Excess Returns to Troubled Debt Restructurings:the Size/Book-to-market Effect or Unexpected Benefits?

Mine H. Aksu*Sabanci University , Istanbul, Turkey

This paper examines the excess returns to financially distressed firms that attempt to restructure their

debt privately with their creditors. As suggested by the economics of the restructuring transaction and option

pricing theory, significantly positive announcement and post-announcement excess returns accrue to

shareholders as their firms renegotiate. In line with the net benefits/information hypothesis, the announcement

provides an unexpected, favorable signal that is stronger for larger firms whose financial distress has already

been disseminated. The finding of an anomalous-signed, positive (negative) size (book-to-market) effect

confirms that the abnormal returns are not an artifact of the size and book-to-market effects on returns.

Key words: debt restructuring, financial distress, size, book-to-market ratio, information markets

JEL classification: G14, G33

** Graduate School of Management, Sabanci University, 34956 Orhanli/Tuzla, Istanbul, Turkey. Phone: +90(216)483-9678; Fax: +90(216)483-9699; e-mail: maksu@sabanciuniv.edu

I. Introduction

As a distinct stage in the financial distress continuum, troubled debt restructurings (TDR)1 have been

acknowledged as viable, less costly alternatives to formal reorganizations under Chapter 11 (Haugen and Senbet,

1988; Gilson et al., 1990; Brown et al., 1993; Franks and Torous, 1994; Chatterjee et al., 1995). However, prior

market based research has consistently found a negative or insignificant market reaction to various financial

distress related announcements, including TDR. Since their objectives were different, these studies on TDR have

used (sub)samples that were either too narrow, small, or non-homogeneous, resulting in findings that

ambiguous in terms of the overall market reaction to a TDR announcement. 2

For example, Brown et al. (1993) and Chatterjee et al. (1995) examine, respectively, exchange offers and

tender and exchange offers of only public debt and find a positive market response only in some of their

subsamples. Aintablian and Roberts (2000) investigate the market reaction in a subsample of only 18 debt

restructurings within an overall sample of 122 new loan announcements and renewals. Since the focus of the

Gilson, John, and Lang (1990) and Gilson (1990) studies is to investigate the choice between private and legal

forms of restructurings in financially distressed firms, their sample consists of a heterogeneous group of poorest

performing CRSP firms that have announced a debt service default, out-of-court restructuring, or bankruptcy

within a year of a restructuring attempt. They report negative, but significantly different excess returns for

private workout firms that subsequently file for bankruptcy and those that do not. This heterogeneity in their

sample has made it hard to infer whether their results are driven by the firms’ TDR, their prior default, their

subsequent bankruptcy, or the fact that they are firms with inherently poor earnings prospects. As a result,

whether a TDR announcement is associated with an overall increase in shareholder wealth is an empirical

question that has not been clearly answered yet. Furthermore, none of the market based studies on TDR have

11. In this study, a TDR is defined as an out-of-court contractual concession given by public/private creditors to their financially distressed debtors in the form of a private workout. It involves a debt reduction or delay via: a) a modification of the terms of the debt contract such as an extension of the maturity date or a reduction in the principal, accrued interest or interest rate, or b) an exchange of the debt with assets or equity at less than its carrying value.

22. Considering that not all TDRs are alike, prior market-based research on TDR has examined return differences associated with the success (successful or unsuccessful) of the restructuring attempt (Gilson et al. 1990); the identity of lenders (public or private) and the change in the priority of claims offered (Brown et al. 1993); the type of security offered in the exchange (cash, debt or equity) (Chatterjee et al. 1995); and the outcome (bankrupt vs. non-bankrupt, consummated vs. unconsummated) and type (according to FASB’s classification of TDRs as modifications vs. full-settlements) of the TDR attempt. The first part of this study, on the other hand, investigates the overall perceived net present value of a, so to say, generic TDR transaction.

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tested or controlled for the size (market value of equity-MVE) and book-to-market equity (BTM) anomalies in

returns that are confounding return factors, especially in studies on financially distressed firms (see e.g., Fama

and French, 1993-1998).

The main objective of this study is threefold: (1) to measure the overall market response to an average first-

time TDR announcement and the returns to shareholders over the restructuring interval; (2) to investigate if the

observed abnormal returns are related to the firm-size and/or BTM effects on returns; (3) to assess the

informational source of the gains to shareholders by exploiting the ambiguity in the expected market reaction in

TDR firms of different sizes and BTM.

For the first inquiry, this study specifically isolates financially distressed debtors that have announced their

first-time intention to privately restructure their debt. A positive market reaction is predicted based on the

economic implications of a restructuring transaction and the option pricing theory, which suggest that a privately

negotiated debt reduction or delay relief is informative and beneficial to the debtor firm. Under this net

benefits/information hypothesis, a positive market response is attributed to: (i) the perceived cash-flow implica-

tions of the benefits of a TDR in excess of its costs and (ii) the "surprise" nature of the announcement leading to

a favorable change in expectations about these firms’ prospects. Market reaction tests performed on both the

TDR sample and a matched sample of non-TDR, non-bankrupt firms indicate that the market reaction is positive

and that shareholder wealth gains continue during the post-announcement restructuring interval.

The second inquiry is related to the confounding return factors that need to be controlled for in market-based

studies that investigate long-term returns, especially those on financially distressed firms. Prior research has

provided considerable empirical evidence that MVE and BTM are the two firm characteristics that best explain

the variation in average stock returns and that small capitalization, high BTM “value” stocks earn

higher returns than large, high priced “glamour” stocks, both in the US and abroad (see

for ex., Fama and French, 1993; Barber and Lyon, 1997, Pontiff and Schall, 1998; Fama, 1998). A compelling

argument for the size and BTM anomalies in returns has been that they are proxies for additional risk factors that

covary with financial distress (Chan and Chen, 1991; Fama and French, 1992, 1993, 1995; Lewellen, 1999).

Hence, the higher returns to TDR firms that are, on average, small-to-medium size risky firms with high BTM

ratios, may just be compensation for their higher systematic risks. Accordingly, I also evaluate the size/BTM

hypothesis, the null hypothesis for the confounding effects, to corroborate that the excess returns are due to the

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announcement and net benefits of TDR and not these ex-ante firm characteristics, which were neither tested nor

controlled for in prior studies on TDR. To evaluate the sensitivity of the observed market response to these

competing explanations, I explicitly investigate size and BTM related patterns in the time series of excess returns

in the TDR and control samples and in cross-sectional multivariate regressions. The results confirm that the

positive excess returns are not a spurious result of the misspecification of the one-factor expected return

generating model which fails to account for these additional risk factors.

In addition to its use as a control for confounding effects, the size/BTM related cross-sectional analysis also

helps in assessing the informational source of the shareholder gains. As mentioned above, the return anomalies

literature has found that size has a negative relationship with financial distress and with returns. On the other

hand, prior research has also observed a positive relationship between size and both pre-announcement

information availability and equity deviations from absolute priority rule (APR) in favor of equıty, which are

also expected to effect the returns to TDR firms.3 I exploit this ambiguous relationship of size with returns to

further test the above mentioned two competing groups of hypotheses. Under the null hypothesis for the

confounding effects, one would expect to find a stronger size and BTM effect on returns in the smaller, more

marginal firms and a negative (positive) coefficient for the size (book-to-market) variable in the cross-sectional

regressions of excess returns, in both the TDR and control samples. On the other hand, higher deviations from

APR, observed more often in private, rather than legal, restructurings and in larger firms than smaller ones

(Franks and Torous, 1994), suggest greater wealth transfers to equity in larger TDR firms. Furthermore, since

size also proxies for the extent to which firm-specific information is disseminated (Atiase, 1985), a TDR

announcement may be perceived as an unexpected, favorable signal for larger TDR firms whose financial

distress is more likely to have been disseminated prior to the announcement. These information and APR

violation arguments lead to the expectation of an anomalous-signed positive size and negative BTM effects in

the TDR sample. Indeed, I find an anomalous-signed size and BTM effect in only the TDR sample and higher

excess returns to TDR firms with larger pre-announcement price declines and other publicized distress signals.

