“A Bitter Result”: Purdue Pharma, a Sackler Bankruptcy Filing, and Improving Monetary and Nonmonetary Recoveries in Mass Tort Bankruptcies

By William Organek (Harvard Law School)

William Organek

Purdue Pharma, the maker of OxyContin, filed for bankruptcy in 2019 to resolve thousands of opioid-related lawsuits.  Two years after filing, a reorganization plan was confirmed: in exchange for a financial contribution of several billion dollars by the Sackler family and relinquishment of their ownership in Purdue, the family would be released from all civil liability associated with their ownership and control of Purdue.  Individual claimants, state attorneys general, the United States Trustee, the Department of Justice, Congress, academics, and others criticized the settlement as an abuse of the bankruptcy system.  These parties contended that granting this immunity over their objections–known as a third-party release–was an unfair remedy.  They stated that such a plan would reduce creditors’ financial recoveries and make it more difficult to achieve their goals of learning about Purdue’s role in the opioid crisis and preventing future corporate malfeasance.  Instead, if the Sacklers were to receive immunity, critics suggested that the Sacklers should be required to file for bankruptcy.  A Sackler bankruptcy filing, they claimed, would increase creditor recoveries and ensure that creditors’ nonmonetary goals would be met.

This Article argues that these criticisms rely on a deeply problematic assumption: on closer inspection, it is not at all clear that a Sackler bankruptcy filing would result in better monetary or nonmonetary outcomes for creditors, and could actually detract from these goals.

From a monetary perspective, demands for a Sackler bankruptcy filing overlook the factual complexity that this would entail, and the corresponding weaknesses in remedies available to creditors under bankruptcy law.  The Sacklers engaged in sophisticated asset protection strategies that limited creditors’ financial recoveries by spreading ownership and control of Purdue, as well as their other holdings, across dozens of domestic and international spendthrift trusts to benefit scores of family members.  Demands for a Sackler bankruptcy filing ignore collections issues, the illiquidity of their holdings, the discounts that might be applied to recoveries of minority interests, and the limitations on creditors’ fraudulent transfer remedies.  To overcome these problems and maximize financial recoveries, the parties agreed to a “de facto substantive consolidation”: a consensual dissolution of the legal barriers separating the assets of individual members of the Sackler family, their trusts, and Purdue.  This ad hoc solution, while effective, depended on Sackler acquiescence.

Achieving creditors’ nonmonetary goals, such as broader disclosure, restrictions on the opioid businesses of Purdue and the Sacklers, and limitations on Sackler charitable donations, would probably have been made more difficult by a Sackler bankruptcy filing.  A bankruptcy filing likely would have pitted family members against one another, making disclosure or other consensual resolutions more difficult.  Courts also have limited ability to force debtors to divest assets or refrain from participating in business or charitable endeavors.  Instead, the Sacklers agreed to these undertakings because it was clear from the commencement of the case that the availability of a third-party release was contingent upon their cooperation.  Only by being able to offer what the Sacklers wanted–civil immunity–could creditors and the court cajole the Sacklers into agreement.

This Article demonstrates the institutional limits faced by the bankruptcy system in addressing certain kinds of monetary harms and nonmonetary objectives.  It ends by proposing reforms to fraudulent transfer law that would close the international spendthrift trust loophole that was so critical to the strategy pursued by the Sacklers to limit creditors’ monetary recoveries.  It also argues that the price of achieving creditors’ nonmonetary goals can be reduced in future mass tort bankruptcy cases by mandating expanded disclosure by parties seeking third-party releases, more consistent appointment of trustees to manage the debtor in mass tort bankruptcies, and appointment of examiners to uncover information about the causes of a mass tort.

The full article is available here.  Comments to the author are welcomed: worganek [at] law [dot] harvard [dot] edu.

[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] The Texas Two-Step and Mandatory Non-Opt-Out Settlement Powers

By Ralph Brubaker (University of Illinois College of Law)

Note: This is the sixth in a series of posts on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), here (by Jared A. Ellias), here (by Anthony Casey and Joshua Macey), and here (by David Skeel).

