By Professor Wei Wang, Yan Yang, and Professor Jingyu Zhang (Smith School of Business, Queen’s University)
Hedge funds holding a large amount of unsecured debt of a financially distressed firm must decide whether to serve on the official unsecured creditors’ committee (UCC) that the U.S. Trustee appoints shortly after the firm files for Chapter 11 bankruptcy. Owing fiduciary duties to all represented unsecured creditors while serving on the UCC, hedge funds gain access to material nonpublic information (MNPI). Such information includes the company’s most recent business plans, management projections, and proprietary analyses of the competitive landscape of related industries.
Because of their information access, UCC members are restricted from trading debt securities of the bankrupt firm. Although debt holders with MNPI may choose to trade through the execution of a big-boy letter, they can still be litigated by the Securities and Exchange Commission. While hedge funds risk substantial penalties for trading debt securities of Chapter 11 firms, little is known about whether they exploit MNPI of bankrupt firms to facilitate their trading across asset markets. In a new study, we investigate whether hedge funds trade equity securities of nonbankrupt firms and profit from such trading after gaining access to MNPI of a bankrupt firm.
We assemble a sample of 144 Chapter 11 cases filed by large public U.S. firms between 1996 and 2019. Those cases have at least one hedge fund serving on the UCC. We use both Refinitive 13F Database and Lipper TASS Hedge Fund Database to obtain their quarterly equity holdings and monthly fund characteristics. Our study sample has more than 3,000 quarters of equity holdings by 79 unique hedge fund management companies. We first find that hedge funds are 25% more likely, relative to the unconditional mean, to have high portfolio turnover in the six quarters after Chapter 11 filing. Similarly, they are 21% more likely to make large size trade, defined as those trades that exceed 95th percentile of all quarterly trades by the hedge fund over the whole sample. We also 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 (i.e., the traded non-bankrupt firms and the bankrupt firm in the same industry, having a customer-supplier relationship, or producing similar products). Considering each large (buy or sell) transaction as an event and constructing 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.
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.
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