The results support the net benefits/information hypothesis.

The study has several contributions. First, the finding of positive excess returns for a clean sample of TDR

firms adds to the literature on the "benefits" of financial distress (Jensen, 1989) and private workouts as an

optimal way of coping with financial distress. Second, the effect of size, BTM, and prior distress information on

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the returns to TDR firms is tested for the first time in literature. The overall market response and the

size/BTM/information related cross-sectional differences are useful to investors who want to invest in

financially distressed firms and to any other stakeholder groups such as the employees, unions, auditors, and

lenders. Finally, the finding of a negative pre-event excess returns (CAR) followed by a persistent positive post-

announcement CAR adds a new event to the medium-term return anomalies literature.

The rest of the paper proceeds as follows. Section two discusses the expectations about the direction of the

market reaction and generates the testable hypotheses. Sample selection, design and methodology issues are

covered in section three. In section four, the financial characteristics of and the excess returns to the sample of

TDR firms are compared with those of the control sample. In section five, the market response in size/BTM

related partitions of the TDR sample is examined and value-relevance of prior distress information is extended

as an explanation for the observed anomalous-signed size and BTM effects. Additional sensitivity tests are also

performed by regressing the excess returns on size and book-to-market ratio, conditional on the firm being a

TDR or control firm. The final section summarizes and discusses the results.

II. A priori expectations and the derivation of the specific hypotheses

The economic consequences of a debt restructuring transaction, the option pricing theory and prior research

on TDR motivate the following testable hypothesis, expressed in the alternative form:

H1: On average, positive excess returns accrue to the shareholders of a debtor TDR firm upon the announcement of a first-time TDR attempt.

A. The Economic Substance of Private Workouts

The announcement of a TDR may embody two conflicting signals about a debtor’s prospects. Although a

TDR is a timely and unequivocal signal of financial distress with its direct and indirect recontracting costs

(Weiss, 1990; Gilson, 1997), the firm has revealed positive information that, at this stage, it is not going to file

for bankruptcy. Furthermore, the debtor is the beneficiary of the TDR transaction. Upon consummation of the

restructuring, the outstanding debt is exchanged with assets or securities that have a lower fair market value than

its current carrying value or the contract terms are favorably altered such that the present value (PV) of the debt

is reduced. As a result, debt-service related cash flows are improved, debt which has reached non-optimal levels

is reduced, and an economic gain is involved. An efficient market should incorporate these favorable changes in

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assessing the solvency, financial flexibility, and the probability of bankruptcy of a TDR firm as of the

announcement date. To the extent that the expected value of the positive information revealed to the market

outweighs the negative information, firm value is expected will increase.

B. Equity's Call Option on the Firm's Assets

The shareholders of financially distressed TDR firms may either abandon their assets or choose their option

to remain a going-concern and adapt their assets to higher return uses. In the latter case, if the creditors have the

incentives to let them continue as residual claimants, a private workout is negotiated.4 A TDR can then be

viewed as an option that favorably revises the terms of the initial contract on the firm's future cash flows. The

effect of a TDR on the market value of outstanding equity and debt claims can thus be analyzed more formally

within the framework of the general option pricing model (Black and Scholes, 1973), where the value of equity

(S) is expressed as a function of the value of the underlying firm assets (V), the standard deviation of their

returns (σ), the face value of the debt (B), the risk-free interest rate (rf), and the time to maturity (T). Despite its

limitations and simplicity, Galai and Masulis (1976) comparative statics analysis is used here to predict the

effect of different types of TDR undertaken by the sample firms on the variables of the model, S = s(V,T,B,σ): 5

δs δs δs δs δs 0 ── 1, ── <0, ── >0, ── >0, ── > 0 (1) δV δB δrf δσ δT

Since TDR firms are highly leveraged, the probability that the market value of the assets will exceed the face

value of the debt is low, making the value of equity insensitive to changes in the value of the assets. The first

partial implies that to the extent the concessions given by creditors reduce the PV of outstanding debt, the

proportion of the change in the value of the assets captured by the stockholders is expected to increase.

A common contract revision is the reduction in the principal owed (B) through debt exchanged with

equity, new debt or assets that have a lower market value than the face value of the canceled debt. Indeed, 55%,

41%, and 38% of the 86 sample firms restructured some debt in these respective categories. The second partial

implies that there will be more asset value left for the stockholders as (B) decreases. Another concession is the

extension of the maturity date which has a a similar value increasing effect on S since it reduces the PV of the

outstanding debt. 68% of sample firms had some debt whose principal or interest payment dates were

postponed. An increase in the risk-free rate, rf, should also have a positive (negative) effect on the value of

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equity (debt). Another type of TDR allows a reduction in the contractual risk adjusted interest rate (ra), and 6%

of the sample firms restructured some debt in this manner. A reduction in the nominal rate is considered here as

a proxy for an increase in rf since both would reduce the risk premium and hence the return to lenders. Finally,

given the stockholders' limited liability, (σ) allows for the possibility of payment to stockholders even when

expected returns from assets are not sufficient to cover (B). Furthermore, (σ) becomes a more important factor

in pricing in firms with higher default risk. Since this variable is unobservable, the change in the standard

deviation of the market adjusted returns as a result of the announcement is used here as a proxy. This measure

increases from 0.00532 in the 300-day estimation period to 0.00683 in the (-3,+40) event window, about twice

the increase in the control sample. Given the assumption that the firm's asset value is independent of its

capital structure, the partial effects on debt will have the opposite signs. Hence, these changes in the variables of

the call option are also expected to lead to a wealth transfer from creditors, consistent with APR violations

observed in both private and legal restructurings. 6

C. Prior Empirical Research on Private Workouts

There is ample evidence that a TDR is beneficial to the shareholders of a debtor firm. Aksu (2004) discusses

the implications of several other valuation theories based on cash-flows, earnings, book-value, and leverage, the

fundamental variables directly effected by the TDR transaction, to predict the positive effect of a TDR on firm

value and to motivate the market reaction and value-relevance tests. Several studies have found that the direct

and indirect cost of a private workout is lower than that of a Chapter 11 reorganization (see, e.g., Jensen, 1989;

Gilson et al. 1990; and Franks and Torous, 1994). Furthermore, although the announcements of covenant

violations, defaults and bankruptcies are unambiguously associated with significant negative abnormal returns

(see, e.g., Beneish and Press, 1995; Gilson et al., 1990; Clark and Weinstein, 1983), Gilson et al. (1990) report

still negative, but significantly different excess returns for TDR firms that have and that have not filed for

bankruptcy within a year. Brown et al. (1993) and Chatterjee et al. (1995) find positive excess returns in about

half of their subsamples. Finally, Franks and Torous (1994) find higher APR deviations in private restructurings

(9.5% of firm value), compared to formal ones (2.3%).7

Gilson et al. (1990) is the only study known to the author that has measured the average market response to a

TDR announcement. They investigate a debtor firms' incentives to choose between private and legal forms of

TDR during the 1978-1987 period. As relative restructuring costs, they report negative, but insignificant, 2-day

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announcement wealth losses of -1.6 % to -3 % in their successful TDR sample and -6.3 % to -8.7 % for their

unsuccessful control firms that file for Chapter 11 within a year. I attribute the difference between the results of

the two studies to their different objectives and, thus, different samples. Given the authors' choice of the

comparison sample, i.e., TDR firms that file under Chapter 11, their conclusion that stockholders fare better in

private workouts than in bankruptcy is not surprising, and they themselves note that the larger price declines in

their bankrupt sample may be due to a selection bias if these are the firms with lower earnings prospects. Also, it

is likely that their results are downward biased due to their announcement day and sample selection procedures.8

Again with a different focus, Brown et al. (1993) and Chatterjee et al. (1995) compare the market reaction in

different subsamples of restructuring firms. The former study finds a significant positive (negative) market

reaction when public bondholders are offered senior claims (junior claims) and when banks are offered junior

claims (senior or secured position). Even though their overall sample is more homogeneous, it includes firms

that subsequently file for bankruptcy and waivers of covenant violations that are, at best, implicit restructurings.