***

Ralph Brubaker

All of the posts in this series have been incredibly thoughtful and incisive in illuminating what’s at stake with the innovative new Texas Two-Step bankruptcy strategy.

As Professors Casey and Macey point out, by isolating and separating Defendant’s mass-tort liability (in a new BadCo) from its business operations (in a new GoodCo) and subjecting only the former to the bankruptcy process, the value of Defendant’s business (which must ultimately pay the mass-tort obligations, under a funding agreement between GoodCo and BadCo) is enhanced by avoiding all of the direct and indirect costs that a bankruptcy filing would entail. At the same time, though, Defendant can nonetheless take advantage of bankruptcy’s beneficial claims resolution process, which consolidates all of the mass-tort claims, both present and future claims, in one forum—the Bankruptcy Court.

That mandatory, universal consolidation of all mass-tort claims, which is entirely unique to the bankruptcy process, is tremendously powerful and is a huge boon to facilitating an aggregate settlement of Defendant’s mass-tort exposure. Indeed, bankruptcy can produce aggregate settlement of mass tort obligations much more effectively and efficiently than the only available nonbankruptcy alternative, so-called multi-district litigation (MDL) under the federal MDL statute.

Professors Casey and Macey acknowledge that the Texas Two-Step bankruptcy is an unalloyed good, however, only if it does not leave tort victims worse off. I share the fear of many that it will, though, and my concern derives from one of the most fundamental differences between the bankruptcy and nonbankruptcy systems for aggregate resolution of mass torts, giving rise to the vertical forum shopping that Professor Lipson highlights.

The due process clauses of the Constitution give an individual tort victim a property right in a cause of action against Defendant. Consequently, that individual must consent to a settlement of that tort claim (i.e., a voluntary transfer or sale of the claim to Defendant). The only circumstance in which a mandatory “settlement” of a damages claim can be imposed upon a nonconsenting claimant (i.e., the claimant’s property can be involuntarily expropriated) is when there is sufficient danger of a common-pool problem, or so-called “tragedy of the commons,” of the kind extremely familiar to bankruptcy scholars and professionals.

Outside bankruptcy, that common-pool problem is the impetus for a so-called “limited fund” class action, which takes away claimants’ unfettered control over their individual claims (i.e., their property) by allowing a fiduciary representative to assert and settle in the aggregate all of the common claims against a limited fund, whether or not individual claimants consent to that aggregate settlement. As the Supreme Court made clear in its Ortiz v. Fibreboard decision, though, if a mass-tort defendant’s resources do not constitute a limited fund that is insufficient to fully satisfy its mass-tort obligations, individual claimants retain an absolute constitutional right to opt out of any aggregate resolution process, as part of their due process property rights in their individual claims.

Bankruptcy, of course, is also designed to address such a common-pool problem, and the binding distribution scheme effectuated by a confirmed plan of reorganization is functionally identical to the mandatory non-opt-out settlement at issue in Ortiz. Both systems enable a mass-tort defendant to impose a judicially-approved hard cap on their aggregate mass-tort liability, without any opt-outs by nonconsenting claimants. That mandatory non-opt-out settlement power works a dramatic change in a mass-tort defendant’s ultimate aggregate liability and the complex bargaining dynamics by which that ultimate liability is determined.

I thus share the concern expressed by Professor Ellias about the prospect of solvent mass tort defendants using Texas Two-Step bankruptcies to resolve their mass-tort liability. And Professor Skeel is right to point out that Judge Kaplan’s LTL Management decision gives too much encouragement to that strategy, for example, by opining that “[t]here is nothing to fear in the migration of tort litigation out of the tort system and into the bankruptcy system” and “maybe the gates indeed should be opened.” Bankruptcy poses a substantial risk of systematically undercompensating mass-tort claimants relative to a nonbankruptcy baseline, particularly for future claimants. Perhaps that risk is acceptable when the debt overhang from massive disputed obligations presents a clear and present threat to entity viability and full payment of all claimants, problems that bankruptcy is designed to address. Absent that, however, the bankruptcy gates should not simply be swung open wide in an attempt to “fix” the mass-tort system, however “broken” it may or may not be. The mass-tort bankruptcy system itself could use some fixing.

