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)
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.
By Michael J. Cohen, Michael A. Rosenthal & Matthew J. Williams (Gibson Dunn)
The recent decision in In re Purdue Pharma did not uphold the third-party releases in the bankruptcy court’s approved plan. This post discuss the third-party releases issue.
— Harvard Law School Bankruptcy Roundtable Editors
On July 28, 2021, certain Democratic members of Congress, primarily in response to the $4.325 billion contribution made by the Sackler family to fund the settlement underpinning Purdue Pharma’s chapter 11 plan, introduced the Nondebtor Release Prohibition Act of 2021 (the “NRPA”), which proposes to amend the Bankruptcy Code to (i) prohibit the use of non-consensual third party releases in chapter 11 plans, (ii) limit so-called “Section 105” injunctions to stay lawsuits against third parties to a period no greater than 90 days after the commencement of a bankruptcy case, and (iii) provide a ground for dismissing a bankruptcy case commenced by a debtor that was formed within 10 years prior to such case via a divisional merger that separated material assets from liabilities.
When viewed against the backdrop of current complex chapter 11 practice, the NRPA is a flawed remedy for issues for which alternative means of redress already exist. First, the proposed elimination of the important bankruptcy tools of non-consensual third party releases and Section 105 injunctions – each of which is extraordinary in nature and only permitted in the rarest of circumstances – is a blunt force measure that threatens to vitiate the longstanding bankruptcy policy of favoring settlements over interminable value-destructive litigation. Second, the loss of these tools may cause inequitable disruption in currently pending cases and stymie the implementation of critical creditor-supported strategies to resolve the most difficult cases going forward. Moreover, a per se prohibition against non-debtor releases would contravene core bankruptcy principles by elevating the interests of a minority of creditors who would otherwise be bound to the terms of a chapter 11 plan containing such a release that is supported by the requisite majorities required under the Bankruptcy Code. Third, while the disincentive against divisional mergers would affect a far more limited set of cases, it appears that the harm raised by some divisional mergers that are followed by bankruptcy may be adequately addressed through clarifying the applicability of fraudulent transfer law to challenge these transactions.
On November 3, 2021, the House Judiciary Committee sent the NRPA to the House floor for further consideration; the Senate Judiciary Committee has yet to act on the bill. For more detail on the NRPA and our analysis of the bill, please find the full article here.
By Diana Bonfim (Banco de Portugal; Catholic University of Portugal – Catolica Lisbon School of Business and Economics) and Gil Nogueira (Bank of Portugal – Research Department)
How does corporate reorganization affect labor outcomes in bankruptcy? The existing literature argues that corporate reorganization affects the reallocation of labor because it retains workers in bankrupt firms. In some cases, bankrupt firms remain alive for too long and retain workers inefficiently. In other cases, reorganization reduces the probability of inefficient liquidation.
In this paper we show that resource retention is not the only determinant of labor outcomes in bankruptcy. The decision process in bankruptcy creates a principal-agent problem between firms’ claimholders and other stakeholders (e.g., workers, suppliers). Claimholders decide bankruptcy outcomes but other stakeholders with limited say in the bankruptcy process are also affected by these outcomes.
Workers are among these stakeholders. They use job contracts with firms as a form of insurance in times of adversity. In the absence of corporate reorganization, workers lose these job contracts and experience persistent costs of job loss. Reorganization improves labor outcomes because it reduces the probability that workers lose the insurance provided by job contracts when the costs of job loss are high.
We test this hypothesis empirically using data from Portuguese reorganization cases. The institutional setting has several features that help design an adequate empirical strategy. First, reorganization cases are randomly allocated across judges. We use this random assignment as a source of variation in the probability of reorganization that is not affected by other factors that also influence workers’ careers. Second, Portuguese firms report financial statements annually, which we use to check whether reorganization affects labor reallocation to more productive or profitable firms. Finally, we link this data to a rich administrative employer-employee matched dataset, which allows us to track workers who eventually change jobs. This dataset is unique because it contains rich job descriptors. We use this data to establish a relationship between corporate reorganization and the scarring effect of bankruptcy on workers’ job functions.
We uncover three main findings. First, we measure the effect of corporate reorganization on the sorting of workers to productive and profitable firms. In five years, only about 20% of the workforce remains in reorganized firms. Many workers from reorganized firms find jobs with new employers. We find no evidence that reorganization affects the reallocation of labor to efficient or profitable firms.
Second, reorganization is an important source of labor insurance against negative productions shocks. In the short term, reorganization increases the probability that workers are employed. In the long term, reorganization increases wages and reduces the scarring effect of job downgrading that is often observed in recessions. Reorganization reduces the probability that workers move to less skill-intensive occupations and increases occupation wage premia.
Third, we show that reorganization improves job transitions to new employers. Reorganization increases the average time it takes to leave a firm that files for bankruptcy by one year. Reorganization reduces the probability that workers move to low-paying jobs and increases the probability that workers find high-paying jobs with new employers.
Overall, our results show that corporate reorganization is an important source of labor insurance in bankruptcy, thereby mitigating the scarring effect of job loss. The full article is available here.