They have both initial and subsequent TDR attempts in their sample and their “clean announcement” subsample

is too small. Chatterjee et al. (1995) investigate the holdout problem in public workouts and find significantly

positive (negative) announcement excess returns for only tender (exchange) offers.

None of these studies have tested for or found a significant positive overall market reaction to a TDR

announcement. Furthermore, they have not controlled for the likely exposure to size and BTM factors which

may account for the observed return differences. For instance, the Brown et al. (1993) finding of a positive

market reaction when private lenders exchange their debt with stock may well be due to the size effect rather

than the identity of lenders and priority changes. Their descriptive statistics indicate that the firms that

restructure their bank loans are smaller than firms that undergo public exchange offers. Franks and Torous

(1994) explicitly state that their results are based on the assumption that their subsamples do not systematically

differ in size.

D. Expectations on the Effect of Size, BTM, and Prior Distress Information

In this study, MVE and BTM are used as proxies for the ex-ante firm characteristics that are likely to impact

the returns to TDR firms. They are used to control for the size and BTM effects in returns, regardless of what the

explanation for these anomalies might be (i.e., the size/BTM hypothesis), while the net benefits to shareholders

and the effect of prior distress information availability (i.e.,the net benefits/information hypothesis) are tested.

7

These two hypotheses are mutually exclusive in the sense that similar values of size and BTM predict different,

in fact, reverse return patterns under the two hypotheses.

As discussed above, there is a well-documented negative (positive) relation between size/BTM and average

returns and these two explanatory variables are linked to firm fundamentals. Thus, the excess returns to the

sample of TDR firms may be attributed to these risk factors. Under this size/BTM hypothesis, the magnitude of

CAR is expected to vary inversely with MVE and directly with BTM in line with the well-established size/BTM

effects in both the TDR and the matched samples. On the other hand, a size related information markets

hypothesis posits a positive relationship between pre-announcement information availability and firm size as a

potential explanation for the size effect.9 Accordingly, the TDR announcement may be the first public disclosure

of financial distress for smaller, overlooked firms for which the negative effect of this distress signal may offset

its favorable surprise impact; that is, the market may react ambiguously to this mixed information signal. In

contrast, the announcement is predicted to signal an unexpected, favorable resolution of financial distress for

larger TDR firms whose financial distress has already been disseminated. In addition, in larger firms with a

richer information environment, there should be less information asymmetry between the stakeholders, leading

to lower agency costs (Myers and Majluf, 1984; Brown et al., 1993), more beneficial restructuring terms and a

higher probability of consummation of the TDR attempt. Finally, size, which reflects bargaining complexity

among creditors, is positively related to deviations from APR (Weiss, 1990; Franks and Torous, 1994).

Accordingly, I predict an anomalous-signed positive size (negative BTM) effect in this study, in support of the

net benefits/information hypothesis:

H2: The announcement excess returns are expected to be greater for larger and low book-to-marketTDR firms than for smaller and high book-to-market ones.

The remaining two hypotheses complement H2 and further disentangle the role of size/BTM as a proxy for

financial distress risk versus its role in disseminating distress related information. The larger, more diligently

followed firms are expected to have negative excess returns in the pre-event period since it is more likely that

their financial distress has been publicized and impounded in prices. To the extent that distress related bad news

is revealed prior to the announcement, the announcement is expected to be an unanticipated, favorable signal:

H3: Firms that experience negative pre-TDR abnormal returns (expected to be larger firms)are hypothesized to have higher positive abnormal returns upon a TDR announcement, compared to firms with non-negative pre-TDR abnormal returns.

8

Financial distress is publicized and impounded in prices through various signals. For example, prior research

has used downgrades in debt ratings as a direct proxy for increased default risk and declining prospects (see for

ex., Barth et al.,1998 and Dichev and Piotroski, 1998). I use pre-TDR downgrades alongside pre-TDR debt-

service defaults, and going-concern qualifications in audit reports as information variables expected to aid the

incorporation of financial distress in stock prices. The last hypothesis helps in determining if financial distress is

impounded through such disclosures, expected to be more abundant in larger firms, and whether they lead to a

cross-sectional variation in excess returns:

H4a: Firms that have at least one financial distress news prior to their TDR announcements (expected to be larger firms) are more likely to have negative pre-announcement excess returns.

H4b: TDR firms with such prior financial distress disclosures (expected to be larger firms) are expected to have higher positiveannouncement and post announcement excess returns than those without any distress signals.

III. Sample Selection, Methodology, and Descriptive Statistics

A. Sample Selection and Data Requirements

An initial sample of 249 TDR firms that had one or more private restructuring negotiations are identified

from the subject volumes of the Wall Street Journal (WSJ) Index and on-line Text-Search Services of Dow

Jones News/Retrieval Service (DJNR), searched for the years 1973-1988 and 1979-1988, respectively. The key

words used are debt, refinancing, restructuring, default, troubled, turnaround, and workout. This sample

period of 15 years is chosen ın order to include the two prominent recessionary periods

of the ’70s and ’80s, while controlling for structural changes in the excess returns and in

the nature of financial crises, likely to be encountered when a longer sample-period is

used. Furthermore, this is approximately the same period used in prior studies and thus

provides a more meaningful comparison with their market reaction results. Finally,

testing for the size effect is more meaningful in the’70s and ’80s after which it seems to

have disappeared in the U.S. (Schwert, 2002). A WSJ Index search is undertaken to ensure that at

the date of the announcement, each sample firm was in financial distress and there was no mention of a previous

TDR attempt during the year prior to the announcement (year t-1). The selection criteria for the final sample of

86 TDR firms, are summarized in Table I.

9

(Table I around here)

The daily returns and financial statement data are obtained, respectively, from the University of Chicago’s

CRSP tapes and S&P's Compustat annual tapes.10 Data on the restructuring types are obtained from the WSJ

Index , the WSJ articles, public debt covenants in Moody's manuals, and the financial statement (F/S) footnotes

related to the TDR. Debt downgrades and other distress signals are hand-picked from the Moody's and S&P

Bond Surveys, the WSJ Index, and the F/Ss.

B. Research Design and Method of Analysis

An ex-post matched-pairs design is employed to compare the financial ratios and excess returns of the TDR

sample with those of a sample of similar non-TDR, non-bankrupt firms. Matching is done on size [total assets

(TA)]11, leverage [total liabilities (TL)/TA)], and the 2-digit S.I.C. code. The (year t-1) fiscal-year end values

are used to select the control firms.12

Pre-test/post-test comparisons are also carried out to underscore the change in excess return patterns at the

time of the announcement and thereafter. Consistent with Gilson (1990), the mean and median length of the

restructuring interval is 201 and 151 days for the 65 sample firms for which this information is available.

Accordingly, the excess returns are evaluated over short and long windows around the identified announcement

day (day t=0). How the shareholders fare during this interval (days 0, 1, 2,...,c, where c represents the date of

consummation or the last WSJ reference to a previously announced TDR) and whether a return drift or reversal

exists are also of particular interest in this study. Excess return patterns in the relevant TDR sample partitions,

dichotomized with respect to size, book-to-market and various proxies for prior distress information are also

examined. Finally, the announcement excess returns to the TDR and control firms are regressed against a TDR

indicator variable, size, and BTM to test their incremental explanatory power.

Firm-specific daily event period excess return (AR) is calculated as the difference between the actual daily

return of each sample firm (Ri) and the market and risk adjusted (βi* Rm) expected return obtained from the

one-factor market model, estimated over a 300-day estimation period ending on day -40. The Rm is measured as

the CRSP equally-weighted index. The significance of the average cumulative market and risk adjusted excess

returns (CAR) is measured using the standard Brown and Warner (1985), BW hereafter, methodology.13

Cumulative market-adjusted returns (CMAR) are calculated to obtain the average and firm-specific excess

returns during the estimation period (for H3 and H4a).

