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 ational model to explain how the exemption may reduce indirect costs of bankruptcy, despite the fact that postpetition trade credit is senior (whichmakes the prepetition claimsimply a sunk cost to the supplier). The idea underlying the model is that suppliers choose to withhold supplies from a bankrupt customer should they have alternative customers (with more stable business operations and less associated uncertainty) that they can sell to. In such a case, the exemption may be awarded if the supplier agrees to continue supplying to the bankrupt customer at existing terms. 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.
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