Over the last decade, the topic of bankruptcy

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1 Commercial Bankruptcy in Canada Jocelyn Martel* Centre interuniversitaire de recherche en analyse des organisations (CIRANO) Over the last decade, the topic of bankruptcy has been an object of growing concern. In Canada, the number of business bankruptcies under the Bankruptcy Act has risen significantly since the beginning of the 1980s. From 6,595 in 1980, the number of bankruptcies rose to 8,664 in 1989, to 14,317 in 1992 to finally settle at 11,810 in In addition, a large but uncertain number of business failures do not use the Bankruptcy Act to wind up their affairs. The net benefits of using the Act would not be worthwhile in many cases. In December 1992, a new legislation governing bankruptcy in Canada came into effect with the main objective of promoting financial reorganization at the expense of bankruptcy (Martel, 1994a and Fisher and Martel, 1994a). Yet, these legislative changes took place without any reference to detailed analysis of the characteristics of firms seeking the protection of the Act as well as those affected (i.e. creditors) and the extent to which each category of creditors is affected. Until recently, the vast majority of the empirical literature on firms in bankruptcy was based on U.S. data. In Canada, this phenomenon has been the object of few studies. Kryzanowsky and Holland (1984) examined the characteristics of 76 firms which filed for bankruptcy under the Canadian Bankruptcy Act. Fisher and Martel (1995, 1994a,b) and Martel (1994b) provided significant evidence on the characteristics of firms in financial reorganization in Canada. However, the analysis is still incomplete due to the lack of information on firms going through straight bankruptcy under the Act. 2 This article addresses the lack of data and provides new evidence on the characteristics of bankrupt firms based on a representative sample of 417 firms which filed for court protection under the Bankruptcy Act for the period The first section offers an overview of the bankruptcy process in Canada prior to December Amendments to specific provisions of the Act are discussed in the notes. This is followed by a detailed analysis of the data. According to the data, firms in bankruptcy are typically small firms. Ninetyeight per cent have a book value of assets less than $500,000. Their financial health is critical with a mean liabilities-to-assets ratio of 72.2 and a median of 8.1. Trustees and legal experts appear to be the greatest beneficiaries in bankruptcy, with administration costs accounting for over 50 per cent of the value of assets liquidated. This is reflected in the substantial losses incurred by unsecured creditors and to a certain extent by preferred creditors with a payoff rate in liquidation of 2.5 per cent and 23.1 per cent respectively. For business failures which do not use the Bankruptcy Act, the losses to unsecured creditors are probably larger. Finally, the last section discusses of possible remedies to minimize the negative effects of bankruptcy. Bankruptcy in Canada In Canada, a business bankruptcy is defined as a bankruptcy which is chiefly attributable to liabilities incurred as a result of the carrying on of a commercial venture or business and includes proprietorships, partnerships and Limited Corporations. In the case of unincorporated businesses, the liabilities attributable to a business venture have to represent more than 50 per cent of the total liabilities in order to qualify as a business bankruptcy (Office of the Superintendent of Bankruptcy, 1995). The Bankruptcy Act identifies three types of creditors in bankruptcy: secured, preferred and unsecured creditors. Generally speaking, a secured creditor is defined as a person holding a mortgage, pledge, charge, lien or privilege on or against the property of the debtor as security for a debt due or accruing to him from Summer 1995 Canadian Business Economics 53

2 the debtor. A preferred creditor is an unsecured creditor who benefits from a priority in the distribution of the proceeds from the sales of the assets. An unsecured creditor is a creditor who s claim does not benefit from the preferred ranking defined in Section 136 of the Bankruptcy Act. Filing for bankruptcy triggers the automatic stay provisions which freeze all unsecured creditors rights against the firm s assets (Bohémier, 1992; Bohémier and Massue-Monat, 1989; and Martel, 1991). The trustee, appointed by the court or selected by the petitioning creditors, takes possession of the debtor s assets, sells them and distributes the proceeds among creditors following the allocation schedule set out in Section 136. Subject to the rights of secured creditors, the proceeds are distributed first to preferred creditors in the following order: i) in the case of a deceased bankrupt, funeral and testamentary expenses; ii) the costs of administration in the following order the expenses and the fees of the trustee, and the legal costs; iii) the Superintendent levy; iv) wages, salaries, commissions and compensations, up to a maximum of $500 per worker for services rendered three months prior to the bankruptcy. Travelling salesmen are entitled to an additional $300 in expenses; 3 v) municipal taxes or levies within the two years preceding the bankruptcy; vi) arrears of rent for a period of three months preceding the bankruptcy; vii) fees and costs referred to in Section 70(2) of the Act; viii)federal deductions at source for income tax, unemployment insurance and employees contributions to the Workers Compensation Board; 4 ix) claims resulting from injuries to employees of the bankrupt to which the provisions of the Workers Compensation Act do not apply; and x) claims of the federal and provincial governments not previously mentioned. 