Bankruptcy in strategic studies: past and promise

Bankruptcy in strategic studies: past and promise

Catherine M. Daily

Schoonhoven, 1990; Reinganum, 1985).

Bankruptcy is a complex process; multiple perspectives are needed to fully capture the phenomenon. Those perspectives which address the role of strategic leaders offer particular promise for increasing our understanding of the failure and recovery processes. The blame for bankruptcy often falls on the shoulders of firms’ leaders. “Chronic mismanagement”, for example, has been suggested as a cause of failure (Chaganti et al., 1985, p. 409).

A variety of approaches may appropriately be employed in bankruptcy studies. The vast majority of research has relied on large sample, matched-pair designs. More focused case studies would greatly enrich our understanding of Organizational research has historically been dominated by a focus on those factors associated with organizational growth and survival. Yet, in order to gain a comprehensive understanding of organizations, researchers must also examine an alternative outcome-organizational failure. Filing for bankruptcy protection provides an explicit case of formal organizational failure; consequently, bankruptcy offers what may be the definitive organizational performance indicator. Unlike alternative performance measures which are more readily manipulated by management, a bankruptcy filing is a discrete event. This paper explores the contributions of the behavioral environmental financial/accounting, and legal approaches to bankruptcy. The challenge currently facing organizational researchers is the integration of these diverse perspectives, particularly as they apply to strategic studies.

The reason why firms succeed or fail is perhaps the central question in strategy.

Porter, 1991, p. 95

Survival may be the predominate goal of organizations (e.g., Donaldson & Lorsch, 1983; Pfeffer & Salancik, 1978). Barnard (1938), for example, has suggested that the only true measure of a firm’s success is its ability to survive. Additionally, Starbuck (1965, p. 463) proposed almost thirty years ago that the “one thing which [the organization] must do, if it is to be an organization at all, is to survive.”

Organizational scholars have relied on a variety of theoretical perspectives to advance our understanding of organizational survival. Population ecologists, for example, believe that an organization’s ability to survive is largely, if not exclusively, determined by environmental forces acting upon the organization (e.g., Aldrich, 1979; Hannan & Freeman, 1977). Managerial discretion is recognized only as a reactionary response to the environment. Alternatively, the strategic choice perspective views managers as the primary determinants of organizational effectiveness vis-a-vis their selection of strategic options (e.g., Child, 1972; Hambrick & Mason, 1984).

A more contemporary view acknowledges the contributions of both strategic leadership and environmental forces in determining organizational effectiveness (e.g., Astley & Van de Ven, 1983; Hrebiniak & Joyce, 1985). Organizational survival is seen as a function of the interaction between strategic leadership and environmental forces as managers attempt to acquire and maintain critical environmental resources (Pfeffer & Salancik, 1978). While the degree to which strategic leaders impact organizational processes and outcomes has not been unequivocally established (e.g., Davis-Blake & Pfeffer, 1989; Day & Lord, 1988; Hambrick & Mason, 1984; Hambrick & Finkelstein, 1987; Meindl & Ehrlich, 1987; Meindl, Ehrlich & Dukerich, 1985; Thomas, 1988), the literature illustrates a growing appreciation of firms’ strategic leaders. Porter (1991, p. 101), for example, has expressed the view that “the essence of strategy is choice.” His position would seemingly support the importance of strategic leadership.

After several decades of inattention to the impact of senior executives on firm outcomes, interest in strategic leadership has received renewed attention. As editor of a special issue of Strategic Management Journal (“Strategic Leaders and Leadership”), Hambrick (1989) noted the inevitability of this resurgence given management’s responsibility for firm performance. Perhaps due in part to this important top management/firm performance linkage, Sutton and Callahan have observed that the “images of organizations and their leaders are intertwined” (1987, p. 405).

Associations between executives and their organizations are common. We immediately associate, for instance, the successes of Microsoft, Disney and General Electric with Bill Gates, Michael Eisner and Jack Welch respectively. These same attributions are made when leaders are associated with less successful outcomes. John Akers of IBM, Paul Lego of Westinghouse, or James Robinson of American Express provide notable examples. The suggested association between strategic leaders and organizational performance would seem unequivocal.

Curiously, organizational research is dominated by those factors associated with organizational growth and survival. Progress in determining the antecedents to organizational success may have occurred at the expense of expanding our understanding of those factors associated with organizational decline and failure. As strategic leaders continue to struggle with increasingly unfriendly operating environments and rising rates of organizational failure, the need to understand the full spectrum of organizational processes and outcomes is imperative.

This study addresses this gap in the literature by focusing on organizational failure. Specifically, formal failure as manifest in the form of a bankruptcy reorganization filing will be addressed. Because bankruptcy is often viewed as the result of a downward spiral of extended decline (Hambrick & D’Aveni, 1988), an overview of decline studies, especially those with implications for strategic studies, is provided. This introductory overview is followed by an examination of the multiple perspectives which have informed bankruptcy research. Lastly, implications for future research which develops linkages between bankruptcy and strategic studies are offered.

History of Declining Organizations

Until the early 1980s, researchers devoted little attention to organizational decline (Whetten, 1980a; 1980b). Much of this neglect has been attributed to a preoccupation with the study of organizational survival and growth (Summer, Bettis, Duhaime, Grant, Hambrick, Snow & Zeithaml, 1990; Whetten, 1980a). Ironically, management’s fixation on growth has been found to bc the primary internal cause of organizational decline (Finkin, 1985; Goodman, 1982; Heany, 1985; Sloma, 1985). In a departure from past tradition, the 1980s witnessed a dramatic increase in the volume of research which addresses organizational decline (e.g., Cameron, 1983; Cameron, Kim & Whetten, 1987; Levine, 1978, 1979; Starbuck, Greve & Hedberg, 1978; McKinley, 1993; Staw, Sandelands & Dutton, 1981; Sutton & D’Aunno, 1989; Weitzel & Jonsson, 1989; Whetten, 1981). As further evidence of the importance of this line of research, a recent special issue of Organization Science (1993), edited by William McKinley, was devoted exclusively to issues of organizational decline and adaptation.

Research in this area has taken the form of both theoretical (e.g., Cameron, Sutton & Whetten, 1988; Harrigan, 1980; Sutton, 1990; Sutton & D’Aunno, 1989; Weitzel & Jonsson, 1989; Whetten, 1980b, 1987; Zammuto & Cameron, 1985) and empirical contributions (e.g., Cameron, Whetten & Kim, 1987; Cameron et al., 1987a; D’Aveni, 1989a; Hambrick & D’Aveni, 1988; Harrigan, 1981, 1982; Miller, 1977; Miller & Friesen, 1977). Much of this research has focused exclusively on the consequences of organizational decline (e.g., Argenti, 1976; Cameron et al., 1987b; Staw, Sandelands & Dutton, 1981; Whetten, 1980b).

Organizational decline denotes a protracted period of decreasing internal resources (Cameron, Sutton & Whetten, 1988). These resources encompass both financial and human resources (D’Aveni, 1989a). Indicators of decline in financial resources include liquidity, profitability, and leverage measures (Altman, 1968). Indicators of decline in human resources include numbers of top managers (D’Aveni, 1989a), managers’ educational achievements (Becker, 1975) and top management team status (D’Aveni, 1990).

While decreasing levels of human resources are characteristic of declining organizations, downsizing in the form of work force reductions, for example, is distinct from decline (D’Aveni, 1989a; McKinley, 1993). Downsizing is viewed as a consequence of decline rather than an element of decline (Cameron et al., 1988; Greenhalgh, Lawrence & Sutton, 1988). Efficiency-oriented activities such as work force reductions are typical organizational responses designed to halt, and potentially reverse, decline (Pearce & Robbins, 1993).

