BEAUTIFULLY BROKEN BENCHES: A TYPOLOGY OF STRATEGIC BANKRUPTCIES AND THE OPPORTUNITIES FOR POSITIVE SHAREHOLDER RETURNS Jerry Paul Sheppard* Simon Fraser University Burnaby, British Columbia Abstract Merchants in medieval Venice who failed to pay their debts were closed by banca roUa - the breaking of the bench from which they did their business. In some cases today, bankruptcy is seen as a beautiful strategic maneuver. While there are currently some positive aspects which can be attributed to filing for bankruptcy, there is still debate as to its merits as a strategy. To allow for a more detailed understanding of the strategic bankruptcy concept, the author de- fines, identifies and categorizes types of bankruptcies. To address the issue of whether bankruptcy is a worthwhile strategy the author also presents a study of the effectiveness of bankruptcy in advancing long-run shareholder wealth. A sample of 155 bankruptcies was employed to study the impact of various strate- gies on returns to shareholders. Some types of strategies were found to result in significantly greater returns than average. Introduction If merchants in medieval Venice failed to pay their debts, creditors closed their operation by breaking the bench from which they did all their business. Italian for "broken bench", banca rotta, is the word from which bankrupt is de- rived (Cifelli, 1983). While the bankrupt party in medieval Venice saw their place of business go from commerce to kindling in moments, the situation in the United States today is different. A business' "broken bench" is not seen as a stack of splintered. wood, but as a beautiful work of art. Bankruptcy, or, to be more ac- curate, Chapter 11 reorganization, has been viewed as a business strategy that can help turn around an ailing company. Like opera, if well performed, the Chapter 11 strategy can be a beautiful thing to behold: the corporation, assaulted by its creditors, is rescued from certain death and brought back to health by the wise ministrations of the court (Sheppard, 1992). Like opera in Italy, Chapter 11 is certainly popular in the U.S. Over 60,000 filings and a total of $82.7 billion in assets wound up in the U.S. bankruptcy '" Special thanks to Sharon Sheppard, Rocky and Rose Sheppard, Elaine Fairly, Maharnad Dhanani, Mark Wexler, Jean Last, Ann Winton and two anonymous reviewers for their assistance in this re- search. The author, however, assumes responsibility for all errors, omissions, etc. 100 Journal of Business Strategies Vol. 12, No.2 courts in 1990 (Duncan, 1991; Sherman, 1991). While there are potentially many desirable aspects one can attribute to filing for Chapter 11 (e.g. see Sheppard, 1992), there is disagreement as to the merits of strategically filing for bankruptcy (Flynn and Faird, 1991; Moulton and Thomas, 1993; Sirower, 1991). Furthermore, there is disagreement as to how strategic bankruptcy should be defined (Delaney, 1992; Flynn & Faird, 1991; Moulton and Thomas, 1993). For an intelligent discourse, a clear definition and conceptualization of stra- tegic bankruptcy - as differentiated from non-strategic bankruptcy - are needed. It would also help to have some parameters within this conceptualization that help identify various types of strategic bankruptcies. This approach would allow one the weighing of possible merits and problems involved with each type of strat- egy. Thus, in this paper four questions will be addressed. One, what is strate- gic bankruptcy? A clearer definition and conceptualization of strategic bankruptcy will be introduced in the sections to follow. Two, how can one identify and cat- egorize strategic bankruptcies? By being able to identify and categorize strate- gic bankruptcies, an improved understanding of the phenomenon can developed. Three, are certain types of bankruptcies effective in advancing the long run wealth of a company's shareholders? There may be situations where filing for bank- ruptcy might aid investor returns. This leads to the final question. What other conditions aid investor returns in situations where the firm files Chapter II? Some understanding of circumstances which might make strategic bankruptcy a viable alternative can be achieved by answering this final question. Sirower (1991) demonstrated that firms that were about to go bankrupt steadily lost value for shareholders in the year prior to the firm's filing date, and such firms steadily gained value for shareholders in the year after the Chapter 11 filing. Therefore, the strategic goal of optimizing long-run shareholder value (Hax and Majluf, 1984) could support a bankruptcy filing. On the other hand, Moulton and Thomas (1993) found little evidence to support the idea that a stra- tegic bankruptcy was useful in optimizing long-run shareholder wealth. This idea that a bankruptcy filing could promote shareholder wealth gave rise to the phrase strategic bankruptcy (e.g. see Cifelli, 1983). However, if the only requirement defining a strategic bankruptcy is that shareholders might benefit, then all bankruptcies can be viewed as strategic. This definition would render the phrase redundant, and therefore useless. Thus, if the phrase is to have any real meaning one needs to ask "what is strategic bankruptcy?" What Is Strategic Bankruptcy? According to Moulton and Thomas (1993) and Delaney (1992), strategic bankruptcy implies two things. First, a petition under Chapter 11 of the U.S. bankruptcy code is initiated by one stakeholder at the expense of others. Sec- ond, strategic bankruptcies are invoked to deal with a single problem (e.g. a law- suit or class of lawsuits). By this logic, all bankruptcies are strategic (Moulton and Thomas, 1993), and there is some validity to this perspective. The competi- Fall 1995 Sheppard: Strategic Bankrupties 101 tive nature of the asset recovery game for creditors may create a situation where some stakeholders are favored at the expense of others. Also, the law gives some stakeholders priority over others in all bankruptcy proceedings (Brown, 1989). Fi- nally, the need to file for bankruptcy, in the end, often appears to result from a single problem (e.g. cash flow problems, equity insolvency, creditor petitions). However, the "all bankruptcies are strategic" perspective is not a very use- ful one. If all bankruptcies are strategic, then why would authors like Delaney (1992) focus only on specific filings (e.g. Texaco)? This perspective also does not tell us much about any variation which might occur within the realm of stra- tegic bankruptcy. Given the wide variation in stakeholder groups that may be concerned with one bankruptcy as opposed to those that gre concerned with an- other there should be different types of strategic bankruptcies. Why are some bankruptcies labeled "strategic" and others not? A more straightforward definition of strategy may help distinguish between the two types of bankruptcy. Mintzberg (1991) gives five definitions of strategy: a plan, a ploy, a pattern, a position, and a perspective. Regarding these