Does Chapter 11 bankruptcy drive away customers – or did losing customers cause the bankruptcy?

“Many firms continue to trade after bankruptcy. But how do their customers react when they file? Samuel Antill and Megan Hunter untangle the causes and the impact of the bankruptcy and show how customers’ attitudes depend on the nature of the business and its relationship with their customers. A common misconception about troubled businesses in America is that when a large company files for bankruptcy it ceases to exist. In reality, a process known as Chapter 11 allows many to restructure their debts and continue to trade as an ongoing concern. Consumers dramatically underestimate how often large companies survive bankruptcy and continue operating. But once that company does file, what happens to the customers? Do they keep shopping, flying or renting as normal? Or does the word “bankruptcy” send them running to competitors? Until now, we did not really know. And the reason is more subtle than it might seem. Companies that file for bankruptcy are typically already in trouble: demand was probably falling before the filing, for reasons that had nothing to do with the legal process itself. A struggling retailer, an airline hemorrhaging passengers, a car manufacturer watching its market share collapse often enter bankruptcy precisely because customers were already leaving. So when we observe a further decline in demand around a bankruptcy filing, we face an identification problem: how much of that decline was caused by the bankruptcy itself, and how much would have happened anyway? Disentangling these two forces is something researchers have never been able to do cleanly with observational data . Any firm you observe going bankrupt was already distressed, and distress and bankruptcy are almost impossible to separate. Yet the answer matters enormously. If the act of filing for bankruptcy itself drives customers away, then the decision to file carries hidden costs that firms, creditors and policymakers need to account for. If customers were leaving regardless, then bankruptcy is simply a legal reorganisation tool with manageable side effects. In our new research we tackle this identification problem directly using randomised experiments. The logic is straightforward: if we inform some consumers that a firm has filed for Chapter 11 bankruptcy while keeping other consumers uninformed, any difference in their willingness to pay for the firm’s products must be caused by the bankruptcy information itself. Everything else about the firm, its products and the consumers is held equal by random assignment. This gives us something that observational studies of real bankruptcies can never provide: a clean causal estimate. The experiments We ran three incentivised experiments covering Hertz , Instant Brands (maker of the Instant Pot), and Spirit Airlines , each conducted during the firm’s active bankruptcy proceedings. In each case, we randomly assigned consumers to either receive or not receive information about the filing, then measured their willingness to pay for the firm’s products using a standard incentive-compatible mechanism – meaning consumers had a genuine financial reason to report their true preferences honestly, not just to guess what the researchers wanted to hear. Across all three experiments, the results pointed in the same direction. Learning that a company had filed for bankruptcy substantially reduced consumers’ willingness to pay for its products: by 28 per cent for Hertz, 20 per cent for Instant Brands and 17 per cent for Spirit Airlines. This is not a marginal effect. A consumer willing to pay $50 for a Hertz gift card before learning of the bankruptcy might only value it at $36 afterwards, even though the gift card functions identically in either case. One complication is that some consumers in the uninformed group had heard about the bankruptcy before the experiment, meaning that our treatment was imperfectly assigned. We account for this statistically, which if anything means our estimates of the effect of bankruptcy knowledge are conservative. Why do consumers react? A fourth experiment conducted as part of this work, covering airlines, car manufacturers and retailers, allowed us to probe the mechanisms. Two distinct concerns drove the reaction. The first is concern about current quality. Consumers fear that a bankrupt company will cut corners to conserve cash, by reducing staff, running down inventory or deferring maintenance. For airlines, the dominant worry was flight reliability and cancellations. For retailers, it was limited stock and difficulty returning items. When we explicitly told consumers that an independent agency had confirmed quality was unaffected by the bankruptcy, the negative effect fell by roughly 60 per cent for both airlines and retailers. The second concern is about future interactions. Consumers worry the company will not survive, rendering warranties worthless, loyalty points valueless and future servicing impossible. For