By Jordan Neyland (Assistant Professor of Law, Antonin Scalia Law School at George Mason University) and Kathryn St. John (Legal Associate, Supreme Court of Victoria)
One of the most important decisions that firms and courts face in bankruptcy is how to dispose of company assets. The differences between the available options are not trivial. A popular mechanism is contained in §363 of the bankruptcy code, which enables the sale of a firm’s assets with court approval. This allows for a quick sale of a firm without the need for developing and approving a plan of reorganization under Chapter 11, which can save both time and money, as the firm’s assets may otherwise sit idle or depreciate.
Despite the benefits of a quicker resolution, 363 sales are contentious because certain classes of claimants, particularly shareholders and unsecured creditors, may lose a valuable opportunity to “wait and see” if the value of the assets will increase. Given that unsecured creditors and shareholders are last in line to get paid, they may gain if the asset value increases, whereas secured creditors prefer a quick sale to cash out before any value is potentially lost. But how much shareholder and unsecured creditor wealth is lost as the lottery-like opportunity, or “option” to wait, disappears? Without an active market for these rights, this value is unseen, yet very real.
In a recent article, we investigate the value of this option and how it affects the wealth of the parties to the bankruptcy. We use well-established financial models (i.e., Black-Scholes-Merton) to put a dollar value on how much shareholders lose with the approval of a 363 sale. We take numerical values from the seminal case In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), which provides an ideal case study because most of the firm value was from equity holdings in a publicly traded company.
The results are dramatic. Under certain conditions, shareholders stand to lose value worth more than one quarter of total firm assets from a 363 sale. That is, by forgoing the “wait and see” option, shareholder value decreases from around one quarter of the firm’s assets to close to zero. In the Lionel case, where the value of the firm’s assets was about $170 million, this decline in value equates to wiping out nearly $45 million in shareholder wealth. Higher priority claimants capture that value.
Even under more conservative estimates, we show that shareholder and lower-priority creditor wealth is dramatically affected by the loss of the “wait and see” option. Large amounts of wealth may be transferred from shareholders to creditors by bringing forward assets sales by just a few months.
We identify factors that are likely to influence the magnitude of the “hidden” shareholder and lower-priority creditor wealth loss. These include the volatility and value of the asset to be sold, in addition to the difference between the time required to arrange an asset sale and the time it may take to finalize a plan of reorganization. We note that the current common law rules governing 363 sales do not require consideration of this set of factors, which are potentially more value-relevant than factors, such as asset depreciation, that courts currently use to determine whether a business justification for a sale exists.
We suggest that courts consider the factors identified in our analysis and the “hidden” wealth effects when deciding whether to approve a 363 sale. This consideration should improve courts’ understanding of parties’ stakes and incentives, leading to better informed decision-making.
By John A. E. Pottow (University of Michigan Law School).
Although discussed nowhere in the U.S. Bankruptcy Code, fiduciary duties play a central role in guiding the administration of an insolvent debtor’s assets. Regulatory oversight of trustees is only loosely circumscribed by statute, but significant lacunae exist regarding specification of the duties of loyalty. In assessing what fiduciary obligations are owed to secured creditors, unsecured creditors, and debtors, some courts build upon the general principle that the trustee’s fiduciary duty of loyalty flows to all creditors. Other courts, though, work from the premise that secured creditors are better situated to look after themselves and that a trustee’s primary obligation is to unsecured creditors, perhaps especially non-priority general creditors. The Supreme Court has also weighed in, stating that a DIP’s fiduciary duties run directly (if somewhat delphically) to “the corporation.” How then does a trustee choose between beneficiaries of the estate, and what remedies are there for losing parties disappointed with this allegiance decision? This book chapter explores the fiduciary obligations of trustees (including DIPs) under both statute and common law. There is a special focus on the intrinsic conflicts that arise within the “menagerie of heterogeneous creditors” that constitute the claimants of a bankruptcy estate. A single normative theory seems unlikely to explain the results (so much for the “residual fiduciary beneficiary”!). What does seem clear is that trustees are “more fiduciary” for some constituencies than for others. Fortunately, U.S. bankruptcy courts are accustomed to shifting allegiances and disalignments of interest. Thus, the bankruptcy system may be well-suited to handle the endemic conflicts of interest between corporate constituencies through various bankruptcy-specific mechanisms, such as the institution of the Creditors Committee and the norm of engaged judicial oversight.
By Shana A. Elberg, Amy Van Gelder, and Jason M. Liberi (Skadden, Arps, Slate, Meagher & Flom LLP)
In recent years, some courts have become critical of the doctrine of equitable mootness, a judicially created abstention doctrine — unique to the corporate bankruptcy world — that allows appellate courts to dismiss appeals from a bankruptcy court’s confirmation order if the relief sought on appeal threatens to unwind a complex debtor reorganization previously approved by the bankruptcy court. The doctrine promotes finality of confirmation orders, encourages the global consensual resolutions often crucial to complex reorganizations, and protects third parties that have justifiably relied upon the bankruptcy court’s confirmation order or transactions effectuated pursuant to that order.
Despite significant concerns expressed by courts regarding the impact of the doctrine on parties’ fundamental appellate rights, equitable mootness persists in some form within every circuit that has jurisdiction over bankruptcy appeals. Thus, plan proponents and objectors alike must be aware of its implications on contested plan confirmation proceedings and prepared to act quickly to advance their interests following plan confirmation.
This article provides a brief overview of the doctrine of equitable mootness, its application by appellate courts, and key considerations for bankruptcy and non-bankruptcy practitioners faced with contested plan confirmations and subsequent appeals.