Decline has been found to occur at varying rates in organizations (Argenti, 1976). In addition to verifying patterns of decline, D’Aveni (1989a) empirically validated several of the consequences of decline identified by Staw et al. (1981) as threat-rigidity responses. Threat-rigidity responses are largely dysfunctional and include: conservatism, questionable escalation, reliance on past policies, rigidity, restriction of information, increased centralization and formalization, low levels of innovative activity, strategic paralysis, and resistance to change (e.g., Cameron et al., 1987a; Cameron et al., 1987b; D’Aveni, 1989a; Dutton & Duncan, 1987; Singh, 1986; Staw et al., 1981; Whetten, 1980b; Whetten, 1987). Increasing centralization and conservatism may be particularly dysfunctional as management focuses on short-term solutions at the expense of long-term, strategic reorientations (Hall & Mansfield, 1971; Smart & Vertinsky, 1977). Examples of short-term solutions include cutting personnel in functional areas such as marketing and R&D, while building areas such as finance and accounting in order to address creditors’ short-term financial concerns (Whitney, 1987).

Threat-rigidity responses need not always be dysfunctional. Efficiency-related actions, for example, may enable the organization to generate enough financial resources in the short-term to keep the organization afloat while longer-term solutions are created (Zammuto & Cameron, 1985). Centralization, too, may prove beneficial for turnaround managers who often rely upon decision-making authority in their attempt to initiate a turnaround.

Unfortunately, these efficiency and centralization responses do little to address the underlying problem of the organization’s inability to adapt to current firm pressures. Increasing centralization, for example, may lead to strategic paralysis which results in higher levels of rigidity as managers attempt to address the organization’s problems through increased supervision (Masuch, 1985; Meyer, 1985). Often, the consequences of decline inhibit the firm’s ability to initiate or implement a successful turnaround (D’Aveni, 1989a).

Empirical support for threat-rigidity responses has been mixed. Cameron et al. (1987a) and Cameron et al. (1987b), for example, found no evidence of these responses among universities experiencing declining revenues. D’Aunno and Sutton (1988), however, found evidence of increasing centralization among drug abuse treatment centers faced with financial threats. Nelson (1979; 1981), too, found that firms facing severe environmental threats focused on short-term planning to a greater extent than firms facing only moderate levels of adversity. D’Aveni and MacMillan (1990) analyzed bankrupt firms’ annual reports and found that management often denied impending crisis.

In an examination of declining firms facing imminent bankruptcy, D’Aveni (1989a) found several indicators of threat-rigidity responses. These firms were characterized by strategic paralysis, as demonstrated by significantly less merger and acquisition activity as compared to a matched group of survivor firms. However, these firms engaged in significantly more liquidations and divestitures. Centralization, too, was evidenced as CEOs increased the numbers of managers directly under their supervision.

Bankruptcy: The Phenomenon

Unrestrained decline typically results in organizational failure. Failure is significantly more damaging than decline or a setback due to its severity and permanence (Makridakis, 1991). While alternative characterizations of business failure have been offered (Giroux & Wiggins, 1984; Handler, 1992; Miller, 1977), failure is typically equated with a formal bankruptcy filing (e.g., Makridakis, 1991). Formal failure, as experienced in the dissolution or reorganization of the firm under protection of bankruptcy legislation, provides the focus for this study. This definition of failure clearly distinguishes decline from failure and focuses on those failures which are visible and have a significant economic impact.

The rate of business failure reached alarming levels in the 1990s (Galen, 1993; Gleckman, 1992; Handler, 1992; Koretz, 1993; Waldera & Sullivan, 1993). Recent surges in failure rates are largely attributed to an increase in the number of large firm bankruptcies (Handler, 1992; Koretz, 1993). Between 1990 and 1991, for example, the number of business failures increased by 44 percent; however, this increase was accompanied by a 96 percent increase in the liabilities associated with bankruptcy filings (Handler, 1992). These data would suggest an increased incidence in the number of large firms declaring bankruptcy.

As evidence of the economic impact of large firm bankruptcies, 125 publicly-held corporations with assets in excess of $80 billion filed for bankruptcy protection in 1991 (Gleckman, 1992). The number of large firm bankruptcies was slightly lower in 1992 with a total of 79 corporations totaling $53 billion in assets filing for bankruptcy protection (Galen, 1993). The number of large firm bankruptcies in any given year may be relatively modest, but the cumulative effect of multiple years of large firm bankruptcies is overwhelming. As some demonstration of the historical significance of bankruptcy, of the 100 largest firms identified by Forbes magazine in 1917, only 22 remained on that same list in 1987 (Makridakis, 1991). The majority of the remaining 78 percent had ceased to exist.

Large firm bankruptcies may be particularly damaging due to the effects felt by the many firms dependent on the bankrupt firm for their own survival. Large firm bankruptcies have led to a dramatic increase in the rate of small firm failures (Koretz, 1993). This phenomenon may explain why approximately 95 percent of business failures in 1991 had liabilities under $1 million, yet those same firms accounted for fewer than five percent of the total liabilities resulting from bankruptcy (Handler, 1992).

The Act versus the Code

Bankruptcy legislation was dramatically altered October 1, 1979 with the passage of the Bankruptcy Reform Act (commonly referred to as the Code; cf. LoPucki, 1992, p. 81; see also Chou, 1991 and Gerber, 1987 for an overview of the legislative differences). Prior to this new legislation the vast majority of bankruptcies ended in liquidation (Gleckman, 1992). In response to the loss of resources (human and financial) created by these liquidations, as well as the complicated political process of determining whether a firm was eligible to file under Chapter X versus Chapter XI, Congress rewrote the existing legislation (the Chandler Act of 1938). The intended outcome of the legislative change was to encourage firms to reorganize rather than liquidate their assets (e.g., Bradley & Rosenzweig, 1992).

While the Code included provisions for both liquidation (Chapter 7) and reorganization (Chapter 11), the focus was clearly directed toward reorganization. Both debtors and creditors tend to prefer a Chapter 11 reorganization as compared to a Chapter 7 liquidation (Lynn & Neyland, 1992). Creditors’ preference is based largely on the valuation of assets under reorganization versus liquidation. Stated simply, company assets are typically more valuable as part of a going concern. Management, too, may prefer reorganization. Under Chapter 7 the management of the firm must yield control of the organization to a trustee responsible for disposition of the assets of the firm.

The primary purpose of Chapter 11 is to provide the bankrupt firm with a protective shield from creditors/shareholders so that it may restructure its debt and emerge from Chapter 11 as a viable entity (Budnitz, 1990; Easterbrook, 1990; Franks & Torous, 1989; Gilson, John & Lang, 1990; Jensen-Conklin, 1992; LoPucki & Whitford, 1990; Moulton & Thomas, 1993). As demonstration of the protection afforded bankrupt firms under Chapter 11 provisions, creditors are prevented from “collecting on their debt or foreclosing on their collateral until the firm leaves bankruptcy” (Gilson et al., 1990, p. 317). Additionally, the bankrupt firm has the option to impose a reorganization plan which is binding, even on recalcitrant creditors (Lynn & Neyland, 1992). The benefits of reorganization are expected to accrue to managers, employees, shareholders, and creditors of the debtor firms, as jobs and assets are preserved (Bradley & Rosenzweig, 1992; Gleckman, 1992).

Passage of the Code eased restrictions on firms seeking protection from creditor and shareholder claims. Prior to the Code a critical contingency for filing for protection under the Act was that the debtor firm be insolvent; this same restriction does not apply to existing legislation (Bradley & Rosenzweig, 1992). Not all observers have embraced this legislative change as positive. The easing of these restrictions, for example, has been blamed for the nearly doubling of firms filing for bankruptcy protection in the years immediately following passage of the Code (Weiss, 1990; Wruck, 1990). Detractors of the Code contend that firms which may be marginally financially distressed prematurely seek protection from creditors and shareholders. Supporters of the new legislation, however, counter that the dramatic increase in Chapter 11 filings may be due to companies in “desperate need of bankruptcy relief, but not legally permitted to file for reorganization under the old law” (LoPucki, 1992, p. 84). An additional criticism of the Code has been that the increased focus on reorganization has aided primarily large firms able to afford the legal help necessary to develop and file a reorganization plan (Gleckman, 1992).