5 All other claims rank as unsecured claims and are paid on a pro rata basis. 6 As pointed out by Bohémier (1992), secured creditors are considered as outsiders in bankruptcy. They are not subject to the stay provisions and they can enforce their liens against the debtor s assets at any time during the proceedings. 7 Excluding the first three items, it is difficult to make a case for the priority given to the claims listed in Section 136 of the Act. The priority for funeral and testamentary expenses is justified for moral reasons. For obvious reasons, administration costs have to be paid before creditors, otherwise there would be nothing left to pay for the administration of the case. 8 This is also true for the superintendent levy which is used to finance the general administration of the bankruptcy system in Canada. The priority given to wage earners is basically for insurance purpose. Whether or not this represents an efficient way of protecting wage earners in the event of bankruptcy remains an open question. The preferred status given to municipal taxes and to arrears for rents is difficult to justify since there are no reasons to treat these claims any differently than unsecured claims. Finally, the priority given to government claims was acquired solely from its legislative power; otherwise there are no reasons to think that these claims would have priority to any other claims in bankruptcy. Sample In Canada, each bankruptcy and reorganization proposal under the Bankruptcy Act is filed with one of 15 regional bankruptcy offices of Industry Canada. The files used for this study originate from two regional offices: Montreal and Toronto for the period From a list of 27,324 commercial bankruptcies, a random sample of 500 firms was selected. 9 The data reported in this study was taken directly from the firms individual files. Due to the fact that some files were not available or to the absence of key information, the final sample was reduced to 417 commercial bankruptcies with 274 files originating from the Montreal regional office and 143 files originating from the Toronto regional office. Financial Variables As Tables 1 and 2 indicate, Canadian firms filing for bankruptcy under the Bankruptcy Act are typically small firms. For the full sample, the mean and median values of assets are 54 Canadian Business Economics Summer 1995

3 Table 1 Financial Characteristics of Firms in Bankruptcy in Canada 1 Variables Mean Median Standard deviation Min Max Total assets 2,3 74,231 5, ,229,000 Total liabilities 232,565 87, ,410 9,377,200 Secured claims 72, ,883,700 Unsecured claims 130,117 50, ,256,660 Preferred claims 26,138 3, ,620,740 Crown claims 20,575 1, ,620,740 Source Deductions claims 4 8, ,890 Total wage claims 5 7,377 1, ,400 Total wage claim per worker ,590 Liabilities to assets ratio ,042,000 Secured claims / total assets ,670 Secured claims / total claims Unsecured claims / total claims Preferred claims / total claims Crown claims / total claims Crown claims / preferred claims Source deductions / crown claims Number of secured creditors Number of unsecured creditors Number of preferred creditors Number of wage creditors Total number of creditors Secured creditors / total creditors Unsecured creditors / total creditors Preferred creditors / total creditors Notes 1. Except where noted, the information reported in this table is based on a sample of 417 files. 2. The total assets, total liabilities, and the claims variables are reported in June 1993 Canadian dollars, deflated by the GDP deflator (series D20556). 3. Based on a sample of 415 files where the information is available. 4. Based on a sample of 395 files where the information is available. 5. Based on a sample of 41 estates with positive wage claims. Summer 1995 Canadian Business Economics 55

4 respectively $74,231 and $5,202 while the average and the median values of liabilities are respectively $232,565 and $87, Nearly 85 per cent of all bankrupt firms have a value of assets lower than $100,000 and 98 per cent of the firms have assets lower than $500,000. None of the firms in the sample has a value of assets greater than $10 million; the largest firm is valued at $8.2 million in assets. Although the distribution of firms by liabilities is less pronounced, the data indicates that 55 per cent of firms have liabilities lower than $100,000 and that 92 per cent of firms have liabilities lower than $500,000. The largest firm has $9.4 million in liabilities. According to Table 4, the incorporated firms are significantly larger than unincorporated firms: the mean value of assets is $177,251 and $31,335 for both types of businesses respectively. 11 Similarly, the mean value of liabilities is $476,293 and $131,758 for incorporated and unincorporated businesses respectively. 