Understanding and predicting the resolution of financial distress

Michael Jacobs, Jr., Ph.D.

+

Senior Financial Economist
Credit Risk Modeling, Risk Analysis Division
Office of the Comptroller of the Currency
One Independence Square, 2nd Floor, Washington, DC 20219
202-874-4728
michael.jacobs@occ.treas.gov

Ahmet K. Karagozoglu, Ph.D.
+

Associate Professor
Department of Finance
Zarb School of Business
Hofstra University
Hempstead, NY 11549
516-463-5701
finakk@hofstra.edu

Dina Naples Layish, Ph.D.
Assistant Professor of Finance
School of Management
Binghamton University
Binghamton, NY 13902
607-777-6854
dlayish@binghamton.edu


September 2010

JEL Classification: G33, G34, C25, C15, C52

Keywords: Default, Financial Distress, Liquidation, Reorganization, Bankruptcy, Restructuring,
Credit Risk, Discrete Regression, Bootstrap Methods, Forecasting, Classification Accuracy

We thank seminar participants at the 2008 Credit and Risk Management: 40 Years after the Altman Z-Score Model
Conference in Florence, Italy, June 2008. We also thank George Papaioannou for helpful comments.
+
The views expressed herein are those of the authors and do not necessarily represent a position taken by the Office
of the Comptroller of the Currency or the U. S. Department of the Treasury.
+
Corresponding author. Karagozoglu acknowledges Summer Research Grant from the Frank G. Zarb School of
Business that partially supported this research.
Abstract
We empirically investigate the determinants of the process utilized to resolve financial
distress (resolution process: private-work out vs. public-bankruptcy filing) and also the outcome
of that financial distress (resolution outcome: liquidation vs. reorganization). Various qualitative
dependent variable models are estimated and compared: ordered logistic regression, local
regression models and feed forward neural network. We select several accounting and economic
variables, measured at the time of default, that we expect to influence the resolution process and
the resolution outcome. Estimation results reveal the ordered logistic regression specification
achieves the best balance between in-sample fit, consistency with financial theory, and out-of-
sample classification accuracy. We find that larger firms with higher liquidity and more secured
debt in their capital structure are more likely to follow a public resolution process. Firms with
higher Z-scores and more total leverage are less likely to follow a public resolution process and
attempt to resolve the financial distress privately. Regarding resolution outcome, we find that
firms with greater liquidity, more secured debt and lower cumulative abnormal returns are more
likely to be liquidated than reorganized. Additionally, firms with more leverage, more intangible
assets and filing a prepackaged bankruptcy are more likely to be reorganized.

1
Understanding and predicting the resolution of financial distress
1. Introduction and summary
In situations of default or financial distress, there are two primary resolution processes that a
firm can pursue: a private resolution, by renegotiating existing claims, or a public resolution, by
utilizing legal bankruptcy channels. When a private arrangement amongst a firms stakeholders
cannot be reached, firms in the U.S. file for bankruptcy and are placed under court supervision.
Bankruptcy is usually settled with a court approved rehabilitation scheme within about 1.5 years
of filing. Whether public or private, these restructurings allow for one of the following
outcomes: emergence as an independent entity, acquisition by another firm or liquidation of
assets and the distribution of proceeds to stakeholders.
Clearly, the resolution process and the resolution outcome is affected by many factors,
including firm characteristics and performance, macroeconomic and market factors. Since firms
in financial distress share similar characteristics (i.e., declining revenues, earnings, asset and
equity values), it is more difficult to differentiate between them and classify the final outcome, as
compared to predicting financial distress among all firms. Consequently, in the prior finance
literature, the problem of predicting bankruptcy resolution has not been studied as extensively as
that of predicting financial distress. Our research studies both the resolution and outcome of
financial distress in an econometrically rigorous fashion with an application to a current dataset
of public defaults. Our modeling of the resolution process and resolution outcome of financial
distress is presented in Figure 1, which also provides the number of firms within our data sample
for each of the categories of process and outcome. Although in general, there are six paths that a
financially distressed firm can follow, not surprisingly we do not observe liquidation as an
outcome when a firm follows a private resolution process (see Figure 1).
2
Figure 1 here
In evaluating the resolution processes and outcomes of financial distress, we examine the
characteristics of firms that are able to resolve their financial distress out of court as compared to
firms that file for bankruptcy. We also examine the indicators that separate firms that are able to
emerge as independent from firms that are liquidated.
We specify variables determining, and postulate relationships to, the resolution process and
the resolution outcome by choosing variables based upon economic theory, prior empirical
results, and exploratory data analysis. We estimate and compare several qualitative dependent
variable econometric models, namely ordered logistic regression (OLR), local regression models
(LRM), and feed-forward neural networks (FNN). We evaluate the classification accuracy of
our models and also conduct a bootstrap experiment in order to assess the out-of-sample
predictive capability of the models. Our use of these econometric modeling and prediction
accuracy techniques make our papers contribution more significant.
We find that larger firms with higher liquidity and more secured debt in their capital structure
are more likely to follow a public resolution process. Firms with higher Z-scores and more total
leverage are less likely to follow a public resolution process, and instead attempt to resolve the
financial distress privately. With respect to the resolution outcome, firms with greater liquidity,
more secured debt and lower cumulative abnormal returns are more likely to be liquidated rather
than reorganized. Firms with more leverage, more intangible assets and filing a prepackaged
bankruptcy are more likely to be reorganized.
In a complementary paper Pindado, Rodrigues, and de la Torre (2008) investigate the
likelihood of financial distress for non-financial firms from G-7 countries and find that
profitability and retained earnings negatively influence the likelihood of financial distress.
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While they used OLR for predicting the distress, we model the process and resolution once a
firm is in distress. Joseph and Lipka (2006) study the marginal utility of accounting information
and find that the usefulness of earnings, cash flows, accruals and book values rapidly declines as
firms enter financial distress. Our empirical results are in accordance with the findings of both
papers.
Our paper focuses on determining which types of firms are able to survive financial distress
and successfully remain as an independent entity. By examining pre-distress firm characteristics,
our aim is to properly predict the five possible outcomes of financial distress. Barniv, Agarwal
and Leach (2002), in a similar approach, model the resolution outcome; while our paper
investigates both the resolution process as well as its outcome and extends the analysis by
including a larger set of variables in the modelling exercise.
The cost to society of firms that file for bankruptcy can be substantial and recent notable
bankruptcies, such as Enron, WorldCom, and significant financial distress experienced in
automobile industry, provide ample evidence of this cost. As a result of such significant cost, the
Sarbanes-Oxley Act of 2002 heightened accountability standards for individuals responsible for
documenting and reporting the financial health of publicly traded firms.
Our research into predicting bankruptcy outcome is of importance to a range of participants in
this domain of finance: investors in distressed equity and debt in building investment strategies,
stakeholders during often prolonged court deliberations in developing a plan of negotiation, and
risk managers in building practical credit risk models. Our results can contribute significantly to
informed decisions regarding the allocation of scarce resources during financial distress.
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Section two presents a review of the literature and testable hypotheses while section three
discusses the empirical methodology. Section four includes the data and univariate analysis,
while section five presents our main empirical results and final section concludes the paper.

