Working Paper

Financial distress and the role of capital contributions by the owner manager

Abstract: This paper examines the implications of bankruptcy law for owner managed firms. These firms are typically (i) smaller, (ii) their value is closely tied to the skills of the owner manager, and (iii) the owner manager represents a feasible source of capital contributions if the firm is in financial distress. The terms of such capital infusions, codified as the new value exception (NVE) to the absolute priority rule (APR), has been the source of considerable controversy, both in terms of its existence, and the economic benefit, if any, that it provides. We show that when the owner manager cannot contribute capital to the distressed firm, creditors allow him to retain some residual value (i.e. APR is violated) in order to create the appropriate incentives for the manager to exert effort. In this setting, we then examine the role of capital contributions by the manager, when his required return is increasing in the amount that he contributes. We consider both the case of symmetric and asymmetric information about the manager's ability to contribute such capital. Such infusions are shown to provide superior outcomes to both creditor financing and external financing. Creditors are better off because of the impact of the infusions on the incentives of the manager. As a consequence, deviations from APR are less severe than they would have been in the absence of these infusions. Moreover, some firms that would have been liquidated in the absence of such capital contributions are now able to continue operations. These results suggest that the current debate over the optimal design of bankruptcy procedures should address the role for capital contributions by owner managers as well.

Keywords: Bankruptcy; Business failures; Capital;

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series, Issues in Financial Regulation

Publication Date: 1996

Number: WP-96-22