I present new evidence on the direct costs of bankruptcy and violation of priority of claims. In a sample of 37 New York and American Stock Exchange firms that filed for bankruptcy between November 1979 and December 1986, direct costs average 3.1% of the book value of debt plus the market value of equity, and priority of claims is violated in 29 cases. The breakdown in priority of claims occur primarily among the unsecured creditors and between the unsecured creditors and equity holders. Secured creditors' contracts are generally upheld.

Eastern Airlines' bankruptcy illustrates the devastating effect on firm value of court-sponsored asset stripping, i.e., the use of creditors' collateral to invest in high-variance negative net present value projects. During its bankruptcy, Eastern's value dropped over 50%. A substantial portion of this value decline occurred because an overprotective court insulated Eastern from market forces and allowed value-destroying operations to continue long after it was clear that Eastern should have been shut down. The failure of Eastern's Chapter 11 demonstrates the importance of having a bankruptcy process that protects a distressed firm's assets, not simply from a run by creditors, but also from overly optimistic managers and misguided judges.