2. Testable hypotheses and review of the literature
In order to explain the resolution of financial distress, twelve variable groupings are chosen
on the basis of theory or prior empirical results in the literature. The dimensions that they
capture, the empirical proxies used and hypothesized relations to the resolution or process type
are listed in Table 1.
Table 1 here
A major factor that affects a firms ability to resolve its financial distress is the amount of
leverage. Greater leverage implies lower recovery in liquidation due to the additional costs of a
formal bankruptcy filing, and therefore serves as an incentive to attempt a reorganization or
avoid bankruptcy altogether. However, individual creditors may have an incentive to hold out,
which affects the resolution process. For example, secured creditors may be better off if the firm
is liquidated. Jensen (1989) argues that firms with more leverage are forced to manage their
investment decisions and cash flow better and may be forced to restructure sooner (i.e., debt acts
as a monitoring mechanism). Therefore, we hypothesize that firms with more leverage
restructure sooner and thereby avoid liquidation. We expect a negative relationship between
leverage and the bankruptcy resolution process and a negative relationship between leverage and
the liquidation outcome.
Alternatively, if the creditor hold out problem prevails, the opposite holds. The effect of
leverage on the resolution process and the resolution outcome is separated by examining the
5
effect of total leverage and the level of secured debt, respectively. Hotchkiss (1993) finds no
empirical evidence that total debt affects the outcome of the bankruptcy filing, but does find that
the type of debt is significant. Specifically, firms with public debt are more likely to be
reorganized rather than liquidated. On the other hand, Zingales (1998) finds that firms with
more debt are more likely to be liquidated, even after controlling for profitability, efficiency, and
the ex ante probability of default and argues that leverage negatively affects a firms ability to
compete and finance new investments.
Some determinants of bankruptcy resolution may in fact be influenced by the desired outcome
on the part of the firm (e.g., a firm that is more likely to renegotiate its debt may also actively
work to keep its leverage down). In such cases, both capital structure and resolution of financial
distress may be endogenously determined by unobservable factors. This potential endogeneity
bias is present in similar research papers modeling financial distress and its resolution.
Larger size/scale of operations should reduce the chances of liquidation. The complexity of
larger firms and self-selection may make a public resolution process (i.e., filing for bankruptcy)
more likely, as bigger firms are better candidates for rehabilitating a business model, and
therefore, are more likely to achieve a successful resolution outcome (reorganization rather than
liquidation). Gilson, John and Lang (1990) as well as LoPucki and Whitford (1993) find that
firms with more distinct classes of debt are more likely to utilize a public resolution process,
concluding that the complex capital structure hinders the firms ability to restructure privately.
We consider the free cash flow and intangible assets of the firm to examine the influence of
agency problems within a financially distressed firm. Lehn and Poulson (1989) argue that a firm
is more likely to emerge successfully from financial distress if it has higher levels of free cash
flow. In addition, creditors of firms with more free cash flow should be more willing to
6
negotiate privately in order to preserve this cash flow and avoid the additional expenses of a
public bankruptcy filing. However, agency problems are greater for firms with greater free cash
flow (Jensen 1989 and Teall 1993), so these firms may be more likely to utilize a public
resolution process and also may be more likely to be liquidated. We expect free cash flow to be
positively related to a private resolution process as well as positively related to a reorganization
outcome. In a related result, Hong (1984) predicts that firms with greater levels of intangible
assets are more likely to experience a successful reorganization outcome.
Kahl (2001) finds that more profitable firms are more likely to use a public resolution process
and are also more likely to successfully emerge from the financial distress as an independent
firm. Alternatively, creditors may be more likely to agree to a private resolution process for
firms with greater profitability. We expect profitability to be positively related to a private
resolution process and also to be positively related to a reorganization outcome due to the higher
intrinsic value of the firm. While firms with higher liquidity may be better candidates for a
private resolution process and also for a reorganization outcome, the agency problems inherent in
a firm with higher liquidity may affect the resolution process and the resolution outcome. On
one hand, higher liquidity implies that a firm is in a better position to continue operations and
creditors may be more favorable to a private resolution. Alternatively, a public resolution would
allow for the sale of these assets, increasing the funds available for distribution.
The capital structure variables, number of major creditor classes at default and percent of
secured debt, are expected to be positively related to both the probability of a bankruptcy
resolution process and of a liquidation resolution outcome. The greater bargaining power among
secured creditors and the creditor coordination problem makes the bankruptcy filing process or
liquidation outcome more likely. In addition, the complexity of the firms capital structure as
7
well as the seniority of the claimants on the firms assets affects the ability of the firm to attempt
an out-of-court settlement. Chatterjee, Dhillon and Ramirez (1996) find that firms utilize a
public resolution process when there is a significant creditor coordination problem.
The credit quality of the firm and the markets reaction to the financial distress also affect the
resolution process chosen and the resolution outcome. Borrowers with lower credit quality prior
to default (measured by credit spread just prior to default, implied loss-given-default on traded
debt at default, investment grade status at origination or the Altman Z-Score one year prior to
default) are considered better candidates for a public resolution process and a liquidation
outcome. This outcome is because higher credit quality might signal assets or a business model
more amenable to privately rehabilitation, and also may predict a successful outcome. Grice and
Ingram (2001) show that Altmans Z-Score model is as useful for predicting financial stress
conditions other than bankruptcy as it is for predicting bankruptcy. We use cumulative abnormal
return (CAR) surrounding the default to examine if the market predicts the resolution process
and/or the resolution outcome and hypothesize that CAR is positively related to a private
resolution process and a successful resolution outcome.
The vintage of debt (time since debt is issued, time to maturity or time between instrument
defaults) is hypothesized to be negatively related to the public resolution process as well as the
liquidation outcome. The rationale is that borrowers that have been around for longer, or that
have had more time to deal with financial distress between default events, may have more
intrinsic value and therefore be better reorganization or out-of-court settlement candidates.
In an economic downturn, creditors are less likely to sell assets when asset values are
depressed, and hence are more likely to attempt a public reorganization outcome. Failing during
an expansion sends a different signal about the ultimate quality of the business than during a
8
downturn. Brown, Ciochetti and Riddiough (2006) develop and empirically test a model using
real estate data and find that in an owner-managed and endogenous default setting, restructuring
as compared to liquidation occurs when industry wealth is low. We measure the macroeconomic
state using the Moodys 12-month speculative or all-corporate default, and the S&P 500 equity
returns. Collateral values are likely to be depressed during a recession, implying that claimants
are more likely to attempt a private resolution process and avoid bankruptcy proceedings.
We expect that, in certain legal jurisdictions, liquidation is less likely. The Southern District
of New York and the District of Delaware bankruptcy courts are notoriously pro-debtor, so these
firms are more likely to both utilize a public resolution process and to experience a successful
outcome. We therefore include a dummy variable for the Southern District of New York and the
District of Delaware.
Finally, we have the Auditors Opinion, an indicator of the quality of the firms financials
at the last filing prior to default. The Auditors Opinion is a numerical score that assesses the
quality of the firms financial statements and controls: the less favorable this assessment, the
more likely there results a public resolution process or a liquidation outcome.
Several other studies are worth mentioning here. Kealhofer (2003) shows that expected
default frequency (EDF) model implemented by the Moodys KMV outperform agency ratings
based on data from 1979 to 1999. Chava and Jarrow (2004) investigate the predictive accuracy
of hazard rate models applied for bankruptcy events and using U.S. corporate default data (1962-
1999), demonstrating the importance of including industry effects in hazard rate estimation.
Duffie, Saita and Wang (2007) find that the term structure of conditional future default
probabilities depend upon a firms distance to default, trailing stock and S&P 500 returns. Gaunt
Gray and Wu (2010) investigate the empirical performance of bankruptcy prediction models and
9
find that various models contain unique information regarding the probability of bankruptcy;
however, their performance varies over time.
Powell and Yawson (2007), using data on U.K. firms, find evidence that financial distress is
due to poor performance, lower growth and higher leverage. Agarwal and Taffler (2008)
compare the performance of market-based models and accounting-ratio-based models in
predicting bankruptcy, finding little difference in their predictive accuracy for U.K. firms.
Jostarndt and Sautner (2009), using data on German firms, find that a higher fraction of total debt
owed to bank-lenders increases the probability of a private workout. Franks and Sussman (2005)
investigate the resolution of financial distress of small and medium-sized U.K. companies and
find that U.K. banks make the liquidation decision close to when the value of such firms equals
the value of the banks collateral. San and Ayca (2006) find that costs of financial distress are
significantly higher in Latin America than in developed countries.

