Executory Contracts and Chapter 11 Restructuring Incentives

Abstract

Chapter 11 bankruptcy provides firms with broad latitude to reject certain executory contracts, which are contracts whose terms have not been fully executed. We focus on the impact of this feature of the Bankruptcy Code by examining one of the most common executory contracts, operating leases. Our sample consists of large, public companies that file for Chapter 11 or undergo a distressed restructuring outside of court between 1991 and 2004. We find that firms with relatively high levels of leased assets are more likely to file for Chapter 11 than to restructure out of court and that firms in Chapter 11 frequently exercise the option contained in the Bankruptcy Code to "put" unwanted leases back to lessors, suggesting that this feature of the Bankruptcy Code can have a substantial impact on the behavior of distressed firms. The magnitude of lease reductions is greater than that of asset sales over the Chapter 11 period. Finally, we find that firms tend to reduce leases more during periods where asset values are likely to be low, thus possibly mitigating some of the asset fire sale problem in bankruptcy.

Keywords: Chapter 11, distressed restructuring, leasing, executory contracts

JEL Classification: G33