Recent Bankruptcy Finance-Related Articles of Interest Available for Downloading from SSRN

The following bankruptcy finance-related working papers, arranged by abstract ID number, can be downloaded from the Social Science Research Network:

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Brandeis University's Jens Hillscher and Harvard University's Jan Szilagyi: "In Search of Distress Risk." (Abstract ID: 917567)

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FDIC's Michael Kimminger: "The Evolution of U.S. Insolvency Law for Financial Market Contracts." (Abstract: 916345)

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Seton Hall Univ. School of Law's Stephen Luben: "Credit Derivatives & the Future of Chapter 11." (Abstract ID: 906613)

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Stockholm School of Economics's Stefano Rossi and Stockholm University's Nicola Gennaoli: "Bankruptcy, Creditor Protection and Debt Contracts." (Abstract ID: 891154)

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Northwestern University's Vadim Linetsky: "Pricing Equity Derivatives Subject to Bankruptcy." (Abstract ID: 889973)

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University of Mainz's Gunther Friedl: "Discussion of 'Optimal Debt Service: Straight vs. Convertible'." (Abstract ID: 899299)

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Penn. State Univ.-Berks's Khaled Abdou and Univ. of New Orleans Oscar Varela: "The Role of Venture Capitalists in Bankruptcy." (Abstract ID: 891642)

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University of Aarhus's Peter Tind Larsen: "Default Risk, Debt Maturity and Levered Equity's Risk Shifting Incentives." (Abstract ID: 887441)

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University of Chicago Law School's Kenneth W. Dam: "Credit Markets, Creditors' Rights and Economic Development." (Abstract ID: 885198)

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Univ. of Georgia's Mark Dawkins and Linda Smith Bamber and SMU's Neil Battacharya: "Systematic Share Price Fluctuations after Bankruptcy Filings and the Investors who Drive Them." (Abstract ID: 881508)

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Abstracts for each of these papers follow.  More importantly, thanks to all who expressed their condolences to me during the past week regarding my mom's recent passing.  Your support provided a source of much comfort to me.

Jens Hillscher and Jan Szilagyi, "In Search of Distress Risk." (Abstract ID: 917567):

This paper explores the determinants of corporate failure and the pricing of financially distressed stocks using US data over the period 1963 to 2003. Firms with higher leverage, lower profitability, lower market capitalization, lower past stock returns, more volatile past stock returns, lower cash holdings, higher market-book ratios, and lower prices per share are more likely to file for bankruptcy, be delisted, or receive a D rating. When predicting failure at longer horizons, the most persistent firm characteristics, market capitalization, the market-book ratio, and equity volatility become relatively more significant. Our model captures much of the time variation in the aggregate failure rate. Since 1981, financially distressed stocks have delivered anomalously low returns. They have lower returns but much higher standard deviations, market betas, and loadings on value and small-cap risk factors than stocks with a low risk of failure. These patterns hold in all size quintiles but are particularly strong in smaller stocks. They are inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress.

Michael Kimminger, "The Evolution of U.S. Insolvency Law for Financial Market Contracts." (Abstract: 916345):

The enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was the most significant change to the United States' insolvency laws for the financial markets in more than fifteen years. Unlike all prior laws defining how financial market contracts would be treated in bankruptcy or a bank insolvency, the new comprehensively updated and harmonized all of the principal laws that could come into play in insolvencies of market participants, including banks, thrifts, credit unions, broker-dealers, investment banks, and other companies.

The 2005 Bankruptcy Reform Act, however, was not a new direction in American law. The special protections provided to termination and close-out netting for capital markets contracts in the new amendments simply continued an evolutionary process in American insolvency law that started with the enactment of the new Bankruptcy Code in 1978. Once the foundation for protection of the liquidity of financial market contracts had been established by 1991, American law provided the basis for effective risk management by market participants. The task of the past fifteen years has been to secure those benefits, clarify the interrelationships between different insolvency laws, and define the scope of flexibility to accommodate market developments.

It must be recognized, however, that these protections are a departure from the pari pasu principle inherent in equitable insolvency laws. Nonetheless, this principle has never meant that all creditors should receive the same proportional share. Insolvency law has always recognized that creditors should be able to benefit from some characteristics of the bargain they made with the debtor before its failure. As illustrated in the article, the fundamental goal of those special protections is the prevention of the risks to the stability of the financial system that could result from a cascade of interrelated defaults if normal insolvency processes prevented termination and settlement of pending trades. As a result, there are limits to the further expansion of those protections if they are to remain consistent with the underlying public policy that supports them.

This article examines the evolution of the special protections for financial market contracts under U.S. insolvency law and the public policy goals underlying those protections, looks at the continuing course of that evolution in the Bankruptcy Reform Act, and provides an overview of what this evolution means for bank and non-bank insolvencies of financial market participants.

