Contagion effects of the world's largest bankruptcy: the case of WorldCom

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Abstract

On July 19, 2002 WorldCom sought protection from its creditors when it filed for Chapter 11 bankruptcy, earning the distinction as the largest bankruptcy filing in U.S. history. The events surrounding this history-making occurrence provide an important opportunity to examine the repercussions for WorldCom's stakeholders. We especially focus on the valuation effects of the WorldCom failure on exposed financial institutions for their important monitoring roles as institutional investors and creditors. Despite the heightened uncertainty facing investors during this period, we find that the market is remarkably efficient in distinguishing among the various types of stakeholders. In particular, institutional investors and creditors are largely unaffected by the events, which is expected based on the benefit of diversification. In contrast, large and key competitors are adversely affected by the events, which may be attributed to scrutiny of rivals that are perceived to be facing similar problems. Furthermore, for large and key competitors, these results indicate that contagion effects dominate competitive effects.

Introduction

Few could have imagined that a company with the stature and the size of WorldCom could collapse so quickly. WorldCom had attained a market value of $180 billion, was the largest Internet carrier, and was the second largest long-distance carrier. Nonetheless, barely five months passed from the time any widespread news report indicated that trouble might be ahead to the time they filed for bankruptcy. On February 6, 2002, the New York Times published an article that focused on WorldCom's aggressive accounting in reporting revenue. On July 19, 2002, WorldCom, with $103.9 billion in assets as of December 31, 2001, made history as the largest bankruptcy in U.S. history, surpassing Enron, which at the time of its filing had $63.1 billion in assets.

WorldCom's problems stemmed, in part, from its highly publicized admission that it had overstated profits by $3.8 billion. Long before the firm's accounting irregularities came to light, however, WorldCom and most of its competitors in the telecommunications industry were being hurt by negative market forces.1 Among these negative forces were overcapacity in their networks, the slowing economy, which had reduced business demand for telecommunications services, and the ongoing price wars that had reduced consumer long-distance rates considerably. Indeed, WorldCom's bankruptcy filing added to an already substantial list of telecommunications firms that had filed for bankruptcy protection in recent years, including Northpoint Communications Group and Global Crossing. Several telecommunications firms were also being probed by the Securities and Exchange Commission (SEC), including Qwest Communications International and Global Crossing, further contributing to a generally unstable environment in the industry.

The existing literature provides evidence that bankruptcy filings have significant repercussions for both the bankrupt firm and a variety of associated stakeholders, including rival firms, client firms, and creditors. For example, Lang and Stulz (1995) and Ferris, Jayaraman, and Makhija (1997) show that bankruptcy announcements generate a dominant industry contagion effect; that is, the stock prices of competitors decline because the bankruptcy reveals adverse information about industry asset values and future prospects. Datta and Iskandar-Datta (1995) also show that stockholders and unsecured creditors are adversely affected by the filing, whereas secured debtholders are unaffected.

These studies analyze the effects of a sample of bankruptcies on different classes of stakeholders. There is evidence, however, that in some cases the sheer magnitude and scope of the bankruptcy of a single firm is sufficiently significant to warrant separate examination.2 In such instances, the failure of a single firm provides a natural laboratory for understanding the ramifications of the event. For example in 1990, Laventhol and Horwath, then the seventh largest public accounting firm in the U.S., filed for Chapter 11 bankruptcy. Baber, Kumar, and Verghese (1995) find that the bankruptcy had significant negative price implications for the firm's clients for two reasons. First, they argue that investors rely on auditors to recover future investment losses. Thus, the failure invalidates this insurance function performed by the auditor.

Second, the failure caused investors to reassess the quality of the firm's audits, triggering a negative share price response for their clients. Other examples of major bankruptcies include the failure of Penn Square Bank in 1982 and Continental Illinois Corporation, a bank holding company, in 1984. In the case of Penn Square, the evidence generally indicates that other banks were adversely affected by the failure (Fraser and Richards, 1985, Karafiath and Glascock, 1989, Lamy and Thompson, 1986, Peavey and Hempel, 1988). However, the market's reaction was not indiscriminate. In particular, banks with the greatest exposure to the failed bank, including upstream banks that had loan participations with Penn Square, were more adversely affected by the events surrounding the bank's failure. In contrast, banks outside Penn Square's economic region were largely unaffected by the events. In the case of Continental Illinois, Swary (1986) finds that the failure had a significant negative impact on other banks, particularly those with a relatively large amount of nonperforming assets.