If you would like to receive a copy of my current work-in-progress exploring these issues, email me at rbrubake [at] illinois [dot] edu.

 

[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Is the Texas Two-Step a Proper Chapter 11 Dance?

By David Skeel (University of Pennsylvania Carey Law School)

Note: This is the fifth in a series of posts on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), here (by Jared A. Ellias), and here (by Anthony Casey and Joshua Macey).

***

David Skeel

Are Texas Two-Steps ever a proper use of Chapter 11?  The argument that they aren’t—a view held by some scholars and reflected in proposed legislation in Washington—isn’t silly. Most current bankruptcy scholars grew up with Thomas Jackson’s creditors’ bargain theory of bankruptcy, which explains bankruptcy as a solution to creditor coordination problems that threaten to jeopardize the going concern value of an otherwise viable firm. The BadCo that files for bankruptcy in a Texas two-step does not have any going concern value. It’s just trying to manage massive liabilities. Why should this be allowed?

In rejecting a challenge to Johnson & Johnson’s recent two-step, the bankruptcy court supplied a forceful rejoinder to the view that preserving going concern value (or otherwise efficiently deploying a distressed company’s assets) is the only proper purpose for Chapter 11. Judge Kaplan points out that bankruptcy is often a superior mechanism for resolving tort liability as compared to the Multidistrict Litigation process or piecemeal litigation outside of bankruptcy. It is more orderly and can give more equitable and consistent treatment to victims. Judge Kaplan’s conclusion that LTL (the BadCo created by the J&J two-step) belongs in bankruptcy, and that a bankruptcy that involves mass tort liabilities but not the ongoing business that caused them is proper, is fully defensible in my view.

Where Judge Kaplan’s opinion goes off the rails is in too cavalierly dismissing the possibility that two-steps will be abused, as when he muses that “open[ing] the floodgates” to two-steps might not be such a bad thing. Those crafting future two-steps will be tempted to leave BadCo with inadequate ability to pay its victims, since nothing in the Texas divisional merger statute prevents this. Bankruptcy supplies two tools for policing these abuses, the good faith requirement [BRTsee this earlier Roundtable post on good faith and Texas Two-Steps] and fraudulent conveyance law. If courts are vigilant, these tools should be sufficient to discourage abusive two-steps. But if courts are cavalier about the potential abuses, the legislation pending in Washington will begin to seem a lot less ill-advised.

Perhaps the best thing that could happen for Texas two-steps would be for courts to bar the use of non-debtor releases outside of the asbestos context, where they are explicitly authorized by section 524(g) of the Bankruptcy Code. The Second Circuit may be poised to take this step in the Purdue Pharma opioid case, if it upholds the District Court’s conclusion that the releases of nondebtors in that case—most notably, the Sackler family—are not authorized by the Bankruptcy Code. If non-debtor releases were disallowed except where explicitly authorized, Texas two-steps would remain viable in asbestos cases such as J&J, but the floodgates would not open in other contexts, since the maneuver only works if the eventual reorganization includes a non-debtor release for GoodCo.

[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Upending the Traditional Chapter 11 Bargain

By Jared A. Ellias (University of California, Hastings College of the Law; Harvard Law School)

Note: This is the third in a series of posts on the Texas Two Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts) and here (by Jonathan C. Lipson).

