The influence of managerial incentives on the resolution of financial distress

This study investigates the influence of managerial incentives on the resolution of financial distress. Our model predicts that when creditors and equityholders prefer different resolution methods, the likelihood of choosing Chapter 11 over private renegotiation is related to the ownership structure of the distressed firm. Empirical test results using a sample of 81 voluntary Chapter 11 firms and 65 private workout firms support the model’s prediction. We show that managerial ownership is positively related to the incidence of Chapter 11 filing when there is conflict between equityholders and creditors over the choice between Chapter 11 and a private renegotiation. Consistent with prior literature, we also find that the choice of resolution methods depends on the extent of creditor holdout problems and the level of economic distress. We also performed the analysis of a subsequent 5 years of post-distress performance for all sample firms. The majorities of firms that file for Chapter 11 lose their independence and are either acquired or liquidated. However, more than half of firms in private workouts survived as independent firms.

The cost and timing of financial distress

Assessments of the trade-off theory have typically compared the present value of tax benefits to the present value of bankruptcy costs. We verify that this comparison overwhelmingly favors tax benefits, suggesting that firms are under-leveraged. However, when we allow firms to experience even modest (e.g., 1–2% annualized) financial distress costs prior to bankruptcy, the cumulative present value of such costs can easily offset the tax benefits.     

Anomalies and financial distress

This paper explores commonalities across asset pricing anomalies. In particular, we assess implications of financial distress for the profitability of anomaly-based trading strategies. Strategies based on price momentum, earnings momentum, credit risk, dispersion, idiosyncratic volatility, and capital investments derive their profitability from taking short positions in high credit risk firms that experience deteriorating credit conditions. In contrast, the value-based strategy derives most of its profitability from taking long positions in high credit risk firms that survive financial distress and subsequently realize high returns. The accruals anomaly is an exception. It is robust among high and low credit risk firms in all credit conditions.     

The financial distress pricing puzzle in banking firms

This paper examines whether the financial distress pricing puzzle observed for non-financial firms is also observed for financial firms and how this puzzle differs according to the extent of short-sale constraints. By using the eight distress measures developed for financial firms, we find that there is a strong negative relation in the cross-section between financial distress and subsequent bank stock returns, regardless of adjustment for risk. However, this distress pricing puzzle is statistically significant only for high short-sale constrained banks, but not for low short-sale constrained banks. Thus, short-sale constraints are at least one non-risk attribute that causes the distress pricing puzzle for financial firms. We also find that despite its simple form, compared to the other complex distress measures, non-performing loans (NPLs) are the most informative in predicting future bank stock returns as well as bankruptcy and failure.     

The impact of target firm financial distress in Australian takeovers

Of the motives that have been advanced to explain corporate acquisitions, the least explored is the acquisition of a target experiencing financial distress. This study addresses this void by examining whether target firm financial distress is related to takeover: attitude, premiums, payment method, competition and outcome. Despite inconsistent findings across our distress measures the tenor of the results suggest that distressed targets receive higher premiums and are less likely to be offered cash consideration. Additionally, takeover completion is lower and takeover competition higher for targets in financial distress. Financial distress does not influence whether a takeover is hostile or friendly.     

Resolution of financial distress under agency frictions

We introduce, in a dynamic-contracting framework with moral hazard, the possibility of recapitalization as an alternative to liquidation when a firm is distressed. This is achieved by considering a risk-averse agent and by allowing (but not requiring) the latter to inject additional capital into the firm when necessary. We show that firm recapitalization may arise in an optimal, long-term contract. As a consequence, we find that there are two mechanisms at a firm’s disposal so as to deal with financial difficulties: one corresponds to a recapitalization process, the other to a liquidation one. The choice of mechanism is based on a cost-benefit analysis.     

Excess corporate payouts and financial distress risk

Firms that follow excessive payout policies (over-payers) are higher on the financial distress spectrum and have lower survival rates than under-payers. In addition, over-payers endure lower future sales and asset growth than under-payers and experience negative abnormal returns in the bond and stock markets. Exogenous import tariff reductions and commodity price jumps reduce the likelihood of overpayment. We interpret this as evidence consistent with financial flexibility considerations, rather than risk-shifting, explaining the decision to overpay. We also find that CEO overconfidence and catering incentives affect overpayment.     

