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Peering into a Cloudy Crystal Ball: Analysts Recommendations Preceding Bankruptcy

In this study we test for the presence of over-optimism in analyst recommendations for a sample of bankrupt firms over the 1995-2001 period. Our findings indicate a pervasive over-optimism in analysts' recommendations. This recommendation bias exists even for firms that are unable to reorganize and must liquidate. Our results indicate that the probability of revision in recommendations does not depend on the analyst reputation, the investment bank's reputation, or existing business ties between the investment bank and the bankrupt firm. Further, the extent of the bias is not attenuated by prior financial signals, such as the existence of a qualified opinion or changes in the firm's auditor. Nevertheless, the market appears to recognize the existence of this bias and ignores analyst upgrades. It only reacts when analysts act against their bias and issue a recommendation downgrade. These findings suggest that recently passed regulations and laws to reduce analyst conflict of interest might be unnecessary to the operation of an informationally efficient equities market.