***

In October 2021, Johnson & Johnson (“J&J”) executed a strategy to use the bankruptcy system to resolve a massive flood of personal injury lawsuits.  In doing so, J&J found a way to obtain the benefits of Chapter 11 without accepting the burden of operating a business under court oversight.  J&J achieved this outcome by executing a corporate law move dubbed the “Texas Two-Step.”  The Two-Step split J&J’s consumer division into two entities: (1) LTL Management LLC, which was allocated all of J&J’s baby powder-related tort liability; and (2) a second entity that contained the assets of its consumer businesses.  LTL Management subsequently filed for bankruptcy without the assets of the consumer business.  In a landmark recent opinion, Judge Michael B. Kaplan of the Bankruptcy Court for the District of New Jersey held that these maneuvers were not a bad faith bankruptcy filing.  As I argue below, Judge Kaplan’s ruling, which attempts to use bankruptcy law to ameliorate weaknesses in tort law, may inspire other wealthy firms to emulate J&J’s tactics.  It may also feed a potential backlash from higher courts and Congress that may make the bankruptcy system less useful to large firms.

In short, J&J’s bankruptcy strategy upends the traditional bargain that Chapter 11 offers to distressed corporations and their creditors.  Congress designed a bankruptcy system that provides companies with powerful protections, such as an automatic stay of non-bankruptcy litigation.  In exchange, companies must submit their assets to court oversight.  To be sure, a bankruptcy filing always undermines some of the bargaining power that mass tort claimants have outside of bankruptcy, such as the ability to bring many individual lawsuits.  However, the burden of court oversight also gives creditors bargaining power, as companies seek to exit bankruptcy quickly to escape the expense and distraction of a bankruptcy proceeding.  J&J argues it has found a better way of using the bankruptcy system: J&J would use a contract to make the assets of the consumer division available to pay any amounts owed to tort victims and its procedural machinations meant that those assets would not be depleted by wasteful court oversight.

As Michael Francus recently argued, J&J’s strategy is best understood as the latest move in the long-standing chess game of hardball bankruptcy tactics between the lawyers who represent tort victims and the lawyers who advise large companies with tort liability.  For example, in 2003, Pfizer resurrected a dead subsidiary and caused it to file for bankruptcy to obtain a judicial order halting all litigation against Pfizer, which potentially had its own liability associated with the subsidiary’s products.  Pfizer’s strategy involved taking a corporation that had been defunct for over a decade, giving it an “independent board of directors,” employees and office space.  By doing so, Pfizer was able to benefit from a bankruptcy court injunction for several years before reaching a settlement after a decade of scorched earth litigation.  Other high-profile companies, most prominently Purdue Pharma, have also tried to stretch bankruptcy law to resolve claims against third parties without those entities filing for bankruptcy themselves.

The “Texas Two-Step” strategy deployed by J&J takes these existing strategies a step further by surgically separating assets from liabilities to create a favorable bargaining environment.  In holding that this maneuver was not a bad faith use of the bankruptcy system, Judge Kaplan opens the door to other wealthy firms to engage in similar maneuvering to resolve mass torts problems. For example, will the next company with headline-grabbing tort liability, such as an unexpected oil spill, respond by “spinning off” its liabilities into a bankruptcy filing?  In the past, this only would have happened if the resulting liability rendered the polluter insolvent, but now even wealthy and solvent firms may decide that their fiduciary duty requires them to use the bankruptcy system to deal with their liability.

In his ruling, Judge Kaplan overruled the arguments of, among others, a group of bankruptcy scholars (including myself) that worry that the complexity of J&J’s maneuvers will undermine public confidence in the integrity of the bankruptcy system. To be sure, Judge Kaplan’s opinion makes persuasive arguments about the limits of the tort system.  The question, though, is whether the ultimate outcome of Judge Kaplan’s attempt to use bankruptcy law to rectify problems in the tort system will be to create new problems for the bankruptcy system as Congress explores new legislation and appellate courts issue rulings that respond to perceived overreach by reducing the power of bankruptcy judges and, as a result, the usefulness of bankruptcy law.

