International Review of Financial Analysis

11 (2002) 39 – 57

The costs of bankruptcy

A review
Ben Branch*
Isenberg School of Management, University of Massachusetts, Amherst, MA 01003, USA

Abstract

Bankruptcy-related costs may be categorized into four areas: (1) Real costs borne by the distressed
firm; (2) Real costs borne directly by the claimants; (3) Losses to the distressed firm that are offset by
gains to other entities; (4) Real costs borne by parties other than the distressed firm or its claimants.
Cost categories 1, 2, and 3 are relevant for claimants, while Categories 1, 2, and 4 are relevant for
society. Focusing on the first three categories, the present study reaches the following conclusions:
First, after allowing for their costs of collections, claimsholders recover approximately 56% of the
bankrupt firm’s predistress value (PDV). Second, dealing with financial distress generally consumes
between 12% and 20% of the distressed firm’s PDV. Taking the midpoint of this range (16%) implies
that the losses that lead to the firm’s distress average approximately 28% of its PDV. These estimated
values demonstrate the importance of bankruptcy costs in determining an optimal capital structure and
explaining the level of risk premiums. Because of its impact on risk premiums, the cost of capital and
needed tax rates, the cost of dealing with financial distress has an adverse impact on resource
allocations throughout the economy. D 2002 Elsevier Science Inc. All rights reserved.

JEL classification: G33

Keywords: Bankruptcy; Liquidation; Reorganization; Chapter 11; Chapter 7

The nature, magnitude, and avoidability of bankruptcy-related costs play a key role in at
least three major controversies: reforming the Bankruptcy Code, the existence (or absence) of
an optimal capital structure, and the premium on risky debt.

* Tel.: +1-413-545-5690; fax: +1-413-545-3858.

E-mail address: branchb@som.umass.edu (B. Branch).

1057-5219/02/$ – see front matter D 2002 Elsevier Science Inc. All rights reserved.
PII: S 1 0 5 7 - 5 2 1 9 ( 0 1 ) 0 0 0 6 8 - 0
40 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

1. 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%. Opler
and Titman (1994) reported that highly leveraged firms in financial distress tend to lose
substantial market share. Finally, 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:

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.

2. 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. This methodology follows the
practice of most prior studies (e.g., Altman, 1984; Franks & Torous, 1994). It facilitates a
useful triaging of the firm’s predistressed value. The predistressed value of the bankrupt firm
is equal to the sum of the loss causing the distress (LCD), the firm’s cost of dealing with the
distress (CDD), and the gross value recovered by claimsholders (GVR):

PDV ¼ LCD þ CDD þ GVR ð1Þ

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 claimsholders (GVR) may itself be divided into the
claimsholders’ cost of obtaining that recovery (CRC) and the net value recovered by
claimsholders (NVR).

GVR ¼ NVR þ CRC ð2Þ

 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 41

In this framework the total bankruptcy-related costs borne by claimsholders in dealing with
the bankruptcy (TDC) is the sum of the firm’s (CDD) and the claimsholders’ (CRC) direct
costs of dealing with the bankruptcy. Thus:
TDC ¼ CDD þ CRC ð3Þ
Substituting Eqs. (2) and (3) into Eq. (1) yields Eq. (4),
PDV ¼ LCD þ TDC þ NVR ð4Þ
where TDC = total firm and claimsholders’ cost of dealing with bankruptcy
(CDD + CRC), NVR = net value recovered by claimsholders’ equal to total value recovered
(GVR) less the claimsholders’ cost of obtaining the recovery (CRC).
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. While the most recent prebankruptcy financial statement may not
accurately reflect the firm’s asset value at the time of its report, that statement’s book values
may still serve as a useful benchmark of the firm’s PDV. We wish to explore what happens to
that value once the firm becomes distressed. How much is the loss that causes the firm to
become distressed? How much value is depleted dealing with the distress? And how much is
recovered by the claimants?

2.1. 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). In another
study, Altman and Eberhart (1994) report recovery rates for firms emerging from Chapter 11
reorganizations. For their sample of 202 defaulted bonds from 91 firms reorganizing over the
1980–1992 period, the average recovery rate amounted to 52.57% of the debt’s par value.
When we take account of both the time value of money (Chapter 11’s typically take about
2 years) and the likely lower rate of recovery for those firms that do not reorganize, this
somewhat higher percentage of distribution at the reorganization seems consistent with the
41% number.
Bank and other types of senior debtholders (who are often protected with collateral) would
generally achieve a higher recovery rate than bondholders (which include both senior and
42 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