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Stephen Luben, "Credit Derivatives & the Future of Chapter 11." (Abstract ID: 906183):

Credit derivatives transfer the default risk of an underlying debt instrument, without transferring legal title. These transactions have several benefits outside of bankruptcy. But once a corporate debtor enters bankruptcy - in particular, chapter 11 - it enters a bargaining process that was bottomed on a model of creditor behavior that may no longer hold because of credit derivatives. A creditor may not act like a traditional creditor if they no longer face the risk of non-payment because that risk has been hedged. In this essay I argue that credit derivatives will substantially alter chapter 11, at least with respect to large corporate debtors.

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Stefano Rossi and Nicola Gennaoli, "Bankruptcy, Creditor Protection and Debt Contracts." (Abstract ID: 891154):

We study theoretically how creditor protection affects the parties' ability to resolve financial distress by contract. Our central finding is that better creditor protection allows parties to write more sophisticated contracts, including options and court intervention - as opposed to cash auctions - to decide whether to liquidate or continue a financially distressed project, thereby attaining higher welfare. Our analysis yields novel predictions on how debt contracts and debt structure should vary around the world. We reconcile current conflicting proposals for bankruptcy reform, and rationalize resolutions of financial distress around the world as a function of creditor protection. The normative implication of our analysis is that bankruptcy law should facilitate contractual resolutions of financial distress by providing an ex post enforcement mechanism to deter debtors' self-dealing and tunneling activities.

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Vadim Linetsky, "Pricing Equity Derivatives Subject to Bankruptcy." (Abstract ID: 889973):

We solve in closed form a parsimonious extension of the Black-Scholes-Merton model with bankruptcy where the hazard rate of bankruptcy is a negative power of the stock price. Combining a scale change and a measure change, the model dynamics is reduced to a linear stochastic differential equation whose solution is a diffusion process that plays a central role in the pricing of Asian options. The solution is in the form of a spectral expansion associated with the diffusion infinitesimal generator. The latter is closely related to the Schrödinger operator with Morse potential. Pricing formulas for both corporate bonds and stock options are obtained in closed form. Term credit spreads on corporate bonds and implied volatility skews of stock options are closely linked in this model, with parameters of the hazard rate specification controlling both the shape of the term structure of credit spreads and the slope of the implied volatility skew. Our analytical formulas are easy to implement and should prove useful to researchers and practitioners in corporate debt and equity derivatives markets.

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Gunther Friedl, "Discussion of 'Optimal Debt Service: Straight vs. Convertible'." (Abstract ID: 899299)

Corporate bond default plays a signifi cant role in today’s business environment. According to Moody’s, a leading provider of credit ratings, corporate bond issuers that it rated as of January 1, 2004, defaulted on a total of US $16 billion in 2004. Credit default not only affects the equity investors of a firm, but also the debt holders, who may loose part of their credit. Default can also have dramatic consequences for a firm’s future operations. Therefore, the decision of if and when to default is important for both the firm and its stakeholders.

There is a substantial body of literature on the determination of optimal default points as a strategic decision by the owners of a firm. According to this view, optimal default occurs when the continuation value of the firm, less the discounted value of all future tax-adjusted coupon payments, falls below zero. However, some studies on optimal default points are limited, since these studies usually assume a simple capital structure with only equity and straight debt.

Christian Koziol extends this literature by relaxing the assumption of a simple capital structure and by allowing for convertible debt. Th e main objectives of his paper are (i) to determine optimal default and conversion strategies, when debt is convertible; and (ii) to highlight the differences between this strategy and the strategy for straight debt. Since convertible debt plays a significant role in corporate finance decisions, Koziol’s approach seems to be both important and of wide interest. To analyze these problems, the author uses a widely accepted time-independent model with a perpetual bond that pays a continual coupon in the presence of both bankruptcy costs and tax deductibility.

My discussion is organized as follows. In section 2, I relate Koziol’s paper to previous literature and provide an intuitive explanation for the results. Section 3 discusses an application in the area of real option games.

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Khaled Abdou and Oscar Varela, "The Role of Venture Capitalists in Bankruptcy." (Abstract ID: 891642):

The role of venture capitalists to distress and bankruptcy in their publicly traded portfolio firms between 1990-2004 is the focus of this paper. A LOGIT analysis on the full sample of 180 VC-backed firms that declared bankruptcy and 180 VC-backed and non-bankrupt healthy matching firms examines the probability of success/failure of public VC-backed companies. An OLS analysis on the VC-backed firms that declared bankruptcy examines the duration of life of these firms before they declare bankruptcy. Most striking is that financial leverage is not, unlike in other studies, a significant factor in predicting bankruptcy for VC-backed companies, or in the duration of life of VC-backed companies that eventually declared bankruptcy. These firms are mostly financed through equity, insulating debt as a factor in bankruptcy. While the extent to which the VC monitors its companies is not a significant factor in prolonging the life of VC-backed companies that eventually declare bankruptcy, these firms have a higher probability of success than firms that are less often monitored. Monitoring pays off in reducing the probability of bankruptcy and hence its frequency. The reputation of the VC measured by its recent successes in publicly placing its companies facilitates a quicker declaration of bankruptcy when a company is distressed, but the experience of the VC prolongs the life of its companies that ultimately go bankrupt. The results are robust even after imposing more strict definition of success for the matched sample and controlling for the ability of VCs to influence managerial decisions in their portfolio firms.

