The Equity Performance of Firms Emerging from Bankruptcy by

This study assesses the stock return performance of 131 firms emerging from Chapter 11. Using differing estimates of expected returns, we consistently find evidence of large, positive excess returns in 200 days of returns following emergence. We also examine the reaction of our sample firms’ equity returns to their earnings announcements after emergence from Chapter 11. The positive and significant reactions suggest that our results are driven by the market’s expectational errors, not mismeasurement of risk. The results provide an interesting contrast, but not a contradiction, to previous work that has documented poor operating performance for firms emerging from Chapter 11. 1 The Equity Performance of Firms Emerging from Bankruptcy With large corporate bankruptcies being commonplace during the late 1980s and early 1990s, there has been a notable increase in the number of firms emerging from bankruptcy (Altman (1993)). When firms emerge from bankruptcy, they often cancel the old stock and distribute an entirely new issue of common stock. The stocks of firms emerging from a Chapter 11 bankruptcy are often called “orphan” equities among practitioners and there have been reports in the popular press about spectacular returns in this market. For example, as Sandler (1991, p. C1) states: While initial public offerings have been grabbing all the glory, there's a shadow market for new stocks that is doing nicely too. It's where people trade shares of companies coming out of bankruptcy or reorganization. In recent months, some investors have made 50% to 100% on their money by trading the new shares of Republic Health, Southland Corp. and Maxicare Health Plans after those companies finished reorganizing their business. The primary purpose of this paper is to test the efficiency of the market for stocks of firms emerging from Chapter 11. Our sample includes 131 firms emerging from Chapter 11 between 1980 and 1993 and we test whether the long-term--i.e., first 200 days of returns after emergence--average cumulative abnormal returns (ACARs) are significantly different from zero. We find significant ACARs that--depending on how the expected returns are estimated--have a lower bound of 24.6 percent (the median CARs, though lower, are also positive and significant). We investigate several explanations for these findings. Since our tests are joint tests of efficiency and the model we use to estimate expected returns, our results may reflect a mismeasurement of the stocks’ riskiness rather than an inefficient market. The results’ robustness with respect to different ways of estimating expected returns casts doubt on this explanation, however. We also examine the reaction of our sample firms to their earnings announcements after emergence. La Porta, Lakonishok, Shleifer and Vishny (1995) argue that the positive excess returns on “value” stocks are due to expectational errors made by the market. Consistent with this assertion, they find that value stocks have 2 unexpectedly good earnings as shown by the positive abnormal returns around their earnings announcements. For our sample, the average and median excess returns are positive and significant around the sample firms’ earnings announcements, providing more evidence that our results are driven by expectational errors made by the market, not a mismeasurement of risk. We also analyze cross-sectional differences in the returns. Specifically, we examine the firms’ stock prices upon emergence, changes in their primary line of business, whether the firm had a pre-packaged bankruptcy and the willingness of institutional investors to accept only equity in the reorganized firm (in exchange for their old claims). Low price stocks often have higher transaction costs and may have higher estimation risks than captured by our estimates of expected returns. We find no evidence, however, that our positive excess returns are concentrated in small price stocks. Firms that change their primary line of business in bankruptcy may also have higher estimation risks because the historical information on the firm is less helpful in predicting the firm’s future performance. Our results, though, show no consistent difference in returns between firms that change their primary line of business and those that do not. Because of their shorter duration, prepackaged bankruptcies may have risk characteristics that differ from the non-prepackaged bankruptcies. However, we find no consistent evidence of a significant relation between returns and a dummy variable equal to one if the firm had a prepackaged bankruptcy and zero otherwise. Finally, Brown, James and Mooradian (1993) argue that the acceptance of equity in a reorganized firm by informed investors, such as banks, conveys favorable private information. We find some evidence that when institutional investors accept only equity (including warrants) in exchange for their claims, the long-term returns are higher. Our results are of broad interest for two main reasons. First, they cast doubt on the informational 3 efficiency of this market and are consistent with recent studies documenting long-term abnormal returns (e.g., Loughran and Ritter (1995), Spiess and Affleck-Graves (1995)). Second, the results provide an interesting contrast, but not a contradiction, to prior work that suggests the Chapter 11 process does not efficiently screen out economically inefficient firms (e.g., Hotchkiss (1995)). Our results suggest that, although