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

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By Dirk Hackbarth, Boston University, Rainer Haselmann, Goethe University Frankfurt, and David Schoenherr, London Business School

The 1978 Bankruptcy Reform Act introduced Chapter 11, replacing two separate corporate reorganization chapters (Chapters X and XI). The reform significantly increased shareholders’ bargaining power in financial distress in the years following its passage, leading to a spike in absolute priority deviations in Chapter 11 and out-of-court reorganizations. We exploit this exogenous variation in the allocation of bargaining power between shareholders and debtholders to study the effect of weakening creditor rights on equity risk premia in distress. We find that, relative to safe stocks, distressed stocks’ valuation rose and their risk and return decreased after the reform. Additionally, distressed firms exhibit a higher cost of credit after the reform, confirming that changes in equity risk premia are driven by a shift in bargaining power from debt to equity.

The reform has a differential effect on distressed equity returns. Stocks of firms in which debtors already have relatively higher bargaining power vis-à-vis creditors before the reform, such as firms with a low fraction of tangible assets or with high inside ownership, are less affected by the reform. This strengthens the evidence that the effect of the reform on security prices is through the bargaining power channel, and suggests that part of the increase in shareholder bargaining power through the introduction of Chapter 11 is a substitute for firm-level characteristics that determine higher shareholder bargaining power. Overall, our results reveal that the design of the Bankruptcy Code affects not only the cost of debt but also the cost of equity, an aspect previously not examined in the literature.

For the full article see Review of Financial Studies, Volume 28, Issue 6, June 2015, pp. 1810-1847, available here.

The Bankruptcy Roundtable will be taking August off, but will return in September.