Unsecured debt of distressed companies is a popular investment for certain hedge funds, not least because it often allows the funds to serve on a distressed company’s unsecured creditors’ committee (UCC) shortly after the firm files for Chapter 11 bankruptcy. Owing fiduciary duties to all unsecured creditors they represent, UCC members are granted access to material nonpublic information (MNPI) of the firm, including the firm’s most recent business plans, management projections, and proprietary analyses of the competitive landscape of related industries. Hence, the Securities and Exchange Commission (SEC) prohibits UCC members from trading debt securities of the bankrupt firm. Though hedge funds thus risk substantial penalties for engaging in such trades, little is known about whether the funds exploit MNPI of bankrupt firms to facilitate their trading across asset markets. In a new paper, we examine whether hedge funds trade securities of nonbankrupt firms after gaining access to MNPI of a bankrupt firm.
Our bankruptcy sample includes 144 Chapter 11 cases filed by large public U.S. firms between 1996 and 2019. We retrieve information on those cases from a few data sources, including Florida-UCLA-LoPucki Bankruptcy Research Database, New Generation Research, and Public Access to Court Electronic Records (PACER) system. In our sample, at least one hedge fund joins the UCC shortly after the Chapter 11 filing. We merge hedge fund company identities with those in Refinitive 13F Database and Lipper TASS Hedge Fund Database to obtain their quarterly equity holdings and monthly fund characteristics such as returns and fund flows. Our final sample has more than 3,000 quarters of equity holdings by 79 unique hedge funds.
We find that hedge funds appointed as UCC members (UCC hedge funds) are 30 percent more likely to have high portfolio turnover. We use alternative measures to quantify portfolio turnover, and our evidence suggests that both buy transactions and sell transactions in equity markets by UCC hedge funds contribute to their high portfolio turnover. We also find that UCC hedge funds are more likely to make large transactions in individual stocks and make a greater number of large transactions upon joining UCC. Examining quarterly trading patterns, we find that despite the first quarter immediately after the UCC formation experiencing the largest equity portfolio turnover, the effect remains economically large in the next few quarters.
A large amount of information about a Chapter 11 filing is typically released through court filings immediately after the bankruptcy filing. Given that it takes on average of only 17 days for a trustee to appoint a UCC after Chapter 11 filing, it is possible that the abnormal trading behavior that we observe is due to hedge funds’ access to public information released upon the bankruptcy filing. However, our results show that hedge funds do not trade differently in quarters where there is a public bankruptcy filing when they are not on the UCC. In addition, we find that hedge funds are even less likely to make large trades in the quarters where other hedge funds are on the UCC. Importantly, other non-hedge fund institutional investors do not trade differently after accessing MNPI through the UCC membership.
We next investigate what firms UCC hedge funds intensely trade. We conjecture that UCC information can be more relevant and valuable for hedge funds in trading securities of firms that have economic links to the bankrupt firm. Specifically, we consider whether the traded non-bankrupt firms and the bankrupt firm are in the same industry, have a customer-supplier relationship, or produce similar products. We find that large transactions by UCC hedge funds are more likely to happen in the stocks of non-bankrupt firms that have an economic link to the bankrupt firm.
In the last section of our study, we consider each large (buy or sell) transaction as an event and construct characteristics-adjusted buy-and-hold returns from 12 months before to 12 months after the trades. We find that, in the 12-month window around large trades, the share price impact of trading by hedge funds while they serve on the UCC is 3.12 percentage points higher than when they do not serve on the UCC. The evidence suggests that large trades by UCC hedge funds are highly likely to be information-driven, and the incremental contribution to returns is substantial.
Our empirical setting focuses on a specific group of hedge funds that specialize in distressed investing, which allows us to compare the stock trading behavior of hedge funds that have access to MNPI and those that have access to only public information of the same bankrupt firm. To the best of our knowledge, ours is the first paper to study whether hedge funds exploit MNPI obtained via their distressed debt holdings and trading in the equity market of non-distressed firms. Our findings feature an important link from the debt market to the equity market, highlighting cross-asset ownership and trading driven by MNPI. This special form of informed trading by hedge funds deserves the attention of regulators to ensure market efficiency and integrity.
This post comes to us from professors Wei Wang, Yan Yang, and Jingyu Zhang at the Stephen J.R. Smith School of Business at Queen’s University. It is based on their recent paper, “Do Hedge Funds Exploit Material Nonpublic Information? Evidence from Corporate Bankruptcies,” available here.