm’s ability to attract and hold the most suitable employees, customers, and suppliers declines as
its condition worsens.

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 Short run focus

Short run focus Bankruptcy will force the firm to shorten its focus. It will need to conserve cash and
avoid undertaking most long-term opportunities and fulfilling previous commitments that are not
already inescapable. A bankrupt firm simply does not have the luxury of pursuing longer-term
opportunities that require cash or otherwise shift attention away from immediately pressing
problems. In essence, it will have to apply a very high discount rate to any cash consuming project.

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 Indirect cost estimates

Indirect cost estimates Most of the work on bankruptcy cost has dealt with the
direct costs of bankruptcy administration. Most of the rest has been focused on what
are generically termed indirect costs. Such costs would include the costs of a short-
run focus, as well as costs stemming from a loss in market share. Little or no work,
however, has been done to disentangle these two categories of indirect costs.

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 Overall cost estimates
The Weiss work suggests that the legal and other professional costs of administering a bankruptcy amount to
3.1% of the book value of debt plus market value of equity.

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 Conclusion

The bankruptcy process imposes costs on a very

wide array of parties including the owners and
direct creditors of the troubled firm and many other
parties. For example, those having contacts with
(landlords, suppliers, customers, employees, etc.) or
potential claims against (e.g., product liability
claims) need to be considered when the magnitudes
of bankruptcy costs are assessed.
1. The loss, which caused the bankruptcy,
consumes about 28%;
2. The cost of dealing with distress consumes about
16%.
3. The net value available to distribute to the claims
holder amounts to about 56%
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