Can punishing managers in bankruptcy backfire?

Conventional wisdom suggests that when companies go bust, the managers of the company should bear some of the consequences. It is also often argued that the threat of punishment prevents bad behaviors such as shirking or inefficient investments. A large academic literature apparently supports this view by showing that stronger creditor rights increase the supply of credit, allowing firms to access credit markets and finance a larger number of profitable investment projects.

One element that is missing from this argument is that companies may become insolvent for reasons other than managerial incompetence or misbehavior. For example, firms may be subject to industry shocks or ex ante good investment projects may fail for various reasons outside of the control of management. As a consequence, the prospect of harsh treatment in the case of bankruptcy may make even well-meaning and competent managers cautious about investing in profitable but risky projects.

Both views have merit. Ultimately, it is an empirical question which of the mechanisms are more relevant in practice. In 2015, Korea underwent a bankruptcy reform that sheds light on this question: Does treating managers more harshly in bankruptcy improve firms’ access to capital and boosts investment? Or does treating managers more harshly in bankruptcy discourage risk-averse managers from seeking financing for investment?

Specifically, the reform, which went into effect in 2016, allowed incumbent management to stay in charge of the firm during bankruptcy proceedings in most cases, whereas before the reform management was routinely dismissed. From the perspective of managers this was a major change, as under the old law filing for bankruptcy was equivalent with job loss, whereas under the new law they face realistic prospects to remain in control of the firm even after the firm went through the proceedings.

As it turns out, the data does not provide an unambiguous answer as to whether treating managers harshly in bankruptcy leads to better or worse outcomes in terms of borrowing and investment. As so often in economics, the answer is: it depends. But what does it depend on?

There are firms in which managers enjoy what is called higher private benefits of control. This may include financial benefits, such as from higher ownership stakes in the firm, but also non-financial benefits, such as the pride of running a family firm through multiple generations. For these firms, the prospect of the manager being dismissed in bankruptcy has a strong negative effect on their willingness to finance investment with credit as this can increase the risk of ending up in bankruptcy.

On the other end of the spectrum, there are firms where private benefits of control are lower, for example widely held firms or firms with older managers who are close to retirement anyways. For these firms, the discouraging effect of dismissing managers in bankruptcy is weaker and dominated by the disciplining effect that increases credit supply and allows the firm to realize more investment projects.

Given the structure of the Korean economy with many family-owned businesses with concentrated ownership, the risk-aversion channel dominates on average suggesting that allowing managers to stay in control during bankruptcy proceedings increases credit usage and investment. In a different economy with more widely held businesses, such as for example the UK, the tradeoff may turn out differently. As a result, the optimal policy needs to take into account the specific context of the economy and ownership and corporate governance structure in the economy.[1]