these firms may not achieve strong operating performance, their performance is better than the market expected at the time they emerged from Chapter 11. Most firms emerging from bankruptcy, however, do not emerge with stock trading on the NYSE/AMEX or Nasdaq and the sample in Hotchkiss includes some of these firms. Therefore, direct comparisons with the sample in Hotchkiss must be tempered by this caveat. A brief review of the bankruptcy process and related literature is presented in the next section. The data and methods are discussed in Section II. The empirical results are presented in Section III and the summary in Section IV. I. The Bankruptcy Process and Related Work Often, as noted earlier, when the formerly bankrupt firm emerges as a public company the old stock is canceled and new stock is issued. If the value of the debt claims exceeds the value of the firm and the absolute priority rule (APR) is followed, then the old shareholders’ claim is worthless. In approximately 75 percent of corporate bankruptcy cases, however, the APR is violated (e.g., Eberhart, Moore and Roenfeldt (1990), Weiss (1990)). Nevertheless, Altman and Eberhart (1994) show that, on average, higher seniority still implies higher payoffs upon emergence from bankruptcy. Creditors usually receive part of their payoff as new stock in the firm, frequently giving them majority ownership. During the bankruptcy process, the estimate of the firm's going concern value that will be used to set the payoffs to each class of claimants is debated. Depending on its priority, each class of claimants has an incentive to present a biased estimate of the firm value. It is in the interest of junior claimants to argue for upwardly biased estimates of firm value because this increases the proportion of the firm value they receive. Conversely, senior claimants--who are often the institutional investors--usually push for a lower estimate of 4 firm value so that they can retain a greater portion of the firm and reap the rewards if the firm's subsequent equity value is higher than would be expected given the riskiness of the stock. Perhaps most important is the bias of management; they have an incentive to value the firm above its liquidation value (to maintain their jobs) but below its true value, assuming its true value is above the estimate of its liquidation value. Therefore, if the market is persuaded by the manager’s forecast, the post-emergence stock performance of the firm will seem superior relative to the equilibrium expected returns and the manager’s performance will look abnormally good. Hotchkiss (1995) documents the operating performance of firms emerging from bankruptcy that filed for Chapter 11 between October 1979 and September 1988. Overall, she finds the median operating performance to be positive. More than 40 percent of the firms, however, continue to experience operating losses in the three years after emergence and 32 percent subsequently file for bankruptcy again or restructure their debt. Moreover, the median industry-adjusted operating performance is negative. More recent evidence by Alderson and Betker (1996) suggests that the operating performance of firms is abnormally positive following emergence from Chapter 11. They examine 89 firms emerging between 1983 and 1993. In contrast to the focus by Hotchkiss (1995) on accounting measures of performance, they focus on the total cash flows provided by the firm. They report that the total cash flow returns for their sample are significantly higher than the returns on the S&P 500 index. In summary, the results in Hotchkiss (1995) suggest that the bankruptcy code is biased toward letting economically inefficient, or poorly restructured, firms reorganize instead of liquidating. Alderson and Betker argue that total cash flow measures and comparisons to the alternative of liquidation are better means of assessing the success of firms emerging from Chapter 11. By their metrics, the Chapter 11 process looks more efficient. Though the focus of this paper is on the efficiency of the stock market, our results are indirectly supportive of Alderson and Betker (1996). 5 II. Data and Methods Our primary source of information on firms emerging from bankruptcy is New Generation Research (Boston, MA). New Generation is a firm that specializes in collecting bankruptcy data. Because New Generation's list of firms emerging from bankruptcy becomes more thorough in the 1990s, we construct our sample in two phases. The first phase is for a list of firms, provided by New Generation, that file and complete a Chapter 11 bankruptcy between January 1980 and December 1989. We supplement this list with a search on the Dow Jones News Retrieval using the key words “bankruptcy” and “emerge.” There are 350 firms in this sample. For the second phase, we use a more comprehensive list provided by New Generation. This list contains 196 firms that emerge from Chapter 11 between January 1990 and December 1993, bringing the total sample to 546 firms. Among the 546 firms, 131 emerge with equity trading on the NYSE, AMEX or Nasdaq. When the firms emerge from bankruptcy, 71 begin trading on the Nasdaq, 37 on the NYSE and 23 on the AMEX; 76 of the stocks trade throughout the bankruptcy process. Though we cannot rule out the possibility that our sample is less than the population, we are confident that we have assembled the vast majority of firms. The average closing price on the first day of trading (post-emergence day 0) following emergence is $6.32 and the median