C. Financial Profiles of the TDR and Control Samples

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Table II presents the summary statistics for selected accounting and market-

based variables for the two samples, as of year (t-1). The p-values are those of

the t-tests of significance of the average difference between each paired

observation. TA, MVE, BTM, and market beta are used as proxies for size, risk, and growth potential of

sample firms. As matching by TA has been successful, there is no difference between the mean and median TA of

the TDR and non-TDR samples. MVE is used as an indicator of size related risk and the information environment.

The TDR sample's equity is significantly less valued than that of the control’s. However, the mean and median

sizes of both samples fall in the same or adjacent size rankings in large scale research done on NYSE, ASE and

IBES firms (Barry and Brown, 1984; Fama and French, 1992). Second, the median MVE of the TDR sample is not

any lower than that of less financially distressed covenant violators (Beneish and Press, 1993) that exhibit negative

announcement excess returns. Finally, the difference in the mean MVE does not justify the observed difference in

the market response.14

(Table II around here)

The BTM ratio is used as a proxy for risk, growth potential, and market mispricing, The TDR firms’ mean

BTM falls in the 8th decile while that of the non-TDR firms falls between 6th and 7th deciles (Fama and French,

1992, Table 4). However, when the negative BTM firms are excluded, the ratio is significantly higher in the

TDR sample, again justifying the concern that the hypothesized excess returns may be due to the size/BTM

effects that need to be controlled for. The market beta, used as a measure of the firm’s systematic risk, is

estimated by regressing the 300-day estimation period daily return against the return on the equally-weighted

market portfolio. As expected, the mean and the median beta are larger for the TDR sample (1.33 and 1.28) than

for the control sample (1.14 and 1.09). Hopefully, this difference is big enough to capture the "true" fundamental

risk differential depicted in the financial and return profiles of the two samples, thus lowering the probability of

a Type I error due to omitted risk factors in the market model used to generate the expected returns in this study.

Next, liqidity and profitability ratios are compared. The working capital/TA ratio is significantly smaller in

the TDR sample, depicting an acute lack of working capital consistent with Hamer (1985). However, the current

and inventory turnover ratios are not significantly different. The means and medians of net income/TA and

retained earnings/TA are negative, and are significantly lower than those of the non-TDR sample, indicating

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diminished going-concern values. Finally, the capital structure and debt service profiles are examined. In spite

of the attempted matching by TL/TA, the mean and median values are higher in the TDR sample. Nevertheless,

the long-term debt/TL and long-term debt/equity ratios are not significantly different in the two samples,

confirming they are good matches in terms of long-term capital structure. The mean EBIT/interest expense ratio

is significantly lower in the TDR sample depicting serious debt-coverage problems. In summary, the financial

profiles of the TDR firms highlight their acute liquidity, debt-service, and profitability problems faced at the

time of the announcement and justify the concern that the expected positive CAR may be due to additional risk

born by the shareholders.

IV. Market Reaction Results

A. Pre-announcement Excess Returns and the Market Reaction:

Table III presents the CAR, the BW portfolio test-statistics, and the p-values, for selected windows between

tradıng days (-340, + 40) for both the TDR and control samples. As shown in Panel A, over the 300 days

preceding the [-40,+40] event window, shareholders have lost 87% value compared to holding an investment in

the market portfolio indicating that their financial distress was impounded in their prices. This is consistent with

Gilson et al.'s (1990) finding of an average CMAR of -134% over the three years prior to successful

restructuring attempts. Control firms also have significant negative excess returns (-28%) over the same period,

even though they are obviously not as financially distressed. The sharp decline in security prices slows down

during the [-40,-2] interval. Although the CAR is not distinguishable from zero under the BW portfolio test, it is

significantly negative at α= 0.07 and 0.04 under the BW and DW standardized tests.

(Table III around here)

As hypothesized, the immediate market reaction to a first-time TDR announcement is significantly

positive, indicating the announcement is informative and signals positive economic consequences for share-

holders. Panel B reports a CAR(-1,0) and AR on day 0 of 2.7% (t-value =3.63) and 2.2% (t-value=4.17) under

the BW portfolio test-statistic while the CAR(-1,0) for the control sample is not significantly different from zero.

Even though the impact of the announcement on prices seems to be small, a 2.7% response is a respectable

increase in shareholder wealth over a two-day window, especially after the persistent loss of value observed in

the estimation period.15 Compared to unadjusted returns of -3.8% for the (-1,0) window around financial

12

distress news items in the WSJ Index (Thompson et al., 1987), a TDR seems to be a value increasing remedy for

financial distress.

B. Post-announcement Returns Behavior:

Although full and speedy dissemination of TDR news is expected, the CAR(-3,40), (-1,40), and even

CAR(1,40) of 6.1% are found to be significantly positive at α levels of 0.007, 0.01 and 0.07, respectively. The

CAR(1,40) for the matched sample is positive but insignificant. To investigate the lucrativeness of investing in

firms that have announced their TDR intentions and to test for a longer term over/under reaction to the TDR

news, the long window post-announcement returns are also measured. The finding of a CAR(-1,+330) of 66%,

significant at α=0.00, is consistent with Gilson et al.'s (1990) restructuring interval excess returns of 41% for his

sample of successful restructurings and with the 42% post-filing holding period returns in bankrupt firms

classified as winners (Indro et al., 1999). Shareholders seem to regain almost all the value which was lost in the

pre-TDR period. These results should be interpreted with caution though, due to the design limitations imposed

by the sample selection criteria and the well-documented misspecification problems encountered in the

measurement of long-horizon returns (see for ex., Barber and Lyon, 1997; Kothari and Warner, 1997). For

example, the long-term positive CAR may have resulted from the intentional exclusion of TDR firms that file

for bankruptcy within six months of the announcement as these are the firms expected to have (-) post-

announcement CAR. However, several measures are taken in the study to attenuate some of the methodological

biases involved: i) excess returns are compared with those of a benchmark portfolio; ii) the post-announcement

CAR are calculated by summing daily excess returns, suggested to pose fewer theoretical and statistical

problems than the buy and hold returns (see for ex., Fama, 1998)16; iii) to mitigate the inevitable survivorship

bias, Moody's as well as Compustat data are used and the post-announcement CAR are estimated for as many

days as data is available, even when the firms do not survive the entire long post-announcement period. Finally,

the long-window CAR is too large to be caused solely by test misspecification and survivorship bias.17

This abnormal behavior of returns in the pre- and post-announcement periods is consistent with both the

return reversals (overreaction) and the underreaction anomalies. As such, the study contributes a new event that

fall in the category of CAPM/market efficiency anomalies that Fama (1998) finds "difficult to interpret" because

there is both an overreaction to the pre-TDR weak performance of TDR firms and an underreaction to the

positive announcement signal since abnormal returns continue.18

13

V. Univariate Tests of Cross-sectional Differences in Returns

A. Market Capitalization and Book-to-market Effects on Returns

The TDR sample is next partitioned into two size and two BTM partitions. The larger, low risk TDR

subsample is made up of 31 firms with MVE in excess of $100 million. The high BTM, value subsample is

composed of 40 firms with high BTM ratios, ranging from 1.48 to 9.15, and 17 firms with negative BTM. The

remaining 29 firms are considered to be the stronger growth firms. The results presented in Table IV indicate

that financial distress is more fully impounded in the prices of large and low BTM firms as evidenced by the

significant, negative CAR(-40,-2) in only these subsamples. Furthermore, the positive announcement and post-

announcement CAR of the large and low BTM firms are significantly higher, except for day 0 and day (-40,-2)

excess returns which are not sıgnificantly higher, leading to acceptance of H2 and rejection of the competing

size/BTM hypothesis.

