Incentives, Information, and Investments in Chapter 11 Bankruptcies

Abstract

As business cycles generate ebb and flow in economic activities, the recurring corporate failures have highlighted how critical bankruptcy regimes are in reviving and stabilizing the economy. The Chapter 11 bankruptcy protection offers a court-supervised venue for defaulting companies to shed debt burdens, reallocate resources to potentially more productive uses, and obtain new capital. Bankruptcy affects not only distressed firms but also healthy firms. The rules of bankruptcy influence the capital structure and investment activities of firms distant from financial distress ex-ante. Therefore, it is crucial to understand the evolution of bankruptcy regimes and their implications for financial market participants. Exploring rich institutional details in Chapter 11 bankruptcies, this dissertation consists of three essays that investigate incentives, information, and investments within this context. The first essay is related to ”incentives”. It examines why managers of bankrupt companies retain top-tier investment banks as financial advisors during Chapter 11 bankruptcies. While these advisors facilitate faster resolutions, they also support incumbent management’s control. The second essay is about ”information”. It analyzes the stock trading activities of hedge funds serving on the Unsecured Creditors’ Committee (UCC) of a bankrupt firm. It shows that these hedge funds have higher portfolio turnover and make large trades in the few quarters after accessing material nonpublic information from the UCCs. The third essay, focusing on ”investments”, examines the performance of equity issued by public companies that emerged from Chapter 11 bankruptcy, namely, post-reorg equity. Although there was significant initial outperformance, it has diminished in recent years due to market expectation corrections and increased participation of institutional investors. Collectively, these essays offer a comprehensive understanding of the dynamics in Chapter 11 bankruptcies, shedding light on their broader implications for financial markets and economic recovery strategies.