Saddled with Attention: Overreaction to Bankruptcy Filings

• Published date: 01 December 2019
• DOI: http://doi.org/10.1111/irfi.12199
• Date: 01 December 2019

Saddled with Attention:

Overreaction to Bankruptcy

Filings*

TOMAS REYES AND NICOLAS WAISSBLUTH

Department of Industrial and Systems Engineering, Pontificia Universidad Católica de

Chile, Santiago, Chile

ABSTRACT

We analyze the effect of investor attention on stock prices around Chapter 11

bankruptcy filings. We measure investor attention as abnormal search volume

from Google, and find that attention-grabbing companies have more negative

abnormal stock returns in the days before and during bankruptcy filings and

more positive abnormal returns immediately thereafter. That is, for companies

receiving high attention, investors overreactto a bankruptcy filing; for compa-

nies receiving low attention, they underreact. This pattern is more pro-

nounced for companies with low institutional ownership and holds after

controlling for standard predictors of stock performance during bankruptcy.

JEL Codes: G14; G33; D82

Accepted: 22 April 2018

I. INTRODUCTION

Limited attention plays an important role in investor behavior and is associated

with multiple market pricing anomalies. Since Kahneman (1973) characterized

attention as a scarce cognitive resource, several authors have argued that lim-

ited attention from economic agents explains numerous financial phenomena

(Hirshleifer and Teoh 2003; Peng and Xiong 2006; Barber and Odean 2008; Del-

laVigna and Pollet 2009; Hirshleifer et al. 2009). Whether investors are paying

attention to specific stock market events affects the way in which they process

information and react to it. This can ultimately alter the effect of both positive

and negative information on asset prices.

There are two standard mechanisms through which attention can affect

stock prices. First, in conjunction with new information, attention can lead to

* We acknowledge the support of FONDECYT (Grants 1160048 and 1171894) and Núcleo Milenio

Research Center for Entrepreneurial Strategy under Uncertainty (Grant NS130028). We thank the

editors and the anonymous referee for their constructive feedback. We also appreciate helpful com-

ments and suggestions from Manuel



Alvarez, Robin Greenwood, Katerina Manoff, Santiago Mingo,

Julio Pertuzé, and Stephen Zhang. We also thank Diego Martínez for excellent research assistance.

Part of the work was completed while Reyes was at UC Berkeley.

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 19:4, 2019: pp. 787–819

DOI: 10.1111/irfi.12199

faster information diffusion and therefore faster price discovery (DellaVigna

and Pollet 2009; Hirshleifer et al. 2009; Drake et al. 2012). Second, attention

itself can artificially drive stock demand and induce noise trading behavior that

ultimately leads to price pressure from retail investors (Barber and Odean 2008;

Da et al. 2011; Joseph et al. 2011). This second theory traditionally applies to

attention driven by both positive and negative information.

In this paper, we posit the existence of a third mechanism through which

attention can exacerbate mispricing that stems from biased beliefs. We look for

evidence for this third mechanism around bankruptcy filings, which are

unusual, associated with large price changes, and yield extremely negative news

stories that are generally not open to interpretation. This empirical setup pro-

vides a powerful natural setting that allows us to diminish any upward price

pressure stemming from a neutral or positive interpretation of a news event. As

a robustness check, we also examine a sample of earnings announcements with

negative earnings surprises and find analogous patterns.

There is an ample body of literature related to bankruptcy issues. However,

most of these studies deal with the prediction of financial distress and the work-

ings of corporate failure mechanisms. In contrast, few studies focus on the mar-

ket performance of firms during bankruptcy (Clark and Weinstein 1983; Datta

and Iskandar-Datta 1995; Dawkins et al. 2007; Coelho 2013). According to

these studies, the average effect of a bankruptcy filing on a firm’s stock is a con-

sistent price decrease over the weeks prior to the filing and a steep price drop at

the time of the filing.