is $3.75. Similar to other studies (e.g., Altman (1993)), we find that the average time spent in bankruptcy (measured, in our case, from the bankruptcy announcement date through the first trading date after emergence) is close to two years with an average of 22.39 months and a median of 20.17 months. There are 78 firms for which we have some information provided by New Generation on the payoffs to each claimant in the formerly bankrupt firm. Over the past several years, New Generation has gathered information on the payoffs from disclosure statements, discussions with attorneys, and other sources. With this information, we can distinguish between cases where institutional investors accept only equity (including warrants) in the newly emerged firm and cases where they demand another form of payment; 10 firms had their 6 institutional investors accept only equity. A. Definition of the First Trading Date Because the emergence procedure varies across firms, so does the appropriate starting point for our efficiency tests. For example, as mentioned earlier, 76 of the sample firms' stocks trade throughout the Chapter 11 period. The stock may trade up to the day the new stock is issued and the old stock is then canceled. Alternatively, additional shares may or may not be issued and the "new" stock often trades under the old name. If the old stock is canceled and new stock is issued, then the first trading date is simply the first day the new stock trades following emergence. If additional stock is issued, then the first trading day is the first day the “new” stock (i.e., with the additional shares) trades following emergence. If no new stock is issued, then the first trading date is defined as the emergence date for the firm (recall that the first return day is for the second day of trading). Our sources for the emergence dates include New Generation, Capital Changes Reporter, Wall Street Journal Index (if we do not have information from the Dow Jones News Retrieval), and Bloomberg. There are only two firms where we know the shareholders retain their shares in the old firm and no additional stock is issued. As noted above, the other two categories are where the shareholders retain their shares and additional stock is issued to pay the debtholders or the old stock is canceled and new stock is issued. The difference between these two categories is not substantive; the old shareholders can have their ownership diluted equally by retaining their shares and having the firm issue additional stock to the old debtholders or by having the firm cancel the old stock and giving the old shareholders a fraction of the new stock. The Center for Research in Security Prices (CRSP) does not always pick up the stock when it first begins trading. So, we hand-collect data from the Standard and Poor's Daily Stock Price Record (SPDSPR) for the 28 firms where the first trading date in the SPDSPR precedes the first trading date on CRSP. The reason for this gap is that all these firms begin trading on a “when-issued” basis (i.e., trading of stock before it is issued). When-issued trading begins after the reorganization plan is confirmed. The exchanges and Nasdaq allow when-issued trading when they are certain the shares will be mailed out by the firm and it will be possible 7 to do settlement shortly afterwards. Therefore, though there can be some liquidity and settlement day differences between when-issued and “regular” stock trading (e.g., Lamoureux and Wansley (1989)), the first trading date can be for when-issued or regular trading, whichever comes first. To check if the 28 firms with SPDSPR prices (preceding the CRSP prices) perform differently from the other 103 firms, we compare the average and median excess returns of the two subsamples over the 200-day period and they are insignificantly different. B. Estimation of Expected Returns Our primary method of estimating expected returns is to use matched firms. For each sample firm, we choose a matched firm that has the same primary 2-digit SIC code as the sample firm and is closest in equity capitalization as of the first trading date for the sample firm. We call this sample the size and industry matched (SIM) sample. We also match firms in the same industry by size and book-to-market ratios. First, we form size deciles within the 2-digit primary SIC code for each sample firm, where size is defined above. Next, we choose the firm in the same size decile as the sample firm that has the closest book-to-market ratio. Seven of the matched firms delist during the 200-day period following emergence from Chapter 11 for our sample firms. In these cases, we fill in the remaining days with the next closest matched firm (where the matching is done as of the first trading day for the sample firm). Because our sample firms have often undergone dramatic restructurings, their book values reported before their emergence cannot be used. Therefore, we use the book values reported in the first annual report following emergence; for the sake of consistency, we use book values for the matched firms as reported in their first annual reports following the emergence dates for the sample firms. We call this the book-to-market, size and industry matched (BMSIM) sample. Because six of our sample firms do not report book values during the 200-day period following emergence, these firms are not included in the sample. As a robustness check, we compute the median book-to-market ratio for our sample firms and match firms to these six firms using this