by Allan C. Eberhart
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: 
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
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).
We investigate several explanations for these findings. For example, it
possible that the stocks in our sample appear to earn unusually
returns because we have underestimated the risk of investing in
stocks. After all, formerly bankrupt firms’ stocks are risky
We carefully check for this possibility, however, using
of risk and the results are robust to our differing
estimates of risk. We
also find that our sample firms consistently have
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
the transaction costs of buying and selling these stocks can be high.
find no evidence, however, that our sample firms with abnormally
returns tend to be smaller stocks. We also find no consistent difference
returns between firms that change their primary line of business and
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
reorganized firm by informed investors, such as banks, conveys
private information. We find some evidence that when
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
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
of the firm’s going concern value that will be used to set the
to each class of claimants is debated. Depending on its
each class of claimants has an incentive to present a biased
of the firm value. It is in the interest of junior
argue for upwardly biased estimates of firm value because this increases
of the firm value they receive. Conversely, senior claimants—who are
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
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.
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
0) following emergence is $6.32 and the median is $3.75. Similar to
studies, we find that the average time spent in bankruptcy (measured,
our case, from the bankruptcy announcement date through the first
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
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.
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
return estimates could explain the results. We investigate
possibilities using differing estimates of expected returns and
for whether other risk or transaction cost proxies explain the
returns. We continue to find excess returns after conducting
investigations. There is some evidence, however, that the willingness
institutional investors to accept only equity (in exchange for their
claims on the formerly bankrupt firm) in the newly emerged firm
positively associated with abnormal returns. This result suggests the
of securities accepted by these informed investors may reflect
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
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
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.
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
Sandler, Linda, 1991, Post-bankruptcy shares: next
big play?, Wall Street Journal
, May 16.
 Eberhart, Allan C., Edward
I. Altman and Reena Aggarwal, 1999, The equity performance of firms emerging
from bankruptcy, Journal of Finance , 54, 1855-1868.