WorldCom's bankruptcy is one that deserves special examination. Coming as it did on the heels of the Enron collapse, the firm's demise occurred during a period of unprecedented investor awareness, anxiety, and uncertainty. Further, given that WorldCom's bankruptcy is the largest in U.S. history, we expect this history-making event may have significant repercussions for the firm's key stakeholders. The significance of WorldCom's bankruptcy is further highlighted in a statement made by the chairman of the Federal Communications Commission, Michael Powell, shortly after the bankruptcy filing. Recognizing the integral role that WorldCom plays in the economy, the chairman issued a statement assuring the public that:

… we do not believe this bankruptcy filing will lead to an immediate disruption of service to consumers or threaten the operation of WorldCom's Internet backbone facilities. It is my understanding that WorldCom has obtained funding necessary to continue operations during the pendency of its bankruptcy proceeding … This Commission stands ready to intervene in bankruptcy proceedings as necessary to ensure that the bankruptcy court is aware of and considers our public interest concerns.

The bankruptcy of WorldCom clearly has consequences for its shareholders, who watched their stocks fall from $6.97 on February 5, 2002, the day before the first negative news event regarding the firm came to light, to $0.83 on July 19, 2002 when the firm ultimately filed for bankruptcy. In this study, we examine how information released about WorldCom in the months prior to its bankruptcy filing affected institutional investors, creditors, and competitors. Despite the heightened uncertainty facing investors during this period, we find that the market is remarkably efficient in distinguishing among the various types of stakeholders. In particular, institutional investors and creditors are largely unaffected by the events leading to WorldCom's failure. These results are consistent with the basic benefit of diversification; a single bankruptcy, even the world's largest bankruptcy, should have no impact on well-diversified shareholders. In contrast, large and key competitors are adversely affected by the events, which may be attributed to scrutiny of those rivals that are perceived to be facing similar problems. Furthermore, contagion effects appear to dominate any effects from competitive repositioning, for large and key competitors. These results indicate that shareholders, analysts, and portfolio managers are considering how firms with indirect ties to a financially distressed company may be affected.

Section snippets

Analyzing the effects on key stakeholders

News releases about the future viability of WorldCom began to be disseminated by the popular press on February 6, 2002, when there was an article published that focused on the aggressive accounting methods used by WorldCom in reporting revenue. Over the next few months, reports were released that indicated WorldCom may have engaged in a variety of fraudulent accounting tactics. A chronology of important events that calls into question the ongoing viability of WorldCom is provided in Table 1.

Data and methodology

To gauge the fallout from information released about the future viability of WorldCom, we examine the response of portfolios returns for institutional investors, creditors, and industry rivals. We require that sample firms have daily stock returns available from CRSP between January 2, 2002 and December 31, 2002. This requirement provides us with a sample of 64 institutional investors, 22 creditors, and 96 competitors.

We use the seemingly unrelated regression (SUR) technique developed by

Results

We evaluate the potential contagion effects related to the important events leading up to the bankruptcy of WorldCom that are displayed in Table 1. First, we analyze the impact of the information disseminated about WorldCom on their shareholders. These results are reported in Table 5. Second, we analyze whether portfolios of WorldCom stakeholder firms were affected. In Table 6, Table 7, Table 8, we report the results for all the stakeholder firms in each category, and for several subgroups.5

Summary

On July 19, 2002 WorldCom sought protection from its creditors when it filed for Chapter 11 bankruptcy, earning the distinction as the largest bankruptcy filing in U.S. history. The events surrounding this history-making occurrence provide an important opportunity to examine the repercussions for WorldCom's stakeholders. We examine the impact of the events on the firm's institutional investors, creditors, and competitors. Despite the heightened uncertainty facing investors during this period,

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