(Table IV around here)

The results are especially strong in comparing low versus high BTM firms: a) neither the CAR(-1,0), nor

the short or long-window post-announcement CAR are significantly different from zero in the high BTM

sample; b) the announcement and the long-window post-announcement CAR in the low and high BTM firms

are, respectively, the highest (5.1% and 83%) and the lowest (1.3% and 11%) observed in any of the sample

partitions. The findings are interesting in three respects: First, both size and, especially, BTM play a role in

explaining the cross-sectional differences in average returns. Second, the finding of an anomalous-signed

size/BTM effect does not support the well-established negative (positive) relationship between size (BTM) and

excess returns and their risk explanation. Finally, this finding is reassuring as it supports the study's central

hypothesis that the positive excess returns result from the announcement and/or net benefits of TDR. Overall, the

average market reaction combined with the anomalous-signed size/BTM effect lend support to the Chatterjee et

al. (1996) finding that economically viable firms prefer workouts rather than Ch. 11 or prepackaged

bankruptcies and to the Franks and Torous (1994) observation that APR deviations are higher in larger

distressed firms.

B. Prior Distress Information: An Explanation for the Anomalous-signed Size/BTM Effect

To determine if the information environment explains the anomalous-signed size/BTM effect, I compare the

14

returns in firms whose financial distress has been impounded in prices prior to the announcement to those that

has not been. Assuming stock market variables contain financial distress information, the firm-specific pre-

announcement CMAR(-340,-41) is first used as the partitioning variable. The first column of Table V depicts

that significant differences in the hypothesized direction obtain only on day 0 and in the long post-announcement

window. Firms with negative CMAR(-340,-41) have an average CAR of 3% and 26 % (significant at α=0.01),

respectively, in these two windows. In the subsample with ≥0 pre-TDR CMAR, the CAR in both windows is

not significantly different from zero, possibly because of the lack of a surprise announcement effect.

(Table V around here)

Since the results based on the 300 day long estimation period are not very strong, the tests are then

replicated using the shorter firm-specific CAR, FCAR(-40,-2), as the partitioning variable, with the hope of

capturing the surprise effect of the announcement better. This classification also results in a sufficiently large

number of firms that have a strictly positive and strictly negative pre-announcement FCAR. As expected, the

results (not reported in the table) are now stronger. The partition with an average FCAR(-40,-2) of -27.6%

have significantly positive day 0 excess returns (at α=0.00). However, the TDR firms with a positive average

FCAR(-40,-2) of 27.8%, have announcement excess returns that are not significantly different from zero, for

any window tested between days -3 and +40. Overall, the results support H3 and medium term return reversals.

The TDR sample is finally partitioned based on the presence of pre-announcement downgrades and other

financial distress signals. As reported in the middle column of Table V, the subsample of firms with debt

securities downgraded by rating agencies in year t-1 or t prior to the announcement, have a pre-announcement

CAR(-40,-2) of -10.6 %, significant at α=0.025, while the CAR is not significantly different from zero in the

subsample with no prior downgrades. The results support H4a and provide evidence that downgrades play a role

in impounding increased default risk in prices. Furthermore, downgraded firms have significantly higher positive

CAR in the (-3,0) announcement and in the long post-announcement window. However, the CAR (1,40)

window CAR are not significantly different than zero in both subsamples.

To the extent that stably rated firms have had other financial distress disclosures, such as a technical or debt

service default or an auditor's opinion with a going-concern qualification, the tests above based solely on

downgrades will lack power. Accordingly, these additional pre-announcement distress signals are also included

along with downgrades to form the two partitions of "any distress sign" and "no distress sign". As expected, the

15

results presented in the last column of Table V provide stronger support for the favorable surprise effect

predicted by the net benefits/information hypothesis and leads to the acceptance of H4b. The CAR(-1,0) and

CAR (-3,0) assume the highest values in the table (3.7% and 5.1%, significant at α=0.00) in the partition with

any prior distress sign and the lowest values (0.007 and -0.001, both insignificant) in the one with none. The

firms with no prior distress signals do not exhibit significant excess returns even in the 223-day post-

announcement window while the firms with such signals earn significantly different positive excess returns over

all the windows tested except for the (1,40) window.

C. The Relationship Between Size and Prior Distress Information Availability

The arguments in H2, H3, and H4 and the results above suggest a positive relation between firm size and prior

distress information availability. To evaluate this contention, whether large (small) TDR firms are more (less)

than equally likely to have pre-TDR financial distress disclosures is tested. Table VI presents the results of the

one-sample binomial tests of population proportions that are run separately on the subsamples of 31 large and 55

small TDR firms that have and that have not had the above mentioned three distress signals. The resultant 95%

confidence intervals for the true population proportions (P) are also included in the table. It is concluded that

larger TDR firms are more than equally likely to have (-) pre-TDR excess returns, prior downgrades, and other

prior distress disclosures (i.e., P>0.50, at α=0.05). The 95% confidence intervals for P constructed for the large

TDR firms consistently have higher lower and upper limits than those of the small firms. Since the information

environment is more related to size than BTM, the same tests on BTM firms provide weaker results.

(Table VI around here)

6. Multivariate tests of the size/BTM effects: Cross-sectional Regressions

To test the incremental explanatory power of the TDR announcement, size, and BTM and the direction

of the relationships in the TDR and the control samples in a multivariate setting, firm-specific event period

CAR for the TDR and matched firms are regressed on these variables. Various specifications of the

following full model are estimated:

CARi = β0 + β1DT,i + β2MVEi + β3DT,iMVEi + β4BTMi + β5DT,iBTMi + εi (2)

where:

CAR = cumulative excess returns for days [-1,0] and [-3,40] around the announcement,

16

DT = 1 if TDR firm and 0 otherwise,

MVE = size as proxied by loge(MVE), measured as of the beginning of the TDR announcement period,

BTM = book-to-market ratio (BVE/MVE), measured as of the beginning of the TDR announcement period,

DTMVE and DTBTM = the interaction variables between size and TDR and between BTM and TDR,

i = 1,...,172 where the first (last) 86 are TDR (non-TDR control) firms.

The interaction terms allow for the effect of TDR and size/BTM to depend on the level of the other. In other

words, the effect of size and BTM on CAR is predicted to depend on whether the firm is a TDR firm. Smaller

control firms are expected to have a higher CAR consistent with the well-established negative size effect. On the

other hand, for smaller TDR firms whose financial distress has not been publicized, the announcement may be

perceived as an offsetting bad news signal leading to a lower CAR, in line with the hypothesized anomalous-

signed positive size effect. For larger TDR firms whose financial distress has already been priced, the

announcement is expected to be a surprise, good news signal. Similarly, an anomalous-signed negative BTM

effect is expected only in the TDR sample. Hence, the estimates of β1 and β3 are expected to be positive, and that

of β5 negative. β2 and β4 estimates are expected to be positive and negative, respectively, for the TDR sample

while the opposite signs are expected in the non-TDR sample. When the two samples are pooled, β2 and β4 may

be indeterminate or insignificant because of the opposite predicted effects of MVE and BTM in the two samples.

OLS estimates of the parameters, their t-values and the R2 metric for various specifications of the full model

in (2) are presented in Table VII. In general, the tests have low adjusted R2 and F-statistics as is the case in most

cross-sectional association tests of announcement excess returns. Panel A presents the results of the regressions

with CAR(-1,0) as the dependent variable, the TDR and control samples pooled together, and without the

interaction variables. The model with the basic variable of interest (DT) as the only regressor is a valid one (F-

statistic=4.005) with a coefficient estimate of 0.026, significant at α=0.05. When MVE and BTM are used as the

only regressors, the coefficient estimates are not significant, probably because of the opposite predicted effects

of MVE and BTM in the two samples. 19

(Table VII around here)

More significant results are obtained in the pooled sample when the longer and more variable CAR(-3,40) is

used as the dependent variable (see Panel B). The coefficient estimates for DT, MVE, and BTM as the only

regressors are all significant at α=0.05, 0.13 and 0.05, respectively. DT explains 6.5% out of the average CAR of

9.4% in this window. This panel depicts the effect of size, both by itself and as an interaction variable. In the

17

model, with the three variables and the interaction term DTMVE (F-statictic=3.125), all the coefficient estimates

are significant except for DT , the effect of which is now picked up by the highly correlated (ρ=0.84) DTMVE.

