Distress Risk, Stock Returns, and the 1978 Bankruptcy Reform Act

Abstract:     
This paper employs a novel identification strategy around an important legal event to study the relation between distress risk and stock returns. Given the mixed evidence for distress risk premia in the cross-section of stock returns, we examine the impact of a major change in the bankruptcy code. The Bankruptcy Reform Act of 1978 unexpectedly increases shareholders' bargaining power in distressed reorganizations, leading, e.g., to large and widely documented violations of the absolute priority rule. We document that (1) the reform reduces portfolio- and firm-level distress premia along with characteristics of distressed stocks, such as CAPM betas and return standard deviations, (2) this reduction in distress premia due to reform-based shareholder advantage is weaker for firms with higher and with more substitutable firm-level shareholder advantage, and (3) the reform increases momentum profits for stocks of distressed firms. Finally, a significant increase in corporate bond credit spreads for riskier firms after the reform and lower distress premia for firms with absolute priority rule violations in bankruptcy provide supporting evidence for our identification strategy.

Number of Pages in PDF File: 51

Keywords: financial distress, law and finance, shareholder recovery, stock returns

JEL Classification: G12, G14, G33

working papers series