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Managers of financially distressed firms: villains or scapegoats?

Article Abstract:

In this article, we provide evidence concerning the extent to which managers are to blame when their firms become bankrupt. We study a sample of firms that file for Chapter 11 and determine the actions taken by the firms' managers during the three-year period before the filing. We compare the sample with a control sample of firms that performed better. We suggest that the comparison provides evidence on the way managers act as their firms sink into financial trouble and whether financial distress is the result of incompetence or excessively self-serving managerial decisions or due to factors outside of management's control. We find that managers of the Chapter 11 firms and the control firms make very similar decisions and that, on average, neither set of managers is perceived to be taking value-reducing actions. These results do not change when we control for managerial turnover or managerial ownership. We also find that when managers are replaced in firms that eventually file for Chapter 11 protection, the market does not respond positively, regardless of whether the new managers are from inside or outside the firm. Our findings suggest that when managers are blamed for financial distress, they are serving as scapegoats. (Reprinted by permission of the publisher.)

Executives, Bankruptcy

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Financial contracting and leverage induced over- and under-investment incentives

Article Abstract:

This paper investigates the effects of seniority rules and restrictive dividend covenants on the over- and under-investment incentives associated with risk debt. We show that increasing seniority of new debt decreases the incidence of under-investment but increases over-investment, and vice versa. Under symmetric information, the optimal seniority rule is to give new debtholders first claim on a new project without recourse to existing assets (i.e., project financing). Under asymmetric information, the optimal debt contract requires equating the expected return to new debtholders in the default state to the new project's cash flow in the same rate. If this is not possible, the optimal seniority rule calls for strict subordination of new debt if the expected cash flow in default is small and full seniority if it is large. With regard to dividend covenants, we show that their effect depends on whether or not dividend payments are conditioned on future investments. When they are unconditioned, allowing more dividends increases the under-investment incentive. In contrast, conditional dividends decrease the under-investment incentive and increase the over-investment incentive. (Reprinted by permission of the publisher.)

Analysis, Investment banks, Investment analysis, Securities analysis, Leverage (Finance), Leverage, Bank investment contracts

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