Due Process Alignment in Mass Restructurings

By Sergio J. Campos (University of Miami School of Law) and Samir D. Parikh (Lewis & Clark Law School)

Sergio J. Campos
Samir D. Parikh

Mass tort defendants have recently begun exiting multi-district litigation (MDL) by filing for bankruptcy. This new strategy ushers defendants into a far more hospitable forum that offers accelerated resolution of all state and federal claims held by both current and future victims.

Bankruptcy’s resolution promise is alluring, but the process relies on a very large assumption: future claimants can be compelled to relinquish property rights – their cause of action against the corporate defendant – without consent or notice. Bankruptcy builds an entire resolution structure on the premise that the Bankruptcy Code’s untested interest representation scheme satisfies Due Process strictures. This Article questions that assumption, and identifies two compromised pillars. Primarily, the process for selecting the fiduciary that represents future victims’ interests (FCR) is broken. Further, the process by which courts estimate the value of thousands of mass tort claims places too much pressure on a jurist unfamiliar with personal injury claims. These compromised pillars raise the risk that the settlement trust will be underfunded and fail prematurely. In this outcome, future victims would have no recourse but to argue that the process did not satisfy Due Process, and the settlement should be unwound.

This Article proposes that the risk of a prematurely insolvent victims’ trust can be reduced considerably by making two adjustments. Our proposal seeks to (i) rebuild the FCR construct in order to ensure that future victims’ interests are effectively represented, and (ii) recalibrate the claim estimation process by facilitating coordination between the bankruptcy court and nonbankruptcy trial courts.

The full article is forthcoming in the Fordham Law Review and is available here.

 

Fifth Circuit Doubles Down on Right to Reject Filed-rate Contracts, but With an Exception

posted in: Bankruptcy, Chapter 11 | 0

By Ronald Silverman, John Beck and Katherine Lynn (Hogan Lovells)

Ronald Silverman
John Beck
Katherine Lynn

The Fifth Circuit recently issued an opinion, Federal Energy Regulatory Commission v. Ultra Resources, Inc., in which it relied on and affirmed its prior 2004 decision — In re Mirant — and held that bankruptcy courts have the authority — at least in many common contexts — to reject filed-rate contracts without the approval of the Federal Energy Regulatory Commission (FERC). The court reasoned that rejection of such contracts only has an indirect effect on the filed-rate and is not a collateral attack, and therefore can be done without FERC’s approval.

Further, the Fifth Circuit held that rejection of a filed-rate contract does not violate 11 U.S.C. § 1129(a)(6) of the Bankruptcy Code because rejection does not change the rate itself, it merely ceases payment of the rate.  Thus, the decision further empowers debtors to reject filed-rate contracts in bankruptcy cases, so long as rejection does not amount to a rate change. 

However, the court did identify an exception to the general rule.  The opinion states that if a debtor seeks to reject a filed-rate contract, but still needs the capacity and seeks to secure a lower rate through rejection, such rejection would be impermissible without FERC’s approval, although that was not the situation in Ultra.  Left for future cases will be the determination of what particular circumstances will require FERC’s permission to reject a filed-rate contract.

Read the full article here.

Mitigating Rejection of Midstream Agreements in Bankruptcy

By David H. Sweeney, Jason P. Rubin, and Laura P. Warrick (Akin Gump Strauss Hauer & Feld, LLP), with Practical Law Oil & Gas

Producers of hydrocarbons generally require some level of gathering, processing, and other midstream services to monetize hydrocarbons. Midstream services are typically secured through contracts between the producers and the midstream providers. The fixed facilities that are required to perform those midstream services require significant investment by the midstream providers and have capacity constraints. To ensure producers’ performance and protect their investment, midstream providers often include in their contracts a dedication clause styled as a “covenant running with the land”. This clause purports to dedicate the land or reserves to the midstream infrastructure and is intended to bind third parties, including estates in bankruptcy, as an interest in real property. 

Decisions in recent Chapter 11 cases have challenged the notion that midstream services contracts containing purported covenants running with the land are not rejectable under section 365 of the Bankruptcy Code. The result is that a debtor may be able to reject a midstream contract containing a covenant running with the land, repudiate future performance of its duties, and a midstream service provider may find its claims reduced to a pre-petition unsecured claim for monetary damages. 

