Reporting Discretion and the Choice of Fresh Start Values in Companies Emerging from Chapter 11 Bankruptcy

Abstract

Using a sample of seventy-two firms that adopted fresh start reporting upon their emergence from Chapter 11 bankruptcy, I test whether management estimates of fresh start equity values are misstated and whether such misstatements are related to characteristics of individual firms' bankruptcy process. I predict that the reported fresh start value reflects a tension between managerial incentives to promote the acceptance of the plan of reorganization, and incentives to enhance future reported performance. I test whether the tendency to overstate the fresh start equity value is increasing in factors affecting the acceptance of the reorganization plan (i.e., bankruptcy claimants' relative bargaining power) and decreasing in factors affecting post-bankruptcy reported performance (i.e., the probability of future losses). I find that, relative to the market value of equity immediately after emergence from Chapter 11, the fresh start equity value is, on average, understated by about 4 percent. The difference between the fresh start equity value and market value also exhibits significant cross-sectional variation (an average absolute error of 11 percent). Consistent with my first prediction, the misstatement is increasing in the relative bargaining power of junior claimants. In contrast to my second prediction, the misstatement is also increasing in the likelihood of future reported losses. This result suggests that firms that are more likely to experience post-bankruptcy financial distress are more concerned with obtaining acceptance for their plan than with the effects of the fresh start equity value on post-bankruptcy performance. Finally, I document that the misstatement in the fresh start equity value is negatively related to whether firms have undergone prepackaged bankruptcies, and positively related to replacement of a pre-bankruptcy CEO.

JEL Classification: G33, M41, M43