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Study by Lie Finds Corporate Debt Sticks Even through Bankruptcy

As more and more companies consider bankruptcy to deal with sky-high debt and an economy in recession, new research by University of Iowa finance professor Erik Lie suggests the move might provide only limited help for many.

Lie's study, to be published later this year, suggests companies that enter bankruptcy emerge too soon and still have too much debt when compared to peer companies to survive long term. The companies also tend to be less profitable than their peers, raising even more questions about their long-term viability.

"We found that a firm's debt is sticky, even through the bankruptcy process, and too much debt and not enough profit is a dangerous combination," said Lie, a finance professor in the Tippie College of Business whose earlier research discovered that some corporate executives were illegally backdating stock options acquisitions. The discovery led to the prosecution and conviction of dozens of executives at U.S. corporations.

Lie and his co-authors, Randall Heron of the University of Indiana and Kimberly Rodgers of American University, studied 172 companies that filed for Chapter 11 bankruptcy protection between 1990 and 2003. The companies filed in U.S. bankruptcy courts for Delaware, the Southern District of New York, and other districts, and all were "fresh start" bankruptcies, where creditors were given 50 percent or more of the firm's equity in exchange for the debt they held. The research will be published in a forthcoming issue of the journal Financial Management.

The researchers found that companies in their sample emerged from bankruptcy with an average long-term debt margin of 40 percent of book value—much higher than their peers--and an average profit margin of only 8 percent—much lower than their peers.

"That's a concern because the long-term debt eventually becomes short-term debt and will need to be paid, and it's a question whether the companies are profitable enough to make those payments," Lie said. "In addition, such a high debt load makes it more difficult to obtain additional debt in the future, which might be needed to help the firm grow and remain competitive."

Indeed, Lie said many of the companies in the research sample continued to have financial problems after emerging from bankruptcy and some have even re-filed for Chapter 11 protection, or so-called "Chapter 22."

Lie's research also found that firms with more debt going into bankruptcy emerge from bankruptcy more quickly. He said this is likely because it's easier and less time-consuming to restructure a company's financial claims than to restructure its fundamental operations. He said the evidence suggests that rather than helping firms to a "fresh start," in some cases Chapter 11 bankruptcy protection may actually hinder a firm's ability to use bankruptcy to make itself more viable. He said firms emerge from bankruptcy prematurely for a variety of reasons.

Company stakeholders, he said, want to move on as quickly as possible and are looking to minimize the damage to its public perception; debt holders are often unwilling to take equity in exchange for their debt claims; and the bankruptcy court wants to clear a case from its docket.

If the evidence is applied to the situation facing General Motors and Chrysler, Lie said, the forecast is not encouraging. While the economic recession is hurting all automakers, only GM and Chrysler are at immediate risk of filing for bankruptcy. If they do in fact go into bankruptcy and emerge with too much debt and too little profitability, they will have a hard time competing in the market against other stronger auto companies.

Lie notes that his study only looked at problems related to a bankrupt firm's debt load and its "financial distress," not its structural issues. He said GM's and Chrysler's well-documented organizational dysfunctions will make long-term success even more difficult to attain.

"If it's only a debt problem, you can emerge from bankruptcy more quickly and have a better chance at long-term success because debt reorganization alone is simpler than a structural reorganization," he said.


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