subordinated issues). Altman and Kishore (1996), for example, find that senior unsecured
bondholders recovered about 50% of par in a default situation. Altman and Saxman (1998)
report that at year end 1997, their index of defaulted bank loans (covering 18 facilities with a
face value of US$3.36 billion) were trading at a market to face ratio of .71 compared to .45
for their public bond index. Similarly, Curty and Lieberman (1996) report a 71% recovery
rate on a small (58) sample of senior secured bank loans and 79% on a larger sample (229) of
small to medium size bank loans. Asarnow and Edwards (1995) found a 65% recovery for
831 Citibank loan defaults for the 1971–1993 period (the sample involved both secured and
nonsecured defaults). Certain other claimsholders (e.g., general creditors, lessors and other
holders of rejected contracts), however, may well recover less than the bondholders. Still the
average recovery rate for claimsholders is probably between that for bondholders (about
40%) and banks (about 70%). Altman (1993b) reports that the typical bankrupt firm has about
US$1.8 of bank debt for every US$1 of bond debt. Applying this ratio to our estimated
recovery rates for bank and bond defaults implies a weighted average gross recovery of about
60% for claimsholders.
The existing literature may be used to obtain a range of estimates for certain categories
of costs.

3. Real bankruptcy costs borne by the firm

3.1. 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). Both Altman
(1984) and Warner (1977) derived similar estimates in earlier studies. Warner estimated
direct bankruptcy costs to be 4% of market value 1 year prior to bankruptcy for a sample of
11 railroads. Altman estimated the costs to be 4.3% for a sample of 11 retailers and 7
industrial firms. In a more extensive and more recent study Betker (1997) estimated direct
costs of 3.93% for 75 traditional Chapter 11 cases and 2.85% for 48 prepackaged Chapter
11’s. Using these sample size numbers as weights, Betker’s composite direct cost estimate is
calculated as 3.51%. Thus all four studies came up with a range of about 3.1–4.3% of
prebankruptcy market value (Ang, Chua, & McConnell, 1982). In a study of 49 prepackaged
bankruptcies, Tashjian (2000) found average direct costs of 1.65% of assets for prevoted
plans and 2.31% for postvoted plans. Her results are consistent with those of the other
 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 43

authors, as prepackaged bankruptcies are known to be considerably quicker and less costly
than other bankruptcy proceedings.
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). One might be tempted, therefore,
to argue that much of this cost represents wealth transfers (e.g., payments from creditors to
bankruptcy professionals). However, the bankruptcy professionals might otherwise have been
working on different projects. That foregone activity (e.g., merges or spin-offs) would
probably have created something of value. Thus the economic cost of having that individual
work on bankruptcy issues is the value that would have otherwise resulted from that foregone
activity. Most of those who work in the bankruptcy area are talented individuals. Accordingly,
their talents are very likely to be transferable to nonbankruptcy work. Presumably, such
individuals produce value in line with their compensation. Thus society foregoes value
approximately equal to their compensation when they work on bankruptcy or related projects.
In exchange for that forgone value society reaps whatever value is generated by the
professionals’ activities.

3.2. 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 confront the business problems that manifest themselves and/
or result from the bankruptcy. The bankrupt firm may also need to negotiate, but, at a
minimum, must communicate with its various categories of interest holders. Their support
will be needed to implement the firm’s reorganization plans. The firm must also be able to
cooperate with and supply information to its hired outside professionals. All the while, the
firm needs to keep its everyday business operations on track under the strained circum-
stances of bankruptcy.
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.
44 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

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 postfailure 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. A second data point is provided by the First Republic Bank
(FRB) Chapter 11 case. For 1990 and 1991, by which time all of its operating subsidiaries
had been sold, FRB incurred approximately US$10 million in professional fees compared
to about US$3.5 million (35% of US$10 million) in internal expenses (Branch & Ray,
1997). These two experiences suggest that the internal costs of dealing with bankruptcy
may be in the range of 17–35% of the external costs. Since the external costs appear to
average about 4% of the bankrupt firm’s PDV, this 17–35% range implies that internal
costs may be in the neighborhood of 0.7% (0.17  0.04 = 0.0068) to 1.4% (0.35 
0.04 = 0.014) of the firm’s PDV. These estimates are, however, based on liquidations.
Legal and related fees are likely to be relatively large and internal staff costs relatively low
for such cases. The staff would have much less to do with ongoing operations that are, in a
liquidation, being sold off or shut down, compared with a reorganization where the staff
must focus on how to keep the business going long-term. Thus, our 0.7–% range may well
be conservative.

