The Association between Bankruptcy Outcome and Price Reactions to Bankruptcy Filings

Abstract

This study investigates the association between bankruptcy outcome and the capital market's reaction to bankruptcy filings. Our sample consists of 77 firms that filed bankruptcy petitions between 1980 and 1996. We investigate whether, at the time of bankruptcy filing, the market differentiates between firms that are subsequently liquidated and firms that are subsequently reorganized. Our results indicate that liquidated firms have significantly larger negative price reactions at bankruptcy filing than reorganized firms. This result holds after controlling for a going-concern audit report in the period prior to bankruptcy filing, a technical or debt service default in the period prior to bankruptcy filing, firm size, prior Wall Street Journal announcement of a possible bankruptcy filing, firm financial condition, and other predisclosure information. Our findings suggest that the market has a high degree of insight into the subsequent bankruptcy resolution.

Strategic Bankruptcies and Price Reactions to Bankruptcy Filings

“…Consistent with Rose-Green and Dawkins (2000), the significantly negative DLIQUID coefficients indicate that subsequently liquidated firms have greater stock price declines than subsequently reorganized firms in the period around bankruptcy filing. The coefficient on the Z-SCORE variable is negative and significant at p 0X048 in the À251Y À2 CAR regression, and insignificant in the À251Y 1 CAR regression.…”

“…Controlling for DLIQUID in the regression analysis ensures that the effect of the type of bankruptcy filing is incremental to any effect of the bankruptcy outcome documented in Rose- Green and Dawkins (2000). We also ran a chi-square test to verify that the type of bankruptcy filing (strategic or financial) is independent of the outcome of the filing (liquidate or reorganize).…”

“…Prior studies show that the magnitude of the price decline at bankruptcy filing is associated with the amount of surprise in the bankruptcy filing as well as the market's assessment of bankruptcy outcome. Dawkins and Rose-Green (1998) report that the greater the surprise the greater the price decline, and Rose-Green and Dawkins (2000) document that firms that subsequently liquidate have greater stock price declines at bankruptcy filing than firms that subsequently reorganize. We think that these two factors explain the lack of significant difference between the abnormal returns of the two groups in the three-day period around bankruptcy filing, since there is greater surprise associated with a strategic bankruptcy filing, but firms that file financial bankruptcies are more likely to liquidate.…”

Residual income, value-relevant information and equity valuation: a simultaneous equations approach

“…Cornett and Travlos (1989) indicate corporate decisions that change the degree of financial leverage have a significant valuation effect on the firm's equity price. Rose-Green and Dawkins (2000) study the association between bankruptcy outcome and the capital market's reaction to bankruptcy filings, and indicate that liquidated firms have significantly larger negative price reactions at bankruptcy filing than reorganized firms. Lim and Tan (2007) suggest that investors perceive the earnings of firms with the higher VAR to be less persistent, and adjust the future abnormal return for the firms with the higher risk exposure.…”

“…In general, the possibility of firm's bankruptcy limits the permissible amount of debt, which can be used as a proxy for a firm's financial risk, will influence the stock price. Existing researches regarding price reactions to bankruptcy filings assume that the magnitude of the price decline is affected by the capital market's prior assessment of a firm's probability of bankruptcy (see Rose-Green and Dawkins, 2000). Ferris et al (1997) show that bankruptcy announcements generate a dominant industry contagion effect; the stock prices of competitors decline because the bankruptcy reveals adverse information about industry asset values.…”