A Nonlinear Wealth Transfer from Shareholders to Creditors Around Chapter 11 Filing

Abstract

Past literature has assumed that negative stock returns around Chapter 11 filing are solely due to new adverse information about firm value. This paper argues that there is also a nonlinear wealth transfer from shareholders to creditors causing shareholder loss. The magnitude of the wealth transfer can be quantified in a setting where equity is a call option on firm assets as in the Merton(1974) model. The wealth transfer originates from maturity shortening of the call option as a result of Chapter 11 filing. We present a parsimonious model to explain why Chapter 11 can be voluntarily filed by managers acting in the interest of shareholders with the existence of the wealth transfer. The model predicted stock return has comparable magnitude as observed stock returns around filing, and explains the cross-sectional variation of the latter.

Keywords: Chapter 11 Filing, Wealth Transfer

JEL Classification: G33