3. Econometric models and measurement of model performance
Classes of models employed in the literature span linear (e.g., multiple discriminant analysis-
MDA), generalized linear (e.g., multinomial logistic regression-MLR), generalized additive
(local regression models-LRMs), and non-linear models (multi-perceptron neural networks-
MNN). Following the seminal work by Altman (1968) utilizing MDA to classify healthy vs.
financially distressed firms, numerous studies in the finance and accounting literature continued
to use this technique. Later studies use generalized linear models (GLM), such as logit (Ohlson,
1980) and probit (Zmijewski, 1984). Among the first of the few existing studies to deal with the
post-bankruptcy scenario, LoPucki (1983) uses linear correlation analysis to examine bankruptcy
outcomes for a small sample of firms. Casey, McGee and Stickney (1986) build an MDA model
10
to discriminate between groups of liquidated and restructured firms using purely accounting
variables. Barniv, Agarwal and Leach (2002) apply an OLR model to predict three resolution
types (liquidation, acquisition or emergence), to a sample of 237 defaulted firms from 1980 to
1995, using five accounting and five non-accounting variables and claim that it is three times
more costly to misclassify liquidation as either an acquisition or emergence than it is to
misclassify the other two. While signs on and statistical significance of coefficients are not
consistent with theory across all specifications, they are able to achieve 70% out-of-sample
classification accuracy relative to random classification scheme. Fisher and Martel (2003) apply
a similar model to 640 bankrupt Canadian firms from 1977-1988 with thirteen accounting and
macroeconomic variables.
In order to probabilistically classify bankruptcy resolution, we compare three approaches. As
the model representative of the GLM class, as well as an overall baseline model, we choose the
MLR. This choice is motivated by the commonness of application in the recent distress and
bankruptcy resolution literature, as well as its simplicity and defensibility relative to more
computationally intensive approaches, both within and outside of this class. MLR assumes that
the dependent variable Y can take on r = 1,.., R unordered discrete values (resolution types) for
each independent observation i = 1,.., N. Then the random variable Y
i
is multinomially
distributed. MLR models the conditional mean probability of observing resolution r linked to a
linear function of explanatory variables through a logistic function:
( )
( )
( )
r
T
i ri
i i 2 R i
R
T
j i ji
j=2
exp +
Pr(Y =r | ) =F ,..., , = i =1,.. N; r = 2,.., R
1+ exp +
c
c

X
X X
X
(1)
For the baseline category, r = 1, we have:
11
( )
( )
i i 2 R i
R
T
j i ji
j=2
1
Pr(Y =1| ) =F ,.., , = i =1,.. N
1+ exp +c

X X
X
(2)
where Pr(.) denotes probability, F(.) is a cumulative distribution function, ( )
1 k
,..,
T
r r r
= is a
vector of regression coefficients for the r
th
resolution type, and ( )
i i1 ik
X ,.., X
T
= X is a vector of
explanatory variables for the i
th
observation. In the 2-state setting for resolution, we can code the
polychotomous dependent variable as (reducing to logistic regression):
0
1
if reorganization
r
if liquidation

We can express this model in terms of a logit transformation of the dependent variable as the log
odds ratio of any outcome relative to the baseline:
r
T i i
i ri
i i
Pr(Y = | )
log + i =1,.. N; r = 2,.., R
Pr(Y =1| )
r
c
| |
=
|
\ .
X
X
X
(3)
We define the dummy variables:
ir
ir
1 if Y =1
d = i =1,.., N; r =1,.., R
0 otherwise

(4)
Then the log-likelihood function is written as:
( ) ( )
N R
1 R 1 1 n ir i i
i=1 r=1
Log L ,.., ; ,.., , Y,.., Y d Pr(Y =r | )
n
=

X X X (5)
The second class of linear qualitative dependent models that we implement, in the generalized
linear model class, is the local regression models (LRMs), as discussed in Hastie and Tibshirani
(1990), Siminoff (1996) and Bowman and Azzalini (1997). LRM represents a generalization of
GLM framework, in which we replace a linear function by an additive predictor, or a linear
combination of smooth functions :
i
f R R :
( )
n
i i i i i
i=1
Pr(Y = r | X ) = L f X +c
| |
|
\ .

(6)
12
where the link function ( )
1
1
x
L x
e

=
+
stands for the logistic function. In GLM terminology, L(.)
relates the conditional mean of the dependent variable (i.e., the probability of occurrence) to a
linear function, which extends in this context to a sum of arbitrary functions satisfying certain
regularity conditions.
In the class of neural networks, we consider the feed-forward neural network model (FNN):
( ) ( )
T
i i i 0 0 i
1
Pr(Y 1| ) F
k
T
j j j i
j
o o o o c
=
| |
= = = + +
|
\ .

X X X (7)
where ( ) ( ) ( )
1
x 1 exp x

= + is used as the logistic function, ( )
0
. is the activation function in the
outer layer,
0
is the bias in the hidden layer, ( ) .
j
is the j
th
activation function (output unit) in
the hidden layer,
j
is the weight on the j
th
activation function,
j
is the coefficient vector in the
j
th
output unit in the input layer with first element
j0
, the corresponding bias, and k is the total
number of output units.
There are various dimensions along which we may measure model performance,
corresponding to competing objectives in how a model is to be implemented. These correspond
to two notions of accuracy - classification accuracy versus predictive accuracy. Classification
accuracy is the ability of the model to discriminate amongst outcomes, or in the parlance of
credit risk modeling, to quantify risk in a relative sense. Predictive accuracy is the ability of the
model to forecast the level of the response variable in an absolute sense, or to measure risk
cardinally. In probabilistic modeling, for default frequency or in the present context of
resolution of default, this represents the ability to produce an estimated probability that is correct
most of the time, on average. Classification accuracy is evaluated by expected cost of
misclassification (ECM), unweighted minimization of misclassification (UMM) and deviation
13
from historical averages (DHA). We also conduct a bootstrap experiment (see Efron and
Tibshirani 1986) in order to assess the out-of-sample predictive capability of the models. Kahl
(2002) finds that correctly separating efficient firms from inefficient firms is extremely difficult.