Another significant change resulting from passage of the Code is the increased control granted to the incumbent management of the bankrupt firm. The new legislation, in effect, enables the executives responsible for the organization’s demise to attempt to save the firm (Chou, 1991; Galen, 1993). Prior to the Code management was forced to relinquish control of the company at the time of filing. One rationale for allowing management to stay intact is based on the population ecology theory which would suggest that the factors leading to the financial demise of the organization were largely external (Moulton & Thomas, 1993).

Critics of bankruptcy reform have attacked this issue as well, labeling Chapter 11 reorganization “strategic bankruptcy” (e.g., Moulton & Thomas, 1993; Skeel, 1993). A strategic bankruptcy is a proactive attempt by firms’ management to contend with some threat posed by a stakeholder group (Delaney, 1992; Flynn & Farid, 1991). Management, for example, may initiate a strategic bankruptcy to deal with undesirable labor contracts (Braniff, Continental, and Eastern Airlines) or to avoid a product liability suit (Manville and A.H. Robins). While the majority of strategic bankruptcies are managerially-initiated, creditors may also initiate this process in order to protect their claims at the expense of other creditors (Moulton & Thomas, 1993).

The notion of strategic bankruptcy may be naive, however, as bankruptcy reorganizations are typically complex processes with a low probability of achieving a successful outcome for any party (Moulton & Thomas, 1993). The average bankruptcy takes approximately two years from filing to resolution (Eberhart, 1992; Franks & Torous, 1989; Gilson, 1990; Jensen-Conklin, 1992; LoPucki, 1993; LoPucki & Whitford, 1991a). More damaging from a management perspective is the outcome when the process is completed. Approximately one-half of the incumbent management will fail to survive the bankruptcy process (Gilson, 1989). Shareholders may elect to reduce potential risk by maintaining diversified portfolios, unlike managers who are typically dependent upon one organization as a source of income (Amihud & Lev, 1981). It may reasonably be argued, then, that no group is more adversely affected by bankruptcy than firms’ strategic leaders.

Bankruptcy: The Past

Bankruptcy has been approached from a variety of perspectives. Four approaches have been identified as having the strongest implications for strategic studies. The financial/accounting literature has investigated financial factors associated with bankruptcy. The legal community has devoted considerable attention to numerous legislative issues surrounding bankruptcy. Organizational theorists have examined the environmental factors associated with bankruptcy. Lastly, an emerging body of literature is found in the behavioral sciences as researchers investigate the human impact of the bankruptcy process. Each of these literatures will be developed in the following section, recognizing that there is at times significant overlap among these domains.

Financial/Accounting Perspective

The perspective most often advanced in the financial/accounting literature has largely focused on identifying financial ratios which predict impending bankruptcy (Aziz, Emanuel & Lawson, 1988). Research by Beaver (1967) and Altman (1968) provided the basis for much of the early work in this area (e.g., Altman, Haldeman & Narayan, 1977; Dambolina & Khoury, 1980; Deakin, 1972; Edmister, 1972; Wilcox, 1971). Beaver (1967) employed a matched pair design in his investigation of five financial ratios associated with 79 failed and 79 non-failed firms. He defined failure as non-payment of preferred stock dividends, bond defaults, and overdrawn bank accounts and controlled for industry in the matching process.

Altman (1968) expanded this work by focusing exclusively on bankruptcy and employing industry and size controls in the matching process. Altman improved upon Beaver’s (1967) work by utilizing discriminant function analysis, as compared to Beaver’s method of testing the financial ratios with independent t-tests. This approach resulted in increased predictive accuracy in the two years prior to bankruptcy, but demonstrated no improvement during the fifth to third years prior to bankruptcy. While the specific financial ratios employed in subsequent studies differed slightly, multiple discriminant function analysis remained the primary method of analysis for predicting impending bankruptcy for several years (e.g., Altman, 1983; Altman et al., 1977; Blum, 1974; Deakin, 1972; Edmister, 1972; Elam, 1975; Frydman, Altman & Kao, 1985; Mensah, 1983; Norton & Smith, 1979; Wilcox, 1973). Studies employing discriminant models have been found to predict bankruptcy with a high degree of accuracy up to five years prior to filing (Aziz et al., 1988; Baldwin & Glezen, 1992).

Multiple discriminant analysis studies have been criticized for their exclusive reliance on financial ratios to predict bankruptcy absent any theoretical basis for the inclusion of various ratios (Aziz et al., 1988; Ball & Foster, 1982; Blum, 1974). In response to these criticisms, more recent analyses have attempted to use models grounded in theoretical approaches (e.g., Aziz et al., 1988; Casey & Bartczak, 1984, 1985; Chen & Shimerda, 1981; Emanuel, Harrison & Taylor, 1975; Flagg, Giroux & Wiggins, 1991; Gentry, Newbold & Whitford, 1985; Ohlson, 1980; Vinso, 1979; Zavgren, 1985). Cash flow models, for example, have been successfully used to generate multivariate models of bankruptcy prediction (e.g., Aziz et al., 1988; Casey & Bartczak, 1984, 1985; Gentry et al., 1985). A series of studies have also integrated financial ratios and failure events to model bankruptcy prediction (e.g., Altman, 1982; Dopuch, Holthausen & Leftwich, 1987; Flagg et al., 1991; Mutchler, 1985).

The conclusion based on this line of inquiry is that the full spectrum of financial ratios covering liquidity, profitability, and leverage measures must be included to accurately predict bankruptcy (Flagg et al., 1991). Despite the accuracy which can be achieved with these models, the financial approach has been criticized for its inability to predict failure in sufficient time to prevent bankruptcy (Zavgren, 1985). In essence, this approach begs the issue of how the firm got into financial trouble in the first place.

A related criticism is that the financial approach largely ignores the potential for errors, distortions, or misrepresentations in the financial statements of declining organizations (Schick & Ponemon, 1993). Large firms, in particular, may be able to hide or distort information not easily detected by auditors (Schultz & Gustavson, 1978). Examples of distortions include the suspension of depreciation charges, the inclusion of reevaluation and sales charges with operating profits, and lengthening the accounting period (Starbuck et al., 1978; Whetten, 1988). Misrepresentations, too, may occur as management suppresses, disguises, or delays the release of potentially harmful information (Kinney & McDaniel, 1989; Schwartz & Menon, 1985; Sutton & Callahan, 1987).

Financial scholars have also addressed the impact of bankruptcy on stockholder value (e.g., Aharony, Jones & Swany, 1980; Clark & Weinstein, 1983; Davidson, Worrell & Dutia, 1993; Morse & Shaw, 1988; Ramaswami, 1987; Skantz & Marchesini, 1987). This line of inquiry has yielded mixed results. Several researchers have found negative stock returns accompany a bankruptcy filing (e.g., Clark & Weinstein, 1983; Ramaswami, 1987). Others, however, have found that the announcement of a reorganization plan (Morse & Shaw, 1988) or the election of voluntary liquidation (Skantz & Marchesini, 1987) are accompanied by positive stock returns.

Gosnell, Keown and Pinkerton (1992) have also examined the impact of bankruptcy on the incidence of insider trading. They found that insiders obtain abnormal profits by selling stock prior to filing bankruptcy (see Loderer & Sheehan, 1989 for conflicting results). Gosnell et al. expanded previous examinations by including OTC firms, as well as exchange listed firms, in their analysis. For OTC firms, insider transactions dramatically increased, as compared to both exchange listed firms and a control group, in the five months prior to the bankruptcy filing date. They attributed the increased trading activity to the size and control position of insiders in OTC firms (Gosnell et al., 1992).