12 In the area of insolvency, the liabilities to assets ratio is often used as an indicator of the firm s financial health. According to Table 1, the financial health of Canadian firms in bankruptcy is critical; the mean and median liabilities to assets ratio are respectively equal to 72.2 and 8.1 for the full sample of firms. 13 Incorporated firms, with a liabilities to assets ratio of 10.6, are, on average, in significantly much better financial condition than unincorporated firms which have a mean ratio of Secured Claims In bankruptcy, secured creditors are typically banks. About 48 per cent of all commercial bankruptcies involve secured claims. The mean and median values of secured claims are respectively $72,761 and 0 for the full sample of firms. Incorporated firms, with an mean value of $159,837, have significantly larger secured claims than unincorporated firms with a mean value of $36,752. Secured claims represent approximately 19 per cent of total liabilities. This proportion does not vary significantly across the two classes of firms. Restricting our attention to files with positive secured claims, the proportion of secured claims in total liabilities is equal to 39 per cent. For the full sample, there is, on average, one secured creditor involved in the proceedings. In absolute terms, there is no difference between incorporated and unincorporated firms. This suggests that larger firms in bankruptcy do not rely more on secured financing than smaller firms. As pointed out by Fisher and Martel (1995, 1994a), secured creditors play an important role in the Canadian insolvency process. They typically represent an important source of capital and can prolong the life of a business by extending new loans. A major determinant of the firm s ability to attract new loans is the presence of free assets in the firm. 14 The data reveals that the mean and median ratios of secured claims to total assets are respectively equal to 1.39 and 0 for the full sample, with incorporated firms having a lower ratio of assets that are secured, 1.30 than unincorporated firms, Considering only the cases Table 2 Distribution of Bankrupt Firms by Assets and Liabilities Distribution of Firms by Range Assets Liabilities less than $100, $100,000 - $500, $500,001 - $1,000, $1,000,001 - $5,000, $5,000,001 - $10,000, greater than $10,000, Total Canadian Business Economics Summer 1995

5 Table 3 Financial Characteristics of Incorporated and Unincorporated Businesses in Bankruptcy 1 Variables Incorporated Businesses Unincorporated Businesses Mean Median Mean Median Total assets*,2 177,252 19,878 31,335 2,382 Total liabilities* 476, , ,758 65,575 Secured claims* 159,837 10,856 36,752 0 Unsecured claims* 254,691 88,845 78,601 42,330 Preferred claims 53,812 10,797 14,022 2,372 Crown claims 39,494 5,342 12,752 1,034 Source Deductions claims 8,628 1,678 9,012 0 Total wage claims*,3 10,526 4,653 1, Total wage claim per worker Liabilities to assets ratio*, Secured claims / total assets Secured claims / total claims Unsecured claims / total claims Preferred claims / total claims Crown claims / total claims Crown claims / preferred claims Source deductions / crown claims Number of secured creditors Number of unsecured creditors* Number of preferred creditors* Number of wage creditors * Total number of creditors * Secured creditors / total creditors Unsecured creditors / total creditors Preferred creditors / total creditors Notes * Indicates a statistical difference between incorporated and unincorporated firms at the 5 per cent level. 1. Of the 417 bankruptcy files in the sample, 122 are incorporated businesses and 295 are unincorporated businesses. 2. The total assets, total liabilities, and the claims variables are reported in June 1993 Canadian dollars, deflated by the GDP deflator(series D20556). 3. Of the 41 files with positive wage claims, 26 are incorporated businesses and 15 are unincorporated businesses. 4. Based on 102 files of incorporated businesses and 262 files of unincorporated businesses. Summer 1995 Canadian Business Economics 57

6 with positive secured claims, the mean and median ratio of secured claims are respectively equal to 2.86 and This confirms that firms using secured or bank financing prior to bankruptcy have practically no assets left to give as security against new loans at the time of bankruptcy. Unsecured claims Every bankruptcy cases involves unsecured claims. For the full sample, the mean and median values of unsecured claims are respectively $130,117 and $50,134. Incorporated firms have a significantly larger value of unsecured claims, $254,691, than unincorporated firms with an average value of $78,601. The proportion of unsecured claims in total liabilities is equal to 68.2 per cent for all bankrupt firms, 66.7 per cent for incorporated businesses and 68.9 per cent for unincorporated businesses. Typically, a commercial bankruptcy involves an average of 20 unsecured creditors. Incorporated firms have almost three times more unsecured creditors than unincorporated firms; the former having an average of 38 unsecured creditors compared to 13 for the latter. Unsecured creditors represent by far the largest class or creditors in bankruptcy. For the full sample, they represent 