Critical Vendors and Bankruptcy

Ramanadh V. Chivukula, Booth PhD candidate

The costs of financial distress are estimated to be as high as 20% of firm value. In this paper, I investigate a mechanism present in the Bankruptcy Code that helps mitigate such costs. The mechanism, Critical Vendor Exemption, provides administrative expense priority to the pre-petition debt of vendors deemed “critical”. I develop a rational model to explain how the exemption may reduce indirect costs of bankruptcy, despite the fact that post petition trade credit is senior (which makes the prepetition claim simply a sunk cost to the supplier). The key idea in my model is that hierarchical suppliers may rationally choose to withhold supplies should they question whether their employees put in an honest effort to make the bankrupt customer repay his claim. The model suggests that the exemption is more likely to be awarded when the suppliers’ inputs are more critical to the firm and that the exemption causes lower costs of distress. These predictions are verified using novel, hand-collected data.