The local effects of bankruptcy
What are the local impacts of firms being liquidated? In a new paper, Professors Bernstein, Colonnelli, Giroud and Iverson show that it negatively affects the activity of closely located firms, mainly through a reduction in consumer traffic and a decrease in knowledge spillover. As a consequence, judges should take into account those negative spillovers when deciding whether or not to liquidate a firm.
Bankruptcy procedures are central to the economic process of resolving insolvency and financial distress. Used by firms that face difficulties to pay back their creditors, more than 1.8 million bankruptcy cases have been judged since 1980 in the US. In a new paper entitled “Bankruptcy Spillovers”, and presented at the 2017 Adam Smith Conference hosted by HEC, Professors Bernstein, Colonnelli, Giroud and Iverson show that when a firm enters bankruptcy and is ultimately liquidated, this has a strong negative impact on firms located in the same area.
Overcoming an empirical challenge by using judges
Empirically determining the local impact of liquidation is a challenging task as local economic conditions and the probability that a firm is liquidated are likely to be correlated. One cannot simply compare the evolution of employment in an area where a firm was liquidated with an area where this didn’t happen, as all firms in the former area are likely to face difficult economic times. The authors overcome this difficulty by using a unique feature of US bankruptcy institutions.
When a firm enters bankruptcy in the US, it can decide whether to opt for liquidation (chapter 7) or reorganization (chapter 11). In the former case, all of the firm’s assets are expected to be sold to repay creditors. In the latter case, filers expect the firm to be restructured but still active after the procedure. However, judges can decide to liquidate firms that filed for reorganization. The interesting thing about that decision is that the propensity to force firms into liquidation varies among judges. Some judges are simply more likely to do so, whether some are reluctant.
Those personal differences between judges allow the authors to compare the evolution of very similar areas that only differ by the type of judges that are in charge of the case, an assignment that is random.
The authors ultimately find that the liquidation of a firm leads to an average decrease of 4% of local employment, mainly due to slower growth of existing establishments and, to a lesser extent, reduced entry into the area.
The liquidation of a firm leads to an average decrease of 4% of local employment
How liquidation affects other firms?
The researchers then aim at disentangling between the potential channels through which liquidation may affect neighbor firms. Three main mechanisms may be at play. Liquidation may affect other firms if the liquidated firms are having a positive impact on the production of others firms through knowledge diffusion. It can also reduce the demand for other firms’ products if the employees of the liquidated firms stop consuming. Finally, it can lead to a reduction in consumer traffic as consumers tend to go in commercial areas where a lot of stores are concentrated, a way for them to reduce their search costs.
The available empirical evidence shows that the drop in economic activity after a liquidation is mainly due to the negative impact of lower knowledge diffusion and a drop in consumer traffic. They show in particular that firms that are the most dependent on consumer traffic, e.g. firms active in nontradable sectors, are particularly affected by the disappearance of a local firm, but only if the liquidated one is also a non-tradable firm. The impact of liquidation therefore depends both on the type of firm being liquidated as well as the type of neighbor firms.
On the welfare implications: a menu for future research
This is the first time that a paper shows the externalities associated with liquidation when compared to reorganization. Such findings will give judges a better understanding on the costs and benefits associated with their decision. The authors however stress that their analysis does not mean that liquidation in itself is inefficient. They highlight the fact that key questions are still pending to draw better welfare conclusions. To go a step further will require analyzing how employees and assets of liquidated firms are reallocated. The welfare impact ultimately depends on the frictions affecting such reallocation, a subject that will be left for future research.
This text was written by Charles Boissel, HEC Paris PhD, based on the working paper "Bankruptcy Spillovers" co-authored by Shai Bernstein (Stanford GSB) , Emanuele Colonnelli (Stanford University), Xavier Giroud (MIT Sloan) , Benjamin Iverson (Kellogg School of Management). This study was presented by Xavier Giroud during the Adam Smith Conference at HEC Paris on March, 2017.