80.8 per cent of all the creditors. There is not a significant difference between incorporated firms and unincorporated firms. An interesting feature of our data set is that it provides information on the distribution of claims among creditors of a same class. The data shows that, on average, the largest unsecured creditor holds 49 per cent of the total unsecured claims. In fact, a single creditor holds more than 25 per cent of the unsecured claims in 82 per cent of the cases examined. When calculated over the total value of preferred and unsecured claims, a single unsecured creditor holds a potential veto right in more than 70 per cent of the cases. This is an important fact when considering that these creditors would have a veto right if the firm had opted for reorganization rather than for bankruptcy. At first sight, this result supports the recent amendment with respect to the softening of the voting requirement in reorganization. Prior to December 1992, to be accepted, a proposal required the affirmative vote of a majority of unsecured creditors representing at least 75 per cent in value of the claims of those unsecured creditors voting at Table 4 Characteristics of the Bankruptcy Process Variables Mean Median Standard deviation Min Max Payoff rate to unsecured creditors 1,2 Payoff rate to preferred creditors 3 Time in bankruptcy (days) ,052 Total administration costs 4 5,892 2, ,280 Trustees fees 3,949 1, ,180 Trustees fees / admin. costs Admin. costs / total assets Admin. costs / total liabilities Notes 1. The information on the payoff to unsecured and preferred creditors originate from the trustees Final Statement of Receipts and Disbursements. The variables are reported in percentages. 2. Based on a sample of 406 proposals where the information is available. 3. Based on a sample of 333 proposals where the information is available. 4. Administration costs and trustees fees are reported in June 1993 Canadian dollars, deflated by the GDP deflator (series D20556). 58 Canadian Business Economics Summer 1995

7 the assembly. The reform to the Bankruptcy Act lowered the percentage of claims requirement to two-thirds, thereby reducing the possibility of a single creditor being pivotal in the creditors decision. However, Martel (1995) has shown empirically that the presence of a single unsecured creditor holding more than 25 per cent of the total claims in reorganization has no significant impact on the creditors decision to accept or reject a proposal. Preferred claims About 78 per cent of all commercial bankruptcy filings involve preferred claims. For the full sample, the mean and median values of preferred claims are respectively equal to $26,138 and $3,862. Incorporated firms have almost four times as much preferred claims than unincorporated firms ($53,812 for the former compared to $14,022 for the latter). Preferred claims represent 12.3 per cent of the firms liabilities at the time of bankruptcy, with this proportion being slightly higher for incorporated firms, 14.0 per cent, than for unincorporated firms, 11.5 per cent. There are only a few preferred creditors involved in a bankruptcy. For the full sample of firms, the mean (median) number of preferred creditors is equal to 3 (2); this number is significantly higher for incorporated than for unincorporated businesses (6 vs. 2 creditors). Crown claims About 66 per cent of all commercial bankruptcies involve Crown claims. On average, Crown claims represent more than 55 per cent of preferred claims and about 10 per cent of total liabilities. For the full sample of firms, the mean value of Crown claims is equal to $20,575 and a median of $1,830. These claims are higher for incorporated firms, $39,494, than for unincorporated firms, $12,752. An important element of Crown claims are the source deductions. 16 According to the data, claims for source deductions represent, on average (median), 40.5 per cent (8.4 per cent) of Crown claims in bankruptcy. Incorporated and unincorporated firms have the same proportion of source deductions in Crown claims. The mean and median values of claims for source deductions are respectively $8,900 and $352 for the full sample and the mean values are equal to $8,628 and $9,012 for incorporated and unincorporated businesses respectively. Wage claims Only 41 files of the full sample have positive wage claims. Incorporated firms account for 26 of these files while unincorporated firms account for 15 files. For the 41 cases, the median value of wage claims is $7,377 and the median is $1,264. Wage claims are significantly higher for incorporated than for unincorporated firms, with a mean value of $10,526 for the former compared to $1,919 for the latter. Approximately 96 per cent of total wage claims rank as preferred claims and 4 per cent rank as unsecured claims. The same distribution holds for incorporated and unincorporated firms. On average, there are 12 wage creditors involved in a bankruptcy. Incorporated businesses, with 18 creditors, have significantly more wage creditors than unincorporated businesses which have 3 creditors. On an individual basis, the mean and median wage claim per worker are respectively equal to $597 ($611) for the full sample of firms. Incorporated and unincorporated have a similar wage claim structure with an average claim of $606 and $583 respectively. The wage claim per worker exceeds the value $500 in 46 per cent of the cases and the value of $800 in 15 per cent of the cases which suggests that maximum amounts allowed by the Act to rank as preferred claim was often binding on wage creditors. However, the amounts involved are relatively low. Payoff Rate to Creditors As Table 4 indicates, bankruptcy imposes substantial losses on unsecured and preferred creditors. For the full sample, the mean payoff on unsecured and preferred claims are respectively equal to 2.5 per cent and 23.2 per cent, with a median value of 0 per cent for both types of claims. 