Divestments and financial distress in leveraged buyouts

This paper investigates the wealth effects of 134 divestments by 41 firms that underwent leveraged buyouts in the 1980s. Stock in these companies is privately owned. Bond returns for publicly traded debt are used to measure the wealth effects of the divestment announcement. These divestments are, on average, not associated with significant wealth effects for the full sample. However, firms that experience financial distress have negative and significant abnormal returns associated with their divestments, while returns in non-event months are insignificant. In contrast, non-distressed firms gain when asset sales are announced. The losses suffered by bondholders in distressed sellers are large and significant when core assets are divested. Bondholders in these firms do not suffer significant losses when non-core assets are divested. Finally, abnormal bond returns are related to the structure of the firms' post-buyout debt. Returns are negatively related to the use of private debt in the capital structure and positively related to the use of subordinated debt.     

The effect of foreign currency hedging on the probability of financial distress

This paper investigates the effect of foreign currency hedging with derivatives on the probability of financial distress. I use Merton’s (1974) structural default model to compute firms’ distance to default as a proxy for their probability of financial distress. Using an instrumental variables approach to control for endogenous hedging and leverage, I find that the extent of foreign currency hedging is associated with a lower probability of financial distress. Whereas previous research finds that the probability of financial distress is a determinant of a firm’s hedging policy, this paper provides direct evidence supporting the hypothesis that the extent of hedging reduces a firm’s probability of financial distress.     

The Covid-19 outbreak,corporate financial distress and earnings management

This study explores the association between the Covid-19 outbreak, corporate financial distress and earnings management practices in China. We investigate whether firms took advantage of the downturn in economic conditions during the pandemic to adjust their earnings using different earnings management techniques. Utilising a sample of 1832 listed firms and underlying theoretical frameworks (i.e., positive accounting and signalling theory), we find that firms were more inclined to manage earnings during the pandemic period. They favoured using the accrual-based rather than the real activity-based earnings management technique. We also find that firms engaged more in income-increasing practices in the shadow of the outbreak. In addition, our results further demonstrate that financially distressed firms were involved in earnings management, particularly accrual-based earnings management. However, compared to privately-owned firms, state-owned enterprises seem to be involved less in earnings management during the Covid-19 pandemic. Findings from this study raise some concerns for policymakers about the credibility of financial reporting information during Covid-19.     

Distressed acquirers and the bright side of financial distress

Extant literature states that managers who fear the consequences of financial distress may inhibit investments in profitable opportunities. Here, we posit that the career and reputational damages that distress and potential default cause are large enough to align the interests of managers and shareholders thus improving investment decisions. We find that financially distressed firms see a 3.5% higher market reaction to the announcement of acquisitions than non-distressed firms. This effect is stronger for poorly governed firms, consistent with the hypothesis that the large reputational cost of failure incentivizes managers to act in the best interest of their firm.     

Bank equity stakes in borrowing firms and financial distress

We derive the optimal financial claim for a bank when the borrowingfirm's uninformed stakeholders depend on the bank to establishwhether the firm is distressed and whether concessions by stakeholdersare necessary. The bank's financial claim is designed to ensurethat it cannot collude with a healthy firm's owners to seekunnecessary concessions or to collude with a distressed firm'sowners to claim that the firm is healthy. To prove that a requestfor concessions has not come from a healthy firm/bank coalition,the bank must hold either a very small or a very large equitystake when the firm enters distress. To prove that a distressedfirm and the bank have not colluded to claim that the firm ishealthy, the bank may need to hold equity under routine financialconditions.     

The effects of financial distress and capital structure on the work effort of outside directors

This paper investigates the conflict of interests between shareholders and debtholders by examining the work effort of outside directors when a company experiences financial distress or has a high financial leverage. We find that at both company level and individual director level: (i) outside directors of a firm with higher financial distress exert less work effort in controlling for financial leverage; (ii) outside directors of a firm with a higher financial leverage work harder controlling for financial distress.     

Consumer perceptions of alternative dispute resolution mechanisms in financial transactions

This research examines consumer perceptions of choices of alternative dispute resolution mechanisms (ADRM) in resolving financial services and product dissatisfaction. The paper begins with a detailed analysis of various dispute resolution mechanisms available to customers and firms in the United States. It then proceeds to highlight the salient features of ADRM. A national random sample of US consumers is used to obtain data on customer perceptions of ADRM and possible choices in using ADRM in conflict resolution. Results indicate that as the cash at risk increases, consumers indicate a preference for litigation over alternative forms of dispute resolution. The findings have strategic implications for strategy formulation in marketing of financial services and product as well as improving customer satisfaction through amicable resolutions of customer complaints.     