This article explores some recent case law regarding covenants running with the land in bankruptcy and offers practical suggestions for how producers and midstream providers might navigate the newly developing reality, including: 

  • Conducting diligence on midstream contracts to identify red flags and address potential issues before they become problems.
  • Addressing the shortcomings of covenants running with the land noted by bankruptcy courts.
  • Replacing covenants running with the land with a substitute, such as a presently possessory interest or a lien.

The full article is available here.

Are Judges Randomly Assigned to Chapter 11 Bankruptcies? Not According to Hedge Funds

By Niklas Hüther (Indiana University) and Kristoph Kleiner (Indiana University)

Niklas Hüther
Kristoph Kleiner

”The bankruptcy system is supposed to work for everyone, but in many cases it works only for the powerful.”  – House Judiciary Committee Chairman Jerrold Nadler, July 28th, 2021

Researchers have long recognized that judicial outcomes are subject to the biases of the ruling judge. To alleviate concerns of fairness, courts in both the U.S. and abroad claim to assign judges to individual court cases randomly. From a policy perspective, randomization promotes public confidence in the judicial process by limiting forum shopping and the individual influence of any individual judge. From an academic perspective, recent empirical research in economics and finance exploits the random assignment of judges to causally identify of a wide range of legal outcomes.

This paper revisits the claim of randomized judicial assignment in the context of U.S. Bankruptcy Court. Our research is motivated by legal scholarship arguing that debtors in recent cases are influencing judicial assignments (Levitin, 2021), as well as renewed interest in these issues from policy makers and the public (Merle and Bernstein, 2019; Randles 2020). Despite these arguments, there are reasons to believe assignment is random. For instance, after contacting all U.S. Bankruptcy Courts, Iverson et al. (2017) found that only one court (the Eastern District of Wisconsin) reports assigning cases to judges non-randomly. In addition, a range of research including Bernstein et al. (2019) provides convincing evidence that debtor characteristics fail to predict judicial assignments. Missing from this literature is any large-scale empirical evidence of non-random assignment.

Analyzing U.S. corporate bankruptcy filings between 2010 and 2020, we provide new evidence that assignment is not random, but predicted by the lending decisions of hedge funds. By focusing on investments made before the assignment of a bankruptcy judge, our technique is not suspect to standard critiques that predictability is merely an outcome of ex-post data mining; instead, in order for investors to systemically invest in firms that are later assigned a preferred judge, it must be possible to infer future judicial assignments. In addition, we focus on hedge funds, as they routinely influence a wide range of bankruptcy outcomes including emergence and debt restructurings.  The prevalence of these investors allows us to explore a new channel of activism in the distress debt market: activist influence in judicial assignment process prior to filing.

In our setting, judges can decide whether to convert a Chapter 11 bankruptcy to a Chapter 7 liquidation; while secured creditors may have a preference for liquidation, unsecured creditors recover more under reorganization.  Exploiting this distinction, we confirm unsecured hedge fund creditors (relative to secured hedge funds) are significantly less likely to be assigned a judge with a tendency to convert Chapter 11 cases.  We also extend our analysis to an alternate bankruptcy outcome measure: the unsecured creditor recovery rate according to the confirmed plan. We find unsecured hedge funds are far more likely to be assigned a judge with a high past unsecured recovery rate.

We next test whether these estimates differ across the filings in our sample. First, we find that unsecured hedge fund claimants are assigned a preferable judge more commonly when the hedge fund invested shortly before the bankruptcy filing, suggesting hedge funds choose to invest explicitly to influence the filing. Second, we show the effects are greatest when the hedge fund is on the board of directors of the debtor at the time of filing, providing further support for the role of communication between debtor and creditor.