17 Unsecured creditors receive a zero payment in 77 per cent of the bankruptcies while preferred creditors receive nothing in 53 per cent of the bankruptcies. The payoff to creditors does not vary significantly between incorporated and unincorporated firms. Summer 1995 Canadian Business Economics 59

8 Bankruptcy Process Table 4 also displays some descriptive statistics on the Canadian bankruptcy process. The average time spent by firms in bankruptcy is 818 days and the median is 690 days. 18 Surprisingly, incorporated firms spend less time in bankruptcy than unincorporated firms (770 days compared to 838 days.). For the full sample, the mean and median administration costs are respectively equal to $5,892 and $2,193. These costs are significantly larger for incorporated, $12,690 than for unincorporated firms, $3,059. On average, administration costs represent approximately 44 per cent of the book value of assets, as reported in the debtor s statement of affairs, and 5 per cent of the book value of liabilities. Clearly, the book value of assets overestimate their market value. Using a ratio of market to book value equal to 50 per cent, the ratio of administration costs to assets is estimated at 55.6 per cent. 19 Compared to unincorporated businesses, incorporated businesses have a significantly lower ratio of administration costs to assets but a significantly higher ratio of administration costs to liabilities. Trustees fees represent an important component of administrative costs in bankruptcy. On average, trustees fees account for 80 per cent of total administration costs. Compared to incorporated businesses, unincorporated businesses have a significantly lower ratio of trustees fees to administration costs. This could be explained by the fact that smaller cases have a larger portion of the fixed-cost component of administrative costs. Many studies (Warner, 1977; Ang, Chua and McConnell, 1982; Gilson, Kose and Lang 1990; and Fisher and Martel, 1994b) found evidence for the presence of a scale effect in administration costs in financial reorganization. To investigate the presence of a similar scale effect in bankruptcy, we estimate the following equation: 20 Administration costs = (6.05) Assets (15.17) 0.666X10 8 Assets 2 (14.18) The regression result indicates the presence of a scale effect in the bankruptcy process and administration costs increase with the real value of assets but at a decreasing rate. As mentioned earlier, the problem with administration costs lies in their size rather than in their preferred ranking. The data supports the claim that trustees and lawyers are the biggest beneficiaries in bankruptcy at the expense of unsecured creditors. Surprisingly, unless the trustee s remuneration is voted at any meeting of creditor, the Act limits the trustee s remuneration to 7.5 per cent of the realization value of the debtor s property. However, this amount can be increased with the court s approval. 21 Clearly, the 7.5 per cent criterion is not binding and trustees have substantial discretion in charging for their services. It is easy to see why this system is subject to abuse. On the one hand, the debtor has no interests in the bankruptcy proceedings since the trustee has taken possession of all the assets. On the other hand, it is difficult for creditors to fully monitor the trustee s work to locate and liquidate the assets which makes it difficult to evaluate the trustee s expenses. This leaves the court with the control of the trustee s remuneration. However, the court suffers from the same information problem than creditors and given the large number of bankruptcy cases, it seems reasonable to think that it generally approves the trustee s expenses without really questioning their work. Discussion The critical financial health of firms at the time of bankruptcy and the losses incurred by unsecured creditors raise an important issue from a public policy perspective: what can be done to minimize the negative effects of bankruptcy? Ideally, one would wish that these firms file for bankruptcy at an earlier stage. But the present system offers little incentives to do so. If insolvent, a firm can make an assignment of its property for the benefits of the creditors or, under certain conditions, it can be petitioned in bankruptcy by one or more creditors. The problem with petitioning a firm in bankruptcy is that the claims of individual unsecured creditors are relatively small and they face a free rider problem in pursuing their actions against the firm. This often leaves the firm with the responsibility of mak- 60 Canadian Business Economics Summer 1995

