The Bankruptcy System's Chapter 22 Recidivism Problem: How Serious is It?

• DOI: http://doi.org/10.1111/fire.12058
• Published date: 01 February 2015
• Date: 01 February 2015

The Financial Review 50 (2015) 1–26

The Bankruptcy System’s Chapter 22

Recidivism Problem: How Serious is It?

Edward I. Altman†

NYU Stern School of Business and NYU Salomon Center

Ben Branch∗

University of Massachusetts

Abstract

This paper is adapted from the keynote address from the Eastern Finance Association’s

2014 meeting in Pittsburg, Pennsylvania. We highlight a recidivism problem: about 15% of

debtors who emerge as continuing entities under Chapter 11, or are acquired as part of the

bankruptcy process, ultimately file for bankruptcy protection again (18.25% when considering

only those firms which emerge as a continuing, independent entity). Weargue that the “Chapter

22” issue should not be dismissed by the bankruptcy community just because no interested

party objects during the confirmation hearing. Applying the Z”-Score model to a large sample

of Chapter 11 cases reveals highly different and significant expected survival profiles at

emergence. Credible distress prediction techniques can effectively predict the future success

of firms emerging from bankruptcyand be used by the bankruptcy court to assess the feasibility

∗Corresponding author: Isenberg School of Management, 121 Presidents Drive, University of Mas-

sachusetts, Amherst, MA 01003; Phone: (413) 545-5690; E-mail: branchb@isenberg.umass.edu.

†Max L. Heine Professor of Finance and Director of Fixed Income & Credit Markets Research Program,

NYU Stern School of Business and NYU Salomon Center, 44 West 4th Street, New York, NY 10012;

(212) 998-0709; E-mail: ealtman@stern.nyu.edu. The original article was published in the Brooklyn J.

Corp. Fin. & Law in May 2014 (#8)-(2014). Professor Altman is indebted to the organizers and members

of the Barry L. Zaretsky Roundtable at the Brooklyn School of Law,November 18, 2013 for proposing and

participating in a discussion on “Avoiding Chapter 22-Predicting Success in Chapter” and to the Eastern

Finance Association for featuring a discussion of this type during Professor Altman’s keynote address at

the 50th Anniversary meeting in Pittsburgh,PA on April 11, 2014. The following article was motivated by

a discussion between Professors Altman and Branch at that meeting.

C2015 The Eastern Finance Association 1

2E. I. Altman and B. Branch/The Financial Review 50 (2015) 1–26

of the reorganization plan, a requirement mandated by the Bankruptcy Code. Branch reviews,

discusses, and critiques in this follow-up article to Altman’s original thesis.

Keywords: C hapter 11,Chapter 22, reorganization, feasibility, Z-Scores

JEL Classifications: G32, G38

1. Introduction

Ever since we first coined the phrase “Chapter 22” (Hotchkiss, 1992;

Altman, 1983), the U.S. bankruptcy community has been debating the fact that some

companies going through the Chapter 11 system need to refile soon after emerg-

ing. Note that 11 U.S.C. Clause 1129(a)(11) (2012) of the U.S. Bankruptcy Code

explicitly provides that: “confirmation of the plan is not likely to be followed by

the liquidation, or the need for further financial reorganization of the debtor or any

successor to the debtor under the plan, unless such liquidation or reorganization is

proposed in the plan.”

Hence, a “feasibility analysis” is one of the requirements for confirmation of

Chapter 11 plans of reorganization. We argue that the courts and restructuring pro-

fessionals should strongly consider utilizing statistical methodologies for predicting

corporate financial distress to complement the traditional feasibility analysis tests

now being used by restructuring specialists. We show that one such technique, the

Altman-Z-Score method, discriminates between firms that file for Chapter 11 at least

once after emergence compared to firms that do not suffer this recidivism event.

In a new study, Altman (2014a) updates and increases the sample size of firms

used to test his theory. He comments for the first time on the extent and frequencyof

Chapter 22, 33, and 44 filings in the United States, and provides some additional tests

(see Altman, Kant and Rattanaruengyot, 2009) about a number of relevant variables.

This paper, reviews his new findings, which set the stage for a more in-depth and

considered thesis.

When the debtor corporation refiles after it emerges, this bankruptcy constitutes

a reorganization failure, both in concept and in cost. This is due to the direct and

indirect costs of bankruptcies, estimated to be between 1% and 6% for direct costs

(e.g., by Warner, 1977; LoPucki and Kalin, 2001) and between 11% and 17% for

indirect costs, depending on the industry (Altman, 1984). The tradeoff between

bankruptcy costs and the tax benefits from additional debt is one of the cornerstones

for several generations of corporate financial theory.

Altman’s (1983) original thesis asserts that the likely refiling of an emerging

entity is not what the advisors or the court expect coming out of bankruptcy, and that

a fast, low cost, and reliable early warning system could greatly reduce the likelihood

of a refiling without materially adding to the costly nature of a long drawn-out

restructuring. See articles by McHugh, Michael and Shaked (1998), Lee (2001), Lee