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

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:

4.1. Professional fees

In a Chapter 11, 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.
If the claim or other interest is sufficiently large, and particularly if the issues are
sufficiently complex, these representatives may monitor the court proceedings and perhaps
the work of the creditor’s committees. If individual proofs of claims need to be filed and
monitored, legal assistance is almost always required. Similarly, if the interest is disputed or
 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 45

subject to counter claims, the interest holder will need legal assistance. Interest holders may
also retain their own accountants, appraisers, investment bankers, etc. to evaluate the
debtor’s findings and proposals and perhaps to represent them on the creditors committee.

4.2. 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: Should the interest be sold or held? Should a reorganiza-
tion plan be voted for or against? Should the interest holder take a position at court on
various issues such as priority or allowability of certain other claims, payment of
professional fees, retention of existing management, or any other matters?
Aside from protecting their own claims and voting on a reorganization plan (or acting on
an exchange offer), holders of small dollar value interests are likely to let the bankruptcy
process take its own course. Large holders, in contrast, may attempt to shape the process in
their favor. In some instances the portfolio managers who purchased the interest will be
asked to follow their respective distressed positions. In other situations, an in-house
specialist will be given the task. Lessors and others having contracts with the bankrupt
firm are particularly likely to absorb additional costs and losses as a result of the bankrupt
firm’s condition. Holders of such contracts are very often pressured to make concessions.
More importantly, many of their contracts are subject to rejection. Rejected contracts
holders may assert damage claims resulting from such rejections. The amounts, however,
are limited and the claims themselves may well be opposed by the debtor and other
claimants. In addition, the holders of rejected contracts may (along with others) be the
targets of affirmative fraudulent conveyance and preference claims by the bankrupt estate.
Such counterclaims could result in substantial disgorgements from the target. Alterna-
tively, they could be used as negotiating chips to induce the interest holder into
compromising his or her claim. Even if the bankrupt estate’s affirmative claim is
unsuccessful, legal fees and other costs are likely to be incurred. Clearly, holders of
contracts with bankrupt firms are likely to incur significant costs (both professional fees and
internal staff resource) to defend their interests. Much of the efforts involved in Items 1 and
2 relate to the pursuit of various claimants’ interests that compete with the interests of other
claimants. Claimants may differ in their time horizons and risk orientations. For example,
institutional investors may advocate a reorganization plan that seeks to maximize values
over a longer time horizon than that preferred by the vulture investors. Similarly, higher
priority claimants often advocate a strategy designed to obtain recoveries sufficient to cover
most of their claims while offering relatively little to more junior claimants. Junior
claimants, in contrast, generally prefer a strategy that in effect risks at least a portion of
the more senior claimants’ potential recoveries to obtain an upside potential that if realized
would be shared with the juniors. In addition, certain creditors may need to resist attacks on
the validity, amount, and priority of their claims. Junior creditors may dispute the priority of
the senior’s postpetition interest claim (i.e., Is the junior’s claim subordinated to the senior’s
46 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

postpetition interest claim?). Certain other claims (e.g., those from past managers or
creditors who may have forced a bankruptcy filing by withdrawing credit facilities) may
be subject to equitable subordination. The amount and validity of severance and other claims
of former employees (particularly senior employees associated with the onset of the firm’s
financial distress) may face opposition. Finally, management will generally seek to devise
and have the creditors accept a plan that preserves their jobs and as much of the enterprise as
possible. Many creditors may prefer extensive management changes and asset sales. Trade
creditors may be more interested in retaining a good customer than collecting fully on their
own prepetition claims. To the extent that one group of interest holders asserts its claims and
positions, other groups may need to incur additional costs to maintain their relative
positions. Additional resources are required to monitor the managers. Moreover the more
resources interest holders focus on monitoring the distressed firm’s management, the more
resources the distressed firm may need to focus on dealing with the interest holders. Vulture
investors are particularly likely to get involved in not only the monitoring but also the
management of distressed firms (Hotchkiss, 2000). Such high levels of involvement are sure
to consume resources.
Krishnan and Mager’s (1994) study of leasing decisions illustrates the importance of these
costs. They find that contrary to leasing theory, leasing is preferred to secured lending where
the lessee/borrower has a significant probability of bankruptcy. Thus lessors seek to protect
themselves from the cost of dealing with a bankrupt creditor by entering into a lease
arrangement rather than a creditor–debtor relationship.
One indication of the magnitude of the creditors’ costs of dealing with the distressed
debtor comes from Platt’s (1994) study of loan workout costs. He examined a large New
England bank’s experience with problem loans. Specifically Platt explored the prebank-
ruptcy ‘‘auxiliary management costs’’ for a large New England bank’s portfolio of defaulted
business loans. He identifies four categories of prebankruptcy workout costs: incremental
bank labor, external legal fees, appraisal fees, and search fees. Thus Platt’s first category
corresponds to our internal staff resources whereas his remaining three categories corre-
spond to our professional fees category. Platt found that these costs averaged 2.4% of the
original size of the loan. This estimate may actually understate the costs incurred by the
holders of claims against distressed firms. First, by only looking at incremental labor costs,
Platt ignored any allocation for overhead or other nonlabor costs. Clearly, workout
specialists require office space, equipment, supervisors, etc. Second, his costs only related
to the prebankruptcy period for the borrower. Finally, his costs only related to large banks.
Banks, particularly large banks, are specialists in loan workout and as such should be able
to achieve meaningful scale economies that are unavailable to many other creditors. Still,
Platt’s study does illustrate the existence of significant financial distress-related costs borne
directly by the creditors. Berger and Young (1997) reach a similar conclusion: ‘‘increases in
non-performing loans tend to be followed by decreases in measured cost efficiency,
suggesting that high levels of problem loans cause banks to increase spending on
monitoring, working out, and/or selling off these loans, and possibly become more diligent
in administering the portion of their existing loan portfolio that is currently performing.’’
These costs are conservatively estimated at Platt’s 2.4% value.
 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 47