definitions, Sheppard (1992) has noted, Chapter 11 does not qualify as a strategy in most respects. Bankruptcy, however, may fit two of Mintzberg's definitions of strategy: a plan and a ploy. As a plan, the strategic bankruptcy must be a "consciously in- tended course of action, a guideline (or set of guidelines) to deal with a situa- tion" (Mintzberg, 1991: 12). In the case of strategic bankruptcy, the plan must deal with a specific stakeholder threat. As a ploy, the strategic bankruptcy must be a "specific 'maneuver' intended to outwit an opponent or competitor l (Mintzberg, 1991: 13)." Daily (1994: 269), referring to earlier work by Delaney (1992) and Flynn & Faird (1991), states that the strategic bankruptcy can be defined as "a proactive attempt by firm's management to contend with some threat posed by a stakeholder group." Delaney (1992), also notes that, in cases of stra- tegic bankruptcy, there is an intention to promote some group of stakeholders at the expense of others. To identify the strategic bankruptcy, one needs to go beyond the items Moulton & Thomas (1993) and Delaney (1992) mention: that a petition is initi- ated by one stakeholder at the expense of others and the filing is invoked to deal with a single problem. A strategic bankruptcy must also be one in which the firm is attempting to use Chapter 11 as a Illm:: or a plan (Mintzberg, 1991) in a proactive fashion (Daily, 1994) to deal with some threat posed by an identifiable stakeholder group. What Is A Non-Strategic Bankruptcy? If one can identify strategic bankruptcies, then one must surely be able to spot non-strategic bankruptcies. Non-strategic bankruptcies may possess some of the attributes of strategic bankruptcies. Thus, differentiating one from the other may be difficult. For example, both strategic and non-strategic bankruptcies greatly impact a single identifiable stakeholder. However, with non-strategic fail- 102 Journal of Business Strategies Vol. 12, No.2 ures the impacted parties are usually commercial or financial creditors (e.g. sup- pliers or lenders, respectively). In these non-strategic cases, the debtor company seeks to obtain a straight-forward stay against the action of creditors. As shall be seen, strategic failures typically, although not always, impact groups other than creditors. This means is that one can file a strategic Chapter 11 which targets creditors, but the objective of the filing must appear to go be- yond a simple stay. In other words, to be defined as a strategic bankruptcy which targets creditors, there must be some evidence that the filing was part of a plan that the firm's managers were unable to execute pre-petition, and that the filing, was being used as a ploy to force the support of creditors". Table 1: Strategic vs. Non-Strategic Bankrupties ATTRIBUTES NON-STRATEGIC STRATEGIC BANKRUPTCIES BANKRUPTCIES Filing impacts one identifiable UsuaIly commercial I UsuaIly stakeholders other stakeholder group financial creditors than commercial/financial greatly creditors (e.g. customers). Filing is at the Impacted identifiable Impacted identifiable expense of others stakeholders usuaIly stakeholders usuaIly assume, and accept. do not intend to accept some level of risk a level of risk in their in their relationship relationship with the with the bankrupt bankrupt corp. (e.g. Dalkon corp. (e.g. Lenders Shield I. U.D. Customers). risk loan default). Filing deals with Creditors are attempting Interference with normal a single problem to seize assets used as operations (e.g. press loan collateral exposure affecting govt. (e.g. foreclosure). contracts). Filing may be Debtor is employing Debtor employs Ch. II seen as a plQy Chapter 11 to stay the to re-negotiate some or plan creditor's actions (e.g. agreement (e.g. lease stop foreclosure). agreements). Filing may be a Debtor is faced with Debtor faces eventual loss proacti ve measure immediate loss due to to stakeholder actions (e.g. stakeholder actions lawsuits overload). (again, foreclosure). Fall 1995 Sheppard: Strategic Bankrupties 103 Given the definition for strategic bankruptcy included in the above section, several subtle differences between the strategic and non-strategic filings can be noted. These differences are summarized in Table 1. In general, non-strategic bankruptcy deals with debts incurred in the normal course of business - e.g. debts owed to suppliers and lenders - and the Chapter 11 filing simply seeks to stay the creditor's actions until the firm can develop a plan for reorganiza- tion. For example, when Pettibone Corp. found itself overburdened with debt from a downturn in the construction industry, it went into Chapter 11 in order to de- vise a plan that would raise equity and return the company to solvency. This action is different from strategic bankruptcies, which attempt to address obliga- tions or problems that either: (l) do not deal with these traditional creditors, or (2) deal with these creditors in ways that were not previously contemplated 3 • A Simple Typology Of Bankruptcies To uncover distinctions between types of Chapter 11 filings, a typology of bankruptcies is developed and presented here. Typologies are typically employed to provide guidance in early exploratory work (Harrigan, 1983). Early strategy research provides numerous examples of such exploratory typologies (Miles and Snow, 1978; Miller and Friesen, 1980; Rumelt, 1974). Since one of the purposes of the present study is to explore the concept of strategic bankruptcy, the usc of a typology is warranted. For a bankruptcy to be strategic, it must be targeted at a stakeholder, and be for a specific purpose. Thus, to identify strategic bankruptcies one would need to identify which stakeholders the firm was attempting to "outwit" and what spe- cific action the firm was attempting to "thwart." Take the example of A. H. Rob- ins. In that case, the firm intended to outwit plaintiffs of the Dalkon shield law- suits in order to thwart their legal claims against the company. Again, strategic bankruptcy was not the simple avoidance of general creditors but something very specific. The Sample and Operationalization To create a bankruptcy typology, a sample of 155 companies that entered Chapter II between October, 1979 (when the current bankruptcy law took effect) and December, 1987 was employed. The list of failed firms was gathered by scan- ning Commerce Clearinghouse's Capital Changes Reporter for companies which declared bankruptcy during the period. Because the rationale behind the Chapter 11, filings for start-ups and heavily regulated or recently deregulated firms could with high probability be attributed to non-strategic reasons, these firms were elimi- nated from the sample. Moody s manuals were used to identify start-up firms (those with less than 100 employees and in existence less than five years) to be eliminated. Such firms are particularly susceptible to the ills of autocratic lead- ership that Argenti (1976) finds critical to firm survival. These start-up firms 104 Journal of Business Strategies Vol. 12, No.2 are also impacted by the liability of newness (Singh and Lumsden, 1990). Heavy industry regulation or a change in the level of industry regulation would be an added factor affecting the likelihood of firm failure (Owen and Brautigam, 1980). Thus, firms in heavily regulated or recently deregulated industries were not con- sidered. These firms were primarily involved in the industries of transportation, telecommunications, utilities, banking, insurance, medical practice, and legal prac- tice (SIC Code Groups 40-42, 44, 48, 49, 60, 63-64 and 80-81). For the remaining firms, business press reports about the bankruptcy filing (from the Wall Street Journal, Business Week, Barrons, Fortune, and regional business newspapers) were analyzed in order to determine the company's reason for filing. Filings classified as strategic bankruptcies had to meet four criteria: 1. There must be one identifiable stakeholder group against which the firm could be employing Chapter 11 (e.g. product users). 