4. Summary statistics and univariate statistical analysis
We build a database of defaulted firms (bankruptcies and out-of-court settlements), all having
rated instruments (S&P or Moodys) at some point prior to default. We compile default data
from various sources and combine it with public sources of information (SEC filings from Edgar,
LEXIS/NEXIS, Bloomberg, Compustat and CRSP). Our resulting dataset contains information
on 518 firms during the period 1985-2004 for which there is an indication for the resolution
process and resolution outcome, in addition to financial statement data from Compustat at the
time of default. Default signifies the earliest date for which we can define a missed interest
payment, violation of a covenant or public announcement of distress.
Most of the firms in our sample file for bankruptcy (public resolution process) and
successfully emerge as an independent entity (reorganization outcome.) Of those that are able to
resolve their financial distress outside of the court system, most (94%) emerge as an independent
entity. Only 74% of the firms that file for bankruptcy are able to successfully resolve the
financial distress. The remaining firms are either acquired (9.5%) or liquidated (16.5%). We
also see that no matter which resolution process is utilized, most firms (78%) remain
independent following the resolution of the financial distress. The likelihood of remaining an
independent firm increases with an out-of-court restructuring.
Table 2 here
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Table 2 presents detailed summary statistics and diagnostic tests on candidate explanatory
variables. Results are broken down by resolution process (out-of-court vs. bankruptcy filing)
and resolution outcome (reorganization vs. liquidation). The degree of separation across
outcome and process are assessed by Kruskall-Wallace (KW) tests of the sample medians and
Kolmogorov-Smirnov (KS) tests of the sample distributions. The multivariate regressions,
incorporating a further sub-set of these variables in each group, are shown in Tables 3 and 4 for
resolution process and resolution outcome, respectively. A detailed comparison of the
multivariate regressions is discussed in the next section.
Table 2 shows that univariate tests of leverage are broadly consistent with hypotheses for
resolution outcome (liquidation vs. reorganization) where sample distributions of Long Term
Debt ratios and Long Term Debt to Market Value ratios (both on an industry adjusted and
industry basis) are significantly lower than for reorganization (e.g., median long-term debt to
market value of 30.15% for liquidations vs. 42.22% for reorganizations.) Exceptions are the
Leverage and the Percent Change in the Change in Long Term Debt to Market Value ratio,
which are not significant in median or sample distribution. Univariate results for size/scale
variables show that firms utilizing a public resolution process (bankruptcy) tend to be larger,
consistent with expectations. The book value of assets is statistically larger for firms that file for
bankruptcy compared with firms that utilize a private workout resolution process.
While Tobins Q is numerically larger for liquidations and bankruptcies than reorganizations
or out-of-court settlements, these counter-intuitive results are not statistically different by either
the KS or KW statistics at the firm level. On the other hand, the Intangibles Ratio is numerically
higher for reorganizations and out-of-court settlements (18.71% and 18.99%) as compared to
liquidations and bankruptcies (9.07% and 16.96%), but this is only significant for the resolution
15
outcome. In Table 2, the Industry Adjusted Tobins Q is significantly greater for the bankruptcy
resolution process, and the Industry Adjusted Intangibles Ratio is significantly greater for the
reorganization resolution outcome.
Net Working Capital to Total Assets ratio and the Industry Adjusted Free Asset ratio is
significantly greater for the liquidation outcome as compared to the reorganization outcome. The
liquidity ratios appear to be significantly greater for out-of-court resolution processes as
compared to bankruptcy resolution processes. We observe that the lower Free Cash Flow or
Cash Flow from Operations is associated with a greater likelihood of liquidation (significantly
more negative) for the resolution process on a univariate basis. Return on Equity, although
negative, appears to be significantly greater for firms that utilize a public resolution process
rather than a private resolution process. Net Cash Flow to Current Liabilities is significantly
lower for liquidations as compared to reorganizations (a sign contrary to the hypothesis) but the
PE ratio is significantly greater for firms that are liquidated as compared to reorganized.
Univariate results for the capital structure variables (number of creditor classes or
instruments; percent secured, bank or subordinated debt) indicate that these are overwhelmingly
statistically indistinguishable by outcome and process. Liquidations have lower, or greater
proportions, number of classes and defaulted instrument as well as percent secured debt, bank
debt and subordinated debt. Z-Score is significantly lower for the liquidation outcome as
compared to the reorganization outcome, whereas CAR is significantly lower for both liquidation
outcome and bankruptcy process. The Weighted Average Spread is significantly lower (contrary
to hypothesis) for bankruptcy by both KS and KW. The LGD is significantly greater for the
bankruptcy process and also for the liquidation outcome.
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Univariate tests for the vintage variables suggest that both Time Since Issue and Time Since
Issue as a Percent of Maturity, weighed across instruments by claims at default, are significantly
lower for liquidations (but not for bankruptcies), which is in line with expectations. The
variables measuring duration between default events - Average Time between Instrument
Defaults, or Time between First Instrument Default and Filing- are all significantly lower for the
liquidation outcome, but not for process (although numerically lower for bankruptcies.)

5. Empirical results based on multivariate models
In this section we compare various multivariate logistic regression models, for explaining the
financial distress resolution process (Table 3), as well as the financial distress resolution outcome
(Table 4). The coefficient estimates are normalized by the median derivative of the fitted logistic
function, representing the partial effect of a change in a dependent variable upon the probability
being modeled, evaluated at the representative value of the covariates. In addition to the usual
likelihood ratio statistic, we show two measures of predictive accuracy (Pseudo R-Squared (PR2)
and Hoshmer-Lemeshow (HL)), and two measures of classification accuracy (Area Under
Receiving Operator Curve (AUROC) and Percent Correctly Classified (PCC)). Although we do
not report in the tables, we perform tests to confirm that results are robust to clustering of
standard errors within industry groups.
Table 3 here
5.1. Resolution process (Bankruptcy filing vs. Out-of-court settlement)
Table 3 presents the results of the logistic regressions for financial distress resolution process.
In each model, the dependent variable is equal to one for firms that file for bankruptcy utilizing a
public resolution process, and is equal to zero for firms that are able to resolve the financial
17
distress privately in an out-of-court settlement. We see that firms that are able to resolve their
financial distress privately have greater leverage, smaller size, lower Tobins Q, more classes of
creditors and more subordinated debt, higher Z-score and higher Cumulative Abnormal Returns
(CARs).
The result for the leverage variable is consistent with Jensens (1989) hypothesis that debt
serves as a monitoring mechanism and forces firms to face their financial trouble sooner before
they become economically distressed. Our finding implies that firms with greater leverage are
more likely to resolve the default privately. We see that firms with more classes of creditors are
more likely to resolve the financial distress out of court. This result contradicts Gilson, John and
Lang (1990), who find that a more complex capital structure reduces the ability of a firm to
utilize an out-of-court workout procedure. We do see that the proportion of secured debt in the
firms capital structure is negatively related to an out-of-court resolution process. This implies
that secured creditors may prefer a court setting in which there is a higher likelihood of
liquidating their collateral, as opposed to an out-of-court settlement in which restructuring debt is
more likely. The results for the proportion of subordinated debt strengthen this conclusion.
Our results suggest that size, as measured by the market value of equity, is positively related
to a bankruptcy resolution process. This variable is significant at the 5% level or better in both
models. The coefficient on the CAR is negative and significant at the 5% level. These results
imply that a larger firm is more likely to utilize a public resolution process, but that the market
prices this. Firms that have higher CARs are more likely to utilize a private resolution process,
at which point size is no longer relevant.
Tobins Q is positive and significant in both regressions. This implies that firms that have
greater intangible assets are more likely to utilize a public resolution process. This result
18
contradicts our expectations that firms would want to preserve the value of intangible assets and
avoid a bankruptcy filing. Including a dummy variable for the technology industry is another
proxy for intangible assets, assuming technology firms have more intangible assets as compared
to other firms. The results here conform to our expectations, in that technology firms in financial
distress are more likely to resolve this distress out of court.
The results on liquidity are not conclusive. The coefficient is positive and significant in
Model 1 but negative and significant in Model 2. The cash flow variables are all insignificant.
Our measure of profitability is not significant; however, the negative coefficient implies that
firms with higher profitability are more likely to utilize an out-of-court resolution process,
consistent with the value preservation goal of creditors.
Altmans Z-Score (in Model 2) is negatively related to a bankruptcy resolution process. The
Z-score measures the default probability of a firm, with a higher Z-score implying a healthier
firm. This result is as expected. We see that the dummy variable for filing in Southern District
of New York or District of Delaware is positively related to utilizing a public resolution process.
This result also is as expected.
The bottom panel of Table 3 compares model diagnostic statistics, both in and out-of-sample.
Although not reported in the tables, have performed variance inflation analysis of the data and
confirm that our models do not suffer significantly from multicollinearity. First, we consider
measures of predictive accuracy (or model fit). Model 1, which has the maximum information
(including Loss Given Default, LGD and CAR) but the greatest loss of sample size, achieves the
highest (McFadden pseudo) r-squared of 68.7% in-sample (51.8% out-of-sample.) Considering
measures of model classification or discriminatory accuracy, Model 1 has the best AUROC of
92.4% in-sample (73.5% out-of-sample). Models 1 also perform best according to the Percent
19
Correctly Classified (PCC), 92.4% in-sample (74.2% out-of-sample). Regarding measures of
predictive accuracy, the Hoshmer-Lemeshow (HL) statistic is highly insignificant in both
models, indicative a good fit to the data.

