Most would assume that the experience of a Chapter 11 filing — if you’re a member of the board of directors of the bankrupt company — isn’t something they would care to repeat.
There’s the huge expense and the high stress and the bad press. The career hit.
But anyone who really knows bankruptcy knows the secret about it: The cases aren’t all, all that bad. And, according to a new study, for directors that learn that secret, risky behavior actually increases.
A group of researchers at Washington University in St. Louis and Indiana University found, in fact, board members that specifically had been through a successful bankruptcy at one of the companies where they serve subsequently engage in more risk-taking on their other boards.
The finding is true in cases where the Chapter 11 filing was relatively clean and quick, like the results often seen in prepackaged cases.
“Most people have a perception that bankruptcy is very bad and to be avoided,” said one of the authors, Todd A. Gormley of Washington University. The study showed, however, that those who have actually been through a successful Chapter 11 come out feeling like “Hey, it’s not so bad,” Gormley added.
As a result, directors become more tolerant of risk and guide other companies toward riskier behaviors.
Although what researchers found was something about the experience of Chapter 11, it wasn’t the question they set out to tackle. The group was looking for a way to measure how much influence members of the board of directors have on the companies they advise. Bankruptcy was simply a mechanism to answer the question.
The group used data from BoardEx, a sister company of The Deal, and the UCLA-LoPucki Bankruptcy Research Database from 1994 to 2013 to identify 718 companies where at least one director was going through a Chapter 11 case at one of 261 separate companies that were in bankruptcy during the same period.
“Relative to the control firms, net leverage at the treated firms [where one of the directors was going through a bankruptcy at another firm] increases in the years following the bankruptcy, and this shift is driven by treated firms issuing relatively less equity and holding less cash. Cash flow volatility, stock volatility and distress events also increase for the treated firms, while their distance to default and number of diversifying acquisitions both decrease,” the researchers wrote in their report, It’s Not So Bad: Director Bankruptcy Experience and Corporate Risk-Taking. The October report from Gormley, Washington University’s Radhakrishnan Gopalan and Indiana’s Ankit Kalda is forthcoming in the Journal of Financial Economics.
This risk-taking behavior, they said, wasn’t just a coincidence of matching companies and directors that both weren’t risk-averse. Instead, they found an actual uptick in risk-taking at the universe of 718 companies versus the previous six years after a bankruptcy at another of the director’s companies, even when the same director was on the board that entire period.
The findings may immediately be surprising to those familiar with research in 1990 that determined bankruptcy had a negative impact on the careers of directors. Indeed, the new study found broadly that directorships did decrease following a bankruptcy. The decrease, however, was concentrated among directors whose companies had been through difficult and expensive Chapter 11 cases.
Researchers found less of an effect on the careers of directors that had been through less expensive bankruptcy cases — the same group where they found a subsequent increase in risk-taking behavior.
Additionally, the research found the risk-taking trend was isolated among so-called gray directors, or those that aren’t independent directors. They didn’t find any evidence that for independent directors their view of distress was altered by the experience of Chapter 11.
Gormley, though, told The Deal this finding speaks more to the influence of certain directors over others than it does the way the experience of bankruptcy may alter the perception of risk.
“I would suspect it’s more about who has the CEO’s ear about decisions that entail risk,” he said.