2. There must be a single identifiable action the stakeholder group was taking that the firm sought to thwart via its filing of Chapter 11 (e.g. collecting on lawsuits). 3. There must be a specific goal which a Chapter 11 filing could aid the firm in accomplishing (such as a reduction in lawsuit awards). 4. The filing must go beyond simply staying the actions of general credi- tors to collect debts. The first two criteria address the notion of bankruptcy strategy as a ploy, the last two ensure that the bankruptcy indicates some kind of plan. All other filings were classified as non-strategic bankruptcies. Classifications Fifty-five of the 155 bankrupt companies in the developed list of companies possessed strategic elements. These were categorized into nine stakeholder groups. These stakeholder groups were then divided into a total of 16 subgroups based on the firm's apparent rationale for filing. These categories and subgroups are described in Table 2. Fall 1995 Sheppard: Strategic Bankrupties 105 Table 2: Typological Categories of Strategic Bankruptices Described PLOY AIMED AT WITH THE INTENT TO COMMENTS & EXAMPLES Creditors Force lenders to allow Prompt lenders to approve pre- for proposed~ bankruptcy proposals to change C structure changes. a finn's capital structure. This A was howMGF hoped to force P debt holders into an equity I swap proposed prior to filing. T A Allow finns to complete The finn attempts to use Ch. II L negotiation for sale of to reduce debt to make it more all/part of the firm. attractive to a waiting buyer. Whippany Paperboard used Ch. II to complete negotiations for sale of the firm to new in- vestors. P Allow a finn to f.i.niill Force lenders to allow com- R restructuring efforts pletion of corporate strategy 0 begun prior to filing. change. Cook United tried V using Ch. II to get additional I funds to complete store re- D modeling. Eastmet tried using E Ch. II to reduce debts involved R in exiting an industry. S Force lender to~ Magic Circle Energy tried assets needed by finn. using Ch. II to attempt to force its bank to release real estate collateral to allow oil drilling. Force lender to provide To get credit to meet seasonal for seasonal borrowing. demand Wicks used Ch. II. Suppliers who shipped after filing gained first priority to assets. Shareholders Stop takeovers /~ Heck's Ch. II aided in thwarting h2!.Qg actions / clear- a potential takeover. up ownership disputes. Schaak used Ch. 11 to support owner ship claims by its CEO. Altec used Ch. II to avoid required payments to preferred shareholders. 106 Journal ofBusiness Strategies Vol. 12, No.2 Table 2: Typological Categories of Strategic Bankruptcies Described (cont'd) PLOY AIMED AT WITH INTENT TO COMMENTS & EXAMPLES Government Pass unfunded pension Significant unfunded pension G costs to government liabilities can be shed in this 0 backed insurance agent. manner. For Wheeling Corp. V the amount of debt shed E was $475 million-more than R 30% of their total debt. N Use legally allowed tax Large losses mean future tax loss carryforward as an free income. MLX had $10 asset to get investors. million in assets / $150 million in debts after selling everything. By convincing lenders to pro- vide equity and back acquisi- tions the firm put to use $300 million in loss carryforward tax credits. The Press Remove industy scandal Ch. 11 gets firm out of the news from~ attention & back to business. Mobile P Home firms did so after bad R press on the bill padding of E FHA Loans. S S Remove company Firm gets back to business once ~ from public out of the press. Wedtech did attention this once it left its government procurement scandal behind. Remove mgmt. scandal Ch. 11 quiets news about its from public attention exec.s so the firm can operate. As worked with Saxon Ind. after news of being looted by their CEO. Fall 1995 Sheppard: Strategic Bankrupties 107 Table 2: Typological Categories of Strategic Bankruptcies Described (cont'd) PLOY AIMED AT WITH INTENT TO COMMENTS & EXAMPLES Buyers & Esca~e unprofitable Revere Copper & Brass was M Suppliers contracts arranged with able to escape over-priced I buyers or suppliers. contracts with its electric sup- S pliers and under-cost contracts C with its aluminum buyers via its use of Ch. II. I Competitors Avoid damage claims Re-negotiate damage awards in single lawsuit brought from a civil suit. Texaco used L by a competitor. Ch. 11 to avoid billions in dam- E ages awarded to Pennzoil. Smith G International used Ch. II to A avoid paying on patent infringe- L ment. I Customers I Avoid damange claims The firm used Ch. II to solve S Prod. Users in mass tort lawsuit many damage claims. Manville S filed by past product used it to handle thousands of U users. asbestos related personal in- E jury claims. A.H. Robins used S it to deal with Dalkon Shield claims. Employees Esca~e unprofitable This is the well known ploy of contracts with union using Ch. II to void union con- employees. tracts. Among firms in the present sample Tobin Packing could have benefited from this use of Ch. II. Lessors Escave unprofitable Renters can get out of un- long term leases. profitable leases. Flannigan's Enterprises was able to re- negotiate over priced leases via Ch. II. By using Ch. 11, HRT Industries was able to shut down 55 of its 192 retail outlets and regain profitability. 