As hypothesized, the coefficient estimate of the interaction term is positive, significant, and larger than the

absolute value of the negative coefficient estimate of MVE. Hence, if the firm is not a TDR firm (DT=0), the

relation between CAR(-3,40) and MVE is negative. However, for TDR firms, the coefficient estimate of size

becomes positive (0.006=- 0.024+0.030).20

In panel C, the negative BTM fırms are excluded to increase power and explore the effect of BTM, both by

itself and as an interaction variable.21 As before, DTMVE picks up the effect of TDR and its significant, positive

coefficient estimate is large enough to change the direction of the relationship between returns and size. To

determine if TDR causes a similar switch in the sign of BTM, DTBTM is added to the model. Its coefficient

estimate is significant at only α=0.20, but it has the hypothesized negative sign and is also large enough to

change the direction of the relationship between CAR(-3,40) and BTM from positive to negative in TDR firms.

VII. Summary and Conclusion

This paper examines the shareholder wealth effects of the TDR stage in the financial distress continuum and

the role of size, book-to-market ratio, and prior financial distress information in explaining the excess returns.

On average, the sample of 86 TDR firms exhibit CMAR of -86% during the 14 months preceding their first-time

TDR announcements and a significant CAR of 2.7% during the two days around the announcement. The

prolonged period of significant post-announcement CAR is consistent with several anomaly theories.

An analysis of the financial and asset characteristics of the TDR and the matched samples reveals that TDR

firms are, in general, small-to-medium size, high leverage firms, with high or negative BTM ratios and acute

liquidity and profitability problems, establishing these ex-ante characteristics as confounding factors likely to be

associated with the positive market reaction. However, market reaction tests on size, BTM, and prior distress

information partitions reveal higher significant positive CAR in larger and in low BTM firms as well as in firms

with pre-announcement financial distress signals. Crossectional regressions confirm the anomalous-signed

positive size and the negative book-to-market effect in only the TDR sample.

The results confirm that the excess returns are due to the unexpected change of fortune signaled by the

announcement and the perceived benefits of TDR, which are stronger in larger, high growth TDR firms, rather

18

than the result of their higher abandonment option value or the size/BTM effects. The finding of an anomalous-

signed size/BTM effect complements the evidence against the "relative distress factor" explanation of the

size/BTM anomaly. Instead, it provides further empirical support to higher APR violations in larger firms and in

private workouts and underscores the value relevance of the TDR firm’s information environment. The

announcement is a more informative and a positive signal for larger firms whose financial distress has already

been publicized prior to the announcement. The results should be of interest to investors who want to invest in

financially distressed firms and to and to any other group that has a stake in TDR firms. The value relevance of

TDR may also have policy implications in terms of the current GAAP on TDR (SFAS NO. 15) which does not

recognize the reduction in the debt and the related gain in “modification” type restructurings.

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Table 1

Selection criteria used to obtain the final sample of 86 TDR firms

────────────────────────────────────────────────────────────────────────-

Number of TDR firms in the initial sample 249

Reasons for elimination:

Firm files Chapter 11 before TDR announcement 41 Firm files Chapter 11 or goes bankrupt within 6 months after TDR 3 No TDR announcement in WSJ or DJNR media 43 Firm not included in daily files of CRSP tape 54 Firm not included in Compustat or in Moody's manuals 5 Firm has confounding event(s) around the event day c 9 Firm has no return data in the short event window (days -1,0,+1) 8 ____

Number of TDR firms in the final sample 86─────────────────────────────────────────────────────────────────────────

The TDR sample is composed of financially distressed firms that have announced their first-time TDR attempts. The sample firms are identified from the subject volumes of the Wall Street Journal (WSJ) Index and on-line Text-Search Services of Dow Jones News/Retrieval (DJNR) Service. 16 firms were originally identified from AICPA’s Accounting Trends & Tech niques , Illustrations of Accounting for Debt under Four Pronounce ments (1973-1986), and Hamer (1985).

22

The exclusion of TDR firms that go bankrupt within close proximity to their TDR announcement is imposed since bankruptcy might confound the presumably special effect of a TDR on the sample firms’ returns. 26 sample firms (30.2%) filed under Chapter 11 or 7 of the Bankruptcy Code between six months to five years after their TDR announcements. This is consistent with the TDR outcomes in Gilson et al.'s (1990) sample. To eliminate confounding events, a WSJ Index search was carried out for omitted dividends, losses, divestitures, defaults, management changes etc. within a week of the TDR announcement date.

23

Table 2Financial profiles of the TDR and the control samples───────────────────────────────────────────────────────────────────────────────────────── TDR FIRMS NON-TDR FIRMS ────────────────────────────── ───────────────────────────────────────Characteristic N Mean Median Min. Max. N Mean Median Min. Max. p-value─────────────────────────────────────────────────────────────────────────────────────────

Size and risk proxies Total Assets ($ million)

86 995.01 314.08 11.79 12555.50 86 999.79 331.79 12.59 13553.20 0.752

Market Value of Equity ($ million) 86 196.87 42.27 1.02 3930.64 85 329.09 77.99 2.08 4252.01 0.028

Book-to-Market Value 83 1.20 1.44 - 9.07 9.15 85 0.94 0.91 -2.95 3.22 0.278

Estimation Period Systematic Risk (β) 86 1.33 1.28 0.11 3.26 86 1.14 1.09 0.09 2.74 0.087

Liquidity Working Capital/Total Assets

79 0.02 0.07 - 0.95 0.67 71 0.14 0.14 - 0.22 0.56 0.028 Current Ratio

79 1.44 1.24 0.02 6.29 71 1.52 1.45 0.39 3.77 0.944

Inventory Turnover 70 8.48 4.13 0.98 54.48 69 12.58 4.51 0.54 92.12 0.175

Profitability Net Income/Total Assets

86 - 0.10 - 0.05 - 0.99 0.10 86 - 0.00 0.02 - 0.58 0.13 0.000

Retained Earnings/Total Assets 86 - 0.03 0.02 -1.30 0.56 86 0.07 0.11 0.90 0.68 0.000

Leverage and debt service Total Liabilities/Total Assets

86 0.82 0.78 0.25 1.66 86 0.75 0.74 0.26 1.11 0.000

Long Term Debt/Total Liabilities 86 0.44 0.46 0.00 0.93 86 0.43 0.45 0.00 0.83 0.807

Secured Debt/Total Liabilities 42 0.16 0.04 0.00 0.83 25 0.21 0.18 0.00 0.69 0.883

Long Term Debt/Equity 86 1.63 0.78 - 13.45 23.58 86 1.16 1.12 -157.96 122.53 0.847

Interest Coverage 84 0.05 0.20 -14.96 5.31 86 3.82 1.69 - 8.26 92.45 0.006

─────────────────────────────────────────────────────────────────────────────────────────The control sample of 86 non-bankrupt, non-TDR firms are matched on total assets, leverage, and 2-

digit industry code. The summary statistics in the table are as of the fiscal year end that precedes the TDR announcement (year t-1). The p- values are those of the t-tests of significance of the average difference between paired observations from the TDR and the matched samples. Interest coverage is measured as "earnings before interest and taxes/interest expense".

24

Table 3The cumulative daily abnormal returns (CAR) for selected event windows

───────────────────────────────────────────────────────────────────────────────────────

TDR Sample (N=86) Control Sample (N=86)──────────────────────────────────────────────────────────────────────────────────────── Days relative CAR t-valuea p-value CAR t-value p-value to the event day

A. Pre-announcement Period

-340 to -41b -0.866 -9.419 0.00* -0.280 -4.610 0.00*

-40 to -2 -0.020 -0.618 0.54 -0.003 -0.096 0.92

B. Announcement Period

-40 to +40 0.067 1.428 0.15 0.180 0.391 0.70

-5 to +5 0.010 0.569 0.57 -0.003 -0.197 0.84

-1 to +1 0.023 2.492 0.01 -0.001 -0.124 0.90

-3 to 0 0.033 3.194 0.00 0.002 0.249 0.80

-1 to 0 0.027 3.630 0.00 0.000 0.058 0.95

0 0.022 4.169 0.00 -0.004 -0.760 0.45

C. Post-announcement Period

+1 to +40 0.061 1.831 0.07 0.022 0.645 0.52______________________________________________________________________________

The average excess returns during the 300 trading day estimation period prior to the event window starting on day -41 are calculated using the cumulative market-adjusted returns (CMAR). The significance of the CMAR is tested using the test-statistic employed in Dennis and McConnell (1986). The event period firm-specific daily excess return (AR) is calculated as the difference between the actual daily return and the market and risk adjusted expected return obtained from the one-factor market model, estimated over a 300-day estimation period ending on day -40. The return on the market portfolio is measured as the CRSP equally-weighted index. The significance of the CAR is measured using the standard Brown and Warner (1985) portfolio test statistics and all tests are two-sided.

