Bankruptcy in Groups

By William H. Beaver, Stanford University; Stefano Cascino, London School of Economics; Maria Correia, London Business School; and Maureen F. McNichols, Stanford University

Group bankruptcies tend to be large and affect a significant number of stakeholders. Business groups constitute a common way for ultimate owners to exercise control over a large number of companies while containing their risk exposure to different parts of the business through limited liability. In countries with underdeveloped financial infrastructures, business groups overcome difficulties in accessing external finance by reshuffling funds within the corporate structure.

In our study, we seek to understand how financial distress takes place within a business group. Using a large cross-country sample of group-affiliated firms, we show that group structure matters for parent and subsidiary bankruptcy prediction. Moreover, we show that the re-allocation of resources among group firms is likely to be a channel through which parent firms manage intra-group credit risk. Parents may be required to support financially distressed subsidiaries as a result of explicit or implicit agreements. Absent these agreements, parents might also have an incentive to support financially distressed subsidiaries as the bankruptcy of a subsidiary may impose severe costs (e.g., reputational damage, cross-default, direct liability under veil piercing). Intra-group support can also flow in the opposite direction as distressed parents may seek financial aid from healthy subsidiaries. The results of our study show that the association between parent and subsidiary default probabilities varies with the level of subsidiary integration within the group and country-level institutional quality. A shock to the parent probability of default is less likely to propagate to subsidiaries in countries with strong anti-self-dealing, investor protection, director liability and related-party transaction regulations.

Our findings are relevant for financial reporting regulators, auditors, investors and credit rating agencies, and speak to the regulatory debate on cross-border insolvencies.

The full article is available here.