Are Stocks of Firms Emerging from Chapter 11 Bankruptcy Underpriced?

by Allan C. Eberhart

Apr 1, 2000

(TMA Global)

When firms emerge from a Chapter 11 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: [1]

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 50-100 percent on their money by trading the new shares of Republic Health, Southland Corp. and Maxicare Health Plans after those companies finished reorganizing their business.

In a paper I recently wrote with Professor Edward Altman of New York University and Professor Reena Aggarwal of Georgetown University, we find that the stocks of firms emerging from Chapter 11 do indeed appear to be underpriced as revealed by their subsequently positive abnormal stock returns (i.e., the stock returns are higher than we would expect given their riskiness). [2]

We investigate several explanations for these findings. For example, it is possible that the stocks in our sample appear to earn unusually good returns because we have underestimated the risk of investing in these stocks. After all, formerly bankrupt firms’ stocks are risky investments. We carefully check for this possibility, however, using different measures of risk and the results are robust to our differing estimates of risk. We also find that our sample firms consistently have positive earnings announcements subsequent to their emergence from bankruptcy. In other words, the market appears to systematically underestimate the earnings that our sample firms produce and this provides more evidence that our results are driven by expectational errors made by the market, not a mismeasurement of risk.

It is also possible that our results are concentrated in small stocks where the transaction costs of buying and selling these stocks can be high. We find no evidence, however, that our sample firms with abnormally high returns tend to be smaller stocks. We also find no consistent difference in returns between firms that change their primary line of business and those that do not. Moreover, firms with prepackaged bankruptcies have no unique advantage or disadvantage in their abnormal stock return performance.

Finally, previous studies 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 old claims on the formerly bankrupt firm, the subsequent abnormal stock returns are higher.

Our results are of broad interest for two main reasons. First, the results cast doubt on the efficiency of this market. 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. 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.

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’ claims are worthless. In approximately 75 percent of corporate bankruptcy cases, however, the APR is violated. Nevertheless, 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 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.

The Sample

Between January 1980 and December 1993, there are 546 firms that emerge from Chapter 11. Among this sample, 131 firms 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, 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.

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 debt-holders 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 debt-holders 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 to do settlement shortly afterwards. Therefore, though there can be some liquidity and settlement day differences between "when-issued" and regular stock trading, 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 abnormal stock return performance of the two sub-samples and they are insignificantly different.

 Summary

Are the stocks of firms emerging from a Chapter 11 bankruptcy underpriced as revealed by their subsequent positive abnormal returns? We find strong evidence of positive abnormal stock returns. Specifically, during the first 200 days of returns after emergence, the average abnormal stock return varies from 24.6 percent to 138.8 percent depending on how the expected returns are estimated. The median abnormal stock returns, though lower, are significant and range from 5.1 to 8.4 percent.

Transaction costs or risk-characteristics not captured in our expected return estimates could explain the results. We investigate these possibilities using differing estimates of expected returns and checking for whether other risk or transaction cost proxies explain the excess returns. We continue to find excess returns after conducting these investigations. There is some evidence, however, that the willingness of institutional investors to accept only equity (in exchange for their old claims on the formerly bankrupt firm) in the newly emerged firm is positively associated with abnormal returns. This result suggests the type of securities accepted by these informed investors may reflect information on the stock’s intrinsic value that is not fully reflected in the stock price upon emergence from Chapter 11.

We also find the average and median excess returns are positive when our sample firms make their earnings announcements. These results are consistent with previous studies and suggest that our findings are the result of the market being surprised by the post-emergence performance of our sample firms.

In summary, our results cast doubt on the informational efficiency of this market. The results also present an interesting contrast, but not a contradiction, to the poor operating results of firms emerging from bankruptcy as reported in previous work. Our results suggest that, although these firms may not do well in their post-Chapter 11 accounting performance, they appear to do better than the market had expected at the time of emergence from Chapter 11.
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This article is a summary of a paper entitled, "The Equity Performance of Firms Emerging From Bankruptcy," written by Allan C. Eberhart of Georgetown University with Dr. Edward Altman of New York University and Professor Reena Aggarwal of Georgetown University, that was published in the October 1999 Journal of Finance .

[1] Sandler, Linda, 1991, Post-bankruptcy shares: next big play?, Wall Street Journal , May 16.

[2] Eberhart, Allan C., Edward I. Altman and Reena Aggarwal, 1999, The equity performance of firms emerging from bankruptcy, Journal of Finance , 54, 1855-1868.

Allan C. Eberhart
Professor of Finance
McDonough School of Business, Georgetown University
eberhara@msb.edu

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