In our paper ‘Director Bankruptcy Experience and Corporate Risk Taking’, we evaluate the extent to which a director’s corporate bankruptcy experience affects the policies their firms follow. We begin by identifying a set of directors that experience a corporate bankruptcy. We then evaluate the extent to which this bankruptcy experience of the director is associated with the subsequent policies of other firms that these individuals serve as directors.
A corporate bankruptcy can be either a liberating or a traumatic experience. If the bankruptcy allows the firm to shed excess debt and obtain a fresh start, it can be a liberating experience. On the other hand, if the bankruptcy is prolonged and destroys significant value, then it can be traumatic. An inefficient bankruptcy can also affect the future career prospects of the director as the market may partially blame them for the bankruptcy. Either way, a bankruptcy is likely to be a significant life experience and affect the director’s outlook towards risk taking.
We find that, on average, firms take on more risk if they have a director who has experienced bankruptcy in the past. Specifically, such firms finance themselves with more debt, are less likely to issue equity, more likely to take up riskier projects, as reflected in the variability of cash flows, and less likely to diversify their business through acquisitions. While surprising at first blush, when we look closely, we find that these shifts are only present when the original bankruptcy was a less expensive affair. That is, when the previous bankruptcy was quick, resulted in a restructuring of the firm, and was accompanied by a smaller stock price decline. We also find that directors who are associated with such bankruptcies do not experience any adverse career outcomes.
Overall, our results highlight that, on average, a past corporate bankruptcy experience might actually increase a director’s willingness to take on risk in the future.
Our paper has a number of important implications. First, our paper offers a potential explanation to the long-standing puzzle in finance as to why firms do not borrow more so as to take advantage of interest tax shields. Our paper’s results highlight that one possible explanation could be managers’ fear of distress costs. A director’s personal experience and gained familiarity with a distress situation may reduce this fear and encourage higher leverage. Our paper is also unique in highlighting the director’s role in influencing corporate policies. By doing so, it departs from the bulk of the literature on directors, which instead focuses on their role in monitoring managers.
An earlier version of this post appeared on the Harvard Law School Bankruptcy Roundtable blog on December 18, 2018.
Radhakrishnan Gopalan is Assistant Professor at Washington University in St. Louis, John M. Olin Business School.
Todd A. Gormley is Associate Professor of Finance, Washington University in St. Louis.
Ankit Kalda is a Acting Assistant Professor at Indiana University, Kelley School of Business, and PhD Candidate at Washington University in St. Louis.