All's Fair in Love, War & Bankruptcy? Corporate Governance Implications of CEO Turnover in Financial Distress

By Bernstein, Ethan S. | Stanford Journal of Law, Business & Finance, Spring 2006 | Go to article overview

All's Fair in Love, War & Bankruptcy? Corporate Governance Implications of CEO Turnover in Financial Distress


Bernstein, Ethan S., Stanford Journal of Law, Business & Finance


Prior discussions of management turnover during financial distress have examined bankrupt and non-bankrupt firms as distinct groupings with little overlap. Separately investigating rates of turnover in-bankruptcy and out-of-bankruptcy, without a direct comparison between the two, has resulted in a narrowing of the accepted influence of bankruptcy law to post-petition, in-court decisions. Based on new evidence of CEO turnover in 2001, I argue empirically that this distinction between in-court and out-of-court restructuring has become meaningless from a governance perspective. In 2001, filing for bankruptcy did not change the rate of CEO turnover when one controls far financial condition. This statistically significant finding indicates that the "shadow of bankruptcy" has lengthened, making bankruptcy law a central tenet of governance policy regardless of whether a Chapter 11 petition is ever filed. After presenting these results, this article considers the implications of these results on the changing perceptions of the role of CEOs and the evolution of the multi-pronged U.S. corporate governance system.

Introduction & Summary of Findings

How much influence does the Bankruptcy Code have on non-bankruptcy corporate governance policy? During the first five years after the adoption of the new Bankruptcy Code (1979-1984), the answer appears to have been very little. Over that time period, Stuart Gilson found that operating in bankruptcy placed unique pressures on management, resulting in a significant difference between levels of management turnover recorded in bankruptcy reorganizations and in nonbankruptcy restructurings.1

After twenty years and several waves of large bankruptcies, however, it is time to revisit that question. New data from 2001 demonstrates that whether a firm operates inside or outside of Chapter 11, the levels of CEO turnover remain constant. The equalization of CEO turnover across these two governance regimes provides concrete proof that the Bankruptcy Code has become so ubiquitous that its rules permeate corporate governance decisions for financially distressed companies, whether or not they file a petition.

This result is counterintuitive, as practitioners are accustomed to thinking of bankruptcy as a specialized environment with completely different rules. In fact, the operating rules for a corporation in bankruptcy are substantially different from those which never file a petition. Simply changing the rules of daily operation, however, does not necessarily change the rules of governance. "Corporate governance" refers to a comprehensive system of rules for complex internal negotiations between disparate parties with conflicting interests. Governance systems dictate how, under what assumptions, and due to which incentives, officers make managerial choices. Though a subtle distinction, it is vitally important to recognize that choosing to operate in bankruptcy no longer appears to change the overall system of governance. Filing for bankruptcy is not a binomial decision, but rather a perpetual choice.

From an historical perspective, this consistency across financial distress regimes is a relatively novel result. Previous authors who studied CEO turnover in the bankruptcy context always found some disparity between rates of CEO turnover in bankruptcy and non-bankruptcy distress.2 Because a majority of U.S. bankruptcy filings are made at the election of management,3 some authors have used that disparity as proof that management behavior is being driven by changes in the Bankruptcy Code-while others have hotly contested that conclusion.4 Regardless of which line of argument one finds most persuasive, the theoretical underpinning is undeniable: the corporate manager, like the child who learns to avoid a hot stove, will generally act out of self-interest and choose the safest haven provided by the rule-based legislation then in effect.

While this study does not profess to explain a causal relationship between changes in the Bankruptcy Code and management behavior, the timeline is noteworthy from a theoretical perspective. …

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