Financial Distress as a Collapse of Incentives

Abstract

This paper explains why companies close to bankruptcy tend to lose their best workers and why the employees who remain lack proper motivation. This collapse of incentives within an organization arises because of a negative interaction between the system of incentives and the capital structure chosen by top management to avoid disciplinary takeovers. Furthermore, the same devices management creates ex ante to entrench itself also make it extremely difficult to renegotiate away the inefficiency ex post. This new approach identifies an additional source of financial distress and also provides a rationale for a mandatory bankruptcy law.

JEL Classification: G33, G34