Bankruptcy as Filtering Failure: Evidence of Filtering Failure in the U.S. Bankruptcy Process

Abstract

The institution of bankruptcy law seeks to facilitate economic efficiency by enabling the reorganization of economically viable but financially distressed firms and facilitating the liquidation of economically failed firms. Does the U.S. Chapter 11 bankruptcy process perform this filtering function efficiently? Using data from large public bankruptcies between 1981-2010, we find that it does not. Specifically, (1) evidence on matched performance differences between bankrupt firms and industry counterparts indicate that there is no improvement in the performance gap between bankrupt firms and industry right before and after bankruptcy, and, (2) firms emerging from bankruptcy do not exhibit financial performance catch-up behavior to their going concern industry counterparts. In addition, we find (3) judicial bias in favor of reorganization in cases involving firms with more employees and operations closer to the judge’s district, suggesting that bankruptcy judges respond to social-political considerations, when deciding whether to reorganize the firm.

Keywords: Bankruptcy Law, Filtering Failure, Judicial Bias

JEL Classification: G33, C55