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E-MailDirk Hackbarth is Associate Professor of Finance at Boston University. This post is based on an article authored by Professor Hackbarth; Rainer Haselmann, Professor of Finance, Accounting, and Taxation at Goethe University, Frankfurt; and David Schoenherr of the Department of Finance at London Business School.
In our article, Financial Distress, Stock Returns, and the 1978 Bankruptcy Reform Act, forthcoming in The Review of Financial Studies, we examine how bargaining power in distress affects the pricing of corporate securities. The nature of Chapter 11 makes bargaining an important factor in distressed reorganizations. Reorganization outcomes depend on the relative bargaining power of the parties involved. A number of papers document that shareholders receive concessions in distressed reorganization even when creditors are not paid in full despite of their contractual (junior) status as residual claimants (Franks and Torous 1989; Eberhart, Moore and Roenfeldt 1990; Weiss 1990). To this end, our research exploits an exogenous variation in the allocation of bargaining power between shareholders and debtholders due to the 1978 Bankruptcy Reform Act to examine how the ex post allocation of cash flows in distress affects the ex ante pricing (return and risk) of corporate securities, such as risky debt and levered equity.
The 1978 Bankruptcy Reform Act created Chapter 11, replacing two different corporate reorganization chapters (Chapter X and Chapter XI). Under the new law shareholders’ bargaining power increased substantially, leading to a spike in reorganization filings and higher concessions to shareholder during Chapter 11 proceedings, and in out-of-court reorganizations (Franks and Torous 1994). Given the shift in bargaining power and hence realized cash flows from debtholders to shareholders in financial distress, we hypothesize that shareholders demand a lower risk premium for holding stocks of distressed firms after the reform. In contrast, debtholders demand compensation for lower recovery in reorganizations after the reform, which should increase the cost of credit. To examine changes in pricing and riskiness of these claims, we split the sample into subsamples of distressed firms that are sensitive to the change in the bankruptcy code, and subsamples of safe firms for whom the new design of bankruptcy law is less relevant using a distress risk model developed by Campbell, Hilscher, Szilagyi (2008). While changes in the bankruptcy code should have a strong effect on the pricing of distressed firms’ securities, securities of safe firms should not experience significant price changes as it is unlikely for those firms to end up in bankruptcy proceedings. Since equity risk premia and the cost of credit may change in the time-series for other reasons than the 1978 Bankruptcy Reform Act, it is important to compare changes in risk premia for distressed and safe firms as this differences out any time-series changes that affect risk premia for all firms equally.
We document that characteristics of distressed firms’ stocks reflect the shift in distress risk borne from shareholders to creditors. Relative to safe stocks, both distressed stocks’ systematic and total risk decrease after the reform. Consistent with lower exposure to distress risk, we find that the abnormal return of a portfolio going long in distressed stocks and going short in safe stocks experiences a significant decrease after the reform. Valuations (e.g., market-to-book ratios) of distressed stocks also increase relative to safe stocks. After the reform, credit spreads increase for distressed firms reflecting the increase in the cost of credit as a consequence of the reduction in cash flows that bondholders expect to receive in financial distress after the reform. The effect of the reform does not apply to all firms equally. Firms in which shareholders already have relative higher bargaining power vis-à-vis creditors before the reform, such as firms with a low fraction of tangible assets or firms with high inside ownership, are less effected by the reform, strengthening the evidence that the effect of the reform on security prices is through the bargaining power channel, and suggesting that part of the increase in shareholder bargaining power through the introduction of Chapter 11 is a substitute to firm-level characteristics that increase shareholders’ bargaining power.
Interestingly, with the emergence of debtor-in-possession financing and key-employee-retention plans in the 1990s that undo some of the effects of the 1978 Bankruptcy Reform by shifting part of the bargaining power back from shareholder to creditors, we find that risk premia on distressed stocks revert back to levels similar as before the reform, further strengthening the view that the allocation of bargaining power in distress has important implications for security prices.
The paper contributes to the literature by empirically documenting the importance of the allocation of bargaining power for the riskiness of different corporate securities and risk premia demanded by holders of those securities. The results in the paper further show that the design of bankruptcy law affects not only the cost of credit but also has significant effects on the pricing of equity in distressed firms, an aspect of bankruptcy law previously not examined in the literature. Gaining a better understanding of these economic mechanisms can help to design optimal bankruptcy codes.
Finally and perhaps most interestingly, the role attributed to creditor rights, according to the law and finance literature, is that they empower creditors to enforce their contracts. Notably, La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998) argue that legal protection of creditor claims supports financial development by lowering the cost of borrowing. Our findings underline that changes in creditor rights can have more subtle implications than previously suggested. In the case of the 1978 Bankruptcy Reform Act, a weaker position of creditors in financial distress is associated with higher bond yields, but it leads to lower funding costs for equity (i.e., lower equity premia). While we make no claim about the net effect on external funding costs due to the reform, our results suggest that changes in creditor rights can have more complex consequences than current literature suggests that should be taken into account when designing optimal bankruptcy procedures, and would therefore be an interesting topic for future research on the interfaces of law and finance.
The full paper is available for download here.