108 Journal of Business Strategies Vol. 12, No.2 To create a more parsimonious set of categories, the nine stakeholder groups in Table 2 have been sorted into four clusters based on common themes (see Sheppard, 1994a for further details). The Capital Providers cluster addressed cases where the bankruptcy strategy thwarted the actions of shareholders or impacted the actions of creditors in ways that are not straightforward stays. The Govern- ment cluster dealt with those cases where the bankruptcy strategy involved the firm receiving some benefit from the government which made the firm's contin- ued existence more likely. The Press cluster involved cases where a firm was connected to a scandal, and the bankruptcy filing removed the firm from public scrutiny and allowed it to get back to business. Finally, the Miscellaneous I Le- gal Issues cluster concerned those firms employing the bankruptcy strategy to resolve some legal issue involving a contractual obligation (contracts, leases, union agreements) or an implied contractual obligation (fair trade, implied warranties of product merchantability). The remaining sample consisted of 100 non-strategic bankrupt companies. A detailed list of the non-strategic bankrupt companies is included in Appendix 1. All companies involved in strategic bankruptcies, and the groups to which they belong, are included in Table 3. Table 3: List of Strategic Bankrupt Firms by Type Ploy Aimed at Intended Action Companies and Filing Year: Creditors Allow Cap. Global MGF Salant '85 Change Marine '86 Oil '84 Complete American Roberts & Vector the Sale of Advent. '86 Porter '83 Graphic '85 Capital the Company Crompton Transcon. Whippany '84 Energy '84 Paper '80 Finish a Cook Mesta Sambos Providers Restructuring United '84 Machine '83 Resturant Previously Eastmet '86 Newbery '87 '81 Begun JAMCO Richton White Ltd. '87 Inteml. '80 Motor '80 Release Computer Magic Assets Depot '86 Circle '85 Seasonal New Sam Borrowings England Soloman Fish '80 '80 Steiger Wickes Tractor '86 Co.s '82 Fall 1995 Sheppard: Strategic Bankrupties Table 3: List of Strategic Bankrupt Firms by Type (cont'd) 109 Ploy Aimed at Intended Action Companies and Filing Year: Share- Stop In- Altec '83 Heck's '87 Schaak holder vestor Act Electric. '85 Govem- Govem- Pension LTV '86 Phoenix Wheeling ment ment Costs Steel '83 Pitts. '85 Tax Loss Allis- McLouth Carry- Chalmers Steel '81 forwards '87 Northwest Itel Corp. Eng. '83 '81 Press Press Industry Commodore Mobile Scandal Corp. '85 Home Ind. Conner '84 Homes '87 Tidwell Ind.s '85 Company Coleman National Wedtech Scandal American Paragon '86 '80 '85 Mega Swanton Intematnl. '85 '82 Mgmt. Rusco '81 Saxon Scandal Industries '84 Buyl Avoid Revere Mise.! Supply Contracts Copper '82 Legal Com- Avoid One Smith Texaco petitors Lawsuit Interntnl. '87 Issues '86 110 Journal of Business Strategies Vol. 12, No.2 Table 3: List of Strategic Bankrupt Firms by Type (cont'd) Ploy Aimed at Intended Action Companies and Filing Year: Prod. Avoid Manville Robins UNR Users Mass Torts '82 (A.H.) '85 Ind.s '82 Employ- Union Tobin ees Agreements Packing '81 Lessors Void Flannigan's HRT Ind.s Lafaytte Leases Ent. '85 '82 Radio '80 Returns To Shareholders The next step of the research involved a determination of how well the com- pany performed from the shareholders' point of view. The reason shareholders were selected was as follows. Since common shareholders are the last in line to receive anything after a bankruptcy, one would assume that if shareholders re- ceived anything, creditors - as well as a wide variety of other stakeholders - would also have obtained something. Thus, the needs of a great many stake- holders would likely have been addressed if common shareholders received some net benefit from the filing. Of concern here, however, are the shareholders. Since managers and directors - in theory - have a responsibility toward sharehold- ers, one would assume that entering into Chapter 11 (particularly, the "strategy" of entering Chapter 11) would be in the shareholders' best interest. To determine what happened to these Chapter 11 firms, computer searches of several databases were run. In addition, the Commerce Clearinghouse's Capital Changes Reporter and Financial Information's Directory of Obsolete Securities were employed to trace securities. Capital Changes Reporter, Moody's manuals and press reports were searched to ascertain what stock conversions (i.e. pre-bank- ruptcy shares traded in for new shares) and dividends had been issued since the firm's Chapter 11 filing. Finally, Standard & Poors' Directory of Corporate Of- ficers & Directors indexes were cross checked in order to trace firm names since, in an effort to 'start over', firms will sometimes change their name. Appendix 2 presents the list of the firms that changed their names. Returns to shareholders were calculated to address the question, "Did the move into Chapter 11 improve the long-run financial well-being of the sharehold- ers?" To calculate returns to shareholders, the share price on the day prior to filing was compared to the share price at the end of 1992. Annual returns to shareholders were calculated as follows: Fall 1995 AR = ASR Sheppard: Strategic Bankrupties AMR 111 where AR = Annual Returns ASR = AMR = and where ASR = AMR = such that Me = = Average Shareholder Returns Average Market Returns T/Y Market value of pre-bankruptcy shares (adjusted for dividends, splits, and payments) at the end of the study period (12-31-92). Market value of common shares on the day prior to filing. Y T = = Years since the bankruptcy until 12-31-92. Three month T-bill rate 4 compounded from date of filingto 12-31-92 Sirower (1991) observed that the price immediately prior to filing is the low- est price a stock will possess. Both Sirower (1991) and Hambrick and D' Aveni (1988) note that this is the point at which the organization's downward spiral halts, that it is possible for conditions to improve from there onward, and that the value of the company to shareholders should also improve. Over half the firms in the sample had a -100% return to shareholders; i.e. their stock was worthless. About 40% of the strategic bankruptcies and about 65% of the non-strategic bankruptcies were worthless. As shown in Table 4, this difference in worthless rates is significant (p <.01). Only 14 of the 155 bank- ruptcies in the sample (about 9%) resulted in a return to shareholders that was positive relative to the market rate. The majority of these 14 companies utilized strategic bankruptcy. Ten of the positive return companies (72%) were strategic bankruptcies, four were non-strate¥ic (28%). This difference in positive return rates is significant (cross-tabs Chi of 7.05, p <.01) - as shown in Table 4. 