The Costs of Bankruptcy

When a corporation declares bankruptcy, employee’s wages decrease significantly. This potential loss in earnings is significant enough that firms with a high risk of bankruptcy must pay their employees a higher wage to compensate them for the risky financial future of the firm.

McMaster Researcher

Citation

Graham, John R. and Kim, Hyunseob and Li, Si and QiuJiaping, Employee Costs of Corporate Bankruptcy (June 14, 2016). Available at SRN: http://ssrn.com/abstract=2276753 or http://dx.doi.org/10.2139/ssrn.2276753

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What is this research about?

This research examines corporate bankruptcy and the many different impacts that filing for bankruptcy can have on the labour force. Workers value stability and they are generally willing to accept lower wages from a firm that is financially secure. When a firm begins to engage in high risk transactions, such as taking on more debt, their risk of going bankrupt increases. In response, employees demand higher wages to compensate them for the uncertain financial future of the firm. This can be considered an indirect cost of raising more debt from the firm’s perspective. This research provides a quantitative estimate of this cost. 

What did the researchers do?

The researchers examined instances of firms filing for bankruptcy and the resulting changes in worker’s wages as well as their movement across firms, industries, and geographic regions.  Data was obtained from the U.S Census Bureau’s Longitudinal Employer-Household Dynamics program as well as from a comprehensive database of public firms bankruptcy filings. Using this data, researchers were able to follow approximately 453,000 employees for six years following their firm’s decision to declare bankruptcy.  These worker’s outcomes were compared to worker outcomes from similar firms that did not declare bankruptcy. The researchers also performed statistical analyses to estimate the cost that firms face in the form of higher wages to compensate workers for the risk of working for a firm that may declare bankruptcy. 

What did the researchers find?

The researchers found that on average, worker’s wages decreased in the year that bankruptcy was declared.  After two years, annual earnings for bankrupt firms’ workers are 14% lower than their pre-bankruptcy earnings. This loss in annual earnings is caused by a reduction in the number of hours worked as well as reduced hourly wages. Employees of bankrupt firms are 10%-17% more likely to move on to new firms, industries and labour markets. The decrease in annual earnings was greater for workers who left their firms post-bankruptcy. The statistical models showed that firms with a high risk of bankruptcy have to pay their workers a significantly higher wage as a means of compensating them for the firm’s uncertain financial future. This additional cost can amount to up to half of the tax benefits of debt and should be an important consideration in firm’s financial decisions. 

How can you use this research?

Firms and businesses can use the results of this research when considering how their financial futures may be affected by debt accumulation. This research may be useful for labour unions as well as individuals who are employed in high risk industries. 

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