One Hat Research LLC
LTL Management: The Third Circuit's View and the Financial Distress of Firms That File for Ch 11
In LTL Mgmt., LLC, the United States Court of Appeals for the Third Circuit reviewed its precedent and found a clear theme: "absent financial distress, there is no reason for Chapter 11 and no valid bankruptcy purpose ... Financial distress must not only be apparent, but it must be immediate enough to justify a filing."
While the Third Circuit is stating its requirements for a good faith bankruptcy, its view is consistent with the financial characteristics of public companies that file for Chapter 11.
Most Chapter 11 filings by U.S. public firms from December 31, 1995 through December 31, 2021 that are members of the Russell 3000 or (starting, December 31, 2005) the Russell Microcap indexes are by firms that appear to be in deep financial distress.
Starting December 31, 1995, and ending December 31, 2021, I obtain data for the union of firms in the Russell 3000 and (starting December 31, 2005 based on no prior availability) Russell Microcap indices. I obtain bankruptcy filing dates from three sources: Bloomberg's bankruptcy filing database (BCY), the UCLA-LoPucki database, and SEC filings. I identify 386 bankruptcy filings for firms within one year of the calendar ends.
Consistent with my earlier post on the power of the one-year return as a bankruptcy predictor, 250 of the 386 firms had one-year returns worse than minus 60 percent at December 31st of the last calendar year end before the year of the bankruptcy filing. Here is a histogram:
In addition, most of the firms have very small stock market capitalization relative to the face value of their debt as a result of these very poor returns, suggesting their equity is becoming worthless, another sign of deep and immediate financial distress. Here is a histogram of each firm's Ps, a measure of leverage developed in Heaton (2019), and calculated as 1 - (stock market cap/face value of debt),
The companies also have very low stock prices at the December 31st before the year in which they file. Here, each bin size is $1:
Interestingly, time to file (TTF) in days from the calendar end shorten as returns are more negative and as Ps approaches 1 and as price approaches 0. There is less obvious pattern in one year returns:
This relationship is confirmed by a simple linear regression of TTF on RET1Y, PsD, and PRICE:
The data are consistent with most public firms filing for Ch 11 only when they are highly financially distressed, with very poor stock returns, very high leverage, and very low stock prices.