Legal Perspective

The legal perspective may provide the most diverse approach to examining the bankruptcy process. A cursory review of The American Bankruptcy Law Journal alone would provide some evidence of the variety of issues covered in the legal arena. The intention here is to provide a brief overview, rather than a comprehensive treatment, of this domain as it relates to strategic studies. The primary areas of consideration include discussions of the changing legal environment for bankruptcy since the passage of the Code (e.g., Bradley & Rosenzweig, 1992; Jackson, 1984; Korobkin, 1992; LoPucki, 1992; Nimmer, 1987; Skeel, 1992; 1993; Warren, 1987), the distribution of assets among various claimants in the bankruptcy process (e.g., Baird, 1986; 1987; Bebchuk, 1988; Eberhart, 1992; Jackson & Scott, 1989; LoPucki & Whitford, 1990; Markell, 1991; Roe, 1983; Waldera & Sullivan, 1993), and “forum shopping” as management seeks the most benevolent legal environment for bankruptcy proceedings (LoPucki, 1981; LoPucki & Whitford, 1991a; Whitford, 1989).

As previously noted, the nature of the bankruptcy process was dramatically altered with passage of the Bankruptcy Reform Act (the Code). Differences between the Act and the Code have generated a considerable amount of discussion and debate (e.g., Bradley & Rosenzweig, 1992; LoPucki, 1992; Skeel, 1993). A variety of perspectives regarding the new legal environment have been offered, including loss allocation decisions (Nimmer, 1987), the role of trusteeship under Chapter 11 (Jackson, 1984), rational constraints in decision making under the Code (Korobkin, 1992), equality of treatment for various classes of claimants (Budney, 1983), differences in costs under state versus federal law (Ryland, 1990), bargaining processes (Skeel, 1992), forum shopping (Baird, 1987), and the political and financial theories applicable to the bankruptcy process. Those areas most directly related to strategic studies due to management’s ability to influence outcomes are the distribution of assets and venue choice.

Asset distribution: The legal community is particularly sensitive to the changing responsibilities of strategic leaders of bankrupt firms. As the firm approaches bankruptcy, management’s focus must shift from one of maximizing value for shareholders to protecting the rights of creditors (Chou, 1991; Waldera & Sullivan, 1993). Markell (1991, p. 70) has noted that “[b]ankruptcy reorganizations proceed upon a simple premise: creditors’ rights take priority over equity interests.”

Despite the increased power of creditors in the bankruptcy process, there is still considerable incentive for cooperation with management. Under a Chapter 11 filing, the bankrupt firm’s management retains control of the corporation. Beyond control, Chapter 11 provides temporary protection from a forced liquidation by creditors (LoPucki & Whitford, 1990). During the first 120 days after filing, the bankrupt firm retains exclusive rights to propose a reorganization plan (Franks & Torous, 1989; LoPucki & Whitford, 1990). Extensions to this 120 day period are routinely granted (LoPucki & Whitford, 1990).

The bankrupt firm as debtor-in-possession must negotiate with creditors and shareholders to draft a reorganization plan which will be passed by a majority vote (Franks & Torous, 1989; LoPucki & Whitford, 1990; Skeel, 1992). This can be a long and contentious process because creditors and shareholders are grouped by class based on similarities in claims or interests (Brudney, 1983; LoPucki & Whitford, 1990). Unsecured creditors can not be grouped with secured creditors, for example, and shareholders are generally placed in a separate class of claimants (Franks & Torous, 1989). All parties in a given class must be treated equally and each class votes on the approval of the reorganization plan.

Those classes of creditors failing to reach agreement on either the original plan or amended plans have a protective device at their disposal. Chapter 11 of the Code provides creditors with a mechanism for protecting their claims under the absolute priority rule (Eberhart, 1992; Franks & Torous, 1989; LoPucki & Whitford, 1991b). Absolute priority stipulates that creditors in a given class be “compensated for the face value of [their] pre-bankruptcy claims only after all other classes designated as senior are paid in full” (Gilson et al., 1990, p. 317).

A special provision of this rule, referred to as the “cram down” procedure, may be employed by the court at the request of senior creditors (Klee, 1979). In the case of cram down an unpalatable reorganization plan is forced upon junior creditors, typically bondholders and shareholders (e.g., Johannes, 1994). Cram down stipulates that dissenting creditors’ claims be subject to payment based upon a valuation of assets, which is typically a lengthy and costly process.

Preemptive cram down may also be forced upon creditors by firm’s management when faced with recalcitrant creditors (LoPucki & Whitford, 1990). Due to the potential for the costs of cram down to further erode the value of a creditor’s claim, this is a powerful threat from management used to discourage creditor dissension. LoPucki and Whitford (1991b) have found that cram down often occurs at the expense of creditors who may emerge from the bankruptcy process with nothing. Losses to creditors in the case of preemptive cram down are potentially huge because, barring a successful appeal to the bankruptcy court for relief from such a motion, officers and directors of the bankrupt firm are no longer under any obligation to represent equity’s interests in the reorganization process (LoPucki & Whitford, 1991b). This means that management no longer maintains a fiduciary duty to creditors and shareholders and is no longer subject to pressure from equity groups during the Chapter 11 negotiation process. Most importantly from a strategic leadership perspective, equity groups can not convene a meeting of shareholders for the purpose of electing new directors and have no voice in the compensation levels of firm executives (LoPucki & Whitford, 1991b).

Venue choice: Another management technique is “forum shopping” which occurs when management attempts to have the firm’s bankruptcy case heard in the arena with the greatest likelihood of a successful outcome (Baird, 1987; LoPucki & Whitford, 1991a). Forum shopping creates the potential for the bankruptcy proceedings to take place in avenue where the bankrupt firm has no physical presence. By petitioning the courts for a change in venue the bankrupt firm may avoid locations which are hostile or overly stringent in regulating attorney fees. Past research has found this practice to have potentially detrimental effects on the amount of distribution which creditors and shareholders receive as a result of the bankruptcy process (LoPucki, 1981; Whitford, 1989). Significant differences are possible as a result of differential application of bankruptcy law as a function of the district bankruptcy judge (LoPucki & Whitford, 1991a).

Environmental Perspective

The relationship between a firm and its environment may be particularly meaningful in the case of bankruptcy. This area has recently gained attention as researchers have begun examining the role of internal and external exchange partners in the face of organizational decline (Schick & Ponemon, 1993). These relationships are central to the debate between population ecologists and strategic choice theorists. Amidst these two seemingly disparate views is the realization that environmental forces at times constrain managerial action (Andrews, 1971; Hannan & Freeman, 1977; Hrebiniak & Joyce, 1985). An important managerial task, particularly when faced with a crisis such as bankruptcy, is the ability to effectively respond to environmental challenges. One such response involves the extraction of critical resources from the firm’s task environment (Pfeffer & Salancik, 1978).

To the extent that firm survival is dependent upon access to critical environmental resources (Aldrich, 1979; Barnard, 1938; Hannan & Freeman, 1977; Katz & Kahn, 1966; Kotter, 1979; Pfeffer & Salancik, 1978; Selznik, 1949; Thompson, 1967), executives will attempt to control environmental forces. One means for retaining control over the environment is to maintain the organization’s legitimacy (Pfeffer & Salancik, 1978). Organizations gain legitimacy via support from their exchange partners (Pfeffer & Salancik, 1978; Thompson, 1967). Bankruptcy, however, signals a situation in which the organization has lost support from at least one constituency: creditors.

The relationship between bankruptcy and organizational legitimacy has recently been explored (D’Aveni, 1989b; 1990). D’Aveni (1990), for example, tested the association between bankruptcy and top management prestige. He suggested that prestigious top managers, as determined by membership in elite social circles, impact the firm’s ability to survive by affecting the perceptions of important organizational constituents as a result of managers’ level of prestige. Prestige enables managers to exercise their influence by convincing creditors to allow the current management to continue operating the firm without the supervision of the bankruptcy courts, even in the face of financial distress resulting from managerial incompetence.

