Managers’ Personal Bankruptcy Costs and Risk-Taking

It has long been argued that strengthening creditor rights facilitates firms’ access to credit financing, leading to larger credit markets and fostering economic growth (La Porta et al. 1997, 1998). The underlying theoretical argument is compelling. If creditors expect higher recovery rates in default states, they are willing to provide more credit at a cheaper price. However, stronger creditor rights not only affect the supply of credit but may also have a negative effect on the demand for credit, as documented in some recent empirical studies (Acharya et al. 2011; Vig 2013).

My paper ‘Managers’ Personal Bankruptcy Costs and Risk-Taking’ exploits a bankruptcy reform in Korea in 2006 to examine whether treating managers harshly in bankruptcy may induce excessive conservatism in firms, leading them to abandon risky but positive NPV projects. Specifically, the reform abolished a system under which managers were forced to resign upon bankruptcy filing and replaced by a court-appointed trustee, replacing it with a system under which managers stay in control during corporate restructuring and negotiate with creditors, similar to Chapter 11 in the U.S. This change in bankruptcy proceedings significantly reduced managers’ personal costs of bankruptcy states.

The paper finds that high personal bankruptcy costs lead managers to run their firms more conservatively. Specifically, risky firms that are sensitive to the design of bankruptcy proceedings reduce their leverage and investment, in particularly risky types of investment such as innovation, when bankruptcy states are costly for managers. In particular, family firms and firms with concentrated ownership where private benefits of control are high exhibit high conservatism when managers are pushed out of the firm in bankruptcy states. Interestingly, they are less willing to take on additional credit for investment, despite credit being cheaper under a regime that provides creditors with higher control in bankruptcy states. Even firms with good investment opportunities forego those opportunities when investment may increase the risk of ending up in bankruptcy states that are costly for managers, leading to lower profits for the affected firms. Under the post-reform regime that allows managers to stay in charge during reorganization, those distortions to firms’ financing and investment behavior are alleviated, leading to a surge in leverage, investment, and innovation for risky firms sharply after the passage of the reform.

Altogether, the results suggest that making bankruptcy states costly for managers may induce excessive conservatism that leads firms to abandon profitable projects. This may have adverse effect on economic growth, as risk-taking and innovation are important drivers of economic development and prosperity in modern societies. The results in the paper show that those adverse effects can outweigh positive effects of strong creditor rights on the supply of credit, which has important implications for bankruptcy law design.

David Schoenherr is Assistant Professor of Economics at the Bendheim Center for Finance, Princeton University.