How Creditors Affect Resource Allocation at Firms in Technical Default

A central topic in financial economics is how the allocation of cash flow and control rights among providers of corporate finance should evolve with firm performance. Theoretically, allowing for a transfer of control to creditors when a firm is in default can alleviate agency problems resulting from the separation of ownership and control, as well as conflicts of interest between debt and equity holders (Jensen and Meckling, 1976).[1] Empirical evidence confirms that governance by creditors has profound effects on not only bankrupt firms (Gilson, 1990), but also a broad spectrum of firms that are merely in technical default.[2] Debt covenant violations shift control to creditors, which, given their right to demand immediate repayment, puts them in a strong position to influence corporate investment and financing decisions (Chava and Roberts, 2008; Roberts and Sufi, 2009).[3] Strikingly, the actions creditors take to protect their interests at firms in technical default lead to improvements in operating performance that ultimately benefit shareholders (Nini et al., 2009, 2012).[4]

In our recent paper, we shed light on creditors’ active role in corporate governance at firms outside of bankruptcy. In particular, we document the precise channels of resource allocation that drive the turnaround in operating performance at firms in technical default. Our empirical tests are based on comprehensive data from the U.S. Census Bureau (henceforth, Census) about “establishments” — economic units that produce goods or services, usually at a single location, and engage in one or predominantly one activity — within a company. These data provide information on the internal organization of firms, permitting an analysis of the resource reallocation and restructuring at firms that have violated covenants. We focus on a sample of covenant violations disclosed to the Securities and Exchange Commission (SEC) covering publicly traded U.S. nonfinancial corporations. We link each of these firms to its establishments in the Census data and measure resource allocation using establishment-level data on employment, investment, and the probably that an establishment will be closed down. We estimate the impact of covenant violations at both the firm and establishment levels by comparing changes in behavior before and after violations between violators and non-violators. We control for performance metrics used in financial contracts, adapting the research design of Roberts and Sufi (2009).

We first provide evidence that companies in violation of covenants reduce employment and labor costs and close their establishments more often. The magnitude of these effects is large. We find, for example, that a typical firm reduces the number of employees by roughly 5 percentage points following a violation. These results survive numerous robustness tests. Importantly, we demonstrate that these employment effects are pronounced for firms receiving contractual restrictions in renegotiated contracts (Nini et al., 2009), suggesting that they are not voluntary but required by creditors.

We then investigate how creditor discipline affects the way companies allocate their resources among their establishments and relate these actions to improvements in violating firms’ operating performance. Two important results emerge. First, we find that more resources are cut from establishments that do not operate in firms’ core business (“peripheral establishments”). Firms in breach of covenants lay off more employees at peripheral establishments and close peripheral establishments more often than they do at establishments engaged in their core businesses. This suggests that creditors improve firm performance by refocusing operations.

Second, firms reduce relatively unproductive operations after violating covenants. To establish this result, we focus on manufacturing firms for which the Census provides highly detailed information on inputs and output of production. We find that relative to non-violating firms, violating firms cut employment and investment at unproductive establishments and close them more often. These actions also help improve firm performance.

In the final part of the paper, we investigate the role of establishments’ operating risk in resource allocation decisions of firms in breach of covenants. We might expect creditors to reduce risk after they gain control of a company, and we do find robust evidence that violating firms withdraw resources from riskier units. However, creditors are selective. Once we characterize how establishment risk and productivity interact, we observe cuts almost exclusively at establishments that are both risky and unproductive. Taken together, our evidence indicates that creditor activism can benefit both the creditors and the shareholders of violating firms by reducing default risk and improving economic efficiency.

ENDNOTES

[1] Jensen, M., Meckling, W. H., 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics 3, 305-360.

[2] Gilson, S. C., 1990. Bankruptcy, Boards, Banks, and Blockholders: Evidence on Changes in Corporate Ownership and Control when Firms Default. Journal of Financial Economics 27, 355-387.

[3] Chava, S., Roberts, M., 2008. How Does Financing Impact Investment? The Role of Debt Covenants. Journal of Finance 63, 2085-2121. Roberts, M., Sufi, A., 2009. Control Rights and Capital Structure: An Empirical Investigation. Journal of Finance 64, 1657-1695.

[4] Nini, G., Smith, D. C., Sufi, A., 2009. Creditor Control Rights and Firm Investment Policy. Journal of Financial Economics 92, 400-420. Nini, G., Smith, D. C., Sufi, A., 2012. Creditor Control Rights, Corporate Governance, and Firm Value. Review of Financial Studies 25, 1713-1761.

This post comes to us from Nuri Ersahin, PhD candidate at the University of Illinois at Urbana Champaign, Professor Rustom M. Irani of the University of Illinois at Urbana-Champaign and Professor Hanh Le of the University of Illinois at Chicago. It is based on their recent paper, “Creditor Control Rights and Resource Allocation within Firms,” available here.

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