5.2. Resolution outcome (Liquidation vs. Reorganization)
Table 4 presents the results of the logistic regressions for the financial distress resolution
outcome where the dependent variable is equal to 1 for liquidations and 0 for reorganizations.
We see that firms with more leverage, more intangible assets and higher cash flow from
operations are less likely to be liquidated, although this variable is not significant. The
size/scale, contractual/vintage and Auditors opinion variables are also not significant.
Table 4 here
If leverage acts as a monitoring mechanism, Jensen (1989) expects that firms with more
leverage will violate protective covenants quicker and be forced to restructure sooner than firms
with lower leverage, as a result firms with higher leverage should be better able to successfully
resolve the financial distress, resulting in fewer liquidations. Our findings confirm this
hypothesis. Both measures of leverage are negative and significant at the 10% level or better in
Model 1. The long-term debt ratio is negative and significant in Model 3. The industry adjusted
long-term debt to market value ratio is negative and significant in Model 2.
Models 1 and 2 show that firms with more intangible assets are less likely to be liquidated
(significant at the 5% level or better.) However, this result disappears when CARs are included
in the regression (Model 3.) The coefficient for CAR is negative but insignificant in Model 3.
Hongs (1984) model predicts that the level of intangible assets affects a firms ability to
successfully emerge from financial distress. It is possible that the CARs provide a proxy for the
20
future potential of the firm and the current intangible assets of the firm. We see in Model 3 that
firms with greater abnormal returns are more likely to be reorganized as compared to liquidated.
Further strengthening this result is the coefficient on the liquidity variable. Net Working Capital
to Total Assets is positive and significant at the 10% or better in Model 3. This indicates that
firms with more liquid assets, which would be liquidated at a value closer to their market value,
are more likely to be liquidated (see Bris, Welch and Zhu 2006.)
The results for the cash flow variable is consistent with Lehn and Poulsons (1989) free cash
flow theory in that firms with more free cash flow should be in a better position to reorganize
their capital structure and get out of bankruptcy successfully. The coefficient on the proportion
of secured debt is positive and significant in Models 1 and 2, and not significant in Model 3. The
positive coefficient indicates that firms with a greater proportion of secured debt are more likely
to be liquidated. This result is as expected due to the secured debt holders interest is resolving
their claims, not necessarily the claims on the entire firm.
As expected the dummy variable for prepackaged bankruptcies is negatively related to
liquidation. Obviously, these firms have negotiated claims prior to filing for bankruptcy and
should be more successful in resolving the financial distress. Altmans Z-Score and the dummy
variable for pro-debtor filing districts are not significant in any of the regressions. Earlier, we
saw that both of these variables affect the resolution process; here they do not affect the
resolution outcome.
In terms of overall model performance, while Model 1 has the lowest r-squared of 20.8%
(15.8% out-of-sample), it has among the highest percent correctly classified (81.2% in-sample
and 64.4% out-of-sample) and AUROC (56.4% in-sample and 44.3% out-of-sample). The r-
21
squared is slightly higher in Model 2 (25.9% in-sample, 19.7% out-of-sample) but the AUROC
declines to the level of Model 1 (56.5% in-sample, 45.3% out-of-sample).

5.3. Out-of-sample and Out-of-time classification and predictive accuracy
We perform model validation tests for all of the plausible models discussed in the previous
section, but present the results for the one that performs best over time (Model 1) for prediction
of bankruptcy filing and prediction of resolution liquidation. We measure the discriminatory
power and predictive accuracy by implementing standard tests (power curve analysis and chi-
squared tests), while classification accuracy is assessed according to alternative categorization
criteria (expected cost of misclassification, minimization of total misclassification and deviation
from historical averages) as compared to nave random benchmarks. While in- and out-of-
sample performance along these dimensions exhibits wide variation across models and criteria,
the OLR and LRM models perform comparably, and the FNN model underperforms consistently.
The statistical significance of these results is rigorously analyzed and confirmed through a
resampling procedure.
Table 5 here
Out-of-sample and out-of-time classification and predictive accuracy results are presented in
Table 5. The technique that we employ is a rolling out-of-time and out-of-sample bootstrap, in
which a model is estimated and performance is measured repeatedly, for increasing estimation
(or training) periods and rolling 1-year-ahead prediction periods. This is repeated 100,000 times,
until the entire sample correspond to the estimation period. The final distribution of out-of-
sample statistics is formed by pooling the nine years of distributions for 1995 through 2004. The
22
results indicate that our logit models perform well and have good in-sample and out-of-sample
classification and predictive accuracy.