4.3. Reduced marketability

As a firm moves from a nondistressed to a distressed state, all of the stakeholders’

interests in it change their characters. The initial holders usually acquired their interests
(e.g., bonds, bank debt, trade debt, equity, etc.) at a time when the firm seemed to be
financially viable. Now they incur two categories of losses. 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. Moreover, the now-distressed instruments are very likely to be less suitable
for the original investor than they were when they were nondistressed instruments. Thus,
these interest holders now must hold a suboptimal (and costly to monitor and defend)
asset or sell it and bear a (potentially much higher) transaction cost that was not expected
when the interest was originally acquired. For example, suppliers who meant only to
extend short-term credit to facilitate a sale may find that their 30-day receivables have
turned into 2-year claims, likely to be paid off at a substantial discount in a bankruptcy
proceeding. Few if any trade creditors would have wanted to own such a claim even if
they could have purchased it at a very attractive price. Similarly, a typical investment
grade or even high yield bondholder is unlikely to wish to hold a defaulted bond. Even
banks that are accustomed to holding a portfolio of workout type loans are unlikely to
seek them out for investment. Thus claimants and other interest holders of a company
that subsequently went bankrupt are very likely to wish to sell their positions. Not only
will such sales allow the holders to redeploy their portfolios to a structure more to their
liking; these sales may also allow the initial holders to derive the corresponding tax
benefit promptly.

4.3.1. 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. Even nondistressed
securities’ bid–ask spreads and commissions tend to be higher in percentage terms on
lower priced issues (Branch, 1977). The additional risks associated with distressed
securities may well cause market makers to widen their spreads even further. Non-
security claims (e.g., bank and trade debt) are even more of a problem to sell once they
become distressed (Case, 1998). The market for nondistressed bank and trade claims is
far from perfect. Nonetheless, the promised or expected maturity date generally provides
a natural exit. Often, little or no transactions cost will be incurred if that natural exit
(i.e., payoff) occurs as promised. Moreover, sales of many such claims are relatively
easy to accomplish in the ordinary course of business (e.g., securitization, participation,
factoring, etc.). 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.
48 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

4.3.2. An example
The FoxMeyer bankruptcy provides an example of some of the problems that may be
encountered when selling trade claims (Jereski, 1996). The drug distributor FoxMeyer filed for
bankruptcy owing about US$500 million in trade claims to such firms as Merck, Eli Lilly, and
Glaxo-Wellcome. These claimsholders negotiated sales of about US$80 million of these
claims to several investment banking firms including Goldman Sachs, Bear Stern, and Merrill
Lynch for about 49¢ on the dollar. These firms in turn expected to sell the claims to investors
such as Odyssey Partners who specialize in distressed instruments. Because of the instruments’
nonsecurity nature (i.e., trade credits are not structured for easy trading), the documentation of
these proposed transactions was complicated and time consuming. As documenting the
transactions was proceeding the market became more aware of the extent of FoxMeyer’s
distress, causing the trade claim’s market value to fall to around 20¢. Not surprisingly, the buy
side of the incompletely documented transactions at 49¢ sought to disown the trade. The sell
side, in contrast, sought to force the transactions through at the original price.

