Research

Unsecured Creditors Lose in Small Business Bankruptcies

Bankruptcy court more often than not leads to a dreadful outcome for unsecured creditors of very small companies, according to a new study by Assistant Professor Ning Zhu and his co-researchers Professor Douglas Baird of the University of Chicago Law School and Professor Arturo Bris of IMD Business School and Yale University’s International Center for Finance. Their study, which analyzes the impact of Chapter 11 bankruptcy filings, was recently featured in The Wall Street Journal and on Bloomberg.com. Conventional wisdom holds that when a firm files for Chapter 11 the unsecured creditors are always protected. This is not necessarily the case, according to Zhu and his co-authors. Their study, “The Dynamics of Large and Small Chapter 11 Cases: An Empirical Study,” examined 139 corporate Chapter 11 cases filed between 1995 and 2001 in U.S. Bankruptcy Courts in Manhattan and Phoenix. Zhu and his co-authors found that when small companies with assets of less than $200,000 file for Chapter 11, non-priority general creditors receive less than 10 percent of their claims and “usually recover nothing.” But larger companies worth more than $5 million will usually spur investors to vie for valuable assets. In these larger and more complex cases, secured creditors receive about 94 percent of what they are owed, and unsecured creditors typically recover half. The reason unsecured lenders are unable to recover anything from small businesses is due to the tax liabilities. The study found that for almost two thirds of small companies, a tax burden amounted to nearly a quarter of secured debt. Anything left over is divvied up among lawyers and secured creditors, so unsecured creditors are more often than not the big losers in small business cases. Zhu and his co-researchers also found that asset sales are the desirable way to deal with Chapter 11. For such fire sales, secured creditors can convince a judge that the company’s assets are worth less than what they are owed. This strategy allows them to grab the equity, again leaving unsecured creditors with close to nothing. “The days in which the old managers used the (Chapter 11) system to keep their jobs and protect the old equity are gone,” according to the study. Zhu presented the paper at the National Bureau Economic Research meeting last November and at the American Law and Economic Association meeting in Cambridge, Mass., in May.

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