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Governance at Distressed Firms Improves Over Time

Governance at Distressed Firms Improves Over Time

By Lauren Comander

Falling into financial distress – including either Chapter 11 bankruptcy or three consecutive years of extremely poor performance – can lead affected firms to improve their governance, according to new research by FIU Business associate professor of finance Qiang Kang.

Controlling for the secular improvements in governance with a bias-corrected matching estimator, Kang and his colleagues studied the dynamics of two governance constructs: managerial influence over the board of directors and CEO compensation.

The result? They found that distressed firms reduce managerial board appointments and CEO pay, intensify managerial incentive alignment, and increase CEO turnover. This change in CEO pay stems largely from the performance-related part of compensation, consistent with the “shareholder value” view of CEO pay.

Results of the research were published in the September 2022 issue of Financial Management.

“This is probably the first study in the field of corporate distress to look at almost 30 years of data,” said Kang, an expert in the interaction between financial markets and corporate governance and corporate decisions.

The study also broke new ground by using a control group of nondistressed firms with similar characteristics to address the potential effects of secular changes in the economy.

“If you just look at distressed firms, you can’t tell if their governance changes are due to the distress or due to the market changes,” Kang said. “That’s the weakness of early studies; they don’t have a control group to address economy-wide changes.”

Researchers addressed this shortfall.

“In our paper, we come up with a control group that mimics changes in the economy, and then we compare the changes in the distressed firms with changes in the control group so we can filter out the effect from the market,” Kang said. “We are able to tell more accurately, ‘Yes, those changes are related to the fact that the company fell into distress; it’s an effect of distress and not an effect of the market changes.’”

Kang conducted the research with Sheng Guo of FIU’s Steven J. Green School of International & Public Affairs and Oscar Mitnik of the Inter-American Development Bank.