112 Journal ofBusiness Strategies Vol. 12, No.2 Table 4: Worthless vs. Non-Worthless Shares / Positive vs. Non-Positive Returns Bankruptcies Bankruptcies Strategic Non- Strategic Non- Strategic Strategic S R h Worth- 23 65 e Positive 10 4 a less (41.9%) (65.0%) t (18.2%) (4.0%) r u e Non- 32 35 r Non- 45 96 s Worthless (58.1%) (35.0%) n Positive (81.8%) (96.0%) s Ch/ = 685 Sig. @ .01 Chi 2 = 7.05 Sig. @ .01, Annual returns 5 for the 100 non-strategic bankruptcies in the sample aver- aged -3.923 (with a standard deviation of 1.94). The 55 strategic bankruptcies averaged an annual return of -1.175 rate (with a standard deviation of 7.94). The returns for the two groups were compared via a test of means - aT-test - (not an uncommon test for bankruptcy data; see Sheppard, 1994b). Strategic bank- ruptcies, on average, had a significantly higher return to shareholders than the non-strategic group (T = 2.53, P <.05). However, neither type of bankruptcy pro- duced an above market rate of return since the returns for both groups are nega- tive. While both strategic and non-strategic bankruptcies result in negative returns, there may be some subgroups of strategic failures which create positive returns. In order to investigate this possibility the one way Analysis of Variance (ANOVA) shown in Table 5 was performed. Fall 1995 Sheppard: Strategic Bankrupties 113 Table 5: ANOVA Results Using Four Clusters of Strategic Bankruptcies STRATEGIC SHAREHOLDER RETURNS BANKRUPTCY TYPES N Mean Std.Dev. ANOVA Results Capital Providers 26 -0.921 0.968 F Statistic= 3.242 (p < .05) Government 7 -1.221 0.201 Scheffe Procedure Press 12 -0.918 1.256 Contrasts (p < .05) Misc.lLegal Issues 10 0.731 1.547 Misc.lLegal #- Capital Provider The results of the Scheffe procedure shown in Table 5 demonstrate that the firms which filed for a strategic bankruptcy when dealing with a Miscellaneous / Legal Issue had significantly different returns from those firms dealing with capital providers (p <.01). While the Miscellaneous / Legal Issues group was the only one in which there were positive returns to shareholders, the ANOVA does not tell us whether the rate of return was significantly better than what could have been achieved in the market over the same time frame. To investigate whether this group of strategic bankrupts performed at better than the market rate, a pairwise T-test comparing average shareholder returns to average market returns was performed. Although firms in this group, on average, out-performed the market rate of return, the difference was not significant (pairwise T of 1.36 was not significant at .1). Within the Miscellaneous / Legal cluster, only firms fend- ing off a single lawsuit had returns significantly higher than market (p < .01 via pairwise T-test comparing average shareholder returns to average market re- turns). Very few strategic bankruptcies had higher than market rates of return. Many categories within the set of strategic bankruptcies had lower than market rates of return 6 . Thus, one is tempted to discard the idea of Chapter 11 filing as a use- ful strategic ploy. However, it is possible that effective use of bankruptcy as a strategy may be contingent upon some other factors. To address this possibility, a final test was run. Other Possible Conditions That May Impact Investor Returns To investigate the possible impact of other factors related to returns from bankruptcy, two variables were studied: (1) the firm's size at filing, and (2) the 114 Journal ofBusiness Strategies Vol. 12, No.2 company's equity at filing. While this list is not exhaustive, given the explor- atory nature of the present research, it should be a sufficient starting point from which to evaluate some contingencies which might suggest that the use of stra- tegic bankruptcy can lead to positive shareholder returns. Corporate Size Firm size has been identified as one of the most important variables that im- pact the relationship between strategy and performance (Hoffer, 1975; Smith, Guthrie and Chen, 1989). Moulton and Thomas (1993) found that firm size was the most important variable in determining whether companies successfully reor- ganized. Firm size has long been recognized as an important determinant for organizational survival in the Population Ecology literature (for a review see Singh and Lumsden, 1990). As well, Finance literature has long been concerned with attempting to control for firm size effects in failure studies due to the impact firm size may have on survival likelihood (e.g. see Altman, 1968). While it is thus important to include size as potential factor in determining the outcome of a Chapter 11 filing, the direction of the relationship between firm size and survival is debatable. Large firms are typically viewed as more likely to be successful. Moulton and Thomas' (1993) research showed that large firms are more likely than small firms to survive Chapter 11 reorganization intact. The likelihood of failure among small firms is well known in the Population Ecology literature as "the liability smallness" (Singh and Lumsden, 1990). However, small- ness may not always be a liability. A small firm may have the advantage of quicker response to environmental change, because smaller firms may be orga- nized in a less mechanistic manner and their response to external threats may thus be quicker than that of a larger organization (Staw, Sandelands and Dutton, 1981; Sutton and D'Aunno, 1989). In order to be consistent with Moulton and Thomas' (1993) study, the mea- sure of size employed here was firm asset size. The list of 155 sample firms was divided into small versus large firms. Small firms had less than the median $49 million in assets; large firms had more than the median $49 million in as- sets. Company Equity Company equity may also impact a company's response to threats. Equity can be considered a form of "organizational slack" (Sheppard, 1994b). Firms lack- ing slack resources may be more likely to encounter managerial paralysis or ri- gidity (Smart and Vertinsky, 1977; Staw, et. aI., 1981) when the need for change is critical - as it is in reorganization. If such rigidity occurs, shareholder value will be dissipated since it is unlikely that management will make timely deci- sions that could halt the company's downward spiral in its earlier stages (Hambrick and D' Aveni, 1988). In addition, part of the logic behind the enactment of the Fall 1995 Sheppard: Strategic Bankrupties 115 1978 bankruptcy law was to encourage companies to file earlier, while they still had some equity from which to rebuild the firm (Cifelli, 1983). If Congress was correct in its estimation that early filing companies are the ones with sufficient equity bases to survive bankruptcy, then equity would be an important variable in determining reorganization success likelihood. The ratio of equity over total assets was used as the measure of a firm's resource base. For financial institutions, net worth over total assets is also a gen- eral indication of solvency (Mun and Garcia, 1983). Pinches and Mingo (1973) and Chen and Shimerda (1981) also mention this ratio as an important, useful one. Therefore, the list of 155 firms was divided into low versus high equity firms. Low equity firms had less than a median equity to asset ratio of 9.1 %; high equity firms had more than a median equity to asset ratio of 9.1 %. Test of the Impact of Size and Equity Base To evaluate how the two factors of size and equity base - along with strat- egy - impacted the returns provided to shareholders, an ANaVA was performed. Results of the ANaVA are shown in Table 6. Table 6 also notes the group which had the highest returns within each category. These high return groups would most obviously be preferred by shareholders (detailed returns for all groups are included in Appendix 3). Table 6: ANaVA Results by Type of Bankruptcy, Size, Equity and Corporate Purchase ANOVA Annual F -Statistic Highest Return Group Results Shareholder Returns F Sig. Group N