Walking Debt or Walking Dead: Canada’s Struggle with Zombie Firms

In a thriving economy, only the fittest companies survive. Yet, some firms defy this natural order, becoming the corporate undead. Like zombies wandering a post-apocalyptic landscape, these businesses, sustained by forbearance extensions and financial wizardry, refuse to die. They drain entire industries, stifle growth, and lock up valuable resources in a state of perpetual limbo. Instead of facing the inevitable destruction, they drag their creditors, stakeholders, and economies along for the ride. From Japan to Canada, this zombie problem is highlighting a pattern connected with deep-seated reluctance to confront financial reality.

Meaning of Zombie Firms

Zombie firms refer to companies that continue to operate despite being financially unviable, often surviving only due to external financial support, such as credit extensions or forbearance from creditors, rather than their own ability to generate profits or positive returns. These firms fail to meet the usual criteria for survival in a competitive market, yet persist due to the reluctance of lenders to recognize their insolvency.

Global History of Zombie Firms

The origin of zombie firms came from studies that analyzed the Japanese macroeconomic stagnation in the 1990s. Weak and insolvent firms were being kept alive by Japanese banks. This took the form of forbearance, where the banks maintained and extended their terms of credit to avoid recognizing non-performing loans on their balance sheets.

Similarly, after the 2008 financial crisis, Southern European banks, particularly in Italy and Spain, avoided writing down non-performing loans to protect their balance sheets. To delay financial distress, they engaged in evergreening, extending credit to failing firms. This distorted credit allocation, prolonged stagnation, and prevented capital from reaching productive businesses, further weakening economic recovery.

A 2023 report by Statistics Canada highlights the significant presence of zombie firms in Canada. An analysis of companies listed on the Toronto Stock Exchange (TSX) and the TSX Venture Exchange (TSXV) estimated that 16% fell into this category. By 2020, a study found that Canada had the highest proportion of zombie firms among 14 OECD countries, with nearly 30% fitting the definition. This trend has been largely attributed to Canada’s resource-driven economy, where zombie firms are often concentrated in commodity-related sectors. Further analysis covering the period from 1980 to 2018 revealed a sharp increase in the proportion of zombie firms, rising from 3% to 25%. Notably, two-thirds of these firms operate in industries highly sensitive to commodity prices, with 75% in metal, coal, and mineral mining, 10% in oil and gas extraction, and the remaining 15% in other resource-driven sectors.

Economic Impact of Zombie Firms

• Capital Misallocation: Zombie firms absorb financial resources that should be directed toward high-growth, productive enterprises. This inefficiency stifles innovation, weakens economic expansion, and drags down overall market efficiency.

• Productivity and Employment Decline: By keeping inefficient businesses afloat, zombie firms reduce industry-wide productivity and limit job creation. Wages stagnate, and economic dynamism erodes as struggling firms fail to invest in growth.

• Market Distortion and Business Exits: Zombie firms crowd out viable competitors by consuming capital and labor that could be better utilized elsewhere. This accelerates the failure of healthy businesses and discourages new market entrants, weakening competitive forces.

• Financial Fragility and Crisis Amplification: Undercapitalized banks often extend credit to zombie firms to avoid recognizing losses, creating systemic financial risks. This practice worsens downturns, prolonging economic distress and increasing vulnerability to future crises.

The Behavioral Economics Behind Zombie Lending

• Loss Aversion: Zombie lending persists due to behavioral biases among banks and policymakers. One significant factor is loss aversion, where financial institutions hesitate to recognize losses from failing loans, fearing reputational damage or regulatory scrutiny. Instead, they continue lending to distressed firms, hoping for recovery. This behavior aligns with prospect theory, which suggests that decision-makers weigh potential losses more heavily than equivalent gains.

• Sunk Cost Fallacy: Another driving force is the sunk cost fallacy, where banks justify continued lending because of previous investments, even when further support is irrational. This leads to ‘evergreening’—rolling over debt to avoid writing off bad loans. Similarly, status quo bias causes lenders to favor inaction over taking difficult steps, such as enforcing bankruptcy proceedings.

• Moral Hazard: Governments also play a role through moral hazard, where support programs incentivize banks to take excessive risks, knowing bailouts or policy interventions might cushion financial shocks.

• Herd Behavior: Herd behavior among financial institutions further perpetuates zombie lending, as banks mirror competitors’ reluctance to pull financing, creating a cycle of systemic inefficiency.

Zombie Lending in Private Credit

According to a study published by the Yale Law Journal, private-credit lenders play a significant role in the persistence of zombie firms. Unlike regulated banks, which must assess and realize losses according to regulatory requirements, private lenders have greater flexibility in deciding when and where to recognize losses. To avoid alarming limited partners or revealing weaknesses in their portfolios, private-credit lenders may delay recognizing distressed loans by extending repayment terms or offering repeated forbearances.

This reluctance to take losses allows financially struggling firms to remain operational despite their inability to repay debt. Such zombie firms accumulate excessive debt and forgo profitable investment opportunities due to their financial constraints. Over time, the core business erodes, leaving little value for restructuring. As a result, when these firms ultimately enter insolvency, they do so at a late stage in their financial distress, often leaving insolvency judges with no option but to preside over liquidation rather than reorganization. This delay not only prolongs economic inefficiencies but also reduces potential recovery for creditors and stakeholders.

Scope for Distressed Investors

Banks and private credit lenders face a fundamental choice: continue subsidizing stagnation or embrace market-driven restructuring. Distressed investors can play a pivotal role in this course correction, extracting the last remaining value from struggling businesses and orchestrating the orderly exit of those beyond repair.

Hesitation is not caution. Preserving firms with no path to viability does not protect portfolios; it weakens them. The longer lenders defer hard decisions, the deeper their exposure, the greater the systemic inefficiencies, and the harsher the eventual reckoning. The alternative is to offload exposure to distressed investors—not as an admission of miscalculation, but as a calculated pivot.

Conclusion

Zombie firms aren’t the problem; they’re a result of the problem—an unwillingness to let go when it's necessary. The real question is: how long can we afford to keep misallocating capital? The answer will define not just our industries but our future economic resilience in these challenging times.

Divi is a restructuring lawyer and the founder of Divi Distressed Investments, L.P., specializing in business rescue and distressed corporate investments. The views expressed are personal.