Do Activist Investors Constrain Managerial Moral Hazard in Chapter 11?: Evidence from Junior Activist Investing

Abstract

This article examines the hedge fund investment strategy of buying junior claims of Chapter 11 debtors and playing an activist role in the bankruptcy process. These hedge funds are often accused of rent-seeking by managers. I use a new methodology to conduct the first empirical study of this investment strategy. I find little evidence that junior activists abuse the bankruptcy process to extract hold-up value. Instead, the results suggest that they constrain managerial self-dealing and promote the bankruptcy policy goals of maximizing creditor recoveries and distributing the firm’s value in accordance with the absolute priority rule. (JEL codes: G23, G30, G33). Hedge funds that specialize in distressed investing have grown to manage more than $140 billion in assets, up from $4 billion in 2000. Some of these hedge funds are activist investors that try to influence the restructuring of distressed firms. One of the most common activist investing strategies is to buy junior claims—such as unsecured debt or equity—and participate in the Chapter 11 * University of California, Hastings College of Law; Stanford Law School. E-mail: elliasjared@uchastings.edu. I thank Barry E. Adler, Kenneth Ayotte, Douglas G. Baird, G. Marcus Cole, John Crawford, Victor P. Goldberg, Michael Klausner, Edward R. Morrison, Menesh Patel, Elizabeth Pollman, Mitch Polinsky, Nancy B. Rapoport, Robert K. Rasmussen, David A. Skeel, David C. Smith, Robert J. Stark, and George T. Triantis and two anonymous referees for their helpful comments. I also thank conference audiences at the Annual Meeting of the American Law and Economics Association, the National Business Law Scholars Conference, the Conference on Empirical Legal Studies, the UC Berkeley/USD Business Law Conference as well as workshop audiences at the Stanford Law School Fellows Workshop, the Stanford Law and Economics Workshop and faculty seminars at Tulane, Cardozo, UC Hastings, Fordham, Michigan, Virginia and Duke. I thank Stanford Law School for its generous financial support of this project. 1 See BarclayHedge Alternative Investment Database. http://www.barclayhedge.com/. While there are other types of activist distressed investors, hedge funds are the most prominent. The Author 2015. Published by Oxford University Press on behalf of The John M. Olin Center for Law, Economics and Business at Harvard Law School. This is an Open Access article distributed under the terms of the Creative Commons Attribution Non-Commercial License (http://creativecommons.org/licenses/by-nc/4.0/), which permits non-commercial re-use, distribution, and reproduction in any medium, provided the original work is properly cited. For commercial re-use, please contact journals.permissions@oup.com doi:10.1093/jla/lav010 Journal of Legal Analysis Advance Access published September 13, 2015