25

Table 4

The cumulative daily abnormal returns (CAR) in size and book-to-market partitions

──────────────────────────────────────────────────────────────────────

S i z e B o o k - t o - m a r k e t ________________________________________ ________________________________Event Window Large Small Difference Low High /(-) Difference

N =31 N=55 N=29 N=57

-40 to -2 -0.084 0.007 -11.8 0.084 0.007 -12.35

(0.029) (0.880) (0.0 (0.125) (0.860) (0.00)

-1 to 0 0.041 0.022 12.17 0.051 0.013 22.77(0.000) (0.034) (0.00) (0.000) (0.164) (0.00)

0 0.023 0.022 0.86 0.039 0.014 21.19(0.000) (0.002) (0.39) (0.000) (0.035) (0.00)

+1 to +4 0.059 0.064 -0.68 0.093 0.054 5.23(0.130) (0.165) (0.50) (0.095) (0.182) (0.00)

+1 to Cons. 0.504 0.353 11.3 0.830 0.110 40.87(0.000) (0.003) (0.00) (0.000) (0.254) (0.00)

───────────────────────────────────────────────────────────────────────

The table presents the CAR and the corresponding p-values (in parentheses) for the TDR sample partitions dichotomized with respect to size (market value of equity) and book-to-market (book value of equity/market value of equity) ratio for selected event windows. The measurement of the CAR and its significance are explained in the legend for Table III. “Cons.” is the latest consummation date by which at least three not yet consummated TDR firms remain in the sample. The return observations of firms with earlier consummation days are considered as missing observations. This last day of the long test window is 274 and 256 for large and small market capitalization subsamples, respectively; and 223 days for both low and high book-to- market subsamples. The two “Difference” columns contain the t-values (p-values) for the significance of the differences in excess returns between the two subsamples .

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Table V

The effect of prior distress information on excess returns to TDR firms

────────────────────────────────────────────────────────────────────

Pre-TDR Excess Returns Deratings Distress Signsa

Days Relative Negative Positiveb Derated Non-derated Any sign No signs

to Event Day N=52 N=34 N=33 N=53 N=58 N=28

-40 to -2 -0.019 -0.023 -0.106 0.034 -0.061 0.048(0.650) (0.660) (0.025) (0.450) (0.134) (0.418)

Diff. 0.56 -21.5 -14.66

-3 to 0 0.025 0.046 0.046 0.026 0.051 -0.001(0.060) (0.005) (0.002) (0.076) (0.000) (0.961)

Diff. -9.2 8.72 21.84

0 0.030 0.010 0.018 0.024 0.022 0.024(0.000) (0.221) (0.016) (0.000) (0.000) (0.012)

Diff. 12.4 -5.73 -1.68

+1 to +40 0.053 0.072 0.059 0.060 0.051 0.076(0.207) (0.167) (0.214) (0.185) (0.217) (0.207)

Diff. -2.7 -0.14 -3.32

+1 to Con.c 0.259 0.142 0.382 0.203 0.231 -0.025(0.005) (0.216) (0.000) (0.060) (0.007) (0.864)

Diff. 14.37 10.45 14.400.000

─────────────────────────────────────────────────────────────────────── The table presents the cumulative abnormal returns (CAR) and the corresponding p-values (inparentheses) for TDR subsamples dichotomized with respect to pre-announcement excess returns (firms with positive CAR are those with market-adjusted CAR(-340-41) 0), downgradings, and prior distress signals (includes downgraded fırms, firms with debt-covenant violations, debt service defaults or qualified auditor opinions. The measurement of the CAR and its significance are explained in the legend for Table 3. To control for the survivorshıp bias, the post announcement cumulation of the CAR is continued until the latest consummation date by which at least three not yet consummated TDR firms remain in the susample. The return observations of firms with earlier consummation days are considered as missing observations. The last day of the long post-announcement window is 193 days for both the negative and positive pre-TDR excess returns subsamples and 223 days for the rest of the remaining four subsamples. The rows tittled as “Diff.” contain the t-values for the significance of the differences in excess returns between the two partitions for each of the three sets of subsamples

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Table 6The relationship between size/book-to-market ratio and prior distress information availability──────────────────────────────────────────────────────────────────────────────────────────────────────── P r i o r d i s t r e s s i n f o r m a t i o n a v a i l a b i l i t y a

────────────────────────────────────────────────────────────────────────────────────────────────────────(-) Pre-TDR returns Prior deratings Any distress information Totals

────────────────────────────────────────────────────────────────────────────────────────────────────────

Size: Yes No Yes No Yes No

Large TDR firmsb 21 10 20 11 24 7 31 95% confidence intervalc 0.52<p<0.84 0.48<p<0.82 0.62<p<0.92

Small TDR firms 31 24 14 41 34 21 55 95% confidence interval 0.43<p<0.69 0.13<p<0.37 0.49<p<0.75

Totals 52 34 34 52 58 28 86 _____

Book-to-Market (BTM) Ratio : High BTM firms 32 24 23 33 38 18 56 95% confidence interval 0.44<p<0.70 0.28<p<0.54 0.56<p<0.70

Low BTM firms 20 10 10 20 20 10 30 95% confidence interval 0.50<p<0.84 0.16<p<0.50 0.50<p<0.84

Totals 52 34 33 53 58 28 86 __________________________________________________________________________________________________________________________

The table presents the 95% confidence intervals for the population proportion P which gives the lower and upper confidence limits for the true proportion of firms expected to have prior distress information in the sampled population of small and large (and high and low BTM) TDR firms. Three proxies are used for prior distress information availability: negative pre-announcement excess returns, prior downgrades, and any pre-TDR financial distress signal (includes technical and debt-service defaults, auditor's going-concern qualification, and downgrades), all measured as dichotomous `yes' or `no' variables. The large TDR firms consist of 31 firms whose market capitalization exceed $100,000,000 while the 29 low BTM

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firms are those with BTM ratios below 1.5.

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Table VIIPooled regressions of the cumulative excess returns (CAR) against size, book-to-market, and a TDR indicator variable──────────────────────────────────────────────────────────────────────────Panel A: (N=172) CAR (0,1) as the dependent variable and no interaction terms

β0 DT MVE DTMVE BTM DTBTM Adj. R2

0.000 0.026 0.020(0.98) (0.05)

0.025 -0.003 0.002(0.12) (0.43)

0.013 0.001 0.005(0.09) (0.72)

0.009 0.024 -0.002(0.63) (0.07) (0.63)

──────────────────────────────────────────────────────────────────────────Panel B: (N=172) CAR (-3,40) as the dependent variable and DT MVE as the interaction variable

0.027 0.065 0.017(0.24) (0.05)

0.115 -0.014 0.010(0.01) (0.13)

0.075 -0.017 0.048(0.00) (0.05)

0.146 -0.057 -0.024 0.030 -0.019 0.048(0.02) (0.49) (0.07) (0.10) (0.03)

──────────────────────────────────────────────────────────────────────────Panel C: (N=149) CAR (-3,40) as the dependent variable, with the interaction terms, and with (-) BTM firms excluded from the samples

0.009 0.065 0.019(0.66) (0.05)

0.081 -0.098 -0.016 0.038 0.033(0.18) (0.26) (0.21) (0.05)

-0.022 0.126 0.030 -0.045 0.018(0.58) (0.03) (0.34) (0.20)