9 ing an assignment and the debtor can only gain by postponing the proceedings. When bankruptcy is declared, creditors face an irreversible situation in which little can de done against the debtor. To deal with this problem, some European countries, such as France, Germany and the United Kingdom, have adopted insolvency systems which encourage debtors to file early for bankruptcy. 22 In France, managers of a firm in financial difficulty have to file for bankruptcy within 15 days of the date they become unable to pay their debts as they are due. Otherwise they can be held personally responsible for the firm s debt and they can be prevented from managing other firms in the future. In addition, the firm s bank can be held responsible for its liabilities. In Germany, managers are required to file for bankruptcy within three weeks of the date they become insolvent. If managers unduly postpone the proceedings, they can face potential civil and criminal liability. Banks can also be sued if they try to conceal the situation. Finally, in the United Kingdom, managers can be held personally responsible for the extra losses incurred by creditors if the firm continues operating after being insolvent. In Canada, Part VIII of the Bankruptcy and Insolvency Act provides for a list of offences which debtors may be guilty of in the context of bankruptcy. 23 Although tough in appearance, these laws can only be more efficient in encouraging early bankruptcy if they are effective. However, White (1993) reports a lack of commitment in enforcing many of these acts, which suggests that the issue of filing early for bankruptcy has more to do with the application of the law than the law itself. From an efficiency perspective, a harsh treatment of managers in bankruptcy may not be the solution to the problem. First, the treatment of managers in bankruptcy has a direct impact on the investment decisions (Gertner and Picker, 1992; and White, 1980 and 1993). Although it creates incentives to work hard prior to bankruptcy, therefore reducing the possibility of becoming insolvent, it can lead to either underinvestment or overinvestment prior to bankruptcy. In addition, proving a manager guilty of bad" management can be a very difficult if not an impossible task in most bankruptcy cases since a manager can always argue that he did the best he could under the circumstances. The present system empowers the trustees to report to the court any offence to the Act committed by the debtor prior and during bankruptcy and it is doubtful that extending the trustees tasks to evaluating the ex ante performance of the debtor from the observation of an ex post result will improve the system and benefit to the mass of creditors. In addition, it is not clear that forcing a firm to file for bankruptcy only two or three weeks after being unable to pay its debt as they become due will bring a better separation of firms in the economy. Although an early filing can leave more to creditors, it may also lead to the liquidation of viable firms with short term cash-flow problems. An alternative solution to this problem is to encourage firms to file for reorganization. Faced with the possibility of coming out of reorganization as a business entity with a new capital structure, this could motivate firms in financial difficulty to file early for reorganization. This is the view prevailing behind the reform to the Bankruptcy Act which aims at promoting the financial reorganization of insolvent firms. To evaluate this solution, one needs to determine whether it represents an efficiency gain for the Canadian economy. Martel (1994b) has shown that firms filing for reorganization are in significantly better financial health, with a mean liabilities to asset ratio of 16.0 and a median equal to 1.8, than firms filing for bankruptcy. This suggests that firms opting for bankruptcy are in the tail of the financially distressed firms. It is illusive to think that an easier access to reorganization will significantly alter the financial situation of these firms at the time of bankruptcy or reorganization. Firms filing for bankruptcy did so deliberately when they could have filed for reorganization. Given that they revealed their preferences by filing for bankruptcy, promoting their reorganization may simply result in an inefficient allocation of resources and additional costs to the Canadian economy (Martel, 1994a). Another interesting subject of analysis of firms in bankruptcy is their use of secured and preferred claims as financial instruments. According to the data, almost 80 per cent of firms ending up in bankruptcy use preferred claims as a financing instrument compared to almost Summer 1995 Canadian Business Economics 61

