Spillover Effects of Intra-Industry Bankruptcy Filings on Firms' Cash Holding Policy

Abstract

The paper finds that on average firms increase their cash holdings following the bankruptcy events of their industry peers. This financial prudence is attributed to both profitability and precautionary motives hypothesis. The magnitude of the adjustment is more pronounced after the year 1991 when Delaware bankruptcy ruling on manager’s fiduciary duties changed to significantly favor the control right of secured creditors over shareholders and management (Becker and Stromberg (2010)). In addition, I find that the bankruptcy spillover effects are stronger for firms that are in geographic proximity with the distressed firms. Our robustness test shows that the results are less likely driven by the spurious causality caused by unobserved and underlying time trends of industry conditions. Taken together, the findings show that not only do creditors and shareholders reassess the perceived default risk of surviving firms as documented in prior literature, but so do the management of these firms. Managers update their beliefs of future business risk and respond by acquiring larger financial slack for their companies. The paper implies strong interdependence of financial policies among industry peers and emphasizes the importance of the industry network effect on firm behavior.