4.3.3. 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. Indeed, investors often participate
indirectly in the trading of such claims by purchasing an interest in the claimsholder (e.g.,
investments in Pennzoil stock while the firm held a disputed claim against a bankrupt
Texaco). Direct claims tend to be difficult to trade. The maker is almost always in the best
position to pursue the claim and to know its realizable value. Thus, the claims are usually
worth more to the maker than to any potential third party buyer. Still, a claim against a
nonbankrupt party is on a well-defined time line toward resolution, in or out of court. Once
bankruptcy threatens, the claim (or in the case of a rejectable contract, the potential claim)
will almost certainly both decline in value and become even less marketable. The anticipated
time line toward its resolution is very likely to be extended and made much less predictable
by the bankruptcy filing’s automatic stay. In fact, a number of bankruptcy filings have sought
to deal with what had become a crushing burden of damage claims (Texaco, Dow-Corning,
A.H. Robins, etc.).
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?
One suggestive data point on this matter is provided in an article on M.J. Whitman making
a market in Kmart receivables (Plitch, 1995). In late 1995, Kmart was viewed as a troubled
firm that might eventually file for bankruptcy. M.J. Whitman was making a market in its trade
credit, at 80¢ bid 83¢ offered. The bid–ask spread on these claims amounted to almost 4%
(0.03/80 = 3.75%). Thus trade creditors who had been expecting to be paid off in full directly
by K-Mart were now faced with the possibility of having to incur a substantial transaction
cost to liquidate their positions at a discount.
 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 49

4.3.4. 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.
Clearly the bid ask spread rises as credit quality declines. We could not explain these
results by other factors such as the size of the issue. Accordingly, these findings suggest that
transactions costs for bank loans tend to increase with risk. For example, the average spread
for a distressed loan is 5.80% compared to 0.61% for a par loan, a difference of 5.16%. The
impact is even greater for severely distressed debt where the average spread widens from
0.61% to 7.71% or a difference of 7.10%. How much of the wider spread to assign as a cost to
claimsholders depends on the proportion of claimsholders who end up bearing the higher
transactions costs. If we conservatively assume that about 50% of the claimsholders will bear
these additional costs, and then assign 50% of the increase in the spread to the seller, the net
effect will be a distress-related marketability cost of between 1.25% (0.50  0.50  5%) and
1.75% (0.50  0.50  7%). These spreads only apply to bank debt. Houg and Warga (2000),
however, find that when bonds are divided into three basic categories — government,
investment grade, and below investment grade — average bid–ask spreads increase with
risk. Schultz (2001), on the other hand, finds no evidence of increased trading costs for lower-
rated bonds. His study, however, only considered trading costs for investment grade bonds.
Thus the threshold point at which marketability costs increase appears to be where credit
quality falls below investment grade.
We see that financial distress imposes two types of costs on its interest holders. The first of
these losses, decline in firm value due to distress, is reflected in the costs borne by the firm.
The other costs, Items 1, 2, and 3 above, are costs incurred directly by the interest holder.
Even though the firm itself does not bear them, at least not directly, it should take these
additional distress-related costs into account in its decision process. First, the firm’s managers
have a fiduciary duty to manage the firm for the benefit of its owners. In a distress situation,
and particularly in a default and/or bankruptcy situation, the creditors begin to take on
ownership characteristics. Thus, the distressed firm’s managers should manage the firm
largely in their creditors’ interests (Varallo & Finklestein, 1992). Second, the claimants will,
or should, take these potential costs into account in their initial pricing decisions. Thus, the
firm tends to incur these costs indirectly in the risk premium that it bears.

Table 1
Bid – ask spreads for 140 bank loans
Loan quality Spread (%) % spread
Par 0.61 0.61
Stressed 2.35 2.48
Distressed 5.80 5.90
Severely distressed 7.71 9.49
50 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

We estimate that the distress-related increased costs of monitoring and managing one’s
investments amount to 2.4% of their par value while the higher transactions costs for holders
who must sell such issues may add another 1.25% and 1.75%. Thus the total direct costs to
the beneficial owners of distressed debt appear to be in the range of 3.65–4.15% (or about
4%) of the claims’ PDVs. Earlier we saw that debt instruments of bankrupt firms typically
pay off around 60% of their par value. Thus, the net recovery of these claimsholders (after
subtracting the incremental costs borne by the interestholders due to the distress) averages
about 56% (60–4%).

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

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.

