Financial distress has a cost. Creditors would say I've just stated the obvious.
In most cases, the borrower incurs the cost in the form of higher interest rates and fees up front, although unanticipated costs, and costs imposed on tort victims, are created by those creditors.
The costs of corporate bankruptcy or reorganization are often considered to encompass two concepts. First, there are the direct costs, composed chiefly of the professionals fees associated with reorganization. But they also include other lesser costs, like court filing fees and, in the United States, quarterly fees due to the United States Trustee's office.
Academics, including myself, examine these costs a lot, in part because they are easy to study. They are spelled out in precise dollars.
In addition, there are indirect costs of a company's financial distress, which are more abstract, like lost revenue, lost opportunities and lost good will.
Some of these costs may be of concern to the company's stakeholders, but not to policy makers if, for example, financial distress simply results in the shifting of sales from the distressed firm to a competitor firm â€" unless the competitor is abroad.
American Airlines, which filed for bankruptcy protection in November 2011, is incurring those costs right now in a public way.
Seats are loose, bloggers are complaining, and pilots are (understandably) unwilling to cut the company any breaks, since the company wants to cut the costs of pilots.
A recent paper in The Journal of Financial Economics (here's a free version) shows that these sorts of indirect costs are incurred for years before the company formally defaults. Rather than a sudden, Lehman-style collapse, the authors say that it is far more common for firms to experience a slow erosion of value.
This finding has a lot of important implications. First of all, it suggests that academics may be focusing too narro wly on fees. Chapter 11 professional fees are sensational â€" the media loves to talk about the high-priced lawyers that help companies go broke â€" but they don't seem to be an important part of the cost here.
And if most of the cost is incurred long before bankruptcy, then we may need to reform the Chapter 11 portion of the bankruptcy code in a way that will allow those costs to be cut sooner.
Of course, management always expects that the turnaround that will help it avoid bankruptcy is just around the corner.
Often it's called terminal optimism.
Stephen J. Lubben holds the Harvey Washington Wiley chair in corporate governance and business ethics at the Seton Hall University School of Law and is an expert on bankruptcy.
