Bankruptcy in Groups

Group bankruptcies tend to be large (e.g., Global Crossing, Maxwell, MG Rover, Parmalat) and affect a significant number of stakeholders. Business groups constitute a common way for ultimate owners to exercise control over a large number of companies while containing their risk exposure to different parts of the business through limited liability. In countries with underdeveloped financial infrastructures, business groups overcome difficulties in accessing external finance by reshuffling funds within the corporate structure. The bankruptcy of business groups can be extremely complex, especially if the group’s assets are spread over multiple jurisdictions. The nature of business group structure and operations may affect the parent’s liability in the event of one of its subsidiaries’ insolvency. As a consequence, this affects the likelihood of transfers of resources from other parts of the group to that specific subsidiary as it approaches financial distress. These “internal capital market” transfers will shape the way bankruptcy takes place within the group.

In our study, we seek to understand how financial distress takes place within a business group. Our analysis is based on large cross-country sample of (bankrupt and non-bankrupt) group affiliated firms, which spans from year 2005 to 2012. The data come from Orbis, a database published by Bureau van Dijk electronic Publishing (BvDEP). We first show that group structure matters for parent and subsidiary bankruptcy prediction. Having documented that the traditional bankruptcy models can be improved by incorporating group structure information, we then examine the cross-sectional variation in the association of bankruptcy probabilities within the group. Parents may be required to support financially distressed subsidiaries as a result of explicit or implicit agreements. Absent these agreements, parents might also have an incentive to support financially distressed subsidiaries as the bankruptcy of a subsidiary may impose severe costs (e.g., reputational damage, cross-default, direct liability under veil piercing). Intra-group support can also flow in the opposite direction as distressed parents may seek financial aid from healthy subsidiaries. We develop predictions regarding the strength of association of intra-group bankruptcy probabilities in settings with higher likelihood of parental support (i.e., propping) or negative intervention (i.e., tunneling). We develop these predictions based on indicators of group integration typically considered in the decision to pierce the veil in bankruptcy proceedings and that may affect the likelihood of group contagion effects. In particular, we measure parent-subsidiary integration along five different dimensions: (1) control rights; (2) shared name; (3) board interlocks; (4) industry overlap; and (5) geographical proximity. The results of our study show that the association between parent and subsidiary default probabilities varies with the level of subsidiary integration within the group and country-level institutional quality. Propping is more prevalent if the subsidiary is named after its parent and if parent and subsidiary have interlocked boards. Our findings further indicate that parents are less likely to tunnel when subsidiaries are domiciled in countries with stricter anti-self-dealing laws, stronger investor protection regulation, higher director litigation, and tighter approval and disclosure of related party transaction requirements.

We conduct a number of tests to ensure that at least part of the documented association in intra-group bankruptcy probabilities is attributable to transfers between group firms as they approach financial distress. First, we run a set of “placebo tests” in which we replace group firms by standalone firms in the same country and industry. These placebo tests mitigate the concern that the association between parent- and subsidiary- bankruptcy probabilities is purely driven by common country-industry level factors. Second, we document increased intra-group loans within the propping and tunneling sub-samples. Third, we examine how a sovereign rating downgrade, a shock to the parent’s credit risk that is exogenous to subsidiaries’ bankruptcy risk, propagates to subsidiaries within the group. We find that this shock is less likely to propagate to subsidiaries in countries with strong anti-self-dealing, investor protection, director liability and related-party transaction regulations.

Our findings are relevant for financial reporting regulators, auditors, investors and credit rating agencies, and speak to the regulatory debate on cross-border insolvencies.

The preceding post comes to us from, William H. Beaver, the Joan E. Horngren Professor of Accounting, Emeritus at Stanford University Graduate School of Business, Stefano Cascino, Lecturer in Accounting at the London School of Economics, Maria Correia, Assistant Professor of Accounting at the London Business School, and Maureen F. McNichols, the Marriner S. Eccles Professor of Public and Private Management at the Stanford University Graduate School of Business.  The post is based on their article, which is entitled “Bankruptcy in Groups” and available here.