5.1. 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. The market share lost as a result of one firm’s bankruptcy is a gain for
one or more of its competitors. The bankrupt firm will incur losses as a result of its reduced
market share and the profits of the share-gaining firms will be enhanced (Chang &
McDonald, 1996). These gains and losses will not generally be of equal magnitudes. They
will, however, tend be at least somewhat offsetting. Indeed the sales declines are very likely
to cause the bankrupt firm’s capacity utilization to fall to less efficient levels. The market
share gainers, in contrast, may already be at or near their optimal (at least in the short run)
capacities. Thus their share gains may cause these competitors to operate at less efficient
above-optimal capacity outputs and/or add capacity while the loser operates at a suboptimal
scale and has underutilized capacity.

5.2. 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. Similarly it will need to accord an equally high implicit return to any
 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 51

opportunity to generate cash quickly by foregoing an insufficiently profitable proposal. This

short-run high-opportunity-cost-of-capital focus causes many potentially profitable possibil-
ities to be foregone. Such opportunities would have been exploited under more normal
circumstances. Similarly, to the extent that a cash-conserving orientation is inefficient, the
firm’s true economic costs of operation will rise. For example, deferred maintenance costs are
likely to have become greater than they otherwise would have been when those expenses
finally can be deferred no longer. Bankrupt firms almost always need, and may well be under
creditor pressure, to shed substantial amounts of assets (Shleifer & Vishny, 1992). These
assets must generally be sold at bargain prices (Pulvino, 1998). A buyer is thereby able to
exploit the seller’s financial distress to acquire useful assets at substantially less than its
reservation price. Such a purchaser has gained at the bankrupt firm’s expense. Moreover, the
more distressed a firm becomes, the greater its need to sell assets. In addition, many of these
assets are illiquid and therefore likely to incur substantial transaction costs (Kim, 1996).

5.2.1. 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.
Cutler and Summers (1988) studied the impact on security prices for one very large
bankruptcy filing, that of Texaco. Pennzoil alleged that it was damaged by Texaco’s improper
interference with its contract to purchase Getty Oil assets. Texaco was forced to file for
bankruptcy court protection as a result of a US$13 billion damage award arising out of that
dispute. Cutler and Summers found that the combined market values of the two firm’s
securities fell by about 30% as a result of the dispute while gaining back only about two-
thirds of this amount after the settlement. These losses are far greater than any reasonable
estimate for direct costs (professional fees, etc.). To quote Cutler and Summers:
By creating uncertainty about Texaco’s long-term viability, making it difficult for Texaco to
obtain credit, and distracting Texaco’s management, the litigation may have reduced
Texaco’s value by more than the expected value of the transfers it would have to make to
Pennzoil. Effects of this kind have been stressed in discussions of credit constraints
(Greenwald and Stiglitz, 1987) and of the burdens associated with LDC debt obligations
(Sachs and Huizinga, 1987).
The most important evidence for the adverse effects of the dispute is an affidavit Texaco
submitted with its bankruptcy filing that described the effect of the week-old Supreme Court
decision on its operations. The affidavit asserted that some suppliers had demanded cash
payments before performance or insisted on secured forms of repayment. Others halted crude
shipments temporarily or canceled them entirely. A number of banks had also refused to
enter into, or placed restrictions on, Texaco’s use of exchange-rate futures contracts. The
affidavit concluded:
The increasing deterioration of Texaco’s credit and financial condition has made it more and more difficult, with
each passing day, for Texaco to continue to finance and operate its business.. . . As normal supply sources become
52 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

inaccessible and other financing is unavailable, Texaco’s operations will begin to grind to a halt. In fact, Texaco
already has to consider the prospect of shutting down one of its largest domestic refineries because of its growing
inability to acquire crude and feedstock.

This sentiment was echoed by journalistic accounts of Texaco’s actions. The New York
Times, for example, noted that ‘‘Texaco has been under extreme financial pressure to resolve
the case because of nervousness among its lenders, suppliers, and business partners about its
future’’ (December 21, 1985, sec. I, p. 37, col. 5). Some analysts even attributed the stock
market reaction to these costs. The Wall Street Journal reported:
One analyst says he believes the market is assuming that Texaco will have to pay roughly US$5 billion in cash to
Pennzoil. But the market has discounted Texaco’s stock even further because, he says, the company already has
been damaged by the litigation ‘‘They’ve been unable to refinance debt they’ve missed opportunities in the oil
patch, and the diversion of management has to cost something’’ (April 8, 1987, sec. I, p.3, col. 5).

Unfortunately, no direct evidence exists on whether these operational problems were really of
major importance.N Indeed, the day after the affidavit was filed; some of the suppliers
mentioned specifically disputed Texaco’s assertions. The principal evidence of their importance
is the observation that most reasonable measures of conventional litigation costs are far below
the observed fluctuations in joint value (ibid.).
N
Attempts to analyze Texaco’s financial statements for evidence on the effects of the litigation were complicated
by the large gyrations in oil prices that occurred over the period.