The symbolic role of managers has also received support (e.g., Pfeffer, 1981). D’Aveni (1990) found membership in the political and economic elite to be negatively related to bankruptcy. Additionally, bankrupt firms’ managers had fewer contacts with the financial community than a matched group of survivor firms. Lack of specific expertise among the top management team may cause important external constituents to withdraw their support as they seek more competent exchange partners (Ashforth & Gibbs, 1990; Meyer & Rowan, 1977). These findings are some indication that firms with less prestigious managers suffer a loss of creditor support as evidenced by the incidence of bankruptcy.

The bankrupt firms in D’Aveni’s (1990) study did attempt to halt organizational decline by hiring new top managers in the years just prior to filing. Unfortunately, this effort at building legitimacy through hiring prestigious managers occurred primarily three years before filing and virtually ceased in the following year. Additionally, any gains as a result of incoming managers were apparently offset by the exit of existing managers.

Ironically, the influx of prestigious managers in the years just prior to filing may thwart the organization’s attempts at a turnaround (D’Aveni, 1990). Newcomers may signal to external constituents (e.g., creditors) that the organization is experiencing internal turmoil. This, coupled with the managerial bailout in the years immediately prior to filing, may initiate creditors’ withdrawal of support for the organization. Gilson (1989), for example, found some support for the role of external constituents in the bankrupt firm. He found that bank lenders frequently initiated executive level changes in financially distressed firms.

A related perspective holds that bankruptcy is “contagious within an industry” (Lang & Stulz, 1992, p. 46). Contagion may manifest itself in the form of creditor and customer withdrawal within an industry as a result of one firm’s bankruptcy. This withdrawal weakens other firms as a consequence. Alternatively, one firm’s bankruptcy may signal to the market that the industry is weak. This is consistent with the view that survival is determined by environmental carrying capacity, defined as the ability of the environment to support a population of firms (Hannan & Freeman, 1977). A strong environment, however, may enable a resource-deficient firm to delay or even avoid bankruptcy (D’Aveni, 1989a).

A third view suggests that organizations fail due to inertia or limited domain initiative (e.g., Argenti, 1976; Miller, 1977). Domain initiative is the extent to which firms change products or markets (Hambrick & D’Aveni, 1988). Limited domain initiative may result from environmental restraints or from an organization’s inability to act (Hannan & Freeman, 1977). Executives’ ability to make needed adjustments may be affected by low resource levels and shifting priorities as they focus on external problems in response to decline (McKinley, 1987). Additionally, executives may fail to attend to internal problems as a result of a tendency to attribute poor performance to external causes (e.g., Bettman & Weitz, 1983; Clapham & Schwenk, 1991; Salancik & Meindl, 1984; Staw, McKechnie & Puffer, 1983).

Domain changes may be particularly difficult for the financially distressed firm. In addition to a lack of resources to initiate widescale changes, bankrupt firms may lack the necessary expertise and experience in this area. Sheppard (1993), for example, found that bankrupt firms are much less diversified than survivor firms. A more focused portfolio of businesses may inhibit moves designed to lessen the likelihood of failure. Diversification may, in effect, serve as a buffer between the organization and its operating environments (Sheppard, 1993).

Behavioral Perspective

The behavioral perspective has largely focused on the role of firms’ strategic leaders in bankruptcy. Strategic leadership research has experienced renewed attention in recent years (Hambrick, 1989). Application of strategic leadership to organizational failure may be particularly fruitful as CEOs, boards of directors, and top management team members have been linked to the cause of organizational failure (Argenti, 1986a; 1986b).

The relationship between firms’ strategic leaders and organizational failure has been addressed from a variety of perspectives. These include the stigma of bankruptcy (Nelson, 1981; Sherman, 1991; Sutton & Callahan, 1987), executive-level reputation and prestige (D’Aveni, 1990; Kaplan & Reishus, 1990), turnover among board and top management team members (D’Aveni, 1990; Fizel & Louie, 1990; Gilson, 1989; 1990; Gilson & Vetsuypens, 1993; Warner, 1977; Wruck, 1990), management control following bankruptcy (Bradley & Rosenzweig, 1992; LoPucki, 1992, 1993; LoPucki & Whitford, 1990; Moulton & Thomas, 1993; Wruck, 1990), and board and top management team composition and structure (Argenti, 1976; Daily & Dalton, in press, a, b; Gilson, 1990; Hambrick & D’Aveni, 1992; Miller & Friesen, 1977).

Bankruptcy has traditionally carried a stigma that attaches itself to the executives employed by the bankrupt firm (Nelson, 1981; Sutton & Callahan, 1987). Sirower (1991, p. 46), however, has suggested that with the increased incidence of failure “bankruptcy has lost much of its sting as an admission of failure.” While the full effects of bankruptcy stigma may have diminished, there are still significant personal costs associated with organizational failure. Gilson (1990), for example, has found that board and top management team members of bankrupt firms face labor market sanctions as they search for employment alternatives following a bankruptcy filing.

Additional sanctions are manifest in the form of a loss of reputation and prestige among firm executives (Sutton & Callahan, 1987). Such reputational losses may lead to executives’ difficulties in the labor market. Perhaps due to the difficulties executives face in obtaining comparable corporate positions, declining firms facing an impending bankruptcy are characterized by a “bailout” phenomenon (D’Aveni, 1990, p. 135). D’Aveni (1990) found that prestigious managers choose to leave the firm before their careers are affected by the stigma of bankruptcy. As a result, bankrupt firms are left with few, if any, prestigious managers. Those managers remaining at the time of bankruptcy face not only the stigma of failure, but the perception that they are less competent than their peers who chose to leave the firm prior to the bankruptcy filing or their peers in successful firms.

Outside directorships provide a measure of executives’ level of prestige (Mace, 1971; Wade, O’Reilly & Chandratat, 1990). Presumably, outside organizations would invite those individuals who are believed to add some measure of prestige to the firm for board service. Kaplan and Reishus (1990) found that organizations rely on executives’ firm performance to assess their level of prestige before inviting them for board service. Furthermore, they found firm performance to be more strongly related to obtaining, as opposed to losing, a board seat.

An additional consequence of bankruptcy is the high rate of turnover among directors and executives of bankrupt firms (D’Aveni, 1990; Fizel & Louie, 1990; Gales & Kesner, 1994; Gilson, 1989; 1990; Gilson & Vetsuypens, 1993; Warner, 1977; Wruck, 1990). In an examination of bankrupt railroads during the time period between 1933 and 1955, Warner (1977) found an annual turnover rate of eight percent during the five years following bankruptcy. Ang and Chua (1981) found a 30 percent turnover rate among the three highest paid executives during the two years following bankruptcy for 52 firms during 1969-1973. More recently, Gilson (1989, 1990) has found that half of the CEOs, presidents, and directors in financially distressed firms lose their jobs (Gilson, 1989, 1990). Gales and Kesner (1994) have found these effects for directors both prior to and following bankruptcy filing. Gilson and Vetsuypens (1993) found that as many as one-third of CEOs whose firms default lose their jobs, and those who remain face substantial cuts in compensation. These turnover rates are compared to rates of approximately 10 percent for profitable firms (Hermalin & Weisbach, 1988; Warner, Watts & Wruck, 1988; Weisbach, 1988). Two years after filing bankruptcy the turnover rate increases to 66 percent (Gilson, 1989). Furthermore, Gilson (1989) found those losing jobs as a result of a bankruptcy filing failed to obtain comparable positions for at least three years.

Among executive turnovers, CEO replacement was most common (Gilson, 1990). This might be expected given the prominence of this position in the organization and its association with performance expectations (Fizel & Louie, 1990). Director turnover, however, has been found to be related to CEO turnover in financially distressed firms. Gilson (1990) found that director “resignations” dramatically increased with the removal of the CEO. Eight percent of bankrupt firms replaced their entire board of directors (Gilson, 1990). Furthermore, post-bankruptcy boards are smaller than pre-bankruptcy boards and departing directors subsequently serve on fewer boards (Gilson, 1990). The decrease in board size is significant given that bankrupt firms tend to have smaller boards than their survivor counterparts initially (Chaganti, Mahajan & Sharma, 1985; Gales & Kesner, 1994). Overall, these findings indicate that those leaders associated with bankruptcy are disciplined for their organization’s poor performance (Gilson, 1990; Wruck, 1990).