6. Conclusions
This study represents a comprehensive analysis of bankruptcy resolution. First, motivated by
economic theory and models, we perform an exhaustive analysis of fundamental data thought to
influence the relative likelihood of the financial distress resolution process (private versus
public) and resolution outcome (liquidation versus resolution), giving rise to a chosen set of
financial variables. Second, we estimate a parsimonious empirical model (ordered logistic
regression) that is consistent with theory and that has superior statistical properties. We then
compare this model to alternative econometric models (local regression models and feed forward
neural networks), both in terms of in-sample fit, as well as out-of-sample classification accuracy.
We extend the literature by considering alternative classification criteria (expected cost of
misclassification, unweighted minimization of misclassification and deviation from historical
average), which in this context is necessary in order to evaluate model performance. We add
rigor to this through the application of resampling methodology, which makes it possible to
study an approximate distribution of classification accuracy statistics, thereby comparing model
performance across classification accuracy criteria relative to random benchmarks. Finally, our
dataset contains a more recent and comprehensive set of defaults for which we have detailed
default and credit related variables.
We find that larger firms with higher liquidity and more secured debt in their capital structure
are more likely to follow a public resolution process. Firms with higher Z-scores and more total
leverage are less likely to follow a public resolution process and attempt to resolve the financial
23
distress privately. Furthermore, filing in a pro-debtor district also increases the likelihood of
utilizing a public resolution process. Regarding the resolution outcome, we find that firms with
greater liquidity, more secured debt and lower cumulative abnormal returns are more likely to be
liquidated rather than reorganized. Additionally, firms filing bankruptcy that have both more
leverage as well as more intangible assets are more likely to be reorganized. Finally, we find
that more complex econometric models do not improve the predictive accuracy of the standard
logistic regression.
24
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26
Table 1
Hypotheses Development: Resolution Process and Resolution Outcome
1985-2004
Dimension Rationale Variables
Hypothesized
Relationship to
Bankruptcy Filing
Likelihood
Hypothesized
Relationship to
Liquidation
Likelihood
Leverage
1. Greater leverage implies lower recovery in liquidation, hence an incentive to
attempt a reorganization or avoid bankruptcy. 2. Chapter 11 if book value is
negative then equity is given a greater say. 3. Higher leverage is a signal that
the fundamental business may be viable in financial distress.
Book leverage & long term debt ratios, debt to market value
of equity ratios.
Negative Negative
Size / Scale
Larger scale of operations implies a better candidate for rehabilitating business
model and therefore a successful reorganization. The complexity of larger firms
and self-selection may make bankruptcy more likely.
Book value of total assets, market value of equity, net sales. Positive Negative
Intrinsic Value /
Tangibility
A greater proportion of intangible assets make a defaulted borrower a more
attractive acquisition candidate or makes liquidation more costly thus lowering
the chances of liquidation. The bankruptcy process may be more destructive of
value with less tangibility, but this may be countered by self-selection.
Tobin's Q, book value ratio of intangible to total assets. Either Negative
Liquidity
Higher liquidity implies that a firm is in a better position to keep operating
through the bankruptcy proceedings and therefore a reorganization is the more
likely outcome. Alternatively higher liquidity can lower the costs of liquidation.
Interest coverage, free asset, and net working capital to total
asset ratios.
Either Either
Cash Flow
Greater cash generating ability indicates better quality of the borrower and
ability to restructure and a lower probability of liquidation. Alternatively, agency
problems are greater (Jensen), but this may not be operative in financial
distress.
Free cash flow and cash flow from operations (dollar and
ratio to book value of assets).
Negative Negative
Profitability
Might mean better chances of improving business (like size) or liquidation more
costly because of franchise value (like intrinsic value).
Profit margin, return on equity, retained earnings to total
assets, net cash flow to current liabilities.
Negative Negative
Greater bargaining power among secured creditors makes liquidation or
bankruptcy filing more likely.
Percent secured debt at time of default.
More parties involved in resolving financial distress imply greater difficulties in
negotiating a reorganization or negotiating an out-of-court settlement.
Number of major creditor classes for defaulted customer.
Credit Quality /
Market Reaction
Firms with higher initial (or at a suitable horizon) credit quality may have a lower
chance of liquidation as this may signal a fundamental capability to successfully
undergo a reorganization or avoid bankruptcy.
Weighted spread at default or loss-given-default on debt,
Altman Z-Score, investment grade indicator, cumulative
abnormal equity returns.
Positive Positive
Vintage
Borrowers that have been around a longer time, or that have had more time to
deal with financial distress between default events, may have more franchise
value and therefore be either better reorganization or out-of-court settlement
candidates.
Time since debt issued, to maturity or between instrument
defaults (weighed by outstanding at default)
Negative Negative
Macroeconomic
Collateral values might be depressed during recession, implying that claimants
are more likely to attempt reorganization or avoid bankruptcy proceedings.
Consistent with this is a signaling story: failing in better times is a sign of
something fundamentally wrong with the business versus just financial distress.
Alternatively, the probability of a new business succeeding might not seem as
high in the midst of a recession and parties may be more likely to "cut their
losses" & liquidate.
Moody's trailing 12 month speculative grade and all-
corporate default rates, S&P 500 equity returns.
Either Either
Under special legal arrangements liquidation or bankruptcy filing may be a less
likely outcome.
Dummy variable for pre-packaged bankruptcy type. Either Negative
In certain jurisdictions liquidation may be a less likely outcome.
Dummy variable for filing district (the Southern District of
New York & Delaware).
Negative Negative
In certain industries liquidation or bankruptcy may be a more or less likely
outcome.
Dummy variable for Utility and Technology industries.
Negative or
Positive
Negative or
Either
Auditor's Opinion
Assessment by independent auditor's of the quality of the firm's financial
statements and controls.- the less favorable this assessment, the more likely is
either bankruptcy or liquidation.
Codes: 0 - Unaudited, 1 - Unqualified Opinion, 2 - Qualified
Opinion, 3 - No Opinion, 4 - Adverse Opinion
Positive Positive
Capital Structure Positive Positive
Regulatory /
Policy / Legal
27
Table 2
Summary Statistics and Distributional Tests for Select Financial Statement Variables by
Resolution Process and Resolution Outcome
Out-of Court
Settlement
Bankruptcy Reorganization Liquidation
Median Median
KS
P-Value
KW
P-Value
Median Median
KS
P-Value
KW
P-Value
Leverage Ratio 106.6% 106.0% 0.5965 0.7006 107.2% 99.74% 0.1111 0.2773
Long Term Debt Ratio 56.75% 53.08% 0.3749 0.8053 55.66% >> 42.49% 0.0410 0.0492
Long Term Debt to Market
Value Ratio
42.58% 39.83% 0.5837 0.4958 42.22% >> 30.15% 0.0240 0.0011
Change in Long Term Debt to
Market Value Ratio
11.56% 15.04% 0.2093 0.2800 15.22% 11.06% 0.2848 0.1786
Long Term Debt to Market
Value Ratio - Ind. Adj.
27.14% 25.66% 0.8898 0.6679 27.30% >> 18.67% 0.0292 0.0611
Market Value of Equity 1.6271 << 1.8194 0.0179 0.0620 1.7579 1.9606 0.4796 0.1676
Book Value Assets 2.5777 < 2.7146 0.0706 0.0210 2.6914 2.6770 0.8522 0.7876
Net Sales 2.5091 2.5913 0.1725 0.1245 2.5747 2.5822 0.5456 0.4271
Change in Market Value of
Equity
-0.3766 -0.2646 0.1980 0.0378 -0.3992 -0.2646 0.1980 0.0378
Market Value of Equity - Ind.
Adj.
266.10 43.86 0.8822 0.7935 39.94 265.47 0.5594 0.5053
Tobin's Q 76.15% 95.28% 0.5605 0.2409 92.12% 94.40% 0.1289 0.5423
Intangibles Ratio 18.99% 16.96% 0.8176 0.5051 18.71% >> 9.07% 0.0018 0.0047
Tobin's Q - Industry 85.49% < 100.1% 0.0713 0.0196 96.75% 101.4% 0.2586 0.7232
Intangibles Ratio - Ind. Adj. 4.14% 4.18% 0.7024 0.5171 4.25% >> 3.69% 0.0069 0.0109
Quick Ratio 92.80% > 78.10% 0.0637 0.2221 80.69% 81.83% 0.1161 0.4438
Free Asset Ratio 8.73% 15.10% 0.7273 0.5567 12.97% 19.42% 0.5229 0.2941
Net Working Capital to Total
Assets
-6.89% >> -9.34% -0.6715 -0.6493 -10.12% < -2.01% 0.0659 0.0741
Quick Ratio - Ind. Adj. -11.0% > -37.05% 0.0920 0.0200 -32.76% -28.8% 0.3532 0.9044
Free Asset Ratio - Ind. Adj.
-17.6% -7.59% 0.1618 0.0720 -10.69% < -2.15% 0.0716 0.0625
Free Cash Flow 89.98 -7.4061 0.2268 0.5401 24.62 -76.72 0.1001 0.0549
Cash Flow from Operations to
Assets
-0.21% -1.04% 0.4233 0.1601 -0.27% >> -4.46% 0.0062 0.0023
Free Cash Flow - Industry
Adj.
76.92 -18.57 0.4814 0.5238 14.08 >> -93.24 0.0481 0.0197
Cash Flow from Operations to
Assets - Ind. Adj.
-10.1% -8.69% 0.8062 0.7821 -8.35% >> -12.3% 0.0103 0.0343
Net Cash Flow to Current
Liabilities
-1.18% -4.27 0.3231 0.2110 -1.35% >> -16.4% 0.0383 0.0087
Return on Equity -331% << -78.7% 0.0380 0.2065 -129.2% -79.2% 0.7745 0.5743
Price / Earning Ratio - Ind.
Adj.
6.31 -6.86 0.2530 0.1955 -4.19 < 8.47 0.0508 0.1325
Number of Creditor Classes 2.2680 2.2328 1.0000 0.6998 2.2545 2.1429 0.1637 0.2177
Number of Defaulted
Instruments
4.4227 4.5558 0.9610 0.4483 4.6339 3.8714 0.3470 0.0410
Proportion of Secured Debt 36.64% 40.32% 0.7875 0.4095 38.76% 45.15% 0.1290 0.2188
Proportion of Bank Debt 30.52% 33.78% 0.8388 0.5615 32.51% 37.40% 0.1249 0.5910
Proportion of Subordinated
Debt
34.80% 33.64% 0.9854 0.8998 33.50% 36.14% 0.8342 0.4672
Altman Z-Score at Default 0.4243 0.2542 0.6584 0.8575 2.5158 >> 0.7422 0.0010 0.0127
Minimum Credit Rating 3.3833 3.6757 0.2338 0.0248 1.3334 3.4255 1.0000 0.3753
Number of Downgrades 1.5556 1.5819 0.2338 0.0240 1.6075 1.3750 0.1646 0.0956
Maximum Downgrade
Distance
3.5079 3.8940 0.9678 0.9936 4.5237 3.4583 0.6597 0.4641
Weighted Average Credit
Spread
8.72% >> 7.29% 0.0488 0.0698 5.04% 6.77% 0.1229 0.0976
Loss Given Default 55.82% << 65.24% 0.0141 0.0061 23.87% << 68.92% 0.0388 0.0317
Original Credit Rating 2.0412 2.1924 0.9116 0.5412 1.7493 2.1571 1.0000 0.9156
Cumulative Abnormal Return
7.2% >> -15.0% 0.0032 0.0049 55.5% >> -37.6% 0.0022 0.0014
Time Since Issue 1088.6 1044.8 0.5118 0.3442 1076.0 >> 905.7 0.0158 0.0091
Time-Remaining-to-Maturity 1772.8 1774.4 0.8536 0.8217 1772.4 1784.6 0.1578 0.2391
Time Since Issue % Time-to-
Maturity
0.4011 0.3845 0.3839 0.5223 0.3937 > 0.3485 0.0707 0.0643
Maximum Time Between
Instrument Default
159.57 116.30 0.7483 0.8024 132.78 >> 70.80 0.0097 0.0037
Average Time Between
Instrument Default
90.28 73.25 0.6896 0.9815 81.56 >> 43.64 0.0195 0.0051
Time Between First
Instrument Default and Filing
42.92 31.72 0.7820 0.7416 35.91 >> 20.47 0.0326 0.0129

