Your client's bankrupt? Think strategically

By Vanessa Sumo     
November 18, 2013

From: Magazine

In the United States, Chapter 11 of the bankruptcy code gives ailing firms some breathing room, time to reorganize and negotiate with creditors while managers remain in control of the company. That has helped companies such as Kodak, which this past September exited Chapter 11 a much leaner firm after it shed some of its unprofitable businesses. Other companies haven’t been as lucky. Circuit City, a former electronics retailer, and Borders, a former bookseller, eventually liquidated.

What makes one reorganization work and another fail? While the process can be complex, research shows that how other players such as suppliers and competitors respond to a distressed company can define the outcome. Professor John R. Birge and Associate Professor Rodney P. Parker, with Song Alex Yang of the London Business School, developed a model that helps them understand the operational strategies of a bankrupt firm, its suppliers, and competitors, and the impact their choices have on each other, as well as on consumers. Their findings, underscored by industry examples, show that supply chain interactions can help save the bankrupt company—or hasten its demise.

Consider a bankrupt company that is having trouble coming up with a viable reorganization plan. A competitor that suspects there’s a good chance the firm will fail can intentionally make matters worse. The researchers call this the “competitor effect.” The competitor might increase production and bring down prices to further squeeze the bankrupt rival’s profits, forcing it to liquidate. Moreover, knowing that the troubled firm will likely have a hard time reorganizing, the competitor could aggressively price its products even before the firm files for bankruptcy, effectively forcing it to do so.

Suppliers will also behave strategically when they see that one of their customers is struggling financially, what the researchers call the “supplier effect.” In this scenario, suppliers may decide to give their distressed clients a discount to help them stabilize operations during reorganization or avoid bankruptcy altogether. Though it means sacrificing some short-term profits, suppliers are willing to do what it takes to hang on to a customer for the long run.

The supplier’s discount could hurt the bankrupt firm’s competitors. Before American Airlines (AA) declared bankruptcy in 2011, it was the only large US legacy carrier that had avoided Chapter 11. Its rivals, when they reorganized under Chapter 11, had benefited enormously from negotiations with labor unions to slash wages and benefits. (Unions can be viewed as “suppliers” of labor.) As a result, AA’s competitors’ labor costs in 2010 were only 3.3¢ to 3.6¢  per available seat mile, compared with 4.3¢ for AA. This cost disad vantage eventually led to AA’s bankruptcy.

In looking at a third scenario—the “interaction effect” between two competitors and a shared supplier—the researchers find that the supplier’s strategy could be complicated by  its ability to push a distressed firm into bankruptcy in order to increase profits from the other firm. This happens when a supplier thinks that its bankrupt client only has a small chance of reorganizing successfully, so it is less inclined to offer discounts. As a bankrupt firm struggles to reorganize, a supplier might find it too costly and risky to grant ever-larger concessions just to keep its client alive. Without those concessions, a competitor might have a much easier time pushing the failing firm out of business.

The case of Borders is instructive. In the bookseller’s final days, book publishers, the company’s main suppliers, rejected the bookstore’s proposal to convert past-due payments to publishers into interest-bearing notes. They were also unconvinced about the soundness of Borders’s restructuring plan. Meanwhile, Barnes & Noble, Borders’s main brick-and-mortar competitor, made it clear that it didn’t want the bookseller to get a special deal from publishers. Barnes & Noble argued that any concessions made to Borders would be unfair, and that publishers should offer the same rate to all booksellers.

Preventing suppliers from giving discounts to a bankrupt firm may not only force the company to fail, as it did to Borders, but may also hurt consumers by limiting competition, the authors contend. If suppliers are restricted from giving concessions to a bankrupt company, the odds increase that it will collapse and leave consumers with fewer companies to compete for their business. Consumers are, therefore, better off when a bankrupt firm reorganizes and emerges from bankruptcy a more profitable and stronger company.

The researchers note one factor that can help a bankrupt firm’s transformation: if its main creditors are also its suppliers. US bankruptcy rules state that in the first 120 days after a firm files for bankruptcy protection, only the bankrupt company itself can propose a restructuring plan. Creditors can present an alternative plan only after this period expires. But if the bankrupt firm’s creditor is also its supplier, the supplier can directly influence the restructuring process without having to wait 120 days. And because suppliers have an incentive to make a reorganization work, the process of restructuring can proceed more smoothly.

Work cited

John R. Birge, Rodney P. Parker, and Song Alex Yang, “The Supply Chain Effect of Bankruptcy Reorganization,” Working paper, May 2013.