Executive changes resulting from bankruptcy may be welcomed in the market place. Davidson et al. (1993) have found that stockholders react positively to succession announcements whether they occur before or after bankruptcy. Bonnier and Bruner (1989), too, have found positive stock market responses to announced executive changes in financially distressed firms. As a means for garnering further support from the market, bankrupt firms tend to replace removed executives with outsiders to a much greater degree than financially healthy firms (Hermalin & Weisbach, 1988; Schwartz & Menon, 1985).

The high turnover rates among bankrupt firms are notable, not just in their frequency, but because the organization is under no legal obligation to remove the extant management of a bankrupt firm. Under Chapter 11, the bankrupt firm’s management retains control of the firm barring fraud or proven incompetence (Bradley & Rosenzweig, 1992; Chou, 1991; LoPucki & Whitford, 1990; Wruck, 1990). One rationale for retaining extant management is that incumbent managers generally have detailed knowledge of the firm’s operations that may enable the firm to more quickly emerge from bankruptcy (Wruck, 1990). Turnaround executives (typically outsiders) often lack a detailed understanding of the firm’s problems and generally don’t trust those managers who may have contributed to the firm’s failure (Miller, 1977).

The practice of allowing these managers to remain in control, however, has received considerable criticism. The incumbent management may lack the ability or the incentives to make use of any firm specific information that they possess (Wruck, 1990). Based on the high turnover rates following bankruptcy, these managers are likely to be removed when the firm emerges from bankruptcy eliminating any incentive to initiate a quick recovery. Additionally, the complexity of the bankruptcy process typically constrains managerial behavior leading to an inability to utilize their firm-specific skills (Moulton & Thomas, 1993). Consequently, incumbent managers and directors may serve to inhibit, rather than enable, a recovery or turnaround (Wruck, 1990).

An extreme view was recently advanced by Bradley and Rosenzweig (1992) who have called for the repeal of Chapter 11 based, in part, on the argument that the Code entrenches incompetent management at the expense of creditors and shareholders. They believe that Chapter 11 enables managers to strengthen their control positions in the firm causing debtholders to bear a disproportionate amount of risk. Their premise is that “the longer managers can retain control of their firm, the greater the wealth they can extract from the firm’s stakeholders”(Bradley & Rosenzweig, 1992, p. 1075). Furthermore, they suggest that Chapter 11 serves to encourage managers to act in a self-interested manner. A sampling of the self-interested behaviors in which management may engage during Chapter 11 includes: (1) maximizing management compensation; (2) utilization of the business to benefit allies, who may not be creditors or shareholders; (3) utilization of organizational monies otherwise due creditors as severance pay or to settle a claim against the company; or (4) maneuvering to purchase the company at a “bargain price” (LoPucki, 1993, p. 734).

Moulton and Thomas (1993) note that the criticism levied against the provision in the Code which allows the incumbent management to remain in control may be unnecessary, or at least exaggerated. Despite some suggestion that management may use the bankruptcy process to serve their own self-interest (e.g., Bradley & Rosenzweig, 1992; Flynn & Farid, 1991), management’s actions remain relatively constrained by the courts. While managers may retain their organizational positions, all actions by managers and creditors occur under the jurisdiction of the bankruptcy judge, are a matter of public record, and are subject to review by any interested parties (Moulton & Thomas, 1993). Management of the bankrupt firm is rarely a powerful force; their jobs and reputation are seriously jeopardized by a bankruptcy filing (LoPucki, 1992).

Financial distress, which often leads to bankruptcy, is frequently accompanied by changes in the composition and structure of the board and top management team (Daily & Dalton, in press, a, b; Wruck, 1990). These changes may be based on evidence that suggests that strategic errors, such as those which lead to bankruptcy, are related to deficiencies in the composition of the top management team (e.g., Gist, Lock & Taylor, 1987; Goodman, Ravlin & Schminke, 1987; Hambrick & D’Aveni, 1992). Strategic errors in the formulation process would include the failure to identify opportunities and threats; strategic errors in the implementation process would include ineffective monitoring systems (e.g., Aguilar, 1967; Starbuck et al., 1978; Thomas & McDaniel, 1990).

A compositionally deficient top management team may fail to include those managers who possess critical functional area expertise. Argenti (1976), for example, examined declining and failing firms and found that a lack of financial expertise among top management team members was associated with bankruptcy. Hambrick and D’Aveni (1992) examined top management teams in bankrupt firms and found bankruptcy to be associated with a dominate CEO, higher top management team turnover, smaller top management teams, and top management teams with lower percentages of members with expertise in marketing/sales, operations, production, and R&D. Additionally, bankrupt firms were caught in a vicious cycle whereby performance declines led to deterioration in the top management team which led to further declines in performance (Hambrick & D’Aveni, 1992).

Boards of directors, too, are associated with poor performance (Daily & Dalton, in press, a, b). Organizations suffering from poor performance alter the composition of the board in response to environmental changes (Boeker & Goodstein, 1991). Daily and Dalton (in press, a), for example, found that boards of large bankrupt firms had significantly higher proportions of affiliated (SEC6b) directors and a greater incidence of CEO duality as compared to a matched group of survivor firms five years prior to a bankruptcy filing. Moreover, they found the interaction between affiliated directors and CEO duality to be associated with bankruptcy. Daily and Dalton (in press, b) also examined the relationship between governance structure and bankruptcy. While they found no simple relationship between board leadership structure and two measures of board composition, they did find a significant interactive effect between board leadership structure and independent director proportion. Firms with the dual leadership structure and lower proportions of independent directors both five and three years prior to filing were more likely to experience bankruptcy. The governance variables were not significant at the time of filing, as the financial status of the bankrupt firms overwhelmed the impact of management and directors. Boards which include fewer outside members (Hambrick & D’Aveni, 1992) and are passive participants in the governance process (Argenti, 1976) have also been found to be related to the incidence of bankruptcy. As the firm emerges from bankruptcy more directors with financial and legal expertise join the board (Gilson, 1990).

Bankruptcy: The Promise

As chronicled here, a variety of theoretical perspectives have informed bankruptcy research. Considerable opportunity remains, however, for continued examinations within current streams of research. In addition there are numerous opportunities for extending previous lines of inquiry. Two promising areas for bankruptcy research within the domain of strategic studies include: (1) bankruptcy as a performance indicator; and (2) factors associated with emergence from bankruptcy.

Bankruptcy as a Performance Indicator

Performance has been suggested as the single most important dependent variable in organizational research (Dalton, Todor, Spendolini, Fielding & Porter, 1980; Schneider, 1985; Venkatraman & Ramanujam, 1986). Specifically, the most important strategic management questions address those factors associated with firm performance (Hambrick, 1980; Lenz, 1981). By inference, the incidence of bankruptcy is especially relevant to strategic studies. Porter (1991, p. 95) has noted this important linkage, suggesting that the “reason why firms succeed or fail is perhaps the central question in strategy.”

In general, organizational researchers concede the importance of performance in strategic studies. Unfortunately, there is no consistency in recommendations regarding what constitutes firm performance (e.g., Chakravarthy, 1986; Cochran & Wood, 1984). Some of the ambiguity may be attributable to the multidimensional nature of performance and its general complexity (Dess & Robinson, 1984). Bourgeois (1980, p. 235), for example, has noted that:

the adoption of any particular set of indicators embroils the researcher in the quagmire of problems of quantification and dimensionality, not to mention the issue of validity choosing the set of indicators which meets universal acceptance.

Keats and Hitt (1988), too, have observed that performance is difficult to define and measure. Much of the difficulty in reaching consensus regarding performance measures is complicated by the almost “infinite” number of indicators that could reasonably serve as performance measures (Weiner & Mahoney, 1981, p. 456).