Subtracting the impact of direct costs, Cutler and Summer’s work suggests a stock market
price-based estimate of 9% of the indirect costs of distress in the Texaco case. Still, this 9%
estimate is only one data point from one high profile case. Moreover, the market had good
reason in this case to believe that ending the uncertainty surrounding the dispute (e.g., via a
settlement or final court determination) would eventually reverse much of these indirect costs.

5.2.2. Other indirect cost studies

In an earlier study, Altman attempted to estimate the indirect costs based on the unexpected
loss of profits for the 3 years prior to bankruptcy. His analysis implies indirect costs of 4.5%
for retail and 10.5% for industrial firms. Wruck (1990), however, criticized Altman’s
methodology: ‘‘because it is impossible to tell whether the loss in profits is in fact caused
by financial distress or whether financial distress is caused by the loss in profits.’’ In another
study of indirect costs, Opler and Titman (1994) found that firms in the top leverage decile in
industries experiencing output contractions suffer a 26% greater loss in sales than do firms in
the bottom leverage decile. The market value of their equity declined similarly. While
suggesting a significant impact, the Opler and Titman findings do not provide a percentage
estimate for the magnitude of the indirect cost of financial distress. Another piece of evidence
on indirect costs comes from Chen and Merville (1995). The authors constructed a sample of
1041 firms from the 1992 Compustat tape. They then triaged the sample into firms based on
the trend in their Altman Z scores (Altman). Category A consisted of firms that moved from
healthy to distressed according to their Z scores while Category C moved in the opposite
direction. Category B exhibited no significant trend in Z score. The firms in Category A from
healthy to distressed, experienced an average annual market value decline of 8.3% of their
total assets subsequent to the time that their Z scores indicated that they had become
 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 53

distressed. The authors conclude from this and related findings that the indirect costs of
financial distress are significant. They do not, however, generate an estimate for the mag-
nitude of these costs.
In yet another study of the issue, Andrade and Kaplan (1998) examine the impact of
financial distress on operating income for 31 highly leveraged transactions. These results
suggest the indirect financial distress costs may be in the range of 10–17% although they
argue that these numbers could be biased upwards.
Notwithstanding their problems, taken together the Altman; Cutler and Summers; Opler
and Titman; Chen and Merville; and Andrade and Kaplan work suggest that the average
indirect costs of bankruptcy are substantial. One might reasonably infer from this literature
that such costs, stemming from loss of business and loss of efficiency, are likely to be at least
5% and quite possibly 10% (or more) of the PDV of the distressed firm, in addition to the
previously reported estimates of 0.7% to 1.4% for internal staff resources required to deal
with financial distress.
Note that our earlier discussed estimates for indirect costs include not only the real costs to
society but also those costs to the firm that are at least partially offset, from society’s
perspective, by gains to others. The existing literature does not provide a basis for estimating
how much of the indirect costs represent transfers from one party to another and how much
real losses to society.

6. 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. Studies by
Warner and Altman suggest a number in the range of 4%. The Gilson et al. (1990) study
suggests that prebankruptcy efforts to deal with financial distress may be in the order of
0.65% of assets. My own investigation suggests that the internal staff costs may amount to
between 17% and 35% of what the outside professionals charge. This extrapolation would
add about 0.7% to 1.4% to the total. The literature on indirect costs points to a very
substantial value impact from the short-run focus and loss of market share (Cutler &
Summers, 1988). We can probably allocate at least another 5% here and the actual cost
could be closer to 10% of the firm’s PDV. In total, this suggests that the firm itself would, on
the average, bear the loss in the neighborhood of 9.5% to 16.5% of the firm’s PDV for dealing
with the effects of financial distress.
Platt’s (1994) work suggests that the claimsholders may incur cost increases of about 2.4%
of the claim in monitoring and managing the problems claim. We estimate the impact of
reduced marketability at between 1.25% and 1.75% of the claim’s par value. Thus the average
cost to claimsholders is in the range of 3.65–4.15%. Accordingly our estimates are shown in
Table 2.
Holders of interests in a bankrupt firm would, on the average, only recover about 56%,
after subtracting costs of about 4% to obtain the recovery, of the value of their claims. They
would see an amount equal to 12% to 20% of their claims consumed in the process of dealing
54 B. Branch / International Review of Financial Analysis 11 (2002) 39–57

Table 2
Bankruptcy costs for firms and claimsholders as a percentage of PDV
Cost to firm
Direct costs
Professional fees while in bankruptcy 3.1 – 4.3%
Prebankruptcy costs 0.65%
Internal staff resource costs 0.7 – 1.4%
Total direct costs 4.45 – 6.35%
Indirect costs 5 – 10%
Total firm costs 9.45 – 16.35%

