Do Activist Investors Constrain Managerial Moral Hazard in Chapter 11?: Evidence from Junior Activist Investing
November 2, 2013 Leave a comment
Jared A. Ellias Stanford Law School
October 23, 2013
Rock Center for Corporate Governance at Stanford University Working Paper No. 155
Stanford Law and Economics Olin Working Paper No. 451
Abstract:
In recent years, hedge funds and other activist investors that specialize in bankruptcy investing have emerged as important players in virtually every large Chapter 11 case. These activist investors buy junior claims and deploy aggressive litigation tactics to gain influence in the restructuring process. The consensus among bankruptcy lawyers is that this behavior has had a negative effect on Chapter 11. Junior activists are considered by many to be out of the money rent seekers that try to extract hold-up value from senior creditors, increasing the administrative costs of bankruptcy and reducing the ultimate recovery of creditors. Junior activists, however, believe they counter the perverse incentives of managers of Chapter 11 debtors. Chapter 11 leaves managers in control of the bankruptcy process and requires them to maximize creditor recoveries. In performing this duty, managers face moral hazard. If the firm is reorganized in a transaction that is appraised at a discount to the firm’s true value, managers and senior creditors can profit at the expense of junior claimants. Junior activists claim they intervene to stop managers and senior creditors from extracting value from junior claimants. In this paper, I perform the first empirical study of junior activism. I develop a new methodology that measures junior activism and I use it to study a hand-collected dataset of large firms filing for Chapter 11 in 2009 and 2010. I find that junior activism is correlated with an increase in the appraised value of the restructuring transaction, supporting the view of junior activists that they constrain management’s ability to extract value from junior claimants by underappraising the firm. Although there is some evidence of cost increases associated with junior activism, these increases are small in relation to the potential benefits of junior activism. The results undermine the consensus view of junior activism and suggest that junior activists promote the bankruptcy policy goals of maximizing creditor recoveries and distributing the firm’s value in accordance with the absolute priority rule.
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