Economic Distress, Financial Distress, and Dynamic Liquidation


  • Matthias Kahl

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    • The Anderson School at UCLA. This is a substantially revised version of the first chapter of my dissertation at the University of Pennsylvania. The paper was previously entitled “Dy-namic Liquidation, Adjustment of Capital Structure, and the Costs of Financial Distress.” I am greatly indebted to my advisors, Gary Gorton and George Mailath, for their constant guidance and support and many helpful discussions. The paper has also benefited very much from comments by two anonymous referees and René Stulz (the editor). I would like to thank Franklin Allen, David Brown, Mike Burkart, Bhagwan Chowdhry, Julian Franks, Amit Goyal, Bruce Grundy, Lutz Hendricks, Stephen Morris, Peter Norman, Richard Rosen, Raj Singh, Avanidhar Subrahmanyam, Walter Torous, Masako Ueda, S. Viswanathan, and seminar participants at Boston University, Chicago, Cornell, Dartmouth, Duke, Florida, Indiana, INSEAD, LBS, LSE, Minnesota, Northwestern, Princeton, Stanford, Texas-Austin, UCLA, Wharton, and Wisconsin, and conference participants at the 1998 meetings of the Western Finance Association and the 1996 meetings of the European Economics Association, European Finance Association, and European Econometric Society for many valuable suggestions. All errors and shortcomings are solely my responsibility.


Many firms emerging from a debt restructuring remain highly leveraged, continue to invest little, perform poorly, and often reenter financial distress. The existing literature interprets these findings as inefficiencies arising from coordination problems among many creditors or an inefficient design of bankruptcy law. In contrast, this paper emphasizes that creditors lack the information that is needed to make quick and correct liquidation decisions. It can explain the long-term nature of financial distress solely as the result of dynamic learning strategies of creditors and suggests that it may be an unavoidable byproduct of an efficient resolution of financial distress.