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Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF, CEPR and ECGI

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Page 1: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Strategic Leverage and

Employees’ Rights in Bankruptcy

Marco PaganoUniversity of Naples Federico II, CSEF and EIEF

Andrew EllulIndiana University, CSEF, CEPR and ECGI

Page 2: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Outline of Presentation2

1. Motivation and background

2. A simple model of strategic debt and workers’ protection in bankruptcy: predictions

3. Contrast with predictions of a non-strategic model of debt issuance with credit rationing

4. Measuring worker protection and public insurance in bankruptcy around the world

5. Empirical analysis

6. Conclusions

Page 3: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Motivation of Research Question

3

Conflict between labor and capital (shareholders, creditors) over the surplus S produced by the firm

For a start, take an all-equity firm with revenue R

If W0 is the reservation wage, and the labor force is standardized to 1, the firm’s surplus is

With Nash bargaining and union’s bargaining power , the wage is:

0 0W W R W

Page 4: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Strategic Value of Leverage

4

With debt, surplus S is divided in three cash flows:

shareholders (residual claimants) creditors workers

If the firm issues debt D and pays its value VD to shareholders before bargaining with unions, it reduces the surplus S on the bargaining table reduces the wage: 0 0W W R W D

the greater unions’ power, the greater debt’s strategic value: Baldwin (1983), Bronars & Deere (1991), Perotti and Spier (1993), Matsa (2010), etc.

Page 5: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Key Tacit Assumptions So Far

5

All previous work in this area tacitly assumes that

1.employees’ claim to unpaid wages, severance pay and social security contributions are junior to other debt in bankruptcy liquidation procedures: otherwise their claim could not be diluted by issuing debt (at least not entirely)

2.workers cannot renegotiate this claim with creditors if the firm is restructured rather than liquidated: again, if they have any bargaining power in such ex post renegotiation, their claim would not be diluted by ex ante debt issuances

Yet these assumptions are NOT universally true: the legal standing of employees in bankruptcy differs a lot across countries. This is the starting point of our work

Page 6: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Time Line: Allowing for Employee Rights in Strategic Debt Models6

Time line:

debt D is

chosen

workers are hired, expecting E(W) W0

hired workers

(re)negotiate wage W

revenue R is

realized insolvency: (i) bankruptcy costs C are paid, (ii) workers and creditors split R+A based on seniority

solvency: (i) creditors are fully repaid, (ii) workers are paid the agreed wage W, (iii) shareholders receive profits

stage 1 stage 2 stage 3 stage 4

stage 5

Page 7: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Key Assumptions7

All players are risk neutral, with no discounting

At wage bargaining stage (t = 3), negotiation occurs via take-it-or-leave-it offers, according to the random proposer model: with prob. union sets set W=Wu , with prob. 1 firm sets W=Wf

At final stage (t = 4), when creditors and workers are to be paid, in solvency states, workers are paid the agreed wage W in default states, workers are senior to other creditors

for a fraction of the wage, junior for fraction 1–

Page 8: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Revenue, Wages and Bankruptcy

8

The firm’s revenue is uniformly distributed:

The firm has positive NPV:

Bankruptcy occurs if , and entails cost C

The firm sets Wf so that in expectation it equals W0 just meets the workers’ participation constraint (PC)

The union sets Wu so as to maximize the expected income of employees, in both solvency and bankruptcy states

Page 9: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Testable Predictions9

Solving the model yields several predictions regarding the firm’s choice of leverage, including some about the sensitivity of leverage to the firm’s asset value and/or revenue

This sensitivity is greater when employees have: strong seniority rights strong wage bargaining power weak bargaining power in restructuring better public insurance in bankruptcy

How specific are these predictions to the strategic debt model? To answer this question, we consider an alternative model…

Page 10: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Alternative Model: Non-strategic Debt Issuance by Constrained Firms10

Suppose that debt is issued: after wage bargaining cannot be used strategically to fund a profitable and scalable investment whose

revenue cannot be pledged firm can pledge only existing assets A and revenue R to fund it

The firm invests all the money it can raise = choose the face value of debt D to maximize the market value of debt VD

In this situation, higher employee seniority and/or bargaining power lowers the firm’s debt capacity

So higher and lower the response of D to changes in asset value or revenue: opposite to strategic debt model!