Our primary hypothesis is that, before and during their bankruptcy filings,

firms receiving higher levels of investor attention experience more negative

abnormal returns (ARs) than their low-attention counterparts; in the period

after their filings; however, these companies experience a significant reversal

marked by higher ARs. That is, a surge in retail investors’attention around

bankruptcy filings leads to an overreaction to the bankruptcy news.

This overreaction is not fully consistent with the two previously mentioned

standard mechanisms through which attention is known to affect stock prices.

If attention were a facilitator of information diffusion (DellaVigna and Pollet

2009; Hirshleifer et al. 2009), we would not expect an overreaction. On the

other hand, if attention were a trigger of retail net buying (Barber and Odean

2008), we would expect a price pressure effect in the opposite direction.

Specifically, in this paper, we test three hypotheses: (i) attention is negatively

associated with abnormal stock returns before and during bankruptcy filings;

(ii) attention is associated with a return reversal after bankruptcy filings; and

(iii) these effects are more significant for companies with low levels of institu-

tional ownership.

To test our hypotheses, we conduct a short-term event study of cumulative

abnormal returns (CARs) around bankruptcy filing dates and analyze these

returns as a function of attention and institutional ownership levels. Our sam-

ple consists of 155 Chapter 11 bankruptcy cases filed between 2004 and 2014

that involve active trading of common stock after the filing date. We measure

© 2018 International Review of Finance Ltd. 2018788

International Review of Finance

attention as abnormal internet search volume for company-specific search

terms from Google Trends. We consider cases after 2004 because data from this

source is available from that time onward.

We start by examining the cross-section of bankruptcy returns for the pre-,

during, and postfiling periods and identify systematic patterns of returns

around the filing date. We find patterns consistent with prior research and the

efficient market hypothesis (Fama 1970); the market is able to anticipate the

bankruptcy filing to some extent, the filing reveals a significant amount of neg-

ative information, and there is no significant drift in the postfiling period given

that no new information is revealed.

However, consistent with our hypotheses, we identify a different pattern of

CARs through time when considering the attention paid to each company.

Companies receiving high levels of attention exhibit evidence of

overreaction—faster stock price declines before and during their bankruptcy fil-

ings, and more positive CARs afterward. In contrast, companies receiving lower

levels of attention show evidence of underreaction—slower decreases in stock

price before and during their filings, and more negative CARs thereafter.

More specifically, for the prefiling and filing periods, we find a statistically

significant difference between the CARs of two groups of companies receiving

high and low levels of attention, respectively. Our results show that companies

receiving higher attention experience significantly larger price drops. In the pre-

filing period, we find a −14.2% CAR for the high-attention group, compared to

−5.16% for the low-attention group. On the filing days, we find a −47.6% CAR

for the high-attention group, and −31.2% for the low-attention group. This

confirms that attention is related to negative CARs before and during bank-

ruptcy filings and supports our first hypothesis.

In contrast, for the postfiling period, we find that companies receiving high

levels of attention have a positive average CAR of 14.8%, 22.2% higher than

the low-attention group, which exhibits a negative average CAR of −7.43%.

This suggests an attention-driven reversal after the filing and supports our sec-

ond hypothesis (i.e., positive short-term postfiling CARs are related to higher

levels of attention).

We then turn to regression models to explain CARs for each period in terms

of attention. Our results reveal a relevant effect of attention that holds when

controlling for standard predictors of bankruptcy stock performance (firm size,

financial distress level, debtor-in-possession financing, and prepackaged bank-

ruptcies). We find economically and statistically significant effects of abnormal

search volume on stock performance, confirming that attention drives prices

down before and during bankruptcy filings, and up thereafter. This differs sub-

stantially from traditional findings regarding attention and stock returns, which

suggest that attention is a facilitator of either information diffusion or retail net

buying.

We also analyze whether the effect of attention interacts with the level of

institutional ownership of bankrupt firms. A higher concentration of individual

investors tends to exacerbate market anomalies, and therefore we expect the

© 2018 International Review of Finance Ltd. 2018 789

Attention to Bankruptcy Filings