──────────────────────────────────────────────────────────────────────────The table includes the regression coefficient estimates for the independent variables, the corresponding p-values in parentheses, and the adjusted R2 for various specifications of the pooled regressions. The measurement of the event window CAR explained in the legend for Table 3. Blank entries correspond to variables excluded from the following full model:

CARi = β0 + β1DT,i + β2MVEi + β3DT,iMVEi + β4BTMi + β5DT,iBTMi + εi.

where: DT = 1 if TDR firm and 0 otherwise. MVE = natural log of market value of equity as of the beginning of TDR announcement year. BTM = Book value of equity/market value of equity as of the beginning of TDR announcement year. DTMVE and DTBTM = the interaction variables between size and TDR and between BTM and TDR

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Acknowledgements

I would like to thank Celal Aksu, John Anderson, Steve Balsam, John Elliott, Thomas Finucane, WilliamFoote, Sevket Gunter, Badr Ismail, Mohamed Onsi, and Eric Press, Nejat Seyhun and the seminar participants at Syracuse University, Temple University, and the session participants at the EFMA'2002 conference for helpful comments and suggestions. Data on troubled debt restructuring announcements were obtained in part from Dow Jones News/ Retrieval of Dow Jones & Company, Inc., and is gratefully acknowledged. I am also grateful for financial support from the Graduate School and Senate Research Committee of Syracuse University

Notes

3. Absolute Priority Rule is the legal principle whereby the junior claimants should not be receiving anything before the senior claims have been fully served. Prior studies have confirmed that APR is routinely violated in both legal and out-of-court renegotiations (see, for ex., Weiss, 1990; Franks and Torous, 1994; Eraslan, 2002; Hege, 2003).

4. Such incentives may arise because: i) The creditors may not be able to force bankruptcy before maturity because of weak provisions; ii) There may be no chance that V will exceed B by maturity (S=0), i.e., the call is deep out-of-the money; iii) Even though S>0, it is still believed to be less than the high costs of bankruptcy; iv) The TDR firms may have high going-concern values at stake at the point of default (Jensen,1989b). As a result, creditors may look forward to increased control and higher cash flows from these firms subsequent to the restructuring; v) Creditor recovery rates are higher under private workouts (Franks and Torous, 1994); vi) Creditors may be willing to give concessions and accept APR deviations to mitigate the under-investment problem associated with high leverage (Myers, 1977) and to restore the incentives of the shareholders to contribute new equity (Franks and Sanzhar, 2002) .

5. Of course this analysis just shows that the value of equity claims outstanding will increase and does not imply that the original equity holders will necessarily be better off because it assumes away ownership dilution faced by firm’s existing shareholders as a result of debt exchanged with claims to equity. I am indebted to the anonymous reviewer that brought this point to my attention. (Also see Gilson et al. (1990)and Agrawal et al. (2004) for the likely claim dilution in financially distressed firms)7 7. Similarly, Hege’s (2003) model of choice between private and formal debt restructuring implies that equity deviations should be higher in private workouts and they are a necessary ingredient for their success.

99. Furthermore, Barry and Brown (1984) and Atiase (1987) find an association between prior information and returns that cannot be accounted for by firm size.

1010. For the 24 firms with missing Compustat data, F/S variables were hand-picked from the Moody's manuals, both to achieve respectable sample sizes and to attenuate the survivorship bias in the Compustat database (Kothari et al., 1992).

1111. MVE is not used in matching to: a) expose the differences in MVE between the TDR firms and the controls which are not particularly in distress, but have high leverage; and b) allow as much variation as possible in MVE and BVE/MVE in the controls to increase the chance of identifying the hypothesized reverse size/BTM effects in the two samples.

6 6. Indeed, Kho et al. (1999) find that the banks that participated in the Long-term Capital Management rescue had an average 3-day excess return of -11%.

88. a) Since the authors’ objective is different, they do not attempt to exclude from their sample of 80 restructuring firms default announcements (29 firms), subsequent references to a restructuring that is in progress (11 firms), announcements of subsequent restructurings and final resolution of the TDR attempt (20 firms), and other confounding events (2 firms), which would introduce Type II errors. Hence, in only 18 firms is the event day the initial announcement of a first-time debt restructuring attempt. b) Since the authors consider a debt restructuring to be successful if the firm does not file for bankruptcy within a year of the last reference to the restructuring, some firms whose bankruptcy filing is later would be included in the successful restructurings sample. c) Their successful and unsuccessful samples are chosen from a pool of firms whose unadjusted returns are at the bottom 5% of NYSE and AMEX. Hence, their sample may consist of inherently lower return firms due to this precondition, which is not imposed in this study.

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1212. There are several limitations of the matching procedure used. First, due to innate differences between the two groups, (especially in terms of leverage) 47 TDR firms were matched only on size and leverage. To the extent that industry differences explain returns, the results should be interpreted with caution. Second, holding size constant, it was impossible to find a match for leverage within the matching limits of less than 20% for six TDR firms. Overall, 85 and 80 of the sample firms are matched within the ±20% limits with respect to size and leverage, respectively. However, whether the firms are pair-wise similar should not pose a threat to internal validity as it is not central to the tests performed.

1313. The standard deviations used in the BW portfolio and standardized test-statistics ignore the predictive nature of the excess returns and the possible increase in variance in the event period. To control the related Type I error and determine the sensitivity of the results to different estimates of the standard error of the mean excess returns, Dodd and Warner's (1983), DW hereafter, and Patell's (1976) standardized test-statistics, which use out-of-sample prediction error variance estimates, are also employed. These results are not tabulated as they are qualitatively the same as those of the BW.

1414. In Fama and French (1992), Table 2, the average return difference between the sixth and eighth deciles, where the TDR and non-TDR firms respectively fall, is 0.07% (1.17 - 1.10). Similarly, in Tables 1 and 2 of Barry and Brown (1984), the unadjusted average return differential between the third and fourth (fourth and fifth) quintiles is 0.15 (0.04) while the risk adjusted CAR in these two adjacent quintiles have exactly the same t-values (-1.57). In comparison, the market and risk adjusted announcement excess return difference, between the TDR and non-TDR firms is at least 2.7% in this study.

15 15. Consider that the average daily return on stocks is approximately 0.04% (10% per year; the strongest 3-day price change resulting from Value Line rank changes is 2.44% (Stickel, 1985); and the price change on day 0 due to the recommendations of analysts that appear in the "Heard on the Street" column of the WSJ is 1.7%.

16 16. Furthermore, using large-scale NYSE/AMEX/NASDAQ data, Barber and Lyon (1997) document a predictable difference of only about 5% between the CAR and the buy-and-hold abnormal returns.

17 17. In Kothari and Warner's (1997) simulated, no event, high BTM sample, which can be considered a control sample for the TDR sample, the highest mean 36-month market model CAR is 25.66% due to test-statistic misspecification, a percentage still lower than the long horizon CAR observed in the TDR sample. Also consider the fact that small firms, in general, underperformed the market in the 1980s which would bias the estimated excess returns downward.

1818. On the other hand, the market may be responding, in a timely manner, to new, firm-specific events engendered by the restructuring process such as value increasing spin-offs or lay-offs and consummation of the TDR attempt.

19 19. To obtain stronger results for MVE and BTM, the regressions are run separately on the TDR and non-TDR samples. In both samples, the coefficient estimates now have the hypothesized signs, but are insignificant, and the relationships are stronger in the control sample. This is expected because a 2-day announcement effect cannot be attributed to the size or BTM effects which are long-term, persistent anomalies in returns.

2020. The sign difference in the size coefficients is also observed when separate, unpooled regressions are run on the control and TDR samples where the coefficients of MVE are -0.024 (significant at α=0.02) and 0.002, respectively. In the TDR sample, only the coefficient of BTM is significant at α=0.11 and has the hypothesized negative sign.

2121. In all the previous specifications tested, the sign of the BTM coefficient estimate has been negative, as predicted for only the TDR sample. Now, the separate regressions for the two samples yield BTM coefficient estimates with the hypothesized opposite signs (not reported). In the pooled sample regressions, only the coefficient estimate of DT (0.065) is significant at α=0.05 when the variables are used as the only regressors.

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