Some of the debate surrounding the selection of performance indicators has resulted from the controversy addressing the differences between accounting and market returns (e.g., Brigham, 1985; Cochran & Wood, 1984; Schellenger, Wood & Tashakori, 1989; Venkatraman & Ramanujam, 1986). The central argument is the extent to which one or the other set of indicators is more subject to managerial manipulation. Executives may elect to sell assets, liquidate inventories, or cut R&D to manipulate accounting returns. Stock splits and borrowing to pay dividends are strategies for altering market return measures.

While it is beyond the scope of this paper to settle the issue concerning the selection of an appropriate set of performance indicators, bankruptcy, as a function of its discrete nature, would appear to be one performance measure which escapes such controversy. Either a firm fails as indicated by a bankruptcy filing or it survives and avoids such a filing. It is this attribute which makes bankruptcy a definitive measure of firm performance.

Emergence from Bankruptcy

Emergence from bankruptcy is also an undeveloped area of research. Several scholars have examined governance structures prior to and at the point of filing bankruptcy (e.g., D’Aveni, 1990; Gilson, 1989; 1990; Hambrick & D’Aveni, 1992), but research that extends beyond the filing date is virtually nonexistent (see Gales & Kesner, 1994; LoPucki & Whitford, 1993; Moulton & Thomas, 1993 for exceptions). LoPucki and Whitford (1993) and Moulton and Thomas (1993) have approached the period after a bankruptcy filing from the perspective of structural outcomes related to a Chapter 11 reorganization. Moulton and Thomas (1993), for example, examined four levels of successful emergence from Chapter 11: successful reorganization, partially successful reorganization, acquisition by another firm, and liquidation. Relying on a similar approach, LoPucki and Whitford (1993) examined “entity survival” whereby the firm emerges from reorganization as the same corporation and “business survival” where the core operating business remains intact. To date, however, no one has empirically examined those governance structures associated with successfully emerging from bankruptcy (see Gales & Kesner, 1994 for a notable exception).

Some of the difficulty in examining factors associated with emergence from Chapter 11 is the result of the low rate of successful reorganization. As few as 17 percent of firms filing Chapter 11 will confirm reorganization plans (Moulton & Thomas, 1993). This confirmation rate, however, is subject to some controversy (LoPucki & Whitford, 1993; Morse & Shaw, 1988). LoPucki & Whitford (1993) found the rate of successful confirmation to be significantly higher for large firms. A further complication is that many of the reorganized firms continue to remain weak and often revisit decline and/or bankruptcy (LoPucki & Whitford, 1993; Moulton & Thomas, 1993). Also, executives in declining or failed firms typically do not welcome intrusions by those wishing to chronicle the organization’s failure events (Weitzel & Jonsson, 1989).

Accepting the premise that organizational performance is a function of strategic leadership and leaders’ response to environmental pressures (Day & Lord, 1988; Hambrick, 1987; Keasey & Watson, 1987), empirical examinations of the relationship between corporate governance and emergence from bankruptcy would seem appropriate and informative. Poor governance, for example, has been blamed for organizations’ financial distress (Wruck, 1990). Lorsch and MacIver focused specifically on the governance function of boards of directors when they observed that:

Accusatory fingers have pointed in many directions but, to date, few have questioned the role of those ultimately legally responsible for the health of America’s corporations–their board of directors (1989, p. 2).

Additionally, leaders with the skills to initiate such a turnaround are in great demand. The Wall Street Journal has reported a “big appetite” for “crisis” executives to reorganize bankrupt firms (Wall Street Journal, 1992, p. A1).

Two aspects of corporate governance have received the majority of researchers’ attention: board leadership structure and board composition. Board leadership structure denotes whether the CEO simultaneously serves as board chairperson (CEO duality), or whether these positions are independently held. Board composition focuses on the extent to which the board of directors is independent of firm management.

Board Leadership

The dual structure is relatively common among large firms, with more than 80 percent adopting this structure (Lorsch & MacIver, 1989). Organizations have recently received a great deal of criticism for the ubiquity of this structure (e.g., Dobrzynski, 1991). Argenti (1986a; 1986b) has suggested that CEO duality is the first warning sign of impending failure. Much of the criticism of the dual structure is a function of the control which it affords the CEO. A powerful CEO who also sits as board chairperson operates “unchecked.” Hambrick has commented that holding multiple executive-level titles is a sign of “power hoarding” on the part of the CEO (Fortune, 1991, p. 13), a propensity which has been linked with poor financial performance (Miller & Friesen, 1977).

Monitoring bodies such as institutional investors are increasingly pressing firms to separate the positions of CEO and board chairperson. As a result of such pressure, separate chairpersons were installed at three prominent, and troubled, large firms during 1993: General Motors, American Express, and Westinghouse (Levy, 1993). Dobrzynski (1992, p. 87) has noted that:

Splitting the job of chairman and CEO, while no panacea, is the way to go at troubled companies. The CEO runs the company, while the chairman runs the board.

Lorsch and MacIver (1989), too, have noted the importance of the independent board leadership structure for distressed firms. They have suggested that a separate board chairperson can significantly add to the board’s ability to prevent crisis. Additionally, this structure enables the board to act quickly when a crisis does occur. In crisis situations, in particular, Lorsch and MacIver regard a separate chairperson as a counterbalance to the CEO’s power.

Financial distress provides organizations with an opportunity to adopt the independent structure. Failing firms are significantly more likely to experience CEO turnover than successful firms (Alexander, Fennell & Halpern, 1993; Schwartz & Menon, 1985). It is at this juncture that the CEO’s power is weakest. Boards may capitalize on this opportunity to appoint separate CEOs and chairpersons.

As CEOs’ tenure increases in the organization, it may be increasingly difficult to remove them from their positions as board chair. The longer CEOs are in office, the more likely they are to control the board of directors (e.g., Comte & Mihal, 1990; Fredrickson, Hambrick & Baumrin, 1988). Over time, CEOs are able to appoint directors who feel some loyalty to the CEO and, consequently, may be reluctant to dismiss the CEO even in the face of crisis. This situation creates a vicious circle whereby CEOs gain control over the organization as their tenure increases; and, as their tenure increases it becomes increasingly difficult to remove a poorly performing CEO (Fizel & Louie, 1990).

Adoption of the independent board leadership structure is not uniformly advocated. Anderson and Anthony (1986) have suggested that the dual structure allows CEOs the autonomy they need to effectively function (e.g., Anderson & Anthony, 1986). The dual structure may be especially appropriate as a firm emerges from bankruptcy. Harrison, Torres and Kukalis (1988, p. 229), for example, have argued that the separation of the positions of CEO and board chairperson in a crisis situation may lead:

to higher board chair turnover, it makes it more difficult to replace either executive when performance declines, and it fails to conform to prevailing institutional norms, which may reduce perceived legitimacy. On the balance, then, the separation may not be desirable for the corporation.

As the bankrupt firm emerges from bankruptcy it may be that the dual structure is superior. Literature which addresses organizational turnarounds often points to the importance of a unified effort, often guided by a powerful CEO (see e.g., Hambrick, 1987, 1989 for a discussion of the necessity for a strong CEO to formulate and implement strategy). Miller (1977) and Miller and Friesen (1977) have noted the “headless” firm, one absent a strong leader/CEO, as an archetype of failure. The unified vision provided by a joint CEO/board chairperson may be one mechanism for turning failure into success.

Board Composition

Board composition is perhaps the most widely studied variable in governance research (Judge & Zeithaml, 1992). Composition may be related to directors’ ability to contribute to organizational performance (Pearce & Zahra, 1992). The relationship between independent director representation and bankruptcy, however, has received little attention (see e.g., Daily & Dalton, in press, a, b; Gales & Kesner, 1994; Hambrick & D’Aveni, 1992).