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Peter Tind Larsen, "Default Risk, Debt Maturity and Levered Equity's Risk Shifting Incentives." (Abstract ID: 887441):

This article addresses the limited empirical evidence on risk-shifting behavior in industrial firms, by focusing directly on asset volatilities implied from the U.S. equity market. These are inferred using the iterative algorithm of Moody's KMV and the Leland & Toft (1996) model. Indeed, Leland & Toft (1996) relate key variables relevant for the equityholders' risk incentives, and allow for intermediate financial distress, bankruptcy costs and tax shields. Hypotheses on risk-shifting and risk-avoidance are carefully derived from the model, with a special emphasis on the role of default risk and debt maturity. The results strongly indicate, that firms with a high default risk or leverage subsequently risk-shift relative to their industry peers. In addition, we find firms with an intermediate level of distress to risk-avoid. Some evidence indicates, that long debt maturity makes asset volatility increases more pronounced for firms close to the default barrier. However, the additional increase is larger for firms with the shortest debt maturity. Indeed, these firms are more default risky.

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Kenneth W. Dam, "Credit Markets, Creditors' Rights and Economic Development." (Abstract ID: 885198): 

Credit markets generate more finance than equity markets, particularly in developing countries. In credit markets the central institution, again especially in developing countries, is the bank. In many such countries, directed lending, crony capitalism, and related lending are key problems. And since banks are corporations, self-dealing involving loans to shareholders, managers, and politically important people is added to the common forms of corporate governance issues.

Initial efforts to analyze credit markets through the lens of legal origin had the shortcoming that the focus was on the law of bankruptcy rather than the law of secured credit. And even within the area of bankruptcy, the focus was on reorganization rather than liquidation, which is more common in both developed and developing countries. The law of secured credit is especially important in countries where mortgages on land are unavailable due to the absence of land titling. Secured credit law is often defective because of the absence of self-help remedies, especially in view of lengthy court delays. Legal origin may be important to the efficacy of creditors rights in developed countries, but there is evidence that it is an unimportant factor in developing countries. The assumption of commonalities within a legal family is doubtful in law pertaining to credit markets, as shown by the sharp differences between U.S. and U.K. bankruptcy law and the many differences in secured credit law found by the EBRD in the transition countries.

Where, as in many developing countries, judiciaries are weak, the law of secured credit is especially important because bankruptcy proceedings are likely to be slow and undependable. In such countries credit registries may, by building on the concept of reputation, provide a partial substitute for judicial proceedings.

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Mark Dawkins, Linda Smith Bamber, and Neil Battacharya, "Systematic Share Price Fluctuations after Bankruptcy Filings and the Investors who Drive Them." (Abstract ID: 881508):

This study presents empirical evidence on the pattern of returns and investor trades around and shortly after Chapter 11 bankruptcy petition filings. Consistent with prior research, we find that share prices plunge before and at the bankruptcy filing date. Beginning in the 1990’s, however, firms often continued to trade on the major national exchanges after filing for bankruptcy. Thus, our primary contribution is new evidence on the patterns of returns and trades after bankruptcy filings.

We document a systematic pattern of returns after bankruptcy filings - the filing period price plunge is followed by a price runup in the immediate post-filing period which turns out to be short-lived. Thus, we find two post-filing reversals: (1) the price plunge in the -1 to +1 filing period is inversely associated with abnormal returns in the day +2 to +5 post-filing period, and (2) returns cumulated over days +2 to +5 are negatively associated with subsequent returns cumulated from days +6 to +10. These reversals are not attributable to bid-ask bounce, and they hold after controlling for various factors associated with post-filing returns (firm size, financial condition, use of debtor-in-possession financing, use of prepackaged filings). Detailed analysis of investor trades suggests these reversals are attributable to the activities of large traders, not to small, arguably less sophisticated traders.

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Special thanks to the folks at ssrn.com, who suggested we let people know of the following policies and procedures in respect of downloading papers from SSRN:

Anyone new to our system who clicks on the link to purchase the paper will be first asked to register their e-mail address on our system. This is something that is required before one can download. The registration is just a security feature and doesn't cost anything, nor will the e-mail address be used for any other purpose but for our system to be able to recognize the user in his use of our services.

Thanks also to Northwestern Univ.'s DeJohn Allen, the firm's law clerk, for helping me assemble this lengthy post.

© Steve Jakubowski 2006