Bankrupt Firms: Who's Buying?

Abstract

This paper asks whether the stocks of bankrupt firms are correctly priced, and explores who trades the stocks of these firms, and why. We show that firms in Chapter 11 are heavily traded by retail investors who are also their main shareholders. We further demonstrate that the stocks of these firms have unique lottery-like characteristics, and that retail investors apparently trade in such stocks as if they were gambling on the market. Considering the price impact of this investor behavior we document that buying and holding such securities leads, on average, to a negative realized abnormal return of at least -28% over the 12-month post-announcement period, a result inconsistent with traditional asset pricing models. However, examining how arbitrageurs might exploit this apparent market pricing anomaly, we find they have little incentive to intervene in this particular market: implementation costs and risks are simply too high. We thus conclude that a combination of gambling-motivated trading by retail investors and limits to arbitrage seems to lead to the apparent market pricing paradox we document. Our paper thus provides a clear answer to Eugene Fama and Kenneth French’s recent question on their blog - “Bankrupt Firms: Who’s Buying?”.