Investing in Shares of Bankrupt Firms: Evidence from Investments by Institutional Investors Shortly before, during and after Chapter 11 Proceedings

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Introduction Why would anyone consider investing in shares of operationally and/or financially unhealthy firms? Do those investors who invest in the risky shares of evidently distressed and/or bankrupt firms follow Anais Nin's motto Good things happen to those who hustle? (1) Or are these investors blissfully unaware of the brewing troubles and unavoidable destiny of the firms? What about sophisticated and informed investors such as institutions? How do their shareholdings change as the firms approach and then file for Chapter 11 protection, work through reorganization and emerge from bankruptcy proceedings? And do these holdings play a role in the effectiveness of bankrupt firms' restructuring and their speed of returning to profitability? Although it has been shown that, in general, bankrupt firms underperform operationally and in the stock market and investors holding shares of bankrupt firms incur significant capital losses, we may find that institutions are capable of identifying undervalued equity and timing purchases and sales of distressed securities. We investigate whether or not institutional ownership is related to performance of distressed firms as they attempt to reorganize. Another main theme of this paper is to examine whether or not institutional managers who acquire shares of bankrupt firms in the quarter prior to Chapter 11 filings, during bankrupt firms' reorganization or shortly after firms emerge from bankruptcy proceedings possess the ability to strategically trade shares of distressed or bankrupt firms to achieve positive returns. In summary, the purpose of this paper is twofold: to analyze the relationships between institutional holdings and performance of bankrupt firms and to evaluate whether or not institutional investors are capable of identifying undervalued investments that results in future positive returns. The relationship between institutional investment decisions and the operating and market performances of struggling firms before, during and after bankruptcy filings have not been systematically analyzed. We do not know if the operating and stock market performances of failing firms with institutional shareholders differ from that of failing firms without investments from institutions. We do know that higher institutional ownership has a positive effect on stock prices and returns (Brown and Brooke 1993 and Gompers and Metrick 2001). Does this finding apply to special situations, such as institutional investments in bankrupt firms? The existing empirical literature on institutional trading does not provide concrete evidence as to how profitable the investment strategies are that institutions employ in their overall trading. While some researchers argue that institutional investors are capable of picking winners and exhibit fully rational herding behavior that promotes price discovery and predicts stock returns (Nofsinger and Sias 1999 and Sias 2004), others conclude that institutional managers mechanically acquire stocks with certain desirable characteristics and price levels (Falkenstein 1996) and irrationally engage in herding, causing temporary price bubbles (Dreman and Lufkin 2000) and future price correction (Gutierrez and Kelley 2009). Irrespective of that, we can, to this point, find no empirical evidence relevant to profitability of institutional holdings/trading of companies as they approach bankruptcy, proceed through reorganization and emerge from Chapter 11. INVESTING IN SECURITIES OF DISTRESSED FIRMS It is well established that the security returns associated with the immediate period around bankruptcy filings are almost always quite negative and investors in filing firms almost invariably suffer losses. Firms usually start experiencing financial difficulties long before petitioning for reorganization or liquidation in the Federal court by filing Chapter 11 or Chapter 7, respectively, (Altman 1968; Aharony, Jones and Swary 1980; Clark and Weinstein 1983 and Campbell et al. …