Predicting Bankruptcy Reorganization for Closely Held Firms.

Abstract Economic theory suggests bankruptcy should serve as a screening process designed to eliminate only those firms that are economically inefficient. However, firms usually file bankruptcy voluntarily choosing either the Chapter 7 liquidation procedure or the Chapter 11 reorganization procedure. An inefficient firm that files under the Chapter 11 procedure is allowed to continue operating in the same line of business in which it was previously making losses until the bankruptcy court, after notice and a hearing, orders the Chapter 11 proceeding converted into a Chapter 7 proceeding. At the conversion hearing an accountant expert witness may be called upon to testify regarding the feasibility of the debtor's rehabilitation. This paper presents a prediction model that the accountant expert witness can use to forecast the probability of bankruptcy reorganization for closely held firms. Probit regression analysis and data from 121 Chapter 11 case files were used to estimate the model's parameters and test its predictive ability. Five factors were found to have significant power in distinguishing firms that reorganize versus those that liquidate: firm size, asset profitability, the number of secured creditors, the presence of unencumbered assets, and the number of under-secured secured creditors. The prediction model accurately classified 78.5% of the sample firms.