Financial Distress, Stock Returns, And The 1978 Bankruptcy Reform Act

Financial Distress, Stock Returns, and the 1978 Bankruptcy Reform Act via SSRN

Dirk Hackbarth

Boston University Questrom School of Business

Rainer F. H. Haselmann

Goethe University Frankfurt – Faculty of Economics and Business Administration

David Schoenherr

London Business School – Department of Finance

September 26, 2014


We study the effect of weakening creditor rights on distress risk premia via a bankruptcy reform that shifts bargaining power in financial distress toward shareholders. We find that the reform reduces risk factor loadings and returns of distressed stocks. The effect is stronger for firms with lower firm-level shareholder bargaining power. An increase in credit spreads of riskier relative to safer firms, in particular for firms with lower firm-level shareholder bargaining power, confirms a shift in bargaining power from bondholders to shareholders. Out-of-sample tests reveal that a reversal of the reform’s effects leads to a reversal of factor loadings and returns.

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Financial Distress, Stock Returns, And The 1978 Bankruptcy Reform Act – Introduction

The nature of Chapter 11 makes bargaining an important factor in distressed reorganizations, both in formal bankruptcy and out-of-court renegotiations. Gilson, John, and Lang (1990), Asquith, Gertner, and Scharfstein (1994), Franks and Torous (1994), and Betker (1995) provide empirical evidence that bargaining power of equityholders in debt restructurings affects the incidence of formal and informal reorganizations, deviations from absolute priority, and debt recoveries. Consistent with Hart and Moore (1994), who show that equityholders of distressed firms default to renegotiate debt even when they can make contractual payments, Davydenko and Strebulaev (2007) find that shareholders can extract surplus that may extend beyond recoveries in liquidity default, due to their decision about whether and when to default (i.e., strategic default). To the extent that stock returns reflect expected recoveries in liquidity defaults and expected benefits from strategic default, they too should depend on the bargaining power of equity holders of firms in financial distress.

This paper analyzes the consequences of an exogenous variation in equity holders’ bargaining power relative to debtholders on distress risk premia. The modifications of Chapter 11 by the 1978 Bankruptcy Reform Act (hereafter, BRA) constitute a material change in the bankruptcy code. One of the main consequences of the BRA is a change in the distribution of bargaining power in distressed re-negotiations.1 A higher level of bargaining power increases shareholders’ expected recoveries and thus also affects the value of the option to default (see, e.g., Bebchuk (2002)).2 We document a significant decline in risk premia for distressed stocks after the passing of the BRA. Additionally, differences in distress risk premia for firms with different levels of characteristics that proxy for firm-level shareholder bargaining power disappear after the reform. Thus, an increase in reform-based shareholder bargaining power attenuates the impact of partly substitutable firm-specific shareholder bargaining power on distress risk premia. Finally, credit spreads increase after the BRA, particularly in firms with low shareholder bargaining power before the reform, further indicating a shift in bargaining power from creditors to debtors.

The BRA influenced distressed reorganizations under Chapter 11 by, e.g., changing the voting rules of a reorganization plan, introducing ‘cramdown’ reorganization, and changing the conditions for voluntary filing (White (1989) and Klee (1979)). Shareholders of distressed firms benefited from these changes in several ways. In case of liquidity default, debtors expect higher recovery rates. In addition, there is an incentive to renegotiate debt by defaulting strategically, which provides a credible threat in out-of-court restructuring. Following the BRA, the incidence of corporate bankruptcy filings by firms opting for reorganization increases and shareholders of financially distressed firms achieve higher deviations from the Absolute Priority Rule (APR) in bankruptcy proceedings (Franks and Torous (1989), Weiss (1990), and Eberhart, Moore, and Roenfeldt (1990)) as well as higher concessions from debtholders in out-of-court restructurings (Franks and Torous (1994)). Because the codification was complex (Klee (1980)) and it was diffcult for market participants to anticipate the interpretation of the new code by bankruptcy judges, the reform’s actual (i.e., positive) effect on shareholder bargaining power, both in formal bankruptcy and in private workouts, was hard to predict.

Bankruptcy Reform

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