By Aras Canipek (Sabanci Business School & Leibniz Institute for Financial Research SAFE)
“for debt to be an effective source of discipline it must be backed by an appropriate bankruptcy (or insolvency) procedure, i.e. there must be an appropriate ‘penalty’ in the event of default. A bankruptcy mechanism that is ‘soft’ on management – e.g. one that, like Chapter 11, keeps creditors at bay for a long period – may have the undesirable property that it reduces management’s incentive to avoid default, thus undermining the bonding or disciplinary role of debt.” — Oliver Hart (1995)
A large body of theoretical research suggests that bankruptcy law penalties can reduce agency problems. In particular, it is argued that the threat of strict penalties, such as management dismissal or firm liquidation, motivates managers to avoid bankruptcy by pursuing high profits rather than unprofitable private benefits. The existence of such penalties varies widely across countries: for example, they have
historically been present in the UK but absent in the US under Chapter 11.
Although the governance role of bankruptcy law has been extensively discussed in theory, empirical evidence remains scarce. In this paper, I provide evidence by examining whether firms implement independent directors as a substitute when bankruptcy penalties are eliminated. For identification, I exploit the fact that penalties are relevant only for risky firms in which poor performance actually leads to bankruptcy, allowing for a natural control group in safe firms.
Across countries, I find that board independence is negatively related to penalties, but only among risky firms. Comparing board independence of risky and safe firms around bankruptcy reforms in Germany (2012), Italy (2005–2006), and the US (1979) confirms the results. Economically, risky firms increase the number of independent directors by 21% relative to safe firms following the elimination of penalties. This large effect suggests that penalties are viewed as a powerful mechanism for disciplining management.
The findings have important implications for optimal bankruptcy design. In particular, they support the notion that, in some situations, the governance function of bankruptcy law should be preserved by penalizing management in default, as otherwise management may face difficulty securing financing ex ante. While the results show that firms attempt to substitute penalties with board independence, they do not indicate whether penalties are perfectly substitutable. For example, penalties may not be substitutable in dual-class firms, in which traditional governance mechanisms tend to function less effectively.
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