Do Activist Investors Constrain Managerial Moral Hazard in Chapter 11?

Chapter 11 creates a system of collective corporate governance that allows stakeholders that are usually passive – such as shareholders or creditors like lenders and bondholders – to play a day-to-day role in overseeing management and monitoring the business.  In recent years, activist investors have begun using this system to improve their return on investment.  They buy the claims of distressed firms, hire lawyers and investment bankers and negotiate to restructure the firm’s business and capital structure.  In some cases, these negotiations conclude with an out-of-court solution, but many firms require a trip through bankruptcy court to solve their financial problems.

In my paper, Do Activist Investors Constrain Managerial Moral Hazard in Chapter 11?, I study one of the most prominent distressed activist investing strategies: buying junior claims – such as unsecured debt or equity – and participating in the Chapter 11 process.   The junior activists who pursue this strategy are well-known for their willingness to challenge managers and senior creditors in the board room and the court room.  Judge Peck on the Southern District of New York recently described a junior activist as using “aggressive bankruptcy litigation tactics as a means to gain negotiating leverage or obtain judicial rulings that will enable it to . . . reap profits in connection with acquired, deeply discounted bankruptcy claims.  Such activist strategies are an increasingly familiar part of the landscape in large [C]hapter 11 cases.”[1]

Like activist investing more generally, junior activism is a source of controversy in corporate finance.  Critics view junior activism as a form of rent seeking and see junior activists as opportunists that file meritless motions and objections to extract hold-up value settlements.  This frivolous litigation also increases bankruptcy costs, undermining the Chapter 11 policy goal of maximizing creditor recoveries.  This view is so widely held that some of the more innovative forms of junior debt include loan covenants that limit the lender’s right to file objections in bankruptcy court in the event the borrower enters Chapter 11.

Junior activists, on the other hand, 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.  Which of these views is accurate?

In my paper, I perform the first empirical study of junior activism to learn more about how junior activists might influence bankruptcy outcomes.  The two views of junior activism provide different empirical predictions about junior activism.  If the rent seeking view is correct, we would expect to find that junior activism is correlated with settlements outside of the absolute priority rule (suggesting that the junior activist might have received hold-up value) and we would expect increases in bankruptcy costs.  If junior activists are correct, we would expect junior activism to be associated with an increase in the appraised value of the restructuring transaction, implying higher creditor recoveries and allocation of the firm’s value in line with the absolute priority rule.  I develop a new methodology that measures junior activism and 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 positively correlated with 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.  Settlements outside of the absolute priority rule are relatively rare and appear to be too small to make an investment in legal fees to acquire hold-up value profitable.  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 rent seeking view of junior activism and suggest that junior activists might promote the bankruptcy policy goals of maximizing creditor recoveries and distributing the firm’s value in accordance with the absolute priority rule.

The full paper can be found here.

[1] In re Ion Media Networks, 419 B.R. 585, 588-89 (Bankr. S.D.N.Y. 2009).