10 50 per cent of firms using secured or bank financing. When taken over the entire sample, the difference between secured and preferred debt is not very large, suggesting that firm can extend their life by not repaying or postponing the payment of debt such as source deductions and other government claims. This type of financing instrument can become useful in situations where the debtor has little or no assets left to give as a security against new bank loans. This suggests that firms declaring bankruptcy have used all means to extend their life and that the protection of the bankruptcy court is the only alternative available to them. Conclusion This article has described a micro data set of 417 firms which filed for bankruptcy under the Canadian Bankruptcy Act for the period To our knowledge, this data set is unique to both Canada and the United States in that it contains micro information from a representative sample of the population of bankrupt firms which use the Bankruptcy Act. According to the data, firms in bankruptcy are small, with 98 per cent of them having a book value of assets lower than $500,000. In addition, their financial health is critical with an average liabilities to assets ratio equal to 72 and a median value equal to 8.1. Among business failures, the firms which do not use the Bankruptcy Act are probably weaker financially than those which do. These facts raise serious concerns with respect to the main objective of the reform to the Bankruptcy Act to promote the reorganization of firms in financial distress. Given the financial situation of these firms, bankruptcy was most likely to be the best decision for the vast majority of them. Encouraging their reorganization may be inefficient and costly for the Canadian economy. The data confirm the view that bankruptcy imposes substantial losses to creditors, in particular unsecured creditors who receive only 2.5 cents for every dollar of claims. Trustees and legal experts appear to be the biggest beneficiaries of bankruptcy. The total administration costs represent 44 per cent of the value of assets at the time of bankruptcy. This proportion rises to 56 per cent if we use a ratio of estimated realizable value to book value of assets equal to 50 per cent. Given the small size of the firms involved in bankruptcy, the average time period of 2.24 years required to complete the proceedings seems unreasonably long. Since there are important fixed Table 5 Characteristics of the Bankruptcy Process: Incorporated vs. Unincorporated Businesses. Variables Incorporated Businesses Unincorporated Businesses Mean Median Mean Median Payoff rate to unsecured creditors Payoff rate to preferred creditors Time in bankruptcy (days) Total administration costs*,2 12,690 5,943 3,059 1,672 Trustees fees* 7,970 3,778 2,287 1,566 Trustees fees / admin.costs* Admin. costs / assets* Admin. costs / liabilities* Notes: * Indicates a statistical difference between incorporated and unincorporated firms at the 5 per cent level. 1. The payoff variables are reported in percentages. 2. Administration costs and trustees fees are reported in June 1993 Canadian dollars, deflated by the GDP deflator (series D20556). 62 Canadian Business Economics Summer 1995

11 costs in the administration of a bankruptcy, this could explain why administration costs take such a large portion of the proceeds from the liquidation. The costliness and time of using the Bankruptcy Act probably deters many failing firms from using the Act. Given the heavy losses imposed on creditors in bankruptcy, one may wish for an earlier detection of a firm s financial difficulties or greater penalties for managers unduly extending their firm s life. It is not clear how potential bankrupt firms could be better detected. There are certainly a number of indicators, such as the liabilities to assets ratio, which convey information to the market about the financial health of a firm, but these could be misleading since they vary with firm size and across industries. For instance, how does a liabilities to assets ratio of 2.4 in the manufacturing industry compares to a ratio of 5.5 in the retail trade industry? In a market economy, bankruptcy is part of the business environment in which all firms operate and it is internalized in the lending conditions negotiated between firms and creditors. From a public policy perspective, one should aim at achieving a better separation between viable and non-viable firms in order to minimize the bankruptcy costs rather than aim at minimizing the number of bankruptcies. The data presented in this study suggest that bankruptcy was the natural outcome for the vast majority of the firms examined and that encouraging their reorganization will increase bankruptcy costs. Notes * This article is a revised version of the first part of Chapter 2 of my Ph.D. thesis. I thank the Bankruptcy Branch of Industry Canada for making available the data used in the study. I am grateful to Jacques Robert, Michel Poitevin, Thomas Lemieux, Tim Fisher, David Slater and three anonymous referees for their comments and to Stephanie Lluis for her technical assistance. Errors and omissions are the responsibility of the author. 1. The term bankruptcy refers to the liquidation of a debtor s assets under the Bankruptcy Act.. 2. Straight bankruptcies represent per cent of commercial insolvency cases under the Bankruptcy Act are. See Martel (1991). 3. Any claims exceeding this limit rank as unsecured claims. The amendments to the Act raised the upper limit on wage claims to $2,000 for services rendered during the six months preceding bankruptcy. Travelling salesmen are entitled to an additional $1,000 in expenses. 4. These claims do not rank as preferred claims after December However, a proposal must provide for their payment in full within six months from approval by creditors to receive confirmation by the court. 