Companies are less risk averse when one of their directors experiences a corporate bankruptcy at another firm where they concurrently serve as a director, according to new research, especially if that director holds a more advisory role with the company.
Using a novel dataset composed of corporate bankruptcy data and board of directors information from U.S. Securities and Exchange Commission corporate filings, a study published May 5 in the Journal of Financial Economics found evidence to suggest that a firm's choice of directors has important implications for the company's future performance, despite candidate background seeming perhaps less relevant in a world where corporate activities are widely publicized and directors can easily learn from each others' personal experiences. Results indicated that corporate risk-taking — measured by observed changes in leverage, cash holdings, distress, volatility and acquisitions — increases in firms where a director has experienced bankruptcy at another company, primarily in inexpensive and brief litigation rather than expensive, more complex bankruptcies.
Radhakrishnan Gopalan, co-author of the study and a professor of finance at Washington University in St. Louis, said he initially expected risk-taking by firms to decrease if one or more of their directors had experienced bankruptcy in the past, out of an abundance of caution. When the results revealed the opposite, Gopalan and his colleagues performed additional analyses to investigate what might be behind the surprising finding.
The answer, they found, might lie in prevailing societal stigma surrounding bankruptcy and its implications for both corporate and personal professional success.
"This stigma makes everybody fear bankruptcy, much more than they need to," Gopalan told The Academic Times. "You don't want to be associated with bankruptcy and you don't want to be a director who drove a firm to bankruptcy, but once you actually end up there, you realize it's not so bad from a shareholder's perspective."
The bankruptcy system in the U.S., Gopalan said, is "reasonably efficient ... and it actually benefits shareholders to some extent," allowing companies to reduce debt and pursue restructuring.
"This [exposure] can help to overcome some of the stigma that a board of directors might carry about bankruptcy and encourage them to take risks at subsequent firms," he said.
Researchers found firms that shared at least one director with a company that filed for bankruptcy experienced a 4.1 percent increase in net leverage, or the ratio of debt to earnings, in the aftermath of a bankruptcy at an "interlocked firm," a term used to refer to a company where a common director sits on the board. This increase in net leverage, according to the paper, does not seem to be the result of greater debt incurred, but of a reduction in cash holdings, which were found to decline by 3.4 percent after an interlocked firm's bankruptcy. Researchers say that decline in cash, in turn, appears to result in part from an approximately 7.7 percent decrease in equity issuances in the years after an interlocked bankruptcy.
Affected companies were 1.1 percent more likely to experience financial distress following a related bankruptcy and faced a 1.6 percent increase in expected frequency of default. Their stock volatility was also found to increase by 0.2 percent after a bankruptcy at an interlocked firm. Finally, affected firms undertook 0.152 fewer acquisitions per year, neglecting a potential avenue for improved risk diversification. Together, these results suggest that firms increase their risk when their boards feature a director involved in another bankruptcy proceeding and directors typically perceive estimated distress costs as lower after involvement in a bankruptcy.
The majority of this increase in risk-taking behavior occurred at companies where the affected director experienced a shorter, less-costly bankruptcy, as opposed to a more expensive and complex case, and where this director currently holds more advisory influence, such as a "gray" position. Gray directors are those who are not executives but also not fully independent, with some connection to the firm.
Researchers noted a decrease in cash holdings, fewer diversifying acquisitions and an increase in distress events among treated firms where a director with more advisory influence had experienced an interlocked bankruptcy. Directors are also more likely to influence others if they regularly attend board meetings.
If directors' advice and prior experiences do affect corporate risk-taking, the study shows, firms should take board of director candidates' background and personal bankruptcy experiences into account, being careful to choose directors whose risk tolerance aligns with that of the company. One question that was not addressed by this study, but which Gopalan considers an important theme for future research, is whether existing social stigma pertaining to bankruptcy can influence shareholders' risk tolerance.
"After a personal bankruptcy experience, directors realize bankruptcy is not so bad and then they are encouraged to take risks. But then we didn't go beyond that to say if corporate risk is good or bad for shareholders," Gopalan said. "Unfortunately our data was not strong enough to make that point in a robust manner, so we just left it at that. I think this is a point that shareholders will have to take with a pinch of salt because while yes, [affected] directors appear to be taking more risks, we are still waiting to see if this risk is efficient or inefficient from a shareholders perspective."
The study, "It's not so bad: Director bankruptcy experience and corporate risk-taking," published May 6 in the Journal of Financial Economics, was authored by Radhakrishnan Gopalan and Todd A. Gormley, Washington University in St. Louis; and Ankit Kalda, Indiana University.