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

45 Pages Posted: 31 Mar 2012

Date Written: March 23, 2012

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

Suggested Citation

Li, Lily Yuanzhi, A Nonlinear Wealth Transfer from Shareholders to Creditors Around Chapter 11 Filing (March 23, 2012). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2031111

Lily Yuanzhi Li (Contact Author)

Villanova University ( email )

United States

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