Mean Main Effects 8.22 .001 Strategy 9.29 .010 Strategic 55 -1.17 Bankruptcies Size .03 Large 77 -2.62 Companies Equity 5.91 .020 High Equity 77 -2.18 Companies 116 Journal ofBusiness Strategies Vol. 12, No.2 Table 6: AVOVA Results by Type of Bankruptcy, Size, Equity and Corporate Purchase (cont'd) ANOVA Annual F -Statistic Highest Return Group Results Shareholder Returns F Sig. Group N Mean Two-way Interactions 1.26 Strategy and Size 0.03 Strategic I Small 19 -0.88 Strategy and Equity 3.62 .060 Strategic I High 28 0.53 Equity Size and Equity 0.07 Large I High 37 -1.70 Equity Three-way Interactions 0.57 Strategy, Size and Equit Strategic / Small 11 1.07 High Equity The ANOVA results show that the main effects were significant (p <.001). In particular, there was a statistically significant relationship between annual share- holder returns, strategy and equity base (p <.05). Corporate size was the only factor not significantly related to returns. Although strategic bankruptcies, large companies and high equity companies all fared well, none of these groups, on average, had returns that exceeded the market rate of return (as shown by their negative return figures), The two-way interaction between strategy and equity in the ANOVA was of minor significance (F = 3.62, p <.1). Each two-way interaction creates four pos- sible sub-groups. Thus, strategy and equity create: (l) low equity, non-strategic bankruptcies, (2) low equity, strategic bankruptcies, (3) high equity, non-strategic bankruptcies and (4) high equity, strategic bankruptcies. Thus, Table 6 also shows which sub-group had the highest returns for each interaction. As shown in Table 6, Strategic I High Equity companies had positive - above market - returns to shareholders. However, a pairwise T-test comparing average shareholder returns to average market returns showed that the returns these for these sub-groups of bankrupt companies were not significantly greater than the market rate of return over the same period (p <. I). Three way interactions in the ANOVA were not significant (p <. I ). Fall 1995 Sheppard: Strategic Bankrupties. Results Summary 117 Generally, the results of the present study show that strategic bankruptcies out-perfonn their non-strategic counterparts. Impacts from other factors are shown in Table 7. Table 7: Summary of Results ! Shareholder Return for Results Comments all Strategic Bankrupt- cies Did finns filing for stra- Yes T-test shows a significant dif- tegie bankruptcy have ference between the two A higher rates of return groups (p < .05). than non-strategic finns? L Did finns filing for stra- No The mean fQr strategic bank- L tegie bankruptcy have ruptcies wa·s below the higher than the market market rate of return. rate of return? Shareholder Return by Strategic Bankruptcy Type Did any types of stra- Yes ANOVA Scheffe Procedure T tegic bankruptcies have Contrast rate Misc. I Legal :t: higher rates of return Capital Provider (p < .05). Y than other types? P Did any types of stra- One Misc. I Legal had positive tegic bankruptcies have returns, but not signifIcant E higher than market rates (pairwise T: p < .1) of return (one small Misc. I Legal Issues finns group) trying to avoid 1 lawsuit had significantly higher than market returns (pairwise T: p < .01). 118 Journal of Business Strategies Table 7: Summary of Results (cont'd) Vol. 12, No.2 Other Impacts on Results Comments Shareholder Returns Was there a firm size / No Not significant return relationship? (ANOVA F: p < .1). a Were there significant None Not significant interactions with size? (ANOVA F: p < .1). T Was there a tirm equity / Yes Positive significant H return relationship? (ANOVA F: p < .05). E Were there significant Strategic / High equity strat. filers out interactions with equity? High Equity performed others significant R (ANOVA F: p < .05). Did any sub-groups None No group mean had a sig- based on strategy, size nificant improvement over and equity out-perform market (pairwise T: p < .1). the market rate of return? (High Equity Most significant improvement Misc. / Legal) over market for sub-group, pairwise T == 1.87: p < .12. In general, Table 7 shows that a larger firm equity base can help sharehold- ers realize more of their investment. Size does not significantly impact these other factors. In any case, only very rarely did shareholders of bankrupt firms realize returns that were greater than the market rate. This result was generally true for both strategic and non-strategic bankruptcies. Discussion Shareholders can make high rates of return in the year following a Chapter 11 filing according to Sirower (1991). The present study looked at the longer run return to shareholders - more than five years. In theory, management shotlld be managing the company for the long run benefit of the shareholders (Hax and Majluf, 1984). Did Chapter 11 bankruptcy - particularly strategic bankruptcy - aid shareholder returns? Were there other conditions that may have helped shareholders earn higher long run returns? Fall 1995 Sheppard: Strategic Bankrupties Synopsis of the Results 119 Generally, Chapter 11 filers are poor long run investments. If one invested equal amounts in each of the 155 companies studied here in the month they went bankrupt, the return on investment would average substantially below what one could have obtained by investing in long tenn risk-free investments during the same time period. Given the risk involved in investing in these types of firms, the long-run return is very low. Strategic bankruptcies, in general, had below market returns. Only single lawsuit cases had significantly higher returns than market. In the single lawsuit cases, investors may have simply over-estimated the ability of the main creditor to press its claims against the debtor where the debtor was about to file for Chap- ter 11 reorganization. Possibly, the fact that the solution to the finn's problems was simple and obvious (re-negotiate the amount of the claim down to an amount the company could afford to pay) that it could be dealt with in a far more easy and legally inexpensive way than investors would have predicted. Size and reorganization success were found to be strongly related to one an- other in Moulton and Thomas' (1993) work. They defined successful reorganiza- tions as those where the firm maintained its identity, continued to be publicly traded on a national exchange and kept at least half its pre-bankruptcy assets. The firms with the highest returns in the, present study - Lafaytte Radio and Sam Soloman - would not have qualified as even partially successful compa- nies for Moulton and Thomas. Both finns were sold: Lafaytte to Circuit City and Sam Soloman to Service Merchandise. The difference in results between Moulton and Thomas' study and the present one may be the result of the differ- ences in how one defines success. In other words, size may be important in allowing a firm to keep its identity, but it has no effect with regard to maximiz- ing shareholders' returns. There is another