Director Bankruptcy Experience and Corporate Risk Taking

By Radhakrishnan Gopalan (Washington University in St. Louis – John M. Olin Business School), Todd A. Gormley (Washington University in St. Louis), and Ankit Kalda (Indiana University – Kelley School of Business – Department of Finance)

In our paper, we evaluate the extent to which a director’s past life experience affects the policies their firms follow. The specific experience we focus on is corporate bankruptcy. We identify 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. These shifts, however, 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.

The full article is available here.