The influence of managerial incentives on the resolution of financial distress

Abstract

This study investigates the influence of managerial incentives on the resolution of financial distress. Our model predicts that when creditors and equityholders prefer different resolution methods, the likelihood of choosing Chapter 11 over private renegotiation is related to the ownership structure of the distressed firm. Empirical test results using a sample of 81 voluntary Chapter 11 firms and 65 private workout firms support the model’s prediction. We show that managerial ownership is positively related to the incidence of Chapter 11 filing when there is conflict between equityholders and creditors over the choice between Chapter 11 and a private renegotiation. Consistent with prior literature, we also find that the choice of resolution methods depends on the extent of creditor holdout problems and the level of economic distress. We also performed the analysis of a subsequent 5 years of post-distress performance for all sample firms. The majorities of firms that file for Chapter 11 lose their independence and are either acquired or liquidated. However, more than half of firms in private workouts survived as independent firms.

Appendix

Parameter values in Fig. 1a and b can be derived based on the payoff structure for creditors and equityholders in both a private workout and Chapter 11 resolution. Assuming that C_B > C_W and δ(B) > δ(W),

$$ \begin{aligned}{} {\text{V}}_{{\text{D}}} {\text{(}}W{\text{)}}& = {\text{min[D, (1}} - \delta {\text{(}}W{\text{))(V}} - {\text{C}}_{{\text{W}}} {\text{), and V}}_{{\text{D}}} {\text{(}}B{\text{)}} = {\text{min[D, (1}} - \delta {\text{(}}B{\text{))(V}} - {\text{C}}_{{\text{B}}} {\text{)],}} \\ {\text{V}}_{{\text{E}}} {\text{(}}W{\text{)}}& = {\text{(V}} - {\text{C}}_{{\text{W}}} {\text{)}} - {\text{V}}_{{\text{D}}} {\text{(}}W{\text{), and V}}_{{\text{E}}} {\text{(}}B{\text{)}} = {\text{(V}} - {\text{C}}_{{\text{B}}} {\text{)}} - {\text{V}}_{{\text{D}}} {\text{(}}B{\text{)}}{\text{.}} \\ \end{aligned} $$

In Fig. 1a, V₂ denotes the firm’s value at reorganization (V) in which creditors are paid in full in a private workout, such that D = (1 − δ(W))(V − C_W). Thus, V = D/(1 − δ(W)) + C_W. V₄ represents V in which creditors are paid in full in Chapter 11, such that D = (1 − δ(B))(V − C_B). Thus, V = D/(1 − δ(B) + C_B. In Fig. 1b, when V > V₄, creditors are paid in full both in a private workout and in Chapter 11. Thus the residual values that equityholders can retain are (V − C_B) − D in Chapter 11 and (V − C_W) − D in a private workout.

When V < V₄, equityholders’ payoff structure in Chapter 11 has changed to the point where V is close to V₃ because in this range, creditors are not fully paid only in Chapter 11. Thus, when V₃ < V < V₄, the payoff to equityholders is (V − C_B) − (1 − δ(B))(V − C_B) (i.e., δ(B))(V − C_B)) in Chapter 11 and (V − C_W) − D in a private workout. V₃ is the point where δ(B))(V − C_B) = (V − C_W) − D. Thus, V₃ denotes V such that

$$ {\text{V}} = \frac{{{\text{D}} + {\text{C}}_{{\text{W}}} - \delta (B){\text{C}}_{{\text{B}}} }} {{1 - \delta (B)}} $$

When V < V₂, equityholders’ payoff structure in a private workout has changed because in this range, creditors are not fully paid both in Chapter 11 and in a private workout. Thus, the payoff to equityholders is (V − C_B) − (1 − δ(B))(V − C_B) (i.e., δ(B)(V − C_B)) in Chapter 11 and (V − C_W) − (1 − δ(W))(V − C_W) (i.e., δ(W))(V − C_W)) in a private workout. Equityholders still can retain higher value in Chapter 11 than in a private workout until V reaches V₁. V₁ is the point where δ(B))(V − C_B) = δ(W))(V − C_W). Thus, V₁ denotes V such that

$$ {\text{V}} = \frac{{\delta (B){\text{C}}_{{\text{B}}} - \delta (W){\text{C}}_{{\text{W}}} }} {{\delta (B) - \delta (W)}} $$

In summary, the parameter values (V₁, V₂, V₃, and V₄) in Fig. 1a and b are denoted as follows.

$$ {\text{V}}_{1} = \frac{{\delta (B){\text{C}}_{{\text{B}}} - \delta (W){\text{C}}_{{\text{W}}} }} {{\delta (B) - \delta (W)}} $$

V₂ = D/(1 − δ(W)) + C_W

$$ {\text{V}}_{3} = \frac{{{\text{D}} + {\text{C}}_{{\text{W}}} - \delta (B){\text{C}}_{{\text{B}}} }} {{1 - \delta (B)}} $$

V₄ = D/(1 − δ(B)) + C_B.

Table A1 Description of the dependent and explanatory variables and their measurements

Table A2 Correlation coefficients