The impact of a competitor’s Chapter 11 bankruptcy on firm risk-taking

Abstract

Using a difference-in-differences method, this study examines the effect of a competitor’s Chapter 11 bankruptcy on a firm’s risk-taking. The contingent nature of a competitor’s Chapter 11 bankruptcy, which protects the competitor from creditors’ demands during financial reorganization, may increase uncertainty in the industry. Consequently, the study tests the hypothesis that other firms in the industry respond to a competitor’s bankruptcy by decreasing risky investments in research and development (R&D), capital expenditures and acquisitions. To validate and extend this hypothesis, the study also hypothesizes that a firm’s strong financial standing—low leverage and good performance—and the firm’s diversification reduce the negative effect of the competitor’s bankruptcy on firm risk-taking. Findings from a study of US public firms suggest that, after controlling for industry conditions, firms indeed reduce their risk-taking when a competitor declares bankruptcy and that lower firm leverage, stronger firm performance, and greater firm diversification mitigate this effect. Together, these findings shed light on the literatures on bankruptcy and firm risk-taking. JEL Classification: L22, M10, D81, D25