Determinants and consequences of financial distress: review of the empirical literature

We synthesise the empirical literature on the determinants and consequences of financial distress, critique the findings and offer suggestions for future research. We categorise these indicators into (i) firm-level fundamental determinants, (ii) macroeconomic determinants and (iii) firm-level corporate governance determinants. We categorise the consequences into (i) financial reporting and auditing consequences, (ii) firm-level operational consequences, (iii) capital market consequences and (iv) corporate governance consequences. We suggest that future research can make a more meaningful contribution, by developing more comprehensive models of predicting financial distress which will entail a departure from the current partial analysis to a more holistic complex analysis.     

A parsimonious model to forecast financial distress,based on audit evidence

This paper provides evidence that audit reports convey relevant evidence for inferring the existence of underlying, unrevealed, financial imbalances. Unlike previous works, which studied US listed-firms bankruptcy, our research deals with Spanish non-financial SMEs under financial stress. Our results indicate that the audit of distressed SMEs has several distinctive features: higher auditor rotation, more qualified reports, and non-compliance with deadlines to approve and file the annual financial statements. We use this evidence to build and test a parsimonious and reliable forecast model. Several implications for auditors’ independence, information quality, and failure forecast are discussed.     

越南金融困局的成因及对中国的警示

2008年5月,越南主要经济指标均超过了安全警戒线,金融市场急剧动荡。越南片面追求经济增长的经济政策导向难辞其咎：政府巨额的投资导致财政赤字;大规模的设备进口导致贸易赤字;过于迷信外资作用,金融开放过快;货币政策过于宽松;对资产价格泡沫危害认识不足;在出现通胀苗头时犹犹豫豫,错失最好的调控时机。借鉴越南教训,中国应严防通胀、防止境外热钱、对人民币升值采取谨慎态度、防止股市大起大落。     

Economic value,competition and financial distress in the European banking system

In this paper we examine the impact of a large number of factors at the bank level (liquidity and credit risks, asset size, income diversification and market power), at the industry level (banking concentration) and macro-level (real GDP growth) on bank financial distress using an unbalanced panel of 308 European commercial banks between 1996 and 2009. The observations falling below a given threshold of the empirical distribution of the Shareholder Value Ratio proxy bank financial distress. We employ a panel probit regression and, given the presence of overlapping data giving rise to residual autocorrelation, we use the Bertschek and Lechner (1998) robust estimator of the covariance matrix of parameters. We show that credit risk, liquidity risk and bank market power are the most influential determinants of distressed Shareholder Value Ratio. Finally we evaluate the model out-sample forecasting performance over the 2008–2009 crisis period.     

The relative contributions of equity and subordinated debt signals as predictors of bank distress during the financial crisis

Bank supervisors utilize early warning signals to predict which banks are likely to become distressed. Previous research has found that market discipline signals do not significantly improve out-of-sample forecasts relative to accounting-based signals. Most of that evidence, however, comes from periods in the 1990s when the U.S. economy and banking system were healthy, potentially neutralizing an advantage of market signals to incorporate new information quickly. For the period between the fourth quarters of 2006 and 2012, we assess the accuracy of two market signals – expected default frequency (EDF) and subordinated note and debenture (SND) yield spreads – relative to accounting-based signals in forecasting which publicly traded BHCs would become distressed. In 2008, EDF signals were relatively more accurate, but they did not lead to economically significant reductions in missed distress events relative to other signals. Supervisors would have been better off devoting slack resources to monitor BHCs with high commercial real estate concentrations. As the crisis subsided, a failure probability model developed from bank failures in the 1980s and early 1990s was consistently the most accurate signal. For the two dozen BHCs with actively traded SNDs, yield spreads over Treasuries were extremely poor predictors of distress because the spreads were distorted by too-big-to-fail subsidies. The Tier 1 leverage ratio was the most accurate distress signal for these large BHCs. In sum, the evidence to justify systematic reliance on market signals by supervisory agencies to forecast bank distress remains weak.