Financial Distress, Stock Returns, and the 1978 Bankruptcy Reform Act
In the new Harvard sponsored article, Financial Distress, Stock Returns, and the 1978 Bankruptcy Reform Act, forthcoming in The Review of Financial Studies, David Schoenherr, Dirk Hackbarth and Rainer Haselmann examine how bargaining power in distress affects the pricing of corporate securities.
The authors study the effect of weakening creditor rights on distress risk premia via a bankruptcy reform that shifts bargaining power in financial distress toward shareholders. They 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.
They note that 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. They observe that 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).
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, they 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.
They note that 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, they 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.
They state that their 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.