HKU Jockey Club Enterprise Sustainability Global Research Institute
World-Class Hub for Sustainability
Bo Becker | Jens Josephson | Hongyi Xu
Non-Financial Liabilities and Effective Corporate Restructuring
Jun 25, 2025
Key Takeaways
- Research Gap: Many insolvency systems focus primarily on restructuring financial liabilities but lack tools for restructuring operational liabilities such as leases and long-term supplier contracts.
- Method and Findings: The U.S. bankruptcy system, particularly Chapter 11, offers the option to reject executory contracts. We model the impact of this feature and show the rejection option enhances firms’ debt capacity. It also reduces the incidence of liquidation and increases the incidence of restructuring.
- We test the debt-capacity predictions in two settings: comparing the U.S. with other countries (which traditionally lack rejection options) and comparing Israeli firms before and after a 2019 reform that introduced flexible rejection. We find the rejection option is associated with higher leverage, particularly in industries with significant executory contract use.
- We complement these tests of firm leverage with tests on the flow of syndicated loans. Results confirm rejection is associated with more debt capacity.
- Implications: The findings suggest addressing non-financial liabilities through operational restructuring is a key aspect of insolvency law, with a large impact on corporate capital structures. It may also be a useful focus for policies aimed at avoiding liquidation of viable firms. The model shows the option to reject executory contracts can be beneficial because it reduces inefficient liquidations of insolvent firms and increases ex-ante debt capacity. We discuss recent reforms in the direction of allowing more flexible rejection in, for example, European insolvency law.
Source Publication: Becker, Bo and Josephson, Jens and Xu, Hongyi, 2024, “Non-Financial Liabilities and Effective Corporate Restructuring”. European Corporate Governance Institute – Finance Working Paper No. 937/2023, Available at SSRN: https://ssrn.com/abstract=4614991
Background and Research Questions
Effective management of insolvency and distress is crucial for credit markets and economic outcomes, yet legal systems vary significantly in their approach. Many systems emphasize restructuring financial liabilities but often overlook operational liabilities such as leases and long-term contracts. This paper proposes that non-financial obligations pose an important challenge that many insolvency systems struggle to handle. The study develops a model to understand how capital structure and insolvency choices depend on whether debtors can reject executory contracts, and empirically tests the prediction that the ability to reject executory contracts increases firms’ debt capacity.
Data and Methodology
The study employs a theoretical model comparing insolvency outcomes under regimes with no restructuring, financial restructuring only, and operational and financial restructuring (including the right to reject executory contracts). Empirical analysis uses three main datasets: Compustat-Capital IQ for firm-level capital structure data and industry-level executory contract intensity, Refinitiv LoanConnector Dealscan for syndicated lending data, and text analysis of SEC 10-K filings to measure long-term purchase obligations. Executory contract intensity by industry is measured using U.S. firm data on operating leases, capital leases, net rental expenses, and purchase obligations, normalized by assets or revenues. This intensity measure is assumed to be indicative across countries. The empirical methodology primarily uses difference-in-differences tests. The first approach compares U.S. firms (where rejection is relatively easy) with firms in other countries (where it is typically limited or cumbersome) across industries with varying executory contract use. The second approach examines Israeli firms before and after a 2019 Company Law reform that introduced the right to reject contracts with few conditions, again focusing on industries with high executory contract use. Regression analysis is used to estimate the effects on leverage and lending volumes, controlling for firm, industry-year, and country-year fixed effects where appropriate.
Findings and Discussion
The study’s theoretical model posits that addressing operational and financial claims simultaneously increases the likelihood of successful business survival during insolvency. Specifically, the option to reject executory contracts strengthens the bankrupt firm’s bargaining power, allowing renegotiation and reduction of operating liabilities alongside financial debts. This expanded restructuring possibility makes liquidation less attractive for a wider range of outcomes than settings with only financial restructuring or no restructuring. The model predicts gross debt is highest in a setting with operational and financial restructuring (like U.S. Chapter 11), lower with only financial restructuring (like many other systems), and lowest with no restructuring possibilities. Furthermore, net debt is predicted to increase faster with the quantity of the executory input in the operational and financial restructuring setting. The possibility of operational restructuring is theoretically valuable because it avoids inefficient liquidation and is predicted to result in higher firm values.
Empirical evidence consistently supports the model’s predictions regarding debt capacity. Comparing U.S. firms with those in other countries, firms in industries with greater executory contract use tend to have higher financial leverage in the U.S. than elsewhere. For example, a change in the ratio of executory contracts to revenue from the 25th to the 75th percentile is estimated to correspond to an increase in leverage of around 5% in the U.S. compared with other countries. The Debt-to-EBITDA measure shows a similar pattern, suggesting about a 10% increase in debt for industries with higher executory contract use in the U.S. relative to other countries.
The analysis of the 2019 Israeli Company Law reform reinforces these findings. After the reform, firms in industries that heavily rely on executory contracts saw a statistically significant increase in leverage. Evidence from syndicated loan data also aligns, showing larger lending volumes in U.S. industries with high executory contract use than in the same industries outside the U.S.. This finding is interpreted as executory contracts reducing debt capacity less in the U.S. system. Together, these empirical results provide strong support for the theoretical argument that the ability to restructure non-financial obligations significantly affects corporate capital structures by increasing debt capacity.
Implications
The findings highlight the crucial role of operational liabilities and the legal framework for addressing them during insolvency. The study provides evidence that the ability to reject executory contracts, as seen in the U.S. and introduced in Israel, increases firms’ financial debt capacity. This mechanism likely allows more viable firms to restructure successfully rather than being liquidated, which can have broader economic benefits. The study suggests the approach of allowing operational restructuring could be a suitable target for policy efforts in jurisdictions seeking to improve their insolvency systems and avoid the liquidation of potentially viable businesses. Although the study focuses on capital structure and lending, it also points to expected implications such as rarer liquidations (difficult to test directly) and potentially increased investment in affected firms and industries (not tested in this paper). Overall, the research underscores that the handling of non-financial obligations is a key design variable in insolvency law, with significant practical consequences for corporate finance and economic outcomes.