Finally, we conduct three robustness tests. First, we find no evidence that a judge’s future conversion rate (after controlling for the past conversion rate) is predicted by hedge fund investment, suggesting hedge funds are explicitly influencing judicial assignment based on information regarding past information. Second, focusing on the subset of districts that explicitly state random assignment within their district, we continue to find hedge fund investments predict assignment. Third, we include district-office-year fixed effects in our analysis and continue to find a relationship between hedge fund investments and assignment.

Moving forward, we believe there are two potential policies that can alleviate these issues. The first, and simplest, is for policy makers to develop a truly randomized process. Alternatively, policy makers can instead increase the number of bankruptcy judges, leading to lower predictability even if assignment is not fully randomized. Policy makers intent on a fairer judicial system should consider both proposals.

The full article is available here.

This piece previously appeared on the Oxford Business Law Blog.

Corporate Bankruptcy Has Lasting Effects on CEO Careers through Frictions in Executive Labor Market

By Andreas Kostøl (Arizona State University – W.P. Carey School of Business; Norges Bank), Morten Grindaker (Norwegian Business School; Norges Bank), and Kasper Roszbach (Norges Bank; University of Groningen)

Andreas Kostøl
Morten Grindaker
Kasper Roszbach

Policymakers have long been concerned about the potential negative effects of bankruptcy for CEOs and business dynamics. Fear of reputational scarring caused by bankruptcy could lead managers to take less risk than desired by owners, which could manifest in lower performance and lower rates of entrepreneurship and job growth.

 

CEOs influence a wide range of decisions, such as organizational practices, debt financing and whether to file for corporate bankruptcy or not. Empirical studies of Chapter 11 bankruptcy show that CEOs of large bankrupt firms suffer significant financial losses. The prospect of individually-borne income loss due to a corporate bankruptcy carries in it a risk that CEOs take decisions that are not aligned with the interest of the owners.

It remains an open empirical question, however, whether the observed personal costs should be attributed to the selection of CEOs with lower managerial skills, firm-specific human capital, or stigma in the executive labor market.

Our analysis attempts to answer this question by disentangling the stigma and skill effects by examining the causal effects of corporate bankruptcy on the personal income and career of CEOs in small and medium-sized companies in Norway. To this end, we exploit that bankruptcy petitions in Norway are randomly assigned to judges who have different degrees of strictness in their approval of bankruptcy filings. This institutional feature generates variation in firms’ likelihood of being declared bankrupt that is unrelated to firm or CEO characteristics. We use administrative panel data that identifies CEO’s sources of wealth and income and corporate positions to examine the effects of bankruptcy on their careers.

Two broad conclusions emerge from our empirical analysis.

First, we find that corporate bankruptcy has a long-lasting impact on CEOs’ careers. CEOs whose firms are declared bankrupt are 25 percentage points more likely to exit the executive workforce. Displaced CEOs find new employment quickly but do so by moving to lower-ranked positions in new firms. Bankruptcy also has an economically significant impact on CEO remuneration; we document an annual fall in capital income equal to about five percent of annual gross income. While the net present value of the average decline in capital income over the remainder of a CEO’s working-age career is equal to 60 percent of pre-bankruptcy annual income, we find no enduring effect on CEOs’ labor income after five years.

Second, our analysis shows that the displacement effects are much larger when default rates in the firms’ industry are low. For example, a CEOs is five times less likely to remain in the executive workforce if her/his firm experiences a bankruptcy while the bankruptcy frequency in the same industry is low. By contrast, variation in CEO wages is not driven by industry conditions. Post-bankruptcy, we find a greater mobility of CEOs between industries and an increased tendency to move to more productive firms with a higher-paid workforce, suggesting that managerial skills are portable.

Taken together, our findings suggest that negative career effects of bankruptcy can be attributed to stigma. When we eliminate the risk of low-skilled CEOs sorting into bankrupt firms, we find that the executive labor market interprets bankruptcy as a signal of lower managerial talent. This stigma effect is greater during better economic times. More details can be found in the full paper that is available here.