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Resolution Process Resolution Outcome
G
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Variables
Tests of Equality -
Bankruptcy vs.
Out-of-Court
Tests of Equality -
Liquidation vs.
Reorganization

Direction is based on p-value of KS test > at 10%, >> at 5%
28
Table 3
Multivariate Logistic Regressions for Resolution Process:
Bankruptcy Filing vs. Out-Of-Court Settlement
Partial
Effects
1
P-Value
Partial
Effects
P-Value
Leverage Leverage Ratio (Lagged) -1.44E-03 0.0246 -0.0349 7.43E-03
Size / Scale Market Value of Equity 8.26E-04 1.91E-03 6.80E-03 0.0392
Intrinsic Value /
Tangibility
Tobin's Q 5.73E-04 0.0958 0.0181 0.0305
Liquidity Quick Ratio (Industry Adjusted) 7.53E-04 1.92E-03 -0.0140 2.37E-04
Free Cash Flow (Time of
Default)
Free Cash Flow (Lagged) -3.17E-07 0.1180 -1.15E-05 0.1030
Profitability Return on Equity 3.73E-04 0.3656 -4.86E-04 0.2364
Number of Creditor Classes -2.61E-04 0.0515 -1.30E-03 0.3347
Proportion of Secured Debt 2.63E-03 2.43E-03 0.0187 0.0244
Proportion of Subordinated Debt -1.80E-03 1.56E-03 -0.0159 0.0188
Altman Z-Score at Default -9.78E-03 0.0511
Loss Given Default 3.28E-03 1.38E-03
Cumulative Abnormal Return
Contractual /
Vintage
Maximum Time Between
Instrument Default
7.58E-06 0.2055 -6.86E-05 0.1653
Moody's Speculative Default
Rate Lagging
-5.40E-03 0.1840 -0.1358 0.1037
S&P Return 0.0146 0.1661 0.1486 0.2476
Filing District 7.82E-04 3.39E-03 0.2460 3.92E-05
Prepackaged Bankruptcy 1.79E-03 0.2921 0.0198 0.0017
Technology -7.84E-04 1.96E-03 -0.0113 0.0040
Utility -6.27E-04 0.0568 0.0122 0.0236
Auditors' Opinion 2.80E-04 0.3415 -1.00E-03 0.1003
McFadden Pseudo R-squared
2
Hoshmer-Lemeshow
3
Area Under ROC Curve
4
Percent Correctly Classified
5
McFadden Pseudo R-squared
Hoshmer-Lemeshow
Area Under ROC Curve
Percent Correctly Classified
Number of Observations 197 265
0.7352 0.6921
0.7417 0.6660
0.9239 0.8323
Out-of-Sample
1
0.5176 0.3445
0.2254 0.2499
In-Sample
0.6873 0.4549
0.9026 1.0000
0.9238 0.8649
Cash Flow
Capital Structure
Credit Quality /
Market
Macroeconomic
Legal /
Regulatory
Diagnostic Statistics
Category Variable
Model 1 Model 2

1 - The derivative of the logistic function evaluated at the median values of the independent variables, an estimate of the change
in the modeled probability for a small change in a covariate.
2 - One minus the ratio of the model to the null deviance, where the deviance is equal to one-half the maximized value of the log-
likelihood.
3 - A normalized average deviation between empirical frequencies and average modeled probabilities across deciles of risk,
ranked according to modeled probabilities, a measure of model fit or predictive accuracy of the model.
4 - The area under the Receiving Operator Characteristic ROC curve or the plot of event proportions in the population vs. the
complement of the risk ranking according to the model, a measure of the discriminatory accuracy of the model.
5 - The proportion of events correctly classified, according to a cutoff model probability that minimizes the Expected Cost of
Misclassification ECM, a measure of the discriminatory accuracy of the model.
29
Table 4
Multivariate Logistic Regressions for Resolution Outcome:
Liquidation vs. Reorganization
Partial
Effects
1
P-Value
Partial
Effects
P-Value
Partial
Effects
P-Value
Long Term Debt Ratio -0.0666 0.0579 -0.0103 0.2356 -0.0615 0.0041
Long Term Debt to Market
Value - Industry
-0.2947 0.0104 -0.0972 0.0191 0.1640 0.3896
Market Value of Equity -
Industry
0.0282 0.1279 9.77E-03 0.1271 1.82E-02 0.4270
Intrinsic Value /
Tangibility
Intangibles Ratio -0.1347 0.0234 -0.0733 0.0057 -1.88E-03 0.4972
Liquidity
Net Working Capital to Total
Assets
0.0256 0.2208 0.0100 0.1746 0.2604 0.0527
Cash Flow Cash Flow from Operations -1.50E-04 0.0270 -5.00E-05 0.0530 -9.18E-04 0.0145
Number of Creditor Classes 1.51E-03 0.4520 -6.13E-05 0.4954 0.0663 0.1176
Proportion of Secured Debt 0.0388 0.0788 0.0276 0.0188 0.0850 0.2263
Altman Z-Score at Default -2.49E-04 0.4812 -7.32E-04 0.3498
Loss Given Default 0.0211 0.1341
Cumulative Abnormal Return -8.92E-04 0.1047
Time Since Issue -3.56E-06 0.3893 -4.13E-05 0.2121
Time Between First Default
and Filing
-6.61E-05 0.2982
Macroeconomic S&P Return 0.0471 0.2357 0.0648 0.0153 0.0317 0.1192
Filing District 3.36E-03 0.3698 2.81E-03 0.2363 2.95E-02 0.2382
Prepackaged Bankruptcy -0.0321 0.0148 -0.0175 0.0050 -0.1196 0.0376
Auditors' Opinion -4.25E-04 0.4914 2.49E-03 0.0648 -5.86E-03 0.3216
McFadden Pseudo R-squared
2
Hoshmer-Lemeshow
3
Area Under ROC Curve
4
Percent Correctly Classified
5
McFadden Pseudo R-squared
Hoshmer-Lemeshow
Area Under ROC Curve
Percent Correctly Classified
Diagnostic Statistics
Number of Observations 216 193 113
0.4528 0.4658
0.6440 0.6269 0.6145
Out-of-Sample
1
0.1542 0.1976 0.1708
0.1725 0.2370 0.1309
0.4435
0.5643 0.5651 0.5857
0.8119 0.7876 0.7788
In-Sample
0.2076 0.2592 0.2274
0.6882 0.9499 0.5256
Leverage
Size / Scale
Capital Structure
Credit Quality /
Market
Contractual /
Vintage
Legal /
Regulatory
Category Variable
Model 1 Model 2 Model 3