Cost to claimsholders
Monitoring costs 2.4%
Marketability costs 1.25 – 1.75%
Total claimsholders costs 3.25 – 4.15%
Total bankruptcy-related costs to firm and claimsholders 12.70 – 20.50%

with bankruptcy. Thus, an amount equal to about 21% (0.12/0.56 = 0.214) and perhaps as
much as 36% (0.20/0.56 = 0.3574) of the amount that the claimsholders recover is on the
average lost in dealing with the distressed circumstances. If these costs could be avoided, the
average recovery of distressed firm’s claimsholders could increase from about 56% of their
claims to a range of 68–76% of their claims.

7. Conclusion

Notwithstanding its limitations, this analysis reaches some important conclusions:

First, 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. The current analysis only begins to explore the magnitude of these costs.
Second, those having direct claims against the bankrupt firms (e.g., creditors and other
claimants) will not only incur losses due to the decline in the value of their interest but also
incur direct individual-specific costs associated with the changed characteristic of that
interest. In particular, an interest in a bankrupt entity is likely to require considerably greater
attention and costs to manage and be considerably more difficult and costly to sell than was
the case when the issuer was not distressed.
Third, the current analysis suggests that, on the average, the par value of the distressed
firm’s prebankruptcy debt is allocated as follows:

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 claimsholder amounts to about 56%.
 B. Branch / International Review of Financial Analysis 11 (2002) 39–57 55

Fourth, since a significant part of the value of the bankrupt firm is consumed in dealing
with its distress, bankruptcy costs play an important role in determining the optimal capital
structure. The costs of dealing with bankrupt securities (particularly those costs that are
borne directly by the interest holder) help explain the magnitude of the risk premium.
Indeed, what has been termed the pure risk premium (gross risk premium less the anticipated
default loss) may be largely explained by the extra management costs that must be incurred
by those who hold interests in bankrupt parties. The cost of dealing with bankruptcy has an
adverse impact on the risk premium, cost of capital and needed tax rates and therefore the
allocation of resources.

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Further Reading

Altman, E. (1984, September). Defaulted bonds: demand, supply and performance, 1987 – 1992. Financial An-
alysts Journal,, 55 – 60.
Altman, E., & Suggitt, E. (1993a, May – June). Default rates in the syndicated bank loan market: a mortality
analysis. Journal of Banking and Finance, 24, 229 – 253.
Branch, B., & Freed, W. (1993b). Bid – asked spreads on the AMEX and the big board. Journal of Finance, 32 (1),
159 – 163.
Brown, D., James, C., & Mooradian, R. (1994, Summer). Asset sales by financially distressed firms. Journal of
Corporate Finance,, 233 – 257.
Brown, T. (1996, November/December). Liquidity and liquidations: evidence from real estate investment trusts.
Journal of Finance, 55 (1), 469 – 485.
Clark, G. (2001). Regulating the restructuring of the U.S. steel industry; Chapter 11 of the Bankruptcy Code and
pension obligations. Regional Studies, 25 (2), 135 – 153.
Clark, G.L. (1991, April). Regulating the restructuring of the US steel industry: Chapter 11 of the Bankruptcy
Code and obligations. Regional Studies,, 135 – 153.
Connor, J. (2001, May). Finding value in distressed properties: a case study. Journal of Corporate Renewal, 14
(5), 16 – 18.
Engleman, K., & Cornell, B. (1998, October). Measuring the costs of corporation litigation: 5 case studies.
Journal of Legal Studies, 25 (2), 377 – 399.
Gilson, S.C. (1982, March). Management turnover and financial distress. Journal of Financial Economics, 25,
241 – 262.
Jog, U.M., Kotlar, I.D., & Tate, G. (1995). Stockholders losses in corporate restructuring: the evident fees from
losses in the North American steel industry. Financial Management,, 185 – 201.
LoPucki, L. M. (1983). The debtor in full control; Systems failure under Chapter 11 of the bankruptcy code?
American Bankruptcy Law Journal, 57, 99 – 126, 267 – 273.
Pulvino, T. (1996). Effect of bankruptcy court protection on asset sales. Unpublished working paper, Northwest-
ern University.
Sutton, R., & Callahan, A. (1977). The stigma of bankruptcy: spoiled organizational image and its management.
Academy of Management Journal, 30, 405 – 436.
Waldman, R., & Altman, E. (1999, july 8). High yield defaults. Solomon Smith, 1 – 13.