The Impact of the Repeal of the Stock-for-Debt Exception on Corporate Bankruptcy Restructurings

This paper investigates the effect repeal of the stock-for-debt exception on corporate bankruptcy restructurings. This exception permitted corporations to exclude cancellation of indebtedness income from gross income provided they exchanged their own common equity for debt while in Chapter 11. Consistent with claims made by Easton (1994), it is found that the change in tax law imposed significant explicit tax costs on bankruptcy filers. Despite these costs, it is found that many of these firms altered their debt restructure method to preserve net operating losses and reduce their cost of equity. Almost half of the sample firms issued significant levels of debt while in Chapter 11. Additionally, approximately a third of these firms responded to the change in tax law to preserve NOLs by electing an alternative provision available under the ownership change rule bankruptcy exception that allows for a one-time reduction in NOL tax attributes. It is also shown that the remaining firms were precluded from changing their debt restructure method, despite the loss of all of their NOL tax attributes, because the financial reporting marginal costs of doing so exceeded any marginal tax benefits that might have been generated