car manufacturers, which produce a durable good where the relationship between consumer and firm extends years into the future, this concern was dominant. When we assured consumers that the firm would almost certainly emerge from bankruptcy and continue operating, the effect fell by around 60 per cent for cars, compared to only 33 per cent for airlines and retailers. This produces a striking and intuitive pattern. For services and non-durable goods like flights and retail purchases, quality concerns explain approximately two-thirds of the consumer reaction, and fears about future interactions explain the remaining third. For durable goods like cars, where warranties, spare parts and long-term servicing depend on the manufacturer still existing, this ratio is essentially reversed: concerns about future interaction dominate. What did not seem to matter in any industry was any inference about the firm’s long-term quality or pre-bankruptcy management failures. Consumers were reacting to concrete near-term risks, not simply condemning the brand. How many consumers are paying attention? These experimental effects only translate into real-world costs if consumers actually know when firms file for bankruptcy. In an awareness survey covering 70 previously bankrupt consumer-facing firms, we found that an average of 38 per cent of consumers were aware of past filings – a figure that, because it was measured years after the fact, likely understates how many consumers knew at the time. Awareness was highest in hotels, airlines and automotive industries where consumers interact directly and repeatedly with firms. Strikingly, we also found that consumers are essentially unaware of pre-bankruptcy financial distress. Companies with very poor credit ratings were no more likely to be perceived as financially fragile than healthier competitors. Since the bankruptcy filing itself is the information event that reaches ordinary consumers, costs arrive sharply at the moment of filing rather than building gradually. Quantifying the damage To translate our experimental findings into dollar figures, we need to answer a question that is impossible to observe directly: what would have happened to a firm’s sales, prices and profits if it had never filed for bankruptcy? To construct this counterfactual, we built a model of how consumers choose between competing airlines and how airlines set their prices in response, combining our experimental estimates of how bankruptcy changes consumer behaviour with historical data on prices and passenger volumes across all flight routes in America. We focus on airlines because rich public data makes the exercise tractable, and because the industry has seen several major high-profile bankruptcies. Armed with this framework, we can simulate two versions of history side by side: one in which Delta Air Lines , American Airlines and United Airlines filed for bankruptcy as they did, and one in which they never filed at all. The difference between the two reveals the true cost of the bankruptcy to the firm. For Delta, the present value of all future profits lost to customer attrition – relative to the world in which it never filed – amounted to 15 per cent of the firm’s total enterprise value. American and United suffered similar losses, at 11.7 per cent and 14.6 per cent respectively. These figures help resolve a long-standing puzzle in corporate finance . Economists have known for decades that firms behave as though bankruptcy is extremely costly, accepting large efficiency losses to avoid filing. Yet the direct legal and administrative costs of Chapter 11 are relatively modest for large firms. Indirect costs – of which customer attrition is the largest and least studied – appear to close that gap substantially. Our estimates are a lower bound: employee attrition, supplier renegotiations and capital market stigma are not included. Room for improvement One finding suggests that some of these costs are rooted in consumer misperceptions that could, in principle, be corrected. Historically, 100 per cent of large car manufacturers that filed for Chapter 11 ultimately emerged as going concerns, yet consumers in our experiments believe as if the survival rate was barely above 50 per cent. Better public communication about what bankruptcy actually means, and what it does not mean, could meaningfully reduce unnecessary customer flight from firms that are restructuring rather than disappearing. This article gives the views of the author, not the position of LSE Business Review or the London School of Economics. You are agreeing with our comment policy when you leave a comment. Image credit: Vitalii Vodolazskyi provided by Shutterstock. The post Does Chapter 11 bankruptcy drive away customers – or did losing customers cause the bankruptcy? first appeared on LSE Business Review .

Summary generated from the RSS feed of LSE Business Review. All article rights belong to the original publisher. Click through to read the full piece on blogs.lse.ac.uk/businessreview.