way this difference between survival and returns may im- pact the results. Large size may cause higher numbers of firms with low average returns to survive. Small firms may be less likely to survive but those that do could have higher average returns. This is in fact the case with the present study. While shares in 69% of small'firms became worthless, only 44% of shares in large firms became worthless (as shown in Appendix 4, cross-tabs Ch/ of 8.93 is significant at .01). Among the non-worthless firms, large firms had a some- what lower annual return to shareholders than smaller firms (though not signifi- cantly so). Small firms had an annual return of - .3 and large firms had an an- nual return of -1.03. Why might this happen? Large companies may have the reputational capital to insure proper funding support (D' Aveni 1989) but their relatively more mechanistic structures (Staw, et al., 1981) may cause great delay in their developing of plans that could stop the downward spiral of decline soon after their filing (Hambrick and D' Aveni, 1988). These firms thus have substantial organizational inertia which better insures their existence but inhibits their ability to change (Hannan and Freeman, 1984). This 120 Journal of Business Strategies Vol. 12, No.2 would be so even when they are under extreme pressure to change (Zajac and Kraatz, 1993) - as is the case in a bankruptcy filing. Thus, these firms pro- duce relatively poor average returns. Conversely, small firms may lack reputational capital to insure proper fund- ing (D'Aveni, 1989) but they may be able to change more quickly due to more organic structures (Sutton and D' Aunno, 1989) and lower organizational inertia (Hannan & Freeman, 1984). Also, small firms may be able to attract new inves- tors who can purchase sufficient equity in the company so that old management can be forced out. This situation would not only provide new capital for a fresh start but also allows the company to bring in people better able to develop new strategies (Slatter, 1984) to break the firm free of its downward spiral (Hotchkiss, 1995). So, it is evident that fewer small firms survive, but the ones that do have higher returns. The net effect is that the average return among these firms will be poor due to the significant number of worthless ones. Thus, the inertial forces which aid the large firm's survival (e.g. reputational capital) are balanced out by those which hinder change (e.g. mechanistic struc- tures). Likewise, inertial forces which defeat the small firm's survival (e.g. lack of reputational capital) are balanced out by those which promote change (e.g. organic structures). Equity was found to be far more important than size in aiding positive share- holder returns. The impact of equity on returns likely stems from two sources. One is the simple point that a stronger equity base is a foundation upon which a restructured company can be built (Sheppard, 1994a). Two, equity allows share- holders some ability to pursue their claims against the company. If there is little to no equity in the company, shareholders fail to be "real parties in interest" at filing (Sabin, Neporent and Weiner, 1991). Without equity, courts could, in theory, block the rights stockholders may have in the bankruptcy proceedings - includ- ing the rights to any claims on the firm or its assets (Sabin, et. al., 1991). Thus, higher levels of equity may simply serve to allow shareholders to better main- tain their claims against the compan/. The interaction of equity and strategy was found to be significant in aid- ing positive shareholder returns. Flynn and Faird (1991) argued that there are circumstances under which early bankruptcy filing may be the best way to maxi- mize shareholder wealth. The present study found that shareholders of strategic early filers - i.e. firms with high equity, filing a strategic bankruptcy - achieved positive returns. However, since the returns were not significantly above the market rate, there is relatively weak support for early filing. This result leads to two questions. One, why was there any effect from the equity I strategy interac- tion on returns? Two, why were these effects not more significant? There are two points to remember. One, a strategic bankruptcy is invoked to proactively deal with a single threat from an identifiable stakeholder group (Daily, 1994). By nature, the strategic bankruptcy is an expedient device to deal with a relatively simple problem (e.g. the threat posed by one lawsuit). Two, the presence or absence of organizational slack (Cyert and March, 1963) in the Fall 1995 Sheppard: Strategic Bankrupties 121 form of equity base (Sheppard, 1994b) alters the organizations' response to threats. Bozeman and Slusher (1979, 346) note that "Scarcity-induced stress causes orga- nizations to behave as if complex, dynamic and interrelated environments are in fact simple, static and unrelated." So, the forces at work are: (1) the simplicity of the problem and (2) the resource base available to deal with the problem. High equity strategic filers would therefore be under less stress due to higher levels of resources (Staw, et. al., 1981). Yet, like many firms in crisis, they would respond by restricting in- formation gathering and alternatives (Smart and Vertinsky, 1977). By doing so, they quickly focus on the simple and obvious solutions to what may be simple and obvious problems 8 • This appropriate response is in contrast to low equity non-strategic filers. These firms would be under more stress due both to a scar- city of resources and a set of problems and solution alternatives that taxes their information processing capabilities (Staw, et. al., 1981). By restricting informa- tion gathering and alternatives, such companies would be less likely to be come to decisions which would allow them to properly allocate resources and break free of their downward spiral (Argenti, 1986a and 1986b; Hambrick and D' Aveni, 1988) Why would equity and strategy not result in returns to shareholders signifi- cantly above market? It is possible that either (1) investors could not correctly estimate the corporation's likelihood of Chapter II filing or (2) they could not correctly estimate the effects that the filing would have upon their investment. In the first case, the filing might have taken investors by surprise and any pos- sible impacts (positive or negative) from filing may not have been factored into the price. This is unlikely since there are many early warning signs of failure that investors could have identifed (e.g. see Argenti, 1986a and 1986b). It is more likely that the investors incorrectly estimated the outcome of the bankruptcy process for firms in this category. Being uncertain of how the courts would in- terpret the new bankruptcy statutes, investors could not have correctly estimated the value of the stock. Implications for Practice What do these results mean for investors of companies facing a Chapter II filing? First, investors should, in general, avoid these stocks as long