Page 11: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Workers’ Protection in Bankruptcy around the World11

There is considerable cross-country variation in workers’ seniority in bankruptcy law () protection of their rights in reorganization procedures () government guarantees ()

We collect data on these items via questionnaires to Lex Mundi law firms (mainly for OECD

countries) information drawn from the web (mainly for non-OECD

countries)

Important: these indicators have low correlation with EPL, which we use as a proxy of union power (as done by Simintzi et al., 2015)

Page 12: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Measuring : Worker Seniority in Bankruptcy

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Worker seniority in liquidation differs across countries

We looked at the rank of workers’ claims relative to the following claim classes: secured debt (e.g. real estate mortgage loans) expenses of the bankruptcy procedure post-petition credit extended to debtor unpaid taxes unsecured debt

Define workers’ seniority from 1 to 5, so that 1 = they are treated as unsecured creditors, 5 = they are the most senior

Page 13: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

13

Measuring : Worker Seniority in Bankruptcy

Significant cross-country variation in ranking of workers in the case of bankruptcy procedures: first in France, Mexico, Brazil, last in Finland

and Germany

Page 14: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Measuring : Workers’ Rights in Debt Renegotiation 14

Two different measures. The first is based on the following summary question: “Can the reorganization plan impair the claims of employees without their consent?”

The second measure is based on a series of detailed questions:1.Can collective bargaining agreements previously entered into

by the debtor be modified by the reorganization plan?

2.Must employees’ representatives be informed of the plan?

3.Must the plan be proposed to employees’ representatives for approval?

4.If the employees do not approve the plan, can it still be carried out if authorized by court (possibly in a modified version)?

Page 15: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Employee Seniority and Rights in Bankruptcy around the World

15

Page 16: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Empirical Analysis16

We use these data to estimate the following specification:

where Sijt-1 = shock to asset value or cash flow of firm i in industry j at time t-1

Recall that the strategic debt model predicts:

Instead, the debt-constrained investment model predicts:

0 1 1 1 2 1 3 1

1' '

ijt ijt c ijt c ijt c ijt

ijt ct i t ijt

D S S S S

X X

1 2 30, 0, 0

1 2 30, 0, 0

Page 17: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Measuring the Shock Sijt-117

Market value of the firm’s real estate:

1. Land only: historical cost valuation of land of each firm in the first year in which it appears in our data set

2. Land and buildings: also includes the valuation of buildings adjusted for their accumulated depreciation

Firm profitability: for a subset of 928 firms that operate in extraction and mining, we instrument their ROA with the price index of the commodity that they produce, to avoid endogeneity (similar to Bertrand and Mullainatahn, 2001)

Page 18: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Company-level and Price Data

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Merge these indicators of workers’ protection in bankruptcy with company-level data from Worldscope (non-US companies) and from Compustat (US companies) in 1988-2013

Exclude financials and utilities; require at least 9 years of data

Leaves us with data for 12,445 firms from 28 countries 205,192 firm-year observations

Real estate prices are from the BIS database and commodity are from Bloomberg

Page 19: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Correlations With Existing Measures

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Page 20: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Leverage and Workers’ rights in Bankruptcy: Real Estate ShocksAs real estate becomes more valuable, leverage increases the most in countries with high workers’ rights

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Page 21: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Constrained vs. Unconstrained Firms

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Unconstrained firms

Constrained firms

Page 22: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Leverage and Workers’ Rights in Bankruptcy: Profitability ShocksAs profitability (instrumented with the commodity price index) increases, leverage increases the most in countries with high workers’ rights

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Page 23: Strategic Leverage and Employees’ Rights in Bankruptcy Marco Pagano University of Naples Federico II, CSEF and EIEF Andrew Ellul Indiana University, CSEF,

Conclusions23

Workers’ rights in bankruptcy differs widely around the world

Theoretically, the strength of these rights should increase the strategic value of debt in unconstrained firms reduce the debt capacity of constrained firms

Empirically, we find that: firms’ real estate gains are associated with a greater increase

in leverage if employees have stronger seniority in liquidation and weaker rights in debt renegotiation

these results are weakened (partly reversed) for constrained firms

in a subsample of mining and oil companies, leverage has a similar differential response to profitability shocks due to changes in the prices of their commodities