5. These claims rank as unsecured claims since December Unsecured creditors are typically suppliers of goods and services. 7. The new Act provides for a temporary stay of proceedings for secured creditors and the possibility for the debtors to include the secured creditors in the proposal. 8. It is argued that the problem with administration costs in bankruptcy is not with respect to their ranking but rather with their size as a percentage of the liquidated assets. This is discussed in the section on Bankruptcy Process. 9. Random sampling was carried out using the Systematic Random Sampling Procedure. The sample equals 1.8 per cent of the population and is representative of the regional distribution of bankruptcies over the years and the regional offices. 10. Dollar values are reported in June 1993 Canadian dollars, deflated by the GDP deflator. The large difference between the mean and the median values is explained by the asymmetric distribution of the firms by size, with the vast majority of firms being small and only a few firms being large. 11. Of the 417 firms in the sample, 288 (70.7 per cent) are incorporated and 119 (29.3 per cent) are unincorporated businesses. None of the firms in the sample have publicly traded shares. 12. We use the term significant" in comparing incorporated and unincorporated firms when the mean value of the two sub-samples are statistically different at a 5 per cent level. 13. Using the assets to liabilities ratio, firms in the sample have a mean ratio of Free assets are defined as assets which have not been given as collateral. 15. It is reasonable to assume that the maximum value for the secured liabilities to assets ratio should be 1. This ratio exceeds the value of 1 in 21 per cent of the cases. Imposing a constraint on the maximum value, the ratio is equal to 0.40 for the full sample; and to 0.45 and 0.37 for incorporated and unincorporated businesses respectively. 16. These are levies for Income Tax, Unemployment Insurance and Canada Pension Plan contributions. 17. The payoff rate to creditors is calculated from the value of filed and approved" claims. 18. The time spent in bankruptcy is the time between the filing date and the trustee s discharge date. Summer 1995 Canadian Business Economics 63

12 19. Kryzanowsky and Holland (1984) estimate that the ratio of estimated realizable value to book value of the assets ranges from 42.5 to 52.5 per cent. 20. Variables are measured in 1993 dollars. There are 406 observations, R 2 = and the absolute values of the t-statistics are given in parentheses. 21. Section 39 of the Act. 22. The reader is referred to White (1993) for a general discussion of the bankruptcy systems in these countries. 23. New name given to the Act since December References Ang, J. S., J. H. Chua and J. J. McConnell (1982) The Administrative Costs of Corporate Bankruptcy: A Note, Journal of Finance, Vol. 37, pp Bankruptcy Act, R.S.C. 1985, c. B-3. Bohémier, A. (1992) Faillite et Insolvabilité, Tome 1, (ed.) Thémis, Université de Montréal. Bohémier A. and H. Massuüe-Monat (1989) Guide Pratique en Matière de Faillite, (ed.) Thémis, Université de Montréal. Fisher, T.C.G., and J. Martel (1995) The Creditors Financial Reorganization Decision: New Evidence from Canadian Data, Journal of Law, Economics and Organization, April Fisher, T.C.G., and J. Martel (1994) Will the Bankruptcy Reforms Work? An Empirical Study of Financial Reorganization in Canada, Canadian Public Policy, No. 3, September, pp Fisher, T.C.G., and J. Martel (1994) Facts About Financial Reorganization in Canada, Canadian Business Economics, Vol. 2, No. 2, Winter, pp Gertner, R. and R. Picker (1992) Bankruptcy and the Allocation of Control, working paper, University of Chicago Law School. Gilson, S. C., J. Kose and L.H.P. Lang (1990) Troubled Debt Restructuring: An Empirical Study of Private Reorganization of Firms in Default, Journal of Financial Economics, Vol. 27, October, pp Government of Canada (1992) An Act to Amend the Bankruptcy Act and to Amend the Income Tax Act in consequence thereof (Bill C-22), S.C. 1992, c. 27. Kryzanowsky, L. and J. Holland (1984) Bankruptcies and Commercial Arrangements in Canada, Insolvency Bulletin, Office of the Superintendent of Bankruptcy, 9, September, pp Martel, J. (1995) Signaling in Financial Reorganization: Theory and Evidence from Canada, Unpublished manuscript, CIRANO, June. Martel, J. (1994) More on the Impact of Bankruptcy Reform in Canada, Working Paper 94s-17, CIRANO, November. Martel, J. (1994) Commercial Bankruptcy and Financial Reorganization in Canada, Working Paper 92c-2, CIRANO, September. Martel, J. (1991) Bankruptcy Law and the Canadian Experience: An Economic Appraisal, Canadian Public Policy, No. 1, March, pp Office of the Superintendent of Bankruptcy (1995) Annual Statistical Summary, Industry Canada. Warner, J. B. (1977) Bankruptcy Costs: Some Evidence, Journal of Finance, Vol. 32, May, pp White, M. (1993) The Costs of Corporate Bankruptcy: A U.S.-European Comparison, Working Paper No. 48, Center for Economic Studies, University of Munich, October. White, M. (1980) Public Policy Toward Bankruptcy: Me-First and Other Priority Rules, Bell Journal of Economics, Vol. 11, pp Canadian Business Economics Summer 1995