Rejecting Executory Contracts: How Non-Financial Liabilities Shape Corporate Restructuring

Many insolvency systems are designed to restructure financial debts but leave other obligations, like long-term leases or supplier agreements, untouched. For many struggling businesses, these operational liabilities can be just as burdensome as bank loans. When they cannot be adjusted, viable firms may be forced into liquidation, destroying value for creditors, employees, and the wider economy.

The paper Non-Financial Liabilities and Effective Corporate Restructuring develops a model showing how insolvency regimes that allow companies to reject such contracts, such as through the U.S. Chapter 11 process, can improve outcomes. It also provides empirical evidence from two natural experiments: the contrast between the U.S. and other jurisdictions, and a 2019 reform in Israel that introduced broad rejection rights. The findings point to  significant increases in credit access for firms with large obligations when rejection is allowed. This result highlights that the treatment of operational liabilities is a central design choice of insolvency law.

Non-financial obligations often reflect “executory contracts,” where both sides to the contract have significant commitments. Examples includelease contracts, long-term supply agreements, and intellectual property sharing contracts. The aggregate value of obligations under such contracts  can be large -  on average for U.S: publicly listed firms, they are comparable to financial debt (18% of book assets vs. 29%) . When revenues fall, such fixed commitments can become impossible to meet, yet counterparties may have little incentive to renegotiate outside a formal procedure.

In Chapter 11, firms can reject executory contracts, converting the counterparty’s claim into an unsecured debt. This right strengthens the debtor’s bargaining position, making it possible to renegotiate more favourable terms or exit unprofitable agreements. High-profile cases like Kmart, which sold its rejection rights to expedite decisions on hundreds of leases, and Hertz, which reshaped its vehicle fleet after COVID-19 by rejecting some leases and keeping others, show how this tool can enable a tailored restructuring of both financial and operational debts, preserving the business.

In most non-US jurisdictions, operational claims are excluded from restructuring, or their rejection is subject to strict limits. Few countries offer unconditional rejection rights comparable to the U.S., with the notable exception of Israel after its 2019 reform. This scarcity helps explain why firms with heavy operational liabilities often have lower borrowing capacity outside the U.S.

The study models three legal settings: no restructuring, financial restructuring only, and combined operational and financial restructuring. When both types of liabilities can be addressed, distressed but viable firms are more likely to survive, creditors recover more, and firms can sustain higher leverage in normal times. The model predicts that industries with heavy use of executory contracts will see the largest difference in debt capacity between systems that allow rejection and those that do not. By lowering the risk that operational liabilities will trigger liquidation, rejection rights reduce lenders’ downside risk and encourage them to extend more credit.

To test these predictions, the industry-level “executory contract intensity” was measured by using detailed U.S. accounting data on leases, rentals, and long-term purchase obligations disclosed in 10-K filings. This metric varies widely: retail, apparel, and hospitality have high operational liabilities, while mining and petroleum have relatively low ones.

The empirical work applies difference-in-difference tests in two contexts. Comparing leverage in high- and low-intensity industries shows that U.S. firms in contract-heavy sectors carry significantly more debt than their counterparts abroad. Moving from the 25th to the 75th percentile of contract intensity is associated with roughly 5% more leverage and around 10% more debt relative to earnings. A second test examines Israel before and after the 2019 Company Law reform. After the reform, high-intensity industries saw a marked increase in leverage of around 3 to 4 percentage points relative to low-intensity industries, with the change occurring immediately after the law took effect.

The study also analyses syndicated loan flows. In the U.S., industries with high contract intensity record larger lending volumes than the same industries elsewhere, consistent with the idea that rejection rights expand debt capacity.

The findings highlight a clear policy lesson. Insolvency regimes that fail to address operational liabilities risk forcing viable firms into liquidation and limiting their access to finance. Giving debtors the option to reject executory contracts can help avoid unnecessary closures, strengthen borrowing capacity, and improve the chances of a successful restructuring. While the analysis focuses on leverage and lending, the mechanism is likely to have wider benefits, including fewer inefficient liquidations, stronger debt markets, and potentially higher investment in affected industries. For policymakers seeking to enhance corporate rescue frameworks, the treatment of non-financial liabilities should be a central consideration.

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Bo Becker is the Cevian Capital Professor in the Department of Finance at the Stockholm School of Economics, a Research Fellow of CEPR, and an ECGI Research Member.

Jens Josephson is a Professor of Financial Economics at Stockholm Business School, Stockholm University, and an Affiliated Researcher at the Research Institute of Industrial Economics. 

Hongyi Xu is a PhD student in the Department of Finance at the Stockholm School of Economics.

This blog is based on a paper presented at the 3rd HKU Summer Finance Conference. Visit the event page to explore more conference-related blogs.

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