1 - The derivative of the logistic function evaluated at the median values of the independent variables, an estimate of the change
in the modeled probability for a small change in a covariate.
2 - One minus the ratio of the model to the null deviance, where the deviance is equal to one-half the maximized value of the log-
likelihood.
3 - A normalized average deviation between empirical frequencies and average modeled probabilities across deciles of risk,
ranked according to modeled probabilities, a measure of model fit or predictive accuracy of the model.
4 - The area under the Receiving Operator Characteristic ROC curve or the plot of event proportions in the population vs. the
complement of the risk ranking according to the model, a measure of the discriminatory accuracy of the model.
5 - The proportion of events correctly classified, according to a cutoff model probability that minimizes the Expected Cost of
Misclassification ECM, a measure of the discriminatory accuracy of the model.
30
Table 5
Bootstrapped
1
Out-of-Sample and Out-of-Time Classification and Predictive Accuracy
Model Comparison Analysis
1985-2004
2
Logistic
Regression
Local
Regression
Neural
Network
Logistic
Regression
Local
Regression
Neural
Network
Median 0.7406 0.6806 0.5875 0.6618 0.5680 0.5112
5th Percentile 0.4347 0.4024 0.2758 0.4040 0.4506 0.3901
95th Percentile 0.8845 0.8450 0.7902 0.7275 0.6443 0.6051
Median 0.7311 0.6138 0.4662 0.4884 0.2826 0.1907
5th Percentile 0.5590 0.4086 0.2092 0.2477 0.0947 0.0504
95th Percentile 0.8975 0.8043 0.6536 0.8364 0.7386 0.6789
Median 0.5635 0.3701 0.2516 0.1902 0.1224 0.0772
5th Percentile 0.1723 0.1177 0.0604 0.0590 0.0367 0.0165
95th Percentile 0.7931 0.5323 0.3437 0.3471 0.2294 0.1536
Median 0.2324 0.1161 0.0581 0.2296 0.1151 0.0776
5th Percentile 0.1110 0.0556 0.0187 0.0527 0.0264 0.0174
95th Percentile 0.3109 0.2076 0.1889 0.3229 0.1611 0.0999
Median 0.9236 0.9660 0.9848 0.8250 0.8804 0.9145
5th Percentile 0.7215 0.7538 0.7730 0.7274 0.7632 0.7754
95th Percentile 0.9432 0.9690 0.9819 0.8907 0.9367 0.9751
Median 0.9118 0.9679 0.9994 0.5891 0.6619 0.7224
5th Percentile 0.6555 0.7154 0.7601 0.3934 0.4394 0.4655
95th Percentile 0.9795 0.9866 0.9947 0.8052 0.8588 0.9055
Median 0.7666 0.8443 0.8879 0.2522 0.3819 0.4634
5th Percentile 0.5624 0.6805 0.7427 0.1029 0.1531 0.1868
95th Percentile 0.9413 0.9415 0.9438 0.5505 0.6627 0.7283
Median 0.8958 0.9025 0.9114 0.9282 0.9376 0.9466
5th Percentile 0.7421 0.7792 0.8181 0.8287 0.8702 0.9137
95th Percentile 0.9472 0.9562 0.9658 0.9764 0.9865 0.9962
Model Test Statistics
I
n
-
S
a
m
p
l
e

/

T
i
m
e

T
r
a
i
n
i
n
g

/

E
s
t
i
m
a
t
i
o
n

P
e
r
i
o
d
ECM - Weighted
Proportions Correctly
Classified
Area Under Receiver
Operating
Characteristic Curve4
McFadden Pseudo
R-Squared3
Hoshmer-Lemeshow
Chi-Squared (P-
Values)
Liquidation vs.
Reorganization
Bankruptcy vs.
Out-Of-Court
O
u
t
-
o
f
-
S
a
m
p
l
e

/

T
i
m
e

1

Y
e
a
r

A
h
e
a
d

P
r
e
d
i
c
t
i
o
n
ECM - Weighted
Proportions Correctly
Classified
3
Area Under Receiver
Operating
Characteristic Curve
4
McFadden Pseudo
R-Squared
5
Hoshmer-Lemeshow
Chi-Squared (P-
Values)
6

1 - In each run, observations are sampled randomly with replacement from the training and prediction samples, the model is
estimated in the training sample and observations are classified in the prediction period, and this is repeated 100,000 times
2 - 199 observations with variables: long term debt to market value of equity, book value of assets quartile, intangibles to book
value of assets, interest coverage ratio, free cash flow to book value of assets, net income to net sales, number of major creditor
classes, percent secured debt, Altman Z-Score, debt vintage time since issued, Moody's 12 month trailing speculative grade
default rate, industry dummy, filing district dummy, prepackage dummy
3 - The proportion of events correctly classified, according to a cutoff model probability that minimizes the Expected Cost of
Misclassification ECM, a measure of the discriminatory accuracy of the model.
4 - The area under the Receiving Operator Characteristic ROC curve or the plot of event proportions in the population vs. the
complement of the risk ranking according to the model, a measure of the discriminatory accuracy of the model.
5 - One minus the ratio of the model to the null deviance, where the deviance is equal to one-half the maximized value of the log-
likelihood.
6 - A normalized average deviation between empirical frequencies and average modeled probabilities across deciles of risk,
ranked according to modeled probabilities, a measure of model fit or predictive accuracy of the model.
31
Figure 1
Process for and Outcome of the Resolution of Financial Distress

Panel A
Modeling Financial Distress




Resolution
Process

Bankruptcy

Filing

Out - of - Court

Settlement

Acquired

(40)

Emerged
Independent

(311)

Liquidated

(70)

Acquired

(6)

Emerged
Independent

(91)

Financial
Distress

_ |__ _ |_____|___ _ ___________|___________________________ ____ ____|____
t - 2 t - 1 t t+m t+n


Resolution
Outcome


Resolution
Outcome


Numbers in each outcome represent the number of firms in our sample.
Time Description
t-2 Two years prior to the event of financial distress
t-1 One year prior to the event of financial distress, firm may or may not exhibit signs of impending
distress
t Event of financial distress: prior to negotiations, for example, default or impending default
t+m Start of Resolution Process: The year the firm files for bankruptcy or begins out of court
negotiations to resolve the financial distress
t+n Outcome of Resolution Process: Financial distress is resolved: firm either emerges as an
independent entity, is acquired or liquidated

Panel B
Sample Breakdown for
S&P and Moodys Rated Borrowers 1985-2004
Out-of-Court
Settlement
Filed for
Bankruptcy
Total
Emerged
Independent
91 311 402
Total 97 421 518
Acquired 6 40 46
Liquidated 0 70 70