term in- vestments. The average return on investment here was substantially below the risk-free rate. Second, the presence of a high return category of strategic bank- ruptcy indicates some limited opportunity for significant returns above the risk free rate. Miscellaneous I Legal strategic bankruptcies may provide investors with a positive return - particularly in cases where the company is attempting to use Chapter II to defend itself against the impacts from a single lawsuit. However, the positive returns found here may be fleeting. When the bankruptcy law was new there may have been uncertainties regarding how the law would impact some types of filings. The price may have been distorted as to allow for some posi- 122 Journal of Business Strategies Vol. 12, No.2 tive returns. With investors having better knowledge of how the bankruptcy process works, the price distortion, along with possibilities for positive returns, may be gone. Finally, company size does not matter for the investor seeking high returns but for managers seeking corporate survival. Managers should be aware that early filing is advantageous. Thus, as soon as managers realize that filing is inevitable, it is in the best interest of share- holders that it is done expeditiously. This outcome holds particularly for com- panies with a high equity base and problems that Chapter 11 can easily address (i.e. early filing strategic bankrupt companies). These companies may be best at achieving some sort of positive outcome from the bankruptcy process for their investors. The high returns for such filings may also suggest that there are cir- cumstances where the threat-rigidity response may work in favor of an organiza- tion in crisis (as suggested by Staw, et. aI., 1981). As previously suggested, such a response would serve to simplify the set of alternative problem solutions under circumstances where such simplification is most appropriate and resources for implementation still exist. Finally, managers of smaller firms going into Chapter 11 should not be totally disheartened - provided their company was a strategic early filer. Though not significantly better than the market, small companies with early filing of strategic bankruptcies had the best rate of return. Limitations As in all studies, there are some limitations to the present research which must be discussed. These include factors regarding definition, sample composi- tion and time period studied, alternatives that may have served Chapter 11 filers better, and learning by investors or courts after the period of study. The definition for strategic bankruptcy used here is a broad one and a nar- rowly-defined one may give different success results. However, a narrower defi- nition may not cover as many possibilities open to managers who wish to pur- sue strategic bankruptcy. Also, given the sample size available, a narrow defini- tion would not lend itself well to testing. Also, different interpretations of the available data might have resulted in different firm classifications. The explor- atory nature of the present study did not allow for a more complete search of all possible data sources. Sample composition may have also had an impact on the results. The mini- mum size and age limits set for sample firms could mean that younger or smaller firms may be at greater risk than the present analysis indicates. Hambrick and D' Aveni (1988) note this possibility as well. There are two important items of note about the time period selected. First, in an effort to ensure firms made it through their Chapter 11 proceedings, no firms which initially filed after 1987 were included in the study. Since prepackaged bankruptcies, or "pre-packs" are a new twist to Chapter 11 in the last five years there are no pre-packs in the sample. The success likelihood of this particular category of strategic bankruptcies will thus require further study. Second, some Fa111995 Sheppard: Strategic Bankrupties 123 firms re-entered bankruptcy after 1987 but have not yet come out of Chapter 11. Such firms were considered to be worthless since there was likely little that would be left for shareholders after a second round of Chapter 11 proceedings - though the full impact of the second filing is unknown. Less than 5% of the firms in the sample were second filings after 1987. 9 Alternatives that may serve shareholders better than Chapter 11 may exist. Returns to investors in companies that managed turnarounds or arranged work- outs with their creditors versus returns to shareholders of companies that filed were not studied. For this reason, early or strategic filing cannot be wholeheart- edly supported. For example, it is unknown how well a company could have done with a debt-for-equity swap as opposed to a Chapter 11 reorganization. Learning by investors may change opportunities for future profitable share- holder returns. The results of the present study may simply demonstrate the fail- ure of the market to price the stock correctly at filing. This failure may have occurred since investors had to deal with a new law (the 1978 Bankruptcy Act) that had yet to be interpreted. As bankruptcy case law has built up over the years, investors should have improved their ability to evaluate good strategic bank- ruptcies. The opportunity for excess returns may have been a fleeting one brought on by a change in the law. In the future, investors may have to look for some new revisions to find future positive returns. Also, the courts may interpret the law more narrowly in the future. For example, if the bankruptcy courts begin to lean toward the plaintiffs side in mass tort or single lawsuit cases, the parts of the broken bench which seemed beautiful may instead provide investors with some painful splinters. Directions for Future Research Several avenues for future research present themselves as a result of the present study. These inquiries would deal with returns regarding specific types of bankruptcies, alternatives to bankruptcy, organizational response to the Chap- ter 11 filing, and learning by investors. The present study found the value of strategically filing for bankruptcy in general to be questionable. However, research into the category of Miscellaneous / Legal strategic bankruptcies, high equity strategic bankruptcies, or pre-packaged bankruptcies may be fruitful avenues for looking into circumstances where Chapter 11 could enrich shareholders. Of particular interest may be the returns to share- holders when the firm is merged into another after Chapter 11. The firms with the highest shareholder returns in the present study fell into this category While it was beyond the scope of the present study, investigation into the returns to shareholders of declining corporations that sought to move away from ruin by other methods may prove an interesting area of study. For example, a financial restructuring or workout arrangement with creditors may have provided better returns for shareholders. 124 Journal ofBusiness Strategies Vol. 12, No.2 The organizati