Financially distressed companies have some obligation to demonstrate “good governance” (Levy, 1993, p. 3) and regain the confidence of important organizational stakeholders. Organizations which are poor performers are more likely than successful organizations to alter their board composition (Boeker & Goodstein, 1991). As with the board leadership structure, bankruptcy may provide the organization with an opportunity to reapportion the board of directors. Often board composition is a function of the internal political structure of the organization (Hambrick & Finkelstein, 1987). The current directors may be more loyal to the CEO, who likely appointed them, than to the shareholders (Patton & Baker, 1987). Replacing these directors with those more likely to attend to their responsibility to serve the shareholders may be necessary to enable the firm to successfully emerge from bankruptcy.

There is almost certainly no universal board structure that would ensure the success of the firm; however, adherence to prescribed structures may benefit those firms in a crisis situation such as bankruptcy. The importance of independent director participation on the board has been the focus of those advocating board reform (Baldwin, 1984; Kesner, Victor & Lamont, 1986). The ability of directors to effectively perform their primary duties of service, resource acquisition, and control is largely a function of the composition of the board (Pearce & Zahra, 1992).

Service role: Directors’ service role involves providing advice and counsel to the CEO. Outside directors provide a quality of advice and counsel often unavailable from inside directors (Alibrandi, 1985; Anderson & Anthony, 1986; Waldo, 1985). Additionally, appointing inside directors to the board may be seen as a duplication of efforts. It has been noted of inside directors:

If you want their advice, you can get it any day between 9 and 5

Jacobs, 1985, p. 23.

Resource role: Related to the service role is that of resource acquisition. The resource dependence perspective suggests that the inclusion of outside directors on the board is a means for managing the firm’s external constituencies (Pfeffer & Salancik, 1978). Outside directors serve as boundary spanning agents (Brady & Helmich, 1984; Provan, 1980). In this capacity they provide the firm with valuable resources and information, help establish the firm’s legitimacy, and facilitate interfirm commitments (Bazerman & Schoorman, 1983; Pfeffer, 1973; Provan, 1980).

Bankruptcy signifies an organization’s inability to adequately maintain its resource base. The propensity for management to remain secretive throughout the decline process (Sutton & Callahan, 1987) in conjunction with the rapidity with which the organization enters the final stages of bankruptcy (Hambrick & D’Aveni, 1988) complicates management’s ability to retain the support of important constituents such as creditors. The withdrawal of external groups serves to weaken the organization’s predicament, nearly guaranteeing failure (Cameron & Whetten, 1983).

Control role: The control role addresses the board’s monitoring function (e.g., Fleischer, Hazard & Klipper, 1988). Effective monitoring, too, is a function of board composition (Fizel & Louie, 1990). Outside directors may be more able to meet this obligation. Inside directors, as subordinates to the CEO, are unlikely to aggressively monitor and evaluate CEO behavior (Fleischer, Hazard & Klipper, 1988; Patton & Baker, 1987). Their loyalty to the CEO may override their duty to shareholders (e.g., Baysinger & Hoskisson, 1990; Kesner & Dalton, 1986). As some demonstration of this tendency, Boeker (1992) found that organizations with higher proportions of inside directors were less likely to dismiss CEOs in poorly performing organizations.

Outside directors, while at times not fully independent of the CEO, do not operate under the same constraints as inside directors. This may be especially true in crisis situations where outside directors may be more able to exercise control in the organization (Mace, 1971; Vancil, 1987; Weisbach, 1988). In support of the value of outside directors during difficult times, Hermalin and Weisbach (1988) found that poorly performing firms tend to remove inside directors and replace them with experienced outsiders. An additional strategy for increasing the level of director monitoring is to increase the amount of outsider ownership of the firm following financial distress (Gilson, 1990). Effective monitoring by directors may serve as a counterbalance to a powerful CEO (Fizel & Louie, 1990).

Reconstruction of the board may be imperative for the bankrupt firm. Those who are most likely to have exited the organization prior to bankruptcy are officers and directors with the option to move elsewhere (e.g., Hirschman, 1970). Those who remain may not only be less qualified than those who exited the organization, but may also resist any efforts at change (Boeker & Goodstein, 1993). Consequently, inside directors may offer little assistance in the recovery process. While they possess a greater knowledge of firm operations as compared to their outside director counterparts, inside directors may lack the ability or appropriate incentives to effectively utilize that information (Puffer & Weintrop, 1991; Wruck, 1990).

Board Committee Representation

The relationship between changes in board composition and board committee membership may also provide insights into methods for successfully emerging from the bankruptcy process. Kesner (1988) provided an analysis of the importance of board committee membership. Few researchers have utilized these findings, however, to guide future examinations of boards of directors. Perhaps representation on the more influential board committees (audit, nominating, compensation, and executive) is most directly related to a bankrupt firm’s ability to recover from failure. Overall board representation (e.g., proportion of outside directors) may be too subtle an indicator to adequately capture the importance of the outside director.

Structuring important board committees to disproportionately represent outside directors, for example, may prove to be a more successful strategy than including inside directors on these committees. It would seem insensible to include a preponderance of inside directors on the compensation committee, as this strategy would likely invite criticism from outside constituents on whom the bankrupt firm depends. Strong relationships with creditors, for instance, become increasingly important as the firm moves from the protection of the courts during the bankruptcy process to “normalized” (unprotected) business operations.

Additionally, it may be that specific categories of outside directors should serve on influential board committees during the emergence period. Kesner (1988) found that business executives dominated influential board committees. Whether this is a judicious strategy for the failed firm remains an empirical question. Placing important creditor groups on the audit committee, for example, may be a means for friendly cooptation of these organizational constituents. By including groups that may be troublesome or contentious, the emerging firm can preempt difficulties which might otherwise arise from lack of communication or lack of information. In contrast, legal experts may be most beneficial for important board committees while in the reorganization process. Attention to board leadership structure, board composition, board committee membership, and director type, then, is necessary to more fully understand the full range of the bankruptcy process.


Given the high rates of business failure it is imperative that organizational researchers continue to devote attention to those factors associated with bankruptcy. Understanding the process of large firm bankruptcy is of particular importance given the economic and social costs associated with failures of this magnitude. Studies which focus exclusively on surviving firms potentially bias research findings and may do little to inform the failure process (Freeman, 1986).

Despite the importance of including failed firms in systematic organizational analyses, researchers have devoted little attention to developing a strong theoretical base from which to operate. This paper is intended to address the shortcomings of current literature noted by Meyer (1988, p. 413):

During a time period when U.S. businesses were chalking up the highest bankruptcy rates in history, most organizational scholars found themselves a long way up the empirical creek without a theoretical paddle.

Failure studies have implications for a wide variety of organizational issues. Factors associated with firm failure, for example, are of interest to a diverse array of organizational constituents which include policy makers interested in economic development, investors, employees, and the communities in which firms operate (Reynolds, 1987). While this paper has dealt primarily with large firm failures, the applications to small and entrepreneurial firms are numerous. Cooper (1993, p. 242) has noted that the reason “some new firms succeed and others fail” remains a central focus of the entrepreneurship literature.

Bankruptcy research is especially relevant to small and entrepreneurial firms for two reasons. The first is related to the liabilities of newness and size (e.g., Hannan & Freeman, 1977; Stinchcombe, 1965). While reports of the actual death rates of small and new firms vary (Reynolds, 1987), common estimates are that upwards of 40 percent of small firms fail within their first five years of existence (e.g., Good & Graves, 1993; Tauzell, 1982). Additionally, it takes an average of eight years for corporate ventures, which typically have substantial financial backing, to be successful (Makridakis, 1991). These firms, then, are more likely candidates for bankruptcy than larger, more established firms.

Additionally, from a strategic leadership perspective, these firms are also more likely to be affected by individual influences. There is an argument, for example, that strategic leaders may lack the discretion, or wherewithal, to affect change in the large firm (Daily & Dalton, 1993). Leaders in the small firm may be less constrained by organizational systems and structures (Dalton & Kesner, 1983; Norburn & Birley, 1988